Interpreting Target2 Balances; German Banks are Pulling Out of Europe

January 6, 2013

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The BIS, the central bank’s central bank, published a paper entitled “Interpreting TARGET2 Imbalances” by Cecchetti, McCauley, and McGuire (2012).

BIS international banking data, by contrast, point to the importance of TARGET2 balances as a symptom of a reduction by core European banks of credit previously extended to borrowers in peripheral Europe. These same data suggest that banks headquartered outside the euro area, particularly UK banks, boosted TARGET2 balances by hedging redenomination risk. As such, TARGET2 balances reflect not only concern regarding actual credit exposures but also potential currency exposures.

Ed Yardeni published a few charts of Target 2 Imbalances. Figure 1 shows that despite the reduction in interest rates, and the ECB’s pledge for unlimited printing, Target 2 Balances remain quite high.

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Cecchetti, McCauley, and McGuire (2012) believe this suggests both foreign and European banks continue to harbor doubts about Europe’s future. 

The downtick in France’s (red) target 2 imbalances is also noteworthy. I’m very negative on French bonds.

The large exposure of German banks to the rest of Europe partly explains the willingness of Germany to back “extend and pretend loans” and ECB printing.

However, German banks are taking advantage of the programs to cut and run from Europe:

…the stock of German banks’ claims on peripheral Europe has fallen by roughly one half since their pre-Lehman peak, from just under €600 billion to €300 billion.

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Graph 9 shows British Banks want out of Europe:

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I have suggested on several occasions that Germany could be among the first to leave the Euro. One could argue this is happening; of course, this trend could reverse.

Catalysts for Germany removal: a. Europe pushes through laws for joint Euro bonds despite Germany’s resistance or b. Europe otherwise passes resolutions that threaten Germany’s sovereignty.  

The less risk German banks have to the rest of Europe, the more likely German removes itself. Regardless, Target 2 balances are worth watching.

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