Target2 and the Rollover of Portugal's Public Debt Feb 1, 2014 by Jose Guilherme Q Ataide

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TARGET2 AND THE ROLLOVER OF PORTUGAL’S

PUBLIC DEBT

ABSTRACT

Based on recent literature that analyzes the payments system of the

eurozone, the text seeks to show how the Portuguese government

could use domestic commercial banks and the TARGET2

mechanism to redeem government debt securities held abroad

without having to resort to new foreign aid. This procedure would

take full advantage of the rules governing cross-border payments

inside the euro area and might also pave the way for overcoming

the current “austerity” while staying inside the euro.

INTRODUCTION

TARGET2 is the payments and clearing mechanism that connects the

European Central Bank (the ECB) to the National Central Banks (the NCBs) of

the Member States of the euro. As a consequence of the operation of this

mechanism, every cross-border payment between banks of different countries

of the eurozone generates automatic credit and debit claims – between the

NCBs of the two countries involved in the transaction and the ECB itself.

TARGET2 underlies the smooth working of cross-border transfers of funds

between eurozone commercial banks and it may be thus considered a linchpin

of Europe’s single currency. Its single-platform system guarantees that a euro

deposited in Portugal, Spain or any other Member of the single currency can

move freely and at par value throughout the territory of the Economic and

Monetary Union.

The statistics provide us with a glimpse on the relevance of TARGET2. It

processes an average of 350,000 payments per day, with a total daily value of

about a third of the eurozone’s annual GDP, including high value interbank

payments (more than 90% of the total) and low-value retail payments, related to

transactions involving consumers in the eurozone1.

Of course, a payment on foreign debt is also necessarily a cross-border

payment and this provides us with the reason that TARGET2 has a key role to

play in a crucial question: how to find a realistic solution for Portugal to pay back

1 http://www.ecb.europa.eu/paym/t2/about/figures/html/index.en.html (accessed on January 19, 2014)

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the massive sums it now owes to public and private creditors domiciled abroad

without crushing its economy in the process.

In this text we will present a non-technical description of a strategy that we

suggest the Portuguese Government adopt for fulfilling its debt obligations

towards foreign creditors with the lowest possible cost to the country.

The course proposed here would require that the Portuguese authorities make

a proactive use of TARGET2 (in conjunction with at least one local commercial

bank) with the strategic objective of rapidly freeing the country from the burden

of external debt. Then, after overcoming this burden, the government would be

in a strengthened position to recapture crucial autonomy for steering the

economy and gradually eschew the current foreign-imposed and highly

recessive austerity policies.

This paper has the following sequence. We start by briefly describing the

situation of financial emergency that led Portugal’s government to ask for an aid

package under the guise of intervention by the EC-ECB-IMF (the “troika”) in the

first semester of 2011. We go on to explain how the Portuguese authorities

could have reacted more effectively to the sudden spike in interest rates on

government bonds that occurred in that period: by borrowing directly from a

state-owned commercial bank with the sole purpose of redeeming securities

that were coming to maturity abroad. The funds thus obtained would be duly

transferred to outside creditors via the TARGET2 system. We argue that this

procedure could have provided for an immediate reduction of market pressure

on public debt yields, and thus release Portugal from the need to ask for foreign

aid. We proceed to examine and refute some possible counter-arguments to the

legitimacy and practical possibility of the government using local commercial

banks for providing essentially all of the funding for the rollover of securities

held abroad. We show how the very same procedure that was not used in 2011

can now be adapted for redeeming the outstanding public debt obligations of

Portugal towards foreign creditors, both private and (more importantly) public2.

Finally, we sum up our argument and conclusions. In an Appendix we present

graphs and accounting tables for TARGET2 processes, quotes by key authors

and references.

Let us then start our story by taking a step back in time, to the first quarter of

2011, when Portugal had not yet asked for financial help from the Troika. What

was the nature of the situation that forced the country to make such an unusual

request?

In Portugal, for many years if not decades, tax revenues have been lower than

government expenditures. This underlying tendency for budget deficits was

2 Debts to the troika are governed by English (not Portuguese) law and this feature renders any future

restructurings or re-denominations extremely problematic – see clause 14 (1) of the agreement between the EFSF and Portugal here: http://www.efsf.europa.eu/attachments/efsf_portugal_ffa.pdf .

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largely a consequence of persistent imbalances in the current account. But it

was strengthened by the sudden collapse of fiscal revenues that was one

inevitable consequence of the economic crisis of 2008. By 2011 a huge gap

between revenues and expenditures was entering its third year with levels

approaching 10% of GDP. One could well imagine a year with 70 in taxes

raised3, public expenditures close to 80, and a deficit of 10 – this in a country

with a GDP of only about 160 (billion) euros.

The Government was thus forced to borrow ever increasing sums from the

markets in order to cover its budget deficit. This is an especially problematic

situation for a country such as Portugal, deprived as it is of full monetary

sovereignty since joining the euro in 1999. In addition to deficit financing,

however, the government also had to borrow massively from the markets for a

second reason: the need to pay back to creditors the debts contracted in the

past. The deficits of previous years had of course generated government debt –

the government had to borrow money in each of those years and the

outstanding debt was reaching a figure close to 100% of GDP4, a significant

part of which was maturing in 2011.

