Last week, Martin Wolf drew international attention to the work of Professor Sinn of the German IFO Institute, who has made a series of alarming claims about the build-up of Target2 imbalances within the European System of Central Banks. Professor Sinn focused on the fact that the Bundesbank is now in credit to other European central banks to the tune of €325bn, with the offsetting debits being held by the central banks of troubled peripheral economies (which Professor Sinn calls the GIPS, an acronym which I prefer to the PIGS).
Sinn also claimed that the provision of German credit to the GIPS had effectively sucked lending capability out of the German banks, thus holding back the German economic recovery. This has triggered an intense debate about whether Germany is at risk from the potential failure of these debts, and whether the ECB has engaged in a “stealth bailout” of the GIPS. (For latecomers to the debate, see Paul Krugman, Tracy Alloway, Olaf Storbeck and Geoffrey Smith.)
Professor Sinn is partly right and partly wrong. Here’s why.
The Target2 imbalances have occurred because payments made by the banks of the GIPS, primarily to Germany, have exceeded payments going in the other direction since 2007. Why has this happened? First, because the GIPS as a bloc have been running current account deficits with Germany and have been paying money into German banks in exchange for German goods. Second, because customers of banks in the GIPS have lost confidence in the peripheral economies, and have shifted deposits into Germany. And, third, because German banks have withdrawn their short term lending to the GIPS, and have brought the money home.
Prior to the crisis, the current account deficits of the GIPS were funded largely by the banking sectors of Germany and France via short term capital flows; since the crisis, the current accounts of the GIPS have stayed in deficit, but the short term capital flows have entirely reversed direction, leaving the GIPS to look elsewhere for funding.
This is where Professor Sinn has made a valid and valuable point. The only place where the GIPS have been able to find funding has been within the arcane activities of the ECB’s Target2 payment system. As money has flowed out of the commercial banks in the GIPS, their central banks have been obliged to go into the red at Target2. Meanwhile, as money has flowed into the German commercial banks, the Bundesbank has acquired credits in Target2. Consequently – and this is an absolutely key point – the activities of the ECB have provided the net capital flows which have allowed large scale balance of payments imbalances within the EMU area to persist.
Professor Sinn claims that these flows have been equivalent to direct loans from the Buba to the GIPS central banks. This claim is clearly wrong. In fact, the Buba has claims on the ECB system as a whole, not on individual national central banks. And these debts are collateralised by holdings of government bonds issued by the GIPS.
Still, Germany could still be liable for a large share of any ultimate defaults by the GIPS. They have a share of about 30 per cent in the capital of the ECB, and could not be confident that any of the heavily indebted countries would pick up their share of the costs if any one of them defaulted. It is easily possible to imagine that Germany could be forced to pay about 40 per cent of the eventual losses if there were national defaults by the GIPS.
Separately, Professor Sinn claims that the provision of credit within Germany could be curtailed because the Buba is in effect lending central bank money to the GIPS. This is very far fetched. There is no restriction on the availability of central bank liquidity by the ECB to Germany or any other economy at present. And anyway the German banks have more than enough cash, much of it flowing in directly from the GIPS. That is why there are no signs whatsoever of any credit crunch within Germany today.
Despite these shortcomings, Professor Sinn’s writings have highlighted one very important point which I at least had not appreciated until now. The central banks within the EMU zone have in fact been operating in a way which is remarkably similar to what would have happened if they had still been operating an old-fashioned fixed exchange rate regime such as the ERM. But because their activities have been conducted in a single currency, they have been far more readily disguised than they would have been in the old days, and have therefore been politically much easier to sustain.
If the 2008 crisis had occurred under the ERM, there would have been immediate downward pressure on the GIPS currencies, and upward pressure on the deutschemark. Initially, this would have led to foreign exchange intervention to hold the ERM together. The foreign exchange reserves of the Buba would have risen, while the reserves in the GIPS would have fallen. This would have led to rising claims held by the Buba on the GIPS, but they would have been denominated in the weakening national currencies of the GIPS, which would rapidly have become unacceptable to the German public. And, meanwhile, the GIPS central banks would have run out of DM in their reserves, so they could not have continued to support the existing exchange rates.
Much the same thing has happened under EMU, except that all of these activities have been denominated in euros, which do not carry direct foreign exchange risk. (Not, that is, unless and until the euro actually breaks up, and devalued national currencies are restored.) But markets have found other ways of speculating against countries like Greece and Ireland, and central bankers have been forced to step in to provide the supporting capital flows which the private sector has not been willing to contemplate.
The key difference is that the process has lasted much longer, with a much bigger build-up of cross-border debt, than would have occurred under the ERM. And that brings with it the risk of a much bigger blow-up at the end of the day.
