This paper develops a model that captures important features of debt crises of the Brazilian type. Its applicability to Brazil lies in the facts that (1) macroeconomic fundamentals were relatively sound in the wake of the crisis (e.g., a nonnegligible primary surplus, a relatively low debt-GDP ratio, and low inflation); and (2) the trigger for the crisis—forthcoming elections with an expected regime change—appears to be extraneous. We rationalize the sort of circularity involved in a country’s credit rating. In particular, we show how country credit ratings could bring about unstable macroeconomic behavior, and explore the implications of such behavior for fiscal policy. [JEL F21, F34, G15]
Brazil’s public finances appeared to have been in a shambles prior to the election in October 2002. The September 2002 stand-by credit gave Brazil a critical boost, providing the central bank with an additional $16 billion in international reserves to defend its weak currency and thereby to contain the explosion of dollar-linked public debt service.1 The package also included a promise to increase the available funds to $30 billion, if the primary surplus had increased. Because three-fourths of Brazil’s debt is in domestic currency, and about one-third of this debt is indexed to the dollar, the policy challenge was not only to defend the strength of Brazil’s currency, but also to reduce the level and volatility of domestic interest rates. However, because most of Brazil’s local currency debt is short term, and thus effectively indexed to the rate of interest, Brazil seems to have been vulnerable to self-fulfilling-expectations reversals in capital flows, with the country-risk ratings at the center of the expectations-coordination failure. But, since the presidential elections in October 2002 that brought to power the leftist Workers’ Party, which had a history of anti-market sloganeering, the new government has worked to reassure the markets that Brazil would pay its debts, curb its budget deficits, and reduce inflation. By March 2003, Brazil’s currency had appreciated and the risk premium that investors demand for holding Brazilian debt had dropped significantly (from more than 20 percentage points in October 2002 to 10 percentage points by March 2003). Did credit rating institutions contribute to an overreaction by the markets in the run-up for Brazil’s 2002 election? The Economist (2003), though in a domestic regulation context, describes the potential circularity associated with ratings as follows:
As ratings have been more widely used in regulation, they have begun to affect the market, in a version of Goodhart’s law (that any variable chosen as a monetary-policy target immediately starts to behave differently). Because regulators and banks use ratings to assess credit risk, a rating downgrade can itself become a trigger requiring higher interest payments from a borrower or even driving it into bankruptcy. Similarly, rather as teachers often teach to the test, financial instruments are increasingly designed solely to carry a particular rating, not the other way round.
In this paper we rationalize the sort of circularity involved in country credit ratings. Our main purpose is to develop a simple, textbook-like exposition of how country credit ratings could bring about unstable macroeconomic behavior, and to explore its implications for fiscal policy. We have previously dealt with this subject in Razin and Sadka (2001). The main differences between this paper and our earlier paper are as follows. (1) Investment behavior in this paper is neoclassical, to assure the reader that no other credit frictions are crucial to the argument. In contrast, in our earlier paper investors are subject to a costly state verification to accommodate for potential defaults (as in Townsend, 1979). (2) This paper deals with fiscal policy implications, while in the earlier work we glossed over such implications. (3) The main insight to be obtained from this paper comes from a simple diagrammatic analysis. Thus, our main argument is not clouded by algebra. This paper is also related to Velasco (1996). That paper’s model, however, deals with a different macroeconomic mechanism that could lead to coordination failure. Consequently, the fiscal policy implications are also quite different.
Calvo, Guillermo, 1988, “Servicing the Public Debt: The Role of Expectations,” American Economic Review, Vol. 78 (September), pp. 647–61.
Townsend, Robert M., 1979, “Optimal Contracts and Competitive Markets with Costly State Verification,” Journal of Economic Theory, Vol. 21 (October), pp. 265–93.
Velasco, Andres, 1996, “Animal Spirits, Investment, and International Capital Movements,” Journal of International Money and Finance, Vol. 15 (April), pp. 221–37.
Assaf Razin is the Mario Henrique Simonsen Professor of Public Finance, Tel-Aviv University, a Research Associate at the National Bureau for Economic Research, Research Fellow at the Center for Economic Policy Research, and Research Fellow, CESifo. Efraim Sadka is the Henry Kaufman Professor of International Capital Markets, Tel-Aviv University and Research Fellow, CESifo. This paper was written while the two authors visited the Economic Policy Research Unit (EPRU) at the University of Copenhagen. We wish to thank Martin Uribe for an illuminating discussion.
Although only $6 billion of the new arrangement with the IMF was available in 2002, Brazil’s central bank was also given more flexibility under the program, which cut to $5 billion (from $15 billion) the minimum level of reserves the central bank promises to hold. Thus, in effect, the central bank had an additional $16 billion to defend its currency.
Differentiating equation (1) totally, using the first-order condition (the Envelope Theorem) yields