In the latest BIS Quarterly Review, the BIS points a finger at the ECB for rising Target2 imbalances.

That sounds highly accusatory, but the BIS also claims this is a “benign by-product of the decentralized implementation of the asset purchase program (APP) rather than as a sign of renewed capital flight.”

I strongly disagree that any of this is “benign” unless and until someone can tell me precisely how Italy, Spain, Greece, etc., are supposed to pay back the claims.

From the BIS (this is complicated) …

TARGET2 (T2) balances are again on the rise. Since early 2015, the T2 balances of euro area national central banks (NCBs) have risen steadily, in some cases exceeding the levels seen during the sovereign debt crisis (Graph A, left-hand panel). However, unlike then, record T2 balances should be viewed as a benign by-product of the decentralized implementation of the asset purchase program (APP) [ECB’s QE] rather than as a sign of renewed capital flight.

Because liquidity operations in the Eurosystem are decentralised, claims or liabilities of NCBs vis-à-vis the ECB can arise. Market operations are to a large extent implemented by the Eurosystem’s NCBs rather than by the ECB. When an NCB disburses liquidity directly to commercial banks, it keeps the claims on those commercial banks on its own balance sheet. But the funds may end up in another commercial bank’s account with a different NCB. As a consequence, the liquidity-providing NCB has a liability vis-à-vis the ECB, while the NCB receiving the reserves holds a claim on the ECB.

The net of such claims and liabilities is referred to as a “TARGET2 balance” because it is recorded as such in the main payment settlement system of the euro area, the second edition of the Trans-European Automated Real-time Gross Settlement Express Transfer System.

In the period leading up to mid-2012, T2 balances grew strongly (Graph A, left-hand panel) due to intra-euro area capital flight. At the time, sovereign market strains spiked and redenomination risk came to the fore in parts of the euro area. Private capital fled from Ireland, Italy, Greece, Portugal and Spain into markets perceived to be safer, such as Germany, Luxembourg and the Netherlands.

Indeed, during that period, the rise in T2 balances seemed related to concerns about sovereign risk. The blue dots in the centre panel of Graph A show the close relationship between the sovereign credit default swap (CDS) spreads of Italy, Portugal and Spain and the evolution of their combined T2 balance from January 2008 to September 2014. Whenever the CDS spreads of those economies rose, the associated private capital outflows increased their T2 deficit. When the CDS spreads decreased after confidence in the euro area was restored in mid-2012, the capital outflows partly reversed, and T2 deficits dwindled.

In contrast, the current rise seems unrelated to concerns about the sustainability of public debt in the euro area. The red dots in the centre panel of Graph A show that, between October 2014 and December 2016, there was no relationship between the sovereign CDS spreads of Italy, Portugal and Spain and the evolution of their combined T2 balance.

The current rise in T2 imbalances seems to have a different cause: the Eurosystem’s APP, which mechanically affects the evolution of these balances. Many APP purchases are conducted by NCBs via banks located in other countries. One example is where the Bank of Italy, as part of its implementation of the APP, buys securities from a London-based bank that connects to the T2 system via a correspondent bank located in Germany. The purchase amount is credited to the account of the German correspondent bank at the Deutsche Bundesbank, thus increasing the T2 surplus of the Bundesbank. Similarly, the Bank of Italy’s T2 deficit widens.

Thus, T2 imbalances will increase whenever any T2-debtor NCB conducts an asset purchase with a counterparty that has a correspondent bank located in a T2-creditor NCB. This is very frequently the case. For example, whereas the Bundesbank itself purchases less than a quarter of the total APP purchases, 60% of all Eurosystem purchases under the APP are conducted via banks that connect to the T2 system via the Bundesbank.icon

As the European interbank market is still fragmented, the liquidity does not circulate in the euro area and T2 imbalances grow as the total holdings under the APP accumulate. Indeed, the overall increase in T2 imbalances can be linked closely to the total purchases under the APP (Graph A, right-hand panel). A recent study, which takes into account the precise geography of the correspondent banks of each and every APP security purchase, shows that APP transactions can almost fully account for the re-emergence of T2 imbalances.icon

This mechanical impact of the APP on T2 imbalances is also confirmed by the evolution of T2 balances vis-à-vis Greece. The country’s sovereign bonds are not eligible for the APP, and consequently the Greek T2 deficit has actually been more or less stable during recent months (Graph A, left-hand panel).

2012 Conclusion

In 2012, the BIS had a different Target2 Conclusion.

The debate over the appropriate interpretation of the TARGET2 balances has involved the analytic question of whether such balances are best associated with ongoing current account balances or whether they reflect a capital account reversal that is motivated by credit concerns. We recognize both but our analysis of the first half of 2012 data emphasises the importance of positioning against redenomination risk. The European Economic Advisory Group (2012, p 62) states, “In the past interest rates diverged due to the fear of depreciation; now they do so because of the fear of default.” Our identification of capital flows as motivated by redenomination risk implies that interest rates diverged into 2012 on fears of depreciation, or hopes of appreciation. Flows of funds suggest that 2012’s last leg up in TARGET2 balances reflected something more akin to a currency attack than current account financing or credit reversal.

Fear of Default

Nothing has changed, except the transfer mechanism. The ECB is now aiding and abetting capital flight.

Here is a simple test question: What would happen to Italian bond yields if Draghi halted QE asset purchases?

If bonds yields would rise, then the ECB is acting to prevent either interest rate risk or default risk. But what is interest rate risk if ultimately not default risk?

German debt has a lower yield than Greek debt and Italian debt for one reason only: default risk.

Italy is on ECB life support. Should Draghi halt QE asset purchases, demand for Italian bonds will plunge.

For discussion, please see Draghi’s Dilemma: Eurozone Inflation Hits 2% with Italy on Bond Life Support.

Stealth Bailout

Zerohedge reported BIS Admits TARGET2 Is A Stealth Bailout Of Europe’s Periphery.

That headline isn’t accurate but the idea is sound. The ECB is bailing out peripheral countries via indirect means.

But whether or not capital flight is direct or indirect, the ECB’s mask does not change reality.

I emailed the ECB a couple of questions on Target2 and found their answers unsatisfactory.

For details, please see Fuse is Lit! Target2 Imbalances Hit Crisis Levels: An Email Exchange With the ECB Over Target2.

Mike “Mish” Shedlock