A Brazilian-Type Debt Crisis Simple Analytics.docVIP

A Brazilian-Type Debt Crisis: Simple Analytics* Assaf Razin( and Efraim Sadka((June 2003 Abstract We develop a model that captures important features of debt crises of the Brazilian type. Its applicability to Brazil lies in the fact that (1) macro fundamentals were relatively sound in the wake of the crisis (e.g., a non-negligible primary surplus, a relatively low debt/GDP ratio, low inflation, etc.); and (2) the trigger for the crisis appears to be extraneous; that is, forthcoming elections with an expected regime change. 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 its implications for fiscal policy. 1. Introduction Brazil public finances appeared to have been in shambles prior to the election in October 2002. The IMF accord from August 2002 gave Brazil a critical boost, providing the central bank with a total additional $16 billion in international reserves to defend its weak currency and thereby to contain the explosion of dollar-linked public debt service. The package also included a promise to increase the loan to $30 billion, if the primary surplus had increased. Because three-quarters of Brazil’s debt is in domestic currency, and around a third of this debt is indexed to the dollar, the policy challenge was not only the strength of Brazil’s currency. The challenge was 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, which brought to power the leftist Workers’ Party that had a history of anti-market sloganeering, the new government ha