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Thursday, February 2, 2012

An update on Target-2

In their March 2011 monthly report (almost one year ago), the Bundesbank revealed that their receivables against foreign banks under Target-2 had reached 325 BN EUR compared with near-zero before the outbreak of the debt crisis. In the commentary, the Bundesbank stated that this increase of roughly 300 BN EUR "did not represent a change in its risk profile". This prompted me to send the Bundesbank a position paper in late April which I translate below. I requested that they should correct any mistaken assumptions on my part. They did not correct anything.



Position paper dated April 27, 2011

Misapplication of funds by ECB/NCBs

One of the ECBs most important tasks (in coordination/cooperation with NCBs) is to provide liquidity to the Euro banking system within established rules and regulations. The Bundesbank states in its March Report that its receivables from foreign banks in the Eurozone had increased to 325 BN EUR (roughly half of the Bundesbank's total assets). Since such receivables were close to zero before the outbreak of the debt crisis, it is safe to assume that these are receivables against banks in deficit countries. The Bundesbank says that this increase "does not represent a change in its risk profile".

Any junior banker knows after his credit training program that every receivable on the asset side of a bank's balance sheet represents risk. If the counterparty doesn't pay, the receivable is worthless. The bank then needs to liquidate its collateral.

The Bundesbank's collateral consists of sovereign debt instruments of those countries whose banks require Target-2 financing for lack of liquidity. Should the Bundesbank need to write-down only 25% of the value of these receivables, that would translate into a charge against its P+L of approximately 80 BN EUR.

According to unofficial statements, Greece accounts for about 80 BN EUR of the above total of 325 BN EUR. What is the Bundesbank financing in Greece? The Bundesbank sends money to Greece so that (a) Greece can import goods instead of producing them on her own; (b) wealthy Greeks can transfer their own money to private accounts offshore; and (c) private offshore lenders to Greece can get repayment of their short-term loans.

Out of the “ordinary course of business”, Greece as a country had in the recent past a monthly withdrawal of liquidity from her banking system of 2 BN EUR (24 BN EUR annually!). This represents the net result of receipts from exports and offshore services minus import payments (current account). To this one would have to add the liquidity required to finance capital flight (estimated at 20-30 BN EUR in 2010). Finally, short-term lenders have cancelled their loans to the Greek banking sector whose repayment also needed to be financed. The resulting “hole” in the Greek banking system had to be financed somehow and it couldn’t be financed through increased savings because the savings rate was negative.

Who closed this hole? The alliance of ECB/NCBs have closed it. Who profited from that? The exporters to Greece, the wealthy Greeks and foreign short-term lenders. Who will suffer from that? In the final analysis, the tax payers. And the Bundesbank has done this totally quietly, seemingly “behind closed doors”!

Nobody forced the Bundesbank to do this. Had it not done this, it would have led to the perfectly normal sequence of events in such situations: a Greek Bank Holiday to implement new laws such as the temporary freeze of deposits.

And afterwards one would have acted like a corporation which has 430 BN EUR in debt (the foreign debt of Greece in mid-2010) and which can no longer service its debt. Specifically: call a meeting of creditors with the aim of forming a Steering Committee; and negotiate with that Steering Committee a consensual rescheduling of this debt. One such solution could have been: 50% of the debt to be repaid with a new 20-year bond; 25% with a 10-year bond; and 25% with a 5-year bond. Capitalization of most of the interest during the first 5 years. Fresh Money from the EU in a senior position.

ECB/NCBs would have taken measures that there would be an active secondary market for these instruments. Based on the prices in that market, the creditors would have had to make adequate risk provision in the P+Ls. The money which was sent to Greece could have been used to bail-out and/or liquidate the banks which couldn’t handle the risk provisions on their own.

This could, of course, could still be done today but the above 325 BN EUR are now „foolishly spilled milk“: they either disappeared in the budget deficit and/or landed in foreign bank accounts.

Talk is now starting about a possible forgiveness of Greek debt („haircut“). Historically, haircuts of sovereign debt have been made either after a one-time event of serious destruction or in the case of extreme national poverties. The thought of saying to a deficit country “we’ll forgive you 40% of your debt because you cannot sustain that”, that is a thought which should never cross the mind of a responsible banker, much less be publicly discussed by a banker.

