JPMorgan's Stunning Conclusion: An Italian Exit May Be Rome's Best Option

With Europe having a near heart attack last week, as Italian bond yields exploded amid deja vu fears that the new populist government would press the "Quitaly" button and threaten the EU with exiting the Eurozone in order to get budget spending concessions from Brussels, the discussion about Europe's record Target2 imbalances quietly resurfaced after years of dormancy. And with €426BN, Italy has the highest Target2 deficit with the Eurosystem (Spain is a close second with €377BN) any discussion about an Italian euro exit raises concerns about costs.

After all, as JPMorgan reminds us, it was only a year ago, in January 2017,  that in a letter to European Parliament MPs, ECB President Draghi made the stunning admission that a country can leave the Eurozone but only if it settles its bill first,  or as Draghi said "if a country were to leave the Eurosystem, its national central bank’s claims on  or liabilities to the ECB would need to be settled in full."

By linking the Eurozone exit cost to Target2 balances, where Germany is on the other end with a receivable balance of nearly €1 trillion, Draghi "reminded" populist politicians in Europe that a euro exit or divorce would be difficult and even more costly relative to the past because of the continued rise in Target2 balances following the ECB’s QE program.

As the chart below shows, and as we and the BIS have discussed previously, due to QE induced cross border flows since 2015, Target2 balances have exploded since the launch of the ECB's QE (and third Greek bailout in 2015), and surpassed the previous extremes from the depths of the euro debt crisis in the summer of 2012.

Here, it is worth noting that as the BIS explained last year, the Target2 balance deterioration since 2015 is different in nature than that seen during 2010-2012, it is not a merely technical consequence of QE but a reflection of investors’ preferences. At the time, during the 2010-2012 euro debt crisis period, the Target2 balance deterioration was driven by a loss of access to funding markets, inducing banks in peripheral countries to replace private sources of funding with central bank liquidity. However, since 2015 the rise in Target2 balances is more the result of the cross-border flows induced by investors’ response to QE. As JPM explains, "for example when the Bank of Italy, via its QE program, buys bonds from a German bank or a UK bank with an account in Germany, this flow causes a rise in Bank of Italy’s Target2 deficit and an increase in Bundesbank’s surplus. Or when the Bank of Italy buys bonds from a domestic investor but this domestic investor uses the proceeds to buy a foreign asset, then the Bank of Italy also builds up its liability with the Eurosystem. In both cases, the liquidity created by the Bank of Italy’s QE program does not stay within Italy, but leaks out to Germany or other jurisdictions."

Additionally, according to the ECB, the vast majority of bonds purchased by national central banks under the QE were sold by counterparties that are not resident in the same country as the purchasing national central bank, and roughly half of the purchases were from counterparties located outside the euro area, most of which mainly access the Target2 payments system via the Deutsche Bundesbank. In other words, due to investors’ preferences, the excess liquidity created by the ECB’s QE program since 2015 did not stay in peripheral countries, but leaked out to creditor nations such as Germany, which got flooded with even more liquidity.

Incidentally, this is precisely the opposite of what Mario Draghi described to policymakers and the general public was the stated intention of the ECB's QE, which was meant to boost the periphery, not the core, as it was already benefiting thanks to the Euro's fixed rate, effectively subsidizing core European exporters at the expense of peripheral nations desperate for external, or currency, devaluation.

In any case, the different nature of the Target2 balance deterioration since 2015 does not change that the fact that Target2 liabilities still represent a cost for a country exiting the euro, assuming of course that country intends to satisfy its unwritten contractual obligations.

In other words, Target 2 balances represent national central banks’ claims on or liabilities to the ECB that, according to Draghi, would need to be settled in full, and thus represented leverage that the Eurozone had over any potential quitters.

But, as JPM notes, this is where the controversy arises, because what if a departing country - most likely about to default on its external liabilities and already set to redenominate its currency - reneges on its Target2 liability? After all, not only are those intra-Eurosystem Target2 claims and liabilities uncollateralized, but any exiting country would have little to lose by burning all bridges with Europe when it gives up on using the "common currency."

