While debates over the significance of the Eurosystem's TARGET2 imbalances may have faded into the background now that sovereign yields in the Eurozone remains broadly backstopped by the ECB's debt monetization generosity, and fears about an imminent European breakdown fall along the lines of populist votes more than concerns about lack of funding, the BIS has finally chimed in with the truth about what the TARGET2 number really showed.
As a reminder, in mid 2012, financial pundits "discovered" the gaping imbalances building up within the Eurozone, as a result of a huge increase in TARGET2 claims at the Bundesbank, offset by a matched surge in liabilities across the European periphery, most notably Italy and Spain.
At the time, most conventional economists and analysts, especially those based in Europe, and certainly the ECB, said to ignore the divergence as it was irrelevant. Others, such as Hans Werner Sinn, and this site, warned that TARGET2 is a "less than thinly veiled bailout for Europe's periphery" as the stealth fund flow amounted to a financing of peripheral obligations, illegal under European rules.
Then, at the end of January, it was none other than Mario Draghi who, almost 5 years later, made the first tacit admission that the skeptics were right when he explained to Italian lawmakers that a country could leave the euro zone but only first it would need to settle its debts with the bloc's TARGET2 (T2) payments system.
"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," Draghi said in the letter. He did not specify in what currency the "settlement" would have to take place. Draghi then suggested that Italeave is possible, but only if the peripheral European state were to first pay down its roughly €357billion in obligations.
In other words, the ECB for the first time admitted what we had said earlier, namely that TARGET2 liabilities, far from some synthetic construct as T2's advocates suggested, were indeed a fungible means to fund the outflows at various peripheral European nations, i.e., a bailout mechanism which however needs to be repaid if a given country had decided that it would no longer need a bailout, tacit or otherwise in the future.
Now, in its latest quarterly report, the BIS analysts Raphael Auer and Bilyana Bogdanova confirm precisely what we speculated, and what Draghi implicitly confirmed in January: that TARGET2 was merely the latest covert means in Europe's disposal to fund sovereigns without breaching the Eurozone's anti-state funding clause, to wit:
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.
This is the BIS' effective admission that absent the T2 system, which provided back door funding as "private capital fled" through the front door, the Eurozone would have collapsed, leading to the end of the Euro, the ECB and imminent currency redenomination or as we explained in 2012, a bailout - whether temporary or not - from Germany - which has the most to lose from a Eurozone failure, in the form of a loan, which as Draghi has since explained, must be repaid should a member state contemplate exiting the common currency.
However, where things get amusing is that while the BIS admits that in 2012 T2 balances were effectively stealth loans, this time around, record imbalances are something far more "benign" according to the Basel-based organization:
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 decentralised implementation of the asset purchase programme (APP) rather than as a sign of renewed capital flight.
Oh ok, so unlike last time around, the massive IOU funded by Germany - again - is nothing to be worried about because it is simply a byproduct of the ECB's QE, which of course, is another stealth way of preventing the Eurozone from imploding by keeping interest rates artificially low. At least back in 2012, Europe did not have Mario Draghi suppressing rates by purchasing €80/60billion or so per month, with the ECB's balance sheet now holding 11% of all corporate bonds in the Euro area. The result was at least a somewhat accurate representation of sovereign risks through record high bond yields. Alas, since then the European bond market has lost all informational relevance as the only trade is whether or not to frontrun the ECB.
The BIS then adds that "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."
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
Well, actually, they are related to concerns of sustainability, however as a result of massive ECB-driven distortions, neither bonds nor CDS are an accurate indicator of sovereign risk. As to whether Europe's fragmented liquidity system and monetary piping - the reason why according to the BIS T2 balances are currently building up - are sufficient to deem the latest build up as benign...
... we will reserve judgment until the ECB is forced to halt its asset purchase program and perhaps raise rates, leading to the same surge in sovereign bonds yields, not to mention CDS surge, that was the hallmark of the summer of 2012 when T2 imbalances hit their previous all time high. After all, what is the ECB's QE other than merely the latest means to keep the Eurozone together by keeping rates of peripheral bonds ridiculously low.
We look forward to a similar report by BIS in the year 2022 when it will, once again, admit that conventional wisdom on Target2 was once again wrong.