Friday, September 13, 2013

The Bundesbank's Target2 Exposures Are Manageable

AEP at the Telegraph has a thought-provoking column about the implications of eurozone exit for the Bundesbank’s (BB) balance sheet. The concern is that, when the peripheral central banks leave the eurozone, they will default on their outstanding balances to the Eurosystem, which are called Target2 Balances. The big Target2 debtors  are the Bank of Italy and the Bank of Spain. The ECB has compensated for the withdrawal of deposits from the Club Med banks by extending ~700B* of credit to the peripheral central banks, financed mainly by the BB.

An illustrative example: Barclay’s risk committee decides move to its euro clearing accounts from Santander to Deutsche (or from its Madrid branch to its Frankfurt branch). Santander borrows the money it owes to Barclay’s from the Bank of Spain, which in turn borrows from the BB. The BB then sells securities (Bunds) to German banks to fund its new loan to the Bank of Spain.  Two weeks later, Spain exits the eurozone, redenominates all of its financial liabilities into New Pesetas (including Target2 and its own bonds), and the Bank of Spain defaults on its loans from the BB. This makes the BB insolvent (on whose balance sheet these loans are booked), thus requiring a bailout from the hapless German taxpayer**. That’s the “crisis scenario”.

But I don’t think that the situation is really so dire. First of all, I believe that the BB’s exposure is to the eurosystem as a whole, and not to the Bank of Spain. So the default causes a solvency problem for the ESCB, not the BB. The ESCB is rendered insolvent, and would require a bailout from its owners (mainly, Germany). Minor difference, but a difference.

[Nomenclature alert: The ECB = the Federal Reserve Board; the European System of Central Banks = the Federal Reserve System; the Bundesbank = the NY Fed, which has the bulk of the system’s assets and liabilities on its balance sheet. Neither the FRB nor the ECB has a balance sheet. They are the boards of directors for their systems, which are made up of regional central banks. Most of the business conducted by the FRB and the ECB is handled by their “lead” banks, the NY Fed and the Bundesbank. The terms “the Fed” and “the ECB” are merely shorthand for the Eurosystem and the Federal Reserve System, banking groups with centralized governance but regional operating entities. The US system has the advantage that its regional central banks are not creatures of the 50 states, and not subject to local political influence. Bill Dudley (NYF) does not confer with Andrew Cuomo (NYS) on monetary policy.]

Furthermore, there is no need for a bailout of the ESCB or the BB. A bailout would be required if the eurosystem was on the dollar standard or the gold standard; in other words, if its liabilities were denominated in a currency that it can’t print. But the ECB prints euros, at no cost to anyone. A printing press doesn’t need capital because it prints its own money. The ECB would not require a bailout from anyone other than its own printing press. The eurozone’s money supply would not be affected, because the eurosystem’s assets have no impact on the monetary aggregates (money is claim on the banking system, not an asset of the central bank). It would be very different if the ECB were on gold, but it’s on Monopoly Money. If you or I were to xerox a euro note, it would be worthless. If the ECB does, it’s money. Photocopied euros are not legal tender. Printed euros are legal tender.

It is true that the eurozone as a consolidated entity would “lose” the amount of money defaulted upon by Spain, but that would have no economic, monetary or fiscal impact.

Take a look at the dollar zone: Imagine that Texas announced that it planned to secede, resulting in a global run on Texas banks. That would require the Dallas Fed to fund the banks by borrowing from the system (i.e., the NY Fed). Then, when Texas does secede from the US, it redenominates into its own domestic currency and defaults on its liabilities to the system. The Fed would lose the amount lent to the Dallas Fed, which would appear on the balance sheet of the NY Fed, as an accounting entry and nothing more. (I’m making the simplifying assumption that Texas nationalizes the Dallas Fed, and that its only members are Texas banks.) No one would worry about the solvency of the NY Fed, or of the FRB. The remaining reserve banks can still print dollars, and the ex-Texas money supply would be unaffected. (The status in the US of currency printed by the Dallas Fed would be problematic, as it would be in the case of Spain. Know your bank notes!)

This discussion harks back to prior conversations about the meaninglessness of central bank solvency, and the option of central bank debt forgiveness as a way of reducing government debt. The difference is that, instead of forgiveness on a planned and orderly basis, the default method would be a fait accompli, but otherwise similar.

I have undoubtedly made a few technical errors in my analysis, but I doubt that they would change my overall conclusion, which is that  Target2 balances don’t matter in economic, financial or fiscal terms.

However, T2 balances are a valid index of the market's assessment of redenomination risk, as the BIS has pointed out***.

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