Target 2 will have a significant impact on UK trade with the EU, finance expert says

Cass professor gives evidence to the Treasury and International Trade Select Committees

Professor David Blake –  from the Finance Faculty at Cass Business School – appeared before the House of Commons International Trade Select Committee to give evidence to the UK’s future trading relationship with the European Union.

The Treasury Committee and the International Trade Committee are jointly examining some of the economic and policy implications of the UK’s approach to international trade, in the context of the UK leaving the European Union.

As written evidence, he submitted a report on ‘Target2’. This discussed some fundamental problems in the Eurozone, which comprises the member states of the EU that have adopted the euro as their national currency.

Professor Blake said:

“The euro was introduced on 1 January 1999. To support its introduction, a Eurozone-wide payments system was needed. Target2 settles euro-denominated cross-border transactions within the Eurozone. It is operated by the central banks of France, Germany and Italy. Its use is mandatory for the settlement of any euro transaction involving the Eurosystem, which comprises the European Central Bank and the national central banks of the Eurozone member states. Target2’s objectives are to: support the implementation of the Eurosystem's monetary policy and the functioning of the euro money market, minimise systemic risk in the payments market, increase the efficiency of cross-border payments in euros, and maintain the integration and stability of the Eurozone money market.

“However, the evidence presented in the report indicates clearly that Target2 has become a silent bailout system that keeps the euro afloat, but in doing so is also keeping key Eurozone economies in permanent recession. A key underlying problem is that the Eurozone does not satisfy the economic conditions for being an Optimal Currency Area, a geographical area over which a single currency and monetary policy can operate on a sustainable long-term basis. The different business cycles in the Eurozone, combined with poor labour and capital market flexibility, mean that systematic trade surpluses and deficits will build up – because inter-regional exchange rates can no longer be changed.

“Surplus regions need to recycle the surpluses back to deficit regions via transfers to keep the Eurozone economies in balance. But the largest surplus country – Germany – refuses formally to accept that the EU is a ‘transfer union’. However, deficit countries including the “largest of these – Italy – is using Target2 for this purpose. Further, the size of the deficits being built up is causing citizens in deficit countries to lose confidence in their banking systems and they are transferring funds to banks in surplus countries. Target2 is also being used to facilitate this capital flight. The result is that the Eurozone economies – particularly those of the southern member states – are stuck in a Japanese-style deflation trap.

“Target2 is clearly not a viable long-term solution to systemic Eurozone trade imbalances and weakening national banking systems. There are only two realistic outcomes. The first is full fiscal and political union – which has long been the objective of Europe’s political establishment, but is not supported by the majority of Europe’s peoples. The second is that the Eurozone breaks up.

“The UK is clearly not immune from what is happening in Target2 and the Eurozone.  The UK has already contributed significantly to the programmes set up to resolve the Eurozone banking and sovereign debt crises.

  • “It helped to bail out the Irish banking system as part of a €85bn rescue package involving the European Central Bank and International Monetary Fund which began in 2010. The UK’s contribution was £7bn. There was an additional £10bn to support Dublin-headquartered Ulster Bank, a subsidiary of Royal Bank of Scotland, which, despite its name, operates mainly in the Irish Republic, as part of the £45.80bn rescue of RBS in 2008.  Similarly, Lloyds Bank transferred £6.41bn of its £20.54bn rescue package to its Irish operation, Bank of Scotland (Ireland), before dissolving the business. In both cases, the funds were used to write off billions of pounds of loans made to Irish commercial property developers and households during the ‘Celtic Tiger’ boom years.
  • “It contributed €3.6bn to help bail out the Portuguese banking system as part of the €78bn ECB-IMF rescue package in 2011.
  • “It increased its contributions to the IMF, thereby allowing the IMF to provide rescue loans to Eurozone states in financial difficulty. The IMF was involved in seven bank bailouts between 2010 and 2015 (Ireland, 2010; Greece, 2010, 2012 and 2015; Portugal, 2011; Spain, 2012; and Cyprus, 2012) and the total contribution of the UK was around €4.5bn.

“Although the Bank of England – as a non-Eurozone central bank – will not be liable to fund any losses of the ECB related to the Eurozone, the UK banking system is still exposed to the Eurozone banking system. UK banks have made significant loans to both Irish and French banks, and the French banks, in turn, have made substantial loans to Italian and Spanish banks. So if any Italian and Spanish banks fail, this could have a negative impact on UK banks, not least by restricting their ability to raise finance in euros and other major currencies. There would also be problems if a Eurozone-headquartered bank, which did significant business in London, got into difficulties.

“UK savers and investors with Eurozone bank accounts or asset holdings could face a haircut. Those with bank deposits above €100,000 could be liable for an 8% haircut if the bank becomes insolvent.

“UK households could also be affected in terms of savings and mortgage rates. If a Eurozone banking crisis affected UK banks, this could raise the interest rate at which UK banks could borrow money on the wholesale money markets which would then lead to higher rates on new mortgages. On the other hands, the UK might be considered a safe haven for Eurozone depositors and investors, and this would help to reduce deposit and mortgage rates in the UK; but it would also raise property prices, especially in London.

“However, the principal reason why the UK should be concerned is the fall in trade with the EU. Jean-Claude Juncker, the president of the European Commission, wants to create a politically and economically United States of Europe by 2025 to avoid a Eurozone break up. But the process of doing this will have an enormous drag on Europe’s economic growth and its ability to buy UK goods and services.  Since the EU itself recognises that 90% of global economic growth will take place in the rest of the world, it should be clear that the UK’s trade alliances in future should not be with a highly protectionist Europe, but with like-minded countries in the Anglosphere (principally the US and Commonwealth countries, such as Canada, Australia, New Zealand and India) and other countries interested in free trade agreements, such as Japan.

“But we can only really see this if we take a great deal more interest in what is happening in Target2.”

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