Working Paper: CEPR ID: DP4293
Authors: Francesco Giavazzi; Alessandro Missale
Abstract: This Paper derives the optimal composition of the Brazilian public debt by looking at the relative impact of the risk and cost of alternative debt instruments on the probability of missing the stabilization target. This allows to price risk against the expected cost of debt service and thus to find the optimal combination along the trade-off between cost and risk minimization. The optimal debt structure is a function of the expected return differentials between debt instruments, of the conditional variance of debt returns and of their covariances with output growth, inflation, exchange-rate depreciation and the Selic rate. We estimate the relevant covariances by: i) exploiting the daily survey of expectations; ii) simulating a small structural model of the Brazilian economy under different shocks; iii) estimating the unanticipated components of the relevant variables with forecasting regressions. The empirical evidence strongly supports the funding strategy of Brazilian Treasury in 2003 of relying heavily on fixed-rate LTN bonds. It also supports its recent decision to revitalize the market for price-indexed bonds with the new NTN-B program of IPCA indexation. Though decreasing, the exposure to exchange rate risk appears too large suggesting that more efforts should be made to reduce funding in foreign currencies.
Keywords: Public Debt; Debt Management; Brazil
JEL Codes: E63; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exposure to exchange rate risk (F31) | minimize (Y60) |
| current high levels of foreign currency-denominated debt (F65) | detrimental to debt sustainability (H63) |
| price-indexed bonds (G12) | positive covariance with output growth and inflation (O42) |
| optimal composition of Brazilian public debt (H63) | minimize fiscal vulnerability (H69) |
| optimal composition of Brazilian public debt (H63) | maximize probability of debt stabilization (H63) |
| well-structured debt portfolio (G51) | mitigate risks associated with unexpected changes in interest rates and exchange rates (F31) |
| Brazilian Treasury's strategy in 2003 (fixed-rate LTN bonds) (E43) | reduce debt servicing costs during periods of falling interest rates (F34) |
| price-indexed bonds (G12) | provide better protection against inflation (E31) |
| price-indexed bonds (G12) | help stabilize the debt ratio (G32) |
| fixed-rate bonds (E43) | reduce likelihood of large interest payments during crises (F65) |
| fixed-rate bonds (E43) | stabilize debt ratio (G32) |