In August, the European balance-of-payments crisis moved beyond the eurozone’s periphery and began buffeting Italy. Interest spreads for Italian government bonds began to rise and Italian Prime Minister Silvio Berlusconi’s administration was alarmed enough to implement an austerity program, while the European Central Bank (ECB) helped with extra liquidity.
The ECB directed the central banks of all eurozone members to buy huge quantities of Italian government bonds during the crisis. While the national central banks have not revealed how much they bought, the aggregate stock of all government bonds purchased rose from 74 billion euros (US$102 billion) on Aug. 4 to 165 billion euros this month. Most of this increase was probably used to purchase Italian government bonds.
The German Bundesbank, which was forced to buy most of the bonds, strongly opposed the program, but was unable to stop it. In response, ECB Chief Economist Juergen Stark resigned. He followed former Bundesbank president Axel Weber, who had resigned in February because of the earlier bond repurchases. Meanwhile, new Bundesbank President Jens Weidmann openly objects to the program, while German President Christian Wulff has publicly accused the ECB of circumventing the Maastricht Treaty.
However, the bond purchases are just the tip of the iceberg. Equally important, but largely unknown, is the fact that the Banca d’Italia has resorted to the printing press to cover Italy’s gigantic balance of payments deficit. The extra money printing and lending, as measured by the so-called Target deficit, effectively means drawing a credit from the ECB.
This credit replaces the private capital imports that had hitherto financed the country’s net purchases of foreign goods, but which dried up because of the crisis and it finances a capital flight, ie, the purchase of foreign assets.
The ECB in turn draws the Target credit from the respective national central banks to which the money is flowing and which therefore has to accept a reduction in its scope for issuing refinancing credit.
Until July, only Greece, Ireland, Portugal and Spain had drawn Target credit, for a combined total of 330 billion euros. Italy was stable and did not seem to need the printing press to solve its financial problems. No longer.
highest target loan
In August alone, Italy’s central bank drew 40 billion euros in Target credit and it probably drew roughly another 50 billion euros last month, when the Bundesbank’s Target loans to the ECB system increased by 59 billion euros (after a 47 billion euros increase in August). This is the highest Target loan ever drawn from the Bundesbank in a single month and in all likelihood it went primarily to Italy.
This is an explosion in slow motion. The stock of overall Target credit that the ECB system has drawn from the Bundesbank was about zero until mid-2007. By the end of last month, it had climbed to 450 billion euros — in addition to the purchases of government bonds that the Bundesbank has been forced to make.
As Italy’s monthly current account deficit approximates only 3 billion to 4 billion euros, the Target credit must have compensated primarily for capital flight. Italian investors sold their assets to the banking system, which paid with newly printed money. The investors then invested the proceeds in Germany, buying shares, bonds and other assets. In essence, Germany and Italy traded Target claims against marketable assets.