The nature of Germany’s foreign investment is often misunderstood or misrepresented. It can be misleading to look only at gross positions. Germany, like most other advanced countries, is enmeshed in a complex web of financial relations, which should be considered as a whole.
In many cases, gross positions are large relative to net ones. Germany’s net international investment position (NIIP) is €1.8tn. For foreign direct investment the gross positions are 5.7 times larger than the net one, for portfolio equity six times, for portfolio debt 66 and for ‘other’ (which includes Target-2 balances) seven. is the Bundesbank’s Trans-European Automated Real-time Gross Settlement Express Transfer system balance, a platform for the processing of cross-border payments for the euro.
To evaluate whether the return on German excess savings is ‘normal’, one has to consider both the asset and liability side. The overall net balance often serves as the foundation to the claim that the large German current account surpluses are being wasted abroad.
Yet a closer examination of overall German investment abroad shows that the return on the country’s foreign assets is comparable to that of its European peers. For example, in 2016 the average return on foreign assets recorded in Germany’s international investment position was 2%, which is slightly higher than the return of 1.9% for France.
The key difference is the return on Germany’s liabilities, namely on foreign investment in Germany. Given the relatively strong performance of the German economy, the return foreigners have made on their investments in German equity has been substantially higher than the return German investors have made on their equity abroad. This is the root cause of the relatively low net investment income of Germany, despite its large net foreign position.
Returning to the Target-2 balances, if a country were to leave the euro, its government would be responsible for indemnifying the European Central Bank for any net claims at the time of separation. This claim would not be without value since, as the UK’s negotiations for leaving the European Union show, the EU is in a strong position. Even if the country leaving the euro were unable or unwilling to indemnify the ECB, the ensuing losses would be shared among the countries that remained in the euro area. This implies that Germany’s Target-2 claims enjoy a guarantee of the other euro area members, such as France, Spain and the Benelux countries. They are thus some of the safest foreign assets Germany can accumulate.
To the extent that the counterpart to the Target-2 balances are short-term German government bonds, a positive carry would remain with Germany, since the yield on the latter is negative.
The Target-2 balances might not represent the best investment instrument, but they have a rather limited impact on what Germany earns on the large amount of excess savings that have been invested abroad. It is more significant that the yield on the foreign equity investment in Germany has been higher than that of German equity investment abroad because the German economy has been stronger. There is no guarantee that the German economy will continue to outperform the rest of Europe, especially if the problems in the German motor vehicle industry continue. In this case, Germany’s net returns could increase suddenly.
The more general point is that two-way cross-border equity investment can be very useful as a shock absorber. The better-performing economies pay more to their foreign investors, and the countries with stagnant economies pay less. With inward equity positions worth between 50% and 80% of GDP, even for the larger euro area economies, this effect can become significant.
Matthias Busse is a Researcher at CEPS and Daniel Gros is Director of CEPS, the think-tank