metadata: authors: 0: author: Bevilaqua, Alfonso S.
1: author: Garcia, Marcio G. P.
count: Brazil
docna: 0: docna: Debt management in Brazil : evaluation of
            the Real Plan and challenges ahead
docty: Policy Research Working Paper
subtopic: Public Sector Economics,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Strategic Debt Management,External Debt,Inflation,Privatization,Energy Privatization,Public Finance Decentralization and
            Poverty Reduction,Debt Markets,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Brazil's domestic debt has posed
            two challenges to policymakers: it has grown very fast and,
            despite progress, remains extremely short in maturity. The
            authors analyze Brazil's experience with domestic
            public debt management, searching for policy prescriptions
            for the next few years. After briefly reviewing the recent
            history of the country's domestic debt, they decompose
            the large rise in federal bonded debt in 1995-98, searching
            for its macroeconomic causes. The main explanations:
            extremely high interest payments (caused by Brazil's
            weak fiscal stance and quasi-fixed exchange rate regime) and
            the accumulation of assets (especially obligations of
            Brazil's states). Simulations of the net debt path for
            the near future underscore the importance of a tighter
            fiscal stance to prevent the debt-to-GDP ratio from growing
            further. The authors' main policy advice is to foster
            and rely more on inflation-linked bonds--the least harmful
            way to lengthen debt maturity.
geo_reg_key: 119228,517191
repnme: repnme: Debt management in Brazil : evaluation of
            the Real Plan and challenges ahead
display_title: Debt management in Brazil :
            evaluation of the Real Plan and challenges ahead
listing_relative_url: /research/2000/07/692996/debt-management-brazil-evaluation-real-plan-challenges-ahead
topicv3: State Owned Enterprises m1326323 721,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Treasury m1327009 1045,Debt Management m1327211 451,Privatization m1327236 1283
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: WB Office: Brasilia, Brazil CMU (LCC5C)
no_of_pages: 56
model_extractions: | Poi ICY RFSEAR H WORKING PAPFR 2402

# **Summary** findings

Brazil's domestic debt has posed two challenges to policymakers: it has grown very fast and, despite progress, remains extremely short in maturity.

Bevilaqua and Garcia analyze Brazil's experience with domestic public debt management, searching for policy prescriptions for the next few years.

After briefly reviewing the recent history of the country's domestic debt, they decompose the large rise in federal bonded debt in 1995-98, searching for its macroeconomic causes. The main explanations: extremely high interest payments (caused by Brazil's weak fiscal stance and quasi-fixed exchange rate regime) and the accumulation of assets (especially obligations of Brazil's states).

Simulations of the net debt path for the near future underscore the importance of a tighter fiscal stance to prevent the debt-to-GDP ratio from growing further.

The authors' main policy advice is to foster and rely more on inflation-linked bonds-the least harmful way to lengthen debt maturity.

This paper-a product of the Brazil Country Office, Latin America and the Caribbean Region-is part of a larger effort in the region to assist in better management of Brazil's domestic debt. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Suman Bery, room 14-173, telephone 202-458-5178, fax 202-522-3130, email address sbery@Cworldbank.org. Policy Research Working Papers are also posted on the Web at www.worldbank.org/research/workingpapers. July 2000. (49 pages) _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about developmient issues. An objective of the series is to get the findings ouit quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._ Produced by the Policy Research Dissemination Center
**Debt Management in Brazil:**

# **Evaluation of the Real Plan and Challenges Ahead**

by Afonso S. Bevilaqua and Mabcio G. P. Garcia Depariment of Economics Pontifical Catholic University of Rio de Janeiro (PUC-Rio) JEL Classification Numbers: E65, H63 Rio de Janeiro
# **Executive Summary**

During the 1995 to 1998 period, the net public debt of<sup>the consolidated public sector in</sup> Brazil increased from 28.5 percent to 42.6 percent of GDP.<sup>This dramatic growth has raised</sup> many doubts about the sustainability of the current economic<sup>policy in the country. These</sup> concerns have been further increased by the exchange rate<sup>devaluation of January of 1999,</sup> which raised even more the stock cf the domestic public<sup>debt--due to the existence of</sup> dollar-linked indexation clauses on part of the debt--,<sup>as well as the stock (in R$) of the</sup> foreign debt. The concerns about sustainability have been<sup>compounded by those related to</sup> the very short maturity of the domestic public debt, which<sup>increased the vulnerability of the</sup> country In this paper we assess the experierce with public debt<sup>management in Brazil in recent</sup> years, attempting to evaluate its mair lessons and derive<sup>policy guidelines for the next few</sup> years, with emphasis on the issues pertaining to the structure<sup>of the debt (denomination,</sup> indexation and maturity). We review in Section II the<sup>genesis of the modern domestic</sup> public debt market in Brazil. After being conceived in the<sup>second-half of the sixties as a</sup> non-inflationary instrument of public finance, and based,<sup>initially, entirely on inflation-</sup> linked bonds, the public debt market expanded substantially<sup>in its early years, generating</sup> for a while a seemingly costless way to fund public expenditures.<sup>During the 1980s, with</sup> the rise in inflation, cash management activities became predominant<sup>in the debt market.</sup> Since then, the maturity of the public debt has been remarkably<sup>short. With inflation</sup> stabilization, the debt has been gradually lengthened while<sup>nominal bonds became more</sup> prevalent, even when total debt was growing fast due to fiscal deficits.<sup>The international</sup> financial crises since 1997 changed that trend in the debt structure.<sup>As of October, 1999, the</sup> share of nominal bonds is only 11.55%, while the average<sup>remaining life of the debt is still</sup> very short.

Section III decomposes the large rise in federal bonded debt<sup>during 1995-1998, searching</sup> for its macroeconomic causes. It attempts to quantify<sup>the contraction and expansion</sup> sources of the rapid increase in the stbck of federal bonded<sup>debt occurred during the period.</sup> The main culprits are the weak fiscal stance, and the very high interest<sup>rates and associate</sup> payments. In Section IV we perform simulation exercises of the public<sup>net debt path until</sup> 2002, the final year of the current presidential term. We show that<sup>even under favorable</sup> macroeconomic conditions the evolution of the public net debt to GDP<sup>ratio will remain a</sup> policy concern in coming years. Policy conclusions are summarized<sup>in Section V, where</sup> we discuss the role of public debt management in Brazil in the near<sup>future. Our main</sup> policy advice is that the rollover of the domestic public debt should be<sup>made with inflation-</sup> indexed bonds, in order to lengthen the maturity without creating<sup>time consistency</sup> problems. We add a few suggestions on how this shift could be accomplished.
# I. **Introduction'**

From 1995 through 1998, the net puiblic debt<sup>of the consolidated public sector in Brazil</sup> increased from 28.5 percent to 42.6 percent of GDP.<sup>This dramatic growth has raised many</sup> doubts about the sustainability of the current<sup>economic policy in the country. These</sup> concerns have been further increased by the exchange<sup>rate devaluation of January of 1999,</sup> which raised even more the stock of the domestic<sup>public debt, due to the existence of</sup> dollar-linked indexation clauses on part of the debt,<sup>as well as the stock of the foreign debt</sup> (in Reais). The concerns about suslainability have<sup>been compounded by those related to</sup> the very short maturity of the domestic public debt.

In this paper we assess the experience with public<sup>debt management in Brazil in recent</sup> years, attempting to evaluate its main lessons and derive<sup>policy guidelines for the next few</sup> years, emphasizing the issues relatedl to the structure<sup>of the debt. Section II discusses the</sup> evolution of the domestic bonded public debt since<sup>1970, with an emphasis on volume and</sup> composition (indexation and maturiLy) during the Real<sup>Plan. Section III decomposes the</sup> large growth observed in the federal bonded debt<sup>during 1995-1998, searching for its</sup> macroeconomic causes. It attempts to quantify the<sup>contraction and expansion sources of</sup> the rapid increase in the stock of federal bonded debt<sup>that occurred during the period. In</sup> Section IV, we simulate paths of the net public debt until<sup>2002, the final year of the current</sup> presidential term. We show that even under favorable<sup>macroeconomic conditions the</sup> evolution of the public net debt to GDP ratio will remain<sup>a policy concern in coming years.</sup>

> ' We acknowledge the World Bank's initiative in commissioning<sup>and financially supporting this study. All</sup> views in the paper are those of the authors. We thank Suman<sup>Bery, Clemente del Valle, Xin Zhang, and Eriko</sup> Togo for comments and Aureo de Paula, Debora Masullo,<sup>Marcelo Rezende, Roberto Cohen and Tatiana</sup> Didier for superb research assistance. All errors are ours.

3
With the previous sections as background, Section V concludes the paper with a policy analysis of public debt management in Brazil in the near future. Our main policy advice is that the rollover of the domestic public debt should employ inflation-indexed bonds, in order to lengthen the maturity without creating time consistency problems.