Summa summarum: the tax paying citizens have very good reasons to be extremely upset about what happened at ECB/NCBs in the last 2 years!



So far the position paper of last April.

Today, the Bundesbank has receivables against foreign banks of nearly 500 BN EUR. Very little of the money sent to Greece has actually had any benefit for Greece. Instead, Greece’s foreign debt is now over 500 BN EUR and liquidity continues to leave the Greek banking system in leaps and bounds.

18 comments:

  1. Herr Kastler - I've tried to understand Target 2, so far I'm struggling

    I've read the postings of Hans-Werner Sinn and his supporters in The Economist and elsewhere.

    And I've read Olaf Storbeck at his Economics Intelligence blog and his supporters http://economicsintelligence.com/category/target-2/

    I would appreciate your thoughts on Sinns thinking on this issue and Storbecks refutations thereof.

    And here's a similar rebuttal,with an Irish flavour, from Karl Whelan at the IIEA - http://www.iiea.com/blogosphere/professor-sinn-misses-the-target

    Cheers CK

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    1. I think this is a debate between highly technical/intelligent experts on the ECBs functioning on one hand and economic reality on the other. Prof. Sinn also belongs to the highly technical/intelligent group but in this case he does not allow intelligence to outweigh his understanding of economic reality (BTW, I only refer to his Target-2 views and not the ones on “crowding out”, where I think he is exaggerating).

      Yes, the Bundesbank has a claim against the ECB (not against Greece) and the ECB ought to be a good risk; right? Well, that depends! If the ECB takes a loss, Germany shares in it with 27%. And if Greece were to fall into the Aegean, all Target-2 claims against Greece would go down with her.

      Thanks to the marvels of double-entry bookkeeping, we know that a liability on the books of one party is an asset on the books of another one. The Bank of Greece shows their Target-2 balances as a liability (well over 100 BN EUR). So they seem to think that they owe that money to “someone”. If they don’t pay, that “someone” will take a loss. That “someone” is the concert of ECB and NCBs. If ECB/NCBs deny that they are owed something by the Bank of Greece (or Greek banks), then their understanding of economic reality is deficient.

      Think of a corporation which has cash management for its two subsidiaries. On a consolidated basis, they show credit balances in bank accounts of 1 million but one subsidiary has credit balances of 16 million and the other one has loans of 15 million. If the latter goes bankrupt and there are no guarantees from the parent company, the lenders to the latter will be unhappy campers. The debit/credit balances of Target-2 are booked in the NCBs; the ECB shows the consolidation.

      Imagine a wealthy Greek goes to his bank to transfer 10 million to Switzerland. Imagine further that this is the only transaction which the Greek bank handles on that day. At the end of the day, the Greek bank will be short of 10 million. It gets those 10 million from the Bank of Greece and they, in turn, get them from the ECB (by the ECB’s increasing its receivable against the BofG).

      Imagine that Greece’s current account deficit turns out at 21 BN EUR for 2011 (close estimate). The current account deficit is seen in the aggregate balance sheets of the Greek banking sector: in sum, Greek banks will have received 21 BN EUR less from offshore than they transferred to it. How is that financed? You got it! Target-2!

      A last example. Imagine Deutsche Bank cancelling 100 MEUR in short-term loans to Greek banks. Yes, at the end of that day, Deutsche has 100 MEUR more in domestic liquidity in Germany but Germany as a country hasn’t changed: what Deutsche got back, the Bundesbank had to lend. Defenders of Target-2 are right when they say that the overall German exposure to Greece hasn’t changed. But it does make a bit of a difference whether the exposure/risk is held by Deutsche or by the tax payers.

      See continuaton below.

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    2. What baffles me about Target-2 (and other ECB-refinancings) is where the collateral is coming from. I mean, if Greece has over 100 BN EUR in ECB-funding, they ought to have at least that much in Greek bonds to pledge to the ECB. But per 12/2011, the Greek banking sector showed only 52 BN EUR Greek bonds on their books. Greece (and others) keeps borrowing from the ECB like it was going out of style but where do they get the collateral from? Are they perhaps signing their commercial loan receivables over to the ECB?

