In the wake of the 2008 crisis, some national central banks, especially those in Greece, Ireland, Italy, Portugal, and Spain (the GIIPS), have dramatically increased their loans to financialinstitutions.
To fund these loans, GIIPS central banks borrowed mainly – via the ECB – from other central banks, in particular the Bundesbank.
In order to fund these loans, the Bundesbank sold its holdings of German assets. As shown in Figure 1, between December 2007 and September 2011 the central banks of the GIIPS increased their loans to domestic financial institutions by nearly €300 billion.
In contrast, the stock of gross German assets in the Bundesbank balance sheet fell sharply to its lowest level in history. The ominous sign – which might set the stage for Act Two in the unfolding Eurozone drama – is the fact that the Bundesbank will soon exhaust the stock of securities that it can sell to fund further loans to the Eurosystem.
At that point, the Bundesbank could sell its gold or increase the deposits it takes from the private sector. Most likely, however, the Bundesbank will face strong pressure from the German public against such action. Hence, it appears as if the Eurozone crisis is entering a second phase in which policy makers feel the need for new measures to prevent market turmoil.
Ιn other words, the Target2 system is indirectly propelling the German Bundesbank to sell off all its assets to finance the lending of other Eurozone central banks. So much so, it hardly owns any assets of its own all anymore. Note the following chart:
As we can see in Figure 2, the drastic decline in securities held by the Bundesbank tracks closely the sharp increase in loans from the Bundesbank to the Eurosystem: the securities of the Bundesbank declined from €268 billion in December 2007 to €21 billion in October 2011. Meanwhile, the loans to the Eurosystem increased by nearly €400 billion.
The latter number is larger because the Bundesbank also borrowed in the private capital market – by taking deposits – as shown inFigure 3 further below.
Here’s some more from the authors on how the mechanisms actually work (our emphasis):
As we have described, in the European monetary union, the stock of securities held by acentral bank can increase in a member country even though the ECB might not pursue anexpansionary policy for the Eurozone as a whole.
This creation of base money is not done viathe printing press as in old times, but electronically. To illustrate the mechanism consider thefollowing example. An owner of Greek government bonds uses them as collateral to borrow from his commercial bank, which in turn borrows from the Bank of Greece.The Greek central bank wires the funds via the ECB to the Bundesbank, which in turn depositsthem in the Frankfurt bank account of the Greek resident. As a consequence, the Bundesbank gets a ‘TARGET claim’ on the ECB and the Bank of Greece gets a ‘TARGET liability’ at theECB.
This TARGET claim is secured by collateral – the Greek government bonds – deposited at the ECB that were previously in the possession of the Greek resident.Through this operation, the increase in the stock of securities at the Bank of Greece ismatched by a reduction of securities in the Bundesbanks’ balance sheet.
The Bundesbank sells some of its assets to be able to deposit the funds into the Greek residents’ private Frankfurt bank account.
As a result, German assets are replaced by ECB collateral (TARGET claims)in the balance sheet of the Bundesbank.
The aggregate Eurozone monetary base, however, isunaffected in this example (see Garber 1998, Sinn and Wollmershäuser 2011, and Buiter et al2011). Figure 4 shows the dramatic increase in loans from the German Bundesbank and theDutch central bank to the Eurosystem.
From 2007 to September 2011, the TARGET liabilities of the GIIPS at the ECB haveincreased by €329 billion, while the TARGET claims of Germany at the ECB haveincreased by €404 billion and those of the Netherlands by €75 billion
. These numbers areextraordinarily large. The TARGET liabilities of the GIIPS amount to 63% of total stock of securities held by central banks in these countries. A comparison of Figures 2, 3, and 4 revealsthat over the period from 2007 to the third quarter of 2011 the increase of the Bundesbank’s
TARGET claims at the ECB tracks its reduction in loans to the private sector plus the increase indeposits it takes from credit institutions.So while the ECB systems’ central banks now hold plenty of periphery debt and other HYPERLINK "http://ftalphaville.ft.com/blog/2010/03/22/182066/the-ecbs-rubbish-collateral-analysed/" \o "The ECB’s ‘rubbish’ collateral, analysed - FT Alhpaville" \t "_blank" rubbishlow-quality assets, they hold hardly any quality collateral at all. Indeed, due to the Target2 system,you could say that most of the good stuff has ended up in a handful of private hands instead.
How long can this collateral laundering operation go on?
In theory for as long as periphery banks have access to ECB acceptable collateral. Though, noteven that would necessarily stop the borrowing, suggest the authors:
Should central banks run out of government bonds, the national governments could issuemore bonds, and sell them to private banks. Banks in turn could use them as collateral toborrow from their central banks.
Thus, practically, there is no limit to the amount of domesticgovernment bonds the national central banks could use as collateral to accumulate TARGETclaims at the ECB. ————
Up to now, Bundesbank loans have allowed GIIPS central banks to buy government bondswithout a corresponding increase in the monetary base of the Eurozone as a whole – ie,without the ECB printing more money (after an expansion in 2008, the monetary basereturned to trend growth).
Before long, however, the Bundesbank’s stock of domestic assets isgoing to hit zero, and it is highly unlikely that it will agree to sell its gold or borrow more in private capital markets.
At that point, the Bundesbank will not be able to lend more funds to the EurozoneTARGET mechanism.
As a result we are heading towards the multiple equilibria zone in which beliefs of a breakdown of the Eurozone are self-fulfilling.And here’s their critical point:In such a situation, market participants may transfer funds from financial institutions in fiscallyweak countries to other ‘safe’ countries like Germany. In tranquil times, such transfers can bedone seamlessly through the TARGET mechanism of the ECB.
However, if a critical mass of agents were to engage in such capital flight away from fiscally weak countries, theTARGET system would be overwhelmed.
In principle, a speculative attack could occur withina day, and the ECB would have to assume all of the marketable securities from countries thatsuffer the speculative attack. Since the ECB has a relatively small capital base, it would not beable to purchase a large amount of assets from countries that suffer the attack.
ΕΛΛΑΣ_ΤO ΜΕΣΑΙΟ ΔΑΧΤΥΛΟ ΣΤΗ BUNDESBANK_EXPOSURE RELOADED_PP
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