Target2 balances harbour substantial fiscal risks

Another perceptible increase in Target2 balances has been apparent in the Eurozone for months. While this trend is caused primarily by the PSPP and less by acute capital flight, as was the case in 2012, public discussion is focusing, above all, on the risks to creditors and debtors.

The financial risks, which would arise – hypothetically speaking – from a withdrawal from the EMU by a country with substantial Target2 liabilities, such as Italy, would be quite considerable. Should the country withdrawing from the EMU not settle the debts, the ECB’s financial buffer, as the creditor of the receivable, would be scarcely sufficient to absorb the loss. Although the ECB can operate even with negative equity, the national central banks as shareholders would intervene, but the risk buffer of all banks would not be sufficient to absorb the loss. While the Bundesbank and the Banque de France have a sufficiently generous risk buffer, the Banco de España, for instance, could find itself in difficulties. Ultimately, it would be up to the government in Madrid to decide whether it wanted to support the bank to the tune of double-digit billions.

If, contrary to expectations, the entire EMU were to break up, the national central banks would possibly have to write-off their Target2 receivables entirely. In this case, this could have immense fiscal repercussions, most notably for Germany, the Netherlands and Finland. In the case of Luxembourg, it is likely to overwhelm the country entirely in fiscal terms. The current situation also harbours risk from the perspective of the Target2 debtors. Should the countries attempt in principle to settle their liabilities in the event of a withdrawal from the Eurozone, this would put the largest debtors, Italy, Portugal and Greece, in dire straits from a fiscal perspective. The countries would probably scarcely be able to absorb the losses of their respective central banks entirely, since their debt ratios would rise by up to 40%. If a country were to opt not to settle its Target2 liabilities for politically motivated renationalisation reasons, this would probably result in a long and onerous legal dispute and sharply increasing risk premiums, meaning that the country’s long-term debt sustainability would fall sharply. In an unfavourable situation, national bankruptcy would be threatened in the event of settlement just as much as in the event of a default on the Target2 liabilities because of the substantial increase in debt. In addition, smaller EMU countries would not be able fiscally to guarantee the liabilities of their central banks in the event of a large EMU country defaulting on its Target2 debts.

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