The Mannheim-based ZEW economic think tank’s monthly poll of economic sentiment climbed to 38.5 from 36.4 in May, beating the consensus forecast in a Reuters poll for a reading of 38.1.

Economists said the survey suggested the German economy was regaining traction after it contracted in late 2012 and only narrowly escaped a recession at the start of 2013 with growth of just 0.1 percent.

“Recently, doubts about the strength of the German economy have emerged again,” said ING senior economist Carsten Brzeski.

“Of course, all good things come to an end at some point in time. For the time being, however, Germany’s economic growth seems to be like an old rock star: it can’t get enough of comebacks.”

Like investor sentiment, business morale has picked up in Germany and the private sector has expanded slightly. The latest data has shown industrial output and foreign trade improving, but orders slumping and unemployment edging up.

ZEW President Clemens Fuest said the German economy would pick up speed in the second half of the year, echoing the view of the Bundesbank and the German government. But he also said more than half of survey participants expected no significant economic impulses in the next six months.

“The results of the current survey indicate that the economy will improve rather slowly,” he said.

The Bundesbank also said on Monday it expected growth to slow over the summer.

On Tuesday Germany’s RWI economic institute was the latest think tank to slash its growth forecasts, cutting its 2013 estimate to 0.4 percent from 0.6 percent in March and reducing its 2014 estimate to 1.9 percent from 2.1 percent.

It said private consumption, which was the economy’s saving grace in the first quarter of this year, would be the main growth driver, helped by higher wages.

Some German companies have been downbeat of late, with truck maker MAN (MANG.DE: Quote, Profile, Research, Stock Buzz) warning its return on sales would shrink significantly this year, steel distributor Kloeckner & Co (KCOGn.DE: Quote, Profile, Research, Stock Buzz) increasing planned job cuts and media conglomerate Bertelsmann’s BERT.UL broadcaster RTL (RRTL.DE: Quote, Profile, Research, Stock Buzz) saying a tough European market would hamper profit.

The ZEW index based on a survey of 257 analysts and investors was conducted between June 3 and June 17, ZEW said.

A separate gauge of current conditions dipped to 8.6 from 8.9 last month, coming in below the mid-range estimate in a Reuters poll for 9.5.

(Writing by Michelle Martin in Berlin; Editing by Noah Barkin)

Central banks meddling in fiscal policy weakens their ability to take care of their main task of keeping inflation low, he added, a day after a round of hearings to the ECB’s bond-buying program ended at the German constitutional court.

In Karlsruhe, the ECB defended itself against suggestions that its role should be more limited, clashing with Germany’s Bundesbank over its main tool in calming the euro crisis.

ECB chief Mario Draghi announced a plan last year to fend off speculation the 17-member euro zone could collapse under the weight of the debt crisis.

The scheme, dubbed Outright Monetary Transactions (OMT), the program to buy the bonds of struggling euro zone members in certain circumstances. Draghi has called the measure “probably the most successful monetary policy measure undertaken in recent time”.

But Weidmann opposes the plan. On Wednesday, he said that central banks’ should stick to their role.

“Recently, the independence and stability orientation of central banks are, however, again questioned,” Weidmann said in a speech at an economist club in Munich.

“The central banks themselves are not without blame in this. They have sometimes strongly stretched their mandate.”

He also warned that central banks should not promise more than they can achieve, adding that that would create additional risks to their independence.

Turning specifically to the 17-country euro zone, he said the crisis policies have caused significant questioning of how binding the budgetary rules in the euro zone are.

“When monetary policy is stretched for fiscal purposes, it will lose in the short-term or long-term its ability to keep prices stable,” Weidmann added.

Another ECB policymaker, Executive Board member Yves Mersch, who has said he was skeptical about central bank asset purchases, said there is more the ECB can do to help the ailing euro zone economy, which has seen six consecutive quarters of negative growth.

“The ECB has not run out of ammunition. We can employ more tools and measures whenever they will be needed,” Mersch said, but added that monetary policy had its limits.

“It is not effective when it comes to structural issues and we should keep in mind the challenges that arise from keeping interest rates too low for too long,” Mersch said.

