Since the beginning of the asset purchase programme, internal claims and liabilities in the euro area among central banks (Target-2 Balances) have been rising. The Bundesbank’s claims have now reached a balance of €675bn, and Italy has passed Spain as the largest debtor with a balance of €344bn. Nevertheless, European Central Bank representatives remain surprisingly calm. ECB President Mario Draghi said, ‘I’m not worried. It’s a completely different phenomenon from what we observed in 2012 and 2011.’ Peter Praet, the chief economist of the ECB, said ‘Target-2 balances do not signal renewed stress in financial markets’.
The ECB is arguing that national central banks themselves are responsible for the change in the Target balance. It is mainly a technical side effect of QE. Whenever a central bank in the euro area purchases a bond that is outside its own jurisdiction, there will be an international transaction that is settled in central bank money.
Furthermore, the ECB points out that central banks buy bonds outside the euro area as well. In fact, this is the majority of bond purchases, as large asset holding companies have their headquarters mostly in London, New York or other major financial centres. When central banks purchase bonds from these institutions, it is the Bundesbank that credits the money to their reserve account if it is in Frankfurt.
The allocation of accounts has a long history. Even before the euro was introduced, most of the large financial institutions globally had their central accounts in Frankfurt. Regardless of which countries’ bonds are bought, the Bundesbank gets to pay if the reserve account of the counterparty is in Frankfurt. Mechanically, Target-2 balances have been increasing along with total QE purchases over the past 18 months.
This line of argument about rising Target-2 balances is not convincing, however, because it focuses on the primary impact and ignores second round effects. If the accounts of the counterparties happened to be in Rome or Athens, instead of Frankfurt, it is very unlikely that Italy and Greece would have become big Target-2 creditors as a result of QE. The key aspect to keep in mind is that the location of the accounts of counterparties only explains the initial allocation of liquidity in the euro area. After the purchases are made, the deposits can be moved freely across borders. If the counterparties were credited on accounts in any of the crisis countries, they would surely have re-evaluated their risk exposure. Within days they would have shuffled their portfolios and wire-transferred their money to Germany, the Netherlands or Finland. In the new equilibrium, the effect of QE on the Target-2 balance would have been the same as in the current situation. Making the allocation of counterparties’ accounts responsible for Target-2 balances is therefore wishful thinking rather than a conscious portfolio-balance decision of financial markets.
A further cause for concern for ECB policy-makers is that purchases outside the euro area not only create internal capital flight in Europe, but can have other side effects. When looking at the balance of payments statistics, one notices a remarkable increase in non-euro area foreign direct investment in Europe. It is important to note that the big international holding companies are not necessarily the owners of the bonds – they mainly act as an intermediary for asset holders worldwide. Thus as a further side effect, one can see changes in the international investment position vis-a-vis non-euro area countries. They sell their bonds to the ECB and in return buy equity and real estate, fuelling the asset price inflation that has been observable in stock- and house-prices in many euro area countries. Most recently offshore financial centres have become the largest net asset holder vis-a-vis the euro area in the ECB’s statistics. Their current balance is €500bn. Before the 2008 financial crisis, this balance was close to zero.
While the balance of payments data certainly reflect other influences, such as price changes and improved data collection, these patterns suggest that the markets are taking advantage of QE to hedge their risks against a partial or complete euro break-up. Liquidity within Europe is moved to Germany, or stays there. Worldwide owners of euro area government bonds become the owners of European real estate and equity. If the euro should break up, they are well positioned to defend their wealth, while the Bundesbank will need to explain to German taxpayers why it viewed more than €500bn worth of Target-2 claims as a safe investment.
When deciding on an extension of the bond purchases programme on 8 December, ECB policy-makers should be aware of these risks and evaluate the mechanism that links QE and Target-2 without any illusions about its underlying determinants.
Frank Westermann is Professor of Economics at Osnabrück University.