## **II. Domestic Bonded Debt**<sup>**2**</sup>

# _II.1. Historical_ **_background (19_** _70-1994)_

The beginning of the existing market for domestic public debt in Brazil was the financial reforms introduced by the military government in the second half of the 1960s. Those reforms envisaged three big measures to solve the inflationary problem of the previous ten years (inflation rose from 15% to 80% a year between 1955 and 1964): the creation of marketable public securities to finance fiscal deficits; the creation of the Central Bank; and the adoption of a banking system with a clear-cut separation between commercial banks and non-bank institutions.

Figure II.1-Federal Bonds: 1970-1999-displays the evolution of the total federal government debt, separating the Central Bank holdings of government debt from the outstanding debt held by the private sector. During the high inflation years--from the early eighties to the mid-nineties--there had been a widening of the fraction of the public debt held by the Central Bank. Under high inflation, cash management activities tended to predominate in the banking sector and the Central Bank backing of such activities required

> 2 This Section draws heavily on Bevilaqua, Carneiro, Garcia, and Wemeck (1999).

4
the automatic provision of liquidity to banks' holdings<sup>of public debt. This situation stood</sup> in marked contrast with the stated objectives of<sup>the reforms. Nevertheless, the objective of</sup> institutional development of a market for<sup>government debt, which had been stated in the</sup> financial reforms of 1964-5, had been attained.

The domestic public debt market in Blrazil started<sup>with indexed bonds in the late sixties.</sup> Only in August, 1970, nominal bond; unindexed<sup>were placed (for the stated purpose of</sup> conducting monetary policy). 3 Indexed bonds (ORTNs - Obrigacoes Reajustaveis do Tesouro Nacional) were seen by asset holders as<sup>a hedge against inflation-induced erosion</sup> of financial wealth despite the fact that,<sup>until 1974, monetary correction was arbitrarily</sup> defined each month by an act of the Mvinistry<sup>of Finance, without official commitment to</sup> any particular price index.

Without indexed bonds, the financial markets<sup>would not have developed as they did in the</sup> face of the accelerating annual inflation from<sup>1973 to 1994. Figure 11.2-Federal Bonded</sup> Debt Structure: 1970-1999-displays the remarkably<sup>mobile structure of the Brazilian</sup> domestic public debt.

During the infancy of the public domestic debt<sup>market (1966-1971), the demand for public</sup> debt grew ahead of the government's immediate<sup>financing needs. A large stock of public</sup> domestic debt was deemed convenient for regulating<sup>short-run liquidity of the banking</sup> system, by means of final sales and purchases<sup>of public debt in the open market. As in</sup> "Say's law", however, the possibility of creating<sup>a large debt supply opened room for the</sup> creation, in the Central Bank, of a wide<sup>range of credit programs designed to fund</sup>

> 3 Simonsen (1995).

5
agricultural projects and regional development, and has fostered the establishment of regional development banks at the state level. The excess demand for public bonds in the early years of the market led the Central Bank to assume the role of a financing agent,<sup>4</sup> an aberration that lasted for years. The development strategy of the 1970s was based in great measure on the public sector's ability to issue debt to fund development projects.

By the late 1970s and early 1980s, it became clear that this growth engine had stalled. The decade witnessed high and unstable inflation, which led to a considerable increase in the volatility of the expected returns on government debt due both to a decline in the use of public savings and to frequent changes in monetary correction rules (i.e., partial disguised defaults). The 1980s were called the lost decade, due to the economic stagnation, the megainflation, and the decline in public, as well as private, investment. As a consequence, the accumulation of public debt seemed to be approaching the end, and, by the turn of the decade, a default on domestic public debt was seen by many as an unavoidable outcome.

In fact, the new government that took office in 1990 decreed the blocking of 80% of all financial assets. The terms of the decree were actually complied with, and the government was able to unblock all the financial assets beginning 17 months later, in 12 monthly installments. During 1993-4, capital inflows added to the demand for high-yield public debt, creating a more stable environment that made the Real Plan possible.

4 For many years the Brazilian Central Bank had a director in charge of Agricultural Development (sic).

6
# **_11.2._** _Recent_ **_Evolution: The Real Plan_**

In July 1994, a new currency, the Real, was introduced, as the last part of the de-indexation program. Both the debt structure and size changed in important ways after the monetary reform, as the annual inflation rate fell from a four-digit figure to a one-digit figure. Until the Asian crisis (October, 1997), foreign capital kept flowing in steadily, and the domestic public debt market experienced a period of gradual maturity lengthening due to decreasing yield volatilities. Since the last quarter of 1997, a series of ups and downs has characterized the international finance scene for the emerging markets,<sup>5</sup> also affecting the domestic public debt market. After a semester when more than US$45 billion of foreign reserves vanished, the Brazilian government decided to float the Real in January, 1999, thereby inaugurating a new phase of the P3lan. We analyze below the debt accumulation process since the introduction of the new currency, the Real, emphasizing debt size and structure (indexation and maturity).

# _I.2.1. Size_

The extremely fast increase of the federal bonded debt during the Real Plan was one of the more ominous macroeconomic indicators. Figure II.3 displays the evolution of the federal bonded debt in constant R$ of April, 1999, and as percent of GDP. It is quite clear that, after remaining stable during the first year of the new currency (July-94 to June-95), both measures of debt accumulation started trending upward. As a percent of GDP, the federal bonded debt. almost quadrupled in less than four years! Section III identifies the factors responsible for this enormous growrth.

7
## _II. 2.2. Composition_

This section analyzes the structure of the domestic debt, i.e., its composition: denomination of the debt (domestic currency vs. foreign currency), indexation (to domestic price levels, to the exchange rate, to short-term interest rates, etc.), and maturity structure. We also explore new measures of risk exposure, as the V@R (Value-at-Risk).

# _I1.2.2.1. Denomination and Inde-xation_

All domestic federal bonded debt is redeemable only in R$. Only the external debt is redeemable in foreign currency. Figure II.4 displays the federal debt composition after the Real Plan. It is clear that when the debt started trending upwards in mid-1995, it was the nominal (non-indexed) part that was mainly responsible for the growth. Notwithstanding the increasing share of nominal in total debt, average maturity kept lengthening. Barcinski

[1997] computed a measure of risk usually applied to financial institutions portfolios the V@R (Value-at-Risk) for the nominal federal debt. The V@R measures the amount of market risk of a given portfolio, i.e., the maximum expected loss of that portfolio in a given time span.<sup>6</sup> He showed that, notwithstanding the increase in the nominal debt and its maturity lengthening, the V@R of the nominal debt actually decreased for the first years of the Real Plan (he analyzed 1994-1996). That reflected the fact that interest rate volatility was decreasing substantially, except for the first semester of 1995, when it increased momentarily as a consequence of the Mexican crisis. This fall in interest rate volatility is displayed in Figure II.5.

> 5 Since 1997, all first semesters have been good ones, and all second semesters have been bad ones for the emerging markets. It is a general hope that the spell will be broken this year.

> **6** For a detailed description of the V@R methodology, see Jorion [19971.

> 7 Adapted from Barcinski [1997].

8
The share of nominal to total debt riemained around 30%- 40% between July 94 and November 95, when it started to grow, reaching 60% around mid-96. That share was maintained until the Asian crisis, in September, 1997, when it started to drop. Until the Russian crisis, in May, 1998, the norninal debt share was still above 50%, despite the precipitous fall in average maturity. With the Russian crisis, the Treasury and the Central Bank started to issue only indexed debt (for reasons that will be analyzed later), and the nominal debt share fell to 3.5% in December 1998.8 After the nomination of the new Central Bank governor, in March 1999, this share has been increasing again.

The share of bonds indexed to the IGP-M (a widely used price index) decreased continuously during the whole period. According to Central Bank sources, this reflected a policy decision to stop issuing inflation-linked bonds, which were deemed inflationary.<sup>9</sup> Dollar-linked bonds remained at around 10% of the total debt between July 94 and August 95, falling then slightly to around 7% of the total between September 95 and February 96. With the deterioration of the economic situation in Asia, these increased once again to reach 15% at the end of 1997. That share rose throughout 1998 to around 21% at year-end, showing that agents were (correctly) hedging against the predicted devaluation. The devaluation of January 13, 1999, and the continuous depreciation after the currency was floated two days later, increased the value of the dollar-linked debt _vis-a-vis_ the other

> 8When commenting on the changes in composition, we will often refer to what we think caused those changes (supply-driven or demand-driven changes). Of course, we are aware that we only observe equilibria data, i.e., the intersection between a supply and a demand curve. Therefore, statements such as the ones we offer would actually need careful studies of -conometric identification conditions in order to be verified. Nevertheless, we will often take a stab on what caused the composition changes: a change in demand, a change in supply, or both.