Let us consider a scenario for the year 2011 under which the State would have

to rollover an amount of 20 in maturing debt of which 15 will be payable to

foreign creditors. Adding the sum of 10 needed to finance the deficit to the 20

required for the rollover one arrives at a total amount of 30 for the government’s

borrowing needs during that year; of which a minimum of 15 would be paid to

foreign lenders holding loans approaching maturity.

It turned out in the course of the first months of 2011 that the markets – for

reasons that have to do with the crisis of 2008 and its impact on a eurozone

composed of governments lacking monetary sovereignty and thus automatic

backing from their Central Bank – began to estimate that the risk of Portugal

defaulting on its debts was increasing, and to ask for ever higher interest rates

as a reward for bearing that risk.

This increase in the yields that investors required for buying Portuguese debt

soon put the government in an untenable situation. When the average interest

rate on public bonds increases from an annual 2% to say 10%, this means that,

in future years, the Government will have to pay in interest – for a loan of 30 –

an amount of 3 per year, instead of 0.6 per year as would be the case before

the crisis. The difference – the sum needed to pay an additional 2.4 in interest

each year in the future – will have to come from "savings" (that is, deep cuts) in

public spending in key sectors: health, education, pensions, etc.

3 The numbers in this example are purely illustrative, but if one assigns to them the unit "one billion" – i.e.,

70 billion euros in taxes and so on – we won't be too far from reality. 4 It is now (early 2014) circa 130% of GDP.

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Unwilling to face the prospect of such huge cuts, the Government opted to ask

for the sum of 30 directly to the Troika, with a few more tens (of billions of

euros) added up so as to provide it with guaranteed access to funding for a

period long enough for the markets to eventually calm down in relation to

Portugal and regain the disposition to lend to the country at acceptably low

rates of interest

TARGET2 AND PORTUGAL – DESCRIPTION OF A PROCESS

And now we come to the role of TARGET2 in this question.

We believe that the Portuguese Government, during the critical period of the

first quarter of 2011, could have chosen an alternative approach to the crisis:

that of taking full account of the payments mechanism of the eurozone with a

view to escape from the pressure of the extreme, irrational yields on public debt

that eventually led it to plead for foreign aid.

This alternative would have ultimately required the recourse to TARGET2 and

had to start with a government decision to temporarily eschew borrowing

through debt markets and rely instead on its own public sector commercial bank

– Caixa Geral de Depósitos, or CGD bank. This bank would lend to the

government the amount of 15 needed to rollover the maturing debt held

abroad5.

Since the Government is the owner and single shareholder of the Bank, it would

have the power to dictate the interest rate on the loan. However, we think it

would be wiser for it to refrain from resorting to this prerogative and choose

instead, for the sake of appearances, to get the funds from the bank at the very

same close to 10% rate then prevailing in the markets. Why? For the reason

that, while this rate is certainly high, it will also generate a huge profit for CGD

Bank. And the government, in its condition of owner of the bank, could use

these excess profits later on as a source of funding for the budget.

This CGD loan would create a bank deposit of 15 credited to the Government, a

sum it could use to pay all of the debts maturing abroad during the year 2011.

We shall now use a stylized example to illustrate the accounting steps involved

in this scenario and the role of TARGET2 in it. In the example, the creditor

receiving the funds is Deutsche Bank. It will use said funds to pay off and

extinguish the Portuguese securities it is holding on its books. At that moment in

time – the moment the funds are transferred from CGD to Deutsche Bank –

TARGET2 shows up on the scene, so to speak, in the sense that it will ensure

5 CGD bank could make a direct loan to the Government; or, in the event of the government not wanting to

formally eschew “the markets”, it could buy bonds in the amount required in new issues of public debt at primary auctions (for example, via the investment banking branch of CGD bank, which has the status of primary dealer). Such buying in the market would also help to quickly ease and then reverse the upward pressure on yields

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that this cross-border payment between two countries of the eurozone will be

completed. Absent that intervention of TARGET2 – and assuming that CGD

bank couldn't get that very same day a loan of bank reserves from Deutsche

Bank – the accounting entries for the transfer would be incomplete and the flow

of funds would not take place. This is shown in Table 1 (below) which describes

what the accounting entries of the transfer from CGD to Deutsche Bank would

be without TARGET2 (the missing items will be duly entered by TARGET2 and

are underlined in yellow):

TABLE 1:

Caixa Geral de Depósitos (CGD)

Banco de Portugal (B de P)

Assets Liabilities

Assets Liabilities

reserves (-) govt. deposit (-) reserves of CGD (-)

Deutsche Bank (DB)

Bundesbank

Assets Liabilities

Assets Liabilities

reserves (+) Deposit ex-govt. (+) reserves of DB (+)

We are now in a position to see how TARGET2 enables cross-border transfers

of funds between countries of the eurozone. In the case under consideration, it

ensures the completion of the transfer from CGD to Deutsche Bank by entering

an advance of funds from the Bundesbank to the Banco de Portugal. This

advance (loan) pays the interest rate prevailing in the euro area (it was 1% in

April 2011; and it is 0.25% in January of 2014), itself set by the European

Central Bank under its prerogatives on monetary policy.

