Brazil: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.
Publication Date:
13 Jul 2017
eISBN:
9781484309919
Language:
English
Keywords:
ISCR; CR; Brazil; only EMs; GDP variable; reversals in the fiscal adjustment; real interest rates to fiscal consolidation episode; rate of consumer inflation; Real interest rates; Fiscal stance; Yield curve; Global
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Selected Issues

Abstract

Selected Issues

The Effect of Fiscal Consolidation on Real Interest Rates in Emerging Market Economies1

In 2016, the Brazilian authorities introduced reforms aimed at controlling the budget deficit to improve fiscal discipline, boost confidence in the economy and increase growth. In this context, the Congress passed a 20-year public spending ceiling. At the same time, Brazil has been slowly recovering from one of the most severe recessions, during which output fell by a cumulative 7.5 percent during 2015–16. In addition, real interest rates have been among the highest in Emerging Market economies (EMs), further hampering growth. Given the authorities agenda geared towards imposing fiscal discipline, we examine the relationship between fiscal consolidation episodes and real interest rates among EMs. The key findings suggest that there are beneficial, but relatively moderate and short-lived effects of fiscal consolidation on real interest rates, possibly reflecting difficulties in continuing the adjustment over a long time.

A. Fiscal Policies in Brazil

1. The policy agenda seeks to promote fiscal discipline. In December 2016, the authorities passed a 20-year constitutional amendment limiting growth in federal noninterest spending to the rate of consumer inflation of the previous year. To further reinforce fiscal discipline and ensure sustainability, an ambitious social security reform bill is being discussed in Congress. Provided they are successfully implemented, the set of policies is expected to put government accounts in order and invigorate business confidence and growth.

2. The implementation of reforms is timely for Brazil as fiscal condition have been on a declining path. In the period 2013–15, the debt-to-GDP ratio increased by about 10 percentage points on average, and the cyclically adjusted primary balance (CAPB), i.e. the non-interest balance adjusted for business cycle effects,2 has been consistently worsening since 2009 (Figure 1).

Figure 1.
Figure 1.

Cyclically Adjusted Primary Balance in a Set of EMs

(In percent of GDP)

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

Sources: IMF WEO and author’s calculations.

3. Many observers think that fiscal consolidation is going to reduce interest rates. Consolidation efforts are expected by many to have positive effects by decreasing real short- and long-term interest rates, which for Brazil have been among the highest in EMs (Figure 2). Earlier studies have shown that episodes of fiscal tightening are likely to be accompanied by expansionary monetary policy to offset the contractionary impact of fiscal tightening (e.g. IMF, 2010). Moreover, a successful implementation of fiscal reforms could increase confidence, improve fundamentals and decrease the risk premium observed in long-term interest rates. To shed light on how fiscal policies could affect interest rates in Brazil, this study builds a panel dataset that consist of 73 countries and identifies episodes of fiscal consolidation during 2001–15. Then, using statistical techniques, it quantifies the effect of fiscal consolidation episodes on real short- and long-term interest rates in EMs to try to draw some lessons that may be useful in the discussion of Brazil.3

Figure 2.
Figure 2.

Real Rates in a Set of EMs

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

B. Fiscal Consolidation Episodes

4. The analysis employs the so-called outcome-based approach in identifying historical cases of fiscal consolidation. Episodes are identified based on changes in the cyclically adjusted primary balance (CAPB).4 There are different ways to calculate the CAPB.5 The approach followed here is the one from OECD (2009):

CAPBt=Rt(Y¯tYt)eR−Et(Y¯tYt)eE

where Rt denotes government revenues, Et denotes non-interest expenditures, Ȳt denotes potential output and Yt denotes actual output; eR and eE are the elasticities of revenues and expenditures with respect to the output gap, which take values of 1 and 0, respectively.6 Then, an episode of fiscal adjustment is identified using the following definition (similar to the one in Alesina and Ardagna (2012):

A fiscal adjustment is a period of 2 years during which the cyclically adjusted primary balance/GDP improves in each year and the cumulative improvement is at least two percentage points of the actual GDP.

