The breakdown in inter-bank lending in Europe and flight of capital from peripheral nations has created imbalances of hundreds of billions of dollars in the Target2 Real Time Gross Settlement system. William Cain asks: How serious are these imbalances for the stability of the European payments system and what can be done about it?
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Target2, as the central plank of the European payments system, is not something which sets the pulse racing in the payments industry it concerns, let alone in the wider financial world.
Yet this bland piece of infrastructure, which enables the transfer of large amounts of funds between banks and central banks in the Euro-zone, has become the centre of an intense debate involving some of Europe’s most prominent economists.
The debate has focused on ballooning imbalances in the Target2 payments system since 2007 which now amount to hundreds billions of Euros owed by peripheral countries, mainly the so-called PIIGS, to the ECB.
Some core countries, notably Germany, have become worried about the scale of the outstanding balances and are calling for the system to be modified. Figures recently published for the month of March show Germany is owed EUR616 as a result of Target2 payments imbalances, which is up over EUR100bn in just two months and EUR291bn from end-2010. Spanish and Italian liabilities to the system have also spiralled, reaching EUR276bn and EUR270bn respectively in March, up from EUR50.9bn of liabilities for Spain at end-2010 and a net positive balance of EUR3.7bn for Italy.
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By GlobalDataSome economists who have studied the ballooning of these imbalances in the wake of the financial crisis say it amounts to a quasi-bailout of peripheral by core nations through the payments system far in excess of the bailouts through the European Financial Stability Fund.
John Whittaker, an academic at Lancaster University, argues the billions owed to Germany and other nations through the Target2 payments system is as risky as their central banks owning Greek or other peripheral nations’ government bonds.
At the end of the day, it’s the Greek government that would have to come up with the repayment of both of those types of debt [government bonds and Target2 liabilities], says Whittaker.
What does all this mean for the stability of the European payments system, why do these imbalances exist and what, if anything, is being done to resolve it?
Theories on the imbalances
Surprisingly, despite the sums of money involved and the apparent scale and seriousness of the imbalances, there has been an argument among economists as to what underlying factors are causing them to exist.
Some papers on the topic initially claimed it was a result of a balance of payments crisis within the euro-zone, and that Target2 imbalances were funding peripheral current account deficits. In a paper last year, professor Hans-Werner Sinn, president of the Ifo Institute for Economic Research at the University of Munich, argued the imbalances were a result of this and that they had caused a number of undesirable economic consequences including a reduction of credit to German businesses.
These claims have been largely dismissed by the likes of Whittaker, Citi’s chief economist Willem Buiter and Karl Whelan, professor of economics at University College Dublin. They say the imbalances are caused to a certain extent by peripheral current account deficits but also capital flight from periphery banks to those in the core countries, mainly to Germany but also the Netherlands.
The scale of this transfer of funds from periphery to core was not envisaged when the Target2 Real Time Gross Settlement (RTGS) system was created. It was expected that intra-country flows of funds would balance out over time. Now, mounting debts within the system from a large number of countries to a few core countries has led to concern about whether this assumption is correct and if the system needs to be changed to stop the imbalances building up.
A breakdown in inter-bank payments
Payments imbalances have started to grow in Target2 because of the way the payments system functions and the dramatic shift in the flows of funds between countries.
John Whittaker, an academic at Lancaster University, whose paper on Target2 in March 2011 kicked off the debate, says that pre-2008 transactions between banks would be settled on their own account via inter-bank counterparties. The reason imbalances are now showing up within the Target2 system is because of a breakdown in more traditional forms of payments between banks.
Under the Target2 system, the transfer is executed between the banks with their own central banks and between the central banks with each other.
In practice funds between the central banks are not transferred because when the system was set up it was expected that over time, transfers between the euro-zone’s central banks would balance themselves out. Instead, the Bank of Greece includes an intra-Eurosystem liability on its balance sheet (Target2 liability) and the Bundesbank includes an intra-Eurosystem asset on its balance sheet (Target2 asset).
This is the payment mechanism by which claims have been built up within the euro-zone’s Target2 system.
One important distinction is that the claims are not directly between one central banks and another but are instead to or from the Eurosystem, effectively the ECB. Citis Buiter says this is a key consideration in considering the risk of the imbalances, because although Germany is owed around EUR616bn through the system, the figure is not a true reflection of risk to the Bundesbank for a number of reasons.