In this case, a euro exit by a debtor country would represent more of a cost to creditor countries such as Germany rather than to the exiting country itself. And, as shown in the chart above, Germany sure has a lot of implicit accumulated costs, roughly €1 trillion to be precise, as a result of preserving a currency union that allowed German exporters to benefit from a euro dragged lower by the periphery, relative to where the Deutsche Mark would be trading today.

But here the analysis gets slightly more complex, as Target2 does not provide the full picture of potential costs (or benefits, assuming a scorched earth approach).

As JPMorgan writes, the Target2 liabilities of a debtor country give only a partial picture of the cost to creditor  nations from that debtor country exiting. This is because Target2 balances represent only one component of the Net International Investment Position of a country, i.e. the difference between a country’s total external financial assets vs. liabilities.  The broader metric that one must use, is of the Net International Investment Position for euro area countries and is shown in the chart below. It shows that contrary to the Target2 imbalance, Italy leaving the euro would inflict a lot less damage to creditor nations than Spain leaving the euro.

This is because Spain’s net international investment liabilities stood at close to €1tr as of the end of last year, almost three times as large as its Target2 liabilities. In contrast Italy’s net international investment liabilities were much smaller and stood at only €115bn at the end of last year, around a quarter of its €426bn Target2 liabilities. This, as JPM explains, is because Italy has accumulated over the years more external assets than Spain and should thus be overall more able to repay its external liabilities.

In other words, while gross external liabilities are similar in Italy and Spain, from a net external liability point of view, an Italian euro exit should be a lot less threatening to creditor nations than a Spanish euro exit. That said, the assets and liabilities are not necessarily owned and owed by the same parties, meaning that one cannot ignore the nearly €3tr of gross liabilities of Italian residents to foreign residents.

Ironically, the surprisingly low net international investment liabilities of Italy are the result of the persistent current account surpluses the country has been running since the euro debt crisis of 2012, and smaller current account deficits compared to Spain before the crisis. The flipside is that the current account surplus - in theory - also makes it easier for a country like Italy to exit the euro relative to a current account deficit country. This is because the higher the current account deficit of a debtor country, the higher the cost of an exit for this country as the current account deficit would have to be closed abruptly following an exit. Similarly, the higher the current account surplus of a creditor country, the higher the cost of an exit, due to a potentially higher currency appreciation. On this metric Italy sits roughly in the middle as shown below.

Most importantly, this means that as a result of Italy’s decent current account surplus, from a narrow current account adjustment point of view, its own cost of a euro exit should be relatively small.

And it's not only Italy. What is remarkable in the chart above is that, with the exception of Greece, all peripheral countries were running current account balances last year, a huge change from the large current account deficits of 2009-2010 before the emergence of the euro debt crisis. This is also shown in the next chart, which depicts this significant adjustment in the savings position of peripheral countries which effectively converged to that of core countries.

Besides Target2 and the current account, another important reflection of the improvement in the savings position of peripheral countries has been what JPMorgan calls the "domestication" of their government debt. On one hand, this represented by the sharp decline in foreign banks' exposure to Italian debt.

The offset, of course, is that as foreign banks dumped their Italian exposure, one particular hedge fund stepped up and bought it all: the European Central Bank, and in doing so, it presented Rome with even more leverage over the ECB, which ironically is headed by an Italian.


Furthermore, the next chart shows that the domestication of Euro area government bond markets has been even more acute for peripheral banks, whose share of non-domestic non-MFI bonds has been hovering close to 15% in recent years vs. a peak of close to 40% in 2006.

Here, JPMorgan points out one curious implication from these government bond market ownership trends, which is often overlooked: debt relief via Private Sector Involvement (PSI) becomes a less attractive option for an indebted peripheral country when most of the bonds are held domestically.  In other words, it is less practical to default on your sovereign debt if you are screwing far fewer foreign creditors, and most impairing your own population.

As JPMorgan puts it, "this narrows the options that a country has in terms of adjusting its economy within a monetary union."

Here some big picture observations: within a monetary union, where currency depreciation and debt monetization are not possible - unless of course, there is divorce with said union - a country has effectively two options: default and internal devaluation.

Greece, for example,  has tried both: default via the Private Sector Involvement of 2012 and internal devaluation - i.e., collapsing wages, rising current account - via the Troika’s ongoing adjustment program.

