The UK’s Brexit negotiating hand is stronger than you think

Don’t tell ze Britisch but ve really need zem…

In a recent reflection on what central bankers get up to when they meet together for some rest and recreation, I attempted to explain what TARGET2 is. This is the settlements system that, since 1999, has facilitated payments between the various Eurozone countries’ internal settlement platforms.

If that sounds boring – it is. So let me tell you something which isn’t boring. The unfolding crisis in TARGET2 will have massive implications for the Brexit negotiations. It turns out that the British hand is stronger than we thought because the Germans are desperate to accommodate the UK’s aspiration to tariff-free access to the Single Market. Otherwise they will be in big trouble.

A Brussels think tank spills the beans…

I have just read an important article by the German academic Gunnar Beck[i] which should be required reading for anyone in finance and economics who seeks to understand what is going on right now. Herr Beck is an eminent constitutional lawyer and legal philosopher who hangs out some of the time at the Brussels-based think tank AECR (Alliance of European Conservatives and Reformists). Now even though AECR is partially funded by the European Parliament, what Herr Beck has to say will be very unwelcome to Messrs Juncker, Verhofstadt, Barnier and their ilk.

Despite all the harsh rhetoric in Bratislava that the British can be given no privileged access to the Single Market if they impose immigration controls, behind the scenes, the German political and financial class is worried. They have come to realise, says Herr Beck how weak Germany’s and the EU’s negotiating position actually is…

There are two reasons why the German elite are justifiably worried. The first is that they fear that in an EU minus Britain, Germany will have to pick up the tab for lost British contributions to EU coffers. The second is that they have realised that the German financial system is sicker than has been apparent. I am not just talking about the travails of Deutsche Bank (FRA:DBK) and Commerzbank (FRA:CBK) – very serious though they are. (I wrote about this last week.) Indeed, there may yet have to be a bail-in on a massive scale (which is why corporate customers are shifting deposits out of Deutsche Bank at record levels). It’s because the Bundesbank itself is in deep trouble.

Das Bundesbank – the mother of all bad banks

Angela Merkel has been adept at keeping the costs of Eurozone integration well disguised. In fact they reside not on the German government’s budgetary statistics but on the balance sheets of the various Eurozone central banks – especially the Bundesbank. We can all remember a time, in the heyday of the mighty Deutschemark, when the Bundesbank was the very model of financial stability – the envy of the world. How times have changed.

Without getting too technical the problem is this. When a German exporter sells goods to an Italian importer, an asset is created on the balance sheet of the Bundesbank and a liability is created on the balance sheet of the Banca d’Italia. The corresponding liability on the Bundesbank’s balance sheet and the corresponding asset on the Banca d’Italia’s balance sheet are facilitated by TARGET2. Now a lot of these “assets” held by the German central bank are in practice non-performing loans (NPLs) – yet there is no way of accounting for this. The bigger the German trade deficit with the rest of the Eurozone, the greater the portfolio of NPLs. The Bundesbank is not just a bad bank with a stash of toxic assets – it is unable to do anything to de-toxify itself.

Then there is the intricate web of “Stability Mechanisms” about which I wrote back in May. These are potentially massive contingent liabilities which are not adequately accounted for on the Bundesbank’s balance sheet as they would be for a commercial bank.

In contrast, when a German exporter sells goods to a British importer, an asset is created on the balance sheet of a UK bank (normally) – and there is no impact on the Bundesbank at all. Now about 7.5% of Germany’s total exports find their way to the UK. In 2015 Germany’s trade surplus with the UK was a staggering €51 billion – more than one fifth of Germany’s total trade surplus.

So here is the point. For the Germans, €1 of trade surplus with the UK is worth much more than €1 of trade surplus with Italy, Spain, Portugal or France.

TARGET2 is in trouble

As of July 2016 the Bundesbank’s unsecured overdraft facility in favour of TARGET2 stood at an astonishing €660 billion. This sum of money is, in Herr Beck’s words, unlikely ever to be repaid… Germany’s trade surplus with the Eurozone therefore is little more than a massive accounting trick.

Moreover the Negative Interest Rate Policy (NIRP) now pursued by the European Central Bank (ECB) is causing havoc in Germany, with the traditionally important life assurance sector in deep trouble. The entire Eurozone financial system is extremely vulnerable to external shocks. Eurozone banks are sitting on an estimated €350 billion of NPLs, according to Wells Fargo – that’s about 15% of their global loan portfolios. One banking collapse right now could engender a systemic crisis of 2008 proportions – or worse.

What they are really thinking in Berlin

In present conditions, Germany cannot allow anything that would endanger healthy trade relations with Britain. Germany is already coping with a refugee crisis that is proving much more intractable than anticipated. Eastern European nations like Hungary are using the refugee issue as a stick with which to beat the Germans. German unemployment is forecast to rise next year. The squeaky sound of moving tanks is coming from Russia. The Italian banking system will need a costly fix very soon. The French are demanding a European Ministry of Finance (another fiendish Gallic plot to wrest political control from Germany).

The very last thing that Mrs Merkel wants right now is to impose tariffs on British goods – a move that would be reciprocated. She has let it be known that she can do business with Mrs May to their mutual advantage – and that is what is going to happen.

Sagen sie die Britishen nicht – aber wir brauchen ihnen wirklich.

[i] Available at: http://www.aecr.eu/gunnar-beck-germany-and-the-eu-cannot-afford-to-drive-hard-bargain-over-brexit/