(BN) Germany’s Hidden Risk: Bloomberg Businessweek Opening Remarks

This is a very interesting article.  Not sure I fully understand it yet, but does help explain why all these national central banks still exist, and how circular everything really is in Europe.

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Germany’s Hidden Risk: Bloomberg Businessweek Opening Remarks

2011-12-15 05:00:00.1 GMT

By Peter Coy

     Dec. 15 (Bloomberg) — Involuntary lending is what happens

when your teenager figures out how to charge stuff to your

credit card. The kid promises to pay for the purchases but never

gets around to it, so your involuntary loan keeps getting

bigger. At some point it dawns on you that you might never get

your money back.

     Something similar is happening in Europe, except the

dysfunctional family consists of central bankers, with Germany’s

Bundesbank in the role of aggrieved parent, Bloomberg

Businessweek reports in its Dec. 19 edition. The figures are

hard to find, policy makers don’t like to talk about them, and

the accounting is far from sexy. Outside of Germany, headlines

have been few. But the numbers are huge — so huge that they may

be one of the biggest factors in whether the euro zone hangs

together or falls apart.

     Expect to hear more about this issue as the glow from the

Dec. 8-9 Brussels summit continues to dim and the stresses on

Europe’s common currency intensify. The term to remember is

Target2. It’s the name for the European Central Bank’s suddenly

important interbank payment system, which before the crisis was

just a lowly bit of financial plumbing.

     The bottom line: Germany’s Bundesbank — BuBa for short —

has quietly, automatically lent 495 billion euros ($644 billion)

to the European Central Bank via Target2. That lending has

balanced correspondingly huge borrowings from Target2 by the

central banks of weaker nations including Greece, Ireland, and

Portugal — and lately Spain, Italy, and even France. They are

technically “claims,” not loans. To find them you have to root

around in the footnotes of the reports of the 17 national

central banks of the euro zone.

 

                        Lose Entire Claim

 

     If the euro zone breaks into sorry little pieces, Germany

could possibly lose its entire claim. It is 60 percent bigger

than Germany’s annual federal budget — and larger than the

lending under the European Financial Stability Facility and

other aid programs that have received more scrutiny.

     Germany’s plight gives it an incentive to keep the euro

zone intact. “If the euro breaks up then the whole claim is

under risk,” Hans-Werner Sinn, president of the Ifo Institute, a

Munich-based economic research group, said in an interview.

Sinn, the first economist to focus attention on the Target2

imbalances earlier this year, wrote in a November research

paper, “This may be the largest threat keeping Germany within

the Eurozone.”

Back-Office System

     Nobody designed Target2 to ensnare Germany as a creditor.

It was the most boring back-office transaction-processing system

imaginable when it was launched in 2007-08 as a successor to the

equally boring original Target (a rough acronym for Trans-

European Automated Real-time Gross Settlement Express Transfer

system). In the early days of the euro currency, Germany wasn’t

even always a creditor: It had a net liability of 31 billion

euros ($40 billion) at the end of 2001.

     Then came the financial crisis of 2007-08. Europe’s

peripheral nations began to suffer capital flight. Until then

their chronic trade deficits were completely offset by inflows

of private capital, both loans and investments. Afterward,

lenders and investors grew leery of putting more and more money

into those countries. Euros began to flow from the periphery

into Germany and to a lesser extent Luxembourg, the Netherlands,

and Finland. The Target2 imbalances are an accounting reflection

of those outflows. From 2008 to 2010, Sinn estimated in his

paper, “Target credits financed almost the entire current-

account deficits of Portugal and Greece and a quarter of the

Spanish one.”

Powerful Forces

     That makes it sound like a central-bank policy decision,

which it wasn’t. On the micro scale it was nothing but routine

transaction-processing. The most powerful forces are the

unguided ones, like the wind and the tides.

     Here’s how it happened. When a Greek businessperson buys a

truck from Germany with money from a checking account, the

transaction is carried out between the two nations’ central

banks via Target2. The truck seller isn’t interested in

financing the purchase — it wants euros now. So the Bundesbank

has to come up with money in order to deposit it in the seller’s

checking account. In accounting terms, the Bundesbank acquires a

liability (what it owes to the truck seller’s checking account)

and an asset (a claim on the ECB).

