EU’s TARGET2 Imbalances Are Rising Again. Goldman Fears Italy Capital Flight Looms
The ECB sovereign systemic risk indicator – capturing pressures on government funding – is approaching the levels seen at the peak of the 2011-12 Euro crisis, as Italian spreads over German yields rise.
As a reminder on TARGET2 liabilities (and assets), Norbert Häring wrote for Handelsblatt earlier in the year,
…Hans-Werner Sinn, the former head of Ifo Institute for Economic Research, a leading economic think tank, told Handelsblatt the figure was basically worthless – an “unsecured credit against the euro system, which cannot be called in and which debtor countries pay no interest on.” A private company would simply write off the amount, he added.
…No one quite knows would happen to the Target2 system in the event of a high-deficit country leaving the euro system. Last year, ECB president Mario Draghi told the European parliament that any deficits would have to be repaid. But it appears that countries have no binding legal obligation to do so; it is simply “guidance” from the ECB.
…If Italy were to withdraw from the euro zone, its banks’ assets and liabilities would be redenominated in its new currency, which would probably see a steep fall in value. The question then would not only be whether Italy should pay its Target2 deficit, but how it possibly could. The Bank of Italy would almost certainly default on a bill for half a trillion euros.
The latest data shows TARGET 2 claims of (core) northern Euro countries (Germany, Netherlands, Luxembourg and Finland) reached a new high level of EUR1.318 trillion (70% of which represents the German claims), very close to the historical peak of June 2018. In parallel, TARGET 2 liabilities of the southern peripheral countries (Italy, Spain and Portugal) also increased further to EUR957 billion.
In contrast with Spain and Portugal, Italy’s TARGET 2 liabilities increased in each month since the market tensions associated with the emergence of the new Italian government last May.
As Goldman Sachs explains, the evolution of Euro area TARGET 2 (im)balances owes to two different underlying driving forces.
A ‘malign driver’, reflecting a “flight to quality”, whereby deposits flee the banks of weaker peripheral countries for the relative safety of banks in stronger core countries. Concerns about the financial soundness of the domestic banking system (and/or perceived risks of an EMU breakup) may lead to deposit outflows and/or shifts in asset holdings from a country perceived as vulnerable towards another country in which assets are considered to be safer, reflecting a flight to quality.
A ‘benign driver’, whereby central bank asset purchases from banks that hold their liquid balances in other Euro area countries (for example, a non-Euro area bank with its continental European subsidiary in Germany or the Netherlands) would lead countries’ TARGET 2 liabilities to increase.
And ‘malign’ strains are starting to show.
In contrast with domestic deposits (namely from residents in Italy) at the aggregated level – mostly reflecting the behaviour of households and non-financial corporations (Exhibit 11) – deposits from pension/insurance companies and other financial institutions have gradually decreased since last May amid greater volatility (Exhibit 12).
The optimistic assumption is that the magnitude of the ‘malign driver’ behind Italy’s TARGET 2 liabilities is relatively contained at present at around EUR100bn (information available until the end of October 2018).
But, more ominously, as Goldman concludes, the reduction of the credit exposure of both foreign investors and non-bank financial institutions (until September) – part of which have been transformed in cash deposits still in Italy – is already a warning signal.
And the latest available data reported in this analysis is prior to the tensions between Italian and EU authorities about the 2019 draft budget. In our view therefore there is a real risk that in the coming months we will observe Italy’s TARGET 2 liabilities being driven more by ‘malign’ than ‘benign’ forces.
Since deposits are more easily transferable than any other financial asset, the ‘malign’ driving force could be rapidly strengthened should political uncertainties and the likely upcoming confrontational debate between Italian and European authorities on the 2019 budget increase substantially.
In this respect, the EC recommendation to launch the EDP in response to Italy’s 2019 budget increases this risk, having in turn the potential to create additional political tensions.
We give the last word to Mike Shedlock who sums up the ignorance of the ever-growing situation succinctly:
“Claims that none of this matters and that there would be no consequences if Italy left the Eurozone and defaulted are as ridiculous as ever…
The harder people attempt to come up with reasons that none of this matters, the sillier they look.“