Mario Draghi’s assurance that the European Central Bank has ring-fenced the risks of its bond-buying program has a caveat.
While the ECB president says the euro area’s 19 national central banks will buy and hold their own country’s debt, the money they create — at least 1.1 trillion euros ($1.3 trillion) — can flow freely across borders through the region’s Target2 payment system. Should a nation build up liabilities and then leave the currency union, the remaining members may have to share the bill.
The risks have been thrown more sharply into focus by the standoff between European governments and a newly elected Greek administration, which has prompted a deposit flight and put the country’s future in the euro in doubt. As ECB officials join politicians gathering in Brussels on Monday to seek a solution to the crisis, Greece ultimately threatens to expose the weakness of measures to address legal constraints and public concern over central-bank stimulus.
“There’s a political signal that comes out of the suspension of risk sharing: there’s no willingness in the ECB to build up fiscal risks via the back door if politicians aren’t,” said Nick Matthews, senior economist at Nomura International Plc in London. “At the same time, asset purchases will create reserves that permeate through the Target2 system. The question of what happens if a country exits hasn’t been addressed.”
Whatever happens in Brussels on Monday, Draghi and his Governing Council will meet in Frankfurt on Wednesday to nail down the details of quantitative easing. Before buying starts in March, policy makers must sign off on the legal act and decide on key elements such as how assets will be bought and how to calculate self-imposed limits.
ECB-style QE will be more complicated than programs by the Federal Reserve and Bank of England because it’ll happen in a currency union that isn’t backed by a fiscal union, with debt mutualization and central-bank financing of governments banned. That makes Target2, the Eurosystem’s financial plumbing, a potential indicator of where risks are building up.
When a lender in one country settles an obligation with a counterparty in another, the assets and liabilities are registered on the central-bank balance sheets. Those balances are aggregated each business day at the ECB, the Eurosystem’s hub, and reflected in Target2.
All five bailout countries are running negative Target2 balances, as are six others including Italy and France, according to data compiled by Germany’s Osnabrueck University. Greece had liabilities of 49 billion euros at the end of last year. The biggest creditor is Germany, which saw claims on the ECB jump to 515 billion euros at the end of January from 461 billion euros the previous month.
Hans-Werner Sinn, president of Germany’s Ifo research institute, has argued that the balances describe effective loans from core euro countries like Germany to southern Europe — a form of stealth bailout that was never approved by legislators. Officials at the ECB and Germany’s Bundesbank have said Target2 is simply a system of double-entry bookkeeping.
Even so, Bundesbank President Jens Weidmann wrote a letter to Draghi in 2012 warning that mounting Target2 claims reflect growing risks in the Eurosystem.
Back then, imbalances were driven by the flood of money provided by central banks in crisis countries to financial institutions shut out of the interbank market. Banks in core nations such as Germany, lacking lending options, found themselves flush with cash which they deposited with their national central banks.
This time, the cash will come from an attempt by the ECB and national central banks to stave off deflation. They’ll add a total of 60 billion euros a month to their balance sheets from March by purchasing government and private debt. At least some of that money is likely to cross borders as investors chase yields on other assets.
An ECB spokeswoman declined to comment on the implications of QE for Target2.
While Greece won’t initially take part in QE because of the size of the ECB’s existing holdings of the country’s debt from an earlier bond-purchase program, Draghi has said he expects it to do so eventually, possibly as soon as July.
Yet with its new government rejecting its aid program and threatening a debt default, the country is already showing how central-bank money creation can escalate in a crisis.
After being cut off from a key avenue of ECB funding this month because of the government’s stance, Greek lenders were granted access to 60 billion euros of Emergency Liquidity Assistance from the Greek central bank at its own risk. They used it within days as they fought to offset deposit outflows, prompting the ECB to raise the allowance to 65 billion euros. That allowance will also be reviewed by the Governing Council on Wednesday.
European politicians are trying to craft a deal that allows the Greek government to keep financing itself while holding to most of the reform requirements that underpinned its bailout. Should they fail, Greece may have to drop the euro, leaving its liabilities behind.
“Is it right to say there’s no risk sharing when you have Target2?” said Nomura’s Matthews. “It depends on what a default would look like. If it’s a default and a messy exit, you have a problem.”