Soaring Target2 Imbalances Stoke German Risk Angst: Euro Credit

German angst is growing as an entry on the Bundesbank’s balance sheet swells to a sum worth about 20 percent of economic output, a sign of the extent to which Europe’s largest economy is funding the region’s laggards.

The European Central Bank’s Target2 system, which calculates debts between the euro region’s central banks, shows the Bundesbank is owed 489 billion euros ($656 billion), up almost 65 percent from a year earlier. German central bank President Jens Weidmann wrote to ECB President Mario Draghi last month to warn about growing systemic risks, Frankfurter Allgemeine Zeitung newspaper reported Feb. 29.

“The Germans are very much justified in their concern,” said John Whittaker, an economist at Lancaster University Management School, who drew attention to the growing imbalances in papers published last year. “The Target2 liabilities are just as risky and just as real as holding the government bonds of Greece and other peripherals.”

Investors demand a yield premium of about 3.28 percentage points to hold Spain’s 10-year debt rather than Germany’s, and 3.15 percentage points to own Italian securities rather than bunds. Both levels are more than double their averages for the past five years. Italy had a Target2 deficit of 191 billion euros as of Dec. 30, while Spain’s was 175 billion euros and Ireland owed 80 billion euros, according to figures compiled by their central banks.

‘Dependent on Germany’

“There would have been a current-account crisis years ago in a multi currency area,” said Darren Williams, who helps oversee about $420 billion as chief European economist at AllianceBernstein in London. “The periphery is dependent on Germany and the core to fund their consumption.”

The Target2 system, named for the Trans-European Automated Real-Time Gross Settlement System, is part of the common currency’s plumbing system to settle transactions.

A Greek importer, for example, might place an order with a German company. Payments to and from the accounts of the buyer and seller are channeled via central banks, so the German exporter’s bank gets a credit with the Bundesbank, which in turn has a claim on the ECB. The Greek importer’s bank owes its local central bank, leaving the Bank of Greece with a debit at the ECB.

Transactions across the 17-member euro region produce a net surplus or deficit between countries at the ECB, and the system depends on each country being able to meet its obligations. The less willing commercial banks are to deal with each other, the more lopsided the balances between central banks become. The Dutch central bank has claims on its peers of 153 billion euros, while Luxembourg is owed 110 billion euros, according to Whittaker.

To The Limit

“The Bundesbank effectively ends up with loans to the other national central banks that are reflected in the Target2 claims on the Eurosystem,” said Andrew Bosomworth, a managing director at Pacific Investment Management Co. in Munich. “The euro zone is doing fiscal policy-like stuff through monetary policy, but it’s not going through the same democratic process. It’s not a good thing from a voter’s perspective when you push it to the limit.”

Greece, which had a Target2 deficit of 105 billion euros as of the end of November, last week carried out the biggest-ever sovereign debt restructuring, forcing private creditors to forego more than half of their principal.

Damaged Collateral

The bonds Greece is issuing in exchange for existing debt are worth less than 30 percent of face value, suggesting investors expect the nation to need another bailout. Bonds of Portugal have yielded more than 12 percent every day bar one since Nov. 24, even as the ECB continues to support the market by buying the notes. The nation’s 10-year borrowing cost is currently 13.83 percent, up from 12.77 percent on Feb. 24.

The Target2 system is underpinned by the collateral held by the central banks, and its stability depends in part on how the value of those assets compares with how much has been borrowed against them.

Germany’s Target2 position is now large enough to account for half of its net investment abroad, according to Greg Fuzesi, an economist at JPMorgan Chase & Co. in London. He questions the value of some of the assets in use, citing government-guaranteed bonds that Italian banks issued to themselves and used to back borrowings through the ECB’s three-year longer term refinancing operations.

Collateral represents “a real credit risk,” according to a research report by Guntram Wolff, deputy director of Bruegel, a Brussels-based research institute. “If the risk materializes in the future, the Eurosystem will incur losses.”

Only Connect

Using money borrowed from the ECB to repay bonds held by foreigners, may increase the imbalances, Fuzesi said. “The risk of the Eurosystem is very much a function of the collateral that’s been posted by the periphery and of the risk management tools applied to it by the central banks,” he said.

Asymmetries in the system will correct as peripheral economies again attract funds from core countries as bailouts, bank recapitalization and declining current-account imbalances restore confidence. A break-up of the euro, however would crystallize the risks, he said.

Target2 makes countries “very, very interlinked,” Fuzesi said. “Everyone has an interest in holding the system together. Certainly the Germans do.”