Inflation Targeting and Debt: Lessons from Brazil

A single variable describes, day-by-day, what investors think about the state of Brazil's economy: the Brazilian component of the Emerging Market Bond Index, the Embi spread. This spread is the difference between the yield on a dollar-denominated bond issued by the Brazilian government and a corresponding one issued by the US Treasury; it is thus a measure of the markets' assessment of the probability that Brazil might default on its debt obligations. This is mainly because the cost of servicing the public debt fluctuates very closely with the Embi spread. Understanding what determines this spread, how it responds to domestic monetary and fiscal policies and to international factors, how it interacts with the exchange rate and domestic interest rates, is thus the necessary first step in order to understand macroeconomic developments in Brazil. The Paper proceeds in three steps. We first document the non-linearity in the response of the Embi spread to international financial shocks. We then study how the Embi spread affects the cost of debt service and thus the dynamics of the public debt: we estimate risk premia on various financial instruments and on the exchange rate, and we show that they all move in parallel with the Embi spread. Finally we analyse a small short-run model of the Brazilian economy to show how the effectiveness of monetary policy depends on the fiscal policy regime.