Do current TARGET2 liabilities mark the end of the Eurozone, or will they help hold it together?

Roberto Antonielli
Written by

21st February 2017

As another year of important elections looms, Europe remains a focal point. Downplayed concerns over the possibility of a Le Pen victory are reminiscent of consensus expectations over Brexit and Trump last year. The chance that political parties advocating to leave the Eurozone are victorious raises concerns over the Eurozone’s financial system which first surfaced five years ago.

Target2 was a much-watched data release in 2011-12, as it was evidence of ongoing capital flight from the Eurozone periphery into the core. To explain, it is the Eurozone’s real-time gross settlement system for euro-denominated payments, which documents the outstanding assets and liabilities of each National Central Bank (NCB) within the Eurozone. The Eurozone debt crisis saw investors sell periphery assets and buy core country assets, and as such spreads between periphery and core government bonds rose. As capital left the periphery, peripheral NCBs saw their Target2 liabilities increase. Current account imbalances, fragmented capital markets and distrust in the periphery’s domestic banking systems were the primary drivers of Target2 liability increases over this period. A normalisation of the situation in 2012 increased investor appetite for periphery assets, and also the ability of peripheral banks to borrow, allowing private financial flows to reduce Target2 imbalances.

Banco De España Net TARGET2 Assets Bono Spreads (%)

Source: Bloomberg, 30/01/2009 – 31/12/2016. Past performance is not a reliable indicator of future results.

Starting in 2015, Target2 liabilities started increasing again. However, this time around the causes appeared different, at least on the face of it. Peripheral economies’ current account deficits, a previous factor of Target2 imbalances, have largely improved. The chart above shows that Spain’s liabilities have increased 140bn since the start of the European Central Bank’s (ECB) Quantitative Easing (QE) programme, to 330bn euros.

The ECB has argued that its QE programme has contributed both to increasing liabilities and to keeping spreads down, and has stated that 80% of the bonds bought as part of its QE programme have been acquired from non-domestic Eurozone investors of the respective purchasing NCB. As these NCBs have disproportionally bought their own peripheral government bonds from investors in other Eurozone countries, their Target2 liabilities have increased.

Roughly 50% of QE purchases were also bought from counterparties located outside the euro area. An additional complication for Target2 imbalances is that non-Eurozone investors generally deal through the Deutsche Bundesbank, which further increases German Target2 assets when non-Eurozone investors sell euro assets to periphery NCBs.

However, rising Target2 liabilities also suggest that investors selling their bonds to periphery NCBs are not then buying other periphery assets. Investors appear to have instead used the QE programme as a means of reducing their peripheral exposure. We believe this is due to both political risks and concerns over the European financial system. While current account balances and QE purchases have played a role in the recent liability expansion, the banking system is a third component. Bank stress as measured by Credit Default Swap (CDS) spreads on European financials indicates that peripheral risk has increased. This will have hampered the periphery banks’ ability to borrow and the attractiveness of the periphery for investors, contributing to an increase in Target2 liabilities.

Nonetheless, Target2 liabilities contain some silver linings. The large amount of Italian and Spanish Treasury Bonds (BTPs and Bonos) now held by the respective central banks have reduced the share of foreign ownership. Should financial market conditions deteriorate further, this reduces the impact that capital flight by foreign investors may have in worsening the situation, which could prove a good thing for the euro system. Domestic investors in peripheral countries have also diversified their portfolios, and they now own fewer domestic assets than they did previously.

Another silver lining, at least from the perspective of the ECB, is the increased difficulty of leaving the Eurozone introduced by these imbalances. ECB President Mario Draghi has clarified that should a country decide to leave the Eurozone, Target2 assets and liabilities of the national central bank will have to be settled with the ECB.

Banca D’Italia Net TARGET2 Assets BTP Spreads (%)

Source: Bloomberg, 30/01/2009 – 31/12/2016. Past performance is not a reliable indicator of future results.

The Five Star Movement’s success in the Italian polls has brought these issues back into the public eye. As the chart above demonstrates, Italy’s Banca D’Italia would likely be left with about 360bn euros of external liabilities, if it left the Eurozone.

Marine Le Pen has been perhaps the most infamous advocate of late for leaving the euro. If France were to leave, it would currently have a 40 billion euro liability to settle. Furthermore, if we see a Le Pen victory, French government spreads to German government bonds (Bunds) will likely blow out, and we would probably see a further increase in French Target2 liabilities, as has been seen through the end of 2016.

Banque de France Net TARGET2 Assets OAT Spread (%)

Source: Bloomberg, 30/01/2009 – 31/12/2016. Past performance is not a reliable indicator of future results.

Of course, if any country leaving was to default on its liabilities instead of repaying them, the impact would be felt by the central banks of remaining Eurozone countries. According to the ECB’s risk-sharing system, this would most impact those Eurozone countries with the largest ECB capital keys. The capacity and willingness of a leaving country to repay its liabilities will vary by country.

Ultimately, our view is that Target2 imbalances themselves will not force a breakup of the Eurozone, and may actually make it harder to leave. Instead, it is more likely that this issue will only need to be fully addressed should the Eurozone start to break up, with this breakup currently more prone to be initiated by political factors. Should the Eurozone break up, however, the size of Target2 imbalances may make things even more complicated… imagine Germany having some 400bn euro legal dispute with Italy! This is one of the reasons that political risk remains very much on our radar for 2017.  Politics is the key factor, but Target2 imbalances may make things even messier.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested.

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