Like with icebergs, the financial hazards you can see are manageable, the ones you can’t - lethal. And similarly for those in the crow’s nest of high finance, once you have spotted the hazard, it’s usually far too late to turn the ship.
“TARGET2” is defined as “an interbank payment system for the real-time processing of cross-border transfers throughout the European Union. Payment transactions are settled one by one on a continuous basis in central bank money with immediate finality. There is no upper or lower limit on the value of payments. TARGET2 mainly settles operations of monetary policy and money market operations. In terms of the value processed, TARGET2 is one of the largest payment systems in the world.”
Put more simply, it is a ledger of the debits and credits between businesses, households and banks within the Eurozone. To simplify further, it is how the flow of money within Eurozone’s single currency is broken down on a country-by-country basis, not so much for the country’s national debt, but more for the man on the street. Quietly however, that distinction has begun to show just how franticly the men on the streets from Athens to Dublin are trying to turn the ship’s rudder.
Whilst the ECB has made available considerable liquidity to European Banks in the form of the LTRO and that same liquidity has helped to drive up the prices on sovereign debt, the Target 2 data shows that the process of “capital flight” on a private level has accelerated at a frightening pace. That is to say, the money that was pumped into the “public” sector in the debt laden southern states of Europe, was simply extracted by the private sector and placed back with the northern states which had, in effect, supplied it in the first place. A convection current of hot money between north and south has emerged, replacing that of the hot air from the politicians.
The scale of the problem is not its only impressive feature, but is also its speed. The process has picked up pace since the LTRO began and shows few signs of slowing.
What this means for Germany is that the cost of losing Greece is not just limited to money it owes the ECB and private investors at the sovereign level. It has much, much more harrowing implications at the private level. Due to the ECB’s structure, the losses on Target2 deposits would be divided amongst the remaining countries, so any future exits would simply increase Germany’s exposure to the ECB’s liabilities.
Curiously, there has been a relative lack of commentary in the popular press on what is seemingly such an important issue. If the crisis were simply a question of writing off the value of the EUR125bill or so of sovereign debt owed by Greece, no doubt that could be swallowed up. The market has already digested a mark down in global assets in the trillions. Perhaps, if they were to also write off the money owed by Greece to the northern states within the Target2 system, the situation would still be manageable (given the ECB might finally be empowered to create a large enough rescue fund).
However, were Greece to leave, what is more likely is that the speed of the capital flight would simply increase. The man on the street (be it Rue de la Paix, Calle del Espiritu Santo or Via Garibaldi) has already lost patience and faith in the system. If / when there is a “Grexit”, there will be no hanging around for the conclusion of another conference filled with empty, career saving rhetoric. He will simply move his Euros as quickly as possible, likely into the nearest lifeboat, the good ship “Bund”.
Were further capital flight to ensue, the cost to Germany of more than one country leaving the Eurozone would increase exponentially. The private deposits held in northern European states would presumably have to be honoured in the new Euro currency (the old Euro ex of whichever country had left), whilst the debts at the interbank level could well be restructured if not written off. At the very least, the value of the debt the ECB holds would be reduced dramatically by the fall of the domestic currency upon exit. (Follow this rabbit down the hole – an investor in Spain moves their money to a bank in Germany – this creates a liability at the Target2 level. They then use that money to buy gold and have the gold transported back to Spain. Spain then exits the Euro and reneges on its liabilities under Target2. Germany (ECB) then has a hard loss. It is of note that under Target2, the National Central Banks do not transfer any collateral to the ECB to cover their liabilities).
For those looking to consider that complexity further, ponder the following. Traditionally, capital flight is all to horribly apparent - foreign investors and all those within the country fortunate enough to have an overseas account remove their money from the domestic banks and exchange it into a more stable currency, usually the US dollar. The currency typically depreciates until it gets to a level where it becomes attractive enough to stabilize itself, the country in question becoming more competitive. However, in this instance, we have “capital flight” with no “run on the currency”. Instead, a huge imbalance of capital is accruing at the ECB and, as we explored before, that liability is split between the solvent ECB partners on a pro-rata basis pegged to each country’s GDP. Shorthand – if it continues for much longer, Germany will be owed so much money by the rest of Europe that the problem will be theirs and not the debtor countries. The age old saying of “if you owe the bank £100, it’s your problem, if you owe them £100mill, it’s theirs” will apply, only on a much bigger and far more complicated scale.
One wonders then, to what degree any increase in activity in the shift in Target2 deposits will play on the minds of the German decision makers in weighing up the real costs of their actions, especially if is about to become “their problem”. The simple truth is that the capital flight within the Target2 system is a process over which the policy makers have little control. The cost of transferring the cash to a “safer” jurisdiction is close to zero. As such, once all faith has been lost in the prospect of monetary policy shoring up the weaker states, the run for the door will be unstoppable. Perhaps a realization of the scale of the problem within Target2 will be the catalyst for a softening of Germany’s position on Eurobonds. For if not, how else will the ECB be able to pay off Germany?
James Conway works for Portman Capital and was one of the authors of the CPS publication "Give Us Our Fair Shares"