By Jim Allen, CFA
I hadn’t been paying particularly close attention to more than high-level issues related to the euro crisis of late. That was until a couple of articles caught my eye on the capital flows between member states and the headaches and fissures they are creating within the eurozone.
To give an update to others who may have had a similarly high-level interest in this ongoing crisis, I have collected an anthology of different media articles from recent weeks. The best summary is here in a blog post from Andrew Stuttaford at National Review Online who tracks the story across Europe, beginning with this article by Nick Malkoutzis in the Greek publication, ekathimerini.com. Malkoutzis explains how the system works and, in the process, gives a good primer on the latest in euro acronyms, starting with LTRO (longer-term refinancing operations); ELA (emergency liquidity assistance); and Target2 (a central payment system).
Malkoutzis reports on how the ELA and Target2 create risk:
’When a depositor in a peripheral economy moves their funds to a bank in another eurozone [sic] country, the payment is processed through the eurozone’s settlement system, creating a claim between the national central bank of the peripheral lender and the rest of the Eurosystem,’ explains Neil Unmack of Reuters.
The specifics are unique to Europe, but the flows are not unprecedented. It used to occur within the United States to meet seasonal credit requirements for different regions. Indeed, the creation of the 12 regional Federal Reserve banks after the panic of 1907 was intended to support these inter-regional flows. These days, the Fedwire helps mitigate regional imbalances from getting too large by requiring regular settlement.
As Bloomberg reported here on 12 April, the flows are unprecedented in the era of the euro. They have grown recently as investors’ and savers’ euros have been fleeing Spain and Italy for relatively secure banks in Germany, Luxembourg, and the Netherlands (though the fall of the Dutch government a week ago may affect flows there). Bloomberg estimates that as much as 335 billion euros had sought refuge in these safe-haven countries in the past seven months — twice the amount that sought refuge in the prior 17 months combined.
The problem for the safe havens is that Target2 doesn’t require regular settlement the way that the U.S. Fedwire does. Consequently, the balances moving south to north in Europe had grown to as much as 789 billion euros in mid-April, according to a Bloomberg estimate. These balances reflect loans from the safe-haven central banks to the central banks of troubled countries. These loans are, in effect, supported by the taxpayers in the safe havens which, as Ambrose Evans-Pritchard of the Daily Telegraph reports, is causing political angst in Germany.
It looks debilitating and potentially troubling, but as Mr. Evans-Pritchard notes in an earlier blog post, it may end in a whimper:
If [European Monetary Union] holds together, the credits are just an accounting detail. Any loses would be divided between the family of central banks, so even a Greek exit could be managed.
But if Germany leaves, those claims would be difficult to enforce, or even unenforceable. The German taxpayer would face very large losses. Ergo, the longer this goes on, the longer the Target2 imbalances build up, the harder it is for Germany to extract itself from the euro.
As one German banker told me, Target2 is the ring through Germany’s nose. It ropes the cash cow.
Is it all that simple, or is this a looming systemic issue? We welcome comments from readers on how this is likely to play out, and what that means for monetary union and global capital flows.