Financial markets have paid vast attention to the European Central Bank’s efforts to inject additional liquidity into the financial system through quantitative easing. Much less scrutiny has been applied to the relatively meagre outcome in terms of ‘broad money’ expansion.
Purchases of government and other bonds by the Eurosystem (the ECB and its member national central banks) started in March 2015 and will continue at least until March next year, with the chances increasing of a further extension until autumn 2017. Over the 12 months to June, the ECB’s aggregated balance sheet has expanded by €1.2tn, taking it back to the level of 2012, in line with the goal proclaimed by Mario Draghi, the ECB president.
Yet the quantity of monetary instruments owned by the resident private sector has expanded by only €520bn (as measured by M3), or only €350bn if one uses an even wider measure of ‘broad liquidity’.
Despite modest improvement in household sector credit trends in Germany and Spain, credit growth is weakening in the hard-pressed Italian banking system and also potentially in France. ECB data from June show an overall decline in bank lending to the non-financial corporate sector (though there has been an increase in net issuance within the corporate bond markets).
The euro area corporate sector has shown a very different reaction to the advent of ultra-low rates and quantitative easing than its US counterpart, probably a result of the still-high real exchange rate and export price deflation. European bank lending to the non-bank financial sector remains very weak and the banks are continuing to divest, albeit slowly, from both the domestic sovereign bond markets and their overseas assets. Consequently, overall asset growth has slowed over recent months, despite the substantial expansion of quantitative easing.
Why is the ECB is gaining only ’30 cents on the euro’ from its efforts? Some of the leakage is because European banks have been the counterparty sellers to some of the ECB’s purchases – circumstances similar to those in Japan – and these types of transaction do not increase the money supply. Similarly, many of the ECB’s counterparties have been foreign investors which have then repatriated the funds. The primary reason for the leakage, however, has been the ‘peripheral’ banking system’s increased requirement to draw on funding under the Eurosystem’s intra-central bank Target-2 system under which NCBs manage their assets and liabilities vis-a-vis the ECB.
Italy provides a useful illustration. Over the last 12 months, the Banca d’Italia has purchased over €100bn of Italian government bonds on behalf of the ECB, roughly five times the current rate of Italian bond issuance. By definition, existing holders must have sold bonds to the central bank. Italian households did indeed sell more than €20bn of domestic public sector bonds. In effect, these ECB bond purchases have created the market liquidity to allow many domestic investors in the periphery, and some foreign ones, to exit their positions in favour of asset acquisitions within the core countries of Germany and Luxembourg. The statistics for Italy are striking: Italian households save only €23bn per annum at present, but they are acquiring over €30bn of foreign assets.
The banking systems of the peripheral countries (particularly Italy) are gaining assets when the central bank buys bonds. But the money that has theoretically been created is leaving their domestic systems and simply piling up as expensive excess reserves within the banks of the core countries.
The core countries’ banking systems are then obliged to deposit the excess reserves into the Target-2 system, which lends the funds back to the peripheral banking systems to make good the ‘gap’ between their now-expanded level of assets and their ‘lost’ liabilities. This is the reason why outstanding balances in the Target-2 system have been expanding and the ECB’s asset growth has not created as much ‘real economy’ new money as some had expected.
However inefficient this state of affairs may seem, it is sustainable so long as the banking systems within the core are prepared to acquire claims on the periphery via Target-2. Given that the Target-2 balances are implicitly underwritten by national governments, an important reason why ‘surplus’ banks should not continue acquiring claims on the Target-2 system would be the spread of the ECB’s own negative rates, which have already led some German financial entities to acquire physical cash rather than interbank claims.
A bigger risk could emerge if one of the debtors threatening to default on its Target-2 liabilities. The currently off-balance sheet nature of the Target-2 system would then come on-balance sheet, revealing its true size and importance. For this reason, Matteo Renzi, the Italian prime minister, may have rather more bargaining power with his European partners than the latter realise.
Deliberately or otherwise, the ECB’s bond purchase programmes have placed more pressure on the Target-2 system and, in so doing, given more bargaining power to the deficit countries. The sustainability of the rapidly expanding Target-2 system is a key variable to watch. If politics were to threaten the implied guarantee on banks’ claims on the Target-2 system, then the euro project would be close to collapse.
Andrew Hunt is the proprietor of Andrew Hunt Economics Ltd, an economics consultancy that was established in 2001 and which has numerous clients in the investment banking, hedge fund, family office, and institutional investor arenas. Prior to forming AHEL, Andrew worked as a senior international economist in the Dresdner Bank Group for more than 10 years.