      I wish the highly intelligent ECB-experts would come down to the level of simple cash flows one day. When Greece as a country loses about 57 BN EUR in liquidity in one year, that can only happen if “someone” outside Greece replenishes that liquidity. That is mathematics and not economics. In 2011, Greece lost about 57 BN EUR of liquidity (21 BN EUR current account deficit and 36 BN EUR bank deposit withdrawals). That is cash going out the doors of the banking system. And the highly intelligent ECB-experts refuse to accept that the replenishing cash going from abroad into the doors of the Greek banking system is not increased exposure/risk to Greece?

      Mind you: the Target-2 payment system has become an unlimited credit card to finance Greece’s standard of living. The card issuers (ECB/NCBs) must pay; period. In the past, ECB/NCBs did have a limit on the card by requiring as collateral investment grade sovereign paper. They would argue that they had to give that limit up because, otherwise, the Greek banking system would have become insolvent.

      I argue that this is exactly what the limit would have tried to achieve. Had the ECB/NCBs stopped lending, Greece would have had to freeze deposits and do all those other unpleasant things which become necessary when a country becomes insolvent. I could witness that more than once in Argentina. But I would argue that, had one done this, Greece today would already be on a recovery track and one would only mildly remember the deposit freeze of 2 years ago and the debt rescheduling going along with it (that is, of course, assuming that the emergency would have forced Greece to implement the needed reforms and economic policies quickly).

      This is why I have tirelessly argued that Greece’s primary problem is not the sovereign debt but, instead, the current account deficit. The budget deficit could be cured overnight if the political will and support of the voters were there. To repair a current account takes years, if not a generation. The current account deficit is the source of the Greek standard of living. Without it, there would be a lot less cars, motorcycles, smartphones, etc. By financing the current account deficit seemingly without limitation, ECB/NCBs are financing the standard of living of a whole country. Sorry, not ECB/NCBs; I meant to say “tax payers” are doing that…

      http://klauskastner.blogspot.com/2011/12/finally-importance-of-current-account.html

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    3. Herr Kastner, Herr King


      I have followed little of the actual letter, but your comments are clear enough. The problem with Greece defaulting last year seems to my mind to have been the CDSs - and more importantly their shadow, their derivative of which there are countless numbers.

      However, to avoid that situation, the result is an equally dangerous dilemma where the extra loans that have been made to Greece are now so large that they cannot easily be written off.

      I am getting a little cross with Frau Merkel (do I hear cheers off-stage from the Brits?) but I am more angry that Mr Cameron has not done more to help sort out this mess as an objective third party.

      Your comment about Greek living standards makes me realize how poor I am: I have a 15yr old car, a duff laptop and a modest council flat. Compared to how we lived in Britain, I am living a life of luxury even with this. To my mind, the Greeks need to have a reality check.

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  2. Thanks a lot Herr Kastner,

    Your "What baffles me about Target-2 (and other ECB-refinancings) is ..." gives me comfort in knowing I'm not alone in my struggle :)

    But I'm now confused even more, but not by your posts. But by some searches I did for TARGET2.

    TARGET is an acronmym - Trans-european Automated Real-time Gross Settlement Express Transfer

    TARGET2 is the name of a Computer System! It provides a common real-time gross settlement facility for the EU. My understanding is that it replaces the settlement systems of the national central banks. It was implemented in 2007. The British and Swedish central banks don't use it, their commercial banks have to clear Eurozone transactions via a foreign central bank, eg HSBC use the Dutch Central Bank.

    TARGET2 replaced the original TARGET computer system which linked the various national clearing systems, it was an interim system. TARGET2 was jointly developed by the French, German and Italian central banks. The rationale for TARGET2 is that it should be cheaper to run one system rather than 27 disparate inter-linked systems.

    Surely a computer system in and of itself would not change the underlying bookkeeping rules (other than by defects). Unless of course there were changes to the bookkeeping rules that were implemented in TARGET2 but not in TARGET.

    One assumes such changes have to be agreed by the 27 central banks at least and that they would be published in an ECB document. If changes were made to the bookkeeping rules then Sinn etc should be referring to these rule changes not the computer system that implemented the rule changes.

