Endowments, Fiscal Federalism, and the Cost of Capital for States: Evidence from Brazil, 1891-1930
Executive Summary — Do endowments matter in determining the cost of capital for a country or state? Endowments, according to Banco de México's André C. Martínez Fritscher and HBS professor Aldo Musacchio, are the conditions that determine what kind of commodities can be produced and exported in a determined geographical region. Studying the determinants of the risk premium of the bonds issued by Brazilian states between 1891 and 1930—a period of extreme decentralization of fiscal revenues and expenditures in Brazil—the researchers find that risk premia are highly correlated with state public revenue per capita. Because these revenues came, to a large extent, from the taxes states levied on commodity exports, the researchers argue that endowments mattered to determine the cost of capital for states. Key concepts include:
- Between 1891 and 1930, the cost of capital for Brazilian states and the probability of issuing state debt in international capital markets were highly correlated with state revenues per capita.
- The relationship among endowments and the cost of capital for states or the capacity to issue debt may have led to marked differences in access to capital and in the capacity that states had to spend on public goods.
- Since differences in expenditures on public goods can lead to market differences in economic development among states, the setup of the 1891 Constitution promoted some of the regional inequality that is still observed today in Brazil.
There is a large literature that aims to explain what determines country risk (defined as the difference between the yield of a sovereign's bonds and the risk free rate). In this paper, we contribute to the discussion by arguing that an important explanatory factor is the impact that commodities have on the capacity to pay. We use a newly created data base with state-level fiscal and risk premium data for Brazil states between 1891 and 1930 to show that Brazilian states with natural endowments that allowed them to export commodities that were in high demand (e.g., rubber and coffee) ended up having higher revenues per capita and, thus, lower cost of capital. We also explain that the variation in revenues per capita was both a product of the variation in natural endowments (i.e., the fact that states cannot produce any commodity they want) and a commodity boom that had asymmetric effects among states. These two effects generated variation in revenues per capita at the state level thanks to the extreme form of fiscal decentralization that the Brazilian government adopted in the Constitution of 1891, which gave states the sole right to tax exports. We end by running instrumental variable estimates using indices of export prices for each state to instrument for revenues per capita. Our IV estimates confirm our results that states with commodities that had higher price increases had lower risk premia. 47 pages.