Public Debt Management in Brazil

denominated in dollars.

The lack of fixed-rate bonds in the optimal debt structure is partly explained by the
strong complementarity between price-indexed and dollar denominated bonds which arises
because of the exchange rate appreciation that follows an inflation shock. If we abstract
from the hedge provided by dollar debt against the returns of the other instruments, issuing
some fixed-rate debt is optimal. Column 5 shows that, in this case, fixed-rate bonds still
account for 16% of the debt in spite of their higher expected return. This case could be
relevant if negative supply shocks, by inducing a deterioration of the fiscal position (that our
model fails to capture), led to a greater EMBI spread and a depreciation of the exchange
rate. The effects of shocks to the country risk premium are discussed in the next section.

5.2.3 EMBI shocks

Tables 9 shows the debt composition that stabilizes the debt ratio against shocks to the
EMBI spread. Changes in the country risk premium may capture changes in international
risk factors or in the perception of risk as well as domestic fiscal shocks, for example,
negative shocks to the budget that increase country risk.

The first Column of Table 9 reports the debt composition that stabilizes the debt ratio
against variations in output and inflation, that is, in the case we abstract from hedging
against variations in the interest payments. The shares of Selic indexed bonds and dollar
denominated bonds are negative, reflecting the strong negative covariances of their returns
with output growth that are shown in Table 8. In fact, EMBI shocks also lead to both
unexpected inflation and exchange-rate depreciation, but the negative covariances of the
Selic rate and the exchange rate with output dominate their positive covariances with
inflation. It follows that fixed-rate bonds should be issued in amounts exceeding the total
debt so as to insulate the budget from unexpected output contractions.

Column 2 shows that issuing fixed-rate debt is still optimal for risk minimization when
we consider the role of each instrument in hedging the returns of the other instruments.
The government should issue an amount of fixed-rate bonds larger than the total debt and
hold both foreign assets and Selic indexed bonds. When, as in Column 4, the debt shares
are constrained to be non-negative, the share of fixed-rate debt reaches 93%.

When cost considerations are introduced into the analysis, as in Column 4 an 5, the
optimal debt composition moves towards price indexation, but the share of fixed-rate bonds
remains substantial despite their higher expected return. Column 5 shows that, when debt
shares are constrained to be non-negative, the optimal share of fixed-rate bonds is as high
as 82%.

5.2.4 Policy conclusions from the structural model

Results from the structural model suggest that a large share of the Brazilian debt should
be indexed to the price level. Price indexed bonds appear to consistently provide a good
hedge against all types of shocks, although their role is limited in the case of EMBI shocks.
Indexation to the Selic rate should be avoided if supply shocks and EMBI shocks prevail
while LFT bonds are a worse alternative to price indexation in the case of demand shocks.
Importantly, there appears to be little role for dollar denominated bonds. Exposure to
exchange rate risk should be avoided in case of demand shocks and EMBI shocks while it
should be limited in the case of supply shocks. In particular, the greater volatility of the

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