The accumulation of TARGET2 balances (claims and liabilities) has two possible sources, current account imbalances and capital flows (Buiter et al. 2011). Thus, Germany’s accumulated TARGET2 claims of approximately €800 billion must be the result of a combination of current account surpluses and capital inflows. This is a matter of definition.
Disagreement arises from the nature of the risk that these TARGET2 claims imply for Germany (Sinn 2012, De Grauwe and Ji 2012). Let me discuss this risk by first concentrating on the German current accounts and then on capital inflows.
The German current account surpluses
Figure 1 shows the current account surpluses of Germany against the rest of the Eurozone (the data are collected by the Bundesbank). We observe that since the start of the Eurozone, a large build-up of German current account surpluses occurs. This coincided with the bubble years in peripheral Eurozone countries (2003-07). The effect of this is that Germany accumulated large net claims on Eurozone countries, which at the end of 2011 amounted to €634 billion.
Figure 1 Current account, Germany vis-a-vis the Eurozone
Source: Deutsche Bundesbank, Zeitreihe BBK01.EC1804: Saldo der Leistungsbilanz / EWU-Mitgliedsldr.
These current account surpluses did not lead to TARGET2 claims during the bubble years because the counterpart of these surpluses were increasing claims held by (mainly) German banks against the other Eurozone countries.
- Somewhat like a car company that lends consumers the money to buy their cars, the German banking system was lending the money to other Eurozone countries to allow them to buy surplus German products – a highly risky affair.
In the parlance of balance of payment statistics the current account surpluses were offset by capital outflows of equal magnitude. As a result, TARGET2 balances did not move.
- This created the illusion that no risk was involved; in fact the risks were increasing every year.
The build-up of net foreign claims (loans) that were the counterparts of increasing current account surpluses created a huge risk for Germany. It should have been obvious that the debtor countries could get into payment difficulties as they were piling up debt made possible by the loans of German banks. Yet the TARGET2 claims were not moving during these years, hiding the significant increase in risk exposure of Germany.
Put somewhat differently: The net foreign claims that Germany was building up could only occur because of past current account surpluses. There is no other way a country can accumulate net foreign claims than by having current account surpluses. This also implies that these net foreign claims have not been affected by the recent surge of TARGET2 claims of Germany. If there is a breakup of the Eurozone, Germany will face the risk that some debtor countries default on their debt. But again this risk is not affected by the size of the TARGET2 claims of Germany.
Risks Germany faces
The risk that Germany faces as a result of its net exposure to other Eurozone countries is therefore entirely of the country’s own making. It is the result of Germany’s preference for current account surpluses, and thus under its control.
Hans-Werner Sinn makes the point that had the ECB not been as liberal in providing financial assistance to peripheral Eurozone countries, the latter would have had lower deficits and thus Germany lower surpluses (Sinn 2012). But this effect must be small. Here are some numbers.
- Since the start of the Eurozone, Germany accumulated €665 billion of current account surpluses against the rest of the Eurozone.
- Only €127 billion was accumulated since the end of 2009 when the TARGET2 balances started to surge.
The largest part of these net foreign claims was built up prior to the debt crisis.
- Surely it must have been Germany’s choice to accumulate these balances.
We guess that Hans-Werner Sinn will not want to contend that peripheral countries and the ECB somehow coerced Germany into accumulating current account surpluses prior to the debt crisis.
TARGET2 flows and current account imbalances
Sinn (2012) asserts that TARGET2 “helped maintain and prolong structural current account deficits” of peripheral countries. The facts are that since the surge in TARGET2 balances, these current account deficits, which are the counterpart of the large German current account surpluses, have declined dramatically. Figure 1 shows the facts.
- Since 2009, when the TARGET2 balances started to take off, current account deficits of the peripheral countries as a whole declined from 9.1% of their GDP to 4.5%.
- These declines were mainly due to deep recessions in these countries.
Sinn (2012) argues that these deficits would have had to decline even faster had there been no financing through the TARGET2 mechanism. This is certainly true. But this is the same as saying that these countries should have pushed their economies into even deeper recessions.
