May 22, 2020/Fitch Ratings

Rapid increases in central bank purchases of government debt provide short-term support for sovereign ratings by reducing interest service burdens and rollover risks, but do not lower government debt stocks or improve most other sovereign credit fundamentals, Fitch Ratings says in a new report. With credit market pricing under considerable central bank influence, we believe it is incorrect to equate the resulting effective ceilings on sovereign bond yields with floors on sovereign credit ratings.

In a special report focused on investors’ questions related to central bank bond purchases, Fitch indicated that, while such purchases are neither new nor unique to the quantitative easing (QE) era, they are much larger and have been undertaken more quickly in response to the coronavirus pandemic, and are therefore accompanied by more meaningful macroeconomic risks and consequences.

There are few technical constraints on central bank balance-sheet expansion in a ‘fiat’ money system, but this unique feature ultimately stems from the private sector’s trust in the currency as a store of value and means of settlement and exchange. Sustained reliance on central banks to support fiscal policy goals would risk undermining their independence to pursue monetary policy objectives and could boost long-run inflation expectations. Were such financial repression policies to become entrenched, they could have adverse consequences for economic performance over the long term – including distortions to risk pricing and the allocation of capital and an over-reliance on debt – and important distributional effects.

From a sovereign rating perspective, one of the most obvious consequences of the pandemic is an increase in government deficits and debts, as policymakers seek to counter the economic fallout. But as debt issuance has gone up, funding costs have generally come down, at least for sovereigns issuing into domestic markets, and especially for those whose central banks are engaged in QE. These more favourable funding conditions are unambiguously positive for sovereign ratings.

However, a government’s cost of funds is only one rating consideration, with the overall sovereign credit profile being determined by the sustainability of the government debt stock, several structural factors, macroeconomic policies and prospects, as well as a country’s external financial position. To the extent that lower interest rates prolong a period of higher government debt, as seems to have been the case for some sovereigns over the past decade, short-term rating gains can be offset over time.

In Fitch’s view, macroeconomic policy coordination between the central bank and government is critical in times of crisis. But since the central bank balance sheet is ultimately underwritten by the government, financial support flowing in the opposite direction cannot be unlimited. From a debt perspective, the agency considers the central bank to be a creditor of government, not part of government.