Large-scale sovereign bond purchases are no longer the preserve of the major central banks. This year, to counter COVID-19-induced economic pain, the central banks of India, Indonesia, and the Philippines have embarked on large sovereign debt purchases. Pushed too far, S&P Global Ratings believes the programs may impair the ability of central banks to respond to future crises, with rating implications for the respective sovereigns.

The policy developments have so far not triggered high inflation or spikes in financing costs in these economies. This reflects the credibility of the central banks concerned, and investors' patience for aggressive action in the face the pandemic. The introduction of these programs have not directly resulted in any sovereign rating actions.

However, if investors begin to view government reliance on central bank funding as a long-term, structural feature of the economy, these monetary authorities could lose credibility. In this scenario, the central banks are effectively "monetizing" the fiscal deficit by using money creation as a permanent source of government funding. In some cases, this could weaken monetary flexibility and economic stability, which could increase the likelihood of sovereign rating downgrades.

Emerging Market Central Banks Jumping In To Ease Fiscal Strains

COVID-19 has plunged the global economy into a deep recession, forcing many policymakers to respond with aggressive stimulus measures. Surging government fiscal deficits have sent sovereign debt issuances sharply higher (see chart 1).

Chart 1

In some emerging markets--including the Philippines, and Indonesia--central banks have introduced measures to smooth the market impact of these large issuances by stepping up their government bond purchases. Although it did not officially introduced a new scheme, the Indian central bank has resumed its net purchases of government bonds after pausing in the second half of 2019 (see chart 2).

Chart 2

Large-scale central bank buying of government bonds became accepted as a monetary policy tool after the global financial crisis of 2008. These were confined to the central banks of advanced economies--especially in Japan, the U.S. and the EU--where investor confidence in the independence of monetary authorities is strong.

The central banks have used these purchases to achieve economic policy objectives, typically to boost GDP and employment in order to keep the inflation rate within a certain range.

Such purchases can also help to stabilize financial markets in the face of soaring government debt issuance. For example, in April this year, the U.K. Treasury extended its overdraft facility with the Bank of England for this reason. The Canadian central bank also started to purchase sovereign debt, along with provincial government debt, to ensure stable access to financial markets.

In our view, the recent purchase programs in some emerging markets are not guided by price-stability objectives. Rather, they are chiefly motivated by concerns that large sovereign issuances amid pandemic-related disruptions may cause excessive financial market volatility.

Investors Are Little Bothered, So Far

The recent central bank purchases of sovereign debt in India, Indonesia, and the Philippines have not altered the sovereign ratings, nor our assessment of monetary policy effectiveness in those countries.

Instead, it is their rising net government debt burden that weighs on the credit quality. Regardless of whether the central bank or commercial investors buy the sovereign debt, we measure the fiscal impact of the debt issued similarly. This debt is included in our estimates and forecasts of the fiscal balance, government debt stock, and interest burden.

In the case of Indonesia, we adjusted the sovereign rating outlook to negative in April this year to reflect a materially higher debt burden. The role of the central bank in the government bond market was not a significant factor in this rating action.

Nevertheless, there are risks to sovereign credit metrics associated with central bank large accumulations of government debt over a long period. Advanced countries typically have deep domestic capital markets, strong public institutions (including independent central banks), low and stable inflation, and transparency and predictability in economic policies. These attributes allow their central banks to maintain large government bond holdings without losing investor confidence, creating fear of higher inflation, or triggering capital outflow.

Chart 3

Conversely, sovereigns with less credible public institutions and less monetary, exchange rate and fiscal flexibility have less capacity to monetize fiscal deficits without running the risk of higher inflation. This may trigger large capital outflows, devaluing the currency and prompting domestic interest rates to rise, as seen in Argentina over parts of the past decade.

We have not seen signs that increased government bond purchases have damaged central bank credibility in India, Indonesia, and the Philippines. Inflation and interest rates have not picked up in these economies, and exchange rate changes have been modest so far (see chart 3 on previous page).

