Blog Post

Should we worry about Target2 imbalances? Why Central Bank negative equity does and doesn’t matter

Over the past few months Germany has become the safe haven of Europe. Depositors fearing a euro break-up have moved their deposits away from the periphery, realizing effective insurance. As a consequence, peripheral banks’ funding has shifted from private to public sources (see e.g. Pisany-Ferry and Merler). The Target2 imbalances that capture this have risen to unprecedented levels.

By: and Date: September 4, 2012 Topic: European Macroeconomics & Governance

Over the past few months Germany has become the safe haven of Europe. Depositors fearing a euro break-up have moved their deposits away from the periphery, realizing effective insurance. As a consequence, peripheral banks’ funding has shifted from private to public sources (see e.g. Pisany-Ferry and Merler). The Target2 imbalances that capture this have risen to unprecedented levels.

The question is whether these matter, especially in the case of a break-up of the eurozone. On the one hand, Hans Werner Sinn claims it does, big time as “Germany would lose $899 billion […] should Greece, Ireland, Italy, Portugal and Spain go bankrupt and repay nothing, while the euro survives”. On the other hand, Felix Salmon writes that there is no reason to worry about these potential losses as it basically boils down to an accounting loss for the Bundesbank since it could simply print new Deutschmarks. According to Salmon, As long as “German banks kept those Deutschmarks on deposit at the Bundesbank, and remained shy about lending them out to borrowers in other countries, the money supply in Germany wouldn’t actually increase at all” and there would be no inflationary consequences. To get a sense of what’s going on in this debate, it is useful to look at a stylized example.

A stylized example with two countries

Let’s consider an imaginary monetary union with two countries (called Germany and Greece for convenience) where households hold 100 euro of deposits, banks invest this money in assets, and capital flight has resulted in a 50 euro Target2 exposure.

The left-hand side depicts the situation before break-up. The starting point is the bottom of the diagram where one sees that Greek depositors have withdrawn half of their deposits from Greek banks and have placed them in German banks. The banks in ‘Germany’ therefore have 150 euro of liabilities, consisting of 100 euro deposits by German and 50 euro deposits by Greek households. In the absence of attractive investment opportunities (or afraid this money might be withdrawn unexpectedly), German banks deposit the Greek households’ 50 euro with the German Central Bank. The German Central Bank incurs a liability of 50 euro and gains an asset of 50 euro vis-à-vis the Eurosystem. The Greek bank, on the other hand, has assets worth 100 euro and only 50 euro in deposits. It needs to borrow 50 euro from its central bank. It can do so against collateral. Then the Greek central bank gains a collateralized asset with a book value of 50 euro and creates 50 euro, which is reflected by a liability of 50 euro vis-à-vis the Eurosystem.

Figure 1: Stylized example of capital flight

Note that in order to be allowed to borrow from the Eurosystem, a Greek bank has to provide collateral (ECB guidelines, p29). It is only when commercial banks default and the collateral posted turns out to be insufficient that central banks make a loss, a point made by Guntram Wolff on this blog. Borrowing from the Eurosystem is managed via its NCB, who is also responsible for assessing the quality of the collateral posted by the bank and holds it as well. And yes, collateral standards have been relaxed over the crisis and recently, some NCBs (those of Ireland, Spain, France, Italy, Cyprus, Austria and Portugal) have been authorized to accept lower quality – less liquid – collateral as a basis for these loans (see box 2 in the ECB’s February 2012 monthly bulletin). However, the fact that these loans are collateralized will reduce the probability and size of losses for central banks in a non break-up scenario.

The right-hand side illustrates the situation after the break-up, when Euros are converted to Drachmas and Marks, respectively. The risk originating from Greek banks that default on Eurosystem loans is now fully carried by the Greek central bank, which has loans outstanding and holds the collateral. At the same time, capital flight from the Greek financial system will intensify. Therefore, it seems reasonable to assume that the Greek central bank defaults on its liability vis-à-vis the Eurosystem and that the German central bank fully writes off its corresponding asset. As a result, the Greek central bank now has 50 euro of positive equity on its balance sheet, while the German central bank has negative equity of 50 euro.