Weidmann also warned against keeping interest rates too low for too long, saying all central banks faced the challenge to exit loose monetary policy once risks to price stability emerged.

(Additional reporting by Eva Kuehnen in Frankfurt; editing by Ron Askew)

The ECB cut its main refinancing rate to 0.5 percent and kept its deposit rate a zero at its May policy meeting, but said it stood ready to act again should economic conditions require more stimulus. It kept rates unchanged in June.

But annual euro zone inflation at 1.4 percent remains far below the ECB’s target of below, but close to two percent and Praet said the discussion about interest rates at the ECB was “very rich”.

“There is room for action in the standard measures,” Praet said in a question and answers session at the Frankfurt School of Finance. “The discussion about standard (measures) is quite rich and quite interesting.”

Praet said the inflation rate was “on the weak side” and the euro zone economy was still in a fragile state, with growth risks to the downside.

“So is it an issue? It is a matter of attention, of great attention. Is it a matter of concern? I would say: we look at inflation expectations are very well anchored, but it is a matter of great attention, that is clear,” he said.

Praet, who is in charge of the economics portfolio at the 6-man executive board running the bank’s day-to-day business, talked about standard and non-standard measures in monetary policy, saying a central bank could cut the interest rate into negative territory.

“But the question of course, if you go into negative rates – which is not impossible conceptually – you have a very big difficulty there from an economic point of view, as the time value of money becomes negative,” said Praet.

“In exceptional circumstances all the instruments can be used … When you talk about negative rates, it is part of the arsenal central banks can use,” he said

Praet added, however, that negative rates might have unintended consequences.

(Reporting by Andreas Framke; editing by Ron Askew)

Exports rose 1.9 percent and imports by 2.3 percent, Federal
Statistics Office data showed on Friday, offering some
encouragement to other euro zone states aiming to export their
way out of the region’s crisis.

But Germany’s central bank said that, after a second-quarter
surge, the economy could slow considerably, cutting its 2013
growth forecast by 0.1 percentage points to 0.3 percent and its
estimate for 2014 growth to 1.5 percent from 1.9 percent.

The Bundesbank’s 2013 prediction brought it into line with
the International Monetary Fund, which halved its forecast for
Germany on Monday.

The cut was “due mainly to downward revisions with regard to
the external environment”, the Bundesbank said, forecasting that
exports could fall by 0.8 percent from last year.

Capital Economics economist Jennifer McKeown called the
trade data encouraging but said a recent rise in the euro
“doesn’t bode well for Germany given that it exports quite a lot
to outside the currency area.”

Imports from the currency bloc rose a healthy 5.4 percent in
April, the statistics data showed.

But the overall German picture on imports was still very
weak due to a lack of investment, McKeown said, so “any hopes
that Germany is about to provide a massive boost to peripheral
(euro zone) countries are far too optimistic.”

Private consumption, supported by wage hikes, moderate
inflation and low unemployment, was the driving force behind
German growth in the first quarter. But the economy expanded
only 0.1 percent, meaning it barely avoided recession after
shrinking in late 2012.

Germany’s traditionally export-driven economy is relying on
domestic demand to prop up growth as foreign trade looks likely
to act a drag this year, given that much of the euro zone, where
it sends 40 percent of its exports, is lingering in recession.

BEYOND EUROPE

Friday’s healthy export figures contrasted with more
downbeat recent data.

Industrial orders dropped 2.3 percent in April as demand for
capital goods at home and abroad weakened, and a survey earlier
this week showed new manufacturing export orders declined
slightly for a third straight month in May.

The Bundesbank warned on Friday that German exporters’ sales
markets would only expand by 1.25 percent this year, which it
said was considerably lower than global trade growth.

German firms are looking to China and other non-European
countries as alternative markets to boost their sales, and
unadjusted trade data showed exports to the euro zone rose by
4.3 percent in April and by 13.6 percent to countries outside
Europe.

Continental AG has said improving markets in North
America should help lift first-half sales to match year-ago
levels and BASF announced it would go on a hiring
spree in the Asia Pacific region as it aims to double sales to
customers there by 2020.

Friday’s import and export numbers were both well above
forecasts.

The seasonally-adjusted trade surplus widened slightly to
17.7 billion euros from 17.6 billion in March. The consensus
forecast was for it to narrow to 17.2 billion euros.

Recent data has painted a mixed picture of the German
economy. Sentiment surveys have improved and the private sector
has expanded slightly but orders have slumped, unemployment has
edged up and retail sales have fallen.

Economic data improved in May and ECB President Mario Draghi
said this week he still sees “a very gradual recovery” starting
later this year, taking pressure off the ECB to act again, as it
had promised to do if necessary after cutting rates in May.

“This can be seen as a reaction to the slight improvement in
the purchasing managers indices (PMIs), which seem to signal
that the worst is over in the euro zone,” said David Kohl, chief
economist for Germany at Julius Baer.

Investors will now shift their focus to the latest ECB staff
projections – to be read out during a news conference that
starts at 1230 GMT – to gauge how the central bank assesses the
currency bloc’s economic prospects.

Analysts expect only minor changes to the ECB’s outlook from
the previous forecasts, released in March.

“They will revise down GDP growth forecasts, while we expect
next year’s inflation forecast to remain unchanged,” Unicredit
economist Marco Valli said.

A firm majority of 81 economists polled by Reuters before
Thursday’s rate decision did not expect the ECB to cut its main
refinancing rate or its deposit rate
this month or in the near future.

But it will not rule out further policy action, if needed.

“Draghi will try to balance two messages. He will try to
sound constructive about the economy and to also leave the door
open to further policy easing,” JP Morgan economist Greg Fuzesi
said in a note to investors.

Purchasing managers index surveys on Wednesday showed euro
zone business activity shrank in May, but at a slightly slower
pace. Downturns have eased in France, Italy and Spain, and
Germany is stabilising, the data showed.

Inflation, which fell to 1.2 percent in April, rose back to
1.4 percent in May, closer to the ECB’s target of just below 2
percent, while Eurostat confirmed the bloc’s economy contracted
by 0.2 percent in the first quarter of the year.

“If data were to disappoint going forward, then a refi rate
cut becomes an option,” ABN Amro economist Nick Kounis said.

DOOR AJAR

One door the ECB will not close is the option of taking its
deposit rate into negative territory from zero now – although
few analysts believe it has immediate plans to do so.

At last month’s post-rate decision news conference, Draghi
said the central bank will look at negative deposit rates “with
an open mind and we stand ready to act if needed”.

But that might be ammunition the ECB wants to keep unused -
at least unless the economy enters a downward spiral.

“It’s not never-ever, but probably a lot would have to
happen for it to happen,” ABN Amro’s Kounis said.

Other possible options could include moves to boost lending
to small and medium-sized firms (SMEs), the economy’s backbone,
although plans to do so are unlikely to have been finalised.

Varying borrowing costs in different parts of the common
currency area have developed into a major headache for the ECB,
with firms and consumers in the debt-ridden south having to pay
much higher interest rates than their counterparts in the north.

After months of hinting at action, the ECB has lately sought
to temper expectations, warning against expecting a bazooka.

ECB Vice-President Vitor Constancio said last week that one
should not “overblow” options the ECB has to repair the market
for asset-backed securities, which could help access to funding
when bank lending channels are blocked.

European Council President Herman Van Rompuy said on Friday
he expected a joint proposal with the European Investment Bank
to improve SME financing this month, although the ECB seems
content to be a junior partner in any such scheme.

The euro zone’s central bank cut its main rate last month and signaled it was ready to do more should a recovery not materialize in the second half of the year as it expects.

With economic data improving in May, the ECB will probably want to save its last remaining policy firepower for a later date, while stressing it is not out of ammunition.

This may include action to boost lending to smaller firms in the euro zone periphery, although plans to do so are unlikely to have been finalized.

“We won’t see any changes on the policy rates,” ABN Amro economist Nick Kounis said. “If data were to disappoint going forward, then a refi rate cut becomes an option.”

The ECB will release its latest set of staff projections after Thursday’s Governing Council meeting, which began at 0700 GMT (3 a.m. EDT).

