The impact of government behavior on debt market expectations

Abstract

This paper proposes a novel measure to gauge market expectations of fiscal commitment and shows that such expectations significantly affect the market’s short- and medium-term expectations for the public debt-to-GDP ratio. We develop a Fiscal Commitment Index for Brazil, which extracts the government’s long-term adherence to fiscal sustainability from a fiscal reaction function using the Kalman filter. Empirically, we demonstrate that an increase in fiscal commitment leads to a reduction in debt expectations, particularly in a high public debt environment. The analysis further reveals that strengthened commitment reduces the volatility and the dispersion between optimism and pessimism in market expectations. Finally, we identify an asymmetric effect: deteriorations in fiscal commitment worsen expectations more severely than improvements do, especially under high debt. The findings underscore that credible long-term fiscal commitment is a critical determinant of market sentiment regarding public debt.