Balance of Payments and TARGET-2
As readers of our blog know, we are keeping a wary eye on the euro area's central bank-directed payments system TARGET-2, where imbalances continue to pile up at astonishing speed. The most recent data are from February 2012 and have been compiled and charted by the German website 'Querschüsse'. (as an aside, the German term 'Querschuss' is probably best translated as 'spanner in the works'). The latest chart is reproduced below:
TARGET-2 imbalances as of February 2012. Legend: 'GNFL' = 'Germany, Netherlands, Finland and Luxemburg', 'PIIGS' = Portugal, Italy, Ireland, Greece and Spain, PIIGSBF is the same group, with the TARGET liabilities of Belgium and France added – click chart for better resolution.
As we have pointed out previously, no comparable settlement procedure exists between the euro area central banks. Thus the payment imbalances have simply kept growing since the beginning of the crisis.
So what do these payment imbalances signify? The German IFO Institute's colorful chief economist Hans-Werner Sinn is not far wrong when he brands them a 'stealth bailout'.
Imagine for a moment that Europe were using fully gold-backed currencies. In that case it would actually not matter if the various member nations of the EMU (European Monetary Union) were using the 'euro' or national currencies backed by a fixed weight of gold – they would still have rigid exchange rates and a common monetary denominator. Imagine further that any payment imbalances were settled at regular intervals by means of gold transfers, similar to how the Fed's district banks settle their payment imbalances.
In that case, the extent to which a country could accumulate a negative balance of payments would be strictly limited by the amount of gold at its disposal. If the deficit became too large, it would have to attract gold by raising interest rates, which would have the effect of curtailing the credit expansion that usually is at the heart of extreme payment deficits.
Even though the boom-bust cycle is independent of whether one uses gold as money, since it is caused by the practice of fractional reserve banking, i.e. the creation of fiduciary media that function as money even though no backing for them exists, it is obvious that booms could not possibly get completely out of hand. There would be far more frequent retrenchments, and they would be accompanied by a money supply deflation back to the specie backing. Obviously, in a 100% reserved system, neither an inflationary expansion of credit and money beyond the available savings nor a subsequent deflation of the money supply would be possible.
However, the euro – although it is a 'common denominator' for the member nations - is not like gold. It is a fiat currency, of which as much as is required can be 'printed'. The result is that the inflationary credit expansion in the euro area's periphery did in fact get out of hand during the boom years and grew to such an extent (in the first decade of the euro's existence, the true money supply of the euro area increased by about 130%) that the inevitable bust became a crisis of previously unimaginable proportions.
In the deficit countries, the boom has altered the entire economy's structure. For instance, we recently came across a remark by an observer regarding the Greek economy. He said (paraphrasing) that 'it became far more profitable for Greek companies to import goods than to continue with production activities of their own. Financing for such imports was ample. Over time, more and more producers vanished and were replaced by import businesses'.
Now that the crisis has arrived, private capital is no longer willing to finance current account deficits. As a result, these deficits are now financed via the 'TARGET-2' system. To be sure, on the balance sheets of the euro system banks that carry TARGET liabilities, there are offsetting claims in the form of assets pledged by commercial banks. Conversely, the central banks that carry large TARGET claims on their balance sheets have offsetting liabilities in the form of excess reserves deposited with them by their commercial banks. None of this is likely to become a problem as long as two conditions remain intact: Firstly, the euro must not break apart. A break-up would be messy and it would likely turn out that it is far more difficult to settle the claims than is currently envisaged (it is not for nothing that Jens Weidmann has begun to worry about these imbalances).
Secondly, the banks must have enough collateral to be able to continue to borrow funds from the central bank system.
This second point is becoming a bit of a problem – in spite of the fact that the ECB has lowered reserve requirements to a negligible 1% (one wonders why it still has a reserve requirement at all) and has changed the eligibility criteria for assets commercial banks may pledge with it to obtain funding several times already, more and more bank assets have ended up encumbered.
