Saturday, 21 July 2012

Euro Area Monetary Data – Hold On To Your Hat

We were remiss yesterday in our update on the latest developments in Spain's banking system not to include a few other data that seem pertinent to the situation. The huge increase in ECB lending to Spain's banks as a result of the dysfunctional interbank lending market has in a certain sense a counterpart in the enormous jump in the Bank of Spain's TARGET-2 liabilities – and these continue to grow by leaps and bounds.

Since there still seems to be some confusion as to why these payment system imbalances are piling up and how the system actually works, here is a brief explanation (hopefully it won't sow even more confusion).

First a few words on trade and current account deficits.

A country with a current account deficit must sport a capital account surplus. There is in principle nothing nefarious about a trade deficit or a current account deficit. National borders really have no economic meaning. No-one is worried about a trade deficit between, say, New York and Philadelphia, so why should one be worried about a trade deficit between the US and China or Spain and Germany? Trade is after all a voluntary activity between individuals – they would not engage in it unless both sides to the trade were to find it beneficial.

It is of course true that in the fiat money era with floating exchange rates, fractionally reserved banks operating everywhere, and mercantilist nations attempting to produce trade surpluses in the erroneous belief that they are the hallmark of prosperity, imbalances can and do grow much bigger than they could under a gold standard.

Under a gold standard, if net exporters no longer wish to invest their surplus in a deficit nation because they e.g. become worried that its banking system has been expanding credit too much, gold will flow out from the deficit nation. Since the amount of gold is limited, this outflow puts a brake on both the inflationary expansion of credit and the trade imbalance.

In a fiat currency regime with floating exchange rates, a fall in investment in the deficit country leads to the devaluation of its currency, which ceteris paribus tends to lower the deficit. The euro however precludes this 'devaluation solution' between member nations of the euro area. So in theory, Spain should no longer be able to afford to run a current account deficit, as foreign investors are no longer prepared to finance it. The main reason why foreign investors no longer want to finance Spain's current account deficit is precisely that the Spanish banking system has inflated money and credit too much and set a massive boom-bust sequence into motion. This has left Spain among other things with a broke banking system, but also with way too high unit labor costs. If Spain wanted to attract foreign investment again, it would have to quickly readjust its economy by means of wide-ranging reforms, bringing down relative prices and wages in the process.

However, payments between citizens and firms in e.g. Germany and Spain are all carried out via the TARGET 2 system. This payment system is unique in that it does not have a final settlement procedure. No gold is going to flow out from Spain. Payments for imports that are cleared between commercial banks in e.g. Spain and Germany go through their national central banks, which then accumulate claims or debits with the ECB. The commercial bank in Spain will either run down its reserve balance with the Bank of Spain or obtain new reserves from it by posting collateral (or obtaining 'ELA' funding), the Bank of Spain will incur a debit with the ECB, while the commercial bank in Germany will increase its reserve balances with the BuBa, which in turn will obtain a claim against the ECB. As long as private investors were willing to finance Spain's current account deficit, these claims and debits would tend to roughly balance out over time. Now the central banks effectively subsidize the deficit nations via the TARGET-2 system – they finance both capital outflows and current account deficits surreptitiously.

It is important to realize that TARGET-2 debits ultimately represent individual debts, while TARGET-2 claims represent the claims of savers. It is therefore erroneous to assert, as several national central bank spokesmen have done, that these imbalances pose no risk. The correct formulation would be 'they pose theoretically little risk as long as the euro area doesn't break up'.
Spain's latest TARGET 2 balance has been published a short while ago (the TARGET balances charts depicted below are from the German site 'Querschü'). It was yet another whopper, as the liability rose by more than €63 billion in a single month to a new record high of €408 billion:

The TARGET-2 liability of the Bank of Spain – up over €63 billion to a new record high of €408 billion, via querschü - click chart for better resolution.

It appears that the main culprit for the sharp increase was 'capital' flight, with the remainder explained by the – lately shrinking – current account deficit.

Spain's current account deficit has begun to shrink as the economy contracts - click chart for better resolution.

