Recently, I published an article detailing the case for shorting German bunds. One of the reasons cited in the article for being pessimistic about the prospects for a continuation of the rally in German debt is the fact that, one way or another, Germany will likely be forced to make concessions on some iteration of a burden-sharing plan (whether it's dubbed 'Eurobonds' or something different, it will be the same in spirit). Indeed, last week's EU Summit witnessed the first instance of Germany 'blinking' in the history of its staring contest with France, Italy and Spain.
What some people undoubtedly do not realize, however, is that Germany is already 'sharing the wealth' in a rather spectacular fashion via its TARGET2 credit with the ECB, which currently stands at around 700 billion euros. If you are unfamiliar with TARGET2, it stands for Trans-European Automated Real-time Gross Settlement Express Transfer System and it essentially makes the ECB the clearing house for cross-border transactions in the Eurozone.
Over the course of the crisis, Germany has seen its TARGET2 credit with the ECB increase by well over 200%. Some analysts argue that this imbalance is inconsequential, as it would only represent a loss to Germany if a debtor country exited the EU and defaulted on its debt to the ECB. Even then, the loss would be spread across member countries, mitigating the effect on Germany. However, there are two main reasons why the growing TARGET2 imbalance is a big deal. First, it says something important about periphery nations' ability to borrow and the way in which they are financing their current account deficits. Second, in the event that either a debtor country leaves the union or the union splits up entirely, Germany could struggle to keep inflation under control.
Before discussing these issues, it is important to set the stage by describing how the system works. Consider the following two scenarios. The first outlines the way the system works normally, while the second outlines how the system works during a debt crisis. Both scenarios are simplified for the purpose of illustration.
A Spanish company gets a loan from a Spanish bank in order to purchase a product from a German company. The Spanish company's bank account is debited for the purchase price by the Bank of Spain, and the Bank of Spain receives a TARGET2 debit for the purchase price from the ECB, which then registers a TARGET2 credit in the same amount for the Bundesbank (Germany's central bank). The Bundesbank then credits the German company's bank for the purchase price. Note here that a TARGET2 imbalance now exists: the Bundesbank has a credit with the ECB, the Bank of Spain has a debit.
Now in order to finance the original loan it made to the Spanish company, the Spanish bank issues a bond which the German company's bank agrees to buy. The German company's bank is debited by the Bundesbank for the amount of the bond purchase, the ECB registers a TARGET2 debit for the Bundesbank and a TARGET2 credit for the Bank of Spain, and the Bank of Spain credits the original Spanish bank. The results of this whole transaction are: an import for Spain (via the purchase of the German product), the private market financing of that import by the German bank (through the bond purchase), and offsetting TARGET2 credits and debits with the Bank of Spain and the Bundesbank (no TAGET2 imbalance).
The first leg of the transaction is the same: a Spanish company gets a loan from a Spanish bank to buy a German product, the Spanish company's bank is debited by the Bank of Spain, the ECB records a TARGET2 debit for the Bank of Spain and a TARGET2 credit for the Bundesbank, and the Bundesbank credits the German company's bank. In the crisis environment, however, the German bank is unwilling to use the new deposits from the purchase of the German product to buy the Spanish bank's bond--the crisis has suppressed risk appetite. Exacerbating the situation is the fact that, in an effort to preserve capital, the Spanish bank's depositors are withdrawing their money, so the bank cannot use deposits to finance its loans (the deposits have probably gone to German banks, but we'll leave that aside for now). The only option left for the Spanish bank in terms of financing its lending operations is to pledge the original loan to the Bank of Spain as collateral for cash.
Notice here however that, in contrast to the normal scenario, there has been no movement of funds from Germany to Spain (the German bank doesn't want to buy the Spanish bank's debt), therefore, there has been no offsetting TARGET2 transaction, and the imbalance that resulted from the Spanish company's purchase of the German product remains. The key issue here is that in the crisis scenario, the Bank of Spain is forced to monetize the original loan, and in the process, the burden of financing Spain's imports shifts from the German private sector (via the German bank's purchase of the Spanish bank's bond) to the public sector (via the TARGET2 credit owed to the Bundesbank). In short: the Bundesbank is now financing the Spanish trade deficit, or as Goldman Sachs puts it
TARGET2 imbalances reflect peripheral countries' continuing need for external financing and are therefore complementary to the persistent large current account deficits seen in the periphery.
In particular, as German banks (the private sector) have ceased lending to the periphery, the Bundesbank has picked up the slack via TARGET2 credits with the ECB. Indeed,
...as far as the drying up of private funding sources for peripheral banks is concerned, there is evidence that German banks have significantly reduced their lending to peripheral banks. Given that it is the Bundesbank that has seen its net claims rising strongly against peripheral central banks, the reduced funding of German banks is simply the counterpart to the TARGET2 imbalances.
