to alternative methods of estimating the optimal debt structure.
Fixed-rate LTN bonds also help to stabilize the debt ratio. Although such bonds have
no role in the case of demand shocks, they are the best instruments to cope with shocks to
the country risk premium. If EMBI shocks prevail, a share of fixed-rate bonds substantially
higher than that currently observed would be optimal even after considering their greater
expected cost. Fixed-rate bonds can also provide insurance against fluctuations in the
primary budget and in the debt ratio induced by supply shocks, but their optimal share
should be smaller than that of price-indexed bonds because of their higher expected return.
The scope for improving on the current structure of the Brazilian debt is substantial.
The composition of the net public debt in Brazil is strongly biased toward debt denominated
or indexed to foreign currencies. Once we account for net external debt and for the foreign
currency swaps of the Central Bank, the exposure to the exchange rate reaches 40%. The
share of debt indexed to the Selic rate is also as high as 40%. By contrast the share of debt
indexed to the price level is slightly above 10% and the fixed-rate component is about 8%.
These facts suggest simple policy prescriptions. First of all, the exposure to exchange
rate risk should be reduced. The cost advantage of bonds denominated or indexed to foreign
currency is not sufficient to compensate for the high risk of variations in the exchange rate.
The exposure to the exchange rate is so high that betting in the direction of a further
appreciation of the exchange rate is highly risky. One of the reasons such a large share of
the domestic debt is indexed to the dollar is the demand for hedge by the private sector.
In Brazil the only entities that bear exchange rate risk are the government and the Central
Bank: the private sector fully hedges its dollar exposure by entering into swap contracts with
the Central Bank. Such a large amount of outstanding hedge cannot be rapidly reduced:
the currency falls sharply whenever the Central Bank announces that it will not fully roll
over the outstanding stock of hedge. The current account surplus that Brazil is now running
offers an opportunity to reduce the demand for hedge by the private sector. This constraints,
however, does not apply to Treasury funding in foreign currencies, which should be avoided,
thus reducing exchange rate exposure at least on this front. Since vulnerability to exchange
rate risk is valued by investors, a smaller share of dollar denominated debt could lower the
risk premium on the Brazilian debt.
The second advice is to increase issuance of price-indexed bonds. Price indexation,
especially the new IPCA indexation program, provides a natural hedge against the impact
of inflation on both the primary surplus and the debt ratio. In the perspective of the asset-
and-liability management approach of the Brazilian Treasury, NTN-C and NTN-B bonds do
not only match future revenues but also the risks of price indexed assets in the government
portfolio (see Ministerio de Fazenda 2003). Since NTN-C bonds have a long maturity, they
also insulates the government budget from roll-over risk, thus representing an important
factor of stability for public debt dynamics. Thus, the decision of the Brazilian Treasury to
revitalize the market for price-indexed bonds finds a strong support in our analysis.
How large the share of price-indexed bonds should be, is more difficult to say. Although
our analysis suggests that such a share should be large, there are a number of reasons why
this may not be optimal or feasible. The amount of price indexed bonds that could be
issued may be limited by reasons of political opportunity or by the likely increase in the
expected return that investors require to hold such bonds when their share increases.
The main obstacle against a strategy of price indexation lies, however, in the long
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