The reason for this automatic advance of funds has to do with the requirements

of basic principles of double-entry bookkeeping. As we observed in table 1,

Deutsche Bank, upon receipt of the deposit from Portugal, receives

simultaneously bank reserves6 which it deposits at the Bundesbank. This

deposit increases the liabilities of the Bundesbank (because the reserves of

Deutsche Bank, an asset for this bank, are a debt of the Bundesbank); it must

thus enter a new asset to stay in balance – the loan to the Banco de Portugal.

6 An easy way to picture this operation is by imagining the "reserves" as an electronic equivalent of

"banknotes" or "cash". For example, if a customer of CGD bank wants to pay a debt of 500 euros to a customer of Deutsche Bank, he/she instructs CGD to transfer 500 euros of his/her deposit at CGD to the German citizen's account at Deutsche Bank. CGD duly transfers the deposit, which will be credited to the German citizen's account, but must also simultaneously transfer a "banknote" of 500 euros to the coffers of Deutsche Bank. Only then will Deutsche Bank be in a position to deliver this "banknote", if its client so requires. (And, until that happens, Deutsche Bank can deposit the "banknote" of 500 euros at the Bundesbank, receiving perhaps a small interest on this deposit).

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In turn, the Banco de Portugal saw its liabilities decrease: a deposit (reserves) of CGD bank "migrated" to Germany. The Banco de Portugal will thus balance its books by taking another debt: precisely, the loan it receives from the Bundesbank.

At the end of the day, the accounts are all settled with the ECB. The Banco de

Portugal will still be owing a sum of 15 – but to the ECB itself, rather than the

Bundesbank. In turn, the German central bank will remain as a creditor, but of

the ECB instead of the Banco de Portugal. The loan’s interest rate doesn't

change: it is always the rate (MRO) defined by the ECB's monetary policy

stance.

All these accounting steps and entries are taken within the framework of

TARGET2. Through this mechanism, as we observed, the central banks of the

eurozone extend to one another credit lines without limit or need for collateral.

And accounting entries are now complete; in table 2 we see the Bundesbank's

loan to the Banco de Portugal:

TABLE 2:

Banco de Portugal (B de P) Bundesbank Assets Liabilities Assets Liabilities

Reserves of CGD (-) reserves of DB (+)

Owed to Bundesbank (+) Loan to B de P (+)

And then, in table 3, we watch it being replaced by a loan of the Bundesbank to

the ECB:

TABLE 3:

Banco de Portugal (B de P) Bundesbank

Assets Liabilities Assets Liabilities

Reserves of CGD (-) reserves of DB (+)

Owed to the ECB (+) Loan to the ECB (+)

European Central Bank Assets Liabilities

Loan to the B de P (+)

Owed to Bundesbank (+)

In both tables, the intervention of TARGET2 is in the items underlined in yellow.

The process has not ended, however. CGD is now in danger of running out of

its stock of Bank reserves; it may lose a total of 15 in reserves if it transfers the

entire amount of the Portuguese government’s deposit to Deutsche Bank. As

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we have seen, bank accounting rules require that every transfer of a deposit (a

liability item) from one bank to another bank be matched by the transfer of an

equal amount of reserves (an asset item). In fact, bank reserves are the

"currency" (the monetary base) that banks must use in order to make payments

to one another.

CGD bank cannot allow itself to run out of reserves, because in that case it

couldn't continue to make payments to counterparties, including foreign banks.

Before the crisis of 2008, Deutsche Bank itself would probably have loaned

back those reserves to CGD at a rate of interest convenient for the German

bank. Ever since the financial crisis broke out in 2008, however, European

banks lost confidence in financial markets and in one another and are no longer

willing to easily lend – as they did hitherto, almost as a matter of routine – bank

reserves in the interbank market, particularly in the overnight market .

Thus, CGD will have to get those reserves through a loan contracted with the

Banco de Portugal7. CGD will deliver as guarantee (collateral) for that loan the

very same government debt securities that it has acquired, with a nominal value

of 15. And the Banco de Portugal will have to accept such a guarantee and lend

the reserves, via either a short-term loan (a "MRO") or a medium term loan (a

"LTRO"). Indeed, if the Banco de Portugal were not forthcoming with that loan it

would risk triggering an immediate interruption of CGD payments to its bank

counterparties, with serious consequences (likely, immediate and generalized

panic) for the Portuguese and European banking markets8.

The following table describes the accounting entries of this last step:

TABLE 4:

Caixa Geral de Depósitos (CGD) Banco de Portugal (B de P)

Assets Liabilities Assets Liabilities

reserves (+) Owed to B de P (+)

Loan of reserves to CGD (+) reserves of CGD (+)

7 In other words, there will be an expansion of the monetary base, with Portuguese reserves created "ex

nihilo" by the Banco de Portugal. In a text published by Citi Research in October 2012, Willem Buiter and Ebrahim Rahbari explain very clearly and concisely this type of expansion: "The ECB controls an interest rate ... in the euro area. The stock of base money (currency plus central bank overnight credit to eligible banks ...) and the stock of central bank credit are then determined endogenously, i.e. demand-determined by commercial banks. (see "TARGET2 Redux", p. 36, our underlines). 8 The need for this type of loan is thus explained by the ECB: "banking communities in some countries that face net payment outflows need more central bank liquidity than those in other countries where commercial bank money is flowing in. The uneven distribution of central bank liquidity within the Eurosystem provides stability, as it allows financially sound banks – even those in countries under financial stress – to cover their liquidity needs "; and also: "banks throughout the euro area currently have unlimited access to central bank liquidity, against adequate collateral" – see ECB Monthly Bulletin October 2011, pp. 35-36 and 38.

