The European Central Bank and the Euro Area balance-of-payments imbalances

Alessandro Govannini

Abstract

Since the introduction of the Euro, ECB has always acted to maintain price stability inside the Monetary Union, completely succeeding in this operation. However the excessive focus only on this target prevented ECB to correctly detect and manage the ongoing Euro Area Balance of Payment crisis, leading the Eurosystem in a potential risky situation.

"The Changing Political Economy of Central Banking" Midterm exam March 2012 Q3: Did an excessive focus on price stability cause central banks to ignore dangerous developments in the financial system which led to the financial crisis which exploded in 2007? (slightly variation of the subject agreed with the Professor)

The ECB mantra of inflation targeting

The European Central Bank (ECB) has been set up with a clear a indubitable objective: price stability, after been the unique target of the Bundesbank, became the mantra of all other Euro Area MSs, revolutionizing monetary policies of the National Central Banks (NCBs) of peripheral countries, used to pursue also other objectives, such as sustaining exports through a weak exchange rate or fostering inflations rises to reduce the real value of government debt. As showed in the Figure 1, it is unquestionable that under the presidency of Jean Claude Trichet, the ECB achieved this not granted goal, maintaining the inflation rate stable close to 2% for more than 6 years. Figure 1: HICP and inflation target
6 HCIP 2% inflation target 5 4 3 2 1 0 -1

Source: ECB statistical Data warehouse Also after the burst of the financial crisis in 2007, the ECB has not changed its policy framework, managing to avoid inflationary or deflationary spirals and, at the same time, sustain the stability of the European financial sector. Despite the adoption of non conventional financing measures (e.g. the Long Term Refinancing Operations), the almost zeroing of the main refinancing operation rate during the peak and also in the following months, the increasing direct activism in open market operations, the primarily declared objective of ECB board remained always the same, as Lorenzo Bini Smaghi, member of ECB board, clearly stated also during the crisis: First and foremost, monetary policy should have remained more closely focused on the maintenance of price stability over the medium term (). Monetary policy should not be burdened with additional objectives, which it is illequipped to pursue1. Hence, judging ECB according to its statutory objective, its action could be considered almost perfect; but is it sufficient? This strong focus on price stability has not represented a costly attention shift on what was happening in that years inside the Euro Area?

Euro Area balance-of-payments crisis

Below the surface of well known Euro Area sovereign debt crisis, lies another element, much less debated and only partially addressed by European policies: the elimination and the subsequent

See: Lorenzo Bini Smaghi: Could monetary policy have helped prevent the financial crisis?, Speech at the Bank of Canada, Toronto, 9 April 2010 http://www.bis.org/review/r100413e.pdf
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misalignment of the internal real exchange rate caused by the implementation of a common currency area, has in fact lead to a balance-of-payments crisis among Euro Area MBs. Figure 3 offers a clear picture of the massive internal imbalances built in the last 10 years: before the introduction of the Euro, the situation of the current account balance was quite similar among MSs, but after 2000 the four Euro Area peripheral countries (notably Greece, Ireland, Portugal, Spain and Italy, henceforth GIPSY) started to run considerable current account deficits, with domestic spending running ahead of domestic incomes. Since the Euro Area as whole has maintained a balanced current account in the same period, these countries had to borrow the needed additional resources almost entirely from other Euro Area MSs: indeed, they came mostly from private investors of Northern Europe, especially Germany. However, from Frankfurts point of view, these imbalances did not represent an ECB problems since they could represent one element of the European convergence2 and they did not prevent the obtaining of the inflation control also in peripheral countries. Figures 4 shows how, even if slightly above the 2%, the inflation remained stable and below the historical levels in GIPSY countries. Figure 3: Euro Area internal current account imbalances
250 200 150 100 50 0 -50 -100 -150 -200 -250

Source: European Commission statistical database Figure 4: GIPSY HCIP (annual average rate of change)
9 Spain Ireland Portugal Greece Italy 8 7 6 5 4 3 2 1 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: ECB statistical Data warehouse

See: Lorenzo Bini Smaghi Addressing imbalances in the Euro Area speech at the Halle Institute for Economic Research, 14 February 201 http://www.bis.org/review/r110215a.pdf
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Billion of Euro

