Thursday, June 14, 2012

The TARGET2 circle of life

Kostas Kalevras, who diligently watches central banks, today observed an increase in Bank of Spain's TARGET2 liability for the month of May. In fact this number has been climbing every month for the past year.

Bank of Spain TARGET2 liability

There are multiple questions that keep coming up on this topic as we see these balances grow. It's worth addressing two of them here.

1. How is it that TARGET2 continues to grow so rapidly even after the LTRO program? The answer is that depositors in Spain are moving money out of Spanish banks, while Spanish banks in turn replace their deposit funding with the MRO short-term funds from the central bank (Bank of Spain). The central bank provides this MRO loan by crediting the Spanish bank and debiting the Eurosystem (increasing the MRO on the asset side, offset by TARGET2 increase on the liability side). And so goes the TARGET2 "circle of life" - see the diagram below. If it turns counterclockwise, the Bank of Spain TARGET2 liabilities rise. If the flow changes direction, the liabilities fall.


2. Who cares? Why do these balances matter at all? The best way to answer this is to address some of Felix Salmon's commentary called Don’t worry about Target2 (ht Advisor Overheard).
Certainly a Greek exit would be small enough not to worry about at all. Greece has a negative Target2 balance of about €100 billion. What that means is that Greek banks owe the Bank of Greece €100 billion, which is fully collateralized; and that in turn the Bank of Greece owes the ECB €100 billion on an unsecured basis. If Greece were to chaotically devalue and default, then it’s entirely reasonable to assume that the Bank of Greece would default on those obligations to the ECB, and would keep the Greek banks’ collateral for itself, to help prop up as much as possible the nascent drachma.
This description of the Bank of Greece exit form the Eurosystem is quite accurate. And the Eurosystem would indeed absorb this loss fairly easily. Nevertheless it is a loss. In the Eurozone, just as it is in the US, the central bank profits go back to the central governments - every year. This loss due to Greece would offset the profits and the central governments (and the taxpayers) would certainly feel it. (Of course there would be other much bigger losses from "Grexit".)

Now if Bank of Spain were to exit the Eurosystem, that loss becomes more than three times as much (as shown in the first chart above). Italy's exit would be even larger. Central banks can of course continue to operate with a large loss. As Felix points out they are central banks, so they can't officially go broke. But that lost money would need to be recovered before central banks pay "dividends" to their governments again. So the taxpayer will feel that loss for years to come (or in one shot, should the governments choose to recapitalize the central banks.) With enough central banks exiting, the remaining Eurosystem will end up operating with negative equity - and it can certainly do that indefinitely. But ultimately the taxpayer gets hurt.

As an example consider why the Fed is so concerned about having Maiden Lane loans repaid to it as quickly as possible. Clearly the Fed can take this loss and not go broke - the central bank can just go on functioning with smaller equity capital. But it doesn't want to take a loss because ultimately it's the US Treasury that will get hurt by having to recapitalize the Fed or via the reduction in the income the Fed is paying out.

Because the Eurosystem can "print money" some argue it can effectively "recapitalize itself". There is simply no mechanism for that. The ECB can buy assets with printed money (QE), but that will cause it to grow its balance sheet, NOT increase its capital base (equity).

Felix argues that in case of the euro breakup, Bundesbank will start fresh with the deutsche mark. It would expand the money supply, somehow recapitalize itself, and the taxpayers wouldn't be responsible for the TARGET2 loss. But remember the "circle of life" above. Right now Germany owes a great deal of money to those Spanish (and other foreign) depositors. And the Eurosystem owes Germany some trillion euros - much of it generated by those same deposits. If Germany were to lose what it expects from the Eurosystem, it is a real reduction in the wealth of that country - no matter how many deutsche marks it prints.

A default on TARGET2 is a loss to the creditor nation even if the legal creditor is a central bank. And when one nation defaults to another, the pain is spread to the citizens, whether the default is on bonds, loans, or TARGET2 liabilities.

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