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Analysis
Steely tone in Handelsblatt interview: Problems ‘bigger than Greece’

Steely tone in Handelsblatt interview: Problems ‘bigger than Greece’

Weidmann focuses attention on Bundesbank’s increased credit risks

Point to remember: Bundesbank five-year balance sheet increase highest since 1876 apart from period of war and hyperinflation

by David Marsh

Fri 17 Feb 2012

Amid reports that the European Central Bank is about to carry out a bond exchange to gain protection against forced losses on its Greek government bond portfolio, all eyes are on the balance sheet of the Eurosystem, made up of the ECB and the 17 national central banks (NCBs) from members of economic and monetary union (EMU). In a detailed interview this week with the German business daily Handelsblatt, Jens Weidmann, the Bundesbank president, spelled out his concerns in no uncertain fashion.

In view of risks on its much-inflated balance sheet, Weidmann poured cold water on the idea that the Bundesbank, along with other NCBs, could quickly register profits from its Greek bond holdings by transferring them to the EFSF rescue fund, in a move that has been mooted as possibly helping Greek bail-out efforts. Weidmann said he could detect ‘no readiness’ for such action.

He refused to rule out Greece leaving EMU, conceding that such a move ‘doesn’t contribute to solving problems’ but adding that rescue measures ‘can provide incentive effects that cause contagion.’ Bleakly, he said EMU’s difficulties spread well beyond Greece and denied that the measures taken so far by EMU governments to forge greater fiscal discipline added up to fiscal union. Pointedly, he said his responsibility was to the citizens of Germany, not to the euro area as a whole.

Weidmann’s steely answers to the Handelsblatt’s questions, in a series of well-calibrated comments, underline the hard line the Bundesbank is likely to take in any further crisis-fighting measures surrounding Greece. Weidmann is a man in the take-no-prisoners mould of Helmut Schlesinger, Bundesbank president between 1991 and 1993 after Karl Otto Pöhl. It’s no coincidence that this confirmation of Bundesbank policy emerges at the same time as Wolfgang Schäuble, the German finance minister, has provoked Greek ire by referring to the channelling of European money to Greece as ‘a bottomless pit.’

Observers who doubt whether the Bundesbank retains influence within the ECB’s governing council should reflect that, in matters of its own balance sheet, the Bundesbank’s board members are legally responsible. Although the balance sheet – making up around 30% of the overall Eurosystem – is shared with the ECB and other NCBs, the German central bank is likely to put up an ever fiercer fight in withstanding wider European measures that add further to risks.

The largest single component of the Bundesbank’s balance sheet at the end of last year is listed simply as ‘other assets’ – balances created through unilateral NCB processes settled via the ECB’s so-called Target-2 system. The Bundesbank’s outstanding credit balances against other EMU NCBs - €494bn at end-2011 – greatly outweigh the peripheral country bonds it has bought as part of the ECB’s securities market programme (SMP) – but have attracted much less attention.

In the case of a breakdown or fragmentation of EMU, involving partial reintroduction of national currencies and/or default of commercial banks that have borrowed from NCBs, central banks from balance of payments-surplus countries holding claims (through the ECB) against deficit states would almost certainly be left nursing large losses. Under ECB rules these losses would have to be shared out among EMU members. But since the credit balances are concentrated on the Bundesbank, any losses that accrued initially to the Bundesbank would be, at least, an embarrassment for the German central bank.

According to Bundesbank figures, its Target-2 balance of €494bn at end-2011 (59% of its balance sheet) compared with €210bn (36%) two years earlier. The rise reflects withdrawals of deposits from commercial banks in the peripheral countries to the ‘hard currency’ northern parts of EMU, and the associated reluctance of northern banks to transfer funds back to the periphery.

There is a parallel with previous periods in the Bundesbank’s history when it was intervening heavily to hold down the D-Mark on foreign exchange markets, resulting in large-scale inflows that led to a potentially inflationary build-up of central bank money in Germany. In a parallel development to such past occurrences, the Bundesbank’s net foreign asset position more than doubled between end-2009 to end-2011 (from €314bn to €668bn), but this was due not to an increase in foreign exchange reserves, but a massive rise (to more than €500bn) of Bundesbank claims in euros against other members of EMU.

Largely reflecting these claims, the Bundesbank’s overall balance sheet rose 25% in 2011 (from €673bn to €837bn). Reflecting its own contribution to the overall extension of the Eurosystem’s balance sheet, the Bundesbank’s balance sheet grew 124% between end-2006 and end-2011. With the exception of the First and Second World Wars and the extraordinary inflation in the Weimar republic in the 1920s, this is the largest increase of the German central bank’s balance sheet over any five year period since the Reichsbank was established in 1876.

