In a widely reported speech on June 2nd, financial baron George Soros gave the European Union 90 days to address the debt crisis engulfing the continent.
The man who “broke the Bank of England” in 1992 said that the German government had a three-month window to resolve the Eurozone debt crisis.
By this, Soros means that the credit the German central bank, the Bundesbank, has extended to debt-plagued Europe will reach its limits within 90 days. His reasoning is that both German public opinion and the markets will drive Chancellor Angela Merkel to limit the ECB’s “indefinite expansion of the money supply.”
But to return to Soros. The centrepiece of his speech was the EU’s interbank clearing system.
Yawn. I hear you. We’ll try to make it interesting. Stay awake there at the back.
Today, we’re looking at Target2. This is the European Central Bank’s (ECB) Trans-European Automated Real-time Gross Settlement Express Transfer System.
With interbank transfers of up to €2.5 trillion per day, Target2 allows the ECB to provide the necessary liquidity to European central banks throughout the 16-member Eurozone area. Commercial banks maintain their accounts with their national central banks and are able to access and transfer debits and credits on a daily basis to settle their accounts.
Target2 is the ECB’s interbank settlements system. In the 1980s, this required entire bank settlements desks, with dozens of people working from print-outs or (too often) numbers scrawled on slips of paper.
The IT revolution of the 1990s and 2000s changed all that. In the Eurozone, the second iteration of Target was introduced in late 2007. As the name suggests, Target2 allows the ECB to lend to Eurozone central banks in real time at very low cost.
Since 2007, under Target2, the ECB has generated liabilities of over €800 billion, and this figure expected to reach €1 trillion by the end of 2012.
Not surprisingly, the central banks that have drawn most heavily upon the ECB’s lending facility come from the EU’s periphery: the PIIGS (Portugal, Ireland, Italy, Greece, Spain) – or GIPS, in more polite Euro-parlance – but even France and Belgium have accumulated significant liabilities under Target2. But I wouldn’t worry too much about Belgium: it’s not a country; it’s a bank.
In fact, only Germany, the Netherlands and Luxembourg have a net surplus position within Target2 (see Figure 1 below).
Now, Target2 has been the, er, target of acrimonius debate among economists in Germany and throughout Europe. Read both sides of the debate here and here. Its most vociferous opponent has been the man dubbed Germany’s leading economist, Hans-Werner Sinn.
Let he who is without Sinn…
Neoclassical economist Hans-Werner Sinn has argued that, first, Target2 credit is allowing peripheral Eurozone economies (the PIIGS) to finance their significant current account deficits. Second, Sinn posits – and Soros repeats the claim – that the German Bundesbank, has claims exceeding €600 billion on central banks in the periphery. Third, if a central bank defaults on its repayments, Sinn argues that the Bundesbank, German banks and, ultimately, the German taxpayer, will be compelled to absorb the consequent losses.
But these numbers do appear on the Bundesbank’s account, as the ECB owes the German central bank over €660 billion. Thus, German banks are financing Eurozone credit. So now you know – where the money’s coming from, that is.
Lender of Last Resort?
“Lend freely at a high rate, on good collateral,” wrote English essayist Walter Bagehot. His dictum developed into the ‘lender of last resort’ thesis, now the modus operandi of all central banks, as well as the International Monetary Fund.
So: upon what basis does the ECB lend so freely? In this case, bad collateral.
This is where the ‘2’ in ‘Target2’ comes in. In November 2007, the ECB under Target2 lowered the quality threshold of collateralized assets significantly. This is despite the fact that the EU’s own studies assert that there is at least €14 trillion in high-grade financial assets owned by EU governments and private banks. The figure is higher if you include lower asset classes.
The ECB has fuelled this expansionary credit binge by accepting the sovereign debt bonds of Europe’s indebted governments as collateral. Or, in fact, any asset as collateral rated above ‘D’. A ‘C’-rated mortgage-backed security, for example, would be relatively risky commercial paper.
Thus, the ECB is facilitating liquidity throughout the Eurozone central and commercial banks by buying junk bonds, in effect. By doing so, the ECB can also control, within limits, the market yield on sovereign debt bonds.
Naturally, not all of the collateral is junk. ‘A’ and ‘B’-class assets also form part of the collateralized debt. And it’s not as if French or Belgian banks don’t have the ability to repay tranches of debt, albeit over a considerable period.
But, as Greece has proven – and Cyprus is about to – some countries simply do not have the financial capacity to meet their debt obligations. As Soros notes, the peripheral EU countries – parts of southern and eastern Europe – are heavily indebted to the ‘core’ or ‘centre’, and the quality of their collateral varies markedly, although much, such as sovereign debt issues, may be classed as junk.
In case you think we’re exaggerating the risk associated with lower classes of debt securities, consider the fact that Jens Weidmann, President of the Bundesbank, has himself expressed concern about the declining asset quality of collateral for loans undertaken by Eurozone national central banks.
Come fly with me
What’s more, all this liquidity that has been created to shore up the EU banks is pumping through the arteries of the Eurozone financial system. In combination with the fragility of the banks – and the EU economy in general – this has led to massive capital outflows.
Spain saw over €66 billion net in capital flight in March 2012 alone, comprising foreign investment outflows and investors liquidating positions and assets and fleeing Espana for safer havens.
Greece is no better. Actually, it’s worse, proportionally. In the last 24 months, Greeks have withdrawn fully one third of deposits from Greece’s banks.
But that didn’t stop the Greek government from injecting another €18 billion into the banks in May.
As Soros notes, there is likely a perverse proportionality between capital outflows from peripheral countries, high bond yields in the PIIGS, and historically-low bond yields in Germany and the UK. Actually, this week, German 2-year notes fell into negative yield territory, as investors fled to the Bundesbond and Bundesobligationen (German federal 10 and 5-year notes). They’re not making their buyers much either, at 1.18% and 0.75%, respectively.
What will Germany do? Enough to save the euro and nothing more to prevent a disorderly breakup, Soros opines.
He is right on that count. But the ECB, like the US Fed and the Bank of Japan, does have some latitude in that it is to a certain extent a self-contained ecosystem (the majority of European trade and investment is within the EU itself).
Tha means the ECB can continue to lend, provide liquidity and print fiat currency, just as the US and Japan do (the US has the advantage of printing the world’s reserve currency, while Japan lends money to itself). Theoretically, the ECB can print as many euros as it wants, albeit at the risk of inflation (which would help inflate away Eurozone debt in any case). A depreciated euro also advantages those all-important German exports.
Depreciation, by the way, has nearly always worked for the US; you don’t have to realise a single percentage point in productivity to gain a competitive advantage over your trade partners. For the same reason, the Bank of Japan is always desperately trying to sell the yen down to reap the same rewards.
Of sages and false prophets
Speaking of false ‘profits’, we wouldn’t be performing due diligence if we didn’t check Soros’ ability to read a crystal ball.
Now, you do have to admire a guy who nets one billion dollars inside a week by betting against central banks, while the rest of us were probably doing worthless things, like volunteering for charity.
In his speech, Soros directs most of his vitriol at professional economists, castigating the notion of ‘economics-as-science’. I do have a certain sympathy with his argument; economists have a dismal record of forecasting.
Which brings me to George’s dismal record of forecasting. In his 1994 book, The Alchemy of Finance, Soros predicted:
- The Japanese economy would surpass the US economy.
- The dollar would depreciate markedly in the 1990s (it didn’t; it appreciated strongly between 1996 and 2002).
So if you took George’s sage advice in the 1990s, you would have bought Nissan shares and sold US dollars. Then you’d be…well…
You’d be Greece. Holding junk bonds.