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Analysis
ECB capital key dilemma on reinvestment

ECB capital key dilemma on reinvestment

Potential Italian friction over bond purchases

by David Marsh and Ben Robinson in London

Tue 23 Oct 2018

The European Central Bank faces a thorny dilemma and potential charges of discrimination from Italy over maintaining its quantitative easing programme next year.

Important technical changes in allocating reinvestment of national central banks' maturing bond holdings in 2019 could exacerbate Italy's dispute with the European Commission over Rome's looser-than-promised budgetary policy.

More generally, a looming row with the eurosceptic Italian government could focus further unwelcome attention on the now built-in – and apparently self-perpetuating – north-south divide in economic and monetary union. The ECB leadership recognises this issue is a powerful and possibly incendiary source of discontent within the single currency.

Potential squabbles centre on the quinquennial recalculation of the ECB's 'capital key', scheduled to come into force on 1 January, which governs the relative weights of individual countries in 19-member EMU. These changes reflect – and may in future aggravate – long-running differences over different countries' benefits and disadvantages from euro membership.

ECB President Mario Draghi pointed to deep-seated tension as long ago as November 2014, when he warned, 'If there are parts of the euro area that are worse off inside the union, doubts may grow about whether they might ultimately have to leave.' That was a prescient reminder of the problems building up in his native Italy. According to the latest Eurobarometer opinion poll on different countries' perceptions of the European Union, only 43% of Italians say EU membership has brought benefits, with 45% claiming it has not done so.

Prospering northern creditor euro states led by Germany and the Netherlands have registered above-average GDP and population growth over the past five years since the last capital key was calculated. The indebted southern states – Italy, Spain, Portugal and Greece – have seen their relative weight decline. As a result, the capital key of Germany and the Netherlands will rise on 1 January to 26.8% and 5.8% respectively from 25.6% and 5.7%, whereas the combined figure for the four southern countries will fall to 33.3% from 35.4%. Italy registers the biggest fall, down to 16.6% from 17.5%.

Crucially, the capital key provides guidelines for planned reinvestment of public sector bonds held in the national central banks' portfolios. The ECB's four-year-old €2tn-plus public sector bond purchase programme is due to end formally on 31 December. But the ECB has pledged to maintain the thrust of the action by ploughing back to the market the proceeds it receives from bonds reaching their redemption date.

Partly reflecting the complexity of the subject as well as fear of political controversy, the ECB's 25-strong governing council has not yet discussed the reinvestment question and has made no decision on next year's precise operational plan. The council has considerable leeway to apply flexibility to avoid worsening friction with Rome, but it will soon run out of time to set 2019 policy. Only two monetary policy decision-taking governing council meetings are due to take place between now and the end of the year, on 25 October and 13 December.

The ECB could theoretically decide to abandon the plan to use the new capital key as its operational guideline next year. But this would expose it to criticism – and possible court action – from northern creditor states alleging illegal application of European rules.

Whatever happens, unless it scraps altogether the new capital key yardstick, the ECB's constituent central banks seem likely to reinvest next year considerably more in German bonds, and less in Italian bonds, than earlier expected. The figures could possibly diverge from plans under the present capital key by up to €20bn for each country.

What counts here is not so much the precise amounts. More significant would be the perception – likely to be seized on by Italian politicians such as Matteo Salvini, deputy prime minister, and Paolo Savona, the European minister – that the ECB is indirectly backing investors who have been widening Italian bond spreads by purchasing German and selling Italian bonds.

Although it has not yet reached the governing council, the reinvestment policy is believed to have been discussed by the ECB's six-person executive board. Different scenarios are under consideration by the various committees that help set the bank's monetary policy implementation, especially the market department as well as legal, risk and others. When the issue finally breaks through to the surface – which could happen as early as at this Thursday's council meeting – the subject will be seen not merely as technically intricate but also as politically explosive.

David Marsh is OMFIF Chairman and Ben Robinson is Deputy Head of Research. Additional research from Pierre Ortlieb. 

This is the first in a series of three articles on the ECB's reinvestment policy. Part two will be published on 23 October.

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