Target2 – Let us not get distracted
Karl Whelan has made another effort to explain the functioning of Target2, the euro payment and settlement system, and related problems – this time not to an audience of ignorant disbelievers, but in a presentation made at the Bank of England’s Centre for Central Banking Studies.
Although this may not be “THAT” Target2 presentation that some commentators see in it, Karl Whelan, Professor at the University College Dublin, with a background in central banking, certainly is “THE ONE” – the most competent authority in the current debate of this topic and a healthy counterbalance to the often deplorably uninformed public discourse.
The reason why I am not perfectly happy this time is that, in my view, the way the topic is presented here, is distracting the attention from the key aspects of the Target2 system to developments and phenomena which, although admittedly very worrying, have nothing to do with the way in which payments are settled in Europe. This is leaving room for misunderstandings with serious policy implications as first reactions to the presentation show.
There are many distractions from the key issues in the Target2 debate which is often heated and full of tensions and animosities. One is personification. Opponents are portrayed as arch enemies in a battle. But this is not about winning or losing a game, or a war, but about one particular aspect of the conditions and consequences of membership in the euro area which should become clear by a sober assessment of facts.
Other distractions result from the creation of scenarios: The stories told about Target2 are full of stealth bailouts, defaulting borrowers, banks running out of liquidity, insufficient collateral and huge sums lost in a breakup of the euro area. I discussed some of these, and their irrelevance to the Target2 debate, elsewhere. Here I would like to draw the attention to two points which may be misleading:
- The neglect of one important system component in the presentation of balance sheets and
- the construction of a relation between Target2 positions and other capital-account components in balance-of-payments statistics.
But, let us start at the beginning.
After a personal introduction Karl Whelan’s presentation starts with some Target2 basics:
The important point here is that in Target2 payments are settled one by one in central bank money with the ECB acting as Central Counterparty (CCP), i.e. becoming a buyer to each seller and a seller to each buyer.
The meaning of this becomes apparent from the next slide:
At the end of each day, each National Central Bank (NCB) has a single net bilateral position vis-à-vis the ECB. This is unusual: Normally in a Real-Time-Gross-Settlement (RTGS) system where payments are processed centrally, no balances remain. The explanation for these positions is found in the two-tier nature of Target2. Apparently, the fathers of the euro did not have enough trust in European monetary union to give up their national payment and settlement systems in favour of a consistent new construct – or, maybe it was simply easier to link the existing systems than to build a new one from the scratch (which, in a sense, is fortunate now because it would facilitate the return to national currencies in case of euro breakup).
The next two slides present balance sheets of two NCBs, one with intra-Eurosystem liabilities:
and the other with intra-Eurosystem assets:
In my view, these two are the first source of possible misunderstandings. What is lacking here is a slide showing the respective counterposition in the ECB balance sheet. This would unveil that – in contrast to the impression (unintendedly?) given here – intra-Eurosystem positions are NOT money created but cancel out each other. The two slides here may easily be interpreted as confirmation that claims of one NCB are the liabilities of another. From there it is only one step to conclude that the system is supporting the granting of “stealth loans”.
That this is not intended becomes apparent in the following two slides. The first stresses the role of consolidation within the Eurosystem and its closedness: The sum of all balances of NCBs and the ECB is zero. There are NO outstanding claims or liabilities of individual Target2 members after consolidation. No money is created by payment settlement, it is only shifted between accounts.
The following slide shows how the ECB fits into this picture taking the example of a Spanish counterparty (Mr. A) paying a German counterparty (Mr. B) via two local banks in Spain and Germany and the two related NCBs:
Allow me to elaborate this point a little further. Take a look at the ECB balance sheet as of 31 December 2010 and 2011:
The table presents the financial position of the ECB and the results of its operations. There are positions related to the money creation process and others such as fixed assets (technical equipment, computers, furniture and plant in building) necessary for running the ECB business. One of the positions not related to money creation stems from the service the ECB is providing to the Eurosystem functioning as CCP in payment settlements in euro via Target2. Its result is included in “Other claims/liabilities within the eurosystem (net)”. End of 2010, the ECB had a net liability, end of 2011 a net claim (see here for an explanation, p. 183).
In my view, the service function the ECB is providing to the Eurosystem does not differ substantially from a firm’s business activity. A shared platform is “subcontracted” for operation (so far producing losses) and the presented claims and liabilities are the outcomes of this business activity. Elsewhere I compared this system to a holding company where claims and liabilities arising from business activities of group members do not represent individual profits or losses, or loans to one another, but intra-group payment flows. No money creation intended or done.
Summing up, so far:
- Target2 is a closed system where balances of individual member NCBs and the ECB cancel each other out.
- No liquidity is created and after aggregating, netting and consolidation no claims and liabilities are left outstanding.
- NCBs are not directly related to one another in the process of payment settlements but via the ECB. In particular, they do not provide loans to one another in Target2.
A look at the next slides illustrates again the ambiguity of the latter point as it is presented here:
Refering to the example of a Spanish/German payment, the slides ask: How has everyone’s balance sheet changed (after this cross-border transaction involving two individuals, two banks in different countries and two NCBs)?
After what was said before, the absence of an important player is noticed immediately. Despite the mentioning of intra-Eurosystem positions: Excluding the ECB balance sheet in my feeling reinforces the impression that in establishing inter-NCB claims and liabilities the burden of settlement is left with the NCBs.
