Why Target2 DOES matter
Target2 is an obscure, technical issue that is becoming an increasingly important discussion point in the future of the euro. Essential to the survival of the single currency, the huge increase in the use of the payments system reflects the collapse of the interbank lending market in Europe, and has significantly increased the exposure of Germany.
In a new Research Note, The Increasing Significance of Target2, published by the Centre for Policy Studies on Monday 25 June, James Conway and Michael O’Connor explain:
- Target2 is the mechanism which ensures that there is neither a 'German' Euro nor a 'Greek' Euro but simply a Euro. It is what makes the Eurozone a single currency area as opposed to a currency pact. In many ways, Target2 is the Euro.
- The financial crises affecting southern Europe over the last five years have had the consequence of creating vast imbalances in Target2. This is a result of the collapse of the inter-bank lending market. The ECB has stepped in to provide liquidity for increasing capital flight from banks of periphery countries, on top of existing trade deficits.
- This has shifted the risk of repudiation of debts by the periphery countries to remaining members of the ECB – most significantly, Germany. It is also a very substantial risk: German exposure to the ECB through Target2 at the end of May 2012 is over €600 billion
As long as uncertainty remains about countries leaving the Eurozone, these imbalances are likely to accelerate. Capital flight can only be expected to continue, further increasing the risk to countries such as Germany.
Germany is therefore in a position where continued capital flight is likely to spark domestic pressure against what has been perceived to be an underhand bailout. This is already beginning to happen. But, paradoxically, these losses will only begin to be crystallised if countries leave the Euro. Public and political pressure to halt Target2 could force this to occur.
If one country were to leave the Euro, the cost of the repudiation of Target2 balances would be shared across remaining Euro area central banks. But this risks a domino effect of other periphery countries then being unable to shoulder their burden. In the event of a complete break-up, the Bundesbank would be forced to take the loss on its full exposure to Target2, whilst likely honouring all the depositors’ funds from southern Europe. The Bundesbank could simply choose to print its way out of this. However, this would raise serious issues for the Germany economy and, more broadly, the concept of ‘fiat” currency.
Of course, if robust and accepted policies were implemented that resulted in the euro remaining in-tact, the imbalances created by capital flight would start to unwind and these increased exposures to Germany no longer remain an issue.