Capital outflows from Spain (mostly in the form of deposit flight and selling of Spanish securities by foreigners) have been persistent throughout the year (chart via CLSA) - click chart for better resolution.

Other Euro Area Monetary Data

The euro area's true money supply has finally begun to grow a bit in the wake of the ECB's pumping exertions. Year-on-year growth is still quite low, but at 3.4% is the highest since early 2011. Quarterly and monthly growth annualized however recently show an accelerating trend at 8.3% and 11.5% respectively. The data are as of the end of May – we will find out whether the momentum persisted into June in about two weeks time. In May the growth drivers were uncovered money substitutes and currency at 14.1% annualized and 13% annualized respectively, while growth in covered money substitutes slowed to 1.3% annualized (however, the quarterly annualized growth of covered money substitutes stood at 376% as a result of the LTRO).

Euro area TMS, quarter-on-quarter and year-on-year growth and the total of the components outstanding. Chart via Michael Pollaro - click chart for better resolution.

Note though that year-on-year, the growth in uncovered money substitutes across the euro area still stood at a negative 14.6%, while the quarterly annualized growth stood at a negative 22.2%, mainly as a result of banking system deleveraging. In that sense May's change toward positive growth in fiduciary media is a new development, but it remains to be seen whether it was merely a fluke or actually indicates a trend change.

TARGET-2 balances across the entire euro-system currently look as follows:

TARGET-2 claims and liabilities of the entire euro-system, via CLSA. This remains an excellent indicator for the severity of the crisis - click chart for better resolution.

Among national central banks with noteworthy TARGET claims or liabilities apart from the Bank of Spain, there is of course the German Bundesbank, which has seen its TARGET-2 claims explode by another €30 billion to a new all time high of over €728 billion.

The Bank of Luxemburg with its over €120 billion in claims – also a new record – has probably the biggest per capita TARGET-2 claims in the euro area.

The Bank of Italy's liabilities have declined a bit, but are best described as stable at a very high level for the moment. This probably indicates that capital flight from Italy has not worsened meaningfully in recent months, but the situation hasn't improved either. Note also that Italy was sporting a positive balance up until mid 2011.

TARGET-2 claims of the German BuBa have reached a new record high of over €728 billion - click chart for better resolution.

TARGET-2 claims of the Bank of Luxemburg are at a new all time high as well - click chart for better resolution.

The Bank of Italy's TARGET-2 liabilities have remained stable over the past few months near the nether regions first reached in February - click chart for better resolution.

In the meantime it has also become clear what has happened with the large amount of excess reverses that has flown out from the ECB's deposit facility after the deposit rate was cut to zero.
The commercial banks transferred the funds merely into their current accounts with the euro-system. In other words, the reserves essentially still are where they were before, only in a different type of account. They sure aren't being lent to other banks.

The risk associated with funding the broke or near-broke banks in the periphery remains firmly with the central bank and governments (to the extent that they guarantee collateral). In short, the public at large is ultimately bearing this risk.

The big move out of the now interest rate-free deposit facility – in recent days, the total has once again fallen below the €400 billion mark - click chart for better resolution.

And this is where the reserves went – the sight deposits of the commercial banks with the euro-system. These accounts are used for transactions, inter alia the TARGET-2 payment streams - click chart for better resolution.

It is interesting to look at how use of the ECB's deposit facility has evolved over the longer term. In pre-crisis times it was barely used at all – then, with every new iteration of the crisis beginning in 2008, use of the facility exploded. Shortly after the initial flaring up of the Greek crisis in April-May 2010, the ECB attempted to slowly remove the extraordinary liquidity it had provided beginning in 2007/ 2008 and up to the point of the first act of the Greek debacle. The period of relative calm that followed the initial bailout decision in May of 2010 didn't last very long.

The ECB's deposit facility over the long term. This too gives us a sense of the growing severity of the crisis that began in 2008 and is still ongoing. In the future the current account holdings of the euro area's commercial banks with the euro system will have to be added to this number in order to keep the continuity of this indicator intact – click chart for better resolution.

Charts by: CLSA, Michael Polaro,, Bloomberg


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