The “defect” is not healed, because with the next slide Karl Whelan, in a sense, changes the subject conjuring up one of the scenarios mentioned in the beginning:
Now, capital flight occurs, a bank runs out of liquidity, a NCB is creating money in lending to the bank, and collateral becomes involved.
Don’t take me wrong: All this may happen, and does happen, in the current euro crisis. It can become very frightening and a big callenge for European monetary policy and the countries involved.
But we must be aware that, at the very moment the question is no longer “which way do payments take to reach the addressee”, but becomes “who is losing money, who is lending and borrowing to whom, and where is money created”, the line of reasoning leaves the realm of payment settlement within the Target2 framework.
Now it is borrowing and lending relations which become the focus of the debate, not payments. Capital flight is a threat. But in this context here it is a distraction from the Target2 topic.
A second, related distraction which in my view unnecessarily increases the uneasiness with the size of the Target2 balances is the construction of a direct relation between those balances and financial flows recorded in the balance-of-payment (BOP).
Target2 transfers to the ECB are part of the national balance-of-payment statistics. Have a look at the following slide which again takes Spain as an example:
I must admit, at first glance, I found it difficult to understand the idea behind this figure, and I am still not sure whether I interpret it right. So comments are very welcome to correct me. But let me try:
As I understand, in this figure, the change in the Spanish Target2 balance, a flow, is contrasted to other BOP components. Generally, changes in Target2 balances are reported in the Financial Account of the BOP statistics as “other investments”. An increase of Target2 claims of the Bundesbank, for example, is recorded as capital export, a decrease of claims, or as in the case of Spain an increase of Target2 liabilities, is recorded as capital import.
According to the BOP identity the sum of current account, capital account and financial account is always zero. What follows is that in a mechanical view a change in the Target2 balance of a country is a match or counterpart to one of its other BOP items, i.e. international trade, direct investments, portfolio investments, changes in foreign exchange reserves … (See the answer of Deutsche Bundesbank to a question from Olaf Storbeck/Handelsblatt).
The following slide explains the relation between Target2 and the balance of payments as seen by Karl Whelan:
Apparently, in the figure above the change in the Spanish Target2 balance is mentally decomposed into a part arising from current account deficits and another resulting from outward financial flows. That this is a mental exercise is my assumption because I cannot imagine how the 300.000 plus daily payments mentioned in one of the slides are categorized respectively. As the Bundesbank wrote:
In der Praxis können natürlich nicht alle grenzüberschreitenden Transaktionen für die Erstellung der Zahlungsbilanz einzeln erfasst werden; die verschiedenen Positionen der Zahlungsbilanz werden daher aus unterschiedlichen Basisstatistiken und Quellen abgleitet. (In practice, of course, the balance of payment does not record all cross-border transactions individually. Balance-of-payments positions are derived from a variety of basic statistics and sources. (Bundesbank, my translation)
The message of the figure is that deposit flight – not portfolio or direct investment, but withdrawal of bank deposits – is the main explanation for the change in the Spanish Target2 balance and that this is “offset by central bank funding” —
It is not. Neither do positive or negative financial investments necessarily “explain” the recorded change in the Target2 balance nor is the Target2 balance an indicator that these financial flows are officially “offset”. Both investments and payments made via Target2 are funded in many different ways.
As emphasized, the relation between a change in a country’s Target2 balance and other balance-of-payment items is a pure mechanical one. They are recorded here because the transfer to the ECB is a cross-border activity. The parallel increase of positions shown in the figure may well be a coincidence and have another explanation – that may be less or even more scaring. To give an example: Probably no one would state that Target2 balances are “contributing” to or “driving” foreign trade or direct investments. But the way of reasoning based on the above mentioned BOP identity would be the same.
As so often, we must not confuse correlation with causality:
As I wrote elsewhere Target2 figures are accumulated net balances. They give no information about gross cross-border payments and their determinants. The Bundesbank mentions three major components with payments carried out via the banking system: foreign trade transactions, securities transactions and lending transactions. As I also wrote, there is no difference in the treatment of domestic and cross-border payments in euro. A euro is a euro no matter where the payment is made or received. Even in the hypothetical case that the Target2 payments were exclusively made and received in Spain, the resulting balance would be transfered to the ECB and recorded in the Spanish balance of payments. On the other side, even if cross-border transactions would account for the bulk of Target2 payments, there would be most probably no perfect match between them and recorded BOP trades and capital movements: Payments are advanced or delayed, offset or compensated by other positions, they may result from activities not captured by official BOP statistics or, the other way round, statistics may include transactions which are settled outside Target2. Without further insight into gross payment flows nothing is won for the Taregt2 debate by refering to the capital flight scenario.
Most of the remaining problems I have with the presentation are rooted in the described distractions. Capital flight, asymmetric lending and substitution of private risks by public risks in the course of market reactions, debt restructuring and bank bailouts are real and scaring problems of the euro area these days. The related settlement of payments is not in this category. Further, I cannot see that with euro breakup huge claims would become manifest that result from the operation of Target2, but I made my point on this elsewhere. Coming back to the policy implications mentioned in the beginning: From my arguments it ought have become clear that in my view Target2 balances are no legitimation for ECB certificates or Eurobills.