The Target system is a payment system that clears payments within the Eurosystem (European Central Bank and national central banks). The balances of the national central banks connected to this payment system were more or less zero in the early years. However, there have been sharp rises in Target balances since the financial and economic crisis in 2007. How could this happen? And what does this rise mean?
How does the Target system work?
Target is the acronym for “Trans-European Automated Real-Time Gross Settlement Express Transfer System“. It was put into operation at the beginning of 1999. The system is used when there are cross-border payments between national central banks within the euro system. An example of this is (see Fig. 1):
- A German machine manufacturer sells machines worth €200,000.00 to an Italian automaker. From Germany’s point of view, this is an export of goods.
- The Italian automaker instructs its commercial bank to transfer this amount to the German commercial bank of the machine manufacturer. The Italian commercial bank debits the €200,000.00 from the account of the automaker.
- The commercial bank then transfers the amount to the Italian Central Bank. The inclusion of the central bank is necessary because it is a cross-border transaction.
- The Italian Central Bank debits the €200,000.00 from the account at the Italian commercial bank and transfers the amount to the European Central Bank (ECB).
- The ECB then transfers the amount to the German Central Bank.
- The German Central Bank (Bundesbank) transfers the amount to the commercial bank where the German machine manufacturer has its account.
- Then the German commercial bank credits the amount of €200,000.00 to the machine manufacturer so that it has received the money for the export of its products to Italy.
The ECB thus acts as a clearinghouse between the national central banks in the case of cross-border transfers within the eurozone.
Where do Target balances come from?
If the payment transaction described here is the only cross-border payment, Target balances are built up:
- The Italian Central Bank transferred €200,000.00 to the German Central Bank via the ECB. From the point of view of the Italian Central Bank, therefore, it has incurred a debt to the ECB in the amount of €200,000.00 if there is no previous credit balance.
- The ECB has credited the German Central Bank with an additional amount of €200,000.00. The described logic means that: The German Central Bank has a new claim against the ECB in the amount of €200,000.00.
In this example, the Target balances of the two involved national central banks are not balanced. The Target balances match the trade balances of the two economies:
- Since there is only one cross-border trade relationship in this example, Germany has an export surplus of €200,000.00. Italy has a trade deficit at the same level.
- The German Central Bank’s claim against the ECB matches the German export surplus. The revenues associated with this export surplus are transferred to Italy. From the point of view of the German economy, there is a capital export. It finances the Italian trade deficit.
- The Italian Central Bank’s debts to the ECB match the Italian trade deficit. From Italy’s point of view, there is a capital import that finances the trade deficit.
How did the Target balances develop?
The change in these balances can be seen, for example, in the monthly Target balances of the German Central Bank (see Fig. 2). This balance was more or less zero until the beginning of the global financial and economic crisis in the summer of 2007.
This can be explained by the fact that German economic stakeholders – especially private companies and banks – were willing to cover the financing needs of European economies with import surpluses by providing loans. For the Germany-Italy example, this means: In addition to the financial transactions mentioned, there is a second economic transaction. It is possible, for example, that the German machine manufacturer does not need its export revenues for the time being and leaves the money in the account of its commercial bank. The German commercial bank can use the amount of €200,000.00 to give the Italian commercial bank a loan and thus earn interest income.
To do this, the ECB must be involved again: The German commercial bank transfers the €200,000.00 to the German Central Bank, which transfers the amount to the ECB. From there, the money flows through the Italian Central Bank to the Italian commercial bank. The Target balances of the participating national central banks are thus zero again (see Fig. 3).
Why have Target balances soared since 2007?
The rapid rise in German claims in the Target system since 2007 is due to the fact that there is no longer balancing by private economic stakeholders. Thus, the financial resources matching the German export surpluses no longer flowed to the southern European countries with import surpluses on the basis of private lending.
The reason for this is probably above all the fear that southern European borrowers will no longer be able to repay all the loans. The decision not to receive interest income in connection with lending is then an economically sensible one. The southern European trade deficits were therefore financed by the national central banks and the ECB instead.