    I can't help but wonder if any problems that do exist with the bookkeeping embedded in Eurozone clearing systems haven't been there since Jan. 1 1999.

    TARGET2 - http://www.ecb.int/paym/t2/html/index.en.html

    The T2S system currently under development will eventually replace TARGET2 - here is the current plan - http://www.ecb.int/paym/t2s/progplan/html/index.en.html

    It also puzzles me that the concern regarding TARGET2 seems to only come from one place - Germany, and maybe only one person - Sinn. Why aren't the French and Italians up in arms about TARGET2.

    Thanks again for your detailed response - I shall continue my struggle ;)

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    1. Yes, Target-2 is a system/platform for electronic financial transactions just like Xetra is such a system. But in both cases the term has become synonymous for what goes on behind them. In the case of Target-2, what goes on behind it is no more and no less than the entire payments flow within the Eurozone (and more). Perhaps it is easier to understand the whole thing when one considers how the system would work if we had no computers yet.

      A country’s Balance of Payments must balance for mathematical (and not economic) reasons; just like a company’s total assets must balance with liabilities and net worth. Before the Euro, everybody understood that because the Balance of Payments meant “foreign currency” as opposed to transactions in local currency.

      Many people make the mistake of thinking that the Euro is now their local currency. Wrong! The nature of the Euro is much more similar to what used to be a foreign currency before the Euro. That goes for Greece as well as for the other 16 Euro-countries. None of the Euro-countries can print the Euro which is, of course, the major difference between a local and a foreign currency.

      Thus, a country’s Balance of Payments is just as important in the Euro-era as it was during the pre-Euro-era. Unfortunately, that fact got totally overlooked in the last 10+ years which is why these horrendous imbalances of trade and services (and cross-border debt!) could build up within the Eurozone.

      Suppose the Greek banking sector were only one single bank and that there would only be one transaction on a, say, Monday: a Greek transfers 10 MEUR from his local account to his account with Deutsche Bank in Frankfurt. Thus, the Greek bank must deliver 10 MEUR to Deutsche on Monday so that Deutsche can credit that amount to the account of the Greek. Suppose the Greek bank already has 10 MEUR in its account (“nostro” they call that) with Deutsche, then the balance in that account would be zero at the end of Monday because it would have been transferred from the nostro account to the Greek’s account. More likely, the Greek bank does not have 10 MEUR in its nostro with Deutsche. Thus, the Greek bank needs to borrow that money somewhere, probably from Deutsche itself. At the end of Monday, the Greek has transferred “private equity” abroad and Deutsche has made a new loan to the Greek bank.

      Continued below.

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    2. Now suppose Deutsche does not want to lend 10 MEUR to the Greek bank, and neither does any other bank. If the Greek bank cannot effect the transfer on Monday, it is insolvent and must close doors. Thus, the ECB becomes the lender of last resort. In pre-computer days, the Greek bank would have had to negotiate with the ECB, etc. etc. Under Target-2, this becomes automatic. And the collateral which the Greek bank must give to the ECB is actually given to the Bank of Greece because it is the NCBs which handle all those collateral transactions on behalf of the ECB.

      If the Greek banking sector were only one bank, all receipts from abroad (exports, foreign services, etc.) would come into this bank and all payments abroad (imports) would be made through this bank. For 2011, that meant that 21 BN EUR more left that bank to offshore than were received by that bank from abroad. From 2001-10, that shortfall was 199 BN EUR!

      Why were there no significant Target-2 balances before the crisis? Because foreign banks like Deutsche were happy to lend Greek banks the money. By 2009, they not only stopped making new loans but, instead, they even called back existing short-term loans. And the Target-2 balances started to sky-rocket.

      I don’t believe that there is a limit to borrowings from the ECB as long as one has sufficient “eligible collateral”. If I am not mistaken, the ECBs rule was that only investment grade sovereign securities counted as eligible collateral. A bank which needed liquidity but no longer had eligible collateral had to find liquidity elsewhere (for example by reducing customer loans). If a bank had collateralized loans from the ECB but the collateral was downgraded below investment grade, it would have to replace that with new eligible collateral or pay back the loans.

