A recent post by Ramanan illustrates some quite important accounting facts about Target2 claims/liabilities and relevant Net International Investment Positions (NIIP) which are not always taken into account when analyzing Eurozone imbalances.

People tend to take a simplicit view that German Target2 claims actually represent net claims of the German economy on the rest of the world. In reality, Target2 claims/liabilities are just the accounting entry where assets and liabilities between Eurozone central banks are recorded and do not necessarily represent a net IIP claim. What they really represent is up to what point German claims are accounted as claims on the official central bank sector instead of the private sector. Let’s use two examples to illustrate this point:

  1. A German bank holds an asset on a Spanish bank (a repo loan or a covered bond). On maturity the German side decides not to renew the contract and moves the funds to Germany. BdE funds the transfer by providing liquidity and Bundesbank increases its Target2 claims. The NIIP has remained unchanged with the asset moving from the private sector (a claim on a Spanish bank) to the official sector (a claim of Bundesbank on the ECB which is accounted as a liability of BdE).
  2. A Greek retail depositor fears that his money is not secure in the Greek banking system and moves the funds to a German bank. Bank of Greece funds the transfer by providing liquidity and Bundesbank increases its Target2 claims. The German economy has acquired both an asset (Target2 claim) and a liability (deposit of a foreignor) which means that its NIIP did not change.

In reality, the NIIP changes through the German current account surplus since that is when the German economy acquires net claims on the RoW. On the other hand, the Target2 balance can change by a large amount through shifts in portfolio and other investment, either by German residents or even by foreign residents (who move funds to Germany).

As long as Target2 claims increase through the above two mechanisms instead of current account surpluses, the overall claims will grow without a relevant increase in the NIIP. The mix of private and official claims will change with Target2 claims even growing to become larger than the NIIP. It is clear that in such a context, Target2 claims are actually a risk for the German economy since one or more Euro exits will reduce its foreign claims (either through a default or revaluation to the domestic currency of the corresponding exiting country Target2 liabilities) and can even lead to a negative NIIP as long as Target2 losses are significant.

The table below shows current NIIP for the Bundesbank, which stands at €1014bn for 2012Q1 (NIIP is contained in the ‘Saldo’ column):

Current (August 2012) Bundesbank Target2 claims stand at €751bn, or 75% of the NIIP. For comparison, they were €463bn in December 2012 (or 50% of the 2011Q4 NIIP). As long as the current Eurozone crisis continues, it is quite possible that during the rest of 2012 or in 2013, the German Target2 claims will be larger than the NIIP. At that point Germany will really have to decide if the Euro is actually irreversible or not and take the appropriate actions. In such a context, having a country exit the Euro, even if that country is Greece poses a serious danger for the German hard earned NIIP since it will increase the flow of funds to the core and exacerbate the Target2 risks while leading to a possible loss on Target2 claims on BoG.

In order to protect its claims Germany will quickly have to make some difficult choises, either to accept a serious and large risk or take the necessary steps for an integrated Europe.