1 Afonso Bevilaqua December 2003 Reducing Public Sector’s FX Exposure: The Brazilian Experience

2 I. Background II. Recent Strategy for Reducing Public Sector’s FX Exposure Reducing Public Sector’s FX Exposure: The Brazilian Experience

3 I. Background Reducing Public Sector’s FX Exposure: The Brazilian Experience

4  From the 80s to 1994:  Despite chronic inflation, Brazilian economy has never dollarized.  Broad and credible indexation substituted the dollar as an instrument to mitigate inflationary losses.  Demand for domestic debt was preserved through indexation mechanisms. Reducing Public Sector’s FX Exposure: The Brazilian Experience

5  From 1994 to 1998:  Monetary reform and exchange-rate anchor succeeded in stopping high inflation;  Public sector provided dollar-indexed securities, safeguarding the administered FX regime;  External crises in mid-90s (Mexico, Southeast Asia, Russia) gradually increased vulnerability of the Brazilian economy, with significant losses of international reserves to sustain FX regime. Reducing Public Sector’s FX Exposure: The Brazilian Experience

6  From 1999 to present:  Provision of dollar-indexed securities helped to smooth the transition from administered to floating FX regime, without generalized financial distress or credit crunch;  No significant balance sheet mismatches in the private sector;  3 major waves of devaluation after the move to floating regime (1999, 2001 and 2 nd half of 2002);  Main impact of the 3 waves of devaluation on the public sector’s debt. Reducing Public Sector’s FX Exposure: The Brazilian Experience

7 Debt/GDP Ratio (1994/03) Sep % % of GDP 57.7% Jul 94 May 95 Mar 96 Jan 97 Nov 97 Sep 98 Jul 99 May 00 Mar 01 Jan 02 Nov 02 Sep : lax fiscal policy + high real interest rates : FX realignment

8 Dollar-Indexed Debt / Total Domestic Debt Ratio (91/03) % * * October/2003

9 Exchange Rate R$/US$ (1994/03) Jul 94Jul 95Jul 96Jul 97Jul 98Jul 99Jul 00Jul 01Jul 02 Jul 03 R$/US$ Nov

10 Real Effective Exchange Rate (1994/03) 4.00 Jul 94Jul 95Jul 96Jul 97Jul 98Jul 99Jul 00Jul 01Jul 02Jul R$/US$

11 Net Public Sector Debt vs Real Exchange Rate (1994/03) Jul 94 May 95 Mar 96 Jan 97 Nov 97 Sep 98 Jul 99 May 00 Mar 01 Jan 02 Nov 02 Sep 03 % of GDP R$/US$ Net Debt/GDP Real Effective Exchange Rate

12 Net Public Sector Debt Increase Decomposition - % of GDP (1995/98) Net debt increase1.4%1.9%1.1%7.4%11.7% 1. Primary surplus-0.3%0.1%0.8%0.0%0.7% 2. Pure interest on the debt6.1%5.4%4.8%7.4%21.2% 3. Depreciation on domestic debt0.1% 0.2%0.5%0.8% 4. Depreciation on foreign debt0.9%0.1%0.3% 1.2% 5. Skeletons1.5%2.0%0.1%1.6%4.5% 6. Privatization proceeds0.0%-0.2%-1.8%-1.4%-3.3% 7. Effect of GDP growth-7.0%-5.6%-3.3%-1.0%-13.5% Debt dynamics (1+2+7)-1.2%-0.1%2.4%6.4%8.4% Currency (3+4)1.0%0.2%0.5%0.7%2.1% Net "skeletons" (5+6)1.5%1.8%-1.8%0.3%1.2%

13 Net Public Sector Debt Increase Decomposition - % of GDP (1999/03) *99-03* Net debt increase7.0%0.1%3.8%4.0%1.2%16.0% 1. Primary surplus-2.9%-3.3%-3.5%-3.4%-3.7%-14.4% 2. Pure interest on the debt8.2%6.8%6.9%7.3%7.4%31.1% 3. Depreciation on domestic debt3.8%0.8%1.5%4.9%-1.4%8.0% 4. Depreciation on foreign debt2.8%0.8%1.5%4.5%-2.6%5.7% 5. Skeletons1.3%0.8%1.5%0.9%0.1%3.7% 6. Privatization proceeds-0.9%-1.8%-0.1%-0.2%0.0%-2.2% 7. Effect of GDP growth-5.4%-3.9%-4.0%-10.2%0.6%-16.7% Debt dynamics (1+2+7)0.0%-0.5%-0.6%-6.2%4.2%0.0% Currency (3+4)6.5%1.6%3.0%9.4%-4.0%13.7% Net "skeletons" (5+6)0.5%-1.0%1.4%0.7%0.1%1.5% * Data for September/2003