And here things get interesting, because according to JPM calculations, the various Greek defaults, also known technically as Private Sector Involvements, provided a net debt relief to Greece of around €67bn or 33% of GDP (even though Greek debt/GDP still remains stratospheric and, as the IMF will remind on regular occasions, is unsustainable.

Applying the same haircut and PSI assumptions (i.e. only general government bonds are subjected to haircuts), the net debt relief to Italy from haircuts on non-domestic holders would be only €267bn or 15% of GDP. In other words, such a cost/benefit analysis of an effective default debt haircut suggests that a Greek-style PSI would be rather unattractive for Italy. Of course, one could imagine a wider restructuring than the Greek PSI, e.g. by including loans and regional or local government debt, but surely such an option would be more difficult to negotiate or keep voluntary and would present greater legal challenges. There are, of course, other far more structural challenges, namely that it is virtually impossible that what worked for Greece, will never work for Italy, where the associated numbers are orders of magnitude higher.

So with little to gain from a default, as indicated in the above analysis, Italy is left with just one adjustment option: internal devaluation. Unfortunately, as JPM calculates, this internal devaluation is not tracking well in the case of Italy. This can be seen in the chart below, which shows the changes in unit labor costs, current account balances
and unemployment rates since 2009.

It also shows that Greece and Ireland have made the biggest adjustment so far, i.e. biggest decline in unit labour costs and current account deficits, while Italy has instead seen a rise in unit labour costs since 2009. In other words, ten years since the Lehman crisis and six years since the euro debt crisis and Italy’s labour cost adjustment has not even begun, and if it does, it is safe to say that Rome faces a political crisis the likes of which it has not seen in a long time.

Putting this all together, the lack of any internal devaluation so far and the unattractiveness of a Greek style PSI leave limited options to Italy to adjust within the monetary union.

This, coupled with Italy's massive Target2 imbalance which becomes an instant asset the moment the country decides to exit the Eurozone and never repay it much to the chagrin of Mario Draghi, together with a decent current account surplus - one which would only soar should Italy revert to the lira supercharging the country's exports, which as explained above reduces the own cost of exiting the euro from a narrow current account adjustment point of view, will likely continue to make the country vulnerable to populist pressures to exit the monetary union.

That is the gloomy, if stunning, JPMorgan conclusion, although as a hedge, the bank also notes that the road to Quitaly, as the Greek fiasco in 2015 showed all too clearly, would be anything but easy and neither Brussles nor the ECB would go down without a fight. JPMorgan also notes that the above take also ignores other potential costs from an exit highlighted by the market reaction this week, such as the possibility that it could trigger a broader crisis and, if the Greek script is repeated, capital controls.

Then again, if Italy ever got to the point where lines of panicked depositors form outside Italian banks a la Greek summer of 2015, one can wave goodbye to the euro and the European experiment.


Last of the Mi… Four Star Sun, 06/03/2018 - 08:30 Permalink

ECB money flow through your country is by definition of a corrupt central government designed to enrich the wealth of people outside your country. It is the basic premise of fiat expansion. A percentage always goes to the house to enrich them beyond what you will ever receive. So no matter how much is printed or loaned you can never catch up on the loan as the debt is what you and your country receive plus the house percentage.

It's con game 101. For the EU to come out and openly say that you can't leave without paying your bills is tantamount to saying your debt yoke is there forever. Sovereignty of any country has the absolute power to cancel all fiat printed debt for the sake of eternal compliance and should be used accordingly.

In short, they're running a line of bullshit.

In reply to by Four Star

OverTheHedge Bunga Bunga Sun, 06/03/2018 - 02:48 Permalink

Very back-of-a-fag-packet maths gets me to €60,000 per Italian, or perhaps quarter of a million euros per household. What could possibly go wrong?

As the periphery gets more mired, the euro becomes less competitive, and the insane German export machine becomes even more effective, but at the expense of everyone else in Europe, who are not allowed to compete with the Ubermenschen.

