Brazil – Spend, Tax, and Lend

Summary

• The new Lula administration finally outlined a new fiscal rule to replace the spending cap after months of negotiations and speculation.
• The rule confirms what I considered the administration’s main objective: increase spending and taxes.
• The economic team was initially considering the net debt-GDP target outlined in a December 2022 contribution but opted for this alternative. The team is now working to releverage state banks to finance quasi-fiscal expenditures.
• The rule limits spending to 70% of tax revenue but does not penalize or outline adjustment policies if the government violates the rule.
• This follows a huge primary spending increase established by the transition bill of December 2022.
• With no real fiscal restrictions, Brazil seems on a path to repeat the 2013-2015 disaster.

Market Implications

• With fiscal expansion, we have expected a lower USD/BRL until credibility fears set in.
• Appropriate monetary policy and lower inflation renders fixed rates attractive up to two years.
• With the fiscal expansion and Roberto Campos Neto’s term ending in 2025, we would not take longer duration risk and look to shift to inflation-linked assets in mid-2024.

The New Fiscal Rule

The new Lula administration finally outlined a new fiscal rule to replace the spending cap after months of negotiations and speculation. The bill is now in Congress and entails constitutional elements that require a two-thirds majority. This new rule follows the transition bill, which increased primary spending by a whopping 2% of GDP that is already showing up in the data, with primary surpluses dwindling (Chart 1).

The fiscal rule or ‘framework’ limits growth in expenditure to 70% of the increase in tax revenue. This seems like a reasonable replacement for The Spending Cap – a constitutional amendment passed in 2017 that prohibits any inflation-adjusted increases in spending. As we argued in December 2022, this rule combined with The Fiscal Responsibility Law and the Golden Rule credibly contained fiscal expansion. However, a moment’s reflection shows this new framework does not work at all.

The New Fiscal Non-Framework

Hereare the main aspects of this new framework:[1]

• It authorizes, immediately, real growth of expenditure without tax increases.
• It limits growth in real expenditure to 70% of the 12-month real increase in tax revenue.
• Primary fiscal balance targets fall within a range of 0.5% of GDP on either side of the target that starts at a deficit of -0.5 in 2023 and increases by 0.5% of GDP every year thereafter.
• Hence, the government expects a balanced primary budget in 2024 after the huge increase in primary expenditure of 2-3% of GDP.
• The bill augments the current spending ceiling with annual increases in primary spending of 0.6-2.5%.[2]
• Any primary fiscal result above the band’s ceiling can underwrite an increase in investment.
• If the primary balance comes in below the band, the government must reduce expenditure growth to 50% of the prior year’s revenue growth.
• Because the Brazilian constitution prohibits an increase in taxes in the same year they are legislated, tax revenue will constantly chase expenditure growth.
• Investment expenditure growth has a floor.
• According to Lisboa and Mendes, the government will need BRL100-150bn after the end-2022 spending binge, which will fall short of the primary target for 2023.
• As there are no penalties or automatic spending cuts – only on expenditure growth – when falling short of primary balance targets, the framework measure fails to provide a binding constraint on fiscal deficits.
• Removing the old spending cap also reinserts several revenue earmarks in addition to the investment floor reducing the scope for adjusting discretionary expenditure in the event of a shortfall.

Simply perusing the contents leads to the preliminary conclusion that this framework is not credible. To formalize this conclusion, Marcos Lisboa, Marcos Mendes, Marília Taveira, Cristiano de Souza, and Rogério Nagamine Costanz ran six different simulations for the new framework. In none does the rule bring primary fiscal balances within the target band, and the government will need an additional BRL58bn in revenue to meet the targets.

One difference between their simulations and the government’s is that they incorporate the recently announced increase in the minimum wage, the return of earmarks, and the constitutionally mandated growth in wages in several sectors including nurses. Moreover, they allow discretionary expenditure in various areas to go to zero in several of the simulations – an almost politically impossible outcome.

So, we get: more tax and more spend. In each of the simulations, the government is continuously trying to play a game of tax revenue catch-up to expenditures. My forecasts are not optimistic on the fiscal front (Chart 1). In all their simulations, net and gross public sector debt to GDP do not stabilize like my forecasts (Chart 2). Not only has the Brazilian government chosen to go down a one-way fiscal road the wrong way, it is accelerating.

Back to Increased Credit Subsidies

In December, I looked at a fiscal rule proposed in a Ministry of Finance paper that would limit expenditure according to limits on public sector net debt. The new government considered that route but discarded it, probably because it would have put focus on net debt that the prior PT administration had abused in hiding increased fiscal expenditure underwritten by public sector banks BNDES, the Banco do Brasil, and the Caixa Economica.

But that does not mean that the administration does not intend to resuscitate that policy. The most recent media updates report that Minister of Finance Fernando Haddad and the president of the BNDES have taken up changing the TLP (long-term lending rate) – the base rate charged by public sector banks – back to the TJLP (long-term lending interest rate).

The change is more than semantic. The outgoing Bolsonaro administration change removed discretion in setting the rate to making it based on the interest rate inflation-indexed NTNBs government-issued securities. That is, it became a market-determined rate from a subsidized one. Likely, we will see a subsidized TJLP, which means the return of invisible fiscal deficits underwritten by the public sector banks with the central government continuously recapitalizing the banks with debt issuance. Chart 2 depicts this as an increase in intergovernmental debt that does not affect net debt.

Chart 3 graphs the TJLP/TLP since 2001. The difference between the SELIC and the TJLP was huge and increasing when the BCB had to tighten money supply. Chart 4 shows the evolution of total credit broken down into its two components. Subsidized credit had a larger share of total credