Target2 payment system gives ECB a €100 billion reason to keep Greece in euro
Amid the brinkmanship surrounding Greece’s attempts to secure a second bailout package, the rise of cross-border imbalances within the eurozone should act as an incentive to keep Athens inside the euro.
Apart from the market turmoil that could be unleashed by the ejection of Greece, it could leave the European Central Bank (ECB) with a €100 billion hole in its finances. Since the start of the financial crisis in 2007, there has been a substantial increase in the volume of cross-border claims within Target2, the Eurosystem payments network that processes financial flows within Europe on a continuous basis.
The national central banks (NCBs) of all 17 eurozone nations, as well as the ECB, participate in Target2.
Before the financial crisis, NCBs usually displayed relatively modest Target2 balances against the ECB. However, since the onset of the 2007/8 financial crisis, those balances have diverged substantially.
Core eurozone countries, such as Germany, Luxembourg, the Netherlands and Finland, now have positive Target2 balances, while peripheral countries, such as Spain, Portugal, Greece, Ireland and more recently Italy, have negative balances.
NCB Target2 claims/liabilities, December 2011
|Source:Reuters EcoWin, NCBs|
Elwin de Groot, senior market economist at Rabobank, says the reason for the divergence has been the freezing up of the interbank lending market.
Previously, a country’s current account deficits were financed by cross-border interbank loans, opposite private portfolio flows, or direct investment. Now, those capital flows have shrunk significantly, mainly due to an increase in investors’ risk aversion.
“Since the start of the financial crisis, peripheral banks have gradually lost their connection with the interbank market, as core eurozone banks reduced their exposure to peripheral banks,” says De Groot.
“With outstanding interbank loans maturing and access to private money practically cut off, the peripheral banks needed more central bank liquidity than usual.”
Target2 imbalances a recent phenomenon
The ECB has stepped in to replace the interbank funding flows. Consequently, the Target2 balances reflect the capital flight from the periphery to the core and the liquidity response from the ECB, which has pumped funds into the peripheral banks through its funding operations.
De Groot says that as long the eurozone remains intact, the imbalances should not be a problem, even though it might take a considerable amount of time for tensions to ease and the banking system to return to normal.
However, should Greece exit the eurozone, the story would become more complicated.
De Groot says it is wishful thinking to suppose that Greece would fully honour the liabilities on its Target2 balances – €109 billion – if it defaulted on its debt and left the euro.
That loss would be distributed among other NCBs, spreading further financial contagion across the region.
De Groot says the Target2 payment system allows for liquidity provision to peripheral eurozone countries, but, as always in economics, it is not a free lunch.
“As long as the eurozone stands firm, there is nothing to worry about,” he says. “However, the situation gets precarious when one or more countries leave the eurozone and Target2 debt obligations cannot be met.
“We believe this is one reason why the ECB has been fighting tooth and nail to prevent a Greek default.”