TARGET2 (T2) balances are again on the rise. Since early 2015, the T2 balances of euro area national central banks (NCBs) have risen steadily, in some cases exceeding the levels seen during the sovereign debt crisis… However, unlike then, record T2 balances should be viewed as a benign by-product of the decentralised implementation of the asset purchase programme (APP) rather than as a sign of renewed capital flight.
That’s from the latest BIS Quarterly Review. It’s awkward because, for those who can remember, back in 2012 an exceptionally heated debate erupted about the importance and/or non importance of growing Target2 extremes.
On team “not important” was every mainstream analyst, economist, the ECB and most of civil Western society.
On team “important/alarming”, meanwhile, there was…well, only one man: Hans Werner Sinn.
Team important/alarming claimed imbalances (which were piling up between Germany and peripheral Europe) amounted to stealth financing by Germany of peripheral obligations (akin to a bailout). Team not-important claimed this was how the system was designed to work. It was not a bailout.
FT Alphaville sat in the middle, explaining that while we agreed with the mainstream that this was a function of how the ECB system was supposed to operate, it did nonetheless give us insight into potentially unsustainable flows and collateral pressures, as well as the failure of the transmission mechanism.
But now we have the BIS saying:
In the period leading up to mid-2012, T2 balances grew strongly due to intra-euro area capital flight. At the time, sovereign market strains spiked and redenomination risk came to the fore in parts of the euro area. Private capital fled from Ireland, Italy, Greece, Portugal and Spain into markets perceived to be safer, such as Germany, Luxembourg and the Netherlands.
Indeed, during that period, the rise in T2 balances seemed related to concerns about sovereign risk. The blue dots in the centre panel of [the graph above] show the close relationship between the sovereign credit default swap (CDS) spreads of Italy, Portugal and Spain and the evolution of their combined T2 balance from January 2008 to September 2014. Whenever the CDS spreads of those economies rose, the associated private capital outflows increased their T2 deficit. When the CDS spreads decreased after confidence in the euro area was restored in mid-2012, the capital outflows partly reversed, and T2 deficits dwindled.
In contrast, the current rise seems unrelated to concerns about the sustainability of public debt in the euro area. The red dots in the centre show that, between October 2014 and December 2016, there was no relationship between the sovereign CDS spreads of Italy, Portugal and Spain and the evolution of their combined T2 balance.
That’s a fairly straightforward admission that had the T2 balance system not existed, and private investors pulled their money from the periphery the way they did in 2012, the flows would not have cleared without a major currency collapse. What the imbalance amounted to was Germany taking a temporal IOU from the periphery — a stealth loan by all objective measures.
As to the current imbalances, the BIS says they result from the fact the European interbank market remains fragmented. Liquidity does not circulate in the euro area and T2 imbalances grow as the total holdings under the APP accumulate. So that would be basically an admission of our original transmission mechanism breakdown point.
Time, we think, for some proper comparative analysis of the ECB eurosystem to the old IIB (International Investment Bank) of the Soviet Comecon/CMEA era. Because the breakdown factors are very similar indeed.
From a paper by David R. Stone on CMEA’s international investment bank and the crisis of developed socialism:
The IIB was set up as one of an array of new institutions designed to promote economic integration among the CMEA countries while at the same time helping them to modernize their economies. Offering loans in transferable rubles and hard currency, the bank financed investment projects throughout the Soviet bloc. Approval of loans supposedly came after rigorous and competitive vetting of investment proposals, and the use of credits was supposed to be stringently audited. Despite these innovations, deliberately modeled on capitalist institutions and mechanisms, the IIB failed in its overall mission to invigorate the stagnating economies of the Soviet bloc. The reasons for its failure, intimately tied to the rigidities of the Soviet command economy, highlight the obstacles to reform of the late Soviet system. The bank’s efforts foundered not only because of the Soviet economy’s dependence on raw material exports but also, more profoundly, because of the Soviet Communist Party’s insistence on maintaining administratively determined prices, central planning, and tight links with the East European satellites. Those fundamental principles of the Soviet system constrained what the IIB could accomplish. From Moscow’s perspective, abandoning these core principles would mean abandoning the Soviet experiment altogether. In that sense, the IIB’s experience suggests that the late Soviet economic system was fundamentally not reformable.
In other words, think of the transferable ruble as the T2 imbalance IOU debit of its time. And in that context the euro project as the latest incarnation of the age-old Soviet experiment that never worked.