To the extent that commercial banks in the 'problem countries' can still borrow from the private sector, they have to heavily over-collateralize such funding. In turn, the assets they pledge to the ECB are often only eligible by dint of sporting a 'guarantee' by their governments. Unfortunately, these governments themselves are either already insolvent or are flirting with insolvency. So the ECB, respectively the euro system – regardless of its insistence that it keeps tight controls on the assets it accepts – surely has amassed a sizable amount of highly dubious collateral by now (this is one reason why a euro divorce could become rather difficult, as at that point, the true value of this collateral would be revealed).
'Good' and 'Bad' Euros
The other impetus (aside from the financing of current account deficits) for the growing TARGET-2 imbalances is inner-European 'capital flight' (it would be better to call it bank deposit flight actually).
Savers and depositors in the periphery can not be calmed by the constant stream of assurances emanating from the eurocracy. They have to worry about two things: Firstly, their banking systems are rickety and many banks would in fact already be insolvent if not for central bank funding. The danger is that support for the banks may not be forthcoming indefinitely. There could be a 'sell by' date on all these bailouts, assertions to the contrary from officialdom notwithstanding.
The second thing they have to worry about is the possibility that their nation may eventually decide to reduce the value of the claims of savers and in turn rescue banks and borrowers (including the governments themselves) by leaving the euro and returning to their old national currencies with the intention of massively devaluing them. Obviously such a desperate step would only be taken when all other options have been exhausted.
As we have noted on previous occasions (and as common sense suggests), an exit from the euro does comes with great costs. In fact, as Edward Hugh has so convincingly argued in the paper he wrote in the context of the 'Wolfson question', the cost is so high that at the moment the euro can be regarded as akin to a roach motel. It was easy to get in, but it is fiendishly difficult to get out.
Nevertheless, savers and depositors remain rightly worried that such a desperate step is by no means off the table. It need not even be taken 'voluntarily', in the sense of a controlled exit procedure. The entire euro project may just blow up into everybody's face – i.e., the crisis could become 'uncontrollable'.
It is no wonder then that deposits are moving from the troubled regions to the 'core', the banks of which are regarded as more likely to survive and which are more likely to either retain the euro or switch back to a national currency that will actually appreciate in value.
So people are basically thinking 'a euro deposited in Germany is a good euro. A euro deposited in Greece or Spain is (potentially) a bad euro.'
The problem is that this flight of deposits is creating a 'self-fulfilling prophecy' effect. The banks in the 'core' are overflowing with deposits, while the true money supply in the periphery is shrinking due to the decline of the amount of money deposited with the banks. The banks in these countries in turn require more and more central bank funding as a result.
A recent Bloomberg article looks at the phenomenon. Below are a few snippets from the article:
“The euro area’s financial troubles appear to be flaring up again, as this week’s gyrations in the Spanish bond market show. In reality, they never went away. And judging from the flood of money moving across borders in the region, Europeans are increasingly losing faith that the currency union will hold together at all.
In recent months, even as markets seemed calm, sophisticated investors and regular depositors alike have been pulling euros out of struggling countries and depositing them in the banks of countries deemed relatively safe. Such moves indicate increasing concern that a financially strapped country might dump the euro and leave depositors holding devalued drachma, lira or pesetas.
The flows are tough to quantify, but they can be estimated by parsing the balance sheets of euro-area central banks. When money moves from one country to another, the central bank of the receiving sovereign must lend an offsetting amount to its counterpart in the source country – a Bank of Spain, for example, ends up owing the Bundesbank when Spanish depositors move their euros to German banks. By looking at the changes in such cross-border claims, we can figure out how much money is leaving which euro nation and where it’s going.” that keeps the currency union’s accounts in balance. The
Bloomberg helpfully provides a chart that shows which countries are on the receiving end of the deposit flight and which ones are bleeding deposits (as the paragraph above indicates, the TARGET system's imbalances have probably been used to make this chart):
The movement of capital within the euro area, via Bloomberg - click chart for better resolution.
