Masaryk university Faculty of and Administration Study programme: European Studies and Economic Policy

THE ROLE OF TARGET2 IN Úloha TARGET2 v Európskej dlhovej kríze

Bachelor thesis

Supervisor: Author: Ing. Jan JONÁŠ, Ph.D. Soňa SIVÁ

Brno, 2019

Author’s first and last name: Soňa Sivá Name of the bachelor thesis: The role of TARGET2 in European debt crisis Department: Department of Economics Supervisor: Ing. Jan Jonáš, Ph.D. Year of defense: 2019

Anotácia Predmetom bakalárskej práce „Úloha TARGET2 v Európskej dlhovej kríze“ je analýza úlohy, ktorú zastáva mechanizmus TARGET2 v kríze, ktorá zasiahla Eurozónu v roku 2008 a ktorej následky trvajú dodnes. Bakalárska práca vysvetľuje ako vznikajú TARGET2 nerovnováhy a polemiku, ktorá sa vedie ohľadom ich pôvodu, riziku, ktoré z nich vyplýva a možných riešení. Dôraz je kladený predovšetkým na rolu TARGET2 v neúplnej menovej únií.

Anotation The goal of the submitted thesis: “The role of TARGET2 in European debt crisis” is to analyse the role played by the TARGET2 mechanism in the crisis which hit the in 2008 and impacts of which last until now. This thesis explains how the TARGET2 imbalances arise and polemic about their origin, risks which they represent and possible solutions. The emphasis is put on the role of TARGET2 in an uncomplete monetary union.

Keywords TARGET2, Eurozone, ECB, European debt crisis, balance of payment crisis, currency union, imbalances

Author's statement

I hereby confirm that I am the sole author of the written work The role of TARGET2 in European debt crisis and that I have compiled it in my own words under the supervision of Ing. Jan Jonáš, Ph.D. Furthermore, I confirm that I have clearly referenced all printed and any other sources in accordance with legal regulations and internal regulations of the Masaryk University and the Faculty of Economics and Administration.

18 April 2019 in Brno

signa ture

Acknowledgements

I would first like to thank my thesis advisor Ing. Jan Jonáš, Ph.D. for his valuable comments and guidance which helped me to accomplish this bachelor thesis. I would also like to thank Dr. Dirk Ehnts who devoted me to this topic at Maastricht summer school and gave me motivation to dedicate further time to its research. Finally, I must express my very profound gratitude to my parents and friends for providing me with unfailing support and continuous encouragement throughout my years of study and through the process of writing this thesis.

Table of content

Introduction ...... 11

1. Eurozone debt crisis ...... 12

1.1. Evolution of Eurozone debt crisis ...... 12

1.2. Euro as an amplifier of the crisis ...... 14

1.3. Imbalances and divergent competitiveness ...... 15

1.4. Alternative interpretation of Euro crisis ...... 17

2. TARGET2 imbalances ...... 18

2.1. Definition of Target2 ...... 18

2.2. balance sheets ...... 19

2.3. TARGET2 and monetary operations ...... 22

2.4. TARGET2 balances and imbalances ...... 24

2.5. Various interpretations of TARGET imbalances...... 26

3. Current account transactions and TARGET2 ...... 28

3.1. Balance of payments ...... 28

3.2. A balance of payment crisis in fixed exchange rate regime ...... 30

3.3. A balance of payment crisis in the Eurozone ...... 31

4. Discussion of possible solutions ...... 33

4.1. Risk emerging from TARGET2 balances ...... 33

4.2. Settlement of TARGET2 balances ...... 36

4.3. Possible solutions of imbalances ...... 37

Conclusion ...... 40

References: ...... 42

List of figures: ...... 45

List of tables: ...... 46

Introduction

European debt crisis revealed more than fiscal indiscipline of the periphery countries. It revealed also that European Monetary Union (EMU) without fiscal union has many shortcomings. Eurozone members are economically diverse and, in this context, we use to distinguish between periphery and core countries. The two part of the Union started to diverge even few years before the crisis emerged which can be seen at the current account imbalances.

After the outbreak of the financial crisis in the European Union, TARGET2 balances also started to evolve in divergent directions which called attention of economics and provoked a discussion about its causes and risks which they imply. The discussion was opened by Sinn and Wollmershäuser in 2011 and, since then, many economists of different theoretical background published articles about TARGET2. And most of them opposed to Sinn and Wollmershäuser.

The TARGET2 is relatively new topic which had not occurred in discussions until the start of the European debt crisis. However, it represents an interesting theme worth profound and long- lasting discussions since it shows the negative sides of an uncomplete monetary union as the Eurozone. Furthermore, an amount of accumulated imbalances is enormous which impose a risk on touched countries, in particular Germany.

The main objective of the thesis is to examine the role of the TARGET2 mechanism in an incomplete monetary union in the context of the European debt crisis and taking specific features of the Eurozone incomplete integration into account. Furthermore, it aims to discuss the risk exposure of the countries holding large TARGET2 claims and to provide possible scenarios and solutions for the future.

The first chapter aims to provide a reader with the most important facts about the evolution of European debt crisis and related internal imbalances within the Eurozone, which are fundamental for understanding the origin of TARGET2 imbalances and their potential solutions. The second chapter explains the TARGET2 and its balances on simplified examples of the payment transaction between Euro member states. It further presents the origin of accumulated TARGET2 imbalances and their interpretations by different authors. The third chapter lays out the basis for understanding TARGET2 balances in the context of balance of payment and the role of such a system in the balance of payment crisis while comparing Eurozone with fixed exchange rate regimes. Analysis of risk exposure emerging from such imbalances is to be found in the last chapter together with a layout for potential solutions to imbalances within Eurozone.

11 1. Eurozone debt crisis

Even though the TARGET2 was introduced few years before the start of the Euro crisis, its characteristics had not come to the surface until the start of the European debt crisis. This thesis does not offer a detailed description of the causes of Euro crisis, but some facts are important to emphasize before the start of the TARGET2 analysis. A focus will be put on the role of common currency as well as internal imbalances within Eurozone member states.

1.1. Evolution of Eurozone debt crisis

European Union is currently facing the impacts of sovereign debt crisis which starting point is dated back to the end of 2009, the aftermaths of the world financial crisis, when some of the European periphery states – Greece, Italy, Ireland, Portugal and Spain (GIIPS) – have plunged into insolvency problems and became unable to repay their debts.

The causes of the crisis reside in preceding credit booms in the periphery states due to joining the Eurozone, related financial liberalization and dynamic global financial markets in the same period. In this context, a common currency permitted banks to raise funds from international institutions in their currency. Related low interest rates and easily available credit resulted in increased borrowing. (Lane 2012, p. 52) The capital was flowing out from the core countries, in particular Germany and Netherlands, to the periphery which led to economic boom, mainly in Greece and Spain. (Krugman 2012) However, the inflowing money was not used to finance investment projects which boost productivity and exports. Instead, it fed a construction and consumption bubble, which later showed as a huge mistake. The inflation and interest rates significantly increased and caused the real exchange rate revaluation. The property bubble in peripheral countries resulted in an inability of private actors to finance their debts which, in turn, resulted in a banking crisis. (Cesaratto 2013, p. 360)

In September 2008, the collapse of Lehman Brother diffused a financial crisis from USA to the world economy including the European Union. European investors, hit by the panic, immediately began to move their investments back to home countries. Hence, countries dependent on foreign investments experienced a shock consisting in a sudden stop of funding. The most affected countries were Spain and Ireland, where construction sector represented a huge component of economic activity. (Lane 2012, p. 55)

12

Figure 1: Yields on Ten-Year Sovereign Bonds, October 2009 to June 2012 (in %).

Figure 2: Target2 balances 2001-2018 (in billions of euro).Figure 3: Yields on Ten- Year Sovereign Bonds, October 2009 to June 2012 (in %).

Source: Lane 2012, p. 57.

In both countries it also negatively affected tax revenues which were interconned to a large extent with construction activities. Owning to recession and untrustworthy and risky banking sector, sovereign bond values decreased leading to public finances deterioration. This unfortunate chain of events resulted in a sovereign debt crisis within Eurozone which appeared in late 2009, when budget deficits of the GIIPS countries were growing faster than their GDPs. (Lane 2012, p. 56)

In Greece, a situation was particularly unfavourable since 2009. Toward the end of the year, newly elected government shocked the public when they presented revised budget deficit forecast for this year and instead of previous 6%, it estimated the deficit of 12,7% of GDP, whereas the final public deficit accounted for 15,1% of GDP. Furthermore, the government revealed revised deficits even for previous years which proved that they had been highly underestimated. Forasmuch as a political elite was putting the emphasis on the criticism of fiscal irresponsibility in the periphery, it was neglacting more serious structural troubles of the Eurozone which will be laid out in the following chapters 1.2. and 1.3.

13 Table 1: Deficit/GDP ratio in the PIIGS for years 2008 – 2017.

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Greece -10,2 -15,1 -11,2 -10,3 -8,9 -13,2 -3,6 -5,6 0,5 0,8

Ireland -7,0 -13,8 -32,0 -12,8 -8,1 -6,1 -3,6 -1,9 -0,5 -0,2

Italy -2,6 -5,2 -4,2 -3,7 -2,9 -2,9 -3,0 -2,6 -2,5 -2,4

Portugal -3,8 -9,8 -11,2 -7,4 -5,7 -4,8 -7,2 -4,4 -2,0 -3,0

Spain -4,4 -11,0 -9,4 -9,6 -10,5 -7,0 -6,0 -5,3 -4,5 -3,1 Source: Eurostat, own editing.

1.2. Euro as an amplifier of the crisis

Euro crisis has its specific characteristics which were unobserved in previous economic history. The problem rests in the structure of Eurozone. An implementation of a common currency without achieving a political or fiscal integration has played a crucial role here. The Eurozone was supposed to trigger a convergence process among the member states, but this has not shown to be the case. Instead, Euro, as it was designed, caused further divergences.

Even though the currency union brings many advantages with it, enumerated by Krugman (2013, p. 440) as „reduced transaction costs, elimination of currency risk, greater transparency, and possibly greater competition“, it also implies a loss of flexibility – individual countries are limited to one-fits-all monetary policy and they lose an adjustment mechanism – which may turn up problematic provided that an adverse shock hits a currency union. For this reason, it should be decided very carefully if a particular region can share a common currency.

Following the Optimum Currency Area (OCA)1 concept, European Union was not an appropriate region for creating a currency union. Despite being considered as non-optimal, European leaders decided to introduce a single currency, following a theory that an integration process will later enforce convergence of economies adherant to the currency union. However, they did not anticipate that an asymmetric shock would have occurred so early and that the structure of the Eurozone would fail to cope with it.

1 Optimum Currency Area (OCA) Theory, founded by Robert Mundell, defines four conditions which are important for long-term survival of a single currency in a specific geographical area: 1. Similar business cycles of different parts of the area without being subject to assymetric shocks, 2. Sufficient wage flexibility and labour mobility, 3. Sufficient price flexibility and capital mobility, 4. A counter-cyclical stabilisation mechanism. (Blake 2018, p. 2) 14 The adverse shock experienced by Eurozone could not be alleviated by currency devaluation as it would be in the fixed exchange rate regime. The monetary policy of the Eurozone was restricted by the ECB's single objective: a price stability. Furthermore, the Stability and Growth Pact sets two rules aimed to ensure the fiscal discipline which, instead of ensuring a convergence within EU members, restrict their fiscal policies. First, the budget deficit can not exceed 3% of GDP of the country and, second, the limit for public debt is 60% of GDP of the country.

The OCA concept suggests coping with it by fiscal policies and structural reforms leading to internal devaluation – especially wage deflation. (Krugman 2012, p. 443) This is also a philosophy of the European Union, influenced by market fundamentalism, which hopes to react to asymmetric shocks through market forces. In effect, the adjustment of prices and wages would make the labour and capital move between regions and sectors of activities, which, consequently, would balance production and employment. (Blake 2018, p. 6)

Nevertheless, this mechanism also showed itself as non-functioning within Eurozone, and, instead of driving convergence, it caused further divergences, as we will further analyse in the following chapter.

1.3. Imbalances and divergent competitiveness

In the context of European debt crisis, the excessive Greek indebtedness and fiscal irresponsibility of peripheral countries are often wrongly emphasized as the main problem. As Mandel and Durčáková (2016, p. 35) point out, the real causes of the crisis are deeper and can be analysed from the perspective of national economies investment positions and evolution of its current accounts. In fact, periphery state have been running current account imbalances few years before the emergence of the crisis. This is shown at the Figure 1, where we can see the opposite development of current accounts in Greece, Portugal and Spain, which are in deficits, and Germany, Netherlands, Finland and Austria with current account surpluses. The divergences appear from mid 90ties, but they peak in 2007-2008 and then start to decrease slowly. However, the most straking is the evolution of German current account position, which has changed from -2% of GDP in 2000 to 7% of GDP in 2007. And this is a reason why the periphery was running such high external deficits.

15

Figure 4: Current account positions of Eurozone member states (in % of GDP).

15

10

5

0

-5 % of GDP of %

-10

-15

-20

2002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Austria Finland France Germany Greece Ireland Italy Netherlands Portugal Slovak Republic Spain

Source: IMF 2018, own editing.

To start from the beginning, current account imbalances within the Eurozone periphery and the core have originated in divergencies in competitiveness together with divergent growth rates of respective Eurozone member states. (Bibow 2013, p. 367) The causes of competitiveness divergencies can be found in disproportional nominal wage evolution and productivity accompanied with irresponsible fiscal behavior in the GIIPS countries. (Mandel and Durčáková 2016, p. 35) Assuming that the Eurozone lost one fundamental adjustment mechanism – an exchange rate – the only way how to achieve internal balances is by a wage-price flexibility. (Bibow 2013, p. 367-368) Surprisingly, the latter was hindered by Germany which was maintaining a wage restraint from 1996. Up until then, other EU members had been stabilisating their inflation rates to the norm of 2%, imposed by Germany. When German norm fell to zero nominal labour cost growth, it started inevitably favouring its exports to a great extent, which, consequently, disrupted competitiveness positions of EU members. (Bibow 2013, p. 369)

In summary, the wage flexibility as adjustment mechanism has not been working in Eurozone, since countries were not able to conform to a common reasonable trend. As Krugman (2012, p. 440) summarises, „changes in relative prices and wages are much more easily made via

16 currency depreciation than by renegotiating individual contracts.“ But economists agree that the Germany's wage restraint is at the heart of the matter as regards intra-area competitiveness and current account imbalances.

1.4. Alternative interpretations of Euro crisis

The presence of imbalances is, in the context of European debt crisis, interpreted variously and, thus, nature of the crisis is subject to discrepancy. Cesaratto (2017) distinguishes two prevailing interpretations of Euro crisis. Firstly, the group of economists with various theoretical backgrounds supports the view that the course of the euro crisis is similar to a traditional balance of payment crisis of fixed exchange rate regimes. Because of large number of supporters, including Werner Sinn, Roberto Frankel, Peter Garber, Carmen Reinhart, Michal Bordo, Fernando Vianello and Massimo Pivetti, this thesis was defined as the „consensus view“.

The second opinion is held mainly by Paul De Grauwe and Marc Lavoie. They deny the possibility of existence of balance of payment crisis in the Eurozone because the TARGET2 mechanism should has prevented the union from such a crisis. They rather see the roots of Euro crisis in the fact that the could not act as a lender of last resort and acted late, which resulted in more serious financial crisis of peripheral countries. Consequently, the austerity measures had to be taken in order to rebalance the fiscal policy.

Cesaratto (2017) claims that even though the balance of payment crisis cannot arise in a sovereign monetary union, it can appear in a stateless monetary union as Eurozone is. The key point in his argumentation is the existence of TARGET2 payment and settlement system which has similar features as Keynes' union. Actually, as we will later see, the TARGET2 is one of the key mechanisms which helped to avoid not only a traditional balance of payments crisis, but also a potential breakup of the Eurozone.

17 2. TARGET2 imbalances

The following chapter aims firstly to inform a reader with the TARGET2 payment and settlement mechanism, its logic and role in international payments. Then we will look at the TARGET2 imbalances and show them in the context of European debt crisis. Finally, the point of views of various economists will be analysed and compared, which will enable us to advance towards further analysis.

2.1. Definition of TARGET2

The term TARGET stands for Trans-European Automated Real-Time Gross Settlement Express Transfer and it is a system which role is to enable cross-border transaction settlements between the commercial banks of in real time. The first version of TARGET was established in 1999. It was decentralised system consisting of real-time gross settlements of national central banks and ECB's payment mechanism. The problem with the first-generation system was that it processed only large payments, particularly payments related to monetary policy operations. While TARGET contributed to the integration of intra-European money markets, its decentralised nature had several shortcomings, in particular with respect to cost efficiency and technical maintenance. Its successor, TARGET2, was designed to overcome these shortcomings. It is based on a single technical platform. The rules for participation in the system as well as the transactions cost structure are to a large extent harmonised between the members of the European system of central banks. (Bindseil and König, 2011, p. 4)

The ECB (2017) defines three main objectives of TARGET2:

• „to provide a safe and reliable mechanism for the settlement of euro payments on a real- time gross settlement (RTGS) basis;

• to increase the efficiency of inter-Member State payments within the euro area; and, most importantly,

• to serve the needs of the monetary policy of the Eurosystem.“

TARGET2 liability arise as a central bank money created by NCB in one country that was used for net acquisition of goods and assets from other Eurozone members. Similarly, TARGET2 claim is money circulating in the country as a consequence of net sale of goods and assets to Eurozone members. (Sinn and Wollmershäuser 2012, p. 474) The system was created with the currency union setup within the EU countries – European Monetary Union (EMU). As we will

18 prove below in the text, it is one of the key elements of the free flow of money inside EU and a common monetary policy of the ECB.

It is worth to be noted that TARGET2 balances are stocks rather than flows. In fact, „at the end of each day, such intra-Eurosystem claims and liabilities are aggregated and netted out throughout the Eurosystem. This leaves each NCB with a single net bilateral position vis-à-vis the ECB, in the form of a positive or negative TARGET2 balance.“ (ECB 2015, p. 42) TARGET2 claims and liabilities bear interest at the main refinancing rate which is applied each year on the individual balances.

2.2. Central bank balance sheets

To see the logic of TARGET2, we should firstly look at the central bank balance sheets and money creation. Central bank balance sheets are divided into two columns – Assets and Liabilities – which have to net out to zero, similarly to accountancy. However, the logic is somehow different from accountancy in private sector, as you can see in Table 2.

Table 2: Central bank balance sheet with Intra-Eurosystem Liability.

Assets Liabilities Assets received by issuance of loans and Capital purchase of financial assets • Loans to banks Created money • Marketable assets • Reserve Account • Bank Notes • Intra-Eurosystem Liabilities Source: Whelan 2014.

At the liability side, money issued by a central bank (CB) – which has the monopoly right to issue a currency – is recorded in reserve accounts or bank notes and together they form a monetary base of country. In fact, money can be created by CB in two ways – issuing of loans to commercial banks2 or buying securities, such as government bonds. Assets side contains all assets which CB receives as counter value to the money it creates. When a CB purchase securities from a bank, it records them as an increase in marketable assets and, similarly, an

2 Henceforth simply reffered to as „bank“. 19 increase in liabilities – either in reserve account or in bank notes – while bank's assets decrease. However, a majority of money is nowadays created by the first methode (Whelan 2014, p. 83), when CB credits a reserve account of the bank at the liability side and records a corresponding sum among loan to banks. Correspondingly, at the bank's balance sheet, reserves rise and it receives also a liability in the form of loan from central bank. 3 The last item – Intra-Eurosystem Liabilities4 – is the money which a CB owns to the Eurosystem central banks. By contrast, if it is the ECB who owns money to the CB, this ECB´s claim is recorded as an Intra-Eurosystem Claim at the left side of balance sheet, as shown in Table 3. This item includes also TARGET2 figures, on which we will focus in this chapter.

Table 3: Central bank balance sheet with Intra-Eurosystem Assets.

Assets Liabilities Assets received by issuance of loans and Capital purchase of financial assets • Loans to banks Created money • Marketable assets • Reserve Accounts Intra-Eurosystem Claims • Bank Notes Source: Whelan 2014; Sinn and Wollmershäuser 2013; own editing.

Besides base money, at the balance sheet in Table 1, you can also see an item Capital which refers to the difference between the current value of assets and liabilities. We will further focus on payment transactions between member states and related TARGET2 flows influence balance sheets of CBs.

At this place, we will describe a payment process on stylized example. Every commercial bank holds a reserve account with the national central bank with central bank money which are transferred between reserve accounts of respective commercial banks every time when a payment transaction between clients of different commercial banks is carried out. For instance, if a client of Tatrabanka (TB) buys a winter coat from a seller who holds his account with Slovenská sporiteľňa (SS), the client just enters a money transfer order and the seller receives money on his account with SS. This is clear, but the process in between is more important for our analysis. The transfer is carried out in co-operation with Slovak National Bank has to debit

3 For more about money creation via issuance of loans see Bindseil and Koning (2011). 4 Apart from TARGET2 net positions, Intra-Eurosystem Assets and Liabilities include: bank-related claims, foreign exchange and ownership of the ECB (Whelan 2014, p. 91-92)

20 the reserve account of Tatrabanka and credit the reserve account of Slovenská sporiteľňa. The whole process is depicted in the Table 4.

Table 4: Payment transaction 1.

National bank of Slovakia

Reserve account TB - 50

Reserve account SS + 50

Tatrabanka Slovenská sporiteľňa

Reserves - 50 Deposits - 50 Reserves + 50 Deposits + 50

Source: own editing.

When subjects of payment transaction hold their accounts in different member states of the EU, money flows via TARGET2 system. Let's consider a money transfer between Slovak and German citizens. The Slovak who hold his current account with TB transfers money to a German's current account with Deutsche Bank (DB). TB reduces deposits of the client by 50 euro, the NBS debits the reserve account of TB which increases the monetary base of Slovakia. Similarly, BB increases its base money by crediting the reserve account of DB by 50 euro. These are recorded in DB as increases in reserves on the left side and deposits on the right side, both by 50 euro.

At the central banks level, assets and liabilities positions would have to be balanced by transferring assets between the National Bank of Slovakia (NBS) and Bundesbank (BB). Nevertheless, it would be required to set the standards on assets which could be accepted as a counter value to the transfer, which makes the whole process too complicated. So, the TARGET2 settlement and payment system of the ECB should facilitate these transfers by recording TARGET2 liabilities and TARGET2 claims of the NCBs vis-à-vis the Eurosystem. These can be found at the balance sheets of national central banks (NCBs) as Intra-Eurosystem Liabilities and Intra-Eurosystem Claims against the ECB. The whole transaction is shown in

21 Table 3. Basically, the monetary base in Slovakia decreases by 50 euro and, inevitably, the German monetary base increases by the same 50 euro. (Sinn and Wollmershäuser 2013, p. 477)

Table 5: Payment transaction 2.

ECB

TARGET2 claim on NBS + 50 TARGET2 liability on BB + 50

National bank of Slovakia Bundesbank

Reserve account TB - 50 TARGET2 claims + 50 Reserve account DB + 50

TARGET2 liabilities + 50

Tatrabanka Deutsche Bank

Reserves - 50 Deposits - 50 Reserves + 50 Deposits + 50

Source: Own editing.

2.3. TARGET2 and monetary operations

The two previous examples do not hide anything which could be perceived as risky for concerned countries. However, following the crisis, the banks of periphery states did not have enough money on their reserve accounts with NCBs. Thus, to satisfy clients' demands to transfer money, commercial banks needed to ask for help their NCBs. The NBCs were forced

22 to create new money by refinancing operations, including Long-Term Refinancing Operations (LTROs)5 or Emergency Liquidity Assistance (ELA).6

Imagine previous example happening between a client of Italian UniCredit bank (UC) and a client of German Deutsche Bank, but, in this case, the two clients represent one German who besides an account with DB holds also an account with Italian UC. The client noticed that Italy is deeply indebted and started to worry about its investment in this economy. Hence, he transfers its funds back to Germany. Since UC is short of liquidity, it asks (BoI) for a loan. Such a case is shown in Table 6. Firstly, BoI grants UniCredit a loan in the form of LTRO, which appears as an increase of reserve account of UC and corresponding asset – loan to UC, and UC increases its reserves as well as loans from BoI – all these steps are marked with (1). Now, the payment transaction between banks can be made. Deposits and reserves of UC marked with (2) diminish. In BoI, a decrease in reserve account of the UC marked with (2) is compensated by TARGET2 liability. The rest of the transaction is the same as in the previous example.

The difference between the examples 2 and 3 is not only that in the third case UniCredit needs to gain more central bank money because its reserves are exhausted. It also shows that TARGET2 balances can arise in two ways. While example 2 shows the case when TARGET2 liability arises as a result of an increase in current account deficit, in example 3 TARGET2 liability rather mean a capital movement.

5 The ECB has at its disposal two regular open market operations. First, Main Refinancing Operation (MRO) with one week maturity and, second, Long-Term Refinancing Operations (LTROs) with two months maturity. However, in December 2011 and February 2012 two extraordinary LTROs with three years maturity were alloted which aimed to support bank lending and liqudity in time of crisis. (ECB 2011)

6 Emergency Liquidity Assistance (ELA) is another ECB´s tool which „aims to provide central bank money to solvent financial institutions that are facing temporary liquidity problems, outside of normal Eurosystem monetary policy operations.“ (ECB)

23 Table 6: Payment transaction 3.

ECB

TARGET2 claim on BoI + 50 TARGET2 liability on BB + 50

Bank of Italy Bundesbank

(1) Loan to UC + 50 (1) Reserve account UC + 50 TARGET2 claims + 50 Reserve account DB + 50

(2) Reserve account UC - 50 TARGET2 liabilities + 50

UniCredit Deutsche Bank

(1) Reserves + 50 (1) Loan from BoI + 50 Reserves + 50 Deposits + 50

(2) Reserves - 50 Deposits - 50

Source: Own editing.

2.4. TARGET2 balances and imbalances

We saw the TARGET2 position and role at the balance sheets of the European CBs, the ECB as well as in the payment system as such. Nevertheless, these items were unnoticed for a long time, as they did not represent a significant amount. Typically, TARGET2 balances were close to zero because the payments among member states flow in both directions. Indeed, the money gained by the export of goods in a country is used for imports from another countries. In other words „private capital flows finance the trade flows, and the balance of payment is in equilibrium.“ (Sinn and Wollmershäuser, 2013; p. 474) TARGET balances rise if money flows in one direction, which happened in the Eurozone in 2008, as we described it in the previous chapter, when foreign investors, hit by the loss of confidence in periphery markets, started to repatriate their funds in large.

Since 2007, TARGET positions of Eurozone countries have been developing in the opposing direction, which is illustrated at Figure 2. Clearly, German Bundesbank accumulated a huge amount of TARGET claims against the central banks of Greece, Ireland, Italy, Portugal and Spain. Whereas Italy held initially positive TARGET balances, in July 2011 a panic about

24 Italian markets broke out, austerity measures had to be introduced and Italy has turned towards the country with largest TARGET liability, together with Spain. (Sinn and Wollmershäuser, 2013; p. 472)

Figure 5: TARGET2 balances 2001-2018 (in billions of euro).

1000 Target2-Balances [bn. €] 900 800 700 600 500 400 300 200 100 0 -100 -200 -300 -400 -500 -600

ECB Austria Cyprus Germany Estonia Spain Finland France Greece Ireland Italy Lithuania Luxembourg Latvia

Source: Institute of Empirical Economic Research.

TARGET2 imbalances have not stopped yet, they are still present and even in a larger extent. German TARGET2 claims peaked in April 2018, when amounting to almost 950 billion euros. Similarly, Spain and Italy accumulated huge TARGET2 liabilities of more than 400 billion euros each.

25 2.5. Various interpretations of TARGET2 imbalances

As shown in the previous chapter, TARGET2 positions of Eurozone member states have been going in a divergent direction. This fact did not remain unnoticed, on the contrary, it provoked a heated discussion on the academic level. The TARGET2 debate had started by the publication of Sinn and Wollmershäuser (2012) when they pointed out, for the first time, to the risk associated with TARGET2 imbalances. In their papers, they associate the TARGET2 imbalances with the intra-Eurozone balance of payments and outright capital flight in the GIIPS. In fact, they claim that the current account deficits of peripheral states are financed via TARGET2 mechanism. The latter permitted that money created by the NCBs of the GIIPS were transferred to the core. TARGET2 thus shifts the monetary base from the periphery to the core and, in consequence, crowded out the refinancing credit in the core.

Additionally, TARGET2 liabilities should represent net foreign debt of the GIIPS to the core countries, since they are created by a central bank without receiving any asset or claim against a commercial bank. But it is rather compensated by the TARGET2 claim.

In reaction to Sinn and Wollmershäuser, many economists of different theoretical persuasion published papers in which they rather disagree with particular statements of Sinn and Wollmershäuser and treat the TARGET imbalances question from the other perspective. Whelan (2014), Bindseil and Konig (2011), Paul De Grauwe and Yuemei Ji (2012) and Buiter et al. (2011) show that the rise in TARGET2 claims in periphery states was driven mainly by capital flight rather than by current account deficits. They do not find a perfect correlation between the rise in current account imbalances and TARGET2 imbalances. In effect, whereas current account deficits peaked in 2008, the most striking imbalances in TARGET2 occurred for the first time in 2010, when the current account deficits were already declining. Moreover, the difference might also be seen in the volatility of the two, as much as the TARGET2 imbalances are much more volatile than the current account imbalances. (see De Grauwe and Ji 2012, p. 4-9) After all, even Sinn and Wollmershäuser (2012) assumed that the correlation between the two variables is not perfect.

Bindseil and Koenig (2011) further warn that when the interbank market came short of providing liquidity after the collapse of Lehman Brothers, it were central banks which took over this role. And even if it caused an increase in liabilities of central banks vis-à-vis the Eurosystem, it helped to avoid the default of periphery states. The importance of TARGET2 mechanism for the Eurozone in times of crisis will be further analysed in chapter 3.

26 On the other hand, Sinn and Wollmershäuser (2012, p. 473) warn of the risks emerging from TARGET2 balances. Flows of money leading to a rise in TARGET2 liabilities of the periphery were facilitated through loans of NCBs which have been granted against no or insufficient collateral. They fear that if Eurozone was to break up, the TARGET2 claims held by Bundesbank would represent an unacceptable risk for Germany. The risk exposure of Germany concerning its TARGET2 claims will be discussed in chapter 4.

To keep an eye on current account deficits and to limit its size, Sinn and Wollmershäuser proposed to set the limit for TARGET2 balances. However, Bindseil and Koenig (2011) oppose to this idea underlying the monetary union structure and the importance of TARGET2 for the stability of the euro area. Additionally, Whelan (2014, p.102) argues that turning off the TARGET2 could have possibly triggered even larger Intra-Eurosystem balances as depositors would worry about their money even more due to the absence of electronic transfers and, thus, would withdraw them in large extent. Only in combination with capital controls would the turning off work, but these are illegal within the European Union. The risk exposure of Germany about its TARGET2 claims and possible solutions reducing this risk will be discussed in chapter 4.

27 3. Current account transactions and TARGET2

Current account deficits in periphery states during Euro crisis are apparent and preceded large TARGET2 imbalances. So, it is worth analysing interconnection of the two. The third chapter will firstly provide a reader with a description of the balance of payments logic. Since Eurozone is often considered as some kind of fixed exchange rate regime, we will compare a balance of payment crisis in the fixed exchange rate regime with the case of Eurozone.

3.1. Balance of payments

The relation between TARGET2 balances and current account deficits or capital movements can be better explained using the balance of payments. Czech National Bank defines the balance of payment as „a statistical statement, which systematically records economic transactions between residents and non-residents of a given area for a given time period.“ (ČNB, own translation)

Balance of payments consists of different accounts which record transactions based on its origin. Four basic accounts are: current account, capital account, financial account and errors and omissions. A current account records exports and imports of goods, services and primary and secondary incomes. A capital account consists of transfers of non-produced non-financial assets and redistribution of a capital nature. Other capital transactions, connected particularly with international investment, fall under financial account. (Mandel and Durčáková 2016, p. 22) The financial account measures net change in financial assets and liabilities, structured into: direct investments, portfolio investment, financial derivates, other investments and reserves. The fourth account, errors and omissions, includes statistically unidentified flows which is basically the difference between current account and financial account balances. (ČNB) These are further divided into sub-accounts, but in this thesis we will work only with main accounts, which are shown in Table 7:

28 Table 7: A simplified balance of payments scheme.

Balance of payments

Current Account Financial Account

Capital Account Errors and omissions

Source: Own editing.

Current account balance is sometimes also referred to as net export (NX) which is basically exports minus imports. In other words, if exports exceed imports, the current account records a surplus (NX>0). Similarly, a current account deficit means that imports are higher than exports (NX<0). In the same way, financial account balance is referred to as net foreign investments (NFI). If financial account is in surplus (NFI>0), more financial instruments flow inside the country than outside, and, similarly, if financial account is in deficit (NFI<0), money flow mostly out of the country.

The fundamental balance of payment identity is as follows:

Current account (NX) + capital account = financial account (NFI) + errors and omissions

Since capital account and errors and omissions represent only small items, we will simplify our analysis by supposing that these equal to zero and we will thus suppose an identity, where current account and financial account net out:

NX = NFI

This identity simply says that net flows of good and services must be accompanied by net financial flows in the same amount. It is because financial assets gained by an economy exporting goods and services are typically used for purchases of other goods and services from abroad. Put it in another way, a current account deficit is compensated by increase in foreign claims on the deficit country or decrease in claims of the deficit country on foreign assets. (Whelan 2014)

An inevitable implication of balance of payments theory is that, should a country not be able to finance its current account deficit, it must adjust instantly. (moneyandbanking.com 2018) In the following sub-chapters, we will analyse what may countries do in such cases, firstly under fixed exchange rate regime and then in the uncomplete currency union as is the case of Euro Area.

29

3.2. A balance of payment crisis in the fixed exchange rate regime

In fixed exchange rate regimes, international payments are settled in reserve currency which is internationally accepted. Suppose that Italy and Slovakia have their own currencies with fixed exchange rate and a Slovak buys a coat from Italian as it was in chapter 2.3. NBS would send foreign reserves to BoI which would worsen the net international investment position (IIP) of Slovakia in favour of Italy´s IIP. (Caseratto 2013, p. 361). So, the amount of payments is restricted by the number of foreign reserves which a country holds. This phenomenon is called foreign constraint.

