Editor’s Note: Our editors are taking a very decent Christmas holiday, so while they are away, we feature the most popular articles of last year. This is from September 19th.
In 2008, investors suddenly discovered what a subprime mortgage is. But what if someone warned you about them in 2006?
In 2000, investors suddenly discovered price-earnings ratio. But what if in 1999 someone pointed out to you the impossible valuations of tech stocks?
In 2010, Troika became a popular name in much of the world. But the Greek boom and bust were completely predictable.
A 2016 poll predicted that another Clinton would win and Britain would stay in the EU. But what if someone explained why the vote was wrong?
In 2017, I drove from Perth to Brisbane and heard the word “bitcoin” at every stop. But what if someone explained it to you in 2009?
Today we look at something you probably haven’t heard of. Just as you’ve never heard of subprime, price-earnings ratios, troikas, Bitcoin, and electoral colleges, until they become important to your investment portfolio or miss an opportunity.
Let’s go one step ahead this time.
I will reveal to you the wonderful world of Target2. A fair warning, it will look like a complex mess that is not worth understanding. As all of the above has been done once. Until they are important to you and you become interested in being too late to do anything about it.
Therefore, it may be necessary to explain why Target2 is important first …
Well, Target2 is like looking in the mirror at Europe’s capital flight. It peaks when the European banks and sovereign debt crisis are reaching their limits. And it is now peaking again. But no one seems to be paying attention to the warning yet. No one yet knows what Target2 is.
Today you stop ignoring Target2 balances and start to understand what they mean. A few months before everyone else wore cotton.
Let’s dig into …
This causes strange problems when many countries share currencies. If Greeks buy German cars, their euro goes to Germany. Over time, countries with trade deficits face a shortage of money for this. This is very bad for the economy.
Target2 is a Eurozone solution to this problem. Target2 is a mechanism by which money is returned again each time it moves internationally within the euro area. The purpose is to stabilize the amount of euros in each country.
Over time, Target2’s balances have increased, reflecting how much trade has flowed between eurozone countries in the past. The number of German cars bought by the Greeks more than the Germans bought the Greek olive oil. It’s a bit like trade debt.
So far, so good. However, trade is not the only way to increase Target2’s balance. Target2 also records capital flight. This is a type of run on the run at the national level.
Target2 is the mechanism by which the central bank sends money back south when money is fleeing the dangerous banking system of Southern Europe for a safer shelter to the north.
It is important to note that Target2 transfers are automatic. This is a system rule or bug. Keep in mind that the idea is to stabilize the amount of money in each country.
This means that monitoring the balances of these Target2s will reveal whether capital flight is occurring in the euro area. And capital flight precedes the national bank and sovereign debt crisis.
That is the conclusion of the Bank for International Settlements, and my emphasis is on:
‘T2 until mid-2012 [Target2] The balance has increased significantly Due to capital flight within the euro.. At that time, tensions in the sovereign market soared and denomination risk came to the fore in parts of the euro area. Private capital has fled from Ireland, Italy, Greece, Portugal and Spain to markets that are considered safer, such as Germany, Luxembourg and the Netherlands.
‘Indeed, during that period, The increase in T2 balances seemed to be related to concerns about sovereign risk..‘
Keep in mind that BIS is one of the few major institutions to warn in advance about the 2008 financial crisis.
The BIS study investigated the link between the risk of default for governments in Southern Europe, the risk of leaving the euro (denomination risk), and the imbalance of Target 2 in their own country.
But it didn’t use logical or sequential arguments. Instead, we used financial market price observations and statistical analysis. And it turns out that the three indicators are closely related. The growing imbalance of Target 2 in the country indicates an increased risk of default and withdrawal from the euro.
This is evidence that the market believes Target2 will reveal capital flight and the burden on the euro, no matter what the European authorities say. Statistical analysis of observations of real financial market behavior confirms that.
So let’s talk about this ambiguous Target2. This is more difficult to explain than to understand. And I’m doing that now because BIS’s view of what happened in 2012 suggests that Target 2 suggests a re-execution of the 2012 European sovereign debt crisis. The target balance is setting a record again.
Return to 2012. But this time, a country much larger than Greece is in trouble. Italy and Spain have record Target2 balance deficits. As you can see on this chart.
Professor Marcello Minenna, a Target 2 expert at the University of Bocconi in Milan, explained what that means.
‘The Target2 imbalance indicates that there is a fundamental problem with the composition of the euro. This is a measure of pressure, and if you continue to apply pressure, the glass will break at some point... “
When Target2’s balances are skyrocketing, seeing those balances increase is like looking at Europe’s capital flight in the mirror. Why is it a mirror? Technically, Target2 imbalance is a measure of the euro system’s automatic response to capital flight, not capital flight itself.
Failure to make this distinction will allow people to speak beyond each other when discussing Target 2 endlessly. One side is horrifying at what is reflected in the mirror. The other side reassures us that it’s just a mirror, so it doesn’t matter.
Who do you believe in?
But that’s why BIS research is so important. By monitoring the actual financial markets, we linked the risk of government defaults and the risk of withdrawal from the euro with the surge in Target 2 balances. This suggests that it was really a 2012 capital flight. Capital flight was bad enough to increase the likelihood of default and withdrawal from the euro.
And now it will get worse in 2020.
But what if the euro fails? Now, when economic and financial imbalances exacerbate this, world leaders solve the problem in an easy way.
Until next time,
Editor, Daily Reckoning Australia
PS: Find out why this gold expert is forecasting a significant rise in Australian gold stock prices. Download the free report now.
European canaries just died — why Target 2 is important
https://www.dailyreckoning.com.au/europes-canary-just-dropped-dead-why-target2-matters-2/2021/01/09/ European canaries just died — why Target 2 is important