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Dollar and euro asset risk

Dollar and euro asset risk

Bundesbank balance sheet growth has outstripped ECB’s

by David Marsh in Berlin

Wed 17 Aug 2016

As one of the world’s largest exporters, Germany saw an important part of the political and economic rationale of entering European economic and monetary union in 1999 as lowering risks on its international commercial interactions.

Nearly two decades later Germany, more than ever, is an export champion. It is likely to register the world’s largest trade surplus this year, according to the Organisation for Economic Co-operation and Development, at $324bn (against China’s $314bn), and will amass a record current account surplus of 9.2% of GDP.

Yet, as a result of the large imbalances within EMU that these surpluses symbolise, Germany is a long way from insulating itself against foreign risks.

The Bundesbank provides the strongest indicator of this state of affairs. The quintessentially hard-money central bank was the role model for the European Central Bank at the heart of the euro bloc. Yet the Bundesbank now confronts on its balance sheet a range of potential hazards that EMU’s founding fathers in the 1980s and 1990s would have regarded as inimical to economic stability and, for that reason, impossible to countenance.

The Bundesbank’s balance sheet rose to €1.2tn in July from €222bn when monetary union started in January 1999. Underlining the Bundesbank’s pivotal role in euro area monetary operations, the German central bank’s balance sheet has expanded faster than that of the Eurosystem (the ECB and the constituent national central banks) as a whole.

The Bundesbank’s balance sheet now encompasses around 37% of Eurosystem assets of €3.3tn (computed on a net basis that strips out individual central banks’ claims and liabilities against each other under the Target-2 payments system – the aggregated balance sheet is around €5.6tn), against 32% at the inception of EMU.

The acceleration stands in marked contrast to the central bank’s stated desire, when monetary union started, to slim down its balance sheet, especially by economising on foreign exchange reserves, held mostly in dollars. These have traditionally (together with gold) made up the lion’s share of the Bundesbank’s foreign assets, but have been cut from €45bn-€50bn when the euro was launched to only €30bn-€35bn in recent years.

The Bundesbank has always been sceptical about risks from undue holdings of dollars. It has now, on the external portion of its balance sheet, replaced dollar risk with assets of much greater potential concern – multiple claims on partner central banks standing behind an array of highly indebted euro partner countries.

This is because of the reemergence, as the main reason for the swelling of the Bundesbank’s balance sheet, of large persistent claims under the Target-2 system, now back to €660bn at end-July, not far from the euro crisis peak level of €751bn in August 2012. The re-appearance of large Target-2 imbalances, as pointed out by OMFIF authors Andrew Hunt and Frank Westermann, underlines the strains caused by the reluctance of German creditor banks to channel funds back to peripheral euro countries which have transferred euros to Germany to purchase goods and services or buy assets.

In a speech in February 2013, Mario Draghi, ECB president, said Target-2 imbalances reflected ‘fragmentation’ of the euro area and pointed out that these imbalances would ‘affect’ German taxpayers in the event of a euro break-up. At the time, the Bundesbank’s Target-2 exposure had decreased by more than €100bn from the August 2012 peak. Now that the figures are rising again, this inevitably must be a source of ECB concern. On the other hand, large Target-2 imbalances – amounting to close to half of Germany’s entire net foreign assets – can also be seen as a powerful force holding the euro area together. Germany would be highly reluctant to acquiesce to a break-up that would inflict large losses on the German state and its taxpayers.

Part of the rise in Target-2 balances since January 2015 is a direct effect of the ECB’s programme of quantitative easing – opposed by the Bundesbank. Liquidity released by central banks' asset purchases in peripheral countries is being used to buy euro assets in Germany, in what critics say is misuse of QE to fund capital flight.

As ECB watchers like Westermann point out, the risk-limitation agreement reached before QE started, under which the Bundesbank agreed to purchase only German and no other countries’ government bonds as part of its QE participation, missed a major element of risk by failing to recognise that the programme could propel a further increase in risky Target-2 claims.

Among the other elements in its assets, the Bundesbank’s lending to banks has fallen substantially, both since the financial crisis of 2008-09 and since monetary union started in 1999, as a result of substantial banking liquidity, particularly in Germany. However it has now acquired a substantial portfolio of government securities, amounting to €280bn – largely German government bonds but also some private sector paper plus around €28bn of peripheral country bonds acquired under an earlier programme started in 2010.

The Bundesbank has always mistrusted the idea of acquiring large quantities even of its own government’s bonds, let alone those of the euro periphery. If the euro did ever break up, German assets would no doubt be seen as the safest in the euro area – but this would be scant consolation for much larger losses elsewhere.

David Marsh is Managing Director of OMFIF.

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