It’s been over a week since the Italian election.
The Five Star Movement was the most voted single party, but it is still short from majority in the lower house.
As Five Star candidate Luigi Di Maio told Bloomberg: ‘The elections were a slap in the face for the old way of doing politics.’
The party is now waiting on policy proposals from other parties.
Di Maio also tried to appease the European Union (EU). He stated, as reported by Bloomberg:
‘I challenge anyone to demonstrate we had an extremist position. I did my campaign saying it was no longer the time to leave the euro, and that Five Star didn’t want to leave the EU. Changes can be made by talking to Brussels, not against Brussels.’
Italy’s debt is holding them back
The truth is that the Italian election has also thrown a spanner into the EU’s plans to reform the bloc.
The French President Emmanuel Macron and German Chancellor Angela Merkel, were planning for more integration.
They want to continue with a banking union to protect members in case of another financial crisis. They also want to change the European Stability Mechanism bailout fund into the European Monetary Fund, something like the International Monetary Fund.
But to get there, Italy’s banks still need work. They still hold 25% of the EU’s bad loans.
With a political stand-off in Italy, it may be hard to do this.
The other problem is Italy’s debt. Italy has a pile of debt that is 132% of their gross domestic product (GDP).
And they owe a lot of money to the European Central Bank (ECB).
In fact, that debt reached a new record high in February. Italy’s net debt towards the ECB’s Target 2 system is now at €444.42 billion.
What is Target 2?
Target 2 stands for Trans-European Automated Real-Time Gross Settlement Express Transfer system. Got it? I know, it’s a mouthful.
In essence, Target 2 is a payment system for the Eurozone. Actually, it’s one of the largest payment systems in the world. To give you an idea, Target 2 settles the equivalent of the entire euro area’s annual GDP…every five days!
The main goal of Target 2 is to maintain financial stability and to make sure the euro moves free around the Eurozone.
In short, Target 2 is an accounting system. One that keeps a tally of what bank owes what on transfers between European central banks.
Central banks and commercial banks use Target 2 to make payments between themselves.
The problem is that Target 2 is also an unlimited credit facility. Backed by collateral from the member country’s central bank and its commercial banks. One with no due dates, no interest and no conditions.
You see, as these electronic euros move around the EU, debits and credits build up between EU countries and their central banks.
The graph below shows the Target balances for EU countries:
Source: European Central Bank
[Click to enlarge]
How is Target 2 a measure of capital flow?
As you can see, Germany holds the biggest credit, while Italy is the biggest debtor.
Target 2 can be looked at as a measure of capital flow.
Usually, in a balance of payments crisis — when a country’s money leaves the nation — the country’s foreign exchange reserves limit the outflows. Once the reserves fall, the country adjusts its currency to attract capital.
With the euro, EU countries can’t do that.
So Target 2 does a similar job in creating foreign exchange reserves for a country suffering a balance of payments crisis. Except that there is no change to correct capital outflow, and money keeps flowing out.
The current system shows Germany in a surplus, with countries like Italy and Spain accumulating large debts. Germany is the biggest economy in the EU and one of the largest exporters, so it makes sense that Germany has big claims.
But how long can this go on?
There was a lot of concern about Target 2 in 2012.
Back then, a lot of electronic money was also flowing into Germany. There was fear that the imbalances were a signal of stress in the financial market.
The graph below shows Target 2’s highest balances from 2008–2016. As you can see, Germany’s 2012 balance is below its current high today:
[Click to enlarge]
How does the European Central Bank affect the Eurosystem?
Yet there is a big difference between 2012 and now. Take a look at the black line that goes across the bottom, which shows the ECB’s balance.
Since 2008, the European Central Bank’s balance has gone from positive to negative. After Italy and Spain, the ECB has the third-largest liability. How does the ECB’s balance go negative?
This is due to the quantitative easing (QE) program. That is, the ECB is purchasing assets, such as bonds, to keep interest rates low.
The ECB does this through the member country’s central bank. Once the commercial bank’s balance sheet is freed, banks have room to take on different assets. The money usually flows back into Germany.
Now, what happens with this liability if any of the EU countries decides to abandon the euro?
On 18 January 2017, Mario Draghi, President of ECB, answered that question in a letter to members of Italy’s Five Star Movement political party and the European Parliament.
In the letter, Draghi cautioned:
‘If a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full.’
In Italy’s case, this means they have a €444.42 billion outstanding bill if they were to ever leave the Eurozone…and counting…
Editor, Markets & Money
PS: After years of low interest rates and increasing debt, Editor Vern Gowdie thinks we are heading for a ‘big one’. That is why he has created a survival guide to protect investors from a massive crash. For more information on his step-by-step guide, click here.