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This loan of bank reserves from the Banco de Portugal to CGD thus completes

the process unleashed by the initial bank transfer designed to pay off a

Portuguese debt security owned by Deutsche Bank.

PRACTICAL RESULTS OF THE PROCESS

From the point of view of substance, the end result of the several steps we

described above is the following: the Portuguese Government managed to pay

its external debt without having to borrow new funds from abroad.

Until the first quarter of 2011 the Portuguese Government owed an amount of

15 to Deutsche Bank. After paying back that debt it still owes a sum of 15, but

with a very substantial difference – it owes it to a public sector Portuguese

bank, CGD. And that bank will also make a nice profit in this process: it lent to

its shareholder, the government, at 10% and will be paying 1% interest on the

amount it borrowed at the Banco de Portugal (1% was the euro interbank

interest rate in April 2011, remember). It will thus earn a 9% spread in the

operation.

As for the Banco de Portugal, it will end up owing 15 to the ECB as a

consequence of the intervention of TARGET2. But it turns out that the debts

contracted between the central banks of the euro system have a special

feature, which is that their principal (their nominal value) has no schedule set for

payback. According to the rules of TARGET2, the outstanding credit and debit

positions of central banks vis-à-vis one another have no upper bound limit9 and

their maturity date is unspecified. These credit and debit positions are the

automatic reflex of the net flow of payments between the banking systems of

the countries of the euro; at any point in time, they may be increasing or

decreasing depending on the direction of these flows (for example, if German

banks return to their pre-crisis practice of lending bank reserves to their

Portuguese counterparties in the interbank market – or, alternatively, if German

consumers start buying more products from Portugal – there will be an increase

in net cash flows from Germany to Portugal, which will reduce both the credits

accumulated by the Bundesbank in TARGET2 and the debts of the Banco de

Portugal in the same system).

Thus, the money balances of TARGET2 owed by the central banks of the

countries of the European periphery simply cannot, according to the euro’s own

logic, have as destination "being paid". Ultimately, any "payments" will only

happen on the day (a day that, according to the euro treaties, will hopefully

never come) a country leaves the euro. Then and only then could these

9 They cannot have an upper bound, because "putting limits on the size of TARGET2 liabilities…would

throw the common currency area back to the system of fixed exchange rates with those central banks that face TARGET2 limits being forced to struggle to maintain their stock of internationally fungible reserves" – see Bindseil and König, "The economics of TARGET2 balances", p. 4. Mr. Bindseil is an economist at the European Central Bank.

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accounts be paid off – but said payments would necessarily involve one or

several new currencies, of the country or group of countries that would have

exited the euro10.

One important conclusion to be drawn from this example must then be this one:

the Portuguese government can manage to honor its commitments to foreign

creditors without needing to ask for new funds abroad – either to private sector

agents or to sovereign entities.

In addition, the example shows the foreign creditors receiving payments

promptly and on schedule, and such a circumstance would likely put an

immediate lid on the pressure of yields on Portuguese debt. It’s quite likely that

after a period receiving payments on time and with a minimum of fuss, lenders

would conclude that the risk of Portuguese default has become quite low –

much lower than the markets estimated in a moment of panic. This

acknowledgement would soon push the yields towards more sustainable

figures, thus reopening the way for a quick return of the Portuguese

Government to the bond markets.

And even abstracting from this likely beneficial effect on the psychology of the

markets, it is logical to assume that the use of the mechanism that we have

described would have helped by itself to overcome the sense of urgency that

prevailed in Portugal in the first semester of 2011 – a feeling that ultimately led

to the fateful decision to request aid from the Troika.

It is quite clear that had Portugal needed to borrow only a sum of 15 from the

panicking markets of 2011 instead of double that amount, the reduced

borrowing needs would have enabled the government to achieve important net

savings in total future interest charges. In the example we used, the

Government would continue to pay a gross amount in annual interest of 3.

However, since half of this cost (1.5) would be a revenue of the state-owned

bank (CGD) the bank could later on return to its shareholder the profit it earned

on the operation: that is, the amount of 15 lent times 9% (the spread mentioned

above), which would provide a refund to the government of 1.35.

This means that the future annual net burden of interest on year 2011 loans

would decrease from an amount of 3 to just 1.65 (3 minus the profit of 1.35 for

CGD, which will be reimbursed to the Government). This is a substantial

decrease, of almost 50%.

