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A debt like no other

Another post, another visit to the Eurosystem’s filthy halls and to the seemingly forgotten topic of TARGET2. In previous posts (here and here) I described the macroeconomic and financial dysfunctions of the euro caused by TARGET2, while in this one I describe the TARGET2 claims as an asset class. I argue that these claims have features of dubious legality which have so far remained unnoticed in the public debate about the eurozone crisis.

A brief piece of theory would be useful to begin with. The following diagram illustrates the flows that comprise the balance of payments of two countries which use different currencies and which for the sake of illustration trade exclusively with each other:

Image 1

Agents in countries A and B trade amongst each other using money as a means of exchange, denominated in units of each country’s currency. Trade consists of goods and services as well as assets, when agents in one country invest in agents of the other. Typically when trading assets, agents also exchange risk which is compensated by investment income. Transfer payments (like foreign aid) on the other hand represent flows of money which are compensated by nothing but the recipient country’s gratitude.

Because of the use of different currencies and because of the need for the books of the countries’ banks to balance at the end of each day, every flow of units of currency XXX out of country A needs to be exactly balanced by a flow of units of currency XXX towards country A, same as with currency YYY and country B. This accounting necessity has the desirable consequence of coordinating the production and distribution of goods and assets between each country in amounts that are equal, or at least perceived to be equal.

The eurozone on the other hand lacks the automatic coordination features of a floating exchange rate system and therefore the net flow of euros to or from each country can be non-zero. This case is depicted in the diagram below:

Image 2

In this example country A’s imports from and investment in country B are assumed to exceed in value the exports to and investment from country B and therefore euros flow from country A to country B. Money flows here include fiscal transfers through EU’s budget, which could be flowing to either country. The books of each country’s banks are balanced with a transfer of an asset from the central bank of country A to that of country B. This asset is recorded under “Intra-Eurosystem claims” on the central banks’ balance sheets and most commonly takes the form of TARGET2 claims. International payments in banknotes and coins are not executed through TARGET2 but create intra-Eurosystem claims of the same nature at the time that these euros are withdrawn or deposited in the banking system of each country. For the moment and for the purposes of this analysis we can leave these intra-ES claims aside.

The reason I am perhaps (but hopefully not) boring you with these examples is because I want to illustrate that everything in today’s non-barter economy – goods, services, assets and risk – is always exchanged for money and conversely money is always exchanged for something. Transfer payments are the only exception in which money is not exchanged for anything. Here is where it gets interesting.

The TARGET2 claims are just accounting entries that do not represent any real flow, yet they bear interest which is a flow, paid from the ES debtor to the ES creditor central bank with the intermediation of the ECB. The interest rate is equal to the ECB’s refinancing rate, currently 0,50%, and could change any time the Governing Council decides. It is hard to say which parties ultimately pay this interest and which ones receive it. In the ES debtor country, the NCB pays interest with money it receives from the funding facility it provides to the local banks (MRO, LTRO, ELA etc.). The local banks can in turn transfer part of the cost to their clients, thereby reducing aggregate demand and the tax income of the state. The recipients are the respective parties in the ES creditor country, although incidentally banks receive now 0% on their excess reserves. Therefore at this moment it is the shareholders of the NCB who earn the interest, the national government being the most prominent among them. This additional income allows the state either to reduce its tax rates or to increase its spending, passing on the TARGET2 revenue into the economy. In brief, we could say that interest is paid collectively from one national economy to the other.

But what does that interest really compensate for? In a typical investment, e.g. a stock or a bond, the investor (the acquirer of the asset) provides some form of capital (most commonly liquidity) to the investee or another investor (the seller of the asset). Typically the transaction also involves a transfer of risk from the investee to the investor. The return that the investor requires represents compensation for a) the provision of capital and b) the assumption of risk. Conversely, this return is the cost that the investee has to pay in order to use this capital and to transfer risk to another party.

TARGET2 assets and liabilities on the contrary do not involve any transfer of capital from the investor (the ES creditor country) to the investee (the ES debtor country). This should be clear in the diagrams above. And despite being economically a form of debt of the ES debtor country, this debt is very different from other types of debt. To understand why, consider the following cases:

-If the government of the ES debtor country decided to sell new debt abroad, its TARGET2 liabilities would decrease by the same amount. In this case the liquidity position of the government would improve and its balance sheet would expand. The external sector would see a reduction in their cash position.