> 9 See previous footnote. In the beginning of the Real Plan the government was fighting several forms of mandatory indexation. It is quite natural to think that courts would be more likely to uphold previous mandatory indexation clauses for wages or other sources of income if the government itself had kept inflation indexation for some of its debt instruments. Apart from this indirect effect, we see no relation between the existence of inflation-linked bonds and inflatiori, (see the policy discussion.)

9
bonds. The share jumped to 30% after the devaluation, but has fallen, since. as the demand for new issues of dollar-linked bond has diminished considerably and the currency appreciated after March, 1999. With the new round of depreciation that started in May, 1999, the demand for dollar-linked debt (or any hedge against the depreciation) has been increasing again, forcing the Central Bank to supply more of this kind of debt'<sup>0</sup> .

The share of bonds indexed to the short-run interest rate (or zero-duration bonds)" was around 25% of the total debt between July 94 and July 95, 35% between August 95 and February 96, falling to approximately 20% in November, 1997. In December, 1997, a large issue of this kind of bonds distorted all debt-statistics. Around R$ 50 billion of bonds were issued as part of a renegotiation deal with the Brazilian state of Sao Paulo,'<sup>2</sup> making the share of zero-duration bonds jump to 35%. After that, as those bonds were swapped with the Central Bank for shorter-maturity ones, their share fell gradually to 21% in May, 1998, when the beginning of the Russian crisis made the Central Bank and the Treasury change strategies regarding the issuance of nominal bonds. As mentioned before, the issuance of nominal bonds stopped, and only zero-duration bonds started being issued. That move made the share of the latter jump from 21% in May to 42% in June. By December, 1998,

> 10 A current important policy issue is how much dollar-linked debt (or other kinds of exchange-rate-risk hedges, as future contracts) should the government provide in the current floating exchange rate regime. l The bond indexed to the short-run interest rate is a security sold at a discount which had its face-value corrected daily by the average daily interest rates during its term. It is a floating interest rate, adapted to the high frequency required by the high inflation and daily indexation conditions prevalent when it was created (1985). It would be equivalent to a bond whose nominal value is accrued every day by the daily accrual of the Libor. This is the closest one can get to perfect indexation in fixed income markets. It corresponds to a bond of duration zero (that being the reason why we call this type of bond **zero-duration bond),** since it does not suffers practically no loss in its value when interest rates go up. These bonds were widely used in times of high uncertainty, as, for example, the crossover to the Cruzado Plan in 1986. On the other hand, monetary policy has a very limited **wealth** effect, since rises in interest rates do not affect the value of the private financial wealth in these fixed income securities (see Pastore, 1996).

12 These bonds were also of a much longer maturity than the average prevailing at the time, fact which will also distort the average-maturity statistic for December, 1997, as we will analyze in the next Section.

10
the zero-duration bond share was almnost 70%. It fell in<sup>January due to the increase in value</sup> of the dollar-linked bonds, and it kept falling later as<sup>the issuance of nominal bonds</sup> resumed after March, 1999. As of September, 1999, its share<sup>was hovering around 60%.</sup>

# _II.2.3. Maturity Structure_

Figure 11.4 shows the average maturity of the debt<sup>during the Real plan. The average</sup> maturity of the total debt has substantially increased in<sup>relative terms although it remains</sup> quite low in absolute terms.<sup>13</sup> As already commented<sup>above, it is nonetheless interesting</sup> that until the Asian crisis (September, 1997), maturity kept<sup>increasing despite the increasing</sup> share (and total value) of the nominal debt.<sup>14</sup> As noted before,<sup>until 1996, Barcinski [1997]</sup> showed that, the V@R (value-at-risk) of the nominal debt<sup>decreased despite the size</sup> increase and the maturity lengthening. In other words, investors<sup>in public debt were not</sup> incurring more price risk, despite the increase in the portfolio<sup>size and in the nominal debt</sup> maturity.

With the international financial crises, this virtuous circle came<sup>to an end. When Brazil</sup> began to suffer the contagion effect of the Asian crisis, in the<sup>form of a speculative attack</sup> during the week of October 27, 1997, the Central Bank quickly<sup>reacted by increasing the</sup> basic interest rate, the TBC, from 20.70% to 43.41% (see<sup>Figure 11.6). After two weeks</sup> without public debt auctions, the rolling over continued with<sup>three-month-maturity bonds,</sup> at rates little below the TBC.

> 13 When talking about debt maturity with foreign economists,<sup>we, Brazilian economists, sometimes cause</sup> some confusion because of different measures. We use<sup>"months" as the measure, while the former use</sup> "years". The same used to happen with inflation measures before<sup>the Real Plan. We used "% per month",</sup> while everyone else was used to "% per year". One hopes<sup>that soon we will able to follow the world</sup> convention!

11
In that environment, the Treasury and the Central Bank probably did not want to issue long maturity debt. An interest rate of 43% per year (with the inflation rate well below 5%<sup>per</sup> year and an exchange-rate devaluation of 7.5% per year) is clearly unsupportable in the long run, being sustainable only briefly to counteract a speculative attack. Therefore,<sup>had</sup> the Treasury and the Central Bank decided to place one or two year bonds at such a high rate, they could conceivably have sparked a panic, because of the informational content<sup>of</sup> such move. Placing debt at 43% for short periods might be desirable, but paying such high rates for long periods puts the govermnent budget on a clearly unsustainable path. That could then trigger expectations of a government default. In other words, in such a situation, there may be no equilibrium with such a high interest rate and long maturity.15 The only equilibrium may be the one with very short maturity bonds. An alternative<sup>explanation is</sup> that the maturity premium asked by the market for longer maturity bonds was beyond<sup>the</sup> maximum premium implied by the auction managers' reservation<sup>prices.16That rollover</sup> strategy had the effect of decreasing the maturity of the stock of debt. Figure 11.6<sup>shows that</sup> interest rate volatilities increased tenfold during this turbulent period.<sup>As a consequence, so</sup> did the V@R measures.

Until the end of 1997, only three-month maturity bonds were placed,<sup>all with negative</sup> maturity _premia._ During the first five months of 1998, the Treasury<sup>and the Central Bank</sup> were able to place nominal debt with increasing maturity. However,<sup>when the Russian</sup> crisis first hit in May 1998, even short-term bonds (three or six months)<sup>became extremely</sup>

> 14 The jump in average maturity that occurred in September, 1997, is a mistake. The Central Bank<sup>is trying to</sup> correc **t** hat statistic. We will replace the Chart when the correct data are ready.

> **'5** The argument here follows the lines of the credit rationing model of Stiglitz and Weiss [ 1981]. 16 We asked the Central Bank staff member what had happened in those<sup>auctions. He answered that the</sup> Central Bank and the Treasury offered longer term bonds, but the bids<sup>were all refused, because they were</sup> deemed insufficient in quantity, and the yields asked were both too high and too<sup>volatile.</sup>

12
costly for the issuers, as yields rose substantially. As a consequence, the market for<sup>three-</sup> month, six-month and one-year bonds vanished, and the only nominal bond placed<sup>in the</sup> auctions after mid-May were one-rnonth BBC's (a nominal bond issued<sup>by the Central</sup> Bank). In June and July, even that became too expensive, and the Central<sup>Bank resorted to</sup> its last resource, the zero-duration bond.

This decision had an immediate impact on the amounts that were rolled<sup>over in each</sup> auction. When the debt maturity decreases, the debt must be rolled over more<sup>often. That is</sup> exactly what was happening until May 1998. The amounts of monthly redeemed and<sup>issued</sup> debt tripled! This, of course, created a new source of risk, that of not being able to roll<sup>over</sup> the debt in the event of a crisis, with possible impact on the exchange-rate anchor that was in place at the time. After May, duce to the strategy of placing only indexed bonds (mostly zero-duration and dollar-linked), average maturity resumed its upward trend, and the rollover risk decreased. However, this happened at a cost: if interest rates had to be lifted<sup>in</sup> the future, the fiscal budget would be badly hit. The same was valid regarding<sup>a</sup> devaluation. With the benefit of hindsight, we know now that both strategies<sup>caused</sup> massive losses to the federal budget.

Even with zero-duration debt, average maturity fell again in the last quarter of 1998, due to the contagion effect of the Russian default. After the devaluation, maturity has been increasing (see Figure II.4). However, if the government were now to decide to quickly change the current debt structure inl favor of nominal debt, either a fall in maturity<sup>or a</sup> substantial cost increase in debt service would be likely, as we will discuss in Section V.