5. How many episodes of fiscal consolidation were there in our sample? Table 1 in the Appendix summarizes the episodes of fiscal consolidation that were identified based on the definition stated above. In total, there were 232 fiscal consolidation episodes for 73 countries in the period 2001–15. On average, fiscal consolidations amounted to 2.2 percent of GDP per year. For the sample of EMs, there were 35 fiscal consolidation episodes, amounting to a consolidation of 1.8 percent of GDP per year on average.7 We also try an alternative definition of an episode, defining it as an improvement in the cyclically adjusted balance by 3 (instead of 2) percentage points of GDP. By this criterion, there were only 18 consolidation episodes identified among EMs, not allowing for reliable econometric analysis.

6. During the period 2001–15 no fiscal consolidation episodes were recorded for Brazil. The public sector underwent a period of fiscal adjustment during the late 1990s, but this happened before the start of our sample period. Throughout most of the 2000s, the cyclically adjusted primary balance remained positive with an average of 2.8 percent of GDP for the period 2003–13. The balance started decreasing in 2009 before turning negative in 2014.

C. Econometric Specification

7. To estimate the effects of fiscal consolidation on interest rates, the Local Projections (LP) method proposed by Jorda (2005), was employed. In a nutshell, the advantage of this method is that it produces Impulse Response Functions (IRFs) using ordinary least squares (OLS). Unlike standard vector auto-regression (VAR) models, this method does not constrain the shape of the IRF, therefore permitting a more robust lag specification. Moreover, since the IRFs are obtained using OLS, interaction terms can easily be added to extend the analysis, allowing for cross-country heterogeneity. The baseline specification follows Alesina and Ardagna (2012) and IMF (2010):

ri,t+h=α+Σj=12βj,hri,t−j+Σj=02φj,hΔCAPBi,t−j+ρhΔCAPBi,tFC+θhΔCAPBi,tFC,EMs+γi,h+μi,h+ϵi,t,

where rit denotes the real policy rate or the real 10-year government bond yield, ΔCAPB is the change in the cyclically adjusted primary balance, ΔCAPBFC is an interaction variable between a fiscal consolidation episode and the change in the cyclically adjusted primary balance (Episode * ΔCAPB), γi is a vector of country fixed effects to capture country-specific characteristics, μt is a vector of time fixed effects to capture global business effects, and εit is the error term. Finally, ΔCAPBFC,EMs is an interaction variable obtained by multiplying ΔCAPBFC with a dummy variable that takes the value of 1 if a country is an emerging market and zero otherwise (EMs * Episode * ΔCAPB). This interaction term allows for the coefficient Θ to differ for EMs compared to all remaining countries in the sample. Then, the marginal effect, calculated as:

∂ri,t+h∂Episode=ρhΔCAPBi,t+θhEM*ΔCAPBi,t

depicts the responses of real interest rates to fiscal consolidation episodes. Given that the marginal effect captures how EMs respond only in comparison to other countries in the sample, we also examine the behavior of EMs alone in Section E (not relative to other economies). In both cases the findings are aligned.

8. Fiscal consolidation episodes are accompanied by decreases in real rates in EMs. Given a fiscal consolidation episode, a one percentage point improvement in the change of the cyclically adjusted primary balance is associated with approximately 100 basis points decrease in the real policy rate (Figure 3, Panel 1). The effect is short lived, but significant for about 6 months during the period of fiscal retrenchment. Based on the experience of EMs, this suggests that fiscal consolidation episodes are accompanied by accommodative monetary policy to counterbalance the effects of fiscal consolidation. The effect of fiscal tightening appears to be less pronounced on the 10-year real government bond yield. Namely, given a fiscal consolidation episode, a one percentage point improvement in the change of the cyclically adjusted primary balance is associated with approximately a 70 basis points decrease in the real policy rate (Figure 3, Panel 2). The response is only significant initially for the first couple of months during the consolidation episode. Under the expectation hypothesis, the 10-year real rate at any point in time encompasses the average of the future short rates over the following 10 years and a risk premium. The results suggest that fiscal consolidation does affect both components, though it cannot be inferred whether the impact on expectations or the risk premium dominates. Nonetheless, the effect does not seem to be long-lasting given that the responses turn insignificantly different from zero as time progresses.

