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Wednesday, June 20, 2012 3:22 AM

Discussion of Target2 and the ELA (Emergency Liquidity Assistance) program; Reader From Europe Asks "Can You Please Explain Target2?"

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Reader Thomas who lives in the Netherlands writes ...

Hi Mish,

I am a daily reader of your blog. I live in the Netherlands. Recently I saw an overview of target2 balances, including charts.

Could you explain target2 and what the graphics mean?

Does it really mean that we in the Netherlands work to export goods to the PIIGS-countries and that they are not paying for the goods we deliver?

That instead of receiving money for our goods, we get a promise from the national bank to pay the money? And that we are paying higher taxes to our government, so that they can give that money to the ESM, which gives it to the national banks of the PIIGS?

In essence: are we really giving away our goods for free?

Target2 Explained

I replied to Thomas ....
Hello Thomas

Here is a Target2 Balance Example:

If a Greek depositor sends money to a foreign bank (say a German bank), that bank now has additional deposits. To the extent it doesn't want to recycle them (in the past, it may have used them to buy Greek government bonds), it deposits them with a NCB (national central bank) - in this case the Bundesbank (Germany's Central Bank).

Target claims are created because the Greek bank that loses deposits gets funding via the ECB's ELA (Emergency Liquidity Assistance) program.

Simply put, the ECB sends money to the Bank of Greece in a kind of open credit line to make up for the cash that left the Greek bank. There are some restrictions, but not many.

This is not a major problem unless Greece changes currencies or defaults. If it does, Greece will repay the credit line with Drachmas, not euros (or if the radical left had won, perhaps not at all). This is precisely one of the things that had everyone excited.

Germany is responsible for its share of any such losses at the ECB according to its percentage in the EMU, roughly 27%.

France, Italy, and Spain are next in line to take losses.

There is a table of percentage Responsibility Percentages on Wikepedia. The table may not be perfectly up to date, but it should be close enough.

The Netherlands would be responsible for about 5.7% of any Target2 losses associated with a Greek default, whether the money is sitting in German banks, Austrian banks, Dutch banks, etc.

If Spain leaves, its 11.9% will be reallocated to the other countries.

You comfortable with this setup?

I hope not.
Responsibility Percentages

click on chart for sharper image

That table refers to EFSF commitments, so the important column is percentages. Percentages apply to the ESM as well as each country's commitment should there be a default. All the percentages change should a country default.

Should Spain default, its  11.9% would have to be redistributed proportionally to the other countries.

Balance of Trade

I bounced my reply off my friend Pater Tenebrarum at the Acting Man Blog who added ...
Your explanation is correct. In the context of a default, however, Thomas is also correct about 'giving away goods for free'.

For example: Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been 'acquired' is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment.
Capital Flight vs. Balance of Trade

Thus, Target2 applies not only to capital flight but also to balance of trade issues.

There is no official breakdown, but Tenebrarum made an attempt to distinguish between the two by subtracting balance-of-payment data from Target2 balances in his May 29 post Another Look at Euro Area Capital Flight.

Tenebrarum notes a problem with delayed data. 

First Rule of the ELA

Tenebrarum also points to the Bloomberg article Frozen Europe Means ECB Must Resort to ELA for Banks.
The first rule of ELA is you don’t talk about ELA.

“The lack of transparency is a double-edged sword,” said David Owen, chief European economist at Jefferies Securities International in London. “On the one hand, it increases uncertainty, but at the same time we do not necessarily want to know how bad things are as it can add fuel to the fire.”

The ECB buries information about ELA in its weekly financial statement. While it announced on April 24 that it was harmonizing the disclosure of ELA on the euro system’s balance sheet under “other claims on euro-area credit institutions,” this item contains more than just ELA. It stood at 212.5 billion euros this week, up from 184.7 billion euros three weeks ago.

The ECB has declined to divulge how much of the amount is accounted for by ELA.

“ELA is a symptom of the strain in the system, and Greece is the tip of the iceberg here,” Owen said. “As concerns mount about break-up, that sparks deposit flight. Suddenly we’re talking about 350 billion, 400 billion as bigger countries avail of ELA.”

For Citigroup chief economist Willem Buiter, there is a bigger issue at stake. ELA breaks a key rule that is designed to bind the monetary union together, he said.

“It constitutes a breach of the principle of one monetary, credit and liquidity policy on uniform terms and conditions for the whole euro system,” Buiter said. “The existence of ELA undermines the monetary union.”
The key sentence is the last one. "The existence of ELA undermines the monetary union."

That explains why they want to keep it a secret.

 Mike "Mish" Shedlock
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