In other words, when the private sector reduces its exposure to the risk inherent in providing financing to the periphery, the public sector unwittingly compensates via TARGET2 imbalances. See "The ECB's Stealth Bailout" by Hans-Werner Sinn, professor of economics and public finance at the University of Munich for more on this.
Now leaving aside the fact that the inability of the periphery nations to finance their deficits in the private market is a rather large problem, there is an argument that these German claims on the Eurosystem don't really matter. For instance, Felix Salmon notes that should the EU fall apart,
Germany's banks, like Deutsche Bank, would see their Target2 balances redenominated from euros into Deutschmarks. And the Bundesbank would have a theoretical claim on the ECB, but at this point the ECB would barely exist. But that's fine, it could simply declare that all those euros were now Deutschmarks, since the Bundesbank can create as many Deutschmarks as it wants.
This analysis ignores the fact that something real has been lost in translation; since the Bundesbank never actually received payment from Spain (hence the Bundesbank's TARGET2 claim on the ECB), all those redenominated claims would not be backed by assets. The German banks are made whole, but what of the Bundesbank? Again, from Goldman Sachs:
The Bundesbank simply 'prints' the money it credits to the account of the German commercial bank[s].
This is all fine and good as long as the Bundesbank still has the TARGET2 claim on the ECB which is, in turn, guaranteed by the country which has an offsetting TARGET2 debit. But when the country on the other side of the equation leaves the EU and defaults on its debt to the ECB, then the Bundesbank is out of luck, and all those new Deutschmarks it just credited to the country's banks to make them whole vis-a-vis their TARGET2 claims have literally been created out of thin air. At the most basic level, a tangible product (a car, a stove, or whatever was imported to Spain from Germany) has left Germany, and upon the importing country's default, nothing whatsoever has returned to the country. Sure, the company who made the product is paid for the product, but with what exactly? The TARGET2 balance was never settled. The money in the German company's bank account was created out of thin air. In this scenario, wealth has unquestionably been destroyed, and fiat money simply created to replace it.
The next argument for why Germany's TARGET2 imbalance wouldn't matter if the EU split up is that, even if the Bundesbank suffered substantial losses on unpaid claims, it would not need to be recapitalized, as there are plenty of examples of central banks operating effectively with negative equity. Furthermore, if the technical accounting side of things did need to be fixed, that can be arranged. According to Karl Whelan, professor of economics at university college in Dublin,
...If German officials were concerned about the need for the Bundesbank's balance sheet to show assets greater than liabilities, then they could agree for the Bundesbank to write itself a cheque equal to the value of the TARGET2 credit and to top it up each year with interest...
I suspect some may suggest that a failure to fiscally recapitalize the Bundesbank would produce a currency that people will have no faith in and/or that this will result in inflation. However, this approach would do nothing to change the amount of money circulating in a post-EMU Germany. And a cheque tossed in an empty vault can't trigger hyperinflation.
Actually it can. Again we turn to Goldman:
Expectations about future price developments play a crucial role in the inflation process: if economic agents were to expect, for whatever reason, an increase in prices and adjust their economic decisions accordingly, expectations would become self-fulfilling. This is why central banks in general monitor inflation expectations carefully. [Furthermore] the credibility of a central bank also depends on its solvency. The Bundesbank's solvency would be questioned if the losses exceeded the net present value of its future income (seignorage).
This is an issue of perception, as even Mr. Whelan acknowledges in his article cited above. Invariably, the German public would find out that the Bundesbank just wrote itself a check to cover hundreds of billions in TARGET2 losses, and the bank's credibility would drop in lockstep with the rise in the public's expectation of an increase in prices.
Furthermore, consider that, at heart, the imbalances represent rising deposits at German banks (capital flight from the periphery to safe havens). Essentially, this means the amount of money in the German system is increasing faster than the German economy is expanding:
Whether these deposits would be inflationary or not would depend on several factors--not the least how quickly these deposits are spent. But it is clear that the greater the amount of deposits held by non-residents after the breakup, the greater the potential inflationary risk.
In sum then, the TARGET2 imbalances represent a serious problem for several reasons. First, they represent the periphery's inability to fund itself via traditional private sector avenues. Second, the imbalances represent the funding of the periphery's current account deficits by the public sector of the core countries (hence, the imbalances represent a quasi-bailout). Third, should the EU breakup, a TARGET2 imbalance the size of that which currently exists between Germany and the rest of the Eurozone could prove quite inflationary for the multiple reasons cited above. Investors would be wise to keep these things in mind when assessing the potential fallout from the partial or complete breakup of the EU. In such a scenario, the policies creditor countries decide to adopt regarding outstanding TARGET2 imbalances will play a key role in determining how effective the core countries are at managing a breakup.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.