Since the early 1950s, German savings have tended to exceed investment with the inevitable result that that Germans have, on net, been investing in foreign assets.
- Most of these excess savings have been intermediated by the domestic banking system.
The banks have difficulties investing German surpluses abroad given that they finance themselves through deposits in the national currency and thus cannot take exchange rate risk. The resulting exchange rate adjusted tended to keep the surplus under 1% to 2% of GDP most of the time.
- With the advent of the euro, exchange rate risk within the Eurozone disappeared and German surpluses vis-à-vis EZ partner countries could and did become much larger.
- Large surpluses seem to have become structurally ingrained at a whopping 6% of GDP; that is more than a quarter of national savings.
As the sovereign debt and banking crisis took the Eurozone in its grip, the appetite of German private investors for Eurozone public and private debt diminished sharply. Investment outside the Eurozone was not an alternative given that a large number of German savings are still intermediated by banks and must thus remain denominated in euro.
To avoid a breakdown of the financial system, the public sector has now had to intermediate German savings surpluses. This happened in two ways:
- Limited loans by the German government (and other governments of countries with large external surpluses) to Greece directly and via the euro rescue fund (EFSF, soon the ESM) to the three countries with a ‘Troika’ programme; and
- The Eurosystem acting as the main intermediary of savings from surplus to deficit countries via Target2 balances.
Its role is reflected in the imbalances within the interbank payment system Target 2, which broadly correspond to EZ countries’ cumulated current account positions since the introduction of the euro; see the illustration below. (For a detailed analysis of the Target2 balances, see Sinn & Wollmershäuser, 2012).
Figure 1. Target2 balances and excess savings
The Eurosystem’s response
The Eurosystem’s role in intermediating large private-sector savings surpluses should not be regarded as abnormal. On the contrary, there are very few examples of countries with consistently large external surpluses being intermediated for long periods exclusively by the private sector.
In most countries running persistent current account surpluses (say, above 3% of GDP for more than five years), the government or the central bank has accumulated large foreign assets either through a sovereign wealth fund or through foreign exchange intervention.
- In raw-material-exporting countries, where the external surplus is generated by the royalties that go to the government, the sovereign wealth fund is the natural choice.
Saudi Arabia and Norway provide the classic examples of natural resources-based surpluses intermediated by the public sector through a sovereign wealth fund.
- In countries where the external surplus arises from excess savings in the private sector, foreign exchange intervention is the usual route to absorb the risk arising from the large net foreign asset position the private sector is accumulating.
Switzerland and Japan can illustrate the tendency of countries with structural private-sector surpluses to rely on the central bank.
The Eurosystem solution is inefficient
If there is indeed a role for the public sector to intermediate very large surplus savings, the question arises: is this intermediation done in an efficient way? From a German perspective, intermediation by the Eurosystem is, on balance, inefficient.
- On the one hand, any credit risk incurred by the Bundesbank through the accumulation of Target2 claims against the ECB is shared with other EZ countries through the distribution of any losses according to the share of countries in the capital of the ECB.
- On the other hand, the Target claims represent a portfolio that is, geographically and across asset classes, very concentrated.
Target2 claims are in the end only backed by the securities of banks in deficit countries delivered as collateral for ECB credits under the various credit facilities. A large part of these securities is probably of dubious quality, even if they often carry a government guarantee.
Target2 is inefficient from an investors perspective. The ECB offers German banks, and hence indirectly the country’s savers, at present a nominal interest rate of zero (which may even move into negative territory in the future), and it demands only 75 bps on its lending to banks in the Eurozone periphery.
- A 'margin' of 75 bps seems totally insufficient to cover the risks taken in the ECB’s operations.
Also, the zero nominal interest rate offered by the ECB's deposit facility translates into a negative real return for German savers of around 2% per annum under the ECB’s target inflation rate. And it could be even less when German inflation rises above the ECB’s target (as would seem necessary to allow internal real exchange rate adjustment in the Eurozone).
Finally, the ECB (by its nature as a central bank) is not able to offer German savers any longer-term investment vehicles. This is a key drawback given the lack of long-term savings vehicles available now because most German government debt has been absorbed by foreign central banks (e.g. from Switzerland and China) and sovereign wealth funds.
Setting up a Sovereign Wealth Fund to kickstart private lending
An alternative to the present system of intermediation of the German savings surplus, which would avoid the aforementioned disadvantages, would be a German Sovereign Wealth Fund (DESWF).
- A government agency would offer German savers a secure vehicle paying a guaranteed positive minimum real interest rate, with a top-up when real investment returns allowed.
- The vehicle would invest the funds in a portfolio that is highly diversified by geography and asset classes.
Positive real returns can be expected in the long run based on positive real global growth.
- With the DESWF channelling a significant part of German excess savings outside the Eurozone, the euro would depreciate.
This would help crisis countries to revive growth through exports, and to close their external deficits so as to recoup their international credit-worthiness.
- Target2 imbalances would gradually disappear and German claims abroad would move from nominal claims on the ECB (with a zero interest rate) to diversified real and nominal claims on various private and public foreign entities in a variety of asset classes around the globe.
Investments into the German sovereign wealth fund could be restricted to longer-term commitments, thereby helping to achieve positive real returns through participation in global growth and thus be equivalent to a funded old-age pension scheme as a supplement to the existing German pay-as-you go scheme.
The DESWF would of course carry the investment risk, including the exchange rate risk, but its ability to deploy large amounts of funds globally with a long-term investment horizon would put it into a better position to handle these risks than individual investors or private financial institutions (such as banks or insurance companies). The latter either pass the exchange rate risk on to their customers or, if they cannot do this, avoid it because of regulatory requirements or in order to save equity capital that would be needed as risk buffer. For example, German insurance companies, which manage of about €1,200 billion of mostly long term assets (equivalent to about one half of German GDP) have invested only about 5% of these funds outside the Eurozone.
Eventually, the enlargement of cross-border capital flows and their concentration on Eurozone countries brought about by the euro will have to be unwound. Only when these flows reflect long-term viable investment opportunities will they no longer constitute a danger for the stability of the euro.
This requires a shrinking of current account deficits as well as surpluses of EZ countries. However, in view of the structural savings surpluses of some EZ member countries, intra-area current account adjustment alone will probably not be enough. What is also required is a redirection of the current account surpluses to countries outside the Eurozone. If the private sector is unable to do this because of its reluctance to assume exchange rate risk, the public sector may have to help. In any case, an increased demand for foreign assets will lower the exchange rate of the euro, which will facilitate efforts by the deficit countries to overcome recession by an expansion of exports.
One might of course object to our proposal that it presents a typical 'Germanic' mercantilist view which transfers the burden of adjustment to the rest of the world. But under the current circumstances one has to choose the lesser evil: a strong euro combined with ever-increasing internal tensions which threaten global financial stability, or a weaker euro without the internal tensions. We believe that the global economy will be better off under the second scenario.