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

Posted by on Dec 15, 2011 in Uncategorized | No Comments

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.

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

‘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