Capital flows in the euro area and TARGET2 balances

This paper explores how the uneven recourse by national banking systems in the euro area to the ECB's unconventional refinancing operations that led to the accumulation of large TARGET2 balances at the NCBs has contributed to the evolution of aggregate economic activity in important member states of the euro area. For the period between 2008 and 2014 we estimate a panel VAR model and identify the structural shocks by means of sign restrictions. Our results suggest that the build-up of TARGET2 balances was driven mainly by capital flow shocks while being barely responsive to other aggregate shocks. Furthermore, on the basis of counterfactual experiments we find that the ability to build up sizeable TARGET2 liabilities has contributed substantially to avoiding deeper recessions in the distressed euro area member countries like Spain, Italy, Ireland and Portugal, while to a smaller extent depressing aggregate economic activity in core member states such as Germany, the Netherlands and Finland. (C) 2020 Elsevier B.V. All rights reserved.