10 Even after (and if) a country exits the euro, this central bank TARGET2 debt might continue to pay

interest only, meaning it would be less burdensome than “normal” government debt with both interest and payment of principal obligations. In this sense, the scheme that we propose would make it less onerous for Portugal to exit the single currency, since it replaces a debt with principal by a kind of perpetuity, tendentially at low interest. On this topic see Karl Whelan, "TARGET2 and Central Bank Balance Sheets", p. 33-34.

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Certainly, such substantial savings in interest expenses – 1.35 per year that

could now be used for essential items of the budget – would lay open for the

Portuguese Government the choice of altogether discarding the request for help

to the Troika.

Of course, this is a description focused on an event from the past, a form of

counterfactual historical analysis, of what could have happened but didn't

happen. We proceed to show its relevance for the present in the following

sections.

IMPLEMENTATION IN THE POST-TROIKA ERA

Today, despite being subject to an aid program, Portugal still has the option of

using the very same process – TARGET2 and the CGD bank, ideally in

conjunction with other Portuguese commercial banks – to pay that part of its

outstanding debt held by foreign creditors11. Namely, the 22.8 billion euros due

to the ECB, the almost 80 billion owed to the Troika and the circa 40 billion

payable to private creditors in Europe, especially banks (December 2013

figures)12.

The procedure that we have analyzed would substitute internal debt for foreign

debt and replace a problem of chronic dependency vis-à-vis the exterior by a

much simpler one, redistributive in nature, in a new context in which Portuguese

citizens could say to one another that "we now all owe these sums to

ourselves".

Plus, it would let the Government save meaningful sums of money by capturing

a portion of the spread between the interest paid on government bonds and the

low loan rate at which commercial banks borrow from the Banco de Portugal.

We have observed how this spread is pure profit for the banking sector; and we

should now stress that in case the banks involved in the purchase of new debt

issues are either: a) fully owned by the Government (CGD) or, b) partially

owned by other public bodies (such as pension and social security funds that

are under government control – they could quickly become shareholders of

Portuguese banks via new IPOs, particularly of those banks that are already

under state intervention and in desperate need of new capital) the whole or a

part of the spread will revert to the public coffers. And even the remaining part

of that spread may well stay in national hands, to the extent that the banks’

private shareholders are Portuguese.

In addition to this, the constant presence of Portuguese banks as strategic

buyers of public debt in the primary markets would probably exert an upward

11 Even before the bonds reach maturity, if the government wishes to speed up the pace of debt payback. 12 http://www.publico.pt/economia/noticia/bancos-portugueses-decidem-sucesso-da-troca-de-divida-

1614784

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pressure on bond prices and send yields downwards to lower levels, and this in

turn would contribute to convey the desired image of a virtuous trajectory

towards the long-term sustainability of public debt.

The above-mentioned reasons indicate that the Government, by adopting the

procedure described in order to pay back the debt held abroad, would

strengthen its negotiating position in the European context – and, perhaps most

importantly, capture valuable financial savings that would place it in a much

better position to exit the foreign-mandated policies of spending cuts and tax

increases that have proved so detrimental to the country's economy13.

POSSIBLE COUNTER-ARGUMENTS

Some might counter-argue that an expansion of the CGD bank’s balance sheet

(loans and deposits) as a result of massive lending to the Government would

put at risk the capital ratios required by the Basle agreements; the answer to

this objection is that the Government could use a small part (say, 10%) of the

financial resources obtained in this process to inject new capital in the CGD

bank, if necessary14.

As for another possible objection – that the ECB could react by suspending the

acceptance of Portuguese Government bonds as collateral that may be

presented by the Portuguese banks in order to borrow from the Banco de

Portugal – the simple answer is that the ECB would certainly think twice before

taking such a step, for it would represent a profound change in the rules of the

game and might thus have an extremely negative impact on the liquidity of the

Portuguese banking system, with undesirable repercussions elsewhere in the

eurozone (footnote 6 also addresses this issue).

But even in an admittedly low probability scenario where the ECB did react in

the manner described in the preceding paragraph, the Banco de Portugal would

still have the option of continuing to make advances to the commercial banks

under a so-called ELA (Emergency Liquidity Assistance), which is not subject to

13 It should be noted that the limitation of this procedure to the rollover of outstanding debt means that we

are not facing here a case of "monetization" of new deficits; also, the payment of debt held by banks abroad would allow Portugal – if necessary – to invoke the "prudential" considerations that, according to the European treaties, may legitimize the "privileged access" of a government to financial institutions (in this case, CGD). In fact, by ensuring the prompt payment of Portuguese bonds held by EU banks, the Government would be contributing to the soundness of the European financial system – a result that might even lead to the process being endorsed by the countries of "core" Europe, in particular Germany.

14 The Government would have an extra option: that of instructing the social security and pension funds

under its control to become shareholders of CGD, thus enlarging its capital base. Or, as we suggest on page 10 of the main text, it could decide to be even bolder and have the funds inject new capital in other commercial banks that are already under some form of State intervention. These banks could then implement a process similar to that described for CGD by lending to the Government a multiple of subscribed capital - either by direct advances or via purchases of government bonds in the primary market. This could "leverage" by up to a multiple of ten the effects of the recent government decision (July of 2013) to use 4 billion euros of social security funds in support of Portuguese public debt.

