What Drives Target2 Balances? Evidence From a Panel Analysis

What are the drivers of the large Target2 (T2) balances that have emerged in the European Monetary Union since the start of the financial crisis in 2007? This paper examines the extent to which the evolution of national T2 balances can be statistically associated with cross-border financial flows and current account (CA) balances. In a quarterly panel spanning the years 1999 to 2012 and twelve countries, it is shown that while the CA and the evolution of T2 balances were unrelated until the start of the 2007 financial crisis, since then, the relation between these two variables has become statistically significant and economically sizeable. This reflects the partial “sudden stop” to private sector capital that funded CA imbalances beforehand. I next examine how different types of financial flows have evolved over the last years and how this can be related to the evolution of T2 balances. While changes in cross-border positions in the interbank market are associated with increasing T2 imbalances, cross-border inter-office flows between banks belonging to the same financial institution have reduced T2 imbalances. Flows to the banking sector that originate from private investors and nonfinancial firms are large in magnitude, but are only weakly correlated with the evolution of T2 balances; changes in banks’ holdings of foreign government debt and deposit flows are strongly correlated with the post-2007 evolution of T2 balances. Overall, these findings point to a sizeable transfer of risk from the private to the public sector within T2 creditor nations the via the use of central bank liquidity. 1 This working paper is a preliminary version of a paper prepared for the 57 Panel Meeting of Economic Policy, April 2013. The author thanks Andreas Fischer, Adriel Jost, Sébastien Kraenzlin, Philip Sauré, and especially Daniel Heller, Philip Lane, and an anonymous referee of the working paper series at the Swiss National Bank for comments and suggestions, and Laurence Wicht for excellent research assistance. The views presented are solely those of the author and do not necessarily reflect those of the Swiss National Bank.