Observers of the euro-area financial crisis typically focus on the yield spreads on peripheral government long-term bonds (compared to German yields) as the “fever thermometer” of the crisis. On that basis (see chart below), the crisis looks like it is over: after peaking in 2012, spreads rapidly receded following European Central Bank (ECB) President Mario Draghi’s promise to do “whatever it takes” to save the euro. Indeed, in Ireland, Italy, and Spain, yields themselves have now sunk to the lowest levels since the euro was created in 1999.
Euro Area: Spread of Harmonized Long-term Interest Rates Over Germany (basis points)
Source: Eurostat. Note: The Greek yield spread peaked at more than 2700 basis points in early 2012.
But long-term yields and yield spreads capture only one aspect of the euro-area crisis: the risk of sovereign default. Following the actual defaults in Greece and Cyprus, that risk has receded markedly with sustained fiscal austerity, shrinking deficits, the creation of the European Stability Mechanism (ESM), and the return in most countries to economic growth (however feeble).
Another aspect of the euro-area crisis is the loss of confidence in the banking systems of peripheral countries like Greece, Ireland, Italy, Portugal, and Spain. Here the story remains less sanguine.
One way to assess faith in these peripheral banking systems is to examine the level of balances in the Target2 system (see chart below). Target2 is the real-time cross-border payment mechanism operated by the Eurosystem, which consists of the European Central Bank (ECB) and the 18 national central banks (NCBs) of the euro area. It records the cumulative surpluses and deficits among the NCBs: that is, the amount that NCBs are effectively lending to each other. The chart below shows how these balances have evolved since 2007.
As one of us outlined in a paper a few years ago, balances in the Target2 system are the consequence of people in one country moving their deposits into another country. In normal times (say, prior to 2007), these cumulative balances are close to zero, reflecting the usual two-sided ebb and flow of deposits across borders. During the euro-area crisis, the flows became one-sided as depositors lost faith both in peripheral banks and in the ability of the peripheral governments to make the banks whole in the event of a collapse. Put differently, depositors came to believe that there was a difference between a euro deposit in Berlin or Amsterdam and one in Madrid or Rome. This crisis of confidence gave rise to something very similar to a run on the banks in the peripheral countries.
The key challenge for the euro area today is to reverse this financial fragmentation that took hold several years ago. Looking at the Target2 balances, we can see how bad it got. At their 2012 peak, deficit countries owed surplus countries in excess of €1 trillion. The primary deficit countries – Greece, Italy and Spain – were in debt to Finland, Germany, Luxembourg, and the Netherlands. For Greece, the Target2 deficit was equal to 24.6% of the assets of its monetary financial institutions (MFIs); Portugal 12.7%; Spain 12.0%; and Italy 6.8%. For Finland, Germany and Luxembourg, the numbers were relatively large as well, representing 9.6%, 8.6% and 11.4% of their MFIs’ assets, respectively (see table below).
At its worst, as depositors were fleeing and interbank lending stopped, the ECB was the only source of funding for peripheral European banks. Over the past two years, the situation has improved, but less so than with market perceptions of sovereign default risk. By April 2014, the most recent complete data available, the equivalent Target2 ratios for the deficit countries are Greece 9.7%, Spain 7.4%, Portugal 11.4%, and Italy 4.2%. For the surplus countries, they are Finland 2.9%, Germany 6.3%, and Luxembourg 11.7%. Overall, the Target2 balances have declined to less than €650 billion.
Only when these numbers return closer to zero will we know that the crisis in Europe is over and that the promise of the euro – to create a single, unified financial market – is a reality and not just an aspiration. If, instead, the banking systems remain fragile and fragmented, it may turn out that investors in the government bonds of the periphery have again become complacent.
