Departamento De Economia Puc-rio Texto Para Discussão N. 464 Public Debt Management, Monetary Policy and Financial Institutions

Despite the large size of the Brazilian debt market, as well the large diversity of its bonds, the picture that emerges is of a market that has not yet completed its transition from the role it performed during the megainflation years, namely that of providing a liquid asset that provided positive real returns. This unfinished transition is currently placing the market under severe stress, as fears of a possible default from the next administration grow larger. This paper analyzes several aspects pertaining to the management of the domestic public debt. The causes for the extremely large and fast growth of the domestic public debt during the seven-year period that President Cardoso are discussed in Section 2. The main culprit is the very high and risky interest rate, with the recognition of old debts (hidden liabilities and state debt renegotiation) coming in second. Section 3 computes Value at Risk and Cash Flow at Risk measures for the domestic public debt. These risk measures show that the current composition of the public debt is very risky. The rollover risk is introduced in a mean-variance framework in Section 4, and the maturity structure evolution is discussed. The increased riskness was the cost to improve the maturity structure. Section 5 discusses a few issues pertaining to the overlap between debt management and monetary policy. Finally, Section 6 wraps up with policy discussion and policy recommendations. 1Introduction.................................................................................................................. 4 2Decomposing the Public Debt Growth ....................................................................... 4 3.Risk Measures for the Public Debt ............................................................................... 7 3.1. Value-at-Risk (V@R) ............................................................................................ 9 3.2. Cash-Flow at Risk (CF@R) ................................................................................ 14 3.3. V@R and CF@R Together................................................................................. 17 4. Rollover Risk............................................................................................................... 18 4.1. Mean-Variance with Rollover Risk........................................................................ 19 4.1.1. An example with two assets ................................................................................. 19 4.1.2. Rollover Risk and the Minimum Degree of Indexation.................................... 20 4.2. The Problem with Multiple Bonds ......................................................................... 22 5. Monetary Policy and Public Debt Management ...................................................... 25 5.1. Monetary Policy Regimes and the Demand for Debt ....................................... 25 5.2. Reserve Requirements ......................................................................................... 26 5.3. The Financial Transactions Tax (CPMF).......................................................... 27 5.4. Open Market Operations and the Provision of Liquidity to Banks................ 28 6.Conclusion and Policy Discussion .............................................................................. 29 APPENDIX 1: Value-at-Risk Methodology ... 501.1 – Nominal and Dollar Linked Bonds .............................................................................................................................................. 50 1.1.1Volatility Estimation ................................................................................................ 50 1.1.2 Mapping: .................................................................................................................. 50 1.1.3Value-at-Risk: ........................................................................................................... 51 1.2 – Inflation-Linked Bonds ............................................................................................. 52 APPENDIX 2: Cash Flow at Risk Methodology.............................................................. 56 2.1 – Vector Auto regression estimation ....................................................................... 56 2.1.1 – Variables.......................................................................................................... 56