The Bloomberg article continues:
“This analysis suggests that capital flight is happening on a scale unprecedented in the euro era — mainly from Spain and Italy to Germany, the Netherlands and Luxembourg In March alone, about 65 billion euros left Spain for other euro- zone countries. In the seven months through February, the relevant debts of the central banks of Spain and Italy increased by 155 billion euros and 180 billion euros, respectively. Over the same period, the central banks of Germany, the Netherlands and Luxembourg saw their corresponding credits to other euro- area central banks grow by about 360 billion euros.
The seven-month increase is about double the previous 17- month rise, and brings the three safe-haven countries’ combined loans to other central banks to 789 billion euros, their highest point on record. In essence, the central banks of the three countries — and, by proxy, their taxpayers — have agreed to make good on about 789 billion euros that were once the responsibility of Italy, Spain, Greece and others.”
The last sentence in the snippet above is a bit of an exaggeration, as any putative losses resulting from the euro system's payment imbalances will be shared among the central banks according to their capital contribution to the ECB – of course this would still leave Germany holding the biggest bag by far (the BuBa's ECB capital key is 27%). Moreover, even if we assume that the assets pledged by commercial banks to the central banks are worth less than advertised, they are are probably worth a great deal more than zero.
'Fiscal Union' Nonsense
The rest of the Bloomberg article is best forgotten. It is yet another vacuous plea to forge a 'fiscal union' in order to get the crisis under control, as if the capital consumption that attended the boom could be undone by imposing the highest possible tax rates on all citizens of the euro area (this is what in the final analysis 'fiscal union' would amount to: tax rates would be 'harmonized' according to where taxes are currently the highest).
Furthermore, it argues in favor of throwing even more tax payer money at the problem, as that is allegedly the only way to 'save' the money that can already be considered as having gone down the drain.
It is of course the avowed goal of the socialist super-state tinkerers in the eurocracy to achieve such a fiscal and eventual political union and eliminate the subsidiarity principle altogether. However, as we have previously pointed out, this is definitely not what the EU is, or at any rate should be about (see 'The European Idea' for details on this topic).
The gold standard of the heyday of economic liberalism in the late 19th and early 20th century proves that using a common currency and making an enormous success of it is not at all dependent on 'fiscal unions' and similar nonsense.
The root of the problem continues to be misdiagnosed by virtually all observers and policymakers alike. As Sean Corrigan pointed out a few months ago, imagine that your neighbor is in financial difficulties and has amassed a $500,000 debt (or take any other number, it's just an example) that he finds it difficult to service or pay back. Does that mean that in order for both of you to continue to use the same medium of exchange you have to enter into a 'fiscal union' with him?
If the answer to this question is no, you also have the answer to the notion that the euro's continued existence depends on forging a fiscal union. This is simply nonsense. What is required is a policy that counters the 'tragedy of the commons' problem dogging the currency area, as detailed by Philipp Bagus here. We will return to this topic in an upcoming article this week.
Selected Credit Market Charts
Below is a selection of our usual credit market charts offering that shows what happened on Monday in the most important markets. Once again, CDS on Spain moved a new all time high and 10 year yields moved to a new interim high above 6%.
Prices and price scales are color-coded – readers should keep the different scales in mind when assessing 4-in-1 charts.
Prices are as of Monday's close.
5 year CDS on Portugal, Italy, Greece and Spain (the break in CDS on Greece is due to the CDS now referring the new post PSI deal bonds). CDS on Spain streaked to a new high on Monday - click chart for better resolution.
5 year CDS on France, Belgium, Ireland and Japan – contagion effects continue to be evident - click chart for better resolution.
Three month, one year, three year and five year euro basis swaps – the dollar funding problem for euro area banks comes roaring back - click chart for better resolution.
Our proprietary unweighted index of 5-year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – a new high for the move was recorded on Monday - click chart for better resolution.
10 year government bond yields of Italy, Greece, Portugal and Spain – Spain's 10 year yield is back above 6%. At around 7% to 7.5% a country usually becomes a ward of the EFSF/ESM if experience is any guide - click chart for better resolution.
Charts by: Querschüsse, Bloomberg
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