This could reflect investor confidence in the central banks of those countries. These institutions have contributed to a track record of moderate and relatively stable inflation in their countries in recent years. At the same time, their government bond purchases so far have been modest (see chart 4).

Chart 4

The exceptional circumstances of the COVID pandemic may also be a factor. Investors likely expect this year's abrupt deterioration in economic and fiscal conditions to moderate in 2021. They may reasonably expect these central banks will swiftly minimize their role in the government bond market once conditions stabilize.

Greater Transparency Reassures Investors

Indonesia and the Philippines have also helped assuage investor concerns by being transparent about the objective, duration and size of the bond buying of their central bank. Bank Indonesia's (BI) burden-sharing plan will only be in operation in 2020. The institution has clearly signaled the size of the program, saying it will buy nearly Indonesian rupiah (IDR) 400 trillion (2.5% of 2020 GDP) of bonds.

The government has indicated that the BI may continue to support its debt sales into 2021, but only as a buyer of last resort. BI will also bear the cost of raising IDR177 trillion to fund the government's stimulus for small and medium enterprises, taking the total program size to IDR575 trillion (3.5% of GDP).

The Bangko Sentral ng Pilipinas, meanwhile, entered into a Philippine peso (PHP) 300 billion government bond repurchase (repo) agreement with the Treasury Bureau. It announced that the term of the agreement was at most six months. At the same time, the central bank also set up a daily one-hour window to buy government securities from the secondary market. It will keep this window open until normal market conditions return.

That Said…Increased Bond Buying May Rattle Traders

The relatively mild market impact of central bank purchases of government bonds in these countries could change if the institutions increased their purchases, or if investors no longer saw the buying as temporary.

The low financing costs that the governments of India, Indonesia and the Philippines currently enjoy with little pushback from investors may convince some that this is the new normal. After all, central banks in countries such as Japan and the U.S. have accumulated huge amounts of government debt without triggering capital flight.

The initially benign consequences of monetizing part of the fiscal deficit could create complacency, potentially boosting calls for more government spending and delaying plans to reduce high fiscal deficits. All three countries would like to improve their public infrastructure and social services. Fiscal constraints have slowed their efforts. If some politicians view central banks as a way around these funding constraints, they may press to expand these programs.

Large increases in central bank holdings of government bonds in these countries--or even a delayed winding down of such holdings--might hurt the inflation-fighting credentials of the institutions. If advanced economies rebound sharply just as the credibility of emerging market central banks declines, investors may pull capital from emerging markets.

The resulting exchange rate depreciations and increases in domestic funding costs could weaken fiscal and external metrics supporting the sovereign ratings. The Indonesian rupiah has depreciated against both regional currencies and the U.S. dollar since Bank Indonesia introduced its debt burden sharing plan July; this despite a period of strength for emerging market currencies. Indonesia's elevated stock of external debt relative to the Philippines and India, as well as a spate of credit events affecting some Indonesian companies that borrow internationally, may have heightened the rupiah's sensitivity to central bank bond purchases.

The hard-won reputations of the central banks in India, Indonesia and the Philippines have helped institutions maintain fiscal and economic stability during the COVID-19 disruptions. Winding down the recent increases in government bond purchases when market conditions no longer argue for them could sustain their credibility.

Conversely, enlarging these purchases when investors are not expecting might lead to speculation that these central banks are de-emphasizing their role in maintaining price stability. This could weaken our assessment of the institutions' monetary flexibility, one of the pillars of our sovereign rating analysis, if it reduces their ability to provide extraordinary policy support in future instances of financial stress.

Related Research

• India 'BBB-/A-3' Sovereign Rating Affirmed; Outlook Stable, June 10, 2020
• Philippines 'BBB+/A-2' Ratings Affirmed; Outlook Stable, May 29, 2020
• Indonesia Outlook Revised To Negative As COVID-19 Hits Fiscal, External Metrics; 'BBB/A-2' Ratings Affirmed, April 17, 2020

External sources

• In-Depth: Is the Fed Monetizing Government Debt?, Federal Reserve Bank of St. Louis, April 1, 2013