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Euro Divorce Costs Go Beyond Rising Target2 Balances

ECB President Mario Draghi recently told European Parliament MPs belonging to Italy’s Five-Star party that a country seeking to leave the eurosystem would need to settle in full its Target2 balances with the ECB.

It marked the first time Draghi spoke of the financial consequences of a euro divorce, even as he battles to keep the Eurozone together. The real costs might be higher, J.P. Morgan said, because Target2 balances, which are already mounting, are only one component of the net international investment position of a country.

Target2 Balances

“These costs could arise either due to debtor countries finding it more difficult to pay their foreign liabilities as their own currency depreciates following a euro exit,” Morgan said in its Flows & Liquidity newsletter last month-end. “Or, due to creditor countries facing a loss on their foreign claims not only because of the inability of debtor countries to pay their liabilities, but also because their own currency appreciates following a euro exit.”

Target2 Balances

In both cases, the bank assumed that claims under international law remain denominated in euros.

Draghi’s explanation came in a letter to European MPs Marco Zanni and Marco Valli, whose Five-Star party led the “No” campaign in Italy’s December referendum on reforms. The insurgent party has pledged to hold another referendum on exiting the Eurozone.

Zanni and Valli had specifically asked the question: “How the Target2 balances would, technically, be settled, especially those in net debtor countries, should a Member State participating in the system decide to quit the single currency?”

Target2 Balances

The rise in Target2 balances

The Target2 balances have sharply risen since 2015, prompting comparison with a similar phenomenon during 2010-12. But this deterioration is different from the earlier one and not merely technical, J.P. Morgan said.

The excess liquidity created by the ECB’s QE program is not staying in peripheral countries but leaking out to creditor nations such as Germany, leading to rising Target2 balances, the bank said. The balances are expected to keep growing because quantitative easing is still ongoing.

Target2 Balances

Target2 Balances

When the Bank of Italy, via its QE program, buys bonds from a German bank or a U.K. 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, Morgan explained. Similarly, when the Bank of Italy buys bonds from a domestic investor who uses the proceeds to buy a foreign asset, the Bank of Italy’s liability with the eurosystem grows.

According to the ECB, almost 80% of bonds purchased by national central banks under the asset purchase programs were sold by counterparties outside the country, and about 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.

“…with investors pushing these Target2 balances to more extreme levels, they are making a euro divorce even more costly,” Morgan said.