13
# **III. Evolution of the Gross Domestic Bonded Debt during the Real Plan: a**

# **Decomposition Exercise**

During the four years of President Fernando Henrique Cardoso's first term, the federal bonded debt increased to more than five times its original value; from R$ 60 billion to R$ 323 billion.'<sup>7</sup> This spectacular debt growth raises many questions about the sustainability of economic policy, especially if one considers the effects of the exchange-rate devaluation in January of 1999, which increased even more the service costs of federal bonded debt, due to the existence of dollar-linked indexation clauses on part of the debt.

This Section decomposes the federal bonded debt growth, searching for the macroeconomic causes of the huge growth that occurred in 1995-1998. We attempt to quantify the contraction and expansion sources of the federal bonded debt.

Consider the federal government and Central Bank aggregate balance sheets in 12/31/94 and 12/31/98, respectively. One of the accounts on the liability side is the federal bonded debt. The value we are interested in explaining is the difference between this account's balances on these two dates. Due to accounting identities, this value is the sum (with opposite sign) of the differences during the period of all the other accounts' balances. Consequently, by aggregating these other accounts' balances in a way amenable to our macroeconomic analysis, we measure the factors responsible for the growth of the federal bonded debt in this four-year period. The idea of this decomposition exercise can be better understood with the accounting framework provided in Table III.1. The table starts from

> '' These numbers obtained great repercussion in the press. The headline of the 2/13/1999 edition of the Sao Paulo's daily newspaper _0 Estado de Sdo Paulo_ was **The public debt increased 424% in FHC term.**

14
the government budget constraint, and works to develop an<sup>accounting identity (equation</sup> (6)) that is amenable to identifying the sources of the growth<sup>of federal bonded debt.</sup> TABLE III.1. DEBT USES: A DECCMPOSITION

- (1) NET DEBT = LIABILITIES - ASSETS

- (2) A (NET DEBT) = A (LIABILITIES) - A (ASSETS)

(3) A (NET DEBT) PRIMARY DEFICIT + INTEREST PAYMENTS +

# ADJUSTMENTS

(4) A (LIABILITIES) = A (DOMESTIC BONDS) + A (OTHER<sup>DOMESTIC DEBT) +</sup>

# A (FOREIGN DEBT)

- (5) A (ASSETS) = A (DOMESTIC ASSETS) + A (FOREIGN<sup>ASSETS)</sup>

- (3), (4), (5) =* (2), and solving for A (DOMESTIC BONDS)

SOURCE OF FUNDS = USES OF FUNDS (6) A DOMESTIC BONDS - PRIMARY DEFICIT + INTEREST PAYMENTS + ADJUSTMENTS + A (DOMESTIC ASSETS) + A (FOREIGN ASSETS) A (OTHER DOMESTIC DEBT) A (FOREIGN DEBT) Thus, we search for an explanation for the R$262,369 million<sup>variation, as shown on Table</sup> 111.2, of the federal bonded debt (federal government + Central<sup>Bank).</sup> 15
TABLE 111.2. FEDERAL BONDED DEBT GROWTH: 1995-1998

||December<br>1994|December<br>1998|Variation|Percent<br>Variation|
|---|---|---|---|---|
|Federal Bonded Debt<br>(R$ Millions)|60,255|322,624|**262,369**|435.7%|
|GDP (R$ Millions)|537,555|912,456|374,901|69.7%|
|Federal Bonded Debt (% GDP)|11.2|35.4|24.1|216.1%|

Initially, we will aggregate the other accounts in the federal government and Central Bank aggregate balance sheet in three groups, each one of them standing for one of the following reasons to issue federal bonded debt'<sup>8</sup> , as laid out in Table 111.1.

# 1) To finance the federal government's (+ Central Bank's) deficit;

# 2) To accumulate foreign and domestic assets; and

# 3) To repay other previous debts (non-bonded debt).

Item #1 represents the difference in the two net worth figures (a fiscal deficit is a loss, and a fiscal surplus is a profit); item #2, the asset accumulation during the period; and item #3, the decrease in the aggregate of all other liability accounts. Thus, considering the federal bonded debt as the "sources", and the other accounts as the "uses" we can observe these uses on Table III.3 and 111.4, expressed in R$ and percentage of GDP, respectively. 1<sup>9</sup>

> 18Here, we are not determining whether the debt movements resulted from the fiscal, monetary, or exchange rate policy.

'9 The total of the uses (in bold in Table III.2A) is equal to the source variation (in bold in Table 111.1), both equal to R$262,369. Since this value results from a sum of nominal values in R$ during four years with significant and variable inflation, it should be used only as an accounting reference.

16
TABLE 111.3. FEDERAL BONDED DEBT USES: 1995-1998

|In R$ (Millions)|December<br>1994|December<br>1998|.|Percentage<br>Variation|
|---|---|---|---|---|
|Net Debt (increase=deficit)|65,836|231,258|165,422|251.3%|
|Asset Accumulation|10)6,308|270,187|163,879|154.2%|
|Other Debts' Repayments (-)|111,889|178,822|66,933|59.8%|
|TOTAL|||**262,369**||

In percent of GDP, the data above are: TABLE 111.4. FEDERAL BONDED DEBT USES IN percent OF GDP: 1995-1998

|In percent GDP|December<br>1994|December<br>1998|Variation|
|---|---|---|---|
|Net Debt (increase=deficit)|12.25%|25.34%|13.10%|
|Asset Accumulation|19.78%|29.61%|9.83%|
|Other Debts' Repayments (-)|20.81%|19.60%|1.22%|
||||24.15%|

Table III.3 shows the federal bonded debt variation. The greatest share of the increases in federal bonded debt was due to the federal deficit (which would be equal to the net debt variation, if it were not for accounting details discussed above). The accumulation of assets was responsible for a little bit less, 62.5% of the federal bonded debt growth. The increase in other debts was responsible for the (negative) residual factor (-25.5%), which means that if the other debts had not grown by R$ 66,933, the federal bonded debt would have increased even more. Measured as a share percent of GDP, the federal deficit was responsible for 54.2% of federal bonded debt growth of 24.15% of GDP (Table 111.4). The accumulation of assets was responsible for 40.7% of the federal bonded debt growth, while 17
the other debts actually decreased as a percent of GDP, being responsible for the remaining

# 5.0% of the federal bonded debt growth.<sup>20</sup>

We now turn to the decomposition of each of these three factors: the federal deficit, the assets accumulation, and the repayment of other debts.

# **_111.1_** _Financing of thefederal government (+ Central Bank) deficit_

In order to make the net debt variation of the period (R$165,422 or 13.1% of the GDP) compatible with the nominal deficits registered during the same period, it is necessary to make three adjustments. The first is to add the states', municipalities' and state-owned enterprises' net debt variation.

The second adjustment recognizes the privatization revenues. Since privatization revenues occur only once, they are not included as current revenue in the public deficit computation. Nevertheless, they are financial inflows public revenues which, _ceteris paribus,_ would lower the net debt (the state-owned enterprises that were sold were not previously included in the public sector assets). Under the hypothesis that everything else stayed constant, and assuming that all the privatization revenues were used for public debt redemption, the gross debt would diminish by the exact amount of these privatization revenues. Therefore, we have to add these revenues to the variation of the total net debt in order to obtain the debt variation concept that best conforms to the public deficit statistics.21 20 In Table 111.3, all figures are in R$, while in Table 111.4, the figures are in percent of GDP. Therefore, given that nominal GDP grew during the four-year period, the fact that "Other Debts" increased in nominal terms, while they decreased as percent of GDP is an indication that the increases occurred more to the end of the period relatively to the decreases.

**21** In reality, the relation between privatization and public debt is much more complex for at least two reasons. The first is that when a state-owned enterprise is sold, its debts are transferred to the private sector, diminishing the net debt by a value greater than the revenue of the privatization. The second reason is that

18
The third adjustment is related to the "Balance Sheet adjustment".22 The idea of this adjustment is that the macroeconomic impacts of the "skeletons" (old debts that were eventually repaid) occurred in the Fast. For example, the public debt issue for Banco do - - Brasil's recapitalization whose accumulated losses were threatening its solvency recognized losses derived from bad credit expansions in the past. Indeed, the debt issue was not related to deficits _during_ the recapitalization period, but to _old_ deficits, that had never been recognized until then. Thus, it i.s necessary to subtract the Balance Sheet adjustment's variation from the total net debt to obtain the debt variation concept comparable to the public deficit, namely, the "Net Fiscal Debt without Privatization".

Therefore, the following accounting identity should hold: for the fiscal statistics published by the Brazilian Central Bank.

Increase in Net Fiscal Debt without Plrivatization = Nominal Deficit.

Making the adjustments, we obtain: some state-owned enterprises held public debt as part of their assets. This debt, apparently was part of the gross debt, but, since it belonged to a slate owned enterprise, was not part of the net debt. After the privatization, it also became part of the net debt. Therefore the study of the relation between privatization and the public debt is still a work in progress.

