Eurozone Target2 imbalances are on the rise again, led by Italy.

Target2 Refresher Course

Before showing the latest Target2 numbers, inquiring minds may need a refresher course as to what Target2 is, as well as the problems associated with rising imbalances.

Target2 stands for Trans-European Automated Real-time Gross Settlement System. It is a reflection of capital flight from the “Club-Med” countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.

Pater Tenebrarum at Acting Man provided this easy to follow example “Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been ‘acquired’ is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment.

Also, if people in one country (Cyprus, Greece, Italy, Spain, anywhere) no longer trust their banks, they may pull their deposits and park them elsewhere.

Please see Reader From Europe Asks “Can You Please Explain Target2?” for a more compete discussion including responsibility percentages (i.e. if Greece leaves the eurozone, what percentage of the liability falls on Germany, France, Spain, etc.)

If Greece, Spain, or Italy elects to abandon the Euro, euro-based claims in those countries would receive an immediate haircut.

Watch Italy

The recent rise in imbalances is not that large, but it primarily rests on the shoulders of Italy.

With that backdrop, Variant Perception says Target2 Imbalances Widen Again – Watch Italy.

Target2 – the payment system used for intra-eurozone transfers – has widened again, with the largest two-month move since mid 2012. A look into its breakdown reveals that it is Italy that is almost completely responsible for the increase in liabilities. Ceteris paribus, an increase in the Target2 liabilities of a central bank means capital leaving the country in question, eg through the importing of goods.

Over the last two months, Target2 liabilities have increased by €67.1bn, while government deposits have fallen €56.6bn, so the net leakage abroad of liquidity in Italy is €10.5bn. Still, this is the largest such two-month net fall in liquidity since April 2012. This is worth monitoring since Portugal’s Target2 liabilities flared up in April 2010 just before government bond yields spiked; Ireland’s Target2 liabilities swelled up in late summer 2010 as deposit flight took root; and Spain and Italy’s Target2 liabilities accelerated just before the eurozone crisis reached its nadir and breakup of the EMU looked imminent.

Target2 Assets vs. Liabilities

The above blip in the last two months does not seem that significant, but it looks more important if you see it all comes from one place.

Target 2 Italy

Charts from Variant Perception. I added the trendline arrows in the second chart.

In this context, Italy, which had been on the mend since July 2012, has reversed course strongly in the last two months. Italy liabilities are 200 billion euros, and that poses a big theoretical risk.

Target2 Imbalances January 2007 – April 2014

Wikipedia has some good information (but also some fluff about how Target2 makes things more stable). Here is a long-term chart from Wikipedia.

Target2 imbalances dramatically improved after ECB president Mario Draghi came out with his “Whatever it takes … And believe me, it will be enough” statement in July of 2012.

In response, Jens Weidman, German economist and president of the Deutsche Bundesbank (Germany’s Central Bank), nearly resigned.

Weidman said in a Spiegel interview that “bond buying made it look as if ECB was financing governments directly — and shouldn’t go ahead”.

Target2 treats all assets and liabilities equal, regardless of country. The mechanism is one of the huge structural flaws in the euro system itself.

Ultimately, what cannot be paid back, won’t. Alternatively, the ECB will make up the difference via printing press. Either way, German banks on the surplus side will take a hit.

Mike “Mish” Shedlock