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the normal rules on collateral guarantees. This is a phenomenon one did indeed

observe in the case of Greece, where the ECB has already tolerated without

much questioning situations in which the Bank of Greece made massive loans

to the banking system of the country while accepting as "collateral" only the

looser guarantees provided by ELA (Mario Draghi's statements in defense of

the Greek ELA, made on November 8, 2012, can be read here:

http://www.ecb.europa.eu/press/pressconf/2012/html/is121108.en.html). The Banco

de Portugal would thus presumably also be allowed to implement an ELA and

any guarantees offered by CGD bank would continue to be accepted by the

Portuguese NCB.

And if the Governing Council of the ECB, in an extreme measure that would

contravene precedents already established (apart from Greece, we have the

example of Ireland, which has been granted ELAs since 2009) decided to

instruct the Banco de Portugal to terminate the ELA15 the Portuguese NCB

would have no option other than ignore the ECB’s orders and keep advancing

funds to the banks, because otherwise there would be a risk of total collapse for

the Portuguese banking system due to lack of liquidity.

If this point ever came to be reached, the only way to prevent indirect financing

of the Portuguese Government through the Eurosystem would be for the ECB

to instruct the other European Central banks to cease lending to the Banco de

Portugal. This would mean the cutting off of Portuguese access to TARGET2,

tantamount to the country being expelled from the eurozone.

In practice, however, this would represent a true rogue move, totally outside of

the eurozone's legal framework, since the European treaties do not even allow

for the possibility of “expulsions” from the eurozone. At any rate, it would be

quite inconceivable that such an outcome be determined by an unelected body

such as the ECB (on this subject, see John Whittaker, '”Eurosystem Debts”,

page 6).

Also, and quite in contradiction to those observers who always characterize the

ECB as being under the sway of a strict “hard money” philosophy, facts have

repeatedly shown the ECB taking the initiative in facilitating the access of

national banking systems to funding by the respective central bank. It’s clear

that the ECB usually strives to minimize – quite logically, by the way – the risk

of liquidity crises arising within the European banking systems. As evidence for

15 On March 21, 2013, during the negotiations that led to the intervention of the troika in Cyprus, the ECB

put severe pressure on Nicosia, threatening to cut off the country’s ELA after only 4 more days – unless Cyprus agreed immediately to the conditions proposed by the troika to grant financial aid. As Cyprus did agree, we don't know whether the ECB would be ready to implement this ultimatum on the announced date. Cyprus is a small economy (15% the size of Portugal’s) dominated by its banking sector, with most of the funding originating from outside the EU. It is doubtful that the ECB would dare to behave in a similar manner vis-à-vis larger economies that are more closely connected to "core" Europe, because in that case it would be playing with a possible collapse of a national financial sector (collapse is what we’re talking about, if there is a sudden suspension of a ELA) that could easily contaminate the entire euro zone.

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this, one could mention the ECB’s decision, back in February of 2012, to

introduce a relaxation of collateral requirements for the banking systems of

seven countries of the eurozone, including Portugal – an instance of a “soft

money” approach that at the time startled many economists, including Willem

Buiter at Citibank.

Taking into account these examples of the near past, we think it highly unlikely

that the ECB would take practical measures to prevent a systematic recourse of

the Portuguese Government to CGD and/or other banks with the purpose of

borrowing the sums it needs to pay back creditors domiciled abroad16.

SUMMING UP THE ARGUMENT

We have seen how the procedures we are advocating here would cause,

ceteris paribus, a decrease in the amounts of government debt owed to foreign

creditors and a corresponding increase in the “TARGET2 debt” owed by the

Banco de Portugal to the ECB. This swap of IOUs would be highly beneficial for

Portugal, considering that TARGET2 debts “are different” in the sense that they

neither have a date of maturity nor an upper bound limit. The only obligation on

these debts is the payment of interest at the MRO rate of the eurozone, which is

right now at a level close to zero.

As we have seen, there are no technical impediments (as opposed to obvious

political obstacles, perhaps due to the absence of a subjective determination to

make full use of the rules of the game of the eurozone, in defense of legitimate

national interests) to prevent the Portuguese Government from taking full

advantage of the openings provided by TARGET2 in order to pay back its

foreign debts.

We believe that once the country’s Government decides to implement the

procedures that we described in this paper the situation will rapidly evolve

towards a substantial restoration of the monetary sovereignty that has now

been completely lost. Portugal will finally be able to pay back the sums it

received from the troika and also reduce, at the same time, the damage being

done to its economy. Plus, it will achieve this result by its own initiative, not

16 In support of our thesis we can mention an example from the recent past (spring of 2012) that shows the

ECB itself successfully mandating the Greek Government to implement a payback mechanism for Greek bonds held on the balance sheet of the ECB that is quite similar to the one we advocate in the text. The story went like this: the ECB put pressure on the Government of Athens for it to issue new short-term debt in the amount of 5 billion euros and sell it directly to Greek commercial banks – this at a time of worsening crisis in the country (on the eve of a general election), when "markets" were not willing to lend new sums to Greece. The banks subsequently transferred the Government's new deposits to the ECB, in order to pay back the (old) Greek bonds on the ECB’s books that were reaching maturity; they borrowed the necessary funds from the Greek Central Bank, under the ELA. This initiative of the ECB provides an important precedent, an additional reason for the Portuguese Government to feel confident in using the country’s commercial banks and TARGET2 on the lines that we propose here. On this subject see: http://yanisvaroufakis.eu/2013/11/08/ponzi-austerity-a-definition-and-an-example/

14

needing to depend on more foreign aid and on the price tag that inevitably

comes associated with it: merciless austerity.

