Le blog du CEPII

Is the Eurozone really a monetary union? (1/2)

Central banks in the Eurozone have accumulated claims and debts between themselves. These "Target 2 imbalances" substituted for the outstanding between private entities, in particular for the interbank loans and there is no mechanism to settle them. Should the Eurozone burst, they would become due.
By Christophe Destais
 Post, July 1, 2013

Since the beginning of the crisis in the Eurozone, the public debate has focused on several issues: the so-called "transfer union", the "fiscal union", and now the "banking union ". Economists have also wondered if the perimeter of the Eurozone corresponds to an "optimal currency area", that is if it satisfies the theoretical criteria of a relevant monetary area. On the other hand, whether the Eurozone as it was designed by the Treaty of Maastricht and implemented afterward really constitutes or not a "monetary union" has not been the subject of a public debate, at least in France.
It has been much more the case in Germany where monetary policy issues are of greater interest among the politicians, the journalists and, now, the judges. As early as the beginning of 2011, the economist Hans Werner Sinn blew the whistle on a complex process of accumulation of claims and debts between the national central banks (NCBs) of the Eurozone. The German Bundesbank was accumulating hundreds of billions of Euros of claims on the central banks of the countries in crisis. Technically, this process was made possible by the functioning of the system of payments of the Eurozone, known under its acronym “Target 2”. The debts and the claims accumulated between the central banks came to be known as "Target 2 imbalances”.
In summary, before the crisis, capital needs from Eurozone deficit countries were covered by private capital flows. These flows took various forms: direct investments, securities purchases and, mostly, interbank loans. The banks of the countries where the supply of savings were in excess of domestic financing needs lent their surplus of liquidities to the banks of the countries in deficit. As soon as the crisis began, these private flows dried up. Rather than lending to the banks of deficit countries, the banks of the surplus countries kept their liquidities in their account at the central bank of their country of origin. Moreover, the financing needs of deficit countries increased because of the capital outflows that resulted from a fear of Eurozone burst. Deprived of interbank financing, the commercial banks of the countries in crisis requested loans from their national central banks who granted them against collaterals, within the framework of decisions made at the level of the ECB. Therefore deficit countries’ NCBs played the role of the lender of last resort. They themselves borrowed this money from the NCBs of countries with an excess of savings through the Target 2 channel or directly from the ECB.
Had the deficit NCBs not been able to borrow this money, the countries in crisis would have experienced a situation similar to Argentina at the end of 2001, when it defaulted on its debt and gave up its fixed exchange rate with the dollar. With the sudden stop of private capital inflows, they would not have been capable of covering their external needs for financing. Commercial banks, governments and companies which roll their debt over, that is, which borrow to pay their debt off, would have defaulted on the latter, causing a systemic crisis. Such default did not occur (except for the default of Greece on its national debt which has so far been kept under control), because public creditors substituted for private creditors to cover the external financing needs of countries in crisis. These public financing took the shape of loans to the governments within the framework of IMF and EU sponsored programs benefiting to four countries (Ireland, Portugal, Greece and Cyprus) and, even before the implementation of these programs, of loans between the national central banks, the "Target 2 imbalances". Surplus countries NCBs (from Germany, the Netherlands, Finland and Luxembourg) accumulated more than one thousand billion Euros of claims on the NCBs of deficit countries (Greece, Ireland, Italy, Spain, Portugal, Cyprus). France remained about neutral, since its financing needs continued to be covered for the main part by private capital inflows. Meanwhile, the German NCB, the Bundesbank, accumulated a 600 billion Euros claim on deficit countries’ NCBs. In the summer of 2012, the Target 2 imbalances exceeded 1000 billion Euros. It has decreased since.
Philippine Cour-Thimann, a principal economist at the European Central Bank, has dedicated to this question an in-depth study which she presented at CEPII on June 27th 2013. This study is published by Cesifo, a German research institute run by H.W. Sinn. Although Sinn has himself clear-cut opinions on the subject - he thinks that the Target 2 imbalances represent an excessive risk for the German economy-, Cesifo has committed to livening up the debate on this question and, thus, to publish works the conclusions of which do not all go in the same direction.