14 II. II. Recent Strategy for Reducing Public Sector’s FX Exposure Reducing Public Sector’s FX Exposure: The Brazilian Experience

15  Different features of the 2001 and 2002 depreciation episodes:  2001: “pure external shocks”  increase in demand for hedge.  2002: confidence crises  reduction in demand for hedge (and reduction in FX liabilities of private sector). Reducing Public Sector’s FX Exposure: The Brazilian Experience

16  Different responses in the depreciation episodes: In 2001:  Net placement of dollar-indexed securities to mitigate impact of increased demand for hedge on the exchange market;  Dollar-indexed domestic debt rollover rate reached 137.0%. In 2002, before the crisis:  Central Bank introduced FX swaps to replace dollar-indexed Treasury notes (NTN-D); swaps perceived as having lower credit risk (daily margin adjustment) than NTN-D. 2 nd Half of 2002:  Increased risk perception reduced the rollover rate to 45.2% during August/October, averaging 66.4% for the year. Reducing Public Sector’s FX Exposure: The Brazilian Experience

17  2003: rapid improvement in fundamentals enabled the Central Bank to actively reduce public sector’s FX exposure;  Since the end of May, Central Bank announced that it would not rollover a fixed rate of FX securities or swaps maturing;  In July, Central Bank disciplined auction procedures, establishing a maximum of two auctions to be carried out for each rollover;  In September, Central Bank reduced number of auctions to one. Reducing Public Sector’s FX Exposure: The Brazilian Experience

18 FX Instruments Rollover Rate* (2001/03) Jan/Nov 2003 % 137.0% 66.4%65.8% * Includes rollover of intermediary and final interests

19 % Jan 03Feb 03Mar 03Apr 03May 03Jun 03Jul 03Aug 03Sep 03Oct 03Nov Average Jan/May: 87.1%Average Jun/Nov: 41.5% FX Instruments Rollover Rate* (2003) * Includes rollover of intermediary and final interests

20 FX Domestic Debt: Total Outstanding in US$ (1999/03) (Includes Swaps) 2003 to November: Reduction of US$ 6.0 billion Dec 99Apr 00Set 00Feb 01Jul 01Dec 01May 02Oct 02Mar 03Nov : Increase of US$ 18.8 billion US$ billion 2002: Reduction of US$ 8.4 billion OBS: This behavior is partly explained by the rise and later fall of the FX coupon, which affected outstanding marked to market (see next slide).

Jan 02May 02Sep 02Jan 03May 03Sep days360 days FX Coupon (2002/03) Pre-elections period %

22 FX-Indexed Debt/Total Domestic Debt (2000/03) Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02 Dec 02 Jun 03 Oct 03 % peak in Sep/02 (40.7%), especially due to price-effect (FX depreciation) Trough in Oct/03 (24.4%) due to price-effect (FX appreciation) and quantity-effect (Includes Swaps)

Dec 99May 00Oct 00Mar 01Aug 01Jan 02Jun 02Nov 02Apr 03Oct % R$/US$ Exchange Rate FX-Indexed Debt/Total Domestic Debt vs. Exchange Rate (1999/03) FX-Indexed Debt/Total Domestic Debt

24 Stock of Hedge at Cetip (2002/03) US$ billion Jan 02 May 02 Aug 02 Nov 02 Mar 03 Jun 03 Oct 03 40, Cetip: Private central securities depository for Brazilian fixed-income securities and derivatives (OTC market). Data excludes intra-market operations.

25 Exchange Rate Volatility (2002/03) 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% Jan 02May 02Sep 02Jan 03May 03Nov 03  Reduction in demand for hedge partly explained by fall in FX volatility Pre-elections period

26  Main Outcomes:  In 2003, Government actively pursued a strategy aimed at reducing dollar-indexed debt;  Rollover rate of FX instruments reduced to 41.5% in the June/November 2003 period, without any major effect on the FX market;  Share of FX debt to total domestic debt fell to 24.4% in October 2003 from peak of 40.7% in September 2002;  Reduction in FX hedge provision by the public sector in 2003 (including early December rollover) reached US$ 17.6 billion. Reducing Public Sector’s FX Exposure: The Brazilian Experience

27 Afonso Bevilaqua December 2003 Reducing Public Sector’s FX Exposure: The Brazilian Experience