Finally – last but not least – it is important to stress once again that all of this

would happen with Portugal acting entirely under the framework of the

accounting rules of the single currency and not abandoning the euro.

CONCLUSION

TARGET2 guarantees that all the citizens and firms of the eurozone can freely

transfer their euro-denominated bank deposits across the borders of the

countries of the EMU. It is a payment and clearing mechanism between central

and commercial banks designed to give shape to a foundational concept of the

single currency: that a euro must be the exact equivalent of any other euro,

independently of the country where it happens to be located. No wonder

TARGET2 can be used by a Government who wants to transfer deposits

abroad, in order to pay foreign creditors back.

By implementing automatic, limitless and uncollateralized credit creation

between the central banks of the eurozone, TARGET2 has allowed the euro

countries with high trade deficits to continue to finance their net imports even

after the interruption of the normal functioning of interbank markets that

occurred in 2008; and it has also enabled depositors in Italian and Spanish

banks to proceed to transfer without any obstacle hundreds of billions of euros

in bank deposits from those countries into Germany, throughout 2012.

These two phenomena – especially the second one, that is, capital flight –

explain the explosive increase in the cumulative amounts of debits and credits

within the TARGET2 system (shown in a graph of the Appendix) in particular

throughout the year 2012.

In recent times we have seen the system at its best, exhibiting a flawless

capability to accommodate a sudden and massive increase in unilateral cross-

border funding flows (as well, subsequently, a limited reversal in said flows); just

like it could deal in the future with massive transfers from Portuguese banks to

accounts in other euro countries with the purpose of paying back debts

contracted by the Portuguese Government in the past. At any rate, the amounts

involved in such transfers, even in the most extreme scenarios, would never go

beyond a few tens of billions of euros per year, i.e. a quantity much lower than

the net sums that have already been successfully processed under TARGET2

in the past.

We can thus conclude that the Portuguese Government, in conjunction with

local commercial banks, has the option of deciding to use TARGET2 in a

strategic and proactive manner, with the purpose of quickly replacing the debts

presently held abroad by new domestic debt, and that such an initiative would

15

also reduce interest expenses and help the country escape its current

predicament of subordination to recessionary policies dictated by external

creditors.

In the appendix that follows we present more detailed Tables with the

accounting entries for transfers under TARGET2, a graph with the evolution of

TARGET2 balances from 2007 until the end of 2013 and excerpts from papers

by Peter Garber, John Whittaker and Marc Lavoie that succinctly describe the

possibilities open to countries in the European periphery – alas, not yet properly

exploited by their Governments – in the context of TARGET2.

São Paulo, February 1, 201417

JOSÉ GUILHERME QUEIROZ DE ATAÍDE, CFA

[email protected]

www.marketbet.com.br

APPENDIX

(EVOLUTION OF TARGET2 BALANCES FROM 2007 to 2013, QUOTES

FROM AUTHORS, ACCOUNTING TABLES AND REFERENCES). GRAPH 1: Target2 positions

In EUR bn, January 2007-October 2013

DNFL = Germany, Netherlands, Luxemburg, France.GIIPS = Greece, Italy, Ireland, Portugal, Spain

Source: DNB

17 A first version of this text (in Portuguese) was published on December 15, 2012.

16

"There is no limit on the extent of the "Other liabilities within the

eurosystem" that a NCB (National Central Bank) can incur; and these liabilities can be carried indefinitely as there is no time prescribed for settlement of imbalances (…) a euro-zone government could, if it had to, continue to finance itself via the ECB even if it could not sell new bonds to the market because of fears of default. Under this scenario, a government might sell its bonds to a local bank, which draws funds from the ECB through its NCB (National Central Bank), depositing the new securities as collateral at the NCB. The government could then use the funds to pay private creditors in other countries who are not rolling over existing debt”. (Peter Garber, "The Mechanics of Intra Euro Capital Flight", 2010 - page 3).

"As long as (a country) remains in the euro, it cannot be excluded

from eurosystem credit, so Germany and any other euro countries

that still have sound finances will keep lending ... If this is not done

via an official loan facility, it will go through the eurosystem

(European Central Bank). The ECB ... is the lender of last resort

whether it likes it or not".

(John Whittaker, "Eurosystem debts, Greece, and the role of

banknotes", 2011 - page 6)

"We can see one way of regaining some currency sovereignty

without disrupting the ECB unwillingness to purchase sovereign

debt: a government that is under pressure from international

financial markets, having trouble in getting foreign financial

institutions to rollover their securities, could direct its domestic

publicly-owned commercial banks to acquire new bond issues at the

price of its choice ... The proceeds of these sales, initially held as

deposits at the domestic bank, could be used to redeem the

securities that foreign banks decline to roll over".

