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Sunday, June 3, 2018

JPMorgan's Stunning Conclusion: An Italian Exit May Be Rome's Best Option

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 does not stay within Italy, but leaks out to Germany or other jurisdictions."
Additionally, according to the ECB, the vast majority of bonds purchased by national central banks under the QE were sold by counterparties that are not resident in the same country as the purchasing national central bank, and roughly half of the purchases were from counterparties located outside the euro area, most of which mainly access the Target2 payments system via the Deutsche Bundesbank. In other words, due to investors’ preferences, the excess liquidity created by the ECB’s QE program since 2015 did not stay in peripheral countries but leaked out to creditor nations such as Germany, which got flooded with even more liquidity.
Incidentally, this is precisely the opposite of what Mario Draghi described to policymakers and the general public was the stated intention of the ECB's QE, which was meant to boost the periphery, not the core, as it was already benefiting thanks to the Euro's fixed rate, effectively subsidizing core European exporters at the expense of peripheral nations desperate for external, or currency, devaluation.
In any case, the different nature of the Target2 balance deterioration since 2015 does not change that the fact that Target2 liabilities still represent a cost for a country exiting the euro, assuming, of course, that country intends to satisfy its unwritten contractual obligations.
In other words, Target 2 balances represent national central banks’ claims on or liabilities to the ECB that, according to Draghi, would need to be settled in full, and thus represented leverage that the Eurozone had over any potential quitters.
But, as JPM notes, this is where the controversy arises, because what if a departing country - most likely about to default on its external liabilities and already set to redenominate its currency - reneges on its Target2 liability? After all, not only are those intra-Eurosystem Target2 claims and liabilities uncollateralized, but any exiting country would have little to lose by burning all bridges with Europe when it gives up on using the "common currency." 

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