Importance of ECB’s expanding Target-2
by Andrew Hunt
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) began 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 (including lending and borrowing to national central banks) has expanded by €1.2tn, taking it back near the level of 2012 (see Chart 1). 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’.
Chart 1: ECB balance sheet nears 2012 peak
Total assets, €tn, 2012-16 (Source: ECB)
Weakening Italian and French growth
Despite modest improvement in household sector credit trends in Germany and Spain, credit growth is weakening in the 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 net issuance within the corporate bond markets has increased. In July, credit growth slowed and monetary growth remained anaemic.
One positive development was that a reduction in bank asset growth allowed the banking system to become a little less dependent on the intra-central bank Target-2 system, under which NCBs manage their assets and liabilities vis-a-vis the ECB. The assets of the European banking system seem to be able to expand only when the Target-2 system is expanding. The ECB appears to have to provide both the assets (bond purchases) and the liabilities (Target-2 funding) for any expansion of the aggregated balance sheet of the European banking system.
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. Overall asset growth has slowed, despite the substantial expansion of QE.
Some of the leakage stems from the fact that European banks have been counterparty sellers to some of the ECB’s purchases: such transactions do not increase the money supply. Similarly, many ECB counterparties have been foreign investors which have then repatriated the funds.
Increased requirements under Target-2
The primary reason has been the ‘peripheral’ banking system’s increased requirement to draw on funding under the Target-2 system.
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, five times the current rate of Italian bond issuance. 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, this has created the market liquidity to allow 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. 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 theoretically has 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 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. Outstanding balances in the Target-2 system have been expanding, despite the slight improvement in July (see Chart 2). And so the ECB’s asset growth has not created as much ‘real economy’ new money as expected.
Chart 2: Outstanding Target-2 balances expand
Target 2 balances, €bn, 2008-16 (Source: ECB)
This is sustainable while banking systems within the core are prepared to acquire claims on the periphery via Target-2. These balances are implicitly underwritten by national governments. An important reason why ‘surplus’ banks should not continue acquiring claims on the system would be the spread of the ECB’s 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 threatened to default on its Target-2 liabilities. The off-balance sheet Target-2 system would then come on-balance sheet.
The ECB’s bond purchase programmes have increased pressure on the Target-2 system, giving more bargaining power to the deficit countries. 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. Back