The Political Dimension of Fiscal Policy Making: Public Debt, Political Cycles and Capital Markets

Compared with the OECD, revenues and expenditures claim a small share of GDP in Latin American
countries. But the differences between them have often produced OECD-sized deficits. The legacy of
those deficits is public debt, the management of which has long posed problems for governments in
the region. Latin America still has high levels of debt, leaving countries in the region vulnerable to
adverse shocks. But this fact should not obscure the considerable progress made by Latin American
countries in managing the composition of that debt, in particular reducing their exposure to currency
mismatches – where government revenues and debt-service obligations are denominated in different
currencies.

A market for public debt denominated in Latin American currencies is not new; what is new is that
Latin American governments have been increasingly able to place local currency debt abroad, aided
by the strong economic conditions. But challenges remain. For instance, while available maturities in
domestic bond markets have increased over recent years, the overall maturity profile of the region’s
debt is short when compared to other emerging markets as well as developed countries.

A major characteristic of Latin American sovereign-bond markets is that they have been keenly
sensitive to political events – for example reacting negatively to the uncertainty that is an inherent
feature of democratic elections. Not just economic policies but also the economic policy platforms
of electoral candidates have a significant influence on the behaviour of Latin American sovereign-
bond markets at these times.

First, investors worry that incumbent political parties will expand spending to encourage political
support, with costs for post-election economic performance. This is not unreasonable: evidence
of such political business cycles has been observed in rich and poor democratic countries alike.
Second, capital markets are unsettled by uncertainty about the economic policies that will be pursued
following the election.

The different reactions in the capital markets to the two elections won by Brazilian president Luiz
Inácio Lula da Silva provide a clear example of the role political parties and candidates play in this
regard. Perceived as the populist opposition to a fiscally conservative government in 2002, markets
reacted with apprehension to Lula’s candidacy as soon as his campaign began to gain momentum
and investment bank recommendations moved sharply negative on Brazil. Yet once in power a
communication campaign and a commitment to credible policies reassured the markets and confidence
returned. When the same Lula was re-elected in 2006, against an opponent who also espoused
credible policies, the presidential elections caused hardly a ripple in the markets.