> 22 Footnote no I of Table XXI of _Nota pcra Imprensa_ (Monetary) of _Banco Central do Brasil_ defines the "Balance Sheet Adjustment"as the following:

"(basis: Dec/95) Computes the bond issues relative to the Banco do Brasil's recapitalization, the reduction of the investment on the monetary reserve fuiid due to the court ruling involving the liquidation of the banks Comind and Auxiliar, securitization of debts, the use of "privatization money" in the PND, renegotiation of the Itaipu and Eletronorte debts with the SFN, the inclusion of constitution funds, besides the foreign debt difference, due to balance conversions, end of period exchange rates and the flows by the monthly average rate." 19
TABLE 111.5. MAKING COMPATIBLE THE NET FEDERAL DEBT STATISTICS AND THE NOMINAL DEBT STATISTICS IN R$: 1995-1998

|In R$ (millions)|Dec/94|Dec/98|Variation|Percentage<br>Variation|
|---|---|---|---|---|
|Net Federal Debt (+ Central Bank)|65,836|231,258|165,422|251.3%|
|+State's and Municipalities' Net Debt|51,091|130,905|79,814|156.2%|
|+ State Owned Enterprises' Net Debt|36,236|26,504|-9,732|-26.9%|
|=Total Net Debt|153,163|388,667|235,504|153.8%|
|-Balance Sheet Adjustment|0|39,516|39,516||
|+ Privatization Adjustment|0|30,656|30,656||
|=Net<br>Fiscal Debt without<br>Privatization|153,163|379,808|226,645|148.0%|

TABLE I11.6. MAKING COMPATIBLE THE NET FEDERAL DEBT STATISTICS AND THE NOMINAL DEBT STATISTICS IN percent OF GDP: 1995-1998

|In percent of GDP|Dec/94|Dec/98|Variation|
|---|---|---|---|
|Net Federal Debt (+ Central Bank)|12.25%|25.34%|13.10%|
|+State's and Municipalities' Net Debt|9.50%|14.35%|4.84%|
|+ State Owned Enterprises' Net Debt|6.74%|2.90%|-3.84%|
|=Total Net Debt|28.49%|42.60%|14.10%|
|- Balance Sheet Adjustment|0.C0%|4.33%|4.33%|
|+ Privatization Adjustment|0.00%|3.36%|3.36%|
|=Net<br>Fiscal Debt without<br>Privatization|28.49%|41.62%|13.13%|

Table III.7 shows the evolution and the composition of the public deficit during 1995-8.

The net federal debt variation is slightly higher than the nominal deficits accumulated in the same period (226,645 - 219,999 = R$6,646). This difference occurred during 1995, when the Balance Sheet adjustments' methodology was not yet implemented. Therefore, an extra 20
item will be included: "Adjustment not computed by the CB", amounting to R$6,646 millions

|TABLE III.7. PUBLIC SECTO|R EORRO|WING RE|QUIRE|MENTS:19|95-1998|
|---|---|---|---|---|---|
|In R$|1995|1996|1997|1998|Accumulated|
|Nominal|48,650|45,741|53,232|72,375|219,999|
|Federal Government and CB|15,632|19,946|22,912|49,351|107,841|
|States and Municipalities|24,141|21,076|26,377|18,416|90,010|
|State Owned Enterprises|8,877|4,720|3,943|4,608|22,148|
|Nominal Interest|51,065|45,001|44,923|72,492|21,3481|
|Federal Government and CB|19,554|22,854|20,537|54,485|117,430|
|States and Municipalities|22,992|16,840|19,941|16,570|76,343|
|State Owned Enterprises|8,519|5,309|4,444|1,437|19,709|
|Primary|-2,415|740|8,309|-116|6,518|
|Federal Government and CB|-3,922|-2,908|2,375|-5,134|-9,589|
|States and Municipalities|1,149|4,236|6,436|1,846|13,667|
|State Owned Enterprises|358|-589|-501|3,172|2,440|

After all these adjustments, the equation which links the federal debt variation (+ Central Bank) with the federal nominal deficit is expressed on Table 111.8. It shows that the largest share of item #1, which can be identified with the financing of the federal public debt (+ CB), was due to interest payments (71.0%). Item #1's second biggest expansion source was 21
the Balance Sheet adjustment. Note that this expansion effect from the Balance Sheet adjustment (23.9%) was substantially weakened by the privatization's contractionary effect (-18.5%). As we have already discussed, none of these items constitutes exactly the public - deficit. According to the definition of the federal deficit, neither of the other items related to states and municipalities (6.2% of item #1's growth) and the state owned - enterprises (19.3%) should be included, since this item (#1) refers only to the federal level.<sup>23</sup> The federal govemment and Central Bank's primary deficit had a contractionist impact during this period (-5.8%).

TABLE 111.8. MAKING THE FEDERAL NET DEBT STATISTICS AND THE FEDERAL NOMINAL DEFICIT COMPATIBLE: 1995-1998

||R$ (millions)|Percentage Share|
|---|---|---|
|=Federal Net Debt Variation (+ CB)|_165,422_||
|+Nominal Interest (Federal Government + CB)|117,430|71.0%|
|+Primary Deficit (Federal Government + CB)|-9,589|-5.8%|
|+Nominal Deficit minus Net Debt Variation of the<br>States and Municipalities|10,196|6.2%|
|+ Nominal Deficit minus Net Debt Variation of the<br>State Owned Enterprises|31,894|19.3%|
|+ Patrimonial Adjustrnent Variation|39,516|23.9%|
|- Privatization Adjustment Variation|-30,656|-18.5%|
|+ Adjustment not Computed by the Central Bank|6,646|4.0%|
|=TOTAL|165,437|100.0%|

**_1112_** _Accumulation of assets_

Table 111.9 decomposes the accumulation of assets during this period. Note that domestic assets growth (194.42%) was substantially greater than the foreign assets' growth (64.04%).

> **23** Thus, it would be expected that the nominal deficit were equal to the net debt variation, for both the states and municipalities as for the state-owned enterprises. Therefore, elucidating these items is still another<sup>work</sup>

22
The growth rates are unequal among the domestic assets also. The states' debts renegotiation, which appears on items 1.3 and 1.4, is responsible for slightly more than half of this increase (55.20%). The Central Bank's credits to financial institutions, which include the Proer (the private banks' bailout program), also played a significant role: 17.04% TABLE 111.9. ASSETS ACCUMULATION IN R$: 1995-1998

||Dec/94|Dec/98|Variation|Percent<br>Variation|
|---|---|---|---|---|
|1. Domestic|73,478.00|216,332.39|142,854.39|194.42%|
|1.1. FAT|10,125.00|27,878.83|17,753.83|175.35%|
|1.2. CB's credits to financial institulions|20,561.00|48,490.18|27,929.18|135.84%|
|1.3. Federal Government's credits<br>(Law 8727 / 93)|0.00|3,849.51|3,849.51||
|1.4. Debt Renegotiations with the sltates|0.00|86,612.46|86,612.46||
|1.5. Others|42,792.00|49,501.41|6,709.41|15.68%|
|2. Foreign Reserves|32,829.88|53,854.84|21,024.96|64.04%|
|TOTAL|106,307.88|270,187.23|163,879.35|154.16%|

# **_I1.3 Repayment of other kinds offeteralpublic debt_**

As shown on Table 111.3, the other debts suffered, in nominal terms, a net increase. Therefore, if the other debts had rernained the same, the federal public debt would have increased even more in nominal terms. Table 111.10 shows the other kinds of debt variation in this period. Once more, the domestic components growth is faster than the foreign one in progress.

23
(84.83% versus 41.96%). Among the domestic net debt components, the greatest share is due to the Monetary Base, responsible for 32.18% of the total net debt variation.

TABLE III.10. OTHER DEBTS VARIATION:1995-1998 R$ Millions

||Dec/94|Dec/98|Variation|Variation|
|---|---|---|---|---|
|||||Percentage|
|1. Other Domestic Debt|46,618.00|86,164.38|39,546.38|84.83%|
|1.1. Monetary Base|17,685.00|39,223.00|21,538.00|121.79%|
|1.2. Others|28,933.00|46,941.38|18,008.38|62.24%|
|2. Foreign Debt|65,270.88|92,657.42|27,386.54|41.96%|
|TOTAL|111,888.88|178,821.80|66,932.92|59.82%|

Table III. 11 summarizes the discussion about the factors of expansion and contraction of the federal public debt (in **nominal** terms). One must keep in mind that, since we are working with nominal values over a period of four years, those values presented on this table can be misleading.24 It is observed that the most important individual factor for debt growth was interest payments (44.8%), followed by the accumulation of the state's debt (33.0%). If we add these interest payments to the accumulation of domestic assets, the quality of which is uncertain, we can "explain" more than 99% of the debt growth in this

> 24 We preferred to present first the nominal values so that the total value to be explained was equal to that published by the Central Bank.

