Is Draghi Biting Off More Than He Can Chew?

 |  Includes: EU, EWI, EWP, FXE, VGK
by: Marc Chandler

ECB President Draghi has stepped up his campaign to buy Spanish and Italian bonds, even though neither country has been inclined to formally ask it to do so. Reports indicate that yesterday (Sept 4) national central banks sent proposals ostensibly to be discussed at the Sept 6 council meeting. It is quite in vogue now to pit Draghi against Bundebank President Weidmann in the uber-drama, but this risks overstating the case.

Weidmann according to some reports threatened to resign over the issue, as his predecessor, Weber and former German board member Stark did. Their objections partly hinged on the ECB's mandate to secure price stability and not permit a monetization of debt. They argue that ECB bond purchases threatens price stability and are tantamount to printing of money to cover countries' debt.

Contrary to conventional wisdom, Draghi agrees. The difference lies in that Draghi tries to square the circle by focusing on the short-term debt instruments. He was quoted on Bloomberg telling the European Parliament that

If we are to buy long-term bonds we are in a very delicate situation, but if we go on the short-term part of the market where bonds have a length in time, a maturity of up to one year, two years or even three years, these bonds will easily expire, so there is very little monetary financing if anything at all that we are doing.

Therein lies the rub. What Draghi says about maturities up to a year seem reasonable. It is when he goes into 2 and 3 year maturities, he is on more contentious grounds. Consider that more than 70% of all the debt Spain has sold this year is for 5 years and less. Last year, this tenor accounted for only 50%. The average maturity of Spanish debt is 6.3 years, the lowest since 2004. The average maturity of Italy's debt is 6.7 years, the lowest since 2005.

Draghi is factually wrong. Spain and Italy have relied on debt of the kind of duration he cites to fund their deficits. Those private sector investors who had Greek debt of 2-3 year maturities did take a substantial haircut. Draghi is on safer ground to limit his proposed buying to bills.

This would serve a couple of functions, while diluting Weidmann's legitimate concerns. First, there is considerably less default risk. Second, and partly what follows from this, is that the issue of seniority can be sidestepped. Third, buying bills would seem to more likely and directly impact the elevated cost of short-term borrowing by non-financial corporations in the periphery, which most directly speaks to the constipated transmission mechanism. Fourth, the issue of sterilization becomes more manageable as the bills mature. Fifth, buying bonds of the 2-3 year maturity range will encourage countries to even borrow more in this tenure and thereby tempt peripheral countries to take on increased roll-over risk. Buying bills would not.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.