Analysts expect a slight downgrade to growth forecasts, while the inflation outlook is expected to be little changed from the previous forecasts, released in March.

ECB President Mario Draghi said on Monday he continued to see “a very gradual recovery” starting later this year.

In a Reuters poll, 78 of 81 economists expected rates to remain on hold this month. A firm majority of respondents do not expect the central bank to cut its main refinancing rate or its deposit rate again in the coming months. <ECB/INT>

With data slightly better in May than in April, there is less need for action. Purchasing managers’ index surveys on Wednesday showed that euro zone business activity shrank in May, but at a slightly slower pace.

Downturns have eased in France, Italy and Spain, and Germany is stabilizing, the data showed.

Inflation, which fell to 1.2 percent in April, rose back to 1.4 percent in May, closer to the ECB’s target of just below 2 percent, while Eurostat confirmed that the bloc’s economy contracted by 0.2 percent in the first quarter of the year from the October-December period.

STAFF PROJECTIONS

Analysts expect only minor changes to the ECB’s outlook.

“They will revise down GDP growth forecasts, while we expect next year’s inflation forecast to remain unchanged,” Unicredit economist Marco Valli said, adding that he expected Draghi to maintain a dovish tone.

The central bank will continue to see a recovery later this year but not rule out further policy action, if needed.

“Draghi will try to balance two messages. He will try to sound constructive about the economy and to also leave the door open to further policy easing,” JP Morgan economist Greg Fuzesi said in a note to investors.

One door the ECB will not close is the option of taking its deposit rate into negative territory from zero now – even though few analysts believe it has immediate plans to do so.

At last month’s post-rate decision news conference, ECB President Mario Draghi said the central bank will look at negative deposit rates “with an open mind and we stand ready to act if needed”.

But that might be ammunition the ECB wants to keep unused – at least unless the economy enters a downward spiral.

“It’s not never-ever, but probably a lot would have to happen for it to happen,” ABN Amro’s Kounis said.

Varying borrowing costs in different parts of the common currency area have developed into a major headache for the ECB, with firms and consumers in the debt-ridden south having to pay much higher interest rates than their counterparts in the north.

After months of hinting at action to help especially small- and medium-sized enterprises (SMEs), the bloc’s economic backbone, the ECB has lately sought to temper expectations, warning against expecting a bazooka.

ECB Vice-President Vitor Constancio said last week that one should not “overblow” options the ECB has to repair the market for asset-backed securities, which could help access to funding when bank-lending channels are blocked.

European Council President Herman Van Rompuy said on Friday he expected a joint proposal with the European Investment Bank to improve SME financing this month, although the ECB seems content to be a junior partner in any such scheme.

(Editing by Catherine Evans and Susan Fenton)

The euro zone’s central bank cut its main rate last month and signaled it was ready to do more should a recovery not materialize in the second half of the year as it expects.

With economic data improving in May, the ECB will probably want to save its last remaining policy firepower for a later date, while stressing it is not out of ammunition.

This may include action to boost lending to smaller firms in the euro zone periphery, although plans to do so are unlikely to have been finalized.

“We won’t see any changes on the policy rates,” ABN Amro economist Nick Kounis said. “If data were to disappoint going forward, then a refi rate cut becomes an option.”

The ECB will release its latest set of staff projections after Thursday’s meeting. Analysts expect a slight downgrade to growth forecasts, while the inflation outlook is expected to be little changed from the previous forecasts, released in March.

ECB President Mario Draghi said on Monday he continued to see “a very gradual recovery” starting in later 2013.

In a Reuters poll, 78 of 81 economists expected rates to remain on hold this month. A firm majority of respondents do not forecast the central bank to cut its main refinancing rate or its deposit rate again in the coming months. <ECB/INT>

With data slightly better in May than in April, there is less need for action. Purchasing Managers’ Index surveys showed on Wednesday that euro zone business activity shrank in May, but at a slightly slower pace. Downturns have eased in France, Italy and Spain, and Germany is stabilising, the data showed.

Inflation, which fell to 1.2 percent in April, rose back to 1.4 percent in May, closer to the ECB’s target of just below 2 percent, while Eurostat confirmed that the bloc’s economy contracted by 0.2 percent in the first quarter of the year from the October-December period.

STAFF PROJECTIONS

Analysts expect only minor changes to the ECB’s outlook.

“They will revise down GDP growth forecasts, while we expect next year’s inflation forecast to remain unchanged,” Unicredit economist Marco Valli said, adding that he expected Draghi to maintain a dovish tone.

The central bank will continue to see a recovery later this year but not rule out further policy action, if needed.

“Draghi will try to balance two messages. He will try to sound constructive about the economy and to also leave the door open to further policy easing,” JP Morgan economist Greg Fuzesi said in a note to investors.

One door the ECB will not close is the option of taking its deposit rate into negative territory from zero now – even though few analysts believe it has immediate plans to do so.

At last month’s post-rate decision news conference, ECB President Mario Draghi said the central bank will look at negative deposit rates “with an open mind and we stand ready to act if needed”.

But that might be ammunition the ECB wants to keep unused – at least unless the economy enters a downward spiral.

“It’s not never-ever, but probably a lot would have to happen for it to happen,” Kounis said.

Varying borrowing costs in different parts of the common currency area have developed into a major headache for the ECB, with firms and consumers in the debt-ridden south having to pay much higher interest rates than their counterparts in the north.

After months of hinting at action to help especially small- and medium-sized enterprises (SMEs), the bloc’s economic backbone, the ECB has lately sought to temper expectations, warning against expecting a bazooka.

ECB Vice-President Vitor Constancio said last week that one should not “overblow” options the ECB has to repair the market for asset-backed securities, which could help access to funding when bank-lending channels are blocked.

European Council President Herman Van Rompuy said on Friday he expected a joint proposal with the European Investment Bank to improve SME financing this month, although the ECB seems content to be a junior partner in any such scheme.

(Editing by Catherine Evans)

The main risks are closely related to economic growth, and a delay to the end of the recession in the 17-country bloc would also increase risks to banks’ health.

“Financial stability has improved but remains fragile … due to weak growth and banking sector vulnerabilities,” ECB Vice President Vitor Constancio told reporters in a presentation of the ECB’s semi-annual financial stability review.

“There is this disconnect between the significant improvements in financial markets in general and the real economy – and the situation in the real economy is affecting banks,” he said. “So this is a cause of concern.”

The ECB highlighted four main stability risks:

1. Further decline in bank profitability, linked to credit losses and a weak macroeconomic environment

2. Renewed tensions in sovereign debt markets due to low growth and slow reform implementation

3. Bank funding challenges in stressed countries

4. Reassessment of risk premia in global markets, following a prolonged period of safe-haven flows and search for yield

ASSET CONCERNS

The ECB credited its own actions, especially the creation of its new bond-buying program last year, with reducing stress.

The probability of two or more large euro zone banks defaulting at the same time had fallen sharply since ECB President Mario Draghi vowed last July to do “whatever it takes” to preserve the euro, Constancio said.

But more information was needed about bank asset quality.

“Concerns – justified or not – related to the lack of information available to evaluate banks’ asset quality weigh on the entire euro area banking sector,” the ECB said.

The ECB will take over supervision of the region’s banks next year and plans to conduct a comprehensive bank asset-quality review in the first quarter.

It said banks have to clean up their balance sheets.

“Currently used risk-weight calculations might not in all cases be an accurate gauge of the true riskiness of the portfolios of financial institutions,” the ECB said.

REFORM DRIVE

The ECB urged governments to keep up their reform drive and continue integration, including a full banking union.

Germany has been critical of the planned joint mechanism for shoring up or winding up banks, saying it might require a change to EU laws, which could take years.

“Swift and complete implementation of a banking union should make an important contribution to key financial stability threats,” the ECB said.

While there has been some improvement in bank funding, stressed countries’ banks often have to pay “prohibitively high” costs which are passed on to consumers and firms.

“Financial fragmentation is contributing to increasingly divergent economic conditions across euro area countries,” the report said.

The ECB also said a better-functioning market for asset-backed securities (ABS) could help small firms access funding. Draghi has said the ECB is in talks with the European Commission and the European Investment Bank on this.