Following the logic of balance of payments, explained in the previous chapter, the current account deficit is financed either by a decrease in foreign reserves or by obtaining foreign loans. (Caseratto 2013, p. 361) A balance of payment crisis arises from the inability to finance a current account deficit or offset capital outflows due to a sudden stop in capital flow, or, more seriously, capital flow reversal. The latter typically leads to a current account surplus and even larger recession. Such a capital flow reversal is often caused by a drop in investors´confidence in markets. A degree of such concerns indicates if a result will be just higher risk premia or a complete stop of funding. (moneyandbanking.com 2018)

When an economy has difficulties to finance a current account deficit, it has to adjust. The adjustment mechanism involves a national currency devaluation and, if the country is unable to pay off the debt, a default is needed. Also, it has to undergo restructuralisation under the IMF supervision. IMF grants a loan to the country in order to pay off the most urgent debts and remaining debts are reprofiled. (Cesaratto 2013, p. 361)

Imagine the case where Italy is not the Eurozone member but has its own currency under the fixed exchange rate regime and plunges into the same situation as Eurozone periphery states in 2008. Foreign investors lose confidence and repatriate their investment to their home countries. Thus, a current account deficit has to be financed by foreign reserves, since foreign funds disappeared. Difficulties arise when Italy runs out also of foreign reserves and it has to adjust. Assuming that Italy has its own currency, it would simply devaluate, which would make Italian exports more attractive and it can reverse its negative current account into positive and the country would gradually gain foreign funding to repay previous debts.

However, the reality is that Italy belongs to Eurozone and uses euro with free floating. Nevertheless, euro is for Italy not only official domestic currency, but serves also as foreign

30 reserve for all Eurozone members. And that is the response to the question how there can be a balance of payment crisis in the Eurozone.

3.3. A balance of payment crisis in the Eurozone

Even though the Eurozone does not have a fixed exchange rate towards the rest of the world, the exchange rates of an individual member state are fixed within the Eurozone. That´s why the Eurozone is very often referred to as a traditional fixed exchange rate regime. Though, differences between the two are more important at this place. Currency union is limited by one- fits-all monetary operations and loses the adjustment mechanism in the form of currency devaluation. Also, EMU differs from traditional fixed exchange rate regimes in the rigidity of the former. Caseratto (2017, p. 986) assumes that „no country has dared to leave it yet“, but such exit is also politically undesirable since it would probably imply a full breakup of the EMU. But this rigidity complicates the adjustment process.

What is sure, however, is that in the Eurozone, hit by the crisis, a fixed exchange rate within the Union turned up to be an obstruction to access international finance, similarly to the case of the gold standard. Consequently, in both cases, it contributed to the emergence of banking, sovereign and foreign debt crisis. (Cesaratto 2017, p. 985-986) We will now explain why TARGET2 helped the Eurozone avoid a traditional balance of payments crisis and more serious scenarios including a breakup of the Euro Area.

But firstly, let's once again consider the similitude of Eurozone with fixed exchange rate regime. Cesaratto (2017) defines two identities which are very helpful to understand the financing of current account deficits. Firstly, traditional BOP identity for an open economy can be written as:

CA + FA = ∆OR

Where CA = current account balance, FA = financial account balance; ∆OR = variation in official reserves held in gold or international currencies. This identity basically says what we explained in the previous chapter. That a current account deficit is financed by foreign reserves.

In the EMU payment is settled by TARGET2 rather than in foreign reserves. So, the identity for a currency union as a closed economy looks like this:

CA + FA = ∆T2

31 Where ∆T2 measures TARGET2. Although TARGET2 balances are denominated in euro, we can think of them as an equivalent of foreign exchange reserves flowing from the periphery to the core. But their nature is somehow different and evokes rather „overdraft loans made by the creditor central bank to the ECB.“ (Bibow 2013, p. 376-377) These two identities nicely show the role of TARGET2 in the EMU which does not settle its intra-area payments with foreign reserves, but in euros.

There is a consensus that various European measures in cooperation with TARGET2 de facto prevented the GIIPS from a default. When banks in core countries started to repatriate their money, NCBs created new money, which was transferred to the core via TARGET2. This was favoured by the expansion of LTROs maturity to three years in 2011. New liquidity financed the acquisition of sovereign debts by banks even though it deepend the sovereign crisis. So, TARGET2 and ECB's refinancing operations permitted foreign investors to repatriate their funds from the periphery back to the core with a recreation of lost reserves of NCBs.

32 4. TARGET2 risk and its possible solutions

The last question which I will treat in this thesis is the risk resulting from TARGET2 balances for concerned Eurozone countries, especially Germany, and whether there is any possible solution to the divergencies facing the Eurozone and, if yes, which of them is the most desirable and probable.

4.1. Risk emerging from TARGET2 balances

We saw that the TARGET2 is a mechanism which keeps the uncomplete currency union – Eurozone – together, facilitates capital movements within it and protects the union from a real balance of payment crisis and default. However, it hides in itself also a risk. If one country, say Greece, left the Eurozone, it would mean that it would have to leave the TARGET2 system and pay off the TARGET2 liability which it owes to the Eurosystem. Assuming that Greece is in financial troubles, it would probably renege on its debts. What risk would this decision mean to the rest of the Eurosystem? Especially Germany worries about its risk exposure due to holding the largest TARGET2 claim vis-à-vis the Eurosystem. However, without questioning the fact that Germany is facing certain risk holding foreign claims, one should be careful assessing the risk arising from TARGET2 imbalances.

De Grauwe and Ji (2012) claim that TARGET2 balances should not be treated as an indicator of risk exposure of a country. It is necessary to remember that net foreign claim of a country is inevitably a result of accumulated current account surplus. As we explained above, in the case of the Eurozone crisis, TARGET2 imbalances have arisen as a consequence of capital movements from the periphery to the core of the Eurozone. In fact, the inward flows of money to Germany changed only the composition of claims and liabilities and not the net claims of Germany. In this case, an increased TARGET2 claim of the Bundesbank is offset by a fall in claims of the German commercial banks vis-à-vis clients of GIIPS commercial banks, which dropped from €538 billion in August 2008 to €290 billion in January 2013. Particularly high fall affected German claims vis-à-vis Spanish and Irish banks. (Whelan 2014, p. 105) So, in other words, previously private claims and liabilities were only transformed into public ones in the form of TARGET2 claims and liabilities. (De Grauwe and Ji 2012, p. 10-11)

Moreover, should the euro break up, Germany would also renege on its liabilities vis-à-vis the Eurosystem related to banknote issuance, which represent unneglectable sum. Between the years 2006 and 2013 these liabilities rose from 84 billion to 199 billion euros. (Whelan 2014,

33 p. 105) These facts clearly show that risk exposure of Germany (and also of other Eurozone member states) is affected by more factors.

In the Eurozone, profits and losses arising from monetary policy operations7 are shared by individual NCBs according to their capital keys which are to be found in Table 8. So, what truly defines the risk exposure of Germany is the total exposure of the Eurosystem and the capital share of the Bundesbank in the ECB. (Buiter et al., p. 11)

Table 8: Capital keys for Eurozone NCBs.