Capital flows explain most of the surge
The main reason why German TARGET2 claims have increased so much since 2010 is capital flows. The flows have taken two forms.
- The first one came about when German banks unloaded their loans made to peripheral countries into the balance sheet of the Bundesbank.
- The second one was the result of non-residents shifting their deposits from their local banks into the German banking system out of fear of a breakup of the Eurozone.
Let us discuss these two forms of capital flows from the perspective of how these have changed the risk of a breakup of the Eurozone for Germany.
Breakdown of the EZ interbank market
As a result of a breakdown in confidence, the Eurozone interbank market has ceased to function since about 2010. This led German banks to stop their credit lines to southern banks (and other northern EZ banks followed). As a result, German banks shifted the credit risk on their balance sheets into the balance sheet of the Bundesbank.
But does this constitute a fundamental increase in the risk that Germany as a whole faces in the case of a Eurozone breakup? The answer is negative.
- To see this, suppose German banks had kept their claims against peripheral banks on their balance sheets instead of shifting them to the Bundesbank.
- Assume now the scenario of a breakup of the Eurozone, which leads to large loan losses of the German banks due to peripheral-debtor defaults.
- Given the size of these losses, the chances are that a number of banks would have to turn to the German government to bail them out.
And surely the German government would not hesitate to do so.
Thus in the scenario of a breakup, with or without TARGET2 claims, the risk of large losses for the German taxpayer is very similar. Germany has exposed itself to large risks by reckless lending by its banks to peripheral countries. And thus the German taxpayer will pay for this if a breakup occurs independently of the TARGET2 system. The risk is there, but not due to TARGET2.
Speculative capital flows
The second type of capital flows arises when non-residents transfer deposits from their domestic banks into the German banking system, out of fear of a possible breakdown of the Eurozone.
- Up to now this has been a relatively marginal phenomenon, as can be seen from the fact that there has been no significant increase in bank deposits in the German banking system since 2010.
It could, however, become important in the run-up to a breakup of the Eurozone. But then, as we argued in De Grauwe and Ji (2012), the Bundesbank can eliminate the risk of such last minute accumulations of TARGET2 balances by converting euros into new German marks only for German residents.
- We have argued that the breakup risk, if it exists, is entirely of Germany’s own making.
- Germany has followed a conscious policy of accumulation of current account surpluses vis-à-vis the rest of the Eurozone, especially during the period before the debt crisis.
- Inevitably this leads to a risk, as the counterpart of the current account surpluses was an accumulation of claims vis-à-vis the Eurozone.
- We have argued that if a breakup were to materialise, this will lead to losses for Germany, independently of the existence of TARGET2.
- Germany could have avoided this by reducing its current account surpluses; it refused to do so and thus the responsibility for this risk is Germany’s, and not some obscure system like TARGET2.
Before the debt crisis, German banks had been willing to lend massive amounts to the rest of the Eurozone. Since the breakdown of the interbank market in the Eurozone, this risk has been shifted to the Bundesbank. We have argued that this shift has not affected the risk for Germany as a whole. With or without TARGET2, the risk that arises from reckless lending by German banks will have to be borne by Germany. Again, it is all too easy to look for a scapegoat outside of Germany.
Put differently, we maintain our conclusion arrived at in De Grauwe and Ji (2012) that the accumulation of TARGET2 claims by Germany has not added to the risks Germany faces in the case of a breakup of the Eurozone. The TARGET2 claims of Germany have not created a new risk in addition to pre-existing ones. The TARGET2 claims are just a repackaging of risks that Germany took by accumulating large current account surpluses and by the fact that, prior to the debt crisis, German banks were willing to lend vast amounts of money to peripheral countries without doing a proper credit risk analysis. No-one other than Germany itself is responsible for taking on these risks.
Buiter, W, E Rahbari and J Michels (2011), “Making sense of TARGET imbalances”, VoxEU.org, 6 September.
De Grauwe, P., and Ji, Y., (2012), “What Germany should fear most is its own fear”, VoxEU.org, 18 September.
Sinn, H,-W., (2012), “TARGET Losses in case of a euro breakup”, VoxEU.org, 22 October.