Why are real interest rates stubbornly high?

Debt dynamics will critically depend on real interest rate dynamics. This raises the (perennial) question as to why real interest rates are so high.⁵ Economic theory (let’s call it ex-post rationalisation) points to national savings that are very low or, which is the same, a national propensity to consume that is very high. If this is so, the solution would consist in a reduction in government consumption (and transfers). A credible medium-term adjustment combined with more immediate fiscal tightening should go a long way in reducing interest rates. Another explanation is to do with the reduced, but still considerable indexation of government debt and its relatively short maturity (for a non-reserve currency country). Practically, pushing out maturities against the backdrop of high real interest rates is financially costly. A fiscal adjustment would seem to be a promising avenue to lower interest rates in the wake of which maturities could be pushed out and debt de-indexed. The problem is perhaps not so much the size of the government deficit, which is relatively modest, but the structure of government spending and the residual risk attached to re-financing.

Comparing Brazil to Turkey is instructive. Brazil’s domestic LCY debt has increased as a share of GDP. It is therefore not entirely surprising that nominal and real interest rates on BRL debt have declined more slowly than the decline in the net debt ratio and the narrowing of the fiscal deficit might suggest. Brazil’s experience differs sharply from Turkey’s. Turkey similarly experienced a major financial and public debt crisis in the early 2000s. Thanks to a tight(er) fiscal policy and higher economic growth, it managed to bring down public debt more aggressively than Brazil. Crucially, Turkey reduced its net public sector debt to 30% of GDP from 70% in 2001, compared to Brazil where the comparable ratio declined from more than 60% of GDP to just below 40% of GDP. More importantly, Turkey’s TRY debt is relatively low at around 30% of GDP compared with more than 50% of GDP in Brazil.

Real ex-ante interest rates are currently zero, compared with around 7% in Brazil. Zero real interest rates are probably not consistent with 5% inflation in Turkey, but the equilibrium real interest rate is no doubt significantly lower than in Brazil. A cursory comparison suggests that Brazil should make a greater effort to reduce its net public debt, ideally via a reduction in gross domestic BRL debt. A glance at GG gross interest payments shows that the savings potential stemming from lower interest rates is enormous.

Fiscal reforms would accelerate decline in real rates

While short-to medium-term debt sustainability is not a problem, the government nonetheless ought to implement wide-ranging reforms in order to create fiscal space and to reduce real interest rates more aggressively. It would be desirable to introduce a “structural” primary surplus rule, which could/should – once the indexation of govern-ment debt and annual financing requirements have declined further – be upgraded to a nominal balance target.

During the first half of the 2000s, the government committed itself to a primary surplus due to the large share of indexed debt, which made interest payments difficult to predict and nominal deficit target difficult to meet due to the unpredictability of interest payments in any given year. It would be desirable to move towards a cyclically-adjusted primary balance target, allowing for tangible short-term deviations from its medium-term target.⁶ This would also make it unnecessary to resort to accounting changes in an attempt to embellish fiscal outcomes (in the short term). It would also prevent Brazil from being forced to pursue pro-cyclical fiscal policies.

From a more short-term and real interest rate perspective, the government should raise the primary surplus more aggressively by reducing current spending as a share of GDP. Federal primary spending has been rising inexorably over the past decade. In the short term, this may not even require large-scale, big-ticket reforms like social security and pension. However, politically, it is difficult to sell a tighter policy when debt is already declining and solvency concerns are not an issue. The government seems to have finally come round to this view. It remains to be seen if the government is able to meet its recently announced enhanced primary surplus target given the rise in the minimum wage, related fiscal spending and significant pressure to raise public sector wages. The need to raise investment spending won’t help, either, from a short-term adjustment perspective.

Brazil should also implement a medium- and long-term adjustment. Medium- and long-term adjustment would require relatively wide-ranging and politically difficult reforms. For example, both revenue and expenditure are very rigid (“earmarking”). The World Bank⁷ estimates that only 10% of expenditure and 20% of revenue are “free” (that is, not linked or earmarked). Much of the expenditure is indexed to the minimum wage, introducing a further element of rigidity. Brazil will face medium- and long-term spending pressure arising from social security and pension obligations. The political challenge is to muster the will to put forward reforms and win the large constitutional majorities necessary for their adoption. Sooner or later, these reforms will have to be introduced due to the pro-jected rise in social security payments.