Friday, April 10, 2009

Why Does Brazil Have High Interest Rates?

Scholars have proposed a few innovative explanations for the fact that Brazilian short-term interest rates are high in nominal and real terms, in spite of the improvement in macroeconomic fundamentals. Nominal and real interest rates have remained high even after the surge in inflation that accompanied the currency and financial crisis of 2001/02 subsided.

Persio Arida, Edmar Bacha and Andre Lara-Resende argue that uncertainties in the settlement and enforcement of contracts, lack of effective collateral, capital controls and legal restrictions on the ability to write contracts denominated in foreign currency ultimately explain high short-term interest rates. This “jurisdiction uncertainty” accounts for why there is not a large long-term domestic credit market in Brazil. Their main conclusion is that short-term interest rates will tend to be higher in Brazil than anywhere else in South America, unless there is an improvement in the enforcement of Brazilian laws and a more “convertible” Brazilian currency.

Fernando Goncalves, Marcio Holland and Andrei Spacov look at the impact of “jurisdiction uncertainty” and the legal restrictions on currency convertibility on a panel of countries that compose the Emerging Market Bond Index (EMBI). They find that short-term interest rates are explained by traditional monetary and fiscal policies, not by “jurisdiction uncertainty”.

Another strand of the literature emphasizes the huge burden of Brazil’s public debt. Carlo Favero and Francesco Giavazzi argue that the risk of sovereign default, and not just future inflationary expectations, explains high interest rates. Short-term domestic interest rates are strongly correlated with Brady-bond spreads. The authors conclude that macroeconomic fundamentals and debt dynamics are the main determinants of the term premium. Accordingly, short-term interest rates will remain high until the debt problem is properly addressed.

Inflation targeting can lead to an increase in the volatility of key nominal variables and to an overestimation of the interest rates required to achieve the target rate of inflation. Roberto Macedo argues that such imprecision in the inflation targeting model may result in high real interest rates in Brazil. An open issue is how fast the Brazilian monetary authority will reduce short rates in 2009 as inflation eases.

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