-If the government of the ES debtor country decided to repay its external debt, its TARGET2 liabilities would increase by the same amount. The cash position of the government would deteriorate and its balance sheet would shrink. On the contrary, the cash position of the external sector would improve.

The TARGET2 liability can in both cases be replaced with government debt (or any other form of private liability for that matter), but the issuance of government debt results in a transfer of money from the foreign investors to the government, whereas the creation of the TARGET2 liability does not.

Despite the fact that there is no provision of capital in the case of TARGET2 claims though, it would make sense that the ES creditor would receive interest merely as compensation for some risk it assumes. Insurance is a typical example where interest in the form of premiums is paid as compensation for the assumption of the risk covered by the insurer. In the case of TARGET2 claims however there is no transfer of risk either, since the exposure is directly to the central bank and therefore is de facto risk free. Now, one may argue (correctly) that there is indeed a transfer of credit risk when the ECB is funding the banking system of the ES debtor country, but in this case the risk is borne by the entire Eurosystem (including the debtor NCB) and is therefore spread across multiple governments according to the capital key (that is the participation of each NCB to the ECB’s capital), not according to the TARGET2 balances. And in the specific case where funding is provided through ELA (an Emergency Liquidity Assistance facility) the risk is borne exclusively by the local NCB. In the event that an NCB suffers losses from ELA, it is the local government that is burdened with the obligation of recapitalizing its NCB. This is a circular credit risk exposure where the national government effectively pays interest while assuming the credit risk on the NCB’s monetary operations.

It should be clear from the above that TARGET2 claims constitute interest-paying assets that the ES creditors acquire without paying any money and without assuming any risk, a feature found in no other type of assets. What is then the expected internal rate of return of this asset? Infinite. And so is the cost of debt for the ES borrower. This has to be the finest achievement of financial engineering yet. And nobody seems to talk about it!

But there is the possibility to take a different view on the TARGET2 interest income. If it represents money received in exchange of nothing, the interest payments could be thought of as a stream of transfer payments. This does not make the situation any better. The table below shows a breakdown of fiscal transfers per country within the eurozone and how TARGET2 interest payments relate to them:

Image 3

The green bars show the receipts of each country from the EU budget, net of contributions. The dark blue bars show the annualized interest each country receives or pays through the TARGET2 claims, calculated simply by multiplying the current TARGET2 balance with the 0,50% ECB rate. The light blue bar shows the additional annual TARGET2 income/expense that would be generated from a 1% rate increase by the ECB, assuming that the ES balances remained unchanged.

As things currently stand, it is not Germany but Italy and France that are the largest net contributors within the eurozone, while Greece, Spain and Portugal remain among the largest recipients. Interestingly, if interest rates increased by just 1%, Germany and Netherlands would become net recipients, while Spain would become a net payer. Cyprus is already a net payer. While an ECB rate hike increase is unlikely to occur in the near future and TARGET2 balances may fluctuate, it can be seen how relatively small changes in interest rates can change the roles of each country within the EU’s fiscal transfer system.

This analysis paints a different picture of who really pays what within the eurozone and raises a few unsettling issues. First, if we took the view that interest on TARGET2 claims constitutes in effect a stream of transfer payments, then the ECB could be in violation of article 21 of its Statute which forbids any form of government financing by the Eurosystem. Second, along with other means of exerting fiscal control in the eurozone (like OMT, as I explained here), the ECB is granted the opportunity to decide the amount of transfers that occur from ES debtor countries to the ES creditors by setting the interest rate independently of any political influence. Fiscal transfers through the EU’s budget are at least decided by democratic institutions, however inefficient these may be. In contrast, the Eurosystem transfers do not go through any democratic process; they are not approved, debated or objected by any member state, their people or their representatives. It only falls upon a tiny number of individuals to decide how large these transfers will be and whether the EU’s budget will really mean anything in the end.

One way or another, interest charges on TARGET2 claims are just another source of stink for eurozone’s central bank and its broken monetary system. The fact that there is no public debate whatsoever on the legality of these interest charges is indicative of how badly understood the workings of the Eurosystem still are.

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