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

BIS Working Papers  |  No 1034  | 
19 July 2022



We study how unconventional monetary policy affects sovereign debt dynamics in a debt sustainability analysis (DSA). We estimate the impact of the ECB's pandemic emergency purchase programme (PEPP) - and its unwinding - on sovereign spreads and how this affects debt trajectories. We also look at the effect of inflation under different central bank responses. 


We incorporate conventional and unconventional monetary policy into a stochastic DSA. The model optimises debt financing, trading off financing cost and refinancing risk. Sovereign spreads depend on the debt level, which pushes up credit risk premia. The PEPP withdraws debt from the market; we calibrate the spread suppression as a function of the asset purchases. The model also evaluates the effects of the central bank balance sheet reduction once the debt matures (passive quantitative tightening (QT)). 


We find that the PEPP substantially improves debt dynamics and that the effects last well beyond the end of the programme. Without PEPP, the debt level would probably be unsustainable. With PEPP, public debt is generally sustainable and returns to below pre-pandemic levels by 2030. Passive QT puts upward pressure on spreads – more intensely the earlier the unwinding – but debt does not return to the pre-PEPP levels. The effect of an inflation surprise depends on the monetary policy reaction, but the impact on debt dynamics is small in the medium term. The model also shows the implications for debt management. PEPP makes it possible for maturities to be lengthened to reduce refinancing risks without increasing financing costs.


We incorporate monetary policy into a model of stochastic debt sustainability analysis and evaluate the impact of unconventional policies on sovereign debt dynamics. The model optimizes debt financing to trade off financing cost with refinancing risk. We show that the ECB pandemic emergency-purchase programme (PEPP) substantially improves debt sustainability for euro area sovereigns with a high debt stock. Without PEPP, debt would be on an increasing (unsustainable) trajectory with high probability, while, with asset purchases, it is sustainable and the debt ratio is expected to return to pre-pandemic levels by about 2030. The improvement in debt dynamics extends beyond the PEPP and is larger for more gradual unwinding of the Central Bank balance sheet. Optimal financing under PEPP induces an extension of maturities reducing the risk without increasing costs. The analysis also shows that inflation surprises have relatively little impact on debt dynamics, with the direction and magnitude of the effect depending on the monetary policy response.

JEL classification: E52, H63, H68.

Keywords: debt sustainability analysis, risk management, unconventional monetary policy, monetary-fiscal mix, PEPP, CVaR optimisation.