Ms Cour-Thimann’s study describes in detail and very clearly the mechanisms leading to the accumulation of claims and debts between Eurozone NCBs. She shows the extent to which these mechanisms played an essential role in the external financing of the countries in crisis. In doing so, she breaks with a certain otherworldliness which, in the name of the defense of the Euro, refrained to examine in detail the external accounts of all the member states on the grounds that it is not relevant to point out the imbalances within a monetary zone. Ms Cour-Thimann’s work demonstrates well how the Target 2 imbalances substituted for the previous private claims and debts. She underlines that, other things being equal, the surplus countries decreased the level of risk they bear because the possible losses of their central banks would be - if the rules are to be applied – born by the ECB. The ultimate risk would thus be shared between member countries in proportion to their share in the capital of the ECB. The Bundesbank holds approximately 75 % of the Target 2 claims but the share of Germany in the capital of the ECB is only 19 %. However, not all the countries have the same actual capacity to absorb losses should they arise and this burden sharing plan remains theoretical.
Ms Cour-Thimann also deals without taboo with the hypothesis of a country exiting the Eurozone or the bursting of the latter. An exit of the Eurozone is not explicitly contemplated by the European treaties which mention, on the other hand, the possibility for a Member State to exit the EU. Ms Cour-Thiman considers that in the "theoretical" case of a country exiting the Eurozone on the occasion of it exiting the EU, it should settle its Target positions and, thus, either pay off its debts or claim its due. The Target 2 debts between national central banks are not collateralized but the NCBs loans to the commercial banks come with pledged securities that are deemed eligible by the ECB as collaterals. If the exit occurs in times of crisis, there is every reason to think that the collaterals held by the NCBs on national debtors would have a low value and that it would be necessary to wait, at best for some time, before this value goes up.
The possible losses incurred by the creditor NCBs in case of an exit would be borne by the whole ECB and ultimately by the Eurozone member states in proportion to their share in the ECB’s capital. It is only in the case of a complete burst of the Eurozone, a situation that Ms Cour-Thimann describes as "purely theoretical", that she contemplates the possibility for the Target 2 imbalances to ultimately fall to each NCB. Ms Cour-Thimann does not discuss this directly but we can reasonably assume that, in both cases, the Target 2 debts would not be honored in the short term.
Contrary to H. W. Sinn, Paul De Grauwe et Yuemei Ji consider that such default do not represent a risk for creditors countries because what makes the value of a currency is not the value of the assets of the central bank that is issuing it but the purchasing power of this currency. So, as long as the issuance of this currency remains under control so as to guarantee the price stability, there is no need to worry that the value of the claims on the asset side of the central bank’s balance sheet might collapse.
Contrary to what exists in the United States (cf. next post) the possibility to settle the claims and the debts between the NCBs by a transfer of assets was not planned. The Target 2 imbalances could thus, in theory, increase infinitely.
When it is confronted with the question of the limits in the accumulation of the Target 2 imbalances, the only possible reply from the ECB is that it is up to the debtor countries to take the necessary steps to reduce their current account deficit and become attractive again for the private international investors, which implies in particular the recapitalization and the restructuring of the insolvent banks.
Indeed, if these adjustment policies are successful, the Target 2 imbalances may decrease and even disappear. But, if they do not work or if they do work only imperfectly, the ECB is confronted with a dilemma. It is at its level that the decision to continue or to discontinue the financing of commercial banks by the NCBs is made (with the exception of the Emergency Liquidity Assistance, a facility that can be implemented by each NCB, at its own risks and with the prior authorization of the ECB). It then faces two options, which are common for a creditor. Either it decides to continue to finance the commercial banks of the countries in crisis and the Target 2 imbalances will continue to grow, or the ECB stops financing the commercial banks in crisis countries via their NCBs but it causes the collapse of the banking system in these countries with an inevitable exit of the Eurozone or even a complete explosion of the currency union. The only way of going out of this dilemma is to impose limitations on the capital outflows of the countries in crisis, as those set up in Cyprus last March and which are always in effect. Such a scenario is difficult to contemplate in a big country of the Eurozone. It would be an acknowledgment that a Euro in Madrid or Rome is not worth the same as a Euro in Berlin and thus that the Eurozone does not really exist anymore.

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