Weidmann’s Handelsblatt interview, reproduced here in full in an English translation, is one of the most important by any European central banker in recent years. In his nuanced but relatively clear-cut comments about what may happen next in the European sovereign debt crisis, Weidmann’s views deserve to be read in full.

WEIDMANN HANDELSBLATT INTERVIEW 15 FEBRUARY 2012

Q. What problem gives you the biggest headache?

A. The problems are all interrelated. This complex situation places significant demands on the central bank. The Eurosystem is often held up as the only institution capable of action, and therefore central banks are asked to take over tasks that are really not their responsibility.

Q. What area needs the quickest operation, so that the euro patient survives?

A. Your picture suggests that the central banks should solve the problem. That’s not the case. First, the sovereign debt crisis must be overcome. The key lies with fiscal and economic policy, with governments. Central banks must beware blurring these lines.

Q. So a solution for Greece has to take priority?

A. Greece is one factor behind the uncertainty. But the question is much bigger than for Greece or other individual countries. The issue is whether we have the appropriate framework for monetary union and whether this can secure its long-term future. The key question is: How can monetary union survive in a system where there is increasing mutualisation of debts? What is the right balance between individual responsibility and solidarity?

Q. Would you have wished for more rigour in the legal framework of monetary union?

A. It’s not a question of more or less rigour. It’s about ensuring solid budgets in each country and to allowing monetary policy to fulfil its mission of price stability. There are two possible routes. The first way requires compliance with the Maastricht fiscal rules. The second way would lead to substantially deeper political integration, commonly referred to as a fiscal union. Recent summits have raised doubts whether this is politically acceptable. I see no willingness decisively to give up sovereignty in fiscal matters.

Q. Is it not misleading if politicians call this a fiscal union?

A. I think politicians should clearly communicate that the path being pursued will not lead to a fiscal union, but rather strengthens the rules within the existing framework. Otherwise, based on this alleged fiscal union, demands could be raised to expand pooling of risks significantly, for example through eurobonds.

Q. Do you see the political will in Athens to tackle the crisis with their own efforts?

A. The decisions that have been taken are important. Yet, ultimately, it is implementation that counts. That requires not only political will but also an administration that carries out the measures and a population that accepts them.

Q. You sound doubtful.

A. That might be justified, based on what has happened up to now. Announcements must be translated into action. Reforms are designed to put the country back on its own feet. This must include a growth perspective. Without Greece’s own efforts, the financial packages make no sense. The real goal is to restore budgetary soundness and make the economy competitive again. Financial assistance can ease the path; this is no substitute for reforms.

Q. How do you view the chance that the second rescue package for Greece will soon be adopted?

A. With Sunday night’s [12 February] parliamentary decisions, Greece has met one condition for the second rescue package. Still pending, in particular, are some promised labour market measures and a binding commitment by all political leaders to implement the reforms after the forthcoming elections. Only when all this is clear do I expect a decision by the [European] finance ministers.

Q. Would monetary union survive a Greek exit?

A. It’s clear that, in itself, a country’s exit from monetary union doesn’t contribute to solving problems. An exit would produce contagion effects that can be difficult to estimate because it would also change the nature of monetary union. On the other hand, it must be said that the rescue measures themselves - with respect both to the conditions or the breaching of these conditions - can provide incentive effects that cause contagion.

Q. What do you mean specifically?

A. If you bring in tougher sanctions with the Stability and Growth Pact but hold out the prospect that, even after repeated violations, assistance comes at a relatively inexpensive price, then you weaken the effect of the sanctions mechanism.

Q. How long will the Eurosystem be forced to buy time until the financial system can function by itself?

A. Our task is not to buy time. Our goal is to provide liquidity and so restore the functioning of the banking system so that it’s again in the position of carrying out necessary lending.

Q. Is this also the case for the [ECB] purchase programme for government bonds?

A. The majority of the [ECB] council justified the programme on the grounds of the disturbed transmission of monetary policy, but we must also see that some unconventional Eurosystem measures reduce pressure for reforms. The government bond buy-back programme greatly expanded our mandate. Therefore, it should end as quickly as possible.

Q. Would not it be good to transfer the bonds purchased [by the ECB] to the EFSF rescue fund?

A. I have no problem with removing from the balance sheet risk positions that we anyway took with some reluctance - as long as this removal doesn’t cause any loss. The crucial point is that we are not allowed to forego claims against a state. That would be a form of monetary financing. If there is a willingness on the part of governments to buy the bonds from us, we certainly wouldn’t refuse to talk. But no such readiness can be discerned.

