Forex Flash: Target2 inbalances between Germany, Spain and Italy narrowed in March - Nomura

Nomura economists Silvio Peruzzo and Stella Wang note that Target2 balances shrank in March but are still very large

The conclude that the imbalances narrowed in March, but as they have noted in the pastm, they remain large compared with thee pre-crisis period. BoP data indicated that until January, most of the improvement in Target2 liabilities was mimicked by a net inflow of funds into Spanish and Italian securities, rather than an improvement in non-portfolio investment flows.

They see that these portfolio inflows were predominantly in debt securities, while welcome and functional for easing funding pressures for sovereign and bank issuers, they can also revert very easily if renewed episodes of uncertainty materialise. They write, “Net foreign portfolio inflows, especially in debt securities, can be policy induced (OMT announcement) or due to “push factors” such as low yields in core countries‟ debt securities and these encourage search for yields in riskier peripheral countries and could easily revert if uncertainty returns.

However, they see that addressing financial fragmentation issues on a more permanent basis requires a pick-up in non-portfolio foreign funding (foreign deposit inflows, foreign bank lending), which might take quite some time to materialise, because of the weak economic outlook, bank deleveraging and increased domestic bias of the major European banking groups. They finish by writing, “As a consequence, a full absorption of the Target2 balances accumulated by the periphery during the crisis is far from being achieved, in our view, and absent a return of non-portfolio foreign funding for the economy, the reliance on ECB funding in the periphery is likely to remain larger than during the pre crisis levels.”