The unscheduled meeting on Wednesday of the European Central Bank (ECB) was to discuss Euro stability. There are worries about the way interest rates for borrowing over longer time periods were rising sharply for some countries in the Euro. This undermines the advantage of belonging to the Euro, which was designed to give the average state borrower lower borrowing costs by belonging to the wider system with its transfers and controls.
Italian ten-year bonds are offering yields above 4%, and Greek ten-year bond yields around 4.5% compared to around 2% for the stronger members. All these bond yields have been managed down to very low levels in recent years by large purchasing programmes organised by the central bank. As these buying programmes come to end, there are worries that markets may take fright at the credit status of the more heavily borrowed Euro members.
Unlike the Fed, which is both ending new bond buying and allowing the retirement of bonds from its portfolio on their maturity, the ECB has made clear it plans to go on reinvesting money paid to redeem a bond it owns. This gives the ECB some flexibility over which bonds it buys with the money.
It has traditionally followed a so-called capital key that buys proportionate amounts of bonds issued by all the member state governments of the area. It may now well decide to buy relatively more of the weaker states’ bonds. All this is unhelpful, as it opens issues about the structure of the currency and the nature of the banking arrangements that underpin it.
The authorities will wish to avoid markets intruding into these matters in a worrying way, as they did during the Euro crises of the early years of the last decade. Then markets turned on Greek and Cypriot banks and bonds, causing banking and market dislocations until the ECB and the EU reached new agreements with the members over how to proceed and how to help finance them in future.
The rising importance of Target 2 balances
The whole Euro system has come to rely heavily on a system known as Target 2 balances. Every day some central banks in the zone need to borrow money from the ECB to be able to meet all the requirements for Euros amongst their commercial banks. Every day, other member states deposit their surplus Euro with the ECB.
Over the years, there have been two important changes in what was meant to be limited and temporary facilities to balance the positions of member states’ central banks. The first is the surpluses and deficits of some states have become large and persistent, so the target 2 system has taken on more of the characteristics of long-term deposit or borrowing facilities. The second is that the ECB has taken down interest rates to zero, so a surplus country earns nothing on its balance and a borrowing state receives free money. There are no requirements on member states to eliminate these balances or draw downs, and all the time these large transfers can be sustained the Euro system is stable.
In the Euro area, regional transfers through EU regional policy are much smaller, so the ECB has supplied the immediate liquidity need by transfers of cash between banking systems and states.
In a single-country currency area, many more of these necessary transfers between financially strong and financially weaker regions occurs through taxes, grants, subsidies and other government-organised transfers. Welfare payments are made on a bigger scale to areas of poverty and high unemployment, and more tax revenue is taken from areas of high employment at good wages.
There are also large transfers through central government payments to local government, sending more to poorer areas. In the Euro area, regional transfers through EU regional policy are much smaller, so the ECB has supplied the immediate liquidity need by transfers of cash between banking systems and states. When it failed to meet all the borrowing requirement of Greece and of Cyprus, the banks in those countries had to ration Euro payments out as they were short, and in Cyprus some depositors were made to accept a loss on their Euro deposits.
Stability is essential for the single currency’s success
Wednesday’s meeting was designed to underwrite the ECB’s commitment to stability. Germany currently has deposits of €1,135bn at the ECB. This nearly matches the €573bn Euros Italy is borrowing, plus the €505bn Spain has drawn down and the €106bn Greece has used.
There are a range of other smaller surpluses and deficits amongst the other member states. The ECB and the EU will be keen to keep Italy well financed, given the size of Italy and the rise of political parties sceptical of some of the Euro scheme. The ECB board has hawks and doves as they belatedly respond to the persistent and high inflation in the zone. There are currently five Euro countries with inflation rates above 10% and several close to 9%.
If the hawks are too successful, the deficit countries will have to start paying for their borrowings and markets may worry more about the yields on state bonds issued by the weaker countries. That is why the ECB had to meet and sought to reassure markets that it will stand behind its more wayward members. We still await a detailed proposal, as they also need to avoid suggestions that are subsidising or bailing out weaker member states.
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