Target2 debt is set to fall in 2023: the reasons why
The ECB has provided “fuel” for the growth of T2 balances-the Eurozone’s cross-border interbank payment system-by allowing excess bank reserves to grow through government and corporate bond purchase programs and concessional loans to banks
The abrupt return to positive interest rates in the Eurozone after a decade with levels pegged below zero and the gradual downsizing of the European Central Bank’s (ECB) balance sheet will impact member countries’ Target2 (T2) account balances. For the first time since 2012, T2 accounts payable/receivable balances are expected to fall, barring abnormal liquidity outflows from the most exposed countries.
And this would be a good thing, despite the fact that these balances are little more than accounting records of “dead” transactions. Indeed, on negative balances, interest is paid at the ECB’s Main Refinancing Rate (MRO), which is expected to rise to 4 percent within a few months. Although much of this interest goes back at the end of the year during the redistribution of profits to national central banks (NCBs), the effect for countries with large debt balances like Italy is not neutral. Let’s take a closer look.
A decade of uninterrupted growth
T2 is the Eurozone’s cross-border interbank payments system. The net T2 balance measures a central bank’s debit/credit to NCBs belonging to the Eurosystem; it is an aggregate accounting measure of liquidity flows to/from abroad as a result of transactions by domestic financial agents.
For example, as of November 2022, the Bank of Italy accounted for €659 billion in debit to other NCBs. At the end of November 2021 this balance stood at “just” 544 billion; in essence, in 12 months about 115 billion left the country.
Overall, the system of T2 balances is “zero-sum”: the sum of negative balances of debtor countries must equal the sum of positive balances of creditor countries. At the end of 2022, the overall picture was as follows.
Not surprisingly, Germany, Luxembourg and the Netherlands over time have proven to be the centers of attraction for liquidity outflows from Spain, Italy and Portugal while the French balance has remained roughly in balance thanks to the transalpine banking system’s great ability to attract capital from abroad.
The contraction of the ECB balance sheet will cause Target2 balances to decline.
Now, more than the redistribution of flows between countries, what is important to note is the time trend of total balances, with the gradual growth of liquidity in the system due to the ECB’s expansionary policy. In other words, the ECB has provided “fuel” for the growth of T2 balances by allowing excess bank reserves to grow through its government and corporate bond purchase programs – Quantitative Easing (QE) and the pandemic program (PEPP) – and its concessional loans to banks (the TLTROs). Not coincidentally, in the graph, the balances shrink at the very time (2012-2013) when banks were repaying en masse the €1 trillion in emergency LTRO loans obtained by the ECB during the 2011-2012 crisis, reducing their excess reserves.
In recent months, with the suspension of the securities purchase programs (QE and PEPP), the total sum of balances automatically stopped growing. Now that the ECB’s balance sheet is expected to shrink during 2023 at the rate of about 30 to 40 billion per month, a gradual contraction of balances can be expected
Of course, the reduction of total balances is not a sufficient condition to ensure that Italy’s T2 debt will contract, since in any case the trend for the individual country depends on the autonomous choices of the operators. However, a favorable environment is created, which in Italy’s case is supported by the expected dynamics of other macroeconomic variables.
Liquidity inflows/outflows from Italy: the situation
The publication of the most recent balance of payments data for November 2022 provides a clear accounting picture of the factors driving recent cross-border liquidity transfers to/from Italy.