Germany

GIPSY

The lack of supervision on ongoing macro financial imbalances among MBs

The first relevant element is linkage of these imbalance with the weaknesses of the Euro financial system: once entered in the EMU, GIPSY had access to financing at much lower interest rates than would otherwise have been possible, thank to the investors belief that ECB would have maintained a strong anti-inflation policy, eliminating the risk that investments in periphery countries debt would be eroded by high ination, as happened before 1999. While international investors were considering Greek and German bonds the same, ECB did could not do otherwise, accepting all sovereign securities as collateral of the same quality, and remaining concentrated only on HCIP differentials among MSs3. Figure 2: Euro Area sovereign interest rate spreads
20 18 Spain Greece Italy Portugal 16 14 12 10 8 6 4 2 0

Source: ECB statistical Data warehouse Lower interest rate fuelled spending and investments in peripheral countries, both on public side (reducing the cost for the governments for additional spending) both on private side, and resulted in a creation of the current account deficits. However, accumulating foreign debt, does not represent a problem per-se for a the financial perspective, since if it finances productive investment projects, it raises national income and it results in the end in a surplus over debt service costs. Regrettably GIPSY countries did not use these funds to build up the higher productive capacity that would enable them to repay the debt, but employed them to finance domestic consumption or investment in nontradable sectors such as housing (see Figure 3 and 4)4. Could ECB be blamed for this lack of supervision? In relation to the housing bubbles, it could be interesting to read again the speech prounenced by President Trichet in may 2007 during the Governing Council press conference in Dublin: answering to a question about the Irish economys over-reliance on the property sector, he stated: very often, I and my colleagues of the

It has been underlined that this represents a rough mistake made by ECB; however, in a MU it is quite impossible acting differently without giving the impression to investors that fixed internal rate have the risk to break up. See: Jaffrey Franke: The ECBs three mistakes in the Greek crisis and how to get sovereign debt right in the future, Vox-EU column 16 May 2011 http://www.voxeu.org/index.php?q=node/6517 4 See: Higgins and Klitgard, Saving Imbalances and the Euro Area Sovereign Debt Crisis, NY FED Current issues in economics and finance, Volume 17, N 5 http://www.newyorkfed.org/research/current_issues/ci17-5.pdf

Governing Council are mentioning the Irish economy as a role model in many respects for the Euro Area5. Even it could be easily arguable that not many saw the risks for the European banking system of this huge imbalances, at the same time it could be underlined that perhaps ECB, focusing too much only on inflation targeting, underestimated the fragility of the Euro Area construct and the risks linked to investors misjudgments about the risks of lending to Euro Area periphery at the same rates of Germany. Figure 3: Household Debt rations (%change 1999-200)
100 80 60 40 20 0 -20 Greece Ireland Portugal Spain Germany US

Source: EUROSTAT, Higgin and Klitagaad (2011) Figure 4: Residential Mortgage Debt % GDP (99-2007)
50 40 30 20 10 0 -10 -20 France Germany Italy Spain Ireland Greece Portugal

Source: European Mortgage Federation, Euro Area NCBs, authors calculation

The ECB role in the BoP crisis: the TARGET2 system

The second element relies more on how ECB has practically dealt with these imbalances, since its main instrument (the definition of the MRO interest rate) was not suitable for addressing the problem. After the burst of the financial crisis and the subsequent collapse of the confidence even among Euro Area MBs, private capital flows suddenly stopped and reversed. This inverted flow left peripheral countries without fund to finance their internal demand, forcing the ECB to step in, building up a bailout plan without parallels. In fact, part of these funds lost have been offset by the
See: Karl Whela, Trichets ECB Presidency: A True Age of Turbulence, EP Policy Paper http://www.europarl.europa.eu/document/activities/cont/201109/20110921ATT27141/20110921ATT2714 1EN.pdf
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well known international official adjustment programs from the IMF and the EU. But another very relevant (and the perhaps the greatest one) source of financing has come from the no-peripheral Euro Area NCBs that put the Eurosystem at the centre of the crisis. The Eurosystem, in fact, is currently managing the current account imbalances of its members trough the NCBs balance sheets, and more precisely by the so-called TARGET2 claims and liabilities. Target is the acronym for Trans-European Automated Real-time Gross Settlement Express Transfer System or, more simply, the Euro Area internal payments system, built with intention to facilitate the daily mechanisms of transfers of money among NCBs. Until 2008, this system was considered just a technical aspects, without any relevance for Euro Area financial stability6: a the scarce importance of TARGET2 system was possible mainly because the internal reciprocal position of the NCBs resulted in that years quite balanced, with GIPSY payments deficit on transaction in goods and services completely offset by a surplus of private foreign capital flows. This balanced situation, however, ended in mid 2007 (when the interbank market in Europe first broke down), putting the TARGET2 system under severe pressures and transforming it in a central element in assuring financial stability in the Euro Area. Figure 5 clearly shows how in the last 4 years GIPSY NCBs had run growing negative TARGET balance vis--vis mainly to the Bundesbank, that accumulated credits for more than 500 billion at the end of 2011. Figure 5: External position of the National Central Banks in the EMU
600000 400000 200000 Millions of Euro 0 -200000 -400000 -600000 -800000 GIPSY NCBs Germany NCB