Figure 3.
Figure 3.

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

9. One criteria to judge the success of the consolidation is by the reversals in the fiscal adjustment, which may explain the short-lived effect of tightening on interest rates. Gupta and others (2002) find that the probability of reversals in fiscal adjustment are as high as 70 percent at the end of the second year (for low income countries). In line with those findings, in the sample of countries studied here, reversals occur on average after the second year (Figure 4, Panel 1), and almost all EMs experience reversals in the fiscal adjustment during the fourth year following the consolidation (Figure 4, Panel 2).8 These reversals are likely to explain why fiscal tightening does not appear to have a long-lasting effect on interest rates.

Figure 4.
Figure 4.

Fiscal Adjustment Reversals in EMs

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

D. The Effect of Debt Outstanding

10. Do countries with larger outstanding debt levels experience larger benefits from fiscal consolidation? There is evidence that the response of interest rates to movements in fiscal policy tends to be of larger magnitude in countries that exhibit higher outstanding debt levels (e.g. Nakamura and Yagi, 2015 among others). To examine this question, we augment the above equation by an additional term to capture the difference in response of interest rates in emerging markets with different outstanding debt levels. In this case, the above equation becomes

ri,t+h=α+Σj=12βj,hri,t−j+Σj=02φj,hΔCAPBi,t−j+ρhΔCAPBi,tFC+θhΔCAPBi,tFC,EMs+ωhΔCAPBi,tFC,EMs,LD+γi,h+μt,h+ϵit,

where ΔCAPBFC,EMs,LD is an interaction variable between ΔCAPBFC,EMs and a dummy variable, which takes a value of one if a country has a gross outstanding debt higher than 60 percent of GDP and zero otherwise.9

11. The negative relationship between interest rates and episodes of fiscal consolidation is observed also when controlling for outstanding debt levels. Given a fiscal consolidation episode, a one percentage point improvement in the change in the cyclically adjusted primary balance reduces the interest rate by almost 200 basis points (Figure 5, Panel 1). The finding is qualitatively the same as before, but quantitatively stronger. On the other hand, the response of the real 10-year government bond yield is of the same magnitude as before (around 70 basis points). However, the effect appears to be significant only during the first year while the fiscal consolidation is still ongoing (Figure 5, Panel 2).

Figure 5.
Figure 5.

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

(D>60 percent of GDP)

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

E. Robustness

12. Control for real GDP-per-capita. The country fixed effects do not control for time-varying country specific characteristics. Therefore, we augment the equations above by the GDP-per-capita levels. The main results are not affected by the addition of real GDP since the coefficients on our key variables of interest, depicting the marginal effect of fiscal consolidation episodes on interest rates, remain intact. This outcome suggests that the country and time fixed effects capture the cross-country and time variation and the GDP variable is redundant in the specification.

13. Control for terms of trade. Since the cyclically adjusted balance may be influenced by other factors such as the terms of trade, especially for countries that are commodity exporters, we test additional specifications by including countries’ terms of trade (defined as the change in the index) as a control. The coefficient on the terms of trade variable is not significant, suggesting as before that the country and time fixed effects control for the terms of trade variation.

14. Change the definition of fiscal consolidation episodes. To examine the extent to which the results are sensitive to the rate at which a fiscal consolidation episode is defined, we modify the definition of an episode to be an improvement in the cyclically adjusted balance by 1.5 (instead of 2) percentage points of GDP. In this case, the effect of fiscal consolidation on interest rates is qualitatively the same, but the responses are of somewhat lower magnitude. This result is not surprising given the more moderate degree of fiscal tightening.