Capital key (%)

Nationale Bank van België / Banque Nationale de Belgique 2,528

Deutsche Bundesbank 18,367

Eesti Pank 0,1968

Banc Ceannais na hÉireann/Central Bank of Ireland 1,1754

Bank of Greece 1,7292

Banco de España 8,3391

Banque de France 14,2061

Banca d’Italia 11,8023

Central Bank of Cyprus 0,1503

Latvijas Banka 0,2731

Lietuvos bankas 0,4059

Banque centrale du Luxembourg 0,227

Bank Ċentrali ta' Malta/Central Bank of Malta 0,0732

De Nederlandsche Bank 4,0677

Oesterreichische Nationalbank 2,0325

Banco de Portugal 1,6367

Banka Slovenije 0,3361

Národná banka Slovenska 0,8004

Suomen Pankki – Finlands Bank 1,2708

Total 69,6176

7 Except ELA facilities. 34 Source: ECB (2018). Note: Capital keys have to be further adjusted for the ECB capital shareholders adherent to the Eurozone.

If Greece left the Eurozone, it would introduce a new currency (or return to the drachma), but would be still obliged to settle its TARGET2 liabilities denominated in euro. But, as I already noted, it is very probable that Greece would, after all, renege on them. What would happen with the whole TARGET2 balances of Eurosystem in this case? TARGET2 claims of the other member states would remain without any change. What would be affected, however, is the ECB's balance sheet and its profit and loss account. At the balance sheet, the writing off the TARGET2 claim to the Bank of Greece would cause the ECB´s Intra-Eurosystem claims being negative instead of zero. Additionally, interest obligations to NCBs with positive TARGET2 would exceed interests received by NCBs with negative TARGET2. (Whelan 2014, p. 107)

However, more uncertain scenario is the one when countries such as Italy and Spain default, since it would probably mean the collapse of the Eurosystem. In such a case, former Eurozone members could possibly further use TARGET2 for settlement payments and NCBs would further apply interests on its TARGET2 liabilities. (Whelan 2014, p. 108) Another scenario is that creditor countries would continue to use euro and insist on the repayment of liabilities. However, we cannot say if all countries would be willing to share the write-off losses of states with net TARGET2 claims as it would become claims on the already non-existent system. (Sinn and Wollmershäuser 2012, p. 473)

Nevertheless, it is worth noting that these are only suggestions and probable scenarios. The final outcome is hard to forecast since it would depend on agreements at the EU level and the amount the GIIPS would be able to repay.

In effect, Sinn and Wollmershäuser (2012, p. 486) are right saying that the „the savers of the core countries will become increasingly concerned if they realize that their wealth is gradually being converted from marketable assets held by their savings institutions into mere claims against their NCBs, which are in turn backed only by TARGET2 claims against the ECB system“. That's why it is also appropriate to discuss potential mechanisms which would reduce the risk exposure of Germany.

35 4.2. Settlement of TARGET2 balances

At the beginning of the TARGET2 discussion, Sinn and Wollmerhäuser (2012) were proposing setting up a limit for TARGET2 balances. This proposal are no more discussed since the importance of TARGET2 for a currency union was emphasised and demonstrated by many economists and the fact that it would contradict monetary union is clear. That's why I will not analyse this solution at this place. I will rather focus on the most probable and functioning solutions, which would limit a perceived risk of TARGET2 balances, although, as we saw, this risk is quite exaggerated.

The solution is a settlement of TARGET2 claims and liabilities with monetary policy assets, following the US system. In the US, Interdistrict Settlement Account (ISA) is an analogical real-time gross settlement system to the TARGET2. However, ISA is multilateral which means that each of 12 District Feds8 holds an account with other District Feds and it carries out payment via these accounts, where it books claims and liabilities not to the entire system, but just to the respective District Fed. An interest is applied neither on claim nor on liability, but it is required to settle balances each year with marketable assets. Fed oversees a clearing portfolio of marketable and interest-bearing assets and, when a settlement is needed, it is Fed who changes ownership shares in it. (Sinn and Wollmerhäuser 2012, p. 496-497)

The same system of the settlement could be introduced in the Eurozone. NCBs of countries with Intra-Eurosystem liabilities would be required to settle them by assets acquired by monetary policy operations. ECB, in turn, would reallocate them to the countries holding TARGET2 claims. This would imply zero TARGET2 balances each year. (Whelan 2014, p. 113)

Sinn and Wollmerhäuser (2012, p. 496) claim that the US never experienced such flows as Eurozone is currently facing thanks to the requirement to hand over tangible assets as a counter value to payment balances. They are of the opinion that should the same system be introduced in the Eurozone, „the NCBs of the GIIPS would no longer have an interest in overexerting their printing presses in order to satisfy their internal credit demand, since there would be no advantage to such a policy over a direct financing of liquidity needs through the capital market.“ (Sinn and Wollmerhäuser 2012, p. 498) Although such settlement seems to be appropriate also

8 US area is divided into 12 districts which comprise several federal states. The districts were defined with the foundation of Federal Reserve System in 1913 according to population dispersion in that period. (Sinn and Wollmerhauser 2013, p. 496)

36 in the Eurozone, it is just a mechanism towards reduced risk exposure (at least its perception), but we cannot claim with certainty that it would also reduce flows of money between Eurozone members.

4.3. Possible solutions to imbalances

Although such settlement would at least reassure countries with positive TARGET2, it is insufficient. I explained in the first chapter that in the context of the European debt crisis we should blame disparities between member states. The settlement of TARGET2 balances with monetary policy assets would not help to alleviate these divergencies and, for this reason, a more profound and structural solution is needed more. The true risk resides in the Eurozone structure itself, since its current shape may lead to another economic and political troubles or, worse, to the euro break up, which is not at all desirable. The only way how to beat Eurozone difficulties for good, along with rising euroscepticism, is to resolve profound structural problems of Eurozone, enumerated in chapter 1. Searching for solutions, many economists use an example of the United States, widespread and functioning currency union. However, I believe that the payment and settlement system is not the only aspect of the USA which the EU could use as an example for itself. There are more important ones.

Federal states of the US are also economically very different one from another. But what functions in the US better than in the EU are adjustment mechanisms. Firstly, labour mobility is more flexible in the US. A common language, one American identity and national programs (such as Medicare and Social Security) are important factors facilitating migration between regions. (Stiglitz 2016, p. 89-90) To compare, free movement of workers in the EU is restricted by cultural and language barriers and imperfect mutual recognition of professional qualification. Secondly, states of the US can receive financial help through automatic stabilizers, for example in the form of national welfare programs such as Medicaid, Medicare, Social Security, etc. while, in the EU, these are financed at the national level. (Stiglitz 2016, p. 91) Thirdly, the banking system of the US is centralised at the federal level which means that if a bank run into troubles, Federal Deposit Insurance Corporation bails it out.

