The Silent Bailout System That Could Rip the Eurozone Apart

Target2 has become a giant credit card for eurozone members that import more than they export to other members. But there are two differences compared with a normal credit card: the interest rate is zero and the loan never needs to be repaid.

By David Blake and cross-posted from Financial News


The debt positions of various eurozone economies are generally well known. The highly indebted Italian government for instance has a net debt of 132% of its gross domestic product. Less well known are the balance of payments positions and foreign debt.

Italy normally has a balance of payments deficit, but it currently has a surplus indicating that it is exporting more than it is importing and/or is receiving more income on its foreign assets than foreigners are earning on their Italian assets. Capital is also flowing out of Italy.

Balance of payments surpluses often indicate a strong economy. The huge surpluses of Germany certainly do so. In Italy’s case the opposite is true: Italy’s low import demand is due to its high unemployment. However, the Italian government is constrained in spending more, and hence expanding its economy by eurozone rules, especially the need to reduce government borrowing. Capital flight is another sign of economic weakness.

The large size of government borrowing in debtor countries like Italy, Greece and Spain means that borrowing becomes difficult. The normal route for borrowing involves the government in selling bonds which are bought by foreign banks and institutions. Such institutions become wary of indebted countries fearing the sort of haircuts and danger of defaults experienced in Greece. However, there is another, less well publicised route for borrowing.

This is the eurozone’s Target2 system.

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Just as the Bank of England acts as the clearing bank for the UK’s commercial banks, Target2 acts as a clearing system for eurozone central banks. When one eurozone country needs to make payments to another country, funds are transferred via Target2. There is a difference however. In the UK case, commercial banks have to supply eligible financial assets to clear their accounts. In Target2, national central banks are allowed to accumulate debts without any requirement to repay them.

Target2 started off as a simple payment system for cross-border transactions in the eurozone, the countries that adopted the euro in 1999. Its use is mandatory for the settlement of any euro transaction involving the European Central Bank and the national central banks of the eurozone member states.

This would not present a problem if eurozone economies were roughly in balance, with payments between them being largely offsetting, but since the financial crisis, this is far from the case.

A key underlying problem is that the eurozone does not satisfy the economic conditions for being an Optimal Currency Area, a geographical area over which a single currency and monetary policy can operate on a sustainable long-term basis. The different business cycles in the eurozone, combined with poor labour and capital market flexibility, mean that systematic trade surpluses and deficits will build up – because inter-regional exchange rates can no longer be changed.

Surplus regions need to recycle the surpluses back to deficit regions via transfers to keep the eurozone economies in balance. But the largest surplus country – Germany – refuses formally to accept that the EU is a ‘transfer union’. However, deficit countries including the largest of these – Italy – have been using Target2 precisely for this purpose…

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