Actual numbers

Of course, the German Central bank and other central bank including the Greek central banks have buffers against such events. How large are these buffers? This ECB document explains that they exist of equity capital, loss provisions, and revaluation reserves. Figure 1 gives an overview of these positions for a subset of EMU countries. The total buffer is approximately 470 billion euro. Compare this with the Target2 liabilities of the Eurosystem periphery in Table 1. Together their size is twice the size of the buffer. The vertical bar shows each member state’s total buffer size, while the horizontal blue line shows what the buffer size for each country would be if this aggregate buffer were distributed over countries according to their ECB capital share.  

Figure 2: NCBs buffer size

Source: National Central Banks’ 2011 annual accounts

Table 1: Target2 liabilities sizes in billion EUR

Country

Target2 liability

Spain

423

Italy

280

Greece

105

Ireland

103

Portugal

73

Total

984

Source: http://www.querschuesse.de/target2-salden/ (accessed 31/08/2012)

Negative equity in principle doesn’t matter

A central bank’s level of equity by itself is meaningless. Although the central bank may lose money, real consequences of these losses only arise if this affects e.g. inflation, investment, or (through the exchange rate) the value of foreign assets. In our stylized example, nothing real changes for Germany as long as Greek depositors keep their money with German banks and German banks keep their money with the central banks: investment doesn’t change and inflation isn’t affected. In this sense, Felix Salmon is right to argue that Target2 assets and liabilities are mere accounting conventions.

But the real world is not static. After a break-up and initial depreciation of the Drachme, Greek depositors may return to their Greek banks, or German banks may restart lending to Greek banks when health is restored to the Greek financial system. Both imply an appreciation of the Drachma and a depreciation of the German Mark; investors are selling German Marks to acquire Greek Drachmas. The cheaper German Mark will fuel the economy, driving up inflation. Alternatively, when Greek depositors keep their money in Germany, German banks may decide to invest these deposits. If they are invested in Germany, its economy may experience a credit boom, overheating the economy and increasing inflation.

Thus, in a dynamic world the Bundesbank will have to respond to increasing or decreasing inflation. It may, for example, want to increase interest rates to bring down inflation. If the Bundesbank retains its credibility and successfully manages inflation expectations, losses will be limited. The extent to which losses occur therefore depends on the credibility of the German central bank’s monetary policy.

And central bank policy can in principle be perfectly credible with negative equity. Incurring a loss of 50 DM of negative equity is the equivalent of creating 50 DM of central bank money. Both have no backing whatsoever: whether the central bank has 50 DM of liabilities or pushes the button and creates 50 DM of assets and annihilates the negative equity is immaterial, as Karl Whelan argues here. Chili and Czech Republic, which are currently running credible monetary policy with negative equity positions, demonstrate this.

Or does it?

Of course there is the issue of central bank dividend payments foregone by the government. In the years following the break-up the German central bank may want to use its profits to regain positive equity value. These are of the order of a few billion euro, 2011 it was 2.2 billion, for example. Although these are indeed real losses, this number is several orders of magnitude smaller than the 1000 billion euro loss others are talking about.

More importantly, however, central banks themselves claim that negative equity may impact a central bank’s willingness to act. This is a self-fulfilling prophecy: if central bankers are unwilling to take on negative equity, it will impact their behavior and then, yes, negative equity does induce losses. For example, the Bundesbank might ask the German government to recapitalize it, which would result in increasing taxes. And it gets even more complicated. It is the expectation of future central bank policies that matters for the inflation rate. If firms and consumers believe central banks are unwilling to take on negative equity (even though they are), central bank policy may lose its credibility.

