Sunday, January 1, 2012

TARGET2 imbalances and the money supply disparity

Let's take a look at the so-called TARGET2 payment system in the eurozone and it's relationship to the disparity in the money supply growth we discussed earlier (hat tip Sid).

We start with our hypothetical friend, an Italian citizen, who may decide for some strange reason to open a bank account in Germany and transfer say 1mm euros into that account. When the euros get transferred, Italy's central bank (Banca D'Italia) in effect is credited 1mm euros by the ECB while the German central bank (Bundesbank) is debited the same amount via the TARGET2 system. This assures that the amount of euros in both countries stays unchanged because the Bundesbank would be down 1mm euros but the German bank where our Italian friend is wiring the money will be up 1mm euros. The opposite would be the case between the local Italian bank where our friend had been banking and Banca D'Italia.

When the Bundesbank is debited 1mm euros by the ECB, the ECB in effect gives the Bundesbank an "IOU" to repay the euros at a later date. When (and if) our friend repatriates her money back to Italy, the ECB credits Bundesbank (repays the "IOU"), and debits Banca D'Italia, reversing the whole process. But until that happens, Bundesbank holds an asset (the ECB "IOU") while Banca D'Italia has a liability to the ECB. TARGET2 keeps track of all this.

But if a great number of our friends in Italy do this, it creates a "temporary" imbalance among the central banks where some have liabilities to the ECB and some who are owed money by the ECB (assets). The chart below shows just how many of our friends have been moving cash from the "peripheral nations" to the "core". The Bundesbank assets ("IOU" from the ECB) as well as the "peripheral" central banks' liabilities to the ECB have been growing.  One might consider this akin to a "run on the periphery banks".

Source: Credit Suisse

With this much TARGET2 imbalance, the periphery central banks have been buying up enormous amounts "eligible collateral" (bonds central banks are permitted to hold) from banks in their respective countries to inject cash that is leaving their countries.  The Bundesbank on the other hand has been returning collateral to German banks who paid off their loans. But now German banks have tremendous access to secured funding because they are awash with eligible collateral, while in the periphery a great deal of the eligible collateral is "trapped" at the central banks. This limits the peripheral privately held banks' ability to borrow on a secured basis (Izabella Kaminska has a good discussion on this topic).   This tremendous difference in access to secured funding makes credit conditions far looser in the "core" than in the "periphery" and shows up in the the money supply disparity.

But there is another aspect of these central bank imbalances.  The ECB owes Bundesbank some 400bn euros, while it is owed roughly the same amount by the periphery central banks. What if a member state were to default or leave the euro (which is essentially the same thing)?  The ECB, supported by its member states (with Germany being the largest contributor), would have to make up for the losses (make Bundesbank whole).  Thus in effect TARGET2 imbalances provide "credit support" to the central banks of the eurozone periphery.  Clearly this is different from providing credit support to periphery governments or privately held banks. Nevertheless some have called it a "backdoor" support that can not be achieved directly under the current EU platform. Being on the hook for that much money to the periphery central banks is clearly another source of unease for Germany and the Bundesbank.

As these imbalances grow, the disparity in the money stock growth will continue, making it more difficult for the ECB to have an impact via monetary easing.  And it will make the Bundesbank increasingly more vocal in its relationship with the ECB and the rest of the eurozone.
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