F&C’s Ted Scott sees crucial role for Target 2 and its role in the eurozone crisis

Ted Scott, F&C director Global Strategy, has outlined the importance of the Target 2 settlement system used across the eurozone, and its role in tackling the ongoing crisis facing the currency union.

The woes of the eurozone debt crisis have concentrated on the problems member states have had in reducing their fiscal deficits and total debt as well as the need to strengthen the banking sector, which remains undercapitalised. However, a third area, which has received much less attention, but is possibly just as important, is the Euro Target 2 system. This is the trade settlement system that enables creditors and debtors to settle cross border trade within the currency union.

This note gives an explanation of Target 2 and then attempts to explain why it is so important in the context of the eurozone debt crisis. Part of the reason it has been under-reported is that the institutions and policy makers within the currency union do not consider it significant (the ECB does not even publish the data) because the settlement system takes place within the eurozone and nets off to zero. However, it has led to huge imbalances within the eurozone which could have major consequences if it were to break-up.

What is the Target 2 payments system?

Target 2 is the system whereby transactions between eurozone commercial banks and central banks are settled. To illustrate how it works imagine the following example: if a Greek consumer buys a German washing machine the money will be debited from the Greek person’s bank account and creates a debit to the ECB from the Bank of Greece. Similarly, the German exporter will be credited, which creates
a credit to the Bundesbank from the ECB. In essence, the payments to the accounts of the buyer and seller are channelled via the respective central banks which in turn have a credit or debit with the ECB.

As mentioned above the data on Target 2 balances are not published by the ECB but since national central banks make disclosures in various formats it is possible to estimate the outstanding balances within the eurozone. The next section looks at the huge imbalances that have recently been created and why they are important in the context of the debt crisis.

Target 2 imbalances

There is an old saying that if you owe a bank £100 it is your problem but if you owe it £1million it is the bank’s problem. The same is true for the Target 2 payments system. While the imbalances were relatively modest it did not represent a potential problem for the eurozone but in the last three years (especially in 2012) huge divergences of money owed or due have opened up between the member states.

The debt crisis ignited in early 2010 ahead of the first bailout for Greece in May of that year. As the chart above shows, even prior to the crisis the German Bundesbank was experiencing a growing surplus but it is only since 2011-12 that the deficits of the periphery countries’ central banks have grown at a fast rate, especially for Spain and Italy, the two largest periphery nations.

While the periphery countries have had trade deficits with the core nations for some time, it did not show up in the Target 2 system prior to the debt crisis because the outflows from the balance of payments for the periphery were broadly offset by a strong inflow of private capital going in the opposite direction (for instance a German bank lending to a periphery bank). Once the financial risks associated with the weaker countries became apparent the inflow of capital to the peripheries largely dried up causing the Target 2 imbalances to increase. This made it more difficult for the periphery countries to make the necessary adjustments to their economy in order for them to become more competitive.

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