43. Simultaneously, the central bank used its large holdings of government securities to conduct debt exchanges, shortening the maturity of public debt held by the market. Between August and October, approximately 52 percent of the outstanding Selic-indexed debt was swapped for shorter term Selic-indexed debt.<sup>13</sup> As a consequence, the average maturity of selic-indexed debt held by the market fell from 36 months in March 2002 to 20 months in January 2003 and the percentage of debt coming due in the following 12 months rose from 6 percent to over 50 percent in the same period. As a result of the crisis, the public debt changed composition, ending up with less fixed rate debt and shorter maturities.

44. Exchange rate risk exposure during the 2002 crisis remained relatively stable, and even decreased. In May 2002, the central bank began issuing swaps seeking to relieve some pressure off the exchange rate without increasing the stock of public debt. The Treasury simultaneously reduced the issuance of dollar-linked debt, but unfortunately net treasury dollar-linked debt did not decrease quickly enough to compensate the higher cost of depreciation. Hence, as the currency depreciated the share of dollar-linked debt (including central bank swaps) rose from 29 percent to 41 percent between March and September. However, in dollar terms, total exposure to exchange rate risk reached a peak in December 2001 and remained at that level until May when it began falling (Table 3). The rise in the proportion of the dollar-linked debt reflects the higher value (cost) in Reais of portfolio composition chosen in the past, in particular during 2001 to alleviate pressure on the exchange rate. The reduction in the exposure to exchange rate risk is crucial to obtain more control of the public debt level. A clearer definition of the monetary and debt management functions would contribute to have a unified and steady debt management strategy that would reduce uncertainty about future funding plans for the overall public sector.

45. To a great extent, debt managers were forced to intervene in the market to support the price of government securities because of the illiquid nature of the secondary markets for delivery. In contrast, the repo or the derivatives markets of government securities are very liquid. However, repo markets can only provide transitory liquidity and hence, cannot be a permanent liquidity source for government securities holders. Therefore, they cannot reduce liquidity risks for bondholders that wish access to cash. In periods of excess volatility, as the 2002 experience demonstrates, debt managers will feel compelled to absorb part of the risk given the absence of proper functioning adjustment mechanisms. Additionally, without secondary markets for delivery of government securities, extending maturity to reduce rollover-risk will be extremely difficult and more costly.<sup>14</sup>

> 13 STN website <u>www.stn.gov.br</u> Leiloes de Permuta

> 14 The derivatives and repo markets have drained much of the liquidity from the cash markets (and from secondary markets for delivery), because these transactions are not subject to reserve requirements or the debit tax (CPMF).  Additionally, repos, futures and swaps until very recently were not considered fixed income securities, and as such were subject to quarterly income or capital gains taxes as opposed to monthly in the case of a cash fixed income instruments.  All these considerations discourage securities trading in the cash market and hence inhibit the development of a secondary market for government debt.

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