      This is where the ECB got between a brick and a hard place. Greek bonds were downgraded as collateral but the Greek banks could not repay the loans. Or Greek banks needed new loans (in order to effect private transfers to Deutsche in Frankfurt…) but had no eligible collateral for it.

      The ECB closed both eyes knowing that they couldn’t stop making new loans, not to even think about calling back existing loans. Had they done that, entire banking systems in Greece, Ireland, etc. would have been closed down. Thus, the ECB lowered and lowered and lowered its definition for eligible collateral. I have heard that nowadays they even accept asset backed securities (perhaps subprime?) as collateral.

      Back to Target-2. Since the Balance of Payments must balance also in Euro-times, any outflow of liquidity must be compensated by an inflow of liquidity. It may be that liquidity leaves the country as private equity and returns as debt, but the books must balance. Greece had tremendous outflows of liquidity (current account deficit and capital flight). Thus, she needed tremendous inflows, too. Until about 2008/09, the inflows came voluntarily from private lenders. Thereafter, the inflows had to come from the ECB (Target-2) because they wouldn’t come from anyone else. And the ECB not only had to send money to Greece for new needs but also for the repayment of existing loans from private lenders like Deutsche.

      At the time of the Lehman collapse, borrowings from the ECB were 14 BN EUR. At YE 2011, they were about 100 BN EUR. This means that the ECB has lent much more money to Greece more or less “behind closed doors” than the EU/IMF have lent under their rescue packages and with a lot of noise before open doors. Quite something, don’t you think?

      And then, of course, there is another almost 110 BN EUR which Greek banks owe to foreign banks and where foreign banks will sooner or later want to see repayment. Not to mention the ongoing needs for foreign funding to cover the current account deficit...

      This is why I have tirelessly argued that by only focusing on the sovereign debt of Greece one is focusing on only part of the problem, and it is the part which is much more manageable than to correct a current account deficit.

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    3. Canutely King

      More on this never-ending saga...

      http://kantooseconomics.com/2012/03/14/wie-eine-berechtigte-kritik-an-target-2-aussahe/

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  3. Thank you sir,

    with your help the message is sinking in, albeit slowly, I hope you don't mind me posting a couple of links I'm also finding useful

    A paper from Berlin Tech - "The Economics of TARGET2 Balances" ===>>> http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2011-035.pdf

    And a book from the ECB - "The Payments System" ===>> http://www.ecb.int/paym/html/index.en.html

    Thanks again - CK

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    1. Thanks for the paper; I have read it. Uff! That was a bit heavy stuff for the brains of a 63-year old! I am always impressed when supreme intelligence attempts to contradict common sense…

      After pages of Einstein-level arguments that Target-2 balances do not finance current account deficits, one of the conclusions is: “We explained that there is little evidence for the hypothesis that recent Target-2 developments reflect the financing of current account deficits of Euro-members Greece and Ireland but they rather mirror the still ongoing funding crisis in these countries”.

      Amen! If the Greek banking sector had no funding crisis (primarily offshore funding, that is), it wouldn’t need to borrow from the ECB. Money is a fungible entity. You can say that the ECB solved the Greek funding crisis and when the banking sector had enough funding, it could again finance the current account deficit, credit replacement and capital flight. Or you could say that the ECB financed the current account deficit, credit replacement and capital flight. The bottom line is the same.

      The paper states correctly that if the ECB had not done that, the banking sector would have collapsed because short-term loans from offshore were called back, deposits were withdrawn and imports had to be paid for. Again you can say that the ECB prevented the collapse of the Greek banking sector or it lent money to Greek banks to finance the above purposes. The bottom line is the same.

      Perhaps these experts should check with the Bank of Greece how they see it. I have done that. They confirmed to me that at that time (before Christmas) their Target-2 liabilities were 92 BN EUR and that they had financed the current account deficit et. al. with these funds.

      In Ireland I would guess that the ECB is primarily financing credit replacement (if I am not mistaken, the Irish current account is balanced). The German HRE had a subsidiary in Ireland which was funded by German banks. When HRE went belly-up, that funding was called back and the ECB had to replace it. The bottom line is that the ECB now funds about 25-30% of the Irish banking sector (I believe).

