A lot of ink has been spilled in recent years on what was once an obscure back-office settlements mechanism. TARGET2, the Eurozone’s real-time interbank payments system, has been labelled a means to finance current account deficits, a passage for capital flight, and a way for non-Eurozone banks to minimise redenomination risk in the event of a break-up of the euro. Actually, all three are true. Identifying the root cause of changes in TARGET2 balances requires a case-by-case analysis.
So how does TARGET2 work? Cross-border financial flows within the Eurozone are intermediated by national central banks, whose transactions are conducted via the ECB. TARGET2 acts as the settlement platform for these flows. This helps maintain the balance of payments identity:
Current Account + Capital Account + Official Settlements Balance ≡ 0
Banks in countries running current account deficits find themselves short of capital due to having transferred customer deposits on its balance sheet to banks in countries with current account surpluses. Under “normal” times, banks in current account deficit countries can recapitalise themselves by turning to the interbank lending market, effectively borrowing back the capital transferred in the deposit transaction. This settles the balance of payments.
In times of financial distress, banks might find borrowing from the interbank market too expensive. Furthermore, the ability to satisfy the balance of payments identity might become strained due to capital flight from distressed countries.
This is where TARGET2 balances come in. Banks in current account deficit countries can post collateral at their domestic central bank, which then transfers the banks cash from the ECB. Sober Look has a simple diagram of this process. TARGET2 liabilities come in via the “Official Settlements Balance” in the balance of payments identity.
Capital has been flowing out of peripheral European banking systems over the past year. GIIPS bank balance sheets shrank 3.2% from March 2012 to March 2013, while Cypriot bank balance sheets were over 8% smaller. Tellingly, in the 11 months from March 2012 to February 2013, GIIPS banking systems contracted 3.3% and Cypriot banking systems only 3.1%. This means the Cypriot banking system diminished a full 5% — more than it had over the past 11 months — during March’s financial meltdown. As steep a downturn as this is, the drop would likely have been far steeper without the strict capital control Cyprus imposed on investors.
Figure 1. Total size of MFI balance sheets, Mar 2012 - Mar 2013
Source: Central Bank of Cyprus, Banco de Portugal, Central Bank of Ireland, Banca d’Italia, Bank of Greece, Banco de España, Bloomberg, Europe Economics.
Given the deteriorating capital accounts of Cyprus and the GIIPS countries, their balance of payments can be settled in two ways: cutting the current account or recapitalising with TARGET2 funds.
The traditional route out of a balance of payments crisis is to slash the current account deficit. To some extent, peripheral Europe has been taking this route. Since the end of 2008, Spain and Portugal have taken steps to bring down their sizable current account deficits. Relative to its peers, Italy has managed its current account deficit fairly well; its current account deficit as a per cent of GDP in the last quarter of 2012 was in line with its medium-term average. Cyprus, however, breaks from this pattern. True, Cyprus’ current account is nowhere near its recent peak of 20% of GDP, but its consolidation has been rocky. Furthermore, the Cypriot current account deficit has been ticking steadily upward, both as a per cent of GDP and in raw numbers, since the middle of last year. Before the euro, Cyprus would have had to dip into its reserves.
Figure 2. Current account deficit as a per cent of GDP, 2006 Q1 – 2012 Q4
Source: Eurostat, Europe Economics
But under the monetary union, Cyprus can instead tap the TARGET2 system, incurring liabilities to the Central Bank of Cyprus and, by extension, the Eurosystem. Starting around the middle of last year, TARGET2 liabilities as a per cent of total banking assets began to fall in both Cyprus and the GIIPS countries. They continued to fall in GIIPS countries in the first three months of 2013, but rose, both as a per cent of bank assets and in levels, in Cyprus.
Figure 3. TARGET2 liabilities as a per cent of MFI assets, Mar 2012 - Mar 2013
Source: Central Bank of Cyprus, Banco de Portugal, Central Bank of Ireland, Banca d’Italia, Bank of Greece, Banco de España, Bloomberg, Europe Economics
Over the past 9 months or so, GIIPS countries have responded to capital outflows by reducing their current account deficits, while Cyprus has become increasingly reliant on TARGET2 support to keep its banks capitalised. That’s not to say GIIPS countries didn’t or now don't need TARGET2 largesse to keep their banking systems afloat. They did, and do. But patterns in their TARGET2 liabilities and current account deficits might be a template for what we can expect in Cyprus over the coming months.
One thing is certain: the Cypriot capital account is not going to surge upward any time soon. Going forward, then, Cyprus can either reduce its current account deficit, or become more reliant on TARGET2 capital. It’s impossible for Cyprus to adjust the current account fast enough to match the speed of capital outflows, even if capital controls will last until September. In the short-term, I expect Cypriot TARGET2 liabilities, both in levels and as a per cent of banking assets, to continue their ascent. Over the medium-term, barring extraordinary action from the ECB, Cyprus will probably bring down its current account, as other GIIPS countries have done since their banking crises.