Quantitative Easing and Target 2

The currency issued by the ECB, or rather by the various national banks of the euro area, goes back, to a good extent, to Germany.

Since the beginning of 2015 until today the deficit of Italy and Spain in the Target 2 system is increased, while at the same grew the German surplus. From passive in the order of -200 billion (end of 2014) for the two Mediterranean countries, it has gone to -327 (Italy) and - 314 (Spain) in early October 2016, while German surplus increased from +500 to + 678 billion. In financial circles (especially Germans) the question arises whether we are again in presence of a fly of capitals like that of 2011 period.

Target 2 is the system that regulates the trans-national payments between euro-countries  and their central banks, who are the main players, along with the larger banks. If an Italian buys a German car, and an Italian bank will transfers money to a German one, there is a decrease of monetary base at the Bank of Italy and an increase at the Bundesbank, and this is recorded in the Target System 2 as a debt of the Bank of Italy to the Bundesbank. In fact in  central bank balance sheets at each change in the monetary base (passive) there must be a change of equal size (active). The opposite if a German operator buys an Italian title (public or private).

The official answer is that this time the deepening of the imbalance is not caused by capital flight, but is largely resulting from operating of the ECB monetary policy, the so called quantitative easing (QE). In a recent speech Peter Praet, a member of the ECB board, has explained that the ECB does not buy government bonds directly, but each central bank of the euro-system buys their own titles: the Bank of Italy buy Italian bonds ( BTP) from Italian and foreign operators, the Bank of Spain does the same with the Bonos and so on. Now, since 80% of bond purchases by the national central banks are done with foreign counterparts, the QE determines the consequences of Target 2. In short, the reason lies in the fact that the Italian and Spanish debt is more spread abroad than is the case for the German one.

However it must be said that, according to ECB data, in the period considered foreign investors bought Italian government bonds for 10 billion, while mutual funds, banks and Italian families have sold for 63 billion. This does not seem to be consistent with the Praet’s statements.

But it does not even mean to be any capital flight. Rather it has been for private individuals and investment funds an occasion to sell BTP; the most likely explanation is that the increase in the price of securities, and the idea that perhaps the decline in interest rates has come to an end. So it was time to realize good capital gains. The money obtained, however, was mainly invested abroad, because the prospects of Italian bonds are not attractive, given the state of economic stagnation. In the case of banks, there is probably also the desire to reduce the possession of government bonds, which had greatly increased in the period 2011-2012, before Draghi’s famous "whatever it takes". In the case of Italian and Spanish banks probably QE provides an opportunity to reduce the size of government securities in portfolio.  There is still the possibility that, under German influence, the European Banking Authority considers sovereign bonds risky, with the need of additional capital requirement.

In the end then the currency issued by the ECB, or rather by the various national banks of the euro area, goes back, to a good extent, to Germany. So we have a new demonstration that Keynes was right when he argued that the issuance of currency to finance public expenditure is fine, but that the only money issue (the so-called open market operations) is of little use.

P. S. 327 (Italy) and 314 (Spain) may seem huge sums of Target 2 debts, in front of, say, 78 (Greece) and 66 (Portugal) billions. But in relation of GDP we get a different ranking:

Target 2 / GDP ratio:
Greece  44,6%;   Portugal  36,9%;   Spai   29,2%;   Italy...9,9%

Ruggero Paladini

Economist - Professor of "Scienza delle Finanze" at University "La Sapienza" Roma; Member of the Economic Board of Insight - ruggero.paladini@uniroma1.it