When Public Credit Meets Monetary Policy: Evidence from Brazil’s Lending System

The paper shows that government credit in Brazil helps protect small firms from rising interest rates during monetary tightening but weakens the overall effectiveness of monetary policy. Earmarked credit, especially when intermediated by private banks, further distorts transmission through lending relationships and cross-subsidization, creating trade-offs between development goals and monetary control.

An IMF working paper, produced by researchers from the International Monetary Fund, the World Bank Group, and the Central Bank of Brazil, explores how government credit programs shape the way monetary policy affects borrowing costs. The study is motivated by the growing use of public credit during crises such as the Global Financial Crisis and the COVID-19 pandemic, when governments relied heavily on banks to keep credit flowing. While the state funds these programs and therefore are fiscal in nature, they operate through the financial system, raising an important question: do they support or undermine the effectiveness of interest-rate policy?

Brazil as a Natural Testing Ground

Brazil provides an ideal setting to answer this question because government involvement in credit markets is both large and diverse. Public banks, especially the Brazilian Development Bank (BNDES), lend directly to firms, often at subsidized rates. At the same time, the government runs extensive earmarked credit programs, where funds are either lent directly by public banks or channeled through private banks under specific rules. Between 2011 and 2016, the period studied in the paper, these programs expanded rapidly as economic growth slowed. By the end of this period, government banks accounted for more than half of total credit, and earmarked loans represented about half of corporate lending, making Brazil a powerful case study of state-led finance.

What Happens to SMEs When Rates Rise

The clearest result of the paper concerns small and medium-sized enterprises. During periods when the central bank tightened monetary policy, loans issued by government banks to SMEs showed a much weaker response to interest-rate increases than loans from private banks. In simple terms, when policy rates went up, SMEs borrowing from government banks were partially protected from higher borrowing costs. This reflects an implicit subsidy built into government lending and supports the developmental goal of helping smaller, financially constrained firms survive tougher financial conditions. However, this protection comes with a cost: because a large share of credit does not fully respond to policy rate changes, monetary tightening becomes less effective overall. Importantly, this effect disappears during periods of monetary easing, when falling interest rates reduce the need for subsidies.

The Complex Role of Earmarked Credit

Earmarked credit intermediated by private banks produces more complicated effects. For SMEs, simply having an earmarked lending relationship does not significantly change how monetary policy is transmitted. For large firms, however, earmarked relationships matter during tightening cycles. Banks that provide subsidized, earmarked loans to large firms tend to pass higher policy rates more strongly onto those firms’ regular, non-earmarked loans. This suggests a form of cross-subsidization: banks use cheap, earmarked credit to lock in clients and then recover profits by raising rates on other loans. This behavior weakens during monetary easing, when credit becomes cheaper, and competition among banks increases.

Relationships, Trade-Offs, and Policy Lessons

The study also shows that the length of the lending relationship matters. Longer earmarked relationships are linked to stronger pass-through on earmarked loans during tightening periods, especially for SMEs, who depend more heavily on subsidized credit. During easing periods, the pattern reverses, as long-standing access to cheap credit becomes less valuable. Overall, the findings highlight a central trade-off for policymakers. Government credit can protect targeted groups and support development goals, particularly during periods of tight monetary conditions. But by muting the response of lending rates to policy changes and creating distortions in bank behavior, it also reduces the overall power of monetary policy. The paper’s key message is that government credit is neither purely helpful nor purely harmful; it reshapes monetary transmission in subtle ways that policymakers must understand if fiscal credit programs and monetary policy are to work together rather than at cross-purposes.