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  4. Dear Sir,

    Very interesting points about TARGET2. But there is much more in it, I believe. TARGET2 in my view is at best a flawed mechanism and at worse a blatant fraud.

    First of all, in any other country around the world which uses its own currency, international transactions do not impact its money supply, and so a current account deficit in money terms is balanced with a capital account surplus also in money terms (and vice versa). In the case of eurozone countries however, the deficit country suffers from a reduction in its money supply and the surplus country from an increase. Thus, in money terms, the balance of payments of the eurozone countries is not balanced. If this imbalance persists, it will inevitably lead to deflation and credit losses in the deficit country (since given the lack of cash, not all bank credit can be repaid) and to inflation in the surplus country.

    So despite having a common currency in the eurozone, the prices of surplus countries will tend to increase relative to the ones of the deficit countries just like it happened before the euro. But isn't this price divergence going against the primary objective of the Eurosystem to maintain price stability and against the very reasons for the adoption of the euro in the first place?

    Secondly, under the current system the surplus countries through TARGET2 acquire a claim against the deficit country on which they receive interest - paid in real money. But there has been no cash outflow to justify this. On the contrary, there has been a cash inflow! So without providing any money, the surplus country receives investment income from the deficit country. Personally, I find it difficult to calculate the IRR of this "investment".

    Lastly, from the NCB's point of view, BofG in your example, what sense does it make to collateralize the loans to the Greek bank with a security that loses value upon the inception of the loan? Isn't the Eurosystem dropping itself (and the euro) into the abyss in this way?

    I am truly convinced that TARGET2 is the fundamental flaw in the euro's design for this reason. The money supply of a country should not be impacted by international transactions. Price stability should not be achieved only on average over the eurozone, but in each country individually. And the the current account deficit of the euro countries should not be financed with funny central bank money but with real money, like it happens everywhere else in the world.

    I would be very happy to read your thoughts on this!

    My best regards,
    2mtm

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    1. Upfront: I am no expert with the functioning of Central Banks. My background is commercial banking and I have common sense. You raise interesting and thought-provoking points. Don’t consider this as “answers from an expert” but only common-sense comments. I like to explain via images.

      Imagine that Greece still had the Drachma. Then the Euro would be a foreign currency. The Balance of Payments (incoming and outgoing Euros and other foreign currencies) would have to balance for mathematical reasons. The current account deficit would be limited by the amount of Euros and other foreign currency Greece could obtain from abroad (either as debt or as equity). If Greece couldn’t obtain enough foreign currency, she would have to curtail imports (or Greeks would have to use their offshore Euros to pay for imports).

      By joining the Euro, Greece (and the other 16) did not get a new local currency. Instead – and this is the key point! – she gave up her local currency (part of her sovereignty) and opted to do business only in a foreign currency, the Euro. I think the major point which is overlooked these days is that the Euro is much more similar to a foreign currency than a local currency for the 17 countries which use it. Not one of the 17 can print the Euro!

      What the 17 countries did is like Argentina deciding to give up their peso and use only USD from now on. Argentina tried something like that a couple of decades ago but they had the good sense not to physically give up the peso but, instead, to only fix it to the USD. When the stage came crashing down, they only had to give up the fixed rate but did not have to create a new local currency.

      Having said this, the Balance of Payments is consequently as important with the Euro as it was before the Euro. I would argue even more important because before the Euro, the BoP had an automatic self-correction: if there was no more foreign currency inflow, there could be no more foreign currency outflow. With the Euro, the BoP has Target-2: when a country has much more outflow of Euros than inflow (i. e. because of imports), the hole is automatically filled by Target-2.

      Target-2 became important for Greece only after the crisis began. Before the crisis, foreign banks simply could not lend enough money to the Greek banking sector (and to Greece), so they filled any hole which opened up in the BoP. Since the crisis, this existing debt is being taken over by the ECB and the ECB finances automatically the entire foreign currency (Euro-) shortfall of Greece.

