Debt sustainability and monetary policy: the case of ECB asset purchases

BIS Working Papers No 1034 Debt sustainability and monetary policy: the case of ECB asset purchases by Enrique Alberola, Gong Cheng, Andrea Consiglio and Stavros A Zenios Monetary and Economic Department July 2022 JEL classification: E52, H63, H68. Keywords: Debt sustainability analysis, risk management, unconventional monetary policy, monetary-fiscal mix, PEPP, CVaR optimisation. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2022. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) Debt sustainability and monetary policy:The case of ECB asset purchasesEnrique Alberola Gong Cheng Andrea Consiglio Stavros A. Zenios1Version of June 23, 2022.AbstractWe incorporate monetary policy into a model of stochastic debt sustainability analysisand evaluate the impact of unconventional policies on sovereign debt dynamics. The modeloptimizes debt financing to trade off financing cost with refinancing risk. We show thatthe ECB pandemic emergency-purchase programme (PEPP) substantially improves debtsustainability for euro area sovereigns with a high debt stock. Without PEPP, debt wouldbe on an increasing (unsustainable) trajectory with high probability, while, with asset pur-chases, it is sustainable and the debt ratio is expected to return to pre-pandemic levels byabout 2030. The improvement in debt dynamics extends beyond the PEPP and is larger formore gradual unwinding of the Central Bank balance sheet. Optimal financing under PEPPinduces an extension of maturities reducing the risk without increasing costs. The analysisalso shows that inflation surprises have relatively little impact on debt dynamics, with thedirection and magnitude of the effect depending on the monetary policy response.Keywords:Debt sustainability analysis; risk management; unconventional monetary policy;monetary-fiscal mix; PEPP; CVaR optimization.1The authors are with the Bank for International Settlements (BIS) (Enrique.Alberola@bis.org at the BIS,Basel, Switzerland, Gong.Cheng@bis.org at the BIS, Hong Gong SAR, China), University of Palermo, Palermo,Italy (andrea.consiglio@unipa.it), and University of Cyprus, Nicosia, CY, Cyprus Academy of Sciences, Letters,and Arts, Non-Resident Fellow Bruegel, Brussels (zenioss@ucy.ac.cy). We gratefully acknowledge valuable com-ments from Matthias Drehmann, Boris Hofmann, Athanasios Orphanides, Ilhyock Shim, discussant Junko Koedaat the 29th NBER-TCER-CEPR Conference, conference participants at the 5th Sovereign Debt Research andManagement Conference and the Bruegel Senior Economists Meeting, and seminar participants at the BIS andthe University of Cyprus Economics Department. We also thank Jimmy Shek for his excellent research assistance.Disclaimer:The views presented in this paper are those of the authors and do not necessarily repre-sent those of the Bank for International Settlements.1 1 IntroductionWe integrate monetary policy intostochastic debt sustainability analysis(DSA) and studythe impact of unconventional monetary policymaking on sovereign debt. The sovereign debt-monetary policy nexus has been of increasing importance since the Great Financial Crisis whenCentral Banks in advanced economies implemented large asset purchase programs.1The Covid-19 crisis reinforced this nexus, raising concerns going forward (BIS, 2020). We introduce mon-etary policy through two channels: a macro-monetary model for conventional monetary policyand a model of the effect of unconventional policies through public debt purchases on debtfinancing spreads. We use the extended DSA model to assess the impact of ECB’s PandemicEmergency Purchase programme (PEPP) on eurozone sovereign debt sustainability.2Current DSA models consider the following variables governing debt dynamics: legacy debtlevel, projected output growth, interest rate on debt, and fiscal balance (Bouabdallah et al.,2017; European Commission, 2020; IMF, 2021; Zenios et al., 2021). Monetary policy and in-flation are assumed as given and considered as neutral in the long run. We introduce themacro-monetary block with standard IS and Phillips curves determining the output gap andinflation dynamics, and a Taylor rule determining the policy rate and conventional monetarypolicymaking.Importantly, given the intensified use of asset purchase programm