With Europe having a near heart attack last week, as Italian bond yields exploded amid deja vu fears that the new populist government would press the "Quitaly" button and threaten the EU with exiting the Eurozone in order to get budget spending concessions from Brussels, the discussion about Europe's record Target2 imbalances quietly resurfaced after years of dormancy. And with €426BN, Italy has the highest Target2 deficit with the Eurosystem (Spain is a close second with €377BN) any discussion about an Italian euro exit raises concerns about costs.
After all, as JPMorgan reminds us, it was only a year ago, in January 2017, that in a letter to European Parliament MPs, ECB President Draghi made the stunning admission that a country can leave the Eurozone but only if it settles its bill first, or as Draghi said "if a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full."
By linking the Eurozone exit cost to Target2 balances, where Germany is on the other end with a receivable balance of nearly €1 trillion, Draghi "reminded" populist politicians in Europe that a euro exit or divorce would be difficult and even more costly relative to the past because of the continued rise in Target2 balances following the ECB’s QE program.
As the chart below shows, and as we and the BIS have discussed previously, due to QE induced cross border flows since 2015, Target2 balances have exploded since the launch of the ECB's QE (and third Greek bailout in 2015), and surpassed the previous extremes from the depths of the euro debt crisis in the summer of 2012.
Here, it is worth noting that as the BIS explained last year, the Target2 balance deterioration since 2015 is different in nature than that seen during 2010-2012, it is not a merely technical consequence of QE but a reflection of investors’ preferences. At the time, during the 2010-2012 euro debt crisis period, the Target2 balance deterioration was driven by a loss of access to funding markets, inducing banks in peripheral countries to replace private sources of funding with central bank liquidity. However, since 2015 the rise in Target2 balances is more the result of the cross-border flows induced by investors’ response to QE. As JPM explains, "for example when the Bank of Italy, via its QE program, buys bonds from a German bank or a UK bank with an account in Germany, this flow causes a rise in Bank of Italy’s Target2 deficit and an increase in Bundesbank’s surplus. Or when the Bank of Italy buys bonds from a domestic investor but this domestic investor uses the proceeds to buy a foreign asset, then the Bank of Italy also builds up its liability with the Eurosystem. In both cases, the liquidity created by the Bank of Italy’s QE program...