For some reason the subject of Eurozone's TARGET2 imbalances continues to be of great interest to many. We keep getting numerous e-mails requesting more information on the topic. The paper included below can serve as a reference on TARGET2 imbalances and hopefully will answer a number of readers' questions.
The key to understanding this issue is to look at this "truck purchase" example in the paper and follow how it impacts the national central bank balance sheets.
In this example the Greek central bank has to reduce "base money" while Bundesbank increases "base money" - effectively "transferring" cash from the Greek banking system to the German banking system (to pay for the truck). Simultaneously Bundesbank now has a future claim on the ECB while the ECB has a claim on the Greek central bank (effectively to reverse the "cash transfer" in the future). With significant periphery trade deficits, these claims have grown quite large.
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| Impact on central bank balance sheets with a cross-border transaction |
The concern around TARGET2 imbalances is that central banks owe a great deal of money to each other via the ECB and should a nation drop out of the Eurozone, these liabilities may not be met. The ECB may then have to take a large loss. A mechanism for a nation's exit from the euro area was never developed.
But one question that few have asked on this topic is what is the net impact on base money in Germany vs. the periphery. Clearly this base money imbalance (table above) will also create uneven money stock and significant liquidity tightening in the periphery vs. Germany.
For example if a corporation in Panama (with bank account at a Panamanian bank), a nation that uses US dollars, by some miracle transferred half a trillion dollars into a bank in the US, the Fed would view it as an unplanned QE and would sterilize it by reducing its balance sheet (selling some bonds). But there is no equivalent capability at Bundesbank. Instead Bundesbank relies on "voluntary" sterilization as German banks with all the new deposits are reducing their net central bank borrowing (for example Deutschebank did not even participate in the LTRO program.) The periphery central banks on the other hand are sterilizing their reduction in base money by lending into their banking system - see the blue text in the above table.
By the same process the collateral held at Bundesbank is decreasing, while the same at the periphery central banks is rising. The collateral therefore is concentrated in the German banking system (banks get it back when they repay their central bank loans) and is trapped at the periphery central banks (who take it in when lending to their banks) - exactly where it is not needed.
One concern is that base money would start growing rapidly in Germany when banks stop reducing their central bank borrowings. If trade deficits continue to widen, this becomes an equivalent of a QE in Germany and potentially a tightening in the periphery - exactly the opposite effect of what's required. If this were China, the central bank would simply issue a note and force German banks to buy it in order to soak up the excess liquidity. However, there doesn't seem to be a legal mechanism in the Eurozone to address this issue.
For further information on the topic, take a look at this paper by Hans-Werner Sinn and Timo Wollmershaeuser. It's a great reference.
TARGET2 Imbalances Paper
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