24
period.<sup>2 5</sup> Therefore, it is quite reasonable to identify the public<sup>debt growth with the</sup> deterioration of the fiscal position.

Table 111.12 summarizes the discussion about the factors of expansion and<sup>contraction of</sup> the federal public debt (in **real** terms). The analysis in real<sup>terms generates a few</sup> discrepancies from the previous analysis, and, of course, is the most<sup>relevant to the current</sup> economic situation The interest rate share increased even more in real<sup>terns: interest</sup> payments, percent at 13.76% of IJDP, alone exceeded the full variation<sup>of the federal net</sup> debt (13.09%). A similar figure (13.95% of GDP) is obtained by adding the items<sup>[Nominal</sup> Deficit minus Net Debt Variation of the States and Municipalities], [Nominal Deficit<sup>minls</sup> Net Debt Variation of the State Owned Enterprises], and [Balance Sheet Adjustment Variation]. Foreign Reserves actually fell as % of GDP (-0.21%), thereby<sup>making the whole</sup> Asset Accumulation much less attractive as an indicator of solvency.

A word of caution is necessary. One should not infer from the previous analysis that the bulk of the explosive growth in domestic bonded debt was due exclusively to the policy of extremely high interest rates, and that had the interest rates been lower, the<sup>bonded debt</sup> would not have exploded. Interest rates were high not only because of the Central Bank's policy decisions, but mainly because the fiscal stance became increasingly lax<sup>as the first</sup> successes of the Real Plan appeared on the inflation front<sup>26</sup> . Bevilaqua and Werneck (1998)

> 25 See Bevilaqua and Wemeck (1998)

> 26 One can decompose the high domestic interest rate along the lines of the covered interest parity condition, to get: domestic interest rate = foreign interest rate + forward exchange-rate premium + covered interest<sup>parity</sup> differential (country risk).

> While the crawling-peg-exchange-rate rolicy adopted in Brazil after April, 1995 created a wedge<sup>(the forward</sup> exchange-rate premium) that hovered around 10 percentage points,<sup>the country risk part had also been</sup> substantial. The country risk component was mainly determined by the perception<sup>of an unsustainable fiscal</sup> policy. Therefore, it is incorrect to say that, had the government abandoned<sup>earlier the crawling-peg policy to</sup> float the currency, interest rates would have fallen to international levels and the debt problem<sup>would have</sup> never existed. To make this counterfactaal scenario plausible, a much stronger fiscal<sup>stance would have been</sup>

25
show that the primary balance of the consolidated public sector deteriorated substantially during 1994-8.

required. And, if that were the case, interest rates would have been much lower even under the crawling-peg regime.

26
# TABLE III.11. FEDERAL DEBT USES:1995- 1998 (R$ Millions)

||**Dec-94**|**Dec-98**|**Variation**|**Percentage Share**|
|---|---|---|---|---|
|**Federal Net Debt (+ CB)**|**65836**|**231258**|**165422**|**63.05%**|
|Nominal Interests (Federal Government + CB)|||117430|44.76%|
|Primary Deficit (Federal Government + CB)|||-9589|-3.65%|
|Nominal Deficit minus Net Debt Variation of the States and Municipalitie|s||10196|3.89%|
|Nominal Deficit minus Net Debt Variation of the State Owned Enterprises|||31894|12.16%|
|Balance Sheet Adjustment Variation|||39516|15.06%|
|Privatization Adjustment Variation (-)|||-30656|-11.68%|
|Adjustment not Computed by the Central Bank|||6646|2.53%|
|**Assets**|**106308**|**270187**|**163879**|**62.46%**|
|1. Domestic|73478|216332|142854|54.45%|
|1.1. FAT|10125|27879|17754|6.77%|
|1.2. CB's credits to the financial institutions|20561|48490|27929|10.65%|
|1.3. Federal Govermment's credits (Law 8727 / 93)|0|3850|3850|1.47%|
|1.4. Debt Renegotiations with the states|0|86612|86612|33.01%|
|1.5. Others|42792|49501|6709|2.56%|
|2. Foreign Reserves|32830|53855|21025|8.01%|
|**Other Debts (-)**|**111889**|**178822**|**-66933**|**-25.51%**|
|1. Domestic|46618|86164|-39546|-15.07%|
|1.1. Monetary Base|17685|39223|-21538|-8.21%|
|1.2. Others|28933|46941|-18008|-6.86%|
|2. Foreign|65271|92657|-27387|-10.44%|
|**TOTAL**|||**262,368**|**100.00%**|

27
# TABLE 111.12. FEDERAL DEBT USES IN percent OF GDP: 1995- 1998

|**Dec-94**|**Dec-98**|**Variation**|
|---|---|---|
|**Federal Net Debt (+ CB)**<br>**12.25%**|**25.34%**|**13.09%**|
|Nominal Interests (Federal Governrment + CB)||13.76%|
|Primary Deficit (Federal Government + CB)||-1.19%|
|Nominal Deficit minus Net Debt Variation of the States and Municipalities||4.17%|
|Nominal Deficit minus Net Debt Variation of the State Owned Enterprises||5.22%|
|Balance Sheet Adjustment Variation||4.56%|
|Privatization Adjustment Variation (-)||-3.44%|
|Adjustment not Computed by the Central Bank||0.87%|
|**Total**||**23.95%**|
|**Assets**<br>**19.78%**|**29.61%**|**9.83%**|
|**1.**Domestic<br>13.67%|**23.71%**|**10.04%**|
|**1.1.**FAT<br>1.88%|3.06%|1.17%|
|1.2. CB's credits to the financial institutions<br>3.82%|5.31%|1.49%|
|1.3. Federal Government's credits (Law 8727 / 93)<br>0.00%|0.42%|0.42%|
|1.4. Debt Renegotiations with the states<br>0.00%|9.49%|9.49%|
|1.5. Others<br>7.96%|5.43%|-2.54%|
|2. Foreign Reserves<br>6.11%|5.90%|-0.21%|
|**Other Debts (-)**<br>**20.81%**|**19.60%**|**-1.22%**|
|**1.**Domestic<br>**8.67%**|**9.44%**|**0.77%**|
|**1.1.**Monetary Base<br>3.29%|4.30%|1.01%|
|1.2. Others<br>5.38%|5.14%|-0.24%|
|2. Foreign<br>12.14%|10.15%|-1.99%|

28
**IV. Challenges Ahead: Deblt Evolution in the Post-Devaluation**<sup>**Period**</sup>

In this section we perform simulations of the public net<sup>debt path to 2002, the final year of</sup> the current presidential term. The starting point for the derivation<sup>of the model used for the</sup> debt-dynamics simulations is the standard budget constraint<sup>of the consolidated public</sup> sector, which in the case of Brazil includes the<sup>central government, states and</sup> municipalities and public enterprises: where M is the monetary base, B is the net domestic debt,<sup>B* is the foreign debt net of</sup> international reserves, E is the nominal exchange rate<sup>in reais per dollar, D is the primary</sup> balance, it is the domestic interest rate, r is the foreign<sup>interest rate, A are privatization</sup> revenues and H represents hidden and contingent liabilities.

It is useful to rewrite equation (1) ir terms of flows and<sup>stocks per unit of domestic product:</sup> or 29
where c, d, a and h are, respectively, seignorage, primary balance, privatization revenues and hidden and contingent liabilities in terms of GDP.

Equation (3) can be further rearranged as: or where b and b* are, respectively, net domestic debt and net foreign debt in terms of GDP, **7i** is the inflation rate, n is the rate of growth of real GDP and s is the rate of devaluation of the nominal exchange rate.