The ECB has long struggled with the problem that its efforts to make credit cheaper do not help all parts of the euro zone equally.

The ABS market for small and mid-sized companies “is a very small thing indeed, very small,” said Constancio. “So let’s not overblow this thing. It’s an option, I won’t say more.”

Finally, the ECB said the real property price outlook remains weak and uncertain. Commercial and residential property is highly overvalued in Belgium, Finland and France, the report said.

(Additional reporting Eva Kuehnen; Editing by Ruth Pitchford)

Loans fell 0.9 percent from the same month a year ago, ECB data showed on Wednesday, a slightly bigger fall than the mid-range forecast for a drop of 0.7 percent in a Reuters poll of economists. EUM3PC=ECI

The ECB, which meets next week, has flooded banks with money but many still remain wary of lending to businesses – particularly in the recessionary periphery of the euro zone – against a weak economic backdrop and uncertain outlook.

Banks granted non-financial firms 18 billion euros less in loans in April than in the previous month, data adjusted for sales and securitizations showed, after a fall of 2 billion euros in March.

“The marked fall in lending to euro zone businesses in April ramps up pressure on the ECB to come up with concrete measures aimed at improving credit availability to companies, especially small and medium-sized ones,” said Howard Archer, economist at Global Insight.

ECB data also showed that loan growth rates vary greatly between euro zone countries, with those hardest-hit by the debt crisis seeing big reductions.

In Spain, lending to firms, excluding banks, fell 8.8 percent from the same month a year earlier. Ireland saw a 5.6 percent decrease, while lending fell 3.3 percent in Greece and 3.5 percent in Portugal.

German lending growth to firms was just above zero, as it recorded a 0.3 percent annual growth rate. Growth in the Netherlands, Finland and France was faster than that.

ECB MEETING

The ECB holds its June policy meeting next Thursday. Last month, it cut its main interest rate to a record low of 0.5 percent and policymakers have left open the possibility of a further cut.

In addition to potentially cutting the main rate, the ECB’s Governing Council is debating whether to cut the deposit rate – the interest paid on money that commercial banks park at the central bank – below zero to encourage them to lend more. Critics say such a move could destabilize money markets.

To boost lending to small euro zone companies, the ECB is also looking at ways to revive an asset class that was widely criticized for its role in the financial crisis – asset-backed securities (ABS).

These allow banks to move at least some credit risk off their balance sheets by packaging individual loans into new instruments and selling them on to other investors.

Credit markets were paralyzed during the crisis when such securities became toxic due to the default of housing loans that underpinned them.

But the ECB is now considering whether such securities could help the euro zone’s small- and medium-sized enterprises (SMEs), the bloc’s economic backbone, saying that not all ABS are bad.

Euro zone M3 money supply – a more general measure of cash in the economy – grew at an annual pace of 3.2 percent in April, accelerating from 2.6 percent in March and above the consensus of 2.9 percent from analysts polled by Reuters.

David Brown at New View Economics said that despite the rise, the money supply figures remained weak, adding that they do “not let the ECB off the hook for further policy easing”.

(Reporting by Paul Carrel and Sakari Suoninen; Editing by Jeremy Gaunt)

Little heard of before the debt crisis exploded, the
currency area’s Target2 payments system which settles
cross-border payments became big news as some economists said
its imbalances – close to a trillion euros at their peak – posed
a grave risk to the bloc.

When Spanish and Italian borrowing costs reached
unsustainable levels last year, fears of a euro zone break hit
fever pitch and Germany’s safe-haven status attracted a wall of
money flows from southern Europe.

That in turn forced central banks in the stronger states to
take IOUs to facilitate those flows which, some argued, could
have saddled Germany and others with huge losses if a country
such as Greece left the euro zone.

Hans-Werner Sinn at Germany’s Ifo institute fuelled Germans’
angst, calling the Target2 imbalances “bailout by stealth” which
represented forced capital exports from core countries to the
periphery.

Others said that argument was flawed but whatever its
merits, the imbalances began to unwind after Draghi’s speech in
London last July. Markets bought his promise and were further
convinced the European Central Bank would backstop the euro when
the bank subsequently presented its bond-buying plan.