(Marc Lavoie, "The monetary and fiscal nexus of neo-chartalism",

2011 - page 24)

ACCOUNTING TABLES (next pages):

17

(The division in two steps is done for convenience of exposition only; in reality, the process is interconnected in so many ways that it is artificial to separate it in neat chronological phases). The process starts with the issuance of a Portuguese Government Bond. In this example, there is a security of 100 (million euros) that the Government "sells" to CGD Bank, thereby creating a government deposit in the Bank. The operation proceeds as follows: Step 1:

The Portuguese Government will use its new deposit at CGD bank to pay back

a bond, presently an asset on the books of Deutsche Bank in Germany. This

payment is processed via TARGET2; Deutsche Bank acquires a new deposit

liability as well as an asset (reserves that it deposits at the Bundesbank). CGD

does not lose reserves, in net terms, because it compensates for the reserves

that left for Germany by new reserves that it borrows from the Banco de

Portugal. The Bundesbank advances funds to the Banco de Portugal.

CGD Banco de Portugal

Deutsche Bank

Bundesbank

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

Deposit Portugal govt. -100

Advance to CGD + 100

Advance from Bundesbank +100

Reserves at Bundesbank + 100

Deposit ex-Portugal govt. + 100

Advance to Banco de Portugal +100

Deposit of Deutsche Bank +100

Advance from Banco de Portugal +100

Step 2:

End of the day: debits and credits of the Banco de Portugal and Bundesbank are transferred to the books of the ECB, where each central bank acquires a

net debit or credit position vis-à-vis the ESCB – the "Eurosystem" or ESBC

(European System of Central Banks); Deutsche Bank had excess reserves as a result of the transfer from Portugal and can now use them to decrease its debt

position vis-à-vis the Bundesbank.

18

Then, at the end of the process, the Portuguese Government’s deposit that was transferred to Deutsche Bank is used to extinguish the Portuguese bond previously held by that Bank. The process led to the following consequences within the Eurosystem: the Banco de Portugal increased its debt position relative to the ESCB/ECB, while the Bundesbank acquired a new claim on the ESCB/ECB. This build-up of debits and credits may continue indefinitely and without limit, within TARGET2. The tables assume the absence of normally active interbank markets, a situation that has prevailed in the eurozone since the financial crisis of 2008. They are based, with adaptations, on Marc Lavoie, "The Fiscal and Monetary Nexus of Neo-Chartalism".

REFERENCES: Ulrich Bindseil and Philipp Johann König, “The Economics of TARGET2

Balances”, June 14, 2011

http://sfb649.wiwi.huberlin.de/papers/pdf/SFB649DP2011-035.pdf

Peter Boone and Simon Johnson, “Europe on the Brink”, July 2011 http://www.piie.com/publications/pb/pb11-13.pdf Willem Buiter, “Is the Eurozone at Risk of Turning into the Rouble Zone?”,

13 February 2012 http://willembuiter.com/roublezone.pdf

Willem Buiter and E. Rahbari, “TARGET2 Redux”, 16 October 2012

www.willembuiter.com/target2redux.pdf

CGD Banco de Portugal

Deutsche Bank

Bundesbank ECB

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

Deposit Portugal’s govt. -100

Advance to CGD + 100

Owed to ECB +100

Deposit ex-Portugal govt. + 100

Credit to ECB +100

Owed by Banco de Portugal +100

Owed to Bundesbank +100

Advance from Banco de Portugal +100

Advance from Bundesbank - 100

Advance to Deutsche Bank -100

19

Bundesbank, “The dynamics of the Bundesbank TARGET2 balance” –

Bundesbank Montly Report, March 2011, pages 34-35

http://www.bundesbank.de/Redaktion/EN/Downloads/Publications/Monthly_Rep

ort/2011/2011_03_monthly_report.pdf?__blob=publicationFile

European Central Bank, “The Implementation of Monetary Policy in the

Euro Area”, February 2011

http://www.ecb.int/pub/pdf/other/gendoc2011en.pdf

European Central Bank, “TARGET2 balances of National Central Banks in

the Euro Area” – ECB Monthly Bulletin, October 2011, Box 4, pages 35-40

http://www.ecb.int/pub/pdf/mobu/mb201110en.pdf

Peter Garber, “The Mechanics of Intra Euro Capital Flight”, December 10,

2010 http://fincake.ru/stock/reviews/56090/download/54478

JKH, “TARGET2 – Window on Eurozone Risk”, September 5, 2012,

http://monetaryrealism.com/target2-window-on-eurozone-risk/

Marc Lavoie, “The Monetary and Fiscal Nexus of Neo-Chartalism”, October

2011 http://www.boeckler.de/pdf/v_2011_10_27_lavoie.pdf

Karl Whelan, “TARGET2 and Central Bank Balance Sheets”, March 17,

2013 http://www.karlwhelan.com/Papers/T2Paper-March2013.pdf

John Whittaker, “Intra-Eurosystem debts”, March 30, 2011

http://mpra.ub.uni-muenchen.de/38368/1/eurosystem.pdf

John Whittaker, “Eurosystem debts, Greece and the Role of Banknotes”,

November 14, 2011

http://mpra.ub.uni-muenchen.de/38406/1/MPRA_paper_38406.pdf