In the beginning of the month, the ECB has increased the volume of asset purchases from 60 to 80 bn. € per month. In this column I argue that quantitative easing, while so far ineffective in stimulating inflation, has the unwelcome side effect of increasing intra-Euro-system imbalances among the national central banks.
There has been a wide debate on the effectiveness of Quantitative Easing by the ECB that was first announced in January last year. On the one hand, it certainly depreciated the Euro vis-à-vis the US Dollar. On the other it appears to have little impact on headline inflation that has largely been driven by oil-price movements. While it may be ineffective with respect to inflation, it does not mean that buying a trillion Euro’s worth of bonds has no effect. The side effects of QE have received much less attention, but have recently become visible in the statistics on intra-Euro-system claims and liabilities, the so called TARGET2 balances.
TARGET2 balances have been heatedly debated since there grew to be sizable items on central bank balance sheets around 2007/8. Our Institute of Empirical Economic Research at Osnabrück University has been monitoring them, based on data from the national central banks monthly bulletins. In September 2015, the ECB has released the data as monthly averages in their statistical warehouse. Our web-page www.eurocrisismonitor.com is now updated, at a lower frequency, from both sources.
The beginning of QE coincides with a major trend-reversal in the evolution of TARGET2 balances. In January 2015, the month of the initial QE announcement, the Bundesbank experienced a 50 bn. € increase in TARGET2 claims, the biggest single-month jump since February 2012. At this time, the second round of the 3-year LTROs was allocated. Overall, it is the third largest single-month increase in the history of German Target2 claims. Since then, the TARGET2 balance displayed a continuous increase, reaching again 600 bn. € by January 2016.
Correspondingly, the TARGET2 liabilities of the countries in crisis, Greece, Italy, Ireland, Portugal and Spain have risen at a rapid pace. In the same time period, and taken together, there has been an increase of 183 bn. € in TARGET2 liabilities. This is a remarkable number, when compared to 600 bn. € in total QE purchases up to this point, of which bonds of countries in crisis approximately account for about 25%.
There are three possible explanations for the resurgence in TARGET2 balances since January 2015. One has recently been mentioned by the Bundesbank president Joachim Weidman. He pointed out that in the QE program bonds are purchased by the national central banks not only domestically, but also abroad. For instance when the Bank of Italy purchases an Italian bond from a bond-owner that has his residence in Germany, and this bond owner – after selling the bond – keeps the liquidity in Germany, this creates TARGET2 imbalances. Mr. Weidman concluded that this changes the interpretation of TARGET2 balances: While before, the Bundesbank viewed them as a signal of financial market tension, it now attributes the recent increase to QE.
Another reason of course could be a new wave of capital flight. If the Bank of Italy purchases the bond domestically, and the previous bond owner uses the money to buy a house in Berlin, it will also drive up TARGET2 balances, as long as the previous house-owner in Berlin is keeping the liquidity in the country and does not balance the transaction for instance by buying assets or real estate in Italy.
Finally, the national central banks could also be buying bonds outside the Euro Area. If the assets are purchased in London, New York, or in other non-Euro Area countries, the TARGET2 values will also go up, if the seller wants to convert the government bonds into assets or real estate in Germany. In all three cases, the Bank of Italy is building up liabilities vis-à-vis the Euro-system, while Germany is accumulating claims. These claims and liabilities are equivalent to an indirect loan among central banks, similar to an international swap-line.
This apparent side effect of QE is a concern for policy makers, regardless of which side of the earlier TARGET2 debate is taken. From the ECB’s perspective, it is worrisome that to a substantial amount the liquidity created is not staying in the jurisdiction of the central bank that conducts the purchases. Countries with liquidity problems thus experience a smaller benefit from QE, while countries with excess liquidity are flooded with money even further.
From the point of view of taxpayers in the creditor countries, the QE program also implies a higher cost of a potential break-up of the Euro-Area, or the exit of individual countries. The summer of 2015 vividly illustrated that this risk is real. When Greece was on the brink of Euro-exit, an option contemplated not only by German Finance Minister Wolfgang Schäuble, the potential losses on TARGET2 claims were certainly on the minds of policy makers weighting the pros and cons of this scenario.
More generally, the increase of TARGET2 imbalances highlights an important aspect of open market operation in the Euro-Area: Purchases of bonds by any central bank will lengthen the balance sheet – both assets and liabilities. But in Europe, in times of crisis, it means that the national central banks in some countries get the assets, and in other countries get the liabilities. The risk-sharing agreement that was reached before QE had started was focusing on the asset side only – and therefore missed an important aspect of reality a currency union with free movement of capital.