Thus, if central bankers believe, or the public believes that central bankers believe, that a negative equity position of the central bank leads to a change in monetary policy, real consequences materialize and central bank equity matters. In that sense, Sinn has a point in claiming that Target2 assets and liabilities will lead to losses in case of a break-up. But this is more complex than simply taking the Target 2 imbalances and equating those to a loss. In particular, a onetime shock beyond control of an otherwise credible central bank is something completely different from a central bank that consistently creates too much money. Why should consumers believe that the German Central Bank has suddenly changed its anti-inflationary policies?  In the end, whether or not Target 2 imbalances lead to losses if a currency union breaks down is largely the German Central bank’s own business.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Live Event

Mar
26
12:30

Spitzenkandidaten series: Yanis Varoufakis

The first event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Maria Demertzis, Martin Sandbu and Yanis Varoufakis Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
2
12:30

Spitzenkandidaten series: Bas Eickhout

The second event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Bas Eickhout, Guntram B. Wolff and Rochelle Toplensky Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
3
12:30

Spitzenkandidaten series: ALDE

The third event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
4
08:30

Spitzenkandidaten series: Jan Zahradil

The fourth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Jim Brunsden, Maria Demertzis and Jan Zahradil Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
9
12:30

Spitzenkandidaten series: Manfred Weber

The fifth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Anne-Sylvaine Chassany, Manfred Weber and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

The shadow of Brexit: Guessing the economic damage to the UK

Under a set of assumptions, this post concludes that UK real income and investment would have been 4% and 6% larger respectively had it not been for the shock of the Brexit referendum result. With somewhat audacious assumptions, the damages already incurred can be scaled up to guess the negative macroeconomic consequence of each of the three possible Brexit outcomes: no-deal, deal or no Brexit.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: March 21, 2019
Read about event More on this topic

Upcoming Event

Apr
11
12:00

Spitzenkandidaten series: Frans Timmermans

The sixth event in the The Road to Europe - Brussels Briefing Live: Spitzenkandidaten series. The series features the lead candidates for the European Elections of six parties and is jointly organised by Bruegel and the Financial Times in March and April 2019.

Speakers: Frans Timmermans and André Sapir Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
11
12:30

Can the euro area weather the next crisis?

Is the euro area strong enough to make it through another crisis? What reforms are still needed. Klaus Regling will join us for this roundtable event in Washington DC to discuss these questions.

Speakers: Masood Ahmed, Klaus Regling, Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: 2055 L Street NW, Washington DC 20036
Read article More on this topic

Blog Post

Talking about Europe: Le Monde 1944-2018

An ongoing research project is seeking to quantify and analyse national printed media discourses about Europe over the decades since the end of the second world war. A first snapshot screened more than 2.8 million articles in Le Monde, out of which 750,000 speak about “Europe”.

By: Enrico Bergamini, Emmanuel Mourlon-Druol, Francesco Papadia and Giuseppe Porcaro Topic: European Macroeconomics & Governance Date: March 20, 2019
Read article More by this author

Opinion

New EU industrial policy can only succeed with focus on completion of single market and public procurement

France and Germany recently unveiled a manifesto for a European industrial policy fit for the 21st century, sparking a lively debate across the continent. The fundamental idea underpinning the manifesto is a good one: Europe does need an industrial policy to ensure that EU companies remain highly competitive globally, notwithstanding strong competition from China and other big players. However, the Franco-German priorities are unsuitable for the pursuit of this goal.

By: Simone Tagliapietra Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: March 18, 2019
Read article Download PDF More on this topic

Policy Contribution

The European Union’s response to the trade crisis

The global trading system is under attack on various fronts. In this Policy Contribution, the authors examine the root causes of the current problems, develop good and bad scenarios for what could happen next, and provide recommendations for how the EU should respond.

By: Uri Dadush and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 14, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The case for a legislative remedy for recessions

Bruegel's Maria Demertzis welcomes Yale Law School professor Yair Listokin to this Director's Cut of 'The Sound of Economics', to discuss how law might be deployed as a macroeconomic tool to counter financial crisis.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: March 12, 2019
Load more posts