Since then, bond yields in Spain, Italy and other euro zone
high debtors have tumbled and investors have been piling back
into those markets, reversing the previous outflows.

The Italian ECB chief returns to London on Thursday to speak
at an event on ‘The Future of Europe in the Global Economy’,
knowing that the euro zone’s future is far more secure since his
last public speech in the British capital that warm July day.

While Draghi never saw the Target2 imbalances as a harbinger
of doom, he has welcomed their reduction – they are now about a
quarter below their peak – as a sign of reduced stress in
financial markets.

“A decrease in Target2 balances is the best sign we have
that there has been a gradual return of confidence,” he said
earlier this month.

The net Target2 claim of the German Bundesbank – the biggest
of the system’s ‘creditors’ – now stands at 608 billion euros
($782 billion), down from a high of 751 billion last August.

Adding other countries with claims toward the ECB -
Luxembourg, the Netherlands and Finland – they top 800 billion
euros but have dropped by more than a quarter of a trillion from
highs reached last summer.

DIMINISHED THREAT

All cross-border payments in the euro zone – almost 2.5
trillion euros daily – go through the Target2 system, maintained
by the ECB and the 17 national central banks forming the
Eurosystem.

It is a hub-and-spoke system, where the ECB forms the centre
and all transfers go through it, and all claims and liabilities
are between national central banks and the ECB.

Before the financial crisis, the system’s imbalances were
generally small as current account deficits in southern European
countries were offset by private-sector capital inflows.

During the crisis, high use of ECB lending by banks in the
south of the bloc wrecked that equilibrium.

ECB funds – while cheap at 0.50 percent – cost well above
the 0.08 percent overnight market rate, which meant
strong banks financed themselves on the market while weaker
ones, many from southern Europe, turned to the ECB for loans.

This turned the Target2 payment system increasingly into a
one-way street with money flowing to the north. But the
availability of that liquidity did buy time for an economic
correction in the debt-crippled countries.

“The availability of Eurosystem credit to peripheral Europe
has allowed for a more gradual adjustment of current accounts,”
a Bank for International Settlements paper, co-authored by its
chief economist Stephen Cecchetti, said.

“A substantial part of the increase in Germany’s Target2
balance in 2012 resulted from international banks re-arranging
their balance sheets to hedge the risk of denomination, the
possibility of a re-emergence of national currencies,” Cecchetti
said.

That threat is now much diminished.

Ifo’s Sinn has accused the Target2 system of allowing a
“forced capital export from the Bundesbank”.

But as the money handed out in ECB liquidity operations is
newly created – it has inflated its balance sheet three-fold
during the financial crisis – that argument is suspect. No
capital is exported from Germany, but rather flows back into it.

“If euro-area monetary policy were centralised at the ECB,
there would not be any Target2 balances; however, this would not
inherently alter the risks associated with providing liquidity,”
Bundesbank President Jens Weidmann has said.

What if a country decided to try its luck outside the common
currency and leave the euro? Even in the case of an exit, “the
risk remains rooted in the nature and volume of the liquidity
provision”, not in the payment system, Weidmann said.

Collateral deposited at the central bank would be first used
to recover losses.

A reduction of Target2 balances is not only due to market
improvements. Decreasing credit flows in the debt-ridden
countries also have an impact. So, it is possible that the
liabilities of peripheral central banks will rise again when the
economy recovers and credit flows again. But this is unlikely.

Economic growth depends to a large extent on consumer and
investor confidence and its return would mean that banks could
finance themselves in the market instead of hanging onto a
central bank drip feed.

Also, peripheral countries’ current account balances have
decreased, so their need for capital inflows have gone down,
which could spell a further decrease in imbalances.

“Given that current account imbalances are rapidly
diminishing, Target2 balances will be reduced once private
capital flows return to the southern euro zone,” said Raphael
Auer, a trade expert at the Swiss National Bank. “This may
happen in the not-too-distant future.

($1 = 0.7778 euros)

(Editing by Paul Carrel/Mike Peacock)