Perfectly rational financial processes can blow up if underlying economics collapse

During any crisis, apart from changes in the operating and regulatory environment which serve to make processes stronger, one of the outcomes is that obscure words?terminologies, institutions, actions?come out of the confines of insiders into a wider lexicon. Sub-prime, Alt-A, CDOs, central bank balance sheets, and so on. Over the past few months, another one, relevant to Europe, more specifically to the interconnectedness embedded in the banking systems of the member states comprising the eurozone, is engaging a great deal of attention. This is Target 2.

Let?s begin with the reason for this article on Target 2, which is the latest macroeconomic update on Europe. Just when there had begun to emerge some hope that the worst of Europe?s troubles had subsided, the IMF?s outlook has again, if not roiled the waters, put the spotlight on underlying weaknesses. And the mechanism for this weakness is another esoteric term: Fiscal Multipliers. If you remember, a precondition for the support of stronger European economies to the weaker ?South? was the implementation of economic reforms for addressing the structural imbalances that had led up to this sovereign debt crisis. These centered around the underlying loss of competitiveness of the southern European states, with inflated wage bills, a bloated public sector and enlarged current account deficits. The ?northern? countries (dominated by Germany, but also Austria, Finland and a smattering of the smaller Scandinavians), assuaging the legitimate sentiments of the electorate, insisted that support be tied to concrete actions by the support-recipient countries to tighten their fiscal belts.

The latest IMF assessment indicates that the downside effects of these linkages were severely underestimated. ?The evidence increasingly suggests that in the current environment, the fiscal multipliers are large. In many countries, banks are still weak, and their positions are made worse by low growth. As a result, many borrowers still face tight borrowing conditions.? In other words, the effects of the fiscal consolidation (in India?s lexicon) might be much larger than is being estimated by governments and multilateral institutions, and being assumed by their respective governments in conducting their fiscal austerity programmes. The growth-slowdown effects might be much larger than is now being estimated. The short point of all this is that Europe is not out of the woods yet, although the chances of a dismantling are now significantly lower.

The implications for the financial support architecture that is the bedrock of Troika (EU/IMF/ECB) interventions are obvious. If many of the mandated macroeconomic parameters are not met, support will become increasingly problematic. This sets up the conditions for a slow burn into eventual dissolution of the economic union. This is where existing liabilities (and in particular, a routine transactional system called Target 2) becomes important.

Target 2 (Trans-European Automated Real-time Gross Settlement System) is akin to India?s RTGS, the high-value electronic funds payments and settlement system. Normally, this is a humdrum, if intensely sophisticated, process. However, the idiosyncrasies of the architecture due to the special characteristics of the eurozone have been exacerbated by the ongoing debt troubles of the member countries. The former arises since each member country of the eurozone, despite the common currency, has its own central bank, and cross-border funds? transfers are a tripartite arrangement between commercial banks, the respective central banks and the ECB.

The debate on Target 2 started in 2011 and has been cropping up periodically. The reasons for this article dredging up Target 2 now are manifold. First, just as a For Your Information heads-up, to disseminate awareness of a mechanism that has the potential to create headaches, if not trouble, in the event that concerns about the eurozone flare up. Second, Target 2 balances are liabilities, which might strain individual country and central bank balance sheets, in the event of what are called ?adverse credit event?, such as a splitting of the eurozone. Third, it is being speculated that Target 2 has become a channel for capital flight out of the stressed southern states. Fourth, and more worrying, is that this represents a ?stealth bailout? of these periphery nations.

What is Target 2? This is described in a Federal Reserve of Richmond paper: ?When a Greek bank transfers money to a German bank, Target 2 debits the Greek bank?s account at the Bank of Greece and credits the German bank?s account at the Bundesbank. The Bundesbank incurs a new liability (the deposit from the German bank) that is offset by a new asset (a claim against the ECB).? Essentially, the Target 2 system is the ECB.

Since the advent of the euro system in 1999, funds have flowed both ways, so there were few imbalances. After the financial crisis, however, the Bundesbank has become a large net positive claimant (see chart) and the periphery nations large negative ones. In particular, during the late summer 2012 phase of increasing volatility in European countries, deposit flows out of troubled periphery countries towards the stronger northern countries picked up pace. This resulted in what is described as a stealth bailout: an expansion of the Target 2 balances with their respective central banks.

Normally, as has been pointed out by scholars, this is not a problem. But if the fiscal multipliers were to aggravate the macroeconomics of the peripheral countries, resulting in (the extreme contingency) of some of the larger peripheries exiting the Euro area, their Target liabilities will be left with the ECB. Their balances then become contingent liabilities of taxpayers of eurozone countries, depending on the share of paid-up capital in the ECB. Germany?s share is 27%, Greece?s 3%. Greece has an approximate euro 100 billion negative Target balance, Spain euro 300 billion. In the event of exits, the ECB would be left with these liabilities, with German taxpayers having to shoulder 27%.

There are other operational implications of the Target balances. Why have they suddenly increased so much? Because individual central banks have used the Target system to fill up the gaps in their balance sheets created by loss of deposits (both individuals and government), their repo operations (LTRO) and others. One reason Germany is apparently concerned is that national central banks do not keep collateral with the ECB for the balances they borrow.

Bottom line? Target contingent liabilities will probably not become a financial threat, but, in having become a shadow funding channel, have emerged as a risk to the euro financial system. At the same time, this has become a parable for the way even routine financial systems transform into channels of financial instability. And, a bit ironically, yet another argument for preserving the eurozone.

The author is senior vice-president, business & economic research, Axis Bank. Views are personal