15. Restricting the sample to EMs countries. The earlier analyses reflect how the responses of EMs differ from the rest of the countries considered in the sample. Here, we inspect whether the same specification delivers similar conclusions on the response of interest rates to fiscal consolidation episodes when the sample is restricted only to EMs. The regression equation now excludes the interaction term ΔCAPBFC,EMs and the coefficient of interest is ρh. Even though the sample now is smaller, the key results continue to hold. The real policy rate responds negatively to a fiscal consolidation episode, but the magnitude is somewhat lower (Figure 6, Panel 1). Similarly, the real government bond yield responds negatively to a fiscal consolidation episode with a somewhat lower magnitude (Figure 6, Panel 2). This difference in responses between the full sample and the restricted sample suggests that not only EMs respond differently to all other countries, but the negative relationship between real interest rates and fiscal consolidation episodes holds within the EM sample alone.

Figure 6.
Figure 6.

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

(Restricted sample to EMs only)

Citation: IMF Staff Country Reports 2017, 216; 10.5089/9781484309919.002.A006

F. Conclusion and Policy Recommendations

16. Fiscal consolidations tend to have beneficial, but relatively moderate and short-lived effects on real interest rates. The study shows that in response to a fiscal consolidation episode, the real short-term rate is likely to decrease by approximately 100 basis points, whereas the real bond yield is expected to decrease by about 70 basis points. The effects, however, appear to be significant only for a short period, likely reflecting the proclivity of fiscal adjustments to falter and suffer reversions after a period of time.

17. Efforts to impose fiscal discipline should be accompanied by policies aimed at alleviating the inefficiencies present in the financial sector. Based on this analysis, the fiscal policies implemented and those on the agenda are certainly in the right direction to decrease rates and allow for more stable growth in the long-run. However, fiscal problems are not the sole culprit of high rates, implying that other factors such as inefficiencies present in the financial sector could provide further explanation to the behavior of interest rates observed in Brazil.

18. What does this mean for Brazil? In principle, we could expect some positive effects from fiscal consolidation, but it is difficult to draw definitive conclusions because of the peculiarities. Brazil’s episode of fiscal consolidation will be long, but it has been preannounced, and is also accompanied by monetary easing. The main lesson to draw is that gains in interest rates can be expected if fiscal consolidation can be maintained.

Appendix I. Data

Table 1 contains the list of all the countries used in the analysis and the years for which fiscal consolidation episodes have been identified using the methodology discussed in the main text.

Table 1.

Outcome-Based Approach: Episodes of Fiscal Consolidation

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The data span over the period 2001–15, however the panel is unbalanced due to availability prior to 2002 with respect to the fiscal variables for some of the countries. All the variables along with the data sources are listed in Table 2. The series for GDP per capita were converted to real by using the countries’ respective GDP deflators from the WEO database. Potential output was estimated using the HP-filter with a penalizing parameter set to 6.5, which corresponds to yearly data.

The sample of Emerging Market economies (EMs) includes the largest EMs based on geographical area: Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Korea, Thailand, Turkey.

Table 2.

Data Sources

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Appendix II. Methodology

The Local Projection (LP) method, suggested by Jorda (2005), comprises of projecting the future behavior of the dependent variable (real interest rates in this study) on an unchanged set of explanatory variables. Then, a series of regressions are estimated in which the set of explanatory variables remains unchanged and only the dependent variable is being forwarded one period ahead for every regression. The coefficients of interest, depicting marginal effects, are stored and plot as impulse responses. More specifically, for the regression equation in Section C, the marginal effects of a fiscal consolidation episode on interest rates are given by

∂ri,t+h∂Episode=ρhΔCAPBi,t+θhEM*ΔCAPBi,t.

In this way, the coefficients above trace the response of interest rates at t+h to a fiscal consolidation episode that has occurred at time t.

One of the challenges that this estimation poses is the serial correlation due to lagging and successive leading of the dependent variable. Furthermore, it assuming cross-sectional independence of the error terms might be problematic. To control for both serial correlation and cross-sectional dependence we use Driscoll-Kraay standard errors.1

References

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  • Blanchard, Olivier J., 1990, “Suggestions for a New Set of Fiscal Indicators,” OECD Economics Department Working Papers No. 79.

  • Caselli, Francesca G. and Agustin Roitman, 2015, “Non-Linear Exchange Rate Pass-Through in Emerging Markets,” IMF Working Paper No. 16/1 (Washington: International Monetary Fund).

