Is Mario Draghi Playing Favorites With French and Italian Bonds?

 | Sep 06, 2017 | 8:00 AM EDT
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When he sits down for his usual news conference this coming Thursday, European Central Bank President Mario Draghi will have reason to congratulate himself. The eurozone economy is growing, unemployment has come down and sentiment is buoyant.

But there will be some uncomfortable questions he will need to answer, too, and not just about when and how the ECB will begin to shrink its balance sheet. The thing that investors should watch out for are Draghi's comments, if any, on remarks by some analysts and media that the ECB's bond purchases have entered a politicized territory, rather than being restricted to a technical one.

The ECB has a unique problem that neither the Federal Reserve nor the Bank of England had when they carried out their own government bond purchases: it must stick to the so-called "capital key" when buying bonds. That is, it must buy government bonds only in direct proportion to the member state's contribution to its capital.

I've argued before that this is silly. In a world where other central banks were buying up any bonds they needed to in order to prop up their economies, sticking to rigid rules is counter-productive. And yet, this is what the ECB largely has done, with some exceptions. Draghi probably will need to discuss these exceptions, among other things, at his news conference.

Societe Generale analyst Ciaran O'Hagan analyzed various data on the ECB's government bond purchases and concluded that since April, "France and Italy have been largely favored by the Public Sector Purchase Program relative to Germany and the Netherlands."

The overweight of France and Italy bond purchases relative to the ECB's "capital key" is running at nearly €2.5 billion ($3.0 billion) a month, and the underweight of Germany and the Netherlands at almost €500 million a month, according to his calculations.

While €3.0 billion "is not a big sum from month to month," added up over one year the cumulative difference will help lower the spreads of French and Italian government bonds versus German Bunds.

"We see no operational reasons to justify this policy," O'Hagan wrote in a recent research note. "By not doing so, the ECB is increasingly favoring the more indebted countries and encouraging indirectly fiscal profligacy."

The ECB probably has received this kind of criticism from members of the German establishment, too. German Finance Minister Wolfgang Schaeuble's aversion to bond purchases by the ECB is well-known.

So far, Mario Draghi has answered journalists' questions on the issue of deviating from the capital key by invoking flexibility, which is allowed under the bond purchases program's rules. If he continues to insist on it, investors should expect French and Italian bonds to outperform.

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