Apologies to my colonial chums, who may believe that sucking on a fag is something unpleasant. (

In reply to by Bunga Bunga

hooligan2009 Bunga Bunga Sun, 06/03/2018 - 10:18 Permalink

or perhaps Germany is employing the Nokia business model from the 1990's, yanno the one that says "can't afford or don't want a Nokia cell phone, well here, we will lend you the money at 0% can you can have a Nokia!"

most german goods have the same quality as dutch, french, spanish, greek or italian goods - the difference is "snob value" and the fact that germans lend others the money to buy goods they can't afford unless (close to) zero interest financing is available.

In reply to by Bunga Bunga

kellys_eye Newsboy Sun, 06/03/2018 - 05:05 Permalink

Any country that leaves (or tries to leave) the EU will be subject to the same dictatorial demands from the EU in terms of 'ongoing payments', 'liabilities' and anything else the EU can fabricate in order to keep their projekt going - just as the UK is currently facing.

And it's not as if Italy would have the Government backbone to resist such demands as they'll inevitably be co-opted for personal gain to follow the EU demand-line in the same way as our own MP's have been.

What is needed to end this Communist dictatorship/take over is an existential crisis that bypasses 'elected' Government officialdom and proves to be insurmountable - the collapse of the Euro would be a good place to start!

As an aside, note the 'disappearance' of Ghordius as the EU implodes and the dirty workings are exposed - even Ghordius would be at odd's to continue promoting the calamity that is the EU despite his love affair with them.

In reply to by Newsboy

Dincap ebworthen Sat, 06/02/2018 - 23:56 Permalink

You are right indeed, the euro adoption by Italy has been a big step into slavery. It is curious, to say the least, to observe that such uncritical step has been pushed forward by the retard of the pretending communist or ex allegedly communist, including the king's son  ex communist leader and then  traitor president of the republic (the actual is just a buffoon). Italy's euro membership would make sense if it reduces contains on income growth, on the contrary it has increased those constrains and drastically reduced growth.

The currency board frame of euro, which converts national debt into foreign one and leaves it without any central bank support is pure insanity and craziness. Only stupid and retard communist could frame that.

Germany on the contrary has benefitted of that and imposed an imperialistic and Nazi war on Italy, using the local parasite and ignorant oligarchy, now for the first time apparently ousted from government after their retard puppets suffered a debacle.

The target2 claims are just very fictional ones since they are just a conventional accounting recording that would not even exist if there were a single ecb. Only in case of an effective gold standard they might have a meaning. As of now they are just a fantasy.

Nice and intelligent article.

In reply to by ebworthen

Dincap OverTheHedge Sun, 06/03/2018 - 06:10 Permalink

The currency board frame and some other rules on balanced budget have been setting strong depressive biases on the demand. Only Germany has taken advantage of it as a way of increasing her huge export and at least her miserable workers have enjoyed the external demand and kept their job, while in other countries are just miserable and unemployed.


In the case of Italy the rules on the deficit have constrained the government spending (they have controlled the debt ratio even in the crisis years), and at the same time for the currency board frame they have year after year lost competitivity   and external demand. The consequent necessary wage devaluation though can help some efficient exporters has drastically reduced the internal demand.

Last but not least the instability deriving from a huge debt converted into a "foreign" currency not backed by a central bank can increase the interest costs at any moment, and the worries about a negative current account has induced the implementation of a mercantilistic policy which contains internal demand and promotes exports.

All these depressive biases on the demand reinforcing one another and present in each country excluding Germany have created a languishing Eurozone. The currency board would have already exploded without the ecb intervention, by the way.

The insane model has just benefitted Germany imperialism and diluting her huge external surplus on all Europe and at expenses of the other countries has allowed them to escape US pressures and a Hotel Plaza ending.

In reply to by OverTheHedge

Dincap Rubicon727 Sun, 06/03/2018 - 00:25 Permalink

They will do that if forced by the Nazis who by the way are ominously  insulting the Italians of the late. They are coward not opening mouth against US but debauching and threatening the weak.

Target2 is pure fictional claim. And they have current account surplus since long and even on the debt side deficit is caused by interest payment only.

