Euroland, the TARGET system and the potential challenges for creditor nations

The official literature states that Euroland’s TARGET2 had been set up as a ‘settlement system’ for cross border transactions within Euroland by the member banking system and it was suggested that it was in effect a copy of the US’s Fedwire System whereby if (for example) the Richmond Fed runs a balance of payments deficit with the San Francisco Fed, then the Richmond Fed will end up with a debit balance in Fedwire with respect to San Francisco. Then, at the end of the financial year, the various debit and credit balances of the various Fed Districts are calculated and settlement then takes place, with the debtors discharging their debts through the use of gold certificates (i.e. claims on the gold reserves in Fort Knox).

On this basis, the US is internally still on something of a gold standard and it is certainly true that if a particular district of the Federal Reserve runs deficits, money will leave the area in question, it will not be replaced (i.e. the local banking system will lose deposits and hence some of its intrinsic ability to create new credit) and there will be a tendency for the region in deficit to deflate. Meanwhile, in the surplus districts, money enters the banking system, and there is therefore a tendency for inflation in that area, often evidenced by what happens to property prices and wages. The system involves both inflation in the creditors and deflationary forces in the debtors, thereby implying that the burden of adjustment is shared. Fedwire, perhaps as a result of its history, still works very much as though it were an old style fixed exchange rate/gold standard system and the fact that there’s settlement at the end of the fiscal year means that any district’s debit or credit balances do not become overly large.

When TARGET2 was set up, it too was explicitly designed to accommodate modest balances, but one very important way in which TARGET2 differs from Fedwire is that there is no settlement date and hence large balances can accumulate within the system, and so they have. In effect, with no scale or time limit, deficit countries are in theory never called to account with funds lost through balance of payments deficits in theory automatically replaced by lending flows from the surplus countries. Hence there is no pressure for monetary deflation in deficit countries. Meanwhile, surplus countries are systematically obliged to expand their central banks’ balance sheets by constantly acquiring claims on the deficit countries on the asset side of their balance sheets, while creating (excess) reserve deposits for their own banking on the liabilities side.

Looking back, as a result of the not unrelated timing of EMU in relation to German reunification, Germany joined the Euro with an exchange rate that was perhaps 20% too high (the Bundesbank’s contemporary estimate). This overvaluation of the “German Euro” implied that it was Germany that experienced a tendency towards balance of payments deficits and borrowing through the TARGET system but crucially Germany was not expected, and indeed did not deflate. Despite talk that Germany deflated its way back to competiveness in the late 1990s does not square with the observation that wages did not fall in any quarter during the period. What did happen was that the then competitive parts of Euroland, the PIGS, inflated and the ‘inflationary Euro’ sank like a stone on the foreign exchanges. Germany’s weakness was therefore accommodated by the Euro System with the result that the Euro exhibited a tendency to high background inflation, and currency weakness. However, by 2003-5, inflation in the PIGS had rendered them uncompetitive, and in theory Germany should then have been the country facing inflationary pressure. However Germany did not experience heightened inflation given the timing of the global financial crisis, which impaired capital adequacy of the German banks and the desire to extend credit, the long term trend in German demographics (aging populations tend to be relatively bad at generating inflation), ongoing weakness in world trade, and the Fed’s monetary policy regime, despite building up excess reserves in its banking system.

Some inflationary pressures have emerged in Germany such as parts of the housing market, and there has been some wage inflation, but Germany does not just need higher unit labour cost inflation than the PIGS to close the competitiveness gap – it needs perhaps inflation of 400–500bp above the periphery and so far it’s fallen well short of that. In consequence, although there is an inflation-biased adjustment mechanism implicit within the design of the TARGET2, it hasn’t functioned that way. Deficit countries have witnessed large ‘supportive’ inflows from the TARGET2 system, so deflationary pressures have been countered but the inflation that was supposed to have occurred in Germany has simply not been sufficient. Hence, the balance of payments deficits in the PIGS, and the surpluses in the core countries, have remained unresolved and the accumulated balances continue to expand.

Over recent months, general awareness of the existence of the TARGET system has increased and commentators have tended to follow the official EU line that TARGET will by design always cover a deficit country’s needs, but TARGET was never designed to cover, and certainly not ‘sold’ to its participants as a system that would cover, countries such as Spain running balance of payments deficits that are now in excess of 30% of their GDP, and heading higher. Indeed, Spain has suffered a BoP deficit of more than €300bn over the last year and Italy is not far behind at almost €200bn. Portugal and Greece have each suffered BoP Crises. Much more positively Ireland has achieved surpluses over the last 12 months, although it still owes a substantial net amount to its TARGET system creditors.

The TARGET system aggregate balances total almost €2tn. These are magnitudes which the system was not designed to cover, and Germany’s €600bn (as of July) positive balance in the system leaves the Bundesbank unhappy, and there is now a concern in Germany over the long term monetary impact of, and the contingent liabilities connected with, the huge build up in claims on the TARGET system despite the ECB and others’ attempts to avoid this debate. To put this in context, Germany’s net positive balance in the TARGET system is the equivalent of around 20% of its GDP, and there is a potential contingent liability for the government of at least €200-300bn (so 10% of GDP) in the event of Euro failure and default by any or all deficit countries. Meanwhile, the build up in TARGET balances at the Bundesbank has also contributed to the creation of the equivalent of 50% of domestic GDP is excess reserves in the German banking system. Thus far, these excess reserves have not resulted in a meaningful pick up in credit growth within Germany but were the banks ever to feel more optimistic and their capital adequacy ratios improve, then such reserves could represent a huge potential inflationary overhang for Germany. However, in proportion to its GDP, Germany is not the most ‘at risk’ from the build up of positive TARGET system. Luxembourg has claims on the TARGET system equivalent to over 120% of its annual GDP while Finland, at nearly 50%, of its GDP is also very exposed to the system.

If the Euro does not break, the build up in TARGET balances could ultimately create a wave of inflation in Finland, Luxembourg and perhaps even Germany at some point. But, if the Euro fails and the debtors default, then the governments of these countries could find their public debt ratios leapfrogging even those of some of the embattled PIGS.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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The Local Authority Treasurers’ Investment Forum September 25th, 2012, London Stock Exchange