Date Published
16 April 2021

Article Posted by
Andrew Kinsey

Featured topic
ECB Target2 statistics


Target2 imbalances reveal why one euro is not the equal of another euro, dependent on the country within the Eurozone. Should the euro eventually crack, with political goodwill finally exhausted, those euros deposited at Commerzbank in Frankfurt will become very valuable German marks.

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The Macro View

“Is there a TARGET(2) on my back?”

European Central Banking

Following on from our recent note on central banking entitled “Now what do they want?” we’re now drilling down to European central banking specifically, as in the ECB. We’ve previously addressed the topic of Target2, the European payment and settlement system, and with the COVID-19 pandemic still swirling and the EU in a slump, it is timely to look at this again. The statistics show an enlargement of the accumulation of TARGET2 liabilities by weaker national central banks toward the German Bundesbank. In theory one euro is the equal of another euro. All things equal, interest rates too should be more or less the same. This is not so in the eurozone. A German domiciled euro is perceived to be safer and more valuable than one in Italy, Spain or Greece. The German Bundesbank has large and expanding claims on other “Club Med” central banks in the Eurozone. Similarly, Swiss franc liabilities over in Switzerland mirror that of Germany. If you want to know why a German bank and a Swiss bank charge you for keeping your cash on deposit rather than offering a small positive rate of interest, this note will give you a startling picture as to why. The German central bank and the German taxpayer, as backdoor supporters of the spendthrift and less productive Southern EU, are shouldering a large liability if the system collapses. Should the euro crack, with the biggest risk being Germany throwing in the towel and reverting to a new German mark, then redenomination risk is huge if you’re in any other eurozone country.

One of the more arcane corners of modern finance is the national and international payment and settlement systems jointly owned and managed by major commercial banks and their regulating national central bank.

In South Africa, the South African Reserve Bank (SARB) operates the South African Multiple Option Settlement (SAMOS) system and the real-time gross settlement (RTGS) system for the SADC region.

Absolutely nothing sinister here. The SARB’s objective is to ensure that all transactions in South Africa and the SADC region between banks, corporates and individuals are completed efficiently and effectively without the chance of failure or fraud.

The equivalent system in the Eurozone is Target. The Target2 balances reflect the net claims and liabilities of Eurozone national central banks (NCBs) across the European Central Bank’s account which result from cross-border payments settled in central bank money.

Necessary Technical Information

Net payment inflows into a country increase the TARGET claim (or reduce the TARGET liability) of its NCB while net payment outflows have the opposite effect.

The total TARGET balance, which is the sum of all positive balances, is only affected when central bank money flows between countries with positive and negative balances.

International cross-border flows of central bank money, as reflected in changes in TARGET balances, are recorded in the balance of payments position of Eurozone countries.

Non-euro area banks may access Target2 via a euro area central bank (the Bundesbank) either by opening an account directly with the central banks or through a correspondent bank with an account at the central bank.

The rebalancing of non-EU investors’ portfolios partly explains the growth of Target2 claims of the national central banks of countries that traditionally intermediate transactions with countries outside the Eurozone.

The chart below illustrates that growth from 2008 to the present day.

Transaction Example

If a South African investment fund sells an Italian bond to the Banco d’Italia they may access the Target2 payments system via the Bundesbank; the transaction being accounted for as if it had occurred between the Italian and German central banks.

The transaction will appear as a German capital inflow. However, the ultimate beneficiary is a counterparty located outside the euro area.

If the example is in fact representative of ex-euro area-initiated transactions, and is a significant contributor to Target2 balance accounting, it may be a causal factor in the trajectory of Target2 balances between countries in Northern Europe, and those in the South, such as Italy and Spain.

Ex-euro area market participants have predominately accessed Target2 through countries which, during the sovereign debt crisis, came to be viewed as less vulnerable.

A second source of Target2 accounting balances is the differentiated access of Eurozone banks to international funding facilities.

Since German commercial banks have no need for financing due to the liquidity inflows, the Bundesbank finances periphery countries indirectly, instead of the German banking system, and thus the assets of peripheral commercial banks serve as collateral.

Is Target2 a shadow transfer system?

  • ECB’s bylaws do not impose any upper limit on the size of an NCB’s TARGET2 liabilities
  • There is no explicit upper bound on the maturity of TARGET2 liabilities
  • Decisions at the ECB are made by majority voting and one-country one-vote applies; therefore, since borrower countries in the system are in majority, creditor countries can easily be outvoted by borrowers.

The ECB’s fixed-rate full allotment refinancing policy and easing of the ECB’s collateral criteria allow weaker Eurozone countries to maintain their current account deficits.

With this fiscal-oriented monetary measure, the ECB practically bailed out periphery countries. Lending becomes a fiscal move as any credit losses will be sustained by the central budget – ultimately, the taxpayers – of the countries concerned.

Given the above, a ‘peripheral national central bank’ does not face the constraints a single central bank that is not part of a common currency union.

This absence of constraints has permitted structural current account deficits to persist, relieving the (political) pressure on periphery countries adopting necessary structural reforms.

The imbalances observed can be equally explained by goods market and capital market developments. Transfers boosting TARGET2 balances are not always initiated by private individuals or corporations, but often reflect interbank transactions.

The flight of banking sector participants from low quality assets leads to portfolio rearrangements. This risk reallocation process will lead to the accumulation of TARGET2 liabilities by weaker national central banks toward the Bundesbank.

As the collateral value of lower quality securities is also lower, the risk associated with these papers is shifted to the central bank. The fiscal nature of monetary policy also manifests itself in this regard, owing to the rules pertaining to the bearing of expected losses.

It is a valid argument that central bank lending permitted the maintenance of deficit in periphery countries, allowing these economies to put off the painful and consistent process of restructuring.

This process is amplified by the following:

Investors (German) reduce their assets in Club Med countries, leading to the reversal of capital inflows. Propped up by central bank refinancing, Club Med banks repay the capital, giving rise to position changes in TARGET2.

In a second case, capital flows are driven by the hedging of the waxing and waning of the fears associated with redenomination risk.

Since German banks may be concerned about a sharp devaluation should say the Greek drachma be re-adopted, German member banks may no longer extend financing to a Greek member bank. Instead, claims on the German bank appear in the balance sheet of the Greek member bank.

Let us review the above chart again. The German Bundesbank has large and expanding claims on other central banks in the Eurozone, predominately Italy and Spain. Periods when those claims rise rapidly, coincide with the onset international financial crises – GFC1 (2008 – 2009), Sovereign debt crisis (2011 – 2012) the COVID-19 pandemic (2020).

The opposite effect is observable of the Italy’s Banco d’Italia and Spain’s Banco de Espana.

I don’t think this is due to Italians and Spaniards suddenly splurging on German manufactured goods as a way of dealing with a financial crisis.

By way of confirmation, I have also included the liabilities of Swiss banking system, denominated in euros, on the chart. Swiss banking deposits are exploding despite the fact that even longer-term deposits attract NEGATIVE interest. (Return OF capital rather than return ON capital.)

In my opinion Target2 balances are a function of the structural weaknesses in the Eurozone, between the fastidious Northerners and profligate Southerners.

The tolerance for, and maintenance of these imbalances is largely dependent upon political goodwill between the nations that make up the Eurozone common currency area. That is not always is equal supply from one year to the next. The next crisis may actually be the straw that ultimately breaks the camel’s back.

To end, here is that chart again. Scary stuff.