A big thank you to Deutsche Bank strategist Peter Garber for this.
It’s a nine-page note oozing with detail about how — precisely — capital flight amongst eurozone members impacts the eurosystem. And it’s timely stuff given that the Bank for International Settlements just reported a (very rough) $107bn outflow from Greece, Ireland, Portugal and Spain in the second quarter of this year.
Here’s the basic premise from Garber:
A cross-border payment between banks in two countries in the euro zone automatically generates balancing credit claims between the national central banks (NCB) and the ECB. This is the mechanism that irrevocably unifies the former national currencies, converting a set of currencies whose exchange rates are merely fixed at par into a single currency. But it also allows any of the euro-zone countries to draw vast credit from the rest of the euro-zone members via the ECB in the event of capital flight that arises from fears of default on sovereign debt, of systemic risks in the banking system, or even of the breakup of the euro itself. In this dimension, it is a mechanism that entwines the capital of the ECB in a default of any of the euro sovereigns.
So, meet the European System of Central Banks (ESCB).
And here’s how it usually works. Imagine if you will, a Greek bank sending a €1m payment to a German bank in a normal day of business operations.
The order is sent by the Greek bank via TARGET2 — the eurozone’s settlement payments system. The TARGET2 software instantly produces a deposit of €1m of funds into the German bank’s account at Germany’s central bank, and subtracts €1m from the Greek bank’s account at the Greek central bank. The Bundesbank’s payment (i.e. increase in liabilities) is balanced by a ‘due from’ Greece’s central bank. While the Greek central bank is slapped with a ‘due to’ the Bundesbank.
At the end of each working day these central bank ‘due froms’ and ‘due tos’ are netted and transferred to the books of the ECB. If a central bank is a net claimant from these payments, the claim appears as an asset on its own balance sheet under the entry, “other claims within the euro system”. If the central bank has made net outgoing payments it shows up as a liability on its balance sheet under the entry, “other liabilities within the eurosystem”. National central banks that owe the eurosystem money via TARGET2 pay the (currently 1 per cent) ECB refinancing rate to the ECB, which itself pays the refinancing rate to creditor national central banks.
Here’s where it gets slightly more complicated.
Imagine that capital flight.
If a bank doesn’t hold enough deposits at its own national central bank it can still tap ECB liquidity via weekly or longer-term refinancing operations. But to do this it still has to post collateral — like government bonds. The payment is then done over the TARGET2 system in the same way outlined above. Which means the ECB would be financing the (bank) capital flight at that 1 per cent rate, and it can keep doing so until the borrowing bank runs out of acceptable collateral.
And the same can be done for a country-wide capital flight:
Similarly, a euro-zone government could, if it had to, continue to finance itself via the ECB even if it could not sell new bonds to the market because of fears of default. Under this scenario, a government might sell its bonds to a local bank, which draws funds from the ECB through its NCB, depositing the new securities as collateral at the NCB. The government could then use the funds to pay private creditors in other countries who are not rolling over existing debt. The ECB then effectively replaces the old creditors of the sovereign and the lender for ongoing deficits—indirectly via the collateral at the NCB. This is how a sovereign debt crisis in one of the euro-zone sovereigns can become a problem for the euro currency and a risk that might overwhelm the capital of the ECB. This is especially so if a sovereign crisis is allowed to fester long enough that the ECB ends up with a significant direct or indirect claim on the sovereign before a default occurs.
Now the ECB can’t really run out of capital — it’s supported by its own shortfall fund and also by eurozone national central banks which can top it up. No doubt, however, that actually having to do so would be deeply controversial. Imagine the German reaction.
That said, there are plenty who think a direct fiscal transfer from stronger eurozone members to weaker ones is exactly what Europe needs. We doubt, however, that they’d necessarily want to be doing it through the ECB. What it might do, however, is give a clue about why European ministers have so far resisted debt restructuring.
Here’s Garber’s conclusion:
In the first instance, an intra-euro zone capital flight appears as a credit from the ECB to the NCB of the country from where capital is fleeing. The flight may arise from a potential restructuring of sovereign debt, an insolvent banking system, or even a notion of secession from the euro. Whatever the case, the mechanics of ESCB operations finance the flight at low interest rates as long as collateral from the country is acceptable at the ECB.
If the fiscal authorities in the EU were tough and pushed for restructuring, then the flight would likely proceed to the point where a substantial part of the national balance sheet is intermediated by the ECB. If the ECB were to cease accepting the country’s paper as collateral to end the hemorrhage, then outgoing payments could no longer be made and the country’s banking system de facto would be cut off from the euro. If the country’s authorities kept the banking system open for internal payments at least, the bank deposits in the country would float against the euro currency.
If the fiscal authorities in the EU instead adopted a credible rescue package to finance the government or capitalize its banks, then the flight might cease or reverse. This would shift the burden of financing the country from the ECB to the fiscal authorities in the EU and eliminate the direct threat to the ESCB.
And there’s that fiscal transfer idea again.
Full note in the usual place.
Related links:
Gobbling 93 per cent of eurozone liquidity – FT Alphaville
Public and private in the Ireland bailout - FT Alphaville
Why the ECB is a good bank with rubbish assets – FT Alphaville