Source: National Central Banks, authors calculation How was it possible this change? GIPSY NCBs, facing an internal demand not profoundly smoothed during the crisis, and without the possibility to rely on private foreign funds, started to lend newly printed money to their national private banks looking for resources to finance the economy (i.e. GIPSY current account deficit). How where the new money came from? Greece and Ireland activated the Emergency Liquidity Assistance (ELA), allowing commercial banks to access funds using collateral not acceptable under the standard rule of the ECB; most of the new money,

For a detailed description of the system see: Hans-Werner Sinn, The ECBs stealth bailout, Vox-Eu column 1 June 2011 http://www.voxeu.org/index.php?q=node/6599,
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however, resulted from loans among NCBs, notably from Germany to GIPSY, giving almost limitless funding to sustain the current account deficits7. This situation, event could seem a positive solution to smooth the needed adjustment process of GIPSY economies, actually could create more problems than resolve them. A type of risk is linket to lending via ELA loans, thus filling NCBs balance sheets with lower-quality collateral. But more important there is a risk linked to the regular refinancing activity conducted through TARGET2 system. In fact, it creates high strain to Eurosytem, splitting the position of Euro Area CBs and increasing the divergences among them. A quite relevant risk, since it could lead to distract the action from on ongoing financial developments in all Euro Area MBs, more than currently already happens due to the divergences on classical monetary policy (i.e. definition of MRO). A taste of this increasing tension has been offered by the letter sent by Bundesbank President Weidmann to ECB president Draghi8 about growing euro-system risks linked to TARGET2 imbalances and with a well defined call for a return to the safety rules that applied before the financial crisis. Body Word Count: 1722

References
Bini Smaghi Lorenzo Addressing imbalances in the Euro Area speech at the Halle Institute for Economic Research, 14 February 201 http://www.bis.org/review/r110215a.pdf Bini Smaghi Lorenzo: Could monetary policy have helped prevent the financial crisis?, Speech at the Bank of Canada, Toronto, 9 April 2010 http://www.bis.org/review/r100413e.pdf Franke Jaffrey: The ECBs three mistakes in the Greek crisis and how to get sovereign debt right in the future, Vox-EU column 16 May 2011 http://www.voxeu.org/index.php?q=node/6517 Higgins and Klitgard, Saving Imbalances and the Euro Area Sovereign Debt Crisis, NY FED Current issues in economics and finance, Volume 17, N 5 http://www.newyorkfed.org/research/current_issues/ci17-5.pdf Sinn at al. Target Loans, Current Account Balances and Capital Flows: T he ECBs Rescue Facility, Cesifo Working Paper No. 3500 http://www.cesifo-group.de/portal/pls/portal/docs/1/1210631.PDF Sinn Hans-Werner, The ECBs stealth bailout, Vox-Eu column 1 June 2011 http://www.voxeu.org/index.php?q=node/6599 Whela Karl, Trichets ECB Presidency: A True Age of Turbulence, EP Policy Paper http://www.europarl.europa.eu/document/activities/cont/201109/20110921ATT27141/2011092 1ATT27141EN.pdf

See: Sinn at al. Target Loans, Current Account Balances and Capital Flows: T he ECBs Rescue Facility, Cesifo Working Paper No. 3500 http://www.cesifo-group.de/portal/pls/portal/docs/1/1210631.PDF 8 See: http://www.bloomberg.com/news/2012-02-29/weidmann-warns-draghi-of-euro-system-risks-inletter-faz-says.html
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