The Eurosystem’s response
The Eurosystem’s role in intermediating large private-sector savings surpluses shouldn’t be regarded as abnormal. On the other hand, there have become few types of countries with consistently large external surpluses being intermediated for long periods exclusively by the private sector.
Generally in most countries running persistent current account surpluses (say, above 3% of GDP for a lot more than five years), the federal government or the central bank has accumulated large foreign assets either through a sovereign wealth fund or through forex intervention.
- In raw-material-exporting countries, where in fact the external surplus is generated by the royalties that visit the government, the sovereign wealth fund may be the natural choice.
Saudi Arabia and Norway supply the classic types of natural resources-based surpluses intermediated by the general public sector through a sovereign wealth fund.
- In countries where in fact the external surplus comes from excess savings in the private sector, forex intervention may be the usual path to absorb the risk due to the large net foreign asset position the private sector is accumulating.
Switzerland and Japan can illustrate the tendency of countries with structural private-sector surpluses to depend on the central bank.
The Eurosystem solution is inefficient
When there is indeed a job for the general public sector to intermediate large surplus savings, the question arises: is this intermediation done within an efficient way? From a German perspective, intermediation by the Eurosystem is, on balance, inefficient.
- On the main one hand, any credit risk incurred by the Bundesbank through the accumulation of Target2 claims against the ECB is distributed to other EZ countries through the distribution of any losses based on the share of countries in the administrative centre of the ECB.
- However, the prospective claims represent a portfolio that’s, geographically and across asset classes, very concentrated.
Target2 claims are ultimately only backed by the securities of banks in deficit countries delivered as collateral for ECB credits beneath the various credit facilities. A big part of the securities is most likely of dubious quality, even if indeed they often carry a government guarantee.
Target2 is inefficient from an investors perspective. The ECB offers German banks, and therefore indirectly the country’s savers, at the moment a nominal interest of zero (which might even transfer to negative territory later on), and it demands only 75 bps on its lending to banks in the Eurozone periphery.
- A ‘margin’ of 75 bps seems totally insufficient to cover the risks used the ECB’s operations.
Also, the zero nominal interest provided by the ECB’s deposit facility results in a poor real return for German savers of around 2% yearly beneath the ECB’s target inflation rate. And it may be even less when German inflation rises above the ECB’s target (as appears to be essential to allow internal real exchange rate adjustment in the Eurozone).
Finally, the ECB (by its nature as a central bank) struggles to offer German savers any longer-term investment vehicles. That is an integral drawback given having less long-term savings vehicles currently available because most German government debt has been absorbed by foreign central banks (e.g. from Switzerland and China) and sovereign wealth funds.
Establishing a Sovereign Wealth Fund to kickstart private lending
An alternative for this system of intermediation of the German savings surplus, which would avoid these disadvantages, will be a German Sovereign Wealth Fund (DESWF).
- A government agency would offer German savers a secure vehicle paying a guaranteed positive minimum real interest, with a top-up when real investment returns allowed.
- The automobile would invest the funds in a portfolio that’s highly diversified by geography and asset classes.
Positive real returns should be expected over time predicated on positive real global growth.
- With the DESWF channelling a substantial part of German excess savings beyond your Eurozone, the euro would depreciate.
This might help crisis countries to regenerate growth through exports, also to close their external deficits in order to recoup their international credit-worthiness.
- Target2 imbalances would gradually disappear and German claims abroad would move from nominal claims on the ECB (with a zero interest) to diversified real and nominal claims on various private and public foreign entities in a number of asset classes around the world.
Investments in to the German sovereign wealth fund could possibly be limited to longer-term commitments, thereby assisting to achieve positive real returns through participation in global growth and therefore be equal to a funded old-age pension scheme as a supplement to the prevailing German pay-as-you go scheme.
The DESWF would of course carry the investment risk, like the exchange rate risk, but its capability to deploy huge amounts of funds globally with a long-term investment horizon would put it right into a better position to take care of these risks than individual investors or private finance institutions (such as for example banks or insurance firms). The latter either pass the exchange rate risk to their customers or, if indeed they cannot do that, avoid it due to regulatory requirements or to conserve equity capital that might be needed as risk buffer. For instance, German insurance firms, which manage around €1,200 billion of mostly long term assets (equal to about half of German GDP) have invested no more than 5% of the funds beyond your Eurozone.
Eventually, the enlargement of cross-border capital flows and their focus on Eurozone countries as a result of the euro should be unwound. Only once these flows reflect long-term viable investment opportunities will they no more constitute a danger for the stability of the euro.
This involves a shrinking of current account deficits and surpluses of EZ countries. However, because of the structural savings surpluses of some EZ member countries, intra-area current account adjustment alone will most likely not be enough. What’s also required is a redirection of the existing account surpluses to countries beyond your Eurozone. If the private sector struggles to do this due to the reluctance to assume exchange rate risk, the general public sector may need to help. Regardless, an elevated demand for foreign assets will lower the exchange rate of the euro, that will facilitate efforts by the deficit countries to overcome recession by an expansion of exports.
One might of course object to your proposal that it presents an average ‘Germanic’ mercantilist view which transfers the responsibility of adjustment to all of those other world. But beneath the current circumstances you have to find the lesser evil: a solid euro coupled with ever-increasing internal tensions which threaten global financial stability, or a weaker euro without the inner tensions. We think that the global economy will be better off beneath the second scenario.