If ECB Goes QE, Remember Bundesbank's T2

Even if Mario Draghi can retain unanimous monetary policy board consent to a really sizeable programme of quantitative easing, the underlying untreated fractures in the Eurozone’s financial system make it difficult to believe it could significantly deflect the Eurozone’s economy much from its current trajectory. Put baldly, the mechanism by which the central bank can hope to transmit monetary policy initiatives throughout the economy are broken. And they are most broken where they are most needed.

Regardless of the ECB’s public policy pronouncements, movements in its balance sheet reveals what policy has actually been. And that policy has been to claw back the support to the Eurozone financial system it provided during the first phases of the Eurozone crisis in 2012. Between 3Q12 and the end of 2014, the ECB’s total balance sheet contracted by just over Eu1tr.  In calendar 2014, the ECB’s balance sheet shrank by Eu251bn, a contraction equivalent to approximately 3% of Eurozone GDP.

In terms of net lending to the Eurozone’s financial institutions, the total has fallen from roughly Eu650bn in 2H2012 to around Eu480bn in 2H14.  Evidently, the desire to shrink the ECB's balance sheet was a higher priority than steering the Eurozone away from deflation, fostering growth or eroding the unemployment totals of Southern Europe.

This will at least please the Bundesbank, since the fractures in the Eurozone banking system have forced it to become a massive lender to the ECB.   The problem is that Germany’s role as the Eurozone’s principal banking system safe haven results in large chunks of Eurozone liquidity pooling into Germany's banking system, which in turn results in the Bundesbank being the chief re-cycler of those funds back to the ECB. The chief tracker of Germany’s save haven/capital recycler role within the Eurozone is the fluctuations of the Bundesbank’s Target 2 net position with the ECB.  When Euro liquidity was fleeing Southern Europe financial systems and washing up in Germany’s commercial banks, the Target 2 net position of the Bundesbank with the ECB rose to a peak of Eu751bn in August 2012.  This was an amount equivalent to just under 25% of the ECB’s total balance sheet. Subsequently, this flow modestly reversed, with the Target 2 total falling to Eu470bn by March 2014, but since ECB also shrank its total balance sheet during the same period, the Bundesbank’s net position is still equivalent to 22% of the ECB’s total assets.  

Since March, however, the position has been largely unchanged, though over the past few months it has expanded very slightly. But this stability is not a return to 'normality': between 2000 and 2007, and prior to the Eurozone debt crisis, the Bundesbank's Target 2 balance averaged under Eu10bn. 

Now consider the implications of the relationship between movements in the size of the ECB’s overall balance sheet and the Bundesbank’s Target 2 balances with the ECB: they rise together than more recently have fallen together, but whilst the ECB’s balance sheet has returned to 2010 levels, the Bundesbank’s Target 2 balances are approximately two and half times what they were in 2010.  

What this tells us is that, despite what the fall in sovereign risk premia may assert, the perceived imbalance of risk in banking systems between Germany and the rest of the Eurozone has not been eradicated.  ECB’s guarantees of liquidity have suppressed risk premia, so that at present, Spanish 10yr sovereigns carry a bare 88bp risk premium, but if that premia has been ‘artificially’ suppressed by central bank actions and/or promises of action, it merely means that investors are no longer paid enough to offset the residual financial system risk. Hence liquidity continues to flow out of the Eurozone’s riskier banking systems and back into Germany’s banking system. 

The underlying fracture in the Eurozone between Germany and the rest of the Eurozone has not mended. The analogy of the ECB using a sticking plaster to treat a fracture is compelling: the smooth surface masks terrible and possibly irreparable damage beneath the skin. 

In particular, it illustrates just how limited any ECB ‘quantitative easing’ must be in effect, even if Germany’s representatives should allowed a concerted effort in that direction. For the evidence suggests that if ECB poured liquidity en masse into the Eurozone’s banking system, the economic and financial fractures in the Eurozone would result in liquidity quickly circling back once again,  quite uselessly, into Germany’s banking system.  Whilst this might – only might – help inflate German asset prices, it can hardly be expected to do the same for, say, Spain CPI, or Italian unemployment, or ex-German Eurozone growth. The underlying divergence directly sabotages the mechanism by which any conceivable (ie, nationally non-specific) monetary policy can take effect. 

It has been claimed that central bank quantitative easing can or has achieved different things at different times, using different mechanisms. The two most common beliefs are that sufficiently aggressive central bank intervention can effect ‘regime change’ which effectively encourages nervous financial systems with depleted risk capital, to reassess likely future returns and expand balance sheets which would otherwise be frozen.   Secondly, it has been asserted that if central banks can crush the risk premium across the range of financial assets, it can drive investors back into those ‘riskier’ assets from which they had recently fled.  

Both make the assumption that although balance sheets may be compromised and risk capital in short supply, the fundamental banking mechanism through which a central bank can act remains sufficiently intact to be rescued.  But in the Eurozone’s case, the enduring size of the Bundesbank’s Target 2 balance tell us that is not the case: Europe has many distinct national banking systems  with different risk characteristics masquerading as a single system.  But it's the still-giant Bundesbank Target 2 balances which reveal the truth.