Euroland update part 2: Bundesbank balance sheet 30% of GDP

Whilst the ECB’s long-term refinancing operation (LTRO) has saved the banks and supported the periphery, we ought to wonder what the eventual recipients of these LTRO funds in the private sector will ultimately do with these monies.

Thus, when the government spends the proceeds of its LTRO-financed bond issues, the money will be passed to the private sector and ultimately end up in the hands of someone who must choose to spend or save, and if save, where to deposit the funds. On the savings front, presumably, they will not want to hold them in the banking system of an economy that not only has a dubious asset quality but also a continuing devaluation risk (with grass roots politics clearly hostile to the strictures of the Euroland system. We may suspect that the LTRO funds, which are implicitly boosting liquidity in Spain and elsewhere, will tend to find their way out of the country and into the German banking system, thereby worsening the balance of payments imbalance between the core and the periphery.

We might go on to assume that this will tend to put more pressure on the TARGET2 system and on the Bundesbank in particular.

Quite simply, if more liquidity is added to countries with existing weak balance of payments positions, we should expect their Balance of Payments positions to deteriorate further as this liquidity leaks out. This will presumably imply that the Bundesbank will have to lend even more to deficit countries.

Of course, if the Bundesbank does this, the system can function but this implies that in effect the Euroland banking system will have ‘collapsed’ onto the Bundesbank’s balance sheet. The German banks will find their claims (i.e. their assets) on the Bundesbank increasing, while the periphery will find that the Bundesbank implicitly accounts for a large part of their liabilities as the TARGET loans are recycled by their central banks into the LTROs. Providing Germany is prepared to allow this situation, in which the Bundesbank becomes the banker and lender to all of Europe, the system can be sustained. But whilst it may be sustainable for now, it cannot reasonably be seen to be rational or optimal.

It looks as if the German Bundesbank’s balance sheet is now the equivalent of 30% of GDP. This ratio is not likely to have been seen since the mid 1940s or perhaps even the days of the Weimar Republic. Intriguingly, despite this implied dramatic expansion of liquidity in Germany, German credit growth remains moribund as a result of the banks’ capital adequacy problems and the population’s long running credit aversion.

In time the banks’ capital constraints may ease and credit growth might conceivably revive but this is unlikely to occur in the next year or two. Inflation in Germany therefore seems a long way off and therefore unlikely to resolve the periphery’s competitiveness problems. Consequently, it would seem that the Euro’s underlying imbalances are getting worse rather than better but the ECB and Mr Draghi have succeeded in papering over the cracks in the system through the use of the LTROs and TARGET system, albeit at the expense of the Bundesbank.

We can therefore discern two immediate losers of the ongoing commitment to keep the Euroland project on the road: the Bundesbank and the people of the Euroland periphery.

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