The EU should follow solutions which would lead to functioning adjustment mechanisms:

a) Wage flexibility

In chapter 1.3. I explained the divergent competitiveness positions of the GIIPS on the one hand and Germany on the other. I also explained the important role of wage flexibility for the external

37 balances among the Eurozone countries which was hindered by Germany´s wage restrain. Thus, assuming that the Eurozone wants to achieve a balanced state, it needs to recall wage flexibility. Currently, the role rest upon Germany which should increase its wages correspondingly and decrease its competitiveness and related current account surplus in favour of the periphery. It can be achieved, e.g., by fixing a minimum wage. Surprisingly, Germany does not have a minimum wage which makes actually the downward pressure on its wages. (Stiglitz 2016, p. 254)

b) Banking Union

An important step towards the deepening of Economic and Monetary Union of the EU is the creation of a banking union which is likely to prevent the Eurozone from shocks on financial markets. The proposal for setting up a banking union within EU arose unsurprisingly from the last financial crisis. It was who called for deeper integration of the banking sector in the EU and European leaders quickly agreed to build up a banking union of the EU. The banking union entails three pillars:

• Single supervisory mechanism (SSM),

• Single resolution mechanism (SRM) and

• European deposit insurance scheme (EDIS). (European Commission 2018)

While SSM gives the ECB power as „central prudential supervisor of financial institutions“, the role of the SRM is „to ensure an orderly resolution of failing banks with minimal costs for taxpayers and to the real economy.“ (European Commission 2018) These two mechamisms – SSM and SRM – are already operational and apply mandatorily to the adherents of the Eurozone and optionally to the other EU countries. However, the most important step of the banking union is the last one – common deposit insurance fund. The main reason is that with deposit insurance for all banks in the Eurozone, investors would find their money safer and a flow of money from the periphery to the core countries would not be relevant. (Stiglitz 2015, p. 129) EDIS was proposed by European Commission in November 2015 but have not been accomplished yet. And, surprisingly, it is Germany who hinders the completion of banking union by rejecting common deposit insurance. (Stiglitz, p. 129-130)

c) Fiscal union

Even though banking union leads towards deeper integration and, to a certain extent, fiscal stability, it is not sufficient. The main problem of the current unfavourable situation in the

38 Eurozone is the insufficient level of fiscal integration. Especially, Eurozone lacks a common federal-style budget which would play a redistributive role among its different regions. Also, ECB should be responsive to European politics and its objective should be not limited to low inflation level, but also full employment. (Cesaratto 2017, p. 991)

A single budget would act as a stabilizer in crisis times. An advantage is that it makes adjustment easier and helps to avoid situations when a country lacks liquidity. It can also better manage business cycles in cases when a country loses access to markets. (Barbieri and Vallée, 2017) It should also represent a fiscal backstop within banking union. The essential is to create a system in which fiscal risk would be shared. For example, a proposal for common unemployment insurance system aims to directly stabilise private incomes.

All these steps lead towards more profound integration. It is important in order to rebalance current accounts of the Eurozone countries as well as private indebtedness – financial accounts. In fact, European Monetary Union was never considered to be just international economic cooperation or a mere introduction of a common currency. In its roots, EMU was seen as a political project leading to the political union. However, national states are reluctant to give more power to the central European authority and bring thus the EU closer to federation.

39 Conclusion

The European debt crisis is commonly discussed from various perspectives. However, I´ve chosen for my thesis a topic which is not known among the broad public in Slovakia nor the Czech Republic. This thesis aimed to provide an analysis of TARGET2 payment and settlement mechanism and, primarily, to analyse its role in the Eurozone on the case of Eurozone debt crisis.

Euro crisis is not only banking and sovereign debt crisis, but also a balance of payment crisis between the core countries and the periphery. From the start of the European debt crisis, periphery states accumulated TARGET2 liabilities towards the core countries, especially Germany. Current account positions of periphery and the core were evolving in the same sense. That is why Sinn and Wollmerhäuser claim that TARGET2 in fact finance current account deficits of the periphery. Based on previous researches conducted by economists that TARGET2 imbalances result from increased flow of capital from the periphery to the core which resulted from the spread of panic on European financial markets. In fact, TARGET2 and respective monetary policy operations of the ECB permitted to finance a capital outflow from the periphery countries back to the core countries.

Based on the balance of payment logic, the TARGET2 system is irreplaceable part of the monetary union and, together with refinancing operations of the ECB, helped to avoid the traditional balance of payments crisis and default of the countries running huge current account deficits. It is supported by the fact that Eurozone member states lack the adjustment mechanism such as a possibility to devaluate their currency.

What is more disputable, however, is the question of risk which TARGET2 imbalances imply. While Sinn and Wollmerhäuser warn that German TARGET2 claims represent a huge risk for the German citizens, other authors see it as exaggerated thesis since TARGET2 balances do not indicate the whole risk exposure of a country. Also, we cannot forecast what would happen should the Eurozone break up. There are many possible scenarios which could happen. But the possible solutions to alleviate risk exposure of the member states is to settle the TARGET2 balances with marketable assets as in the US.

In the last chapter, I focused on the solutions of the TARGET2 imbalances. I argue that it is necessary to create mechanisms which would help to avoid asymmetric shocks within Eurozone countries which would consequently reduce the risk resulting from TARGET2 imbalances. To this end, Eurozone should deepen its integration. The first step is to complete the banking union by the foundation of the common deposit insurance fund. But it is not sufficient. More desirable

40 is to build a fiscal union with a common European budget. However, there is no political will to accomplish it and it does not seem feasible in near future.

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22. WHELAN, Karl. TARGET2 and central bank balance sheets. Economic Policy. January 2014.

44 List of figures:

Figure 1: Yields on Ten-Year Sovereign Bonds, October 2009 to June 2012 (in %)...... 13 Figure 2: Current account positions of Eurozone member states (in % of GDP)...... 16 Figure 3: Target2 balances 2001-2018 (in billions of euro)...... 25

45 List of tables:

Table 1: Deficit/GDP ratio in PIIGS countries for years 2008 – 2017...... 14 Table 2: Central bank balance sheet with Intra-Eurosystem Liability...... 19 Table 3: Central bank balance sheet with Intra-Eurosystem Assets...... 20 Table 4: Payment transaction 1...... 21 Table 5:Payment transaction 2...... 22 Table 6: Payment transaction 3...... 24 Table 7: Balance of payments ...... 29 Table 8: Capital keys for Eurozone NCBs ...... 34

46 List of abbreviations

BB – Bundesbank

BoI – Bank of Italy

CB – central bank

DB – Deutsche Bank

EDIS – European Deposit Insurance scheme

EMU – European Monetary Union

ELA – Emergency Liquidity Assistance

EU – European Union

ISA – Interdistrict Settlement Account

LTRO – Long-Term Refinancing Operations

MRO – Main Refinancing Operations

NBS – National Bank of Slovakia

NCB – national central bank

OCA – Optimum Currency Area

PIIGS – Portugal, Ireland, Italy, Greece, Spain

SRM – Single Resolution Mechanism

SS – Slovenská sporiteľňa

SSM – Single Supervisory Mechanism

TB – Tatrabanka

UC – UniCredit

US – United States

47