First, it only needs to be repaid if one or a number of countries exit the European single currency. Second, even if a country did exit the euro, that country’s liabilities would be to the EU as a whole rather than to individual countries, so any losses would be divided between member states based on their share of ownership of the ECB.
To extend this argument further, if Greece, as one of the euro-zone countries that is most under pressure, sought to leave the euro, it would have around EUR87bn in Target2 liabilities to the ECB.
Any loss of these funds would be borne by the ECB and shared between all euro-zone member states. So in this example, Germany would be liable for its share of the ECB’s paid-in capital, which is about 27% of the EUR87bn.
Impacts on payments stability
The increase of funds owed by peripheral countries to Germany and other core countries through the ECB is clearly of importance in the debate about debt levels of certain European countries. The issue has a bearing on the stability of the European financial system and also the way the area performs economically.
Target2 is simply the transmission mechanism which has contributed to the creation of additional liabilities between countries. The stability of the payments system in the Euro-zone could be threatened only if one or more countries decided to exit the single currency or if core countries became so concerned about the build up of liabilities that they cut off access to Target2 for some countries.
Cutting off or restricting access of peripheral countries to Target2 has been suggested as a potential solution by Sinn, although the idea has been largely dismissed by other economists.
They say that restricting access to the system for countries like Greece, Portugal, Italy and Spain would most likely precipitate their exit from the euro-zone and lead to far more serious problems than a malfunctioning payments system.
The cutting off of some countries’ access to Target2 and/or the exit of countries from the euro are a possibility, according to Whittaker, although he says they are unlikely to happen any time soon.
I don’t think there’s any problem provided each national central bank has its credit lines open, says Whittaker.
For me, that will be the crunch, when Germany or someone else says they’ve really had enough of lending to Greece. The only way you could stop lending to Greece is by stopping to send the EFSF funds and the other bail-outs to Greece but in addition, they’d have to tell the other national central banks that from now on, they cant clear any payments.
In that scenario, you are basically cutting Greece out of Target2 and when you do that it means that a retail customer at a Greek bank wouldn’t be able to clear an overseas payment. That’s effectively throwing them out of the euro-zone.
Bundesbank suggests Target2 changes
Although any default on the funds owed to Germany, as the biggest creditor to the Target2 system, would be shared between euro-zone countries, the Bundesbank is concerned about the development of the imbalances.
In March, Jens Weidemann, the president of the Bundesbank, wrote a letter to the European Central Bank that questioned the sustainability of the status quo regarding Target2. It has been reported the letter suggested collateral from refinancing operations held by national central banks should be pooled into the ECB and also that the quality of collateral to be accepted could be improved. This might provide a bigger safety net to creditor countries worried about their exposures within the system.
The periodic settlement of RTGS payments imbalances through the use of collateral is is not an unusual arrangement.
In the US, a similar system, called the Interdistrict Settlement Account, exists between individual states. Any imbalances between states have historically been settled at the end of each year with collateral including US government Treasury Bills. Interestingly, the requirement for collateral settlement has been temporarily suspended between Federal Reserve Banks in the US, creating similar imbalances within its internal payments system as those in Target2. Richmond Fed liabilities created through US RTGS transfers are USD134bn while the New York Fed has a surplus of over USD250bn.
A similar suspension of the annual balancing of the Interdistrict Settlement Account was enacted in 1933, the last time the US went through a period of prolonged financial crisis. This suggests payment system imbalances between states or, in the European case, countries, could be used as a temporary means of ensuring the smooth functioning of the economies and financial system of an economic area.
However, the trade-off is that eventually the balances need to be settled which is done through the process of ‘discounting’. This effectively writes off part of the intra-state/country imbalances . Doing this is easier in a country like the US, where the balancing of funds between the regional Federal Reserve bodies is described as being like playing a game of Monopoly between friends by the Brussels-based economic think-tank Bruegel. It is more difficult between a loose affiliation of countries with their own strong domestic political agendas.
The alternative to ‘discounting’ is continued ‘mounting’ of the imbalances and this looks like the most likely course for some time to come. While nervous central banks in Europe’s core might want to move to a system where collateral quality is improved and held at an ECB level, Whittaker thinks it is unlikely they will get it.
[Jens Weidemann’s letter to the ECB] is an overt recognition that they believe there is a problem there and that’s why they are asking for some remedy, he says. But their remedies aren’t feasible. There’s not much being done and there’s not much that can be done as far as I can see. So he’s whistling in the wind a little bit.