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  • Driscoll, John and Aart Kraay, 1998, “Consistent Covariance Matrix Estimation with Spatially Dependent Panel Data,” The Review of Economics and Statistics, Vol. 80(4), pp. 549–560.

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  • Guajardo, Jaime, Daniel Leigh, and Andrea Pescatori, 2011, “Expansionary Austerity: New International Evidence,” IMF Working Paper No. 11/158 (Washington: International Monetary Fund).

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  • Gupta, Sanjeev, Benedict Clements, Emanuele Baldacci, and Carlos Mulas-Granados, 2002, “Expenditure Composition, Fiscal Adjustment, and Growth in Low-Income Countries,” IMF Working Paper No. 02/77 (Washington: International Monetary Fund).

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  • International Monetary Fund, 2010, “Will it Hurt? Macroeconomic Effects of Fiscal Consolidation,” World Economic Outlook, Chapter 3.

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  • Jorda, Oscar, 2005, “Estimation and Inference of Impulse Responses by Local Projections,” American Economic Review, Vol. 95(1), pp. 161–82.

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  • Nakamura, Koji and Tomoyuki Yagi, 2015. “Fiscal Consolidation and Long-term Interest Rates,” Bank of Japan Working Paper, No. 15-E-10.

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  • OECD, 2009, “Computing Cyclically Adjusted Balances and Automatic Stabilizers,” Fiscal Affairs Department.

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1

Prepared by Nina Biljanovska (WHD).

2

The methodology for the calculation of the CAPB is discussed in Section C.

3

Real interest rates are calculated using the Fisher equation, rt = it – πt, where it is the average annualized interest rate in year t and πt is the realized inflation in the same year.

4

An alternative way to identify the fiscal consolidation episodes is the action based approach (Romer and Romer, 2010), which identifies episodes based on records of fiscal actions found in historical documents (Budget Speeches, Budgets, central bank reports, IMF Staff Reports, IMF Recent Economic Developments reports, and OECD Economic Surveys, see for example Guajardo, Leigh, Pescatori, 2011). Even though this method would be preferred because of the discretionary nature of the policy actions, there is no ready-to-use dataset containing the information on such policy changes for the large sample of countries considered in this study.

5

For example, Blanchard (1990) calculates the cyclically adjusted balance as the change between a measure of the fiscal variable at period t, computed as a function of the unemployment rate at t-1, and the actual value of the fiscal variable at t-1.

6

These elasticities are rough approximations in the absence of country specific information, and are likely to be more accurate in the context of EMs.

7

The sample of EMs includes the large emerging markets based on geographical areas: Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Thailand, Turkey.

8

Fiscal adjustment reversals are calculated as the difference between the CAPB as a percentage of GDP at period t+h and period t, where h denotes the number of periods after the fiscal consolidation episode has taken place.

9

This threshold level, although arbitrary, is familiar owning to the Maastricht Treaty.

1

Driscoll and Kraay (1998) suggest an estimator that generates heteroskedasticity and autocorrelation-consistent standard errors that are also robust to cross-sectional dependence (see for e.g. Caselli and Roitman, 2015).

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Cover IMF Staff Country Reports
Brazil: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.
Volume/Issue:
Volume 2017: Issue 216
Publisher:
International Monetary Fund
ISBN:
9781484309919
ISSN:
1934-7685
Pages:
111
DOI:
https://doi.org/10.5089/9781484309919.002
  • View in gallery

    Cyclically Adjusted Primary Balance in a Set of EMs

    (In percent of GDP)

  • View in gallery

    Real Rates in a Set of EMs

  • View in gallery

    The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

  • View in gallery

    Fiscal Adjustment Reversals in EMs

  • View in gallery

    The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

    (D>60 percent of GDP)

  • View in gallery

    The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

    (Restricted sample to EMs only)

Cyclically Adjusted Primary Balance in a Set of EMs

(In percent of GDP)

Real Rates in a Set of EMs

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

Fiscal Adjustment Reversals in EMs

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

(D>60 percent of GDP)

The Response of Real Interest Rates to Fiscal Consolidation Episodes in EMs

(Restricted sample to EMs only)