Eurozone Finances Have Deteriorated

i] so by using similar CPI methodology the Eurozone’s statisticians are misrepresenting the true effect of rapidly increasing monetary inflation. It is not going to be transient. Consequently, not only will interest rates begin to rise in the US, but they will also rise from a negative ECB deposit rate of minus 0.5%. Amongst others, the Italian government will no longer be paid to borrow.

The policy of continual monetary stimulation has run out of time, creating a crisis for ECB policymakers. Like their opposite numbers in the US and other major central banks they face the growing certainty of rising interest rates, falling financial asset values, and a slump accompanied with soaring prices. According to neo-Keynesianism, the combination is an impossibility, yet that is now in prospect.

Not only is the starting point negative interest rates, but so is an average level of government debt to GDP of 103%. Averages conceal extremes, and with Greece’s debt to GDP officially at 217%, Italy at 151%, and Portugal at 137% (they are likely to be higher once off-balance sheet debt for nationalized industries etc. are considered) a combination of an economic downturn and soaring prices will destroy their parlous finances.

Under “Whatever it takes” Mario Draghi, the ECB used every trick to cover over the cracks of a failing Eurozone. At the heart of the trickery was bad debt being concealed within the TARGET2 settlement system. It is only by this subterfuge that major banks have been prevented from failing.

As the chart of the TARGET2 central bank balances shows, creditor balances are increasing again. To understand why we should consider what is driving them.

The chart illustrates the imbalances in the TARGET2 settlement system between the national central banks and between them and the ECB. It reveals three notable features. Germany and Luxembourg between them are owed a net €1.4 trillion. Italy and Spain between them owe the system €1,024bn. And the ECB owes the national central banks €353bn. The effect of the ECB deficit, which arises from bond purchases conducted on its behalf by the national central banks, is to artificially reduce the TARGET2 balances of debtors in the system to the extent the ECB has bought bonds from government and other issuers within an NCB’s jurisdiction and not yet paid for them.

Inside the workings of TARGET2

The way TARGET2 works, in theory anyway, is as follows. A German manufacturer sells goods to an Italian business. The Italian business pays by bank transfer drawn on its Italian bank via the Italian central bank through the Target2 system, crediting the German manufacturer’s German bank through Germany’s central bank.

In the past, the balance was restored by trade deficits, in Italy, for example, being offset by capital inflows as residents elsewhere in the eurozone bought Italian bonds, other investments in Italy and the tourist trade collected net cash revenues. As can be seen from the chart of TARGET2 balances, before 2008 this was generally true. Part of the subsequent problem was down to the failure of private sector investment flows to recycle trade-related payments.

Then there is the question of “capital flight”, which is not capital flight as such. The problem is not residents in Italy and Spain opening bank accounts in Germany and transferring their deposits from domestic banks. It is that those national central banks which are heavily exposed to potentially bad loans in their domestic economy know that their losses, if materialized in a general banking crisis, will end up being shared throughout the central bank system, according to their capital keys in the TARGET2 settlement system.

If one national central bank runs a Target2 deficit with the other central banks, it is almost certainly because it has loaned money on a net basis to its commercial banks to cover payment transfers, instead of progressing them through the settlement system. Those loans appear as an asset on the national central bank’s balance sheet, which is offset by a liability to the ECB’s Eurosystem through Target2. But under the rules, if something goes wrong with the TARGET2 system, the costs are shared out by the ECB on the pre-set capital key formula.

It is therefore in the interest of a national central bank to run a greater deficit in relation to its capital key by supporting the insolvent banks in its jurisdiction. The capital key relates to the national central banks’ equity ownership in the ECB, which for Germany, for example, is 26.38% of the euro-area national banks’ capital keys.[iii] If TARGET2 collapsed, the Bundesbank would lose the trillion-plus euros owed to it by the other national central banks, and instead must pay up to €400bn of the net losses.

To understand how and why the problem arises, we must go back to the earlier European banking crises following Lehman, which has informed national regulatory practices. If the national banking regulator deems loans to be non-performing, the losses would become a national problem. Alternatively, if the regulator deems them to be performing, they are eligible for the national central bank’s refinancing operations. A commercial bank can then use the questionable loans as collateral, borrowing from the national central bank, which spreads the loan risk with all the other national central banks in accordance with their capital keys. Insolvent loans are thereby removed from the PIGS’ national banking systems and dumped onto the Eurosystem.

In Italy’s case, the very high level of non-performing loans peaked at 17.1% in September 2015 but by March this year had been reduced to 5.3%. The facts on the ground state that this cannot be true. Given the incentives for the Italian regulator to deflect the non-performing loan problem from the domestic economy into the Eurosystem, it would be a miracle if any of the reduction in NPLs is genuine. And with all the covid-19 lockdowns, Italian NPLs will have soared again, explaining perhaps why the Italian central bank’s TARGET2 liabilities have increased by €137bn over the course of covid lockdowns.

In the member states with negative TARGET2 balances there have been trends to liquidity problems for legacy industries, rendering them insolvent. With the banking regulator incentivized to remove the problem from the domestic economy, loans to these insolvent companies have been continually rolled over and increased. The consequence is that new businesses have been starved of bank credit because bank credit in the member nation’s banks is tied up with supporting the government and zombie businesses that should have gone to the wall long ago. The added pressure on failing Italian businesses from covid-19 is now being reflected in the Bank of Italy’s soaring TARGET2 deficit. The system could not be more calculated to cripple the Italian economy over the longer term.

Officially, there is no problem, because the ECB and all the national central bank TARGET2 positions net out to zero, and the mutual accounting between the national central banks keeps it that way. To its architects, a systemic failure of TARGET2 is inconceivable. But, because some national central banks end up using TARGET2 as a source of funding for their own balance sheets, which in turn fund their dodgy commercial banks using their non-performing loans as collateral, some national central banks have mounting potential liabilities, the making of national bank regulators.

The Eurosystem member with the greatest burden is Germany’s Bundesbank, now lending well over a trillion euros through TARGET2 to central banks exploiting the system. The risk of losses for the TARGET2 lenders is now accelerating rapidly because of Covid lockdowns, as can be seen in the chart of TARGET2 imbalances above. The Bundesbank should be very concerned.[iv]

Current imbalances in the system total over €1.6 trillion. According to the capital keys, in a systemic failure the Bundesbank’s assets of €1.102 trillion would be replaced by liabilities up to €400bn, the rest of the losses being spread around the other national banks. No one knows how it would work out because failure of the settlement system was never contemplated; but many if not all the national central banks will have to be bailed out on a TARGET2 failure, presumably by the ECB as guarantor of the system. But with only €7.66bn of subscribed capital the ECB’s balance sheet is miniscule compared with the losses involved, and its shareholders will themselves be seeking a bailout to bailout the ECB. A TARGET2 failure would appear to require the ECB to effectively expand its QE programs to recapitalize itself and the whole eurozone central banking system.

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