Draghi breaks the ultimate euro taboo

When Mario Draghi said on July 26 that a 'convertibility risk' was preventing the smooth functioning of the ECB's monetary policy across national borders inside the eurozone, he was breaking a taboo which has been stubbornly followed by all of his predecessors in the project to create a durable single currency. That taboo is that no one in the ECB should ever admit that the euro might break apart.

The objective of the taboo (which admittedly has previously been broken in the "special case” of Greece) has always been to ensure that markets should not feel the need to reflect any concerns about possible foreign exchange risk among the member states which comprise the euro.

By admitting that this 'convertibility risk' now exists, the ECB president has implicitly acknowledged that the permanence of the single currency is not fully credible in the financial markets. The recognition of redenomination risk after a potential devaluation is one reason, he implies, why sovereign bond yields are now so high in Spain and Italy. He has said that this prevents the ECB from transmitting its intended monetary stance into those economies, which gives the ECB the right to take direct action to reduce these bond yields.

After last Thursday's ECB meeting, it appears that this direct action will be to purchase short dated government bonds in Spain and Italy, provided that these governments have previously applied for support from the EFSF/ESM mechanism, and have accepted any conditions attached. The question is whether this action will be enough to put the convertibility genie back into the bottle.

Until Draghi's recent remarks, the ECB's line on convertibility risk was that the different members of the eurozone should be treated like the different districts of the Federal Reserve system in the US. In other words, they should be seen as the component parts of a single payments union, where the value of the euro is guaranteed to be the same throughout the eurozone. The bedrock of this guarantee is our old friend the ECB's Target 2 payments system, which ensures that payments made in euros by solvent and liquid entities will always clear, wherever they are made within the eurozone. By this means, the ECB ensures that the market does not need to worry that a Greek or Spanish euro will ever be worth less than a German euro.

What lies behind this guarantee is, however, an obscure mechanism which in effect means that the national central banks of the strong economies (eg the Bundesbank) are offering to extend a potentially unlimited amount of credit to the central banks of the weaker economies (eg the Bank of Spain) in order to ensure that the monetary union stays intact.

They in fact do this by via the ECB balance sheet, which stands between the Bundesbank and the Bank of Spain. But this does not alter the basic fact that the original design of the euro did not take into account the strains which would be placed on this mechanism if a country like Spain were to run a large and persistent balance of payments deficit (on current and private capital account) against Germany, which is what has been happening.

A balance of payments deficit means that Spanish residents are making larger outgoing payments to (say) Germany than German residents are making to them. Since 2008, the outflow has been driven by private sector capital flows, not by a current account deficit, but it still needs to be financed. So how does this outflow of private money actually get financed? It gets financed by an equal and opposite flow between the central banks. As a result, the Bank of Spain builds up a debit and the Bundesbank builds up a credit.

In the case of two completely independent countries, these debits and credits would get settled by a payments flow of between the relevant central banks. Under the Gold Standard, this flow would be in gold itself. Under the Bretton Woods system, it would be in dollars. In either case, the outflow of official reserves would force Spain to take steps to eliminate its balance of payments deficit by tightening monetary policy or allowing the exchange rate to depreciate, so the problem would, in principle, be self correcting.

The key difference between these situations and the euro mechanism is that the the debits of the Bank of Spain never get settled at all; they just get larger and larger, for as long as the Spanish balance of payments imbalance persists. And the same applies to the 'credits' of the Bundesbank. This is why the Target 2 imbalances inside the ECB balance sheet have grown so large in recent years. As long as the national central banks are willing to allow these imbalances passively to rise, then the single currency simply cannot break up. That is what makes it a single currency.

However, as Draghi has now implicitly acknowledged, the markets are no longer convinced that the Target 2 imbalances will be allowed to rise without limit. Although the Bundesbank has pointed out many times that Germany's credits under this system are against the ECB, and not against any individual country, potential Target 2 losses after a euro break up have become a political issue within Germany, undermining market confidence in the ultimate stability of the euro.

It is risky for a central banker to acknowledge that the payments system on which the currency stands may not be fully credible. Draghi could simply have repeated the old line that the operation of the Target 2 system is enough to ensure that the euro can never fall apart. By admitting the reality that the system is no longer 100 per cent credible in the eyes of the market, the ECB president has invited investors to ask whether his proposed interventions are powerful enough to deal with problem he has raised.

This question requires a more complete analysis at a later date. However, it is worth noting that Draghi's latest idea – ECB purchases of short dated bonds under a reactivated Securities' Market Program – will not increase the scale of official capital inflows into Spain, since they will (mostly) be undetaken by a Spanish entity, the Bank of Spain*. This means that reactivation of the SMP will not eliminate the need for Target 2 imbalances to continue rising, which ultimately could undermine confidence in the single currency still further. In order to prevent that, more drastic action to raise official capital flows into Spain, like providing a banking licence for the ESM, would be required.

* The exact impact of the SMP on capital flows, and therefore on the need for further increases in Target 2 imbalances, is not a straightforward or transparent matter. After consulting several macro-economists on this (Martin Brookes and Juan Antolin-Diaz at Fulcrum, Huw Pill at Goldman Sachs and David Mackie at J.P.Morgan), I have concluded that most SMP purchases have been made by national central banks from entities within their own countries, so that no cross border flows have been involved. I assume this pattern continues under SMP2.

Copyright The Financial Times 2012.