Wednesday, August 2, 2006

Fiscal Dominance in Brazil: Another Game of Chicken in 2007?

The ’fiscal theory of the price level’ suggests that fiscal deficits may or may not lead to high inflation depending on whether there is ’fiscal dominance’ or ‘monetary dominance’ in a ’game of chicken’ between the monetary and fiscal authorities. If there is ‘fiscal dominance’, fiscal deficits will eventually force the central bank to monetize the deficit, i.e. to increase seigniorage and use the inflation tax to finance an exogenous fiscal deficit path. If there is ’monetary dominance’, a credible central bank commitment not to monetize the deficits forces the fiscal authority to adjust its budget policy (cut spending or raise taxes) to satisfy its inter-temporal budget constraint.

Tanner & Ramos evaluate whether the policy regime in Brazil during the 1990s can be characterized as either fiscal or monetary dominant. The empirical results show some evidence of a monetary dominance between 1995-97, though what appeared to be a monetary dominant regime became a fiscal dominant one when the Asian crisis began. However, Brazil has been living under an inflation targeting regime since 1999. For such a regime to be successful the country cannot maintain fiscal dominance; instead, fiscal authorities should produce persistent primary surpluses to avoid an increase in debt or inflation.

Blanchard illustrates the fiscal dominance view with reference to the 2002 presidential elections in Brazil. In the months prior to the election, a sharp increase in the yields on Brazilian government dollar-denominated debt suggested that investors had a greater degree of uncertainty on the future of Brazil’s economic policy, in general, and Brazil public debt, in particular. The puzzling issue is why the Central Bank did not increase domestic interest rates in order to assure that it would meet its inflation target. Blanchard argues that the Central Bank was correct not to increase rates. This is so because higher interest rates would have led to an increase in the country’s probability of default given Brazil’s large public debt stock, triggering an outflow of capital, depreciation of the Real and hence even higher inflation. Brazil had to reduce its fiscal dominance by producing greater primary surplus before the Central Bank could credibly use monetary policy as a tool to prevent inflation.

Favaro & Giavazzi note that the ability of Brazil’s economy to withstand international financial shocks depends on investors perceptions of the country’s future fiscal stance. They find that investors’ perception of the risk of default on Brazil’s external debt -- as measured by the Emerging Market Bond Index (Embi) -- changes according to the state of domestic fiscal policy. When the level of primary budget surplus is adjusted so that its level is large enough to keep the debt ratio stable, a negative external shock does not lead to a change in Brazil’s Embi spread. However, if Brazil is hit by a negative external shock but does not increase its primary surplus in such a way that the debt to GDP is constant, then the dynamics can differ. Without an increase in primary surplus sufficient to keep the debt/GDP ratio unchanged in the face of the shock, the rise in ratio of debt to GDP leads investors to assign a higher probability of default, which is usually reflected by an increase in the Embi spread. The higher spread may induce an outflow of capital and hence a depreciation of domestic currency, higher inflation expectations and eventually higher inflation. This in turn, might induce the Central Bank to increase its interest rates, which will mainly lead to an increase in Brazil’s domestic debt stock and growing concerns about external default. In other words, to avoid ‘fiscal dominance’ the government should increase its primary surplus according to negative external shocks.

One might then infer that Brazil’s significant primary surpluses have eliminated the problem of ‘fiscal dominance’. Unfortunately, investors’ expectations on Brazilian fiscal solvency are not yet clear. This point is explored in detail by Gruben & Welsh. They conclude that fiscally dominated governments, like Brazil, may have to produce a primary surplus greater than the one predicted by the markets, as a way to enhance the country’s credibility and solvency.

The issue of fiscal dominance likely will become important again in Brazil. Markets currently expect the policy rate (Selic) in Brazil to fall sharply from the current 14.75% to 14% by the end of 2006 and down to 13% by the end of 2007. But the recent increase in primary spending associated with the election cycle has to be of concern to monetary authorities as it may increase inflation via its demand effect and may lead to higher debt if the primary surplus shrinks. In turn, monetary authorities may reduce the Selic rate less than currently expected by the markets unless the fiscal authorities, after the election, reduce the current runaway fiscal spending. So a new ‘game of chicken’ is likely to be played in Brazil in the next year.

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