      You are perfectly right: a BoP must balance! Thus, a deficit in the current account must mathematically be offset by a surplus in the capital account. No way around that. Unfortunately, with the Euro, people didn’t really pay much attention anymore to things like current account deficits because they believed that, with a common currency, all of this didn’t matter any longer. They should have looked to the unified Germany. The former East has the same currency as the West but it has an enormous current account deficit with the West. The result is that the West has had to make transfer payments to the East to the tune of almost 100 BN EUR for over 20 years now.

      Contrary to what you say, all BoPs of Eurozone countries (of all countries) are balanced. Interestingly, even the current account for the entire Eurozone is balanced, which is sensational! What is totally out of whack are the current account balances of individual countries (Greece had a deficit of almost 21 BN EUR in 2011; staggeringly high but a lot less than the 44 BN EUR of 2008…).

      Continued below.

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    2. Knowing that a current account deficit must be offset by a surplus in the capital account, Greece will need an inflow of foreign currency for as long as she has a current account deficit. Since Greece has no oil and does not produce cars, motorcycles, smartphones, etc., she is likely to have a significant current account deficit for many years to come. How many years? Until revenues from exports and tourism are increased so much that the cover the hole (and I Ieave it up to you to guess how long that will be…).

      And this is one of my major points: one could forgive Greece her entire sovereign debt and even the foreign debt of the private sector, all roughly 500 BN EUR, and she would still need upwards of 10 BN EUR funding from abroad annually today (in growth times upwards of 25 BN EUR!) to sustain the current standard of living. If that capital inflow stops coming, the Greek economy is thrown back by decades. Since it is unlikely to come as much in the form of debt as in the past, it now must come in the form of equity (foreign investment). Thus, I see only 3 solutions for the Greek economy: foreign investment, foreign investment and, again, foreign investment.

      On one point I need to correct you: it’s not the prices in the surplus countries which increased relative to the prices in the deficit countries. That would be wonderful for Greece if it were so! Instead, the prices in the deficit countries have increased faster. Relative to Germany, Greece has allegedly become 40% more expensive. However, the international purchasing power of the Greek Euro remained the same as that of the German Euro. Thus, the Greeks logically decided to buy their products abroad (imports) instead of domestically. Only a fool would buy Greek toothpaste if it is twice as expensive as foreign toothpaste.

      A current account deficit means that liquidity is being withdrawn from the economy (as you say). In the case of Greece, it was substituted by foreign debt (instead of foreign equity). If Greece had no current account deficit, she would not need funds from abroad (neither debt nor equity). With a current account deficit, the foreign funds requirement is mathematically automatic. Put differently, if there are no more funds from abroad, the imports come to a halt (and the living standard goes out the door).

      If Target-2 liabilities build up on the books of the Bank of Greece, then the BoG has received funds on which it legitimately pays interest. You can receive funds in 2 ways: either by actually receiving them or by increasing liabilities (source of funds is ether decrease in assets or increase in liabilities/equity).

      How can I explain to you the point about collateral when I don’t understand it myself? I mean, I heard that in Italy some banks no longer had securities to offer the ECB as collateral for loans. So they issued a promissory note for the money they owed the ECB, had the state guarantee it and – surprise, surprise! – they now had eligible collateral!

      I don’t think Target-2 is a fundamental flaw in the Eurosystem. It is the cash management system of the Eurozone and apparently a very well functioning one. Like with PCs, when something goes wrong, it is often the user’s fault and not the fault of the PC. If ECB/NCBs had enforced the rule that only investment grade securities qualified as eligible collateral, Target-2 balances could never have reached the levels where they are now.

      Perhaps these links will explain more to you how I think.



      http://klauskastner.blogspot.com/2011/10/thinking-aloud.html
      http://klauskastner.blogspot.com/2011/12/finally-importance-of-current-account.html
      http://klauskastner.blogspot.com/2011/10/letter-to-ekathimerini-on-foreign.html
      http://klauskastner.blogspot.com/2011/10/importance-of-foreign-investment.html
      http://klauskastner.blogspot.com/2011/09/endgame-for-greece.html
      http://klauskastner.blogspot.com/2011/06/letter-to-mr-george-papakonstaninou.html

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  5. I found this post and discussion helpful in improving my understanding the TARGET2 controversy