     The transformation of the Bundesbank’s balance sheet

through this slow-but-steady process has been stunning — and to

hard-money Germans, sickening. At the end of 2006, Target claims

represented just 7 percent of the Bundesbank’s assets. By this

October they represented 64 percent, according to data compiled

by economists Aaron Tornell of the University of California-Los

Angeles and Frank Westermann of Germany’s University of

Osnabrück. The collateral the ECB holds to back those loans is

primarily the sovereign debt of the euro zone’s weakest nations.

It’s a far cry from the gold that’s the Bundesbank’s second-

biggest asset (17 percent).

     Any losses on Target2 are supposed to be shared by the euro

zone’s 17 central banks in proportion to their share of the

ECB’s capital, which for Germany is 28 percent of the total. But

since the central bank of any country that couldn’t repay

Target2 obviously wouldn’t share in the losses, Germany would

have to pick up even more than its share. And as Sinn notes,

there are no laws governing who would be responsible for the

claim if the euro zone broke up entirely.

     The European Central Bank is trying to be reassuring about

the growing Target2 imbalances. In its October monthly bulletin

it said “the uneven distribution of central bank liquidity

within the Eurosystem provides stability, as it allows

financially sound banks — even those in countries under

financial stress — to cover their liquidity needs.” The ECB,

though, doesn’t report which central banks are in the black and

which are in the red on Target2, since the combined positions

always net out to zero.

Obscure Table

     The 17 member central banks don’t exactly trumpet the

numbers, either. At the Bundesbank, the most up-to-date figures

are available only in an obscure table called “Time series

EU8148: External position of the Bundesbank in the EMU / Claims

within the Eurosystem / Other claims (net).”

     As Europe’s financial crisis has worsened, the ECB has

benevolently turned a blind eye to the poor quality of

collateral posted by the Bank of Greece and others. But a

reckoning is due. In an interview with Bloomberg News on

Dec. 13, Bundesbank President Jens Weidmann expressed more

concern about the collateral than the volume of ECB balances.

“In a situation like the current one, where we are providing

solvent banks with liquidity,” he said, “for me the size of the

Target2 balances is less important than the risks we are taking

on. It is my concern that we limit these risks as much as

possible.”

‘Being Alarmist’

     An alternate theory is that there’s really nothing to worry

about. University College Dublin Professor Karl Whelan says

Sinn, Tornell, Westermann, and other economists who have raised

red flags over Target2 are being alarmist. While Europe has

plenty of other problems, “this is a crisis that is not about to

happen,” Whelan wrote in a recent article posted at VoxEU.org, a

forum mostly for European economists.

     Yeah, maybe. What happens next depends on how far Germany

is willing to go in converting its treasured central bank into a

repository for more claims on the ECB, which are ultimately

backed by the junk debt of Southern Europe. To fund more loans

to Target2, BuBa could either sell some of its gold (unlikely)

or take in more euro deposits, which it could then recirculate

via the ECB (much more likely). “In principle this can go on

indefinitely,” says Ebrahim Rahbari, an economist for Citigroup

in London.

     Germany faces a dilemma familiar to anyone who has ever

made a bad loan — whether to keep throwing good money after bad

to keep the debtor afloat or pull the plug and suffer the

consequences. The half-trillion-euro claim the Bundesbank has on

the ECB is an important but poorly understood factor in the

decisions over the future of the euro. So it’s in the interests

of everyone that central bankers provide more transparency when

it comes to Target2. Says Citi’s Rahbari: “From the moment that

you seriously start to consider breakup as a plausible scenario,

these issues should probably be given more prominent space in

the public debate.”

 

For Related News and Information:

Credit crunch page: WWCC <GO>

Central bank rates worldwide: CBRT <GO>

Top economic stories: TECO <GO>

Global economy watch: GEW <GO>

 

— With assistance from Jeff Black in Frankfurt. Editors: Romesh

Ratnesar, Gail DeGeorge

 

To contact the editor responsible for this story:

Romesh Ratnesar at +1-212-617-8427 or rratnesar@bloomberg.net