Will Covid-19 Force Brazil’s Fiscal Reform?

September 22, 2020

Four months after Brazil opened its health, fiscal and monetary toolbox to fix the Covid-19 crisis, there are signs of a nascent recovery as the second half of the year begins. It’s been tough. Brazil has been one of the world’s most affected countries, with the third-highest death toll.

Despite peaking in May, the curve of fatalities only started to significantly decline from the middle of July. Given that it’s a developing country with 210 million people and of continential proportions, dealing with 27 different state pandemics at varying stages, Brazil’s coronavirus management was not as bad as sometimes portrayed in the international media. But it was costly.

Economic impact

The economic impact in Latin America´s largest economy has been acute. More than 500,000 companies have closed and formal unemployment rose to its highest tracked level as an astonishing 7.8 million lost their jobs in the three months to May. The economic brunt will be felt in the second quarter, with the Reuters consensus forecast projecting a contraction of over 12% in annual terms. A base case GDP contraction of around 5% is expected for 2020. That would be one of the country’s worst downturns and, following the recession of 2015 to 2017, the worst economic decade.  No wonder then, that the central bank cut interest rates to a historic low of 2% in August.

And yet, to paraphrase an old Persian saying, this too shall pass. A basket of economic indicators are once again ticking upwards. Industrial output rebounded and notched its best reading since June 2018 in May, retail sales also increased at a record rate in the same month. Manufacturing PMI pointed to expansion in June as did service sector expectations. Private savings are at record levels. The local stockmarket is up 60% since March and optimism has raised Ibovespa projections to over 130,000 by the end of the year, something that seemed extremely unlikely just a few months ago. BNP Paribas has third quarter GDP growth at 9% and 2% in quarter four. 2021 is expected to see above trend growth of 3-4%. The Senate’s Independent Fiscal Institute expects GDP growth to average 2.5% to 2030.

Growing debt

This growth will be sorely needed. Pandemics are expensive and the bill will be due soon. Figures from the central bank show that Brazil’s national debt and public sector deficit have hit record highs over the last few months. The government is currently forecasting a R$829 billion hole in the accounts by year end – a 12% primary account deficit – due to the macroeconomic shock and a surge in government spending to cushion the blow from the pandemic including emergency assistance programs, furloughing and direct transfers to states and municipalities. In other words, expect greater government spending and less income this year. By August the federal government had already authorised R$521 billion in coronavirus-related expenditure via an emergency budget law to allow spending above constitutional limits. That´s a huge 7% of 2019 GDP.

And it will get worse before it gets better. The Economics Ministry expects the government´s general gross debt metric [DBGG by its Portuguese acronym) will reach 98.2% of GDP by the end of 2020, an increase of 22.4 percentage points over the end of 2019 when it totalled 75.8% of GDP. This is well above the 20-year average of 67%, and in another planet from the 35% seen in the years just before the re-emergence of the democratic era in 1985. Indeed, Brazil now has far more debt, even as a proportion of GDP, than it did during the 1980s debt crisis. The difference this time is Brazil’s deeper local funding market, large bank deposits, higher international currency reserves and lower interest rates. They provide short term scope to fund fiscal expansion this year but the real question is if it can be controlled from 2021.

And it will get worse before it gets better. The Economics Ministry expects the government´s general gross debt metric will reach 98.2% of GDP by the end of 2020…

Treasury Secretary, Mansueto Almeida, is confident it will. Speaking to Reuters he noted that, “all the growth in public sector expenditure will start and finish in this fiscal year, which means we are not contaminating next year”. He added that he wasn´t “worried now about debt sustainability. I could be worried, one or two years from now, if we fail to approve anything [on economic reforms] or for some reason we don’t comply with the spending cap”. Almeida insisted the government’s agenda of cutting public spending, speeding up privatisations and concessions, and pushing ahead with tax reform will help the economy rebound and attract increased private-sector investment as well as potentially recovering the country’s investment grade rating.

Over the medium term, gross debt is forecast to rise slightly, reaching 98.6% of GDP in 2024 before trending down to 92.2% in 2029. The relative stability of the gross debt/GDP metric between 2021 and 2024, even with significant primary deficits, can be explained by low real interest rate expectations and recovery in real GDP growth. The average primary budget surplus required to close 2029 at 2019 levels would be close to 2% of GDP over the period. Public sector net debt (DLSP) is expected to reach 69.9% of GDP in 2020, 14.2 percentage points above 2019, The DSLP will rise to 81.7% in 2029. Yet that increase is mitigated by the appreciation of Brazil´s international currency reserves, currently valued at $336.8billion.

Reform agenda

Large fiscal deficits have historically been one of Brazil´s economic weak points. That was a driver of the 2016 spending law. The adoption of a pension reform in 2019 was another necessary step towards more fiscal sustainability. Now it is more important than ever, and indeed the government and the legislative will probably need to go further, faster. For Brazilian economist Gabriel Cardoso, “additional structural reforms, including tax, will be needed to lower government debt in the medium term and restore long-term investor confidence.”

Every cloud has a silver lining and the seriousness of this fiscal challenge has put the much-heralded reform agenda back in focus after legislative ambivalence last year. Rodrigo Maia, the powerful speaker of the lower house, has come out in support in getting reforms finalised before his term expires early next year, as has the large central block of congressman, which makes up more than 50% of seats in the chamber. A key objective is streamlining the country´s complex tax system. Right on cue, the Economics Ministry has recently proposed a unified sales tax (CBS) in congress, as a first step towards the government’s contribution to tax reform, which could also include income tax, industrial product taxes and dividends. The aim is to simplify the tax framework to make it easier to streamline tax cuts over the long term. There are hurdles for such bills to pass but as Capital Economics put it, we shouldn´t “underestimate the potential benefits”. Structural reforms that aim at boosting private investments and productivity will improve the debt-to-GDP ratio. For instance, a new law has just made it easier for private investment in public sanitation networks.

Every cloud has a silver lining and the seriousness of this fiscal challenge has put the much-heralded reform agenda back in focus after legislative ambivalence last year…

This is stoking optimism, as an FT article recently noted, “the ebullience that dominated the early days of the Bolsonaro administration has begun to return, fuelled by a resurgent stock market, fresh optimism on reforms and improving economic data”. If this is the broad macro direction, then talk of another “lost decade” in Brazil may be exaggerated. Brazil has had ample experience in debt challenges since the “ruinous loan” of 1829. Analysis suggests that most EM economies will face a painful adjustment of fiscal balances in the aftermath of the pandemic, Brazil included. Nevertheless, the country currently seems to be at an economic crossroads between stagnation on one side or fiscal adjustment, sustainable growth paths and structural reforms on the other. Brazil seems to have controlled the health crisis. The next year will be crucial to containing the economic fallout.