    Is There an ECB ===>>> http://ineteconomics.org/blog/money-view/there-ecb

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    1. Canutely King

      Here is another instalment on this issue. It is diametrically opposed to my view but this seems to be a subject where you ask 3 people and you get 4 answers.

      http://www.handelsblatt.com/politik/oekonomie/nachrichten/geldpolitik-target2-und-was-wirklich-dahinter-steckt/6318300.html

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  6. Und so, Herr Kastner
    the rumours of your death were greatly exaggerated.
    The entire ECB >><< national central bank interpayments system has been hijacked by reckless borrowers. We can only assume once more that Rip Van Trichet nodded off while it was going on.
    I hold to my belief that Merkel will weigh her options, but that most likely Greece will be pushed into default...around about 9 pm on March 23rd...a Friday, after the euromarkets have closed, and the foreign law holdout is confirmed.
    Was denken-Sie?
    Either way, an incredibly informative blog and I shall be returning regularly.
    Vielen Dank
    The Slog
    http://hat4uk.wordpress.com/2012/03/09/march-23rd-it-just-keeps-on-and-on-turning-up/

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    Replies
    1. John, I can confirm that I am alive and well, and getting ready for the next trip to my wife’s home country Greece where we spend about half the year. I am making price lists of supermarket products here in Austria so that I can compare them with prices at the Gran Masoutis. Since 2 years now, I am waiting for Greek prices to come down. As of December of last year, they hadn’t (admittedly, our apartment is not in an average area of Thessaloniki).

      Default on March 23? Maybe yes, maybe no. My guess is that there won’t be a default but your guess is just as good.

      The troika’s goal is to take Greece off the capital markets for up to 10 years buy lending the government all the money it needs. Well, no borrower who is assured of continued funding can go broke.

      One of the major points in my blog is that Greece’s sovereign debt is by far not the most important issue. Suppose the Troika indeed funds the Greek government for the next 10 years. They will soon discover that this is not enough by far.

      At the rate of 2010-11, Greece lost about 20 BN EUR (plus) annually in liquidity for the current account deficit and another 30 BN EUR (plus) for deposit withdrawals. To replace that funding through the ECB makes funding the government’s deficit look like peanuts.

      The current account deficit is not going to go away and there are still another 160-170 BN EUR in bank deposits which can be withdrawn. Those are some real big numbers which need to be transferred to Greece unless the 2 major holes in the pit are closed: curtailment of imports through special taxes and capital controls. Greece has no chance of making it if one does not curtail these 2 EU-freedoms at least temporarily (to allow for some “infant-industry protection”). If that means violating EU-treaties for a while, so be it. France/Germany where the first ones to set the precedent of violating EU-treaties. This is an emergency and emergencies require emergency legislation. Treaties can be amended; at least temporarily.

      The measures so far have served to make the borrower weak and the creditors stronger than they were before. That, of course, is a process which can’t go on forever.

      Government-steered stimuli will have one major effect in Greece: they will drive up the bank deposits which wealthy Greeks hold in offshore accounts. That is why I have been arguing seemingly endlessly that Greece needs private foreign investment in middle-market type of projects (initially substitution of imported consumption goods). The investors must be private parties who watch out what their money is used for. And to incentivate them to invest in Greece, the EU should guarantee the political risk of such investments (not the economic risk).

      There is no point in trying to draw water from a dried-out well. Neither is there a point in dumping water into that well so that it can be drawn afterwards. The well must be repaired so that it generates water on its own again. If some money is required for that purpose, be my guest!

      Thanks for your compliments on my blog. To make it easier for you, at the beginning there is a table of contents of the more important articles.

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  7. Klaus, just in case, and I have no idea about this anyway. As a matter of fact to look closer without any chance to really understand starts to frighten me, really. ...

    But I got your idea of a "current account" versus "state debts", vaguely, wondering to what extend it may be related to some blogs or comments I follow, more indirectly, in other words as somewhat assumed knowledge I do not have.

    In any case, our friend Dean Passaras or as I like to call him Cerberos, now links to Yanis excellent, I guess, result in that context.

    With ratzilla Schauble breathing down your neck

    His link directly:
    Trading Economics: Greece Current Account 1997-2015

    L

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