In the end, the Italians gave it away themselves. Not the World Cup, their capital flight. Deposits are fleeing the country.
The European Central Bank (ECB) might not be releasing its Target2 balances for another few weeks. But the Bank of Italy released its own last week. And it confirmed my prediction that, in May, there was capital flight out of Italy.
According to the figures, the Bank of Italy lost €39 billion. Which promptly returned to the country via the Target2 system, where it counts as a liability of the Italian central bank. The sudden surge left the total Target2 liability at a record-breaking €465 billion. Worse than during the European sovereign debt crisis.
But what money specifically left Italy? A research note from JP Morgan points out that major financial institutions reduced their deposits at the Bank of Italy by most of the €39 billion loss. That suggests it’s banks’ deposits with the central bank that fled the country.
The banks of Italy are expecting a banking crisis. One that the government of Italy, the central bank of Italy and the ECB cannot handle. If ordinary Italians join the bank run next, that’ll trigger the very banking crisis everyone is worried about.
Ambrose Evans-Pritchard pointed out that my prediction made in Capital & Conflict last week will come true next. The politics of Germany will join Italy’s in the news:
On the other side of the ledger, the Bundesbank’s Target2 credits in Germany jumped by €54bn to a record €956bn in May. If the figure blows through €1 trillion in coming months there will be Gothic headlines in Bild Zeitung, Die Welt, and the Handelsblatt. A political storm in Berlin is inevitable given that the anti-euro AfD party is now the official opposition in the Bundestag, and chairs the budget committee.
The good news for Capital & Conflict readers is that I can speak German. The bad news is what I found in the German papers.
Money for nothing and debt for free
There are no Gothic headlines to report just yet. But the Germans are perfectly aware of what’s going on. And they don’t like it.
The original Target2 exposer Hans-Werner Sinn explained to Bild Zeitung that the crisis is in full swing, and so is capital flight into Germany. At some point, capital controls are inevitable. The free movement of capital in Europe will end. The four freedoms of the EU are having a hard time lately…
Perhaps the Germans will refuse to fund Italy via Target2. A refusal to send funds back south as they flee north would mean a currency shortage in Italy that the ECB can’t legally balance out for long.
It’s no wonder the Germans are worried. Under Target2, half of Germany’s net foreign assets are at stake, the newspaper Handelsblatt pointed out. Imagine having half of Britain’s net foreign wealth resting on the existence of a doomed currency regime.
But what about Mario Draghi’s promise to make Italy pay up if it wants to leave the euro? Handelsblatt reports this has no legal basis, let alone is it economically possible.
The newspaper also pointed out that, as the ECB’s quantitative easing (QE) falls, the Target2 imbalances should rise to take their place in soaking up southern Europe’s financing needs. That’s precisely what’s happened. The coming end to QE in Europe will expose the European sovereign debt crisis never ended.
The Germans are getting worried. Which means the rest of the world should be too. If the newspapers and Alternative for Germany (AfD) in opposition kick up a fuss, you have antagonism introduced into the equation of lender and borrower. At 0% interest due on Target2 liabilities, it doesn’t pay for the Germans to put up with this.
But they’re stuck. If they pull the pin on Target2, it unleashes the crisis they’re worried about. If they do nothing, the stakes go up over time.
Meanwhile, Italy’s trade surplus means that it has less to fear from an exit of the euro than other nations. In fact, the cost benefit analysis of an Italexit done by JP Morgan analysts supposedly shows Italians have least to gain from remaining in the euro and the damage of leaving would be least severe as compared to other troubled countries. If you put politics aside, leaving is the least painful thing to do.
The issue with that is politics can’t be put aside. A government which leads Italy out of the euro would also trigger a default on euro debts. And that would amount to the biggest default in history. Anyone who thinks the world’s banking system can handle that better read this.
Is a shared currency a shared debt?
An interesting take on the situation comes from Marcello Minenna, the head of quantitative analysis and financial innovation at Consob, the Italian securities regulator. He wrote the following for the Financial Times:
[…] look back to 2011: At that time, banks in Germany (and elsewhere) started a massive reduction of their exposures to Italian sovereign risk, forcing Italian banks to nationalize a large share of the public debt of their country. This risk segregation strategy has continued with QE, in which there is essentially no risk sharing and national central banks directly buy securities issued by their respective governments. Today, the Bank of Italy holds over €370 billion BTPs.
I’ll try to explain. European banks used to own a diversified set of European government bonds. That’s why they all got into trouble in 2011 together. But the European sovereign debt crisis led northern countries to avoid the PIIGS debt, leaving the PIIGS banking systems holding their own debt to a dangerous extent. This is particularly true of Italy.
Minnnena’s key point is that, as a result of this “risk segregation strategy” since the European sovereign debt crisis, each nation is now more responsible for its own risks more separately than before.
Risks are now segregated, but more concentrated within each nation because they are less diversified. Europe is no longer a shared risk pool but a collection of risk waterballoons that can explode individually.
The trouble with that is, a collective rescue is no longer needed. Each of the other risk bundles has less incentive to rescue the one that is going to explode. And Italy’s problems are too big to be solved by existing EU level bailout and rescue mechanisms either. Italy itself certainly can’t solve its own problems. Not without leaving the euro, defaulting and issuing its own currency which can be printed…
Italy’s risks might be segregated from the rest of Europe, but that makes them so much more concentrated in one place that a failure is likely.
Because of this, in turn, Italian depositors are fleeing their banking system for the safety of the north, which thinks it is isolated from Italy’s banking mess.
It’s hard to know if Minenna believes his own words. A crisis in Italy will spill over into the rest of Europe within minutes. Banking systems are intertwined, no matter who holds whose debt. The British banking system is more entwined than others despite being outside the euro, by the way. We’re more at risk from an Italy collapse than anyone but Italy. Find out exactly why, and how it will play out here.
You can’t diversify away the type of risk Europe is presenting to your finances right now. At least not within the financial system. Whether Europe agrees to share and pool its risks, or segregate them so that each nation bears its own, the crisis looms large enough to swamp everyone.
The May Target2 balances confirm that the crash is playing out right now.
Minnena also pointed out other sure crisis indicators.
In real terms, the spread between German and Italian bonds is at the levels of 2011 already.
The Italian yield curve is inverting as the Greek one did before the Greek crisis thanks to a crashing two-year bond.
The spread between bonds that are under local versus foreign law has exploded. Local law bonds are under the control of the Italian government in the case of a default into another currency. Foreign law bonds are protected from this to some extent. If the interest rate offered between the two diverges, it tells you about the risk of a return to the lira. That risk has approximately tripled since the beginning of May.
The crisis isn’t coming back. It never left.
Until next time,
Nick Hubble
Capital & Conflict
Category: The End of Europe