Fitch Ratings says in a report that bank bail out measures recently introduced across western and northern Europe do not threaten sovereign ratings. While the fiscal costs of the measures are substantial they are within tolerances of existing ratings, but they clearly reduce fiscal room for manoeuvre in the face of shocks.

In Fitch's opinion, it is not appropriate to add together all the various measures, including central bank liquidity support and deposit guarantees, to conclude that government debt has "exploded" to 100% and more of national income (GDP). Instead, Fitch is focused on the direct fiscal costs associated with capital injections into financial institutions, purchases of assets and emergency liquidity support (loans) to troubled institutions.

Fitch views government guarantees of bank debt and deposits as a "commitment mechanism" by the sovereign, signalling its willingness to intervene in a bank if it becomes necessary and as a crucial element of underpinning public confidence in the financial system. The risk of these contingent liabilities being crystallised onto government balance sheets on a large scale is, in Fitch's opinion, very low, and the agency will not be adding guarantees to government debt as if the risk has been realised.

Nonetheless, the fiscal costs of financial sector support measures recently announced across Europe are large by the standards of past financial crises in advanced economies and range from 6%-7% of GDP in the UK, Germany, Belgium and the Netherlands up to 13% in Switzerland. Fitch estimates that gross fiscal outlays associated with announced bank rescue measures (including emergency liquidity support for troubled institutions) so far total EUR477bn (equivalent to 4% of western European GDP in 2007). Historical evidence suggests that the net fiscal costs of financial support are typically lower than gross outlays but there are uncertainties in either direction and Fitch does not discount the possibility that further up-front fiscal outlays could be required.

The impact on European public finances of the bank bailout measures will be substantial. If the full EUR477bn is funded by government borrowing, it will increase public debt stocks by 7%. And combined with the expected deterioration in underlying fiscal positions as economic recession takes hold, government debt is projected by Fitch to approach 70% of GDP by 2010, a level last seen in the late 1990s and compared to 61% of GDP (in aggregate for the affected countries) last year. One of the fastest rates of increase in government debt will be in the UK, partly reflecting the size of the underlying fiscal deficit before the crisis. Fitch projects UK government gross debt to reach the Maastricht guideline of 60% of GDP by 2010, its highest level since the mid 1970s.

Moreover, the associated increase in the borrowing of European governments will intensify the competition for funds and could place upward pressure on government bond yields. Smaller countries with less liquid government bonds will likely see the greatest impact. This may be mitigated by the fact that the private sector will be borrowing less as de-leveraging continues, but such large scale shifts in the flow of funds could result in volatility. While the cost of future funding could be higher than would otherwise have been the case, Fitch does not anticipate that any highly-rated government will be unable to meet its financing requirements.

While the expected increase in government debt is not sufficiently large to threaten sovereign ratings - a public debt/GDP ratio rising above 80% is Fitch's threshold at which a rich country's 'AAA' rating would start coming under downward pressure - fiscal flexibility in the face of future shocks would clearly be reduced. This increases the importance of credible medium-term fiscal strategies to restore public finances to health once an economic recovery is underway early in the next decade.