Are the high Target balances a problem?
Whether the high claims and debts now in the Target system represent an economic problem, has been the subject of intense discussion since 2011. Hans-Werner Sinn, former President of the Ifo Institute, pointed out the growing Target balances in the eurozone for the first time in February 2011.
An assessment of the ensuing discussion would go beyond the scope of this post. Only six points should be mentioned here in regard to the Germany-Italy example:
- Basically, the following can be said: Any trade deficit (a country’s exports are smaller than its imports) requires financing from abroad. In a world where there are only two countries, this funding must come from the country with an export surplus. This financing may be provided either by private lenders (commercial banks, savers, investment funds) or by the central bank, which is part of the public sector of the economy (see Figure 4). The amount of foreign debt is basically critical for the creditworthiness of Italy. High Target balances are not an economic problem in this regard.
- It should also be noted, however, that: The fact that private lenders are unwilling to finance the Italian trade deficit can be taken as an indication that Italy’s credit rating is low. The fact that central banks have to step in is problematic because growing Target balances indicate an increasing risk of default.
- At the same time, however, it is necessary to consider that if the Italian trade deficit is financed by Target balances, the Italian central bank is involved. As long as it is solvent, there will be no asset losses for the ECB. The situation is different if Italy should leave the European common currency. Then there is the threat of losses from the loans given to Italy. Nevertheless, the result will not necessarily be a total loss: The ECB would negotiate with the Italian Central Bank or its successor institution and try to reach a settlement that would at least result in a partial repayment of the borrowed money.
- It is also possible that private lenders’ lack of willingness to finance represents only a temporary liquidity crisis, which has been triggered by a negative downward spiral on financial markets and is not due to a fundamentally poor credit rating for Italy. In this case, financing through the Target balances can be seen as a stabilization tool that prevents a self-reinforcing liquidity crisis (“self-fulfilling prophecy”). In fact, the European debt crisis had characteristics of such a vicious circle and countries like Ireland, Spain and Portugal have been successfully stabilized by the combination of aid from the euro bailout programs, ECB commitments and target balances.
- If the ECB actually suffers losses on claims against the Italian Central Bank, this represents a loss that reduces the ECB’s capital. Since all national central banks are co-owners and lenders of the ECB, the Member States bear the losses incurred by proportionately replacing the lost capital – as does Germany through its central bank, the Bundesbank.
- If the eurozone broke up, all claims of national central banks would be lost. The central banks would then have claims against an institution that no longer exists. In addition, the claims are not backed by real assets (e.g. gold) against which the claims could be exchanged.
The importance and risks of the Target balances are discussed intensively among economists. In addition to the question of how great the risk of loss is for the creditors, there is, among other things, also the question of whether rising Target balances increase the money supply and what importance these balances have for perpetuating trade deficits. However, despite all the disagreements, there is at least a consensus on one point: As long as the euro system does not break down and no national central bank drops the euro, creditors will not suffer any loss of assets.
This is reassuring on the one hand. But it also gives rise to a danger on the other: Countries that have high Target claims must prevent the insolvency of the highly indebted central banks in order to secure their claims, and must participate in appropriate rescue packages. Hans-Werner Sinn, already mentioned above, speaks of a “Target Trap” in this context. The result may be a constant rise in the debt of the southern European crisis states.
To make matters worse, there are no agreed repayment dates for Target debts. Thus, the central banks with Target claims have no opportunity to collect their claims. Accordingly, a reduction in German Target claims, for example, will only take place when there is a trade deficit in Germany (German exports are smaller than German imports) or when private lenders in Germany are willing to finance the trade deficits of foreign countries through their lending. Both are unlikely at the present time. The Target balances will therefore continue to accompany us into the future.
Reading recommendation: The special issue “The European Balance of Payment Crisis” of CESifo Forum (Vol. 13, 2012) provides a good overview on several topics concerning Target claims and Target debts.