In reply to by Rubicon727

Etteguj Guj Sat, 06/02/2018 - 21:54 Permalink

It ain't gonna happen, bruthas and sistas - one squeak from the Wops about leaving and the EU will be building rafts in Libya for the new arrivals to cross the pond.

waspwench Etteguj Guj Sat, 06/02/2018 - 22:20 Permalink

It is the EU which demands that members accept the illegal migrants.   Once outside the EU Italy will be able to refuse to permit the landing of illegal migrants on their shores.   They can use their navy to tow the boats back to Africa and/or prevent them from landing.

Apropos settling their bill before they exit the EU I do not see how Brussells can enforce this.   Italy announces it's departure from the EU, Brussells presents it's bill, Italy declares their inability to pay, the EU threatens repercussions, Italy says:  "You and whose army?"   Fortunately the EU army has not yet been formed (and it behooves all EU members to make their exit before any such alien force becomes a reality because if it ever does they will all be well and truly screwed.)   The EU can attempt to impose sanctions and make various demands but if individual nations ignore them and continue to trade and have diplomatic relations with Italy the EU can do nothing at all about it.   I imagine Poland, Greece, Spain, the UK - to mention only a few) would all be happy to spit in Junckers eye.

If I owe you ten quid I have a problem.   If I owe you ten billion quid you have a problem. 

In reply to by Etteguj Guj

HRH of Aquitaine 2.0 waspwench Sat, 06/02/2018 - 23:01 Permalink

So far the only EU army, if you can call it that, is a bunch of hired guns that go by the name of Frontex. You couldn't find a bunch of more worthless douch bags than if you went slumming for the crappiest low-grade mall security guard! And that insults mall security guards!


Oh look, the Eurofags have a Twatter page, too!

And they have a Utube page:

FFS they even have a LinkedIn page! Want a job with Frontex? Go here!

In reply to by waspwench

OverTheHedge waspwench Sun, 06/03/2018 - 03:04 Permalink

If I owe you ten quid I have a problem.   If I owe you ten billion quid you have a problem. 

If it's three trillion? 

Three trillion really is quite a lot of cash money, irrespective of which currency you out it in (with the exception of Zim dollars, and whatever the Argentinians are wiping their arses with this week)…

(The eBay link is quite safe (?) but it does show there can be a need for short links occasionally. Apologies, but you might like the trillion dollar notes for sale)

In reply to by waspwench

Mazzy Sat, 06/02/2018 - 22:12 Permalink

Looks like Germany might get stabbed in the back YET AGAIN! 

Oy vey.  But this time they did it to themselves by trying to play banker (and labor broker) to the rest of the world.

Son of Captain Nemo Sat, 06/02/2018 - 22:16 Permalink



Should tell anyone reading this that Jamie wishes he could be reliving the London "Whale" right about now like a Bill Murray in "Ground hog Day!...

Living in very interesting times folks!!!

Bunga Bunga Sat, 06/02/2018 - 22:16 Permalink

Italeave would crash the Euro overnight, since the Target2 surplus money was printed already but the assets (Italy's obligations) of the ECB have to be written down. The ECB (namely the other members) have to provide fresh liquidity to the ECB, otherwise the ECB would be bankrupt. This requires government payments by the member states to the ECB. Since governments don't have 450 billion sitting in saving accounts it will require massive debt issuances.

OverTheHedge Bunga Bunga Sun, 06/03/2018 - 03:19 Permalink

So, does this mean that other, northern governments, who are sensible and forward-thinking, will start printing replacement paper notes as an "emergency contingency measure"? Should we be looking at De la Rue share price as an indicator?

Ahh, this reminds me so much of the time when Greece's wheels fell off. I've come over all misty-eyed and nostalgic.

In reply to by Bunga Bunga

Son of Captain Nemo Sat, 06/02/2018 - 22:21 Permalink

Hey Jamie... Does this mean based on your "massive" holdings of Silver that the spot price for Ag will finally be 30 to 1 with Au "x"  (the number of paper contracts) to each troy ounce?... Of course!

roark183 Sat, 06/02/2018 - 22:55 Permalink

What if the UK and Italy simply waled away from the EU and denied any debt to the EU?  After all, what has the EU done to earn that money?  Nada !!!

Perhaps Italy and the UK should submit a bill to the EU.