Equation (5) may be used to simulate the path of the net domestic debt in Brazil over the medium term taking into account specific assumptions about the primary balance, inflation rate, rate of growth of real GDP, nominal exchange rate devaluation, domestic and foreign interest rates, and seignorage revenues. In addition, since the government intends to 30
continue its privatization program, one needs to make assumptions<sup>about how that program</sup> will be implemented. Finally, it is necessary to take into account the fact that<sup>the</sup> government has hidden and contingent liabilities which<sup>will be recognized in coming</sup> years.<sup>27</sup> The main assumptions for the baseline scenario (Scenario<sup>1) are shown in Table IV.1. The</sup> primary balance path corresponds to the full implementation<sup>of the IMF supported program</sup> over the period 1999-2001. According to the agreed targets,<sup>the consolidated public sector</sup> will generate primary surpluses of at least 3.1 percent of GDP<sup>in 1999, 3.3 percent of GDP</sup> in 2000, and 3.4 percent of GI)P in 2001. For 2002,<sup>the final year of the current</sup> presidential term and end of the simulation period, it is assumed<sup>that the improved fiscal</sup> stance is sustained, with the primary surplus remaining at 3.4<sup>percent of GDP.</sup> TABLE IV.1. SCENARIO 1 - BASIC ASSUMPTIONS

|Variables|1998|1999|2000|2001|2002|
|---|---|---|---|---|---|
|Primary balance|0.0%|3.1%|3.3%|3.4%|3.4%|
|Real GDP growth|0.2%|0.0%|3.0%|3.5%|4.0%|
|Domestic inflation rate|1.4%|10.0%|6.0%|6.0%|4.0%|
|Nominal depreciation (R$/US$)|8.2%|65.0%|-5.0%|5.0%|4.0%|
|Nominal Domestic interest rate|29.5%|26.0%|16.0%|13.0%|11.0%|
|Foreign interest rate|8.5%|8.8%|9.0%|8.8%|8.5%|
|Seignorage|0.8%|0.3%|0.2%|0.2%|0.2%|
|Privatization|1.4%|1.0%|1.0%|1.0%|1.0%|
|Hidden liabilities|2.3%|2.5%|2.5%|2.5%|2.5%|

27 The social security burden, which is thie biggest contingent<sup>liability for the public sector, is incorporated in</sup> the primary balance.

31
Total revenues from privatization are projected at about 1.0 percent of GDP in 1999, and 1.0 percent of GDP thereafter. The bulk of the resources should come from the completion of the privatization of federal electricity generation companies in 1999, the privatization of the electricity transmission network from 2000, sales of remaining shares of previously privatized companies, such as CVRD and Light, and sales of the noncontrolling share of Petrobras. The amount for 1999 was assumed to be less than the original figure of 2.8 percent of GDP contemplated in the IMF supported program, and less than the 1.3 percent assumed in the July 1999 revision of the program, because of the privatization results as of October 1999. In addition, it is assumed that the government will recognize about 2.5 percent of GDP in hidden and contingent liabilities every year during 1999-2002.28 The tightening in the fiscal stance will help to reduce the burden on monetary policy and will allow for a decline in the domestic real interest rate from about 15 percent in 1999 to 9 percent in 2000, and 7 percent in 2001 and thereafter. The reduction in the domestic real interest rate in response to the improved fiscal stance should be a natural consequence of the improvement in the risk assessment of the country as the fiscal adjustment is sustained over the years. The drop in the real interest rate will induce a recovery in economic activity, with the rate of growth of real GDP increasing to 3 percent in 2000, 3.5 percent in 2001, and settling at about 4 percent. Finally, the change in the policy mix brings about a steady decline in the inflation rate from 10 percent in 1999 to 4 percent in 2002. It also 28 This amount of hidden and contingent liabilities is higher than what is assumed in the IMF program.

32
results in a substantial devaluaticn in<sup>the real exchange rate in 1999, which is partially</sup> reversed in 2000 by a nominal exchange<sup>rate appreciation.2 9</sup> Results for the simulation of the consolidated<sup>public sector debt path during 1999-2002 are</sup> presented in Table IV.2. The model simulates<sup>the values of total net debt in the last line of</sup> the table and then distributes it according<sup>to the relative shares of net domestic and net</sup> foreign debt observed in the preceding year.<sup>Under the assumptions of Scenario 1, the ratio</sup> of net public debt to GDP rises tc 50.1<sup>percent in 1999 and then declines slightly to about</sup> 49.1 percent in 2002. This scenario highlights the key role played<sup>by the sustained</sup> improvement in the fiscal stance in stabilizing<sup>the net debt to GDP ratio in the medium</sup> term, even as the federal govermnent recognizes<sup>a substantial amount of hidden and</sup> contingent liabilities every year.

TABLE IV.2. SCENARIO 1 - NET DEBT<sup>PATH, 1998/2002</sup>

|Variables|1998|1999|2000|2001|2002|
|---|---|---|---|---|---|
|Net Domestic Debt|36.0%|39.3%|39.3%|38.9%|38.5%|
|Net Foreign Debt|6.6%|10.8%|10.8%|10.7%|10.6%|
|Total Net Debt|42.6%|_50.1%_|50.0%|49.6%|49.1%|

In order to stress further the inLportance of the<sup>programmed primary surpluses for the</sup> stabilization of the net debt to 3iDP ratio<sup>over the medium term, a second scenario is</sup> considered in which there is a milder adjustment<sup>in the fiscal position of the consolidated</sup> public sector, perhaps because cf delays in<sup>the implementation of fiscal reforms. Table</sup>

> 29 The inflation rate in the debt simulation<sup>exercises should be a proxy for the GDP deflator. Here it is</sup> measured by the average IGP-DI.

33
IV.3 presents the basic assumptions of this alternative scenario (Scenario 2). After increasing to 3.1 percent of GDP in 1999, the primary balance is assumed to decrease to 2 percent of GDP in 2000 and remain at this level thereafter. To put this number in perspective, a 2 percent of GDP surplus represents a much tighter fiscal stance for the consolidated public sector than what was observed during any year in the 1995-1998 period.

TABLE IV.3. SCENARIO 2 - BASIC ASSUMPTIONS

|Variables|1998|1999|2000|2001|2002|
|---|---|---|---|---|---|
|Primary balance|0.0%|3.1%|2.0%|2.0%|2.0%|
|Real GDP growth|0.2%|0.0%|2.5%|3.0%|3.5%|
|Domestic inflation rate|1.4%|10.0%|8.0%|6.0%|4.0%|
|Nominal depreciation (R$/US$)|8.2%|65.0%|6.0%|_5.0%_|4.0%|
|Nominal domestic interest rate|29.5%|26.0%|18.0%|16.0%|13.0%|
|Foreign interest rate|8.5%|8.8%|9.0%|8.8%|8.5%|
|Seignorage|0.8%|0.3%|0.2%|0.2%|0.2%|
|Privatization|1.4%|1.0%|1.0%|1.0%|1.0%|
|Hidden liabilities|2.3%|2.5%|2.5%|2.5%|2.5%|

With the weaker adjustment in the fiscal position, monetary policy is supposed to carry a larger share of the burden for keeping inflation low. It is assumed that the real interest rate will drop to 11 percent in 2000 and will remain at 9 percent after 2001. Real GDP growth will rise to 2.5 in 2000, 3 percent in 2001 and 3.5 percent in 2002. In this alternative scenario the inflation rate is reduced to 8 rather than 6 percent in 2000 and the currency has a further nominal depreciation in the same year. The assumptions about the other 34
macroeconomic variables remain **the** same in order<sup>to facilitate the comparison with</sup> Scenario 1. 30 As Table IV.4 indicates, this scenrrio for the primary<sup>balance implies a significantly</sup> different path for the net-debt to GD P ratio. The total net<sup>debt ratio increases steadily from</sup> 50.1 percent of GDP in 1999 to 57.3 percent of GDP in 2002.

TABLE IV.4. SCENARIO 2 - NET DEBT PATH, 1998/2002

|Variables|1998|1999|2000|2001|2002|
|---|---|---|---|---|---|
|Net Domestic Debt|36.0%|39.3%|41.2%|43.0%|44.9%|
|Net Foreign Debt|6.6%|10.8%|11.3%|11.8%|12.3%|
|Total Net Debt|42.6%|_50.1%_|52.5%|54.9%|57.3%|

# **V. Policy discussion**

As the simulation results from the previous section indicate,<sup>even under very favorable</sup> macroeconomic conditions the evoluition of the net debt to<sup>GDP ratio will remain a policy</sup> concern in coming years. Under these circumstances, what role should<sup>be played by public</sup> debt management in the near future?

We see public debt management as constrained by a fundamental<sup>policy consideration in</sup> the short-run. Although perceptions about the likelihood of a debt<sup>rollover crisis in Brazil</sup>

> **30** Though some of them, such as the paths for the inflation and nominal<sup>interest rates after 2000, are at odds</sup> with the weaker fiscal stance and the nominal devaluation. We do that<sup>to stress the importance of a tougher</sup> fiscal instance.

_35_
have improved considerably since the January 1999 devaluation, the large stock of shortterm debt remains an important source of anxiety, especially on the part of foreign investors. Even if there are reasons to believe that such a concern is somewhat misplaced<sup>3 1</sup> , a practical implication of this fact is that the risk premium on Brazilian securities remains higher than what it would likely be if the same public sector borrowing requirements were financed with longer maturity debt. A central priority of debt management in the short and medium-run, therefore, should be to intensify efforts to lengthen the average maturity of the public debt. Furthermore, given the need to reduce the interest burden of the debt and increase the sustainability of the current fiscal stance, such maturity lengthening should naturally be implemented at the lowest possible cost.

