Eurosystem’s Target2 balances again aiding deficit countries?

There was a time when Target2 balances were seen as the reasons which kept Eurozone going. These are balances which National Central banks of Eurozone countries adjust with ECB. At ESB level these balances net out to zero but there are wide inter-country differences. Like we saw earlier that Germany’s Bundesbank had surplus balances against ECB but likes of Greece had negative balances. Earlier these differences in balances were seen as a result of capital flight. Gradually things improved and these balances declined. See more about the mechanics in my paper here.

It seems that these Target2 balances are again rising, though fir different reasons.

Mishtalk blog quotes from the BIS quarterly review (this is indeed complicated stuff):

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).

However Mishtalk says nothing has changed. ECB continues to bailout deficit countries:

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.

Complex central bank mechanisms at work..

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