ensure a sufficiently fast reduction of debt servicing costs in the event of a rapid fall in
interest rates. If the term premium required on fixed-rate bonds is not too high, issuing
such bonds in exchange for Selic-rate bonds increases the probability of debt stabilization.
We provide evidence on the term premium which suggests that such a strategy is indeed
optimal.
The empirical evidence strongly supports the funding strategy of Brazilian Treasury in
2003 of relying heavily on 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 remains too large suggesting that more efforts
should be made to reduce funding in foreign currencies.
2. The government problem
In this section we present a simple model where debt management helps to stabilize
the debt ratio and thus reduces the probability of a debt crisis. Debt stabilization calls for
funding at low cost but also for minimizing the risk of large payments due to unexpected
changes in interest rates and the exchange rate. Hence, the choice of debt instruments
trades off the risk and the expected cost of debt service.
Risk minimization is accomplished by choosing debt instruments which both ensure a
low return variability and provide a hedge against variations in the primary budget, in the
interest payments and in the value of the other liabilities (see e.g. Goldfajn 1998). Reducing
the uncertainty of the debt ratio, for any expected cost of debt service, is valuable in that it
lowers the probability that debt stabilization may fail because of bad shocks to the budget.
This strategy is consistent with the asset-and-liability management approach adopted by
the Brazilian Treasury (see Tesouro National 2003).
To provide insurance against variations in the primary surplus and the debt ratio, public
bonds should be indexed to nominal GDP. However, this would be a costly innovation.
Indeed, a high premium would have to be paid: for insurance; for the illiquidity of the
market and; for the delay in the release of GDP data and their revisions. Therefore, we
focus on the main funding instruments that are currently available to the Brazilian Treasury:
bonds indexed to the Selic rate (LFT), fixed-rate bonds (LTN), bonds indexed to the IPG-
M price index (NTN-C) or to the IPCA index (NTN-B), domestic bonds indexed to the
US dollar and external debt denominated in foreign currency. (We refer to the latter two
instruments as dollar denominated bonds in what follows.)
The aim of the government is to stabilize the debt ratio, Bt . To this end, the govern-
ment decides a fiscal correction taking into account the realization of debt returns, output,
inflation and the exchange rate.4 However, since the result of the government’s efforts is
uncertain (and the fiscal adjustment is costly) a crisis cannot be prevented with certainty.
Denoting the result of the fiscal adjustment (in terms of GDP) with At+1 - X, a debt crisis
arises if
BtT+1 - Bt > At+1 - X (1)
where At+1 is the expected adjustment, X , denotes the uncertain component of the fiscal
4The choice of the government can be modeled by assuming that it wheighs the cost of the adjustment
and the probability of debt default. The formal analysis of the government problem is not carried out since
it does not affect the results for debt management.