What kind of debt instruments will be more appropriate under these conditions? It is expected that under the current IMF supported program the share of external and foreign exchange-indexed debt in the total public debt will be reduced gradually. Therefore, the process of debt maturity lengthening must be conducted through the issuance of domestic debt, either nominal or indexed.

What should be the relative shares of these instruments in debt placements? For the sake of clarity of the exposition, we partition the question of how much of each kind of debt should be issued in two layers. First, one should determine how much nominal against indexed debt should be issued. Second, among the several kinds of indexed debt, how much of each kind should be issued (zero-duration and inflation-linked). Although the determination of

> 3' See Bevilaqua and Garcia (1999).

36
the debt structure is a multiple-choice allocation<sup>problem, the two-layered scheme is</sup> adequate for the Brazilian case, as wo now<sup>explain.</sup> To lengthen the average maturity of<sup>the debt requires the issuance of indexed debt, since</sup> long nominal debt (above two or thiee<sup>years) can only be issued at an abnormally high-risk</sup> premium. Therefore, the basic policy<sup>recommendation concerning the public debt structure</sup> for the Brazilian economy in coming<sup>months is to issue nominal debt with the highest</sup> possible maturity without creating an<sup>extremely upward sloping yield curve at the end. For</sup> the time nodes previously "conquered",<sup>issue the highest possible amounts that do not</sup> create "price-pressure" effects. For the bulk<sup>of the rollover and for the new additions to the</sup> debt stock, indexed debt should be issued,<sup>to lengthen the maturity structure as much as</sup> possible.

In terms of placement procedures, the authorities<sup>should announce the auctions as far in</sup> advance as possible<sup>3 2</sup> and avoid p]acing<sup>unexpected amounts of short-term securities in</sup> order to profit from the low maturity premia<sup>of the shorter maturities. Placing short-term</sup> debt because it is cheaper in an env-ronment<sup>of lack of confidence jeopardizes the situation</sup> of the previous long-debt holders, because<sup>the short-debt holders have a liquidation option</sup> over those, and harms the debt market in<sup>the long run. It is akin to the issue of debt</sup> seniority: the short-term debt holders hold<sup>debt that is senior</sup><sup>_vis-ai-vis_the long-term debt</sup> holders, since the former will matuwe before the<sup>latter. Information regarding the process of</sup>

> 32 This measure was included in the debt<sup>management strategy package recently announced by the Brazilian</sup> authorities. According to the newspaper _The_<sup>_Economist_(11/11/1999), ...</sup><sup>_among the main features of the_</sup> _central bank's planned reforms are: to haldfewer,_<sup>_bigger auctions of debt, with dates announcedfurther in_</sup> _advance; to reduce drastically the types of bonds_<sup>_on the market (there are currently more than 200, many of_</sup> _them small, illiquid issues relating to former state_<sup>_firms); to allow banks to have "short" positions on the_</sup> _bond market (ie, to sell bonds they do not own),_<sup>_plus other rule-changes to promote liquidity and to be more_</sup> _open in publishing details of the debt._

37
debt lengthening must be well conveyed to the market, so that debt holders know in advance that they will be purchasing liquid instruments, and that the government will not "cheat" on them by placing shorter instruments in the future.

An important question remains on how much of each kind of indexed debt (zero-duration, inflation-linked, exchange-rate-linked, or another form as discussed below) should be issued. The exchange-rate-linked debt share, as already mentioned, must conform to the guidelines of the current IMF supported program. Given the current inflation targeting framework the use of zero-duration debt poses a version of the well-known time consistency problem. The over reliance on zero-duration debt, as in the current situation with almost 60% of total debt in this form, may reduce monetary policy credibility and commitment, because policy makers may become more exposed to choices and trade-offs between tight money policies to contain inflation and the budgetary impact of higher shortterm rates. Therefore, it is advisable to reduce the share of this kind of indexed debt in the total public sector debt.

Therefore, the remaining instrument to be used in the process of maturity lengthening is inflation-linked debt. The main objection to this kind of debt indexation is that it may have inflationary effects. Nevertheless, as Price (1997) emphasizes (...) _the academic literature suggests no necessary connection between indexed bonds (or indexation in general) and inflation. The emergence of inflation depends on other circumstances and policies that are independent of indexation. Recent government issuers of indexed bonds in fact point to credibility enhancements that may result from issuing indexed bonds, by neutralizing the_ 38
_inflation tax._<sup>_33_</sup> Price's advice is that (..) _in newly developing or transition markets, they_

[indexed bonds] _could be envisaged as part of a concomitant package of fiscal and monetary reforms to foster longer-term capitalformation, along with strong commitments to price stability._<sup>_3 4_</sup> The current share of inflation-linked debt is negligible. This was a result of a policy decision after the Real Plan, when debt managers-convinced that inflation-linked debt was inflationary by conveying to the market a lack of anti-inflationary commitment of the government-decided to phase it DUt. Our policy advice is to reverse that decision. It is reasonable to assume that there is a natural demand for such long-term-inflation-linked bonds from pension funds, insurance companies, and other market participants whose liabilities are both long-term and display high correlation to the price level. For these market participants, long-term-inilation-linked bonds constitute a hedge, and, therefore, may be sold at a lower yield (higher price).<sup>35</sup> 3 Page 53.

Page 55.

3 In order to encourage discussion about the best transition strategy toward a higher share of long-terminflation-linked bonds, we list here a few ideas of financial engineering that were collected among market participants and add a few ideas of our own. One possible instrument is a bond that would pay the higher of two indices: the inflation index plus a real rate (defined ex-ante), or a percentage of the accrual of the daily interest rates (Selic) during the bond's lif . In the auction, market participants would bid for the percentage of the accrual of the daily interest rates (the lower the percentage, the more likely to win). This "mongrel" bond could provide a natural transition betwe en the current zero-duration bonds and the inflation-linked bonds. While the holders of the "mongrel" bonds would guarantee the natural hedge provided by inflation protection (plus the real rate), they would also retrieve an option to profit from the high interest rates. The gain for the govemment would be the decrease of the harm in the fiscal accounts posed by an increase in short-term interest rates, thereby alleviating the time consistency problem discussed before. Another similar "mongrel" bond could be constructed by adding options to a standard inflation-linked-bond (plus an ex-ante real rate) with maturity of several years. These options, to be exercised at the beginning of each year of the bond's maturity, would change the yield from iniflation plus the real rate to a percentage of the accrual of the daily interest rates during the following year. I.e., every year the debt holder would decide _ex ante_ which index would be used to compute the bond's return. As before, the percentage of the accrual of the daily interest rates would be defined in the auction. Tlie expectation is that with the success of the plan, market participants would not exercise the options, thereby in fact migrating to inflation-linked bonds, and alleviating the fiscal, and the derived monetary policy, time consistency problems. Again, the possible benefit of these "mongrel" bonds would be to allow the maturity lengthening of the debt with the minimum possible fiscal cost and without generating time consistency prot lems for the inflation targeting framework.

39
Of course, as the Real Plan achieves its long-term goals of promoting growth in a low-inflation environment, the debt structure should naturally shift towards nominal debt, including long-term securities. However, since it would be infeasible to try to engineer this shift at present, we see the indexation to inflation as the least harmful way to lengthen the debt maturity.

40
# VI. **References**

Barcinski, A. (1997). "Risco de Taxa de Juros e a Divida Publica Federal no Brasil P6sReal." Rio de Janeiro: BNDES. 85p.

Bevilaqua, A. S. and M. Garcia '1999). "Banks, Domestic Debt Intermediation and Confidence Crises: the Recent Brazilian Experience" Rio de Janeiro: PUC, Departamento de Economia.

Bevilaqua, A. S. and R. L. F. Werneck (1998). "The Quality of the Federal Net Debt in Brazil." Rio de Janeiro: PUC, Departamento de Economia. 18p. (discussion paper # 385) Bevilaqua, A. S., D. D. Carneiro, M. G. P. Garcia and R. L. F. Werneck (1998). " The Structure of the Public Sector Debt in Brazil". mimeo. Departamento de Economia.

Jorion, Philippe (1955). "Value at Risk: The New Benchmark for Controlling Market Risk." University of California, Irvine. 332p.

Pastore, A. C. (1996). "Por que a poLitica monetaria perde eficacia ?". Revista Brasileira de Economia, vol.50, July/September.

Price, R. (1997). "The Rationale ancL Design of Inflation-indexed Bonds." Washington DC, IMF. Working paper series no. 97/12.

Simonsen, M. H. (1995). "30 Anos de Indexagao." Rio de Janeiro: Ed. da Fundac,o Getuilio Vargas. 176p.

Stiglitz, J. and A. Weiss (1981). "Credit Rationing in Markets with Imperfect Information." American Economic Review 71, 3 (.[une), 393-410.

41