OREANDA-NEWS. Fitch Ratings says in a new report that a credible and effective quantitative easing (QE) programme can provide support to sovereign ratings and potentially reduce the risk of downgrades, relative to the counter-factual of no action.

QE can support public finances, mitigate deterioration in budget deficits and government debt/GDP ratio, by reducing the risk of prolonged deflation and recession. The ability to implement QE without triggering serious financial disorder increases authorities' policy flexibility once the "zero lower bound" of interest rates is reached or approached. QE may also support sovereign funding flexibility in the short to medium term as sovereign bonds are the most typical assets purchased in QE programmes.

QE can stimulate the real economy and help to drive inflation back to target through various channels: portfolio rebalancing; boosting asset prices and interbank liquidity; weakening exchange rates; and affecting expectations and confidence. However, there is substantial uncertainty regarding the strength and effectiveness of these channels given the limited empirical evidence.

Fitch's baseline approach is that QE is purely a monetary policy operation, an inter-temporal substitution between bonds and money, which has no permanent, direct impact on public debt levels, although higher GDP growth could provide an indirect effect. Central banks are assumed to eventually unwind asset purchases as the economic outlook stabilises. However, exiting from QE will likely be difficult and could be only over the very long term. None of the world's major central banks that launched QE since 2009 have sold assets purchased during QE or increased interest rates so far.

The potential weakening of central bank independence could lead to institutional risks. A large and prolonged QE programme could increase a government's reliance on seigniorage to improve fiscal sustainability. The situation could ultimately lead to fiscal dominance with excessive future inflation. The fiscal policy framework, fiscal (consolidation) strategy and QE exit strategy are key factors in assessing these risks.

Unintended consequences could be relevant. QE may lead to a build-up of risks to financial stability by inflating asset prices and encouraging excessive leverage. QE by the world's major central banks may also generate negative economic spillovers - with potential negative rating implications - for countries with shallower capital markets, particularly emerging markets. These spillovers could include greater volatility of capital flows and exchange rates, heightened financial stability risks, worsening external balances and difficulties in servicing foreign currency debt.

The full report, entitled 'Quantitative Easing: Impact on Sovereigns' is available at www.fitchratings.com or by clicking the link above.