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ECB’s New Dilemma: Neediest Nations Receive Less Stimulus

Partly due to bank’s rules, its bond-buying has undershot Portugal and Ireland

When it extended its giant bond-purchase program this month, the European Central Bank needed to choose between buying bonds at extremely negative returns or gearing stimulus toward eurozone nations that need it the most.

It chose the former.

Every move by policy makers in the single-currency eurozone is supposed to avoid benefiting some nations over others. But now, due in part to the design of ECB rules, more stimulus is delivered to the healthiest economies and less in those that are lagging behind.

Earlier this month, ECB President Mario Draghi announced the bank would extend the central bank’s asset-purchase program from its projected March end-date until December 2017. This change has forced officials to relax the rules guiding the scheme to avoid running out of eligible bonds to buy.

The central bank has so far been mandated to spread its purchases according to how much capital each country has at the ECB. Keeping this quota intact has been a key goal for politicians in Northern Europe, chiefly Germany, as it helps ensure countries don’t have to share the debt burdens of others through the central bank.

However, the ECB already bought debt of the eurozone’s most distressed nations under an emergency program between 2010 and 2012, and is now having to buy less from these countries than national quotas would dictate. This is because the ECB had two other main self-imposed rules constraining its actions. One, it isn’t allowed to own more than a third of a single issuer’s outstanding debt. Two, it couldn’t buy bonds with yields below its own deposit-facility rate, currently at a minus 0.4%.

As a result, since it expanded bond-buying in March, the ECB has undershot Portuguese bond purchases by well over €3 billion and overshot purchases in Germany by €8 billion.

“Speaking to some of our own clients, the idea that the central bank is running into a wall is a concern for them, especially when it comes to Ireland and Portugal,” said Marchel Alexandrovich, economist at U.S. investment bank Jefferies Group LLC.

The aim of the bond-buying program is to help the economy by lowering borrowing costs further, and Portugal clearly needs it more: Its 10-year government yield is almost at 4%, second only to Greece, reflecting a floundering economy. Germany, a country at full employment, has its 10-year yield close to 0.3%.

But the central bank’s decisions this month did little to address concerns that it will keep undershooting purchases in the neediest nations.

“We don’t think the ECB announcement is good for the periphery,” said Bert Lourenco, head of rates strategy for Europe, Middle East and Asia at British lender HSBC.

To expand the pool of eligible assets, officials chose to remove the prohibition to buy bonds below the minus 0.4% deposit rate, which will allow the ECB to buy more German and Dutch bonds. They didn’t touch any of the main obstacles that are driving the central bank to buy less in Portugal and Ireland.

The reason, Mr. Draghi told journalists, is that “there was an increasing awareness of the legal and institutional constraints that would make such a change difficult.”

This decision isn’t a painless one for Germany either. When the ECB buys a bond yielding, say, minus 0.5%, it does so by creating a deposit in its own accounts. If the rate it pays on this deposit is minus 0.4%, it means it’s getting less from the bond than it’s paying, exposing itself to losses.

In reality, national central banks do most of the purchases at the ECB’s behest, and yields are only very negative in the safest eurozone nations—in Germany, all bonds up to five years of maturity return less than 0.4%. This means that removing this rule will hurt, most of all, the German Bundesbank’s profits.

Still, “the Germans prefer to take the heat on their own purchases than to relax constraints on the periphery,” said François Savary, chief investor at Geneva-based advisory firm Prime Partners. “It’s a political choice.”

To be sure, these bonds may still prove profitable if rates go lower in the future. And even if some specific bonds generate paper losses, overall purchases are unlikely to.

Also, the stimulus ideally reaches beyond borders—Germans may use lower borrowing costs to import more products from Portugal, for example.

But some investors see the inflexibility of the rules as another concerning sign of the political struggle of the eurozone to stay together.

While profits and losses don’t theoretically mean much to central banks, they often do in practice. Bundesbank President Jens Weidmann spoke against the removal of the deposit floor earlier in the year, while German economists—like Hans-Werner Sinn, president of the Ifo Institute for Economic Research—have often suggested all of the ECB’s actions end up hiding under-the-table bailouts for Southern European countries.

Any step toward targeting monetary policy toward the neediest countries has long been politically controversial and challenged in German and European courts. Some fear these constraints on the ECB could impair its ability to deliver more stimulus going forward.

“Political constraints appear to now be dominating,” Bank of America Merrill Lynch told its clients last week. “Come another large shock, the central bank would have little ammunition left.”

Earnings/guidance: LEN +2.3%

M&A: XGTI +25.2% (signs final definitive business purchase agreement to acquire Vislink Communication Systems)

Other news: TNXP +41.3% ( announces that the FDA has granted Breakthrough Therapy designation to TNX-102 SL for the treatment of posttraumatic stress disorder (PTSD)), GSAT +28% (reports the FCC has put the company's revised proposal on circulation), BCLI +12.4% (reports on End-of-Phase 2 Meeting w/ the FDA; the FDA has accepted the key elements of the Phase 3 program to support a BLA for NurOwn in ALS), ACHN +7.7% (ticking higher, still checking for anything).

Analyst actions: CRI +3.9% (upgraded to Buy from Neutral at Citigroup), ASML +1.5% (upgraded to Buy from Neutral at BofA/Merrill).

Other news: VLTC -22% (disclosed that the NASDAQ determined to delist its common stock effective December 23 at the open), SSI -4.1% (light volume, increases total capacity under its senior secured revolving credit facility from $350 million to $450 million), CLLS -3.0% (light volume; co to host call Dec 20 at 8:30 am ET to discuss the National Institutes of Health Recombinant DNA Advisory Committee meeting held on Dec 14), AZN -2.3% (Innate Pharma announced the appointment of Mondher Mahjoubi as Chairman of its Executive Board; Dr Mahjoubi, MD is currently Senior Vice President, Therapeutic Area Head-Oncology, Global Product and Portfolio Strategy, at AstraZeneca), FCX -1.7% (still checking for anything specific).

Analyst actions: MT -2.7% (downgraded to Sell from Neutral at UBS), DB -2.2% (downgraded to Sell from Neutral at Citigroup).

China Vice Fin Min Zhu Guangyao: China hopes there will not be a trade war with the US, which would harm not only the interests of the world's two biggest economies, but that of the whole world. Japan cabinet official sees govt raising FY17/18 GDP to 1.5% from 1.2% July forecast

Japan trade data were mixed. While trade surplus missed expectations, exports and imports declines were smaller than expected at -0.4% v -2.3%e and -8.8% v -12.1%e respectively. Shipments to Asia and China rose mid-single digits, and exports to US and Europe fell low single-digits.- China property prices saw m/m increases in 55 out of 70 cities, down from 62 prior, as sequential price increases also slowed from 1.2% to 0.4%. In Beijing, home prices were flat m/m - the first time there was no increase in nearly 2 years. Separately in China, PBoC set Yuan midpoint slightly firmer - the first strengthening of the fix since Dec 12th. US-China political tensions were also further tested as Chinese naval vessel seized a US underwater reconnaissance drone off the coast of Philippines. China has since promised to release the drone, and accused the US side of "hyping up" the seizure.

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