Q. Profits will be generated if the Eurosystem holds the bonds to maturity and they are redeemed. Would you be ready to pay out these profits quickly through a special dividend to governments?

A. There is no basis for distribution of hypothetical future profits. Considering the impact of the debt crisis on our balance sheet, I am more concerned about potential losses. Overall, the risks on our balance sheet have increased rather than decreased
Q. Shouldn’t the Eurosystem be more conciliatory here?

A. The debate obscures the fact that, ultimately, it’s the taxpayers who stand behind the central bank’s balance sheet. Central banks shouldn’t give away the assets entrusted to them.

Q. The risks in the Bundesbank's balance sheet are an important issue in public opinion, because people fear that, ultimately, the taxpayer will pay for them. If an emergency takes place, is that really the case?

A. Our balance sheet necessarily becomes more risk-prone in the financial crisis. The aim must be to control and limit these risks as much as possible. Ultimately, taxpayers bear the risks - and that’s why it’s so important that we central banks constrain our behaviour in line with our mandate and take on risks only if they directly relate to monetary policy. We shouldn’t perpetually widen our responsibilities, or allow them to be widened. If we start to distribute insolvency risks among states, then this is clearly the domain of parliaments. Losses accrued [at the Bundesbank] will reduce central bank dividends to the finance minister - and thus become a matter of significance to the taxpayer.

Q. What will be the Bundesbank’s position for the past year?

A. In the past the Bundesbank has indeed made provisions for risks in its balance sheet and it will review the adequacy of these provisions in the balance sheet that is now pending.

Q. That was a sum of €1.6bn in additional provisions. Will that be as much this year?

A. Of course I do not want to prejudice the press conference, but it is obvious, because of the increased risks, that we need more provisions, not less. This will have a corresponding effect on the level of Bundesbank's profit.

Q. The ECB has recently adjusted its rescue policy. The ECB is buying fewer government bonds, but is helping the banks with billions of credits. Is this path not just as risky?

A. One is not a substitute for the other. Certainly the additional bank credits are also fraught with risks that we must keep to a minimum.

Q. The yields on Italian and Spanish government bonds have fallen heavily in recent weeks. Is this the result of the half a trillion euros of three year loans that the ECB has given the banks?

A. That may have played a role. But we mustn’t forget that reform efforts have made progress, for example in Italy, and that in this respect investors take the new government seriously. A similar effect can be seen in Spain.

Q. Are three year credits at favourable interest rates to banks with dubious creditworthiness consistent with the Eurosystem’s mandate?

A. Yes, in periods of high uncertainty; they aim to increase bank’s security of planning and hence also their lending capacity. The decisive factors are collateral, which must meet high quality standards, and the pricing of the three year credits, which should not lead banks to opening up new business areas involving stability risks.

Q. Do you believe the interest rate for three year credits is adequate?

A. I don’t want to comment on these decisions retroactively. But probably the same goal could have been reached with more differentiated pricing.

Q. Germany has claims on the ECB of almost €500bn, the so called Target 2-balance, because above all banks in the southern countries of monetary union take funds from the ECB and then transfer them to Germany. Does this bring the danger of high inflation?
A. The overall provision of extensive liquidity can lead to an inflationary perspective. Given sluggish economic development in the euro area as a whole, I see no danger of inflation for the foreseeable future. That could change, so we have to watch the development and reduce liquidity again at the right time. The risks from these liquidity measures have to be faced: Are we doing business with banks that are sufficiently solvent enough, and do they offer sufficient collateral?

Q. Are you addressing the expansion of potential collateral for the three year tenders?

A. Mr Draghi has admitted that risks rise as a result of the collateral extensions. He stated that these additional risks are well managed. I see this as an obligation

Q. Mr. Draghi mentioned the lack of unanimity [in the ECB Council] about the collateral extension. Did you vote against it?

A. We have a sensible agreement that we do not make our meeting proceedings public. But I've already made clear that I regard the risk in our balance sheets with some concern. I am making efforts to keep these risks to a minimum.

Q. Following the resignations of Axel Weber and Jürgen Stark, many people believe Germany’s influence in the [ECB] Council has weakened. Is this impression correct?

A. The question is not about acting for German interests, it’s about how to fulfil our mandate for price stability.

Q. Mr Weber and Mr Stark gave up the fight. Do you have more staying power?

A. I took up my position with the firm intention of fulfilling my eight year term, since that is the best way to uphold the values for which the Bundesbank stands and to which I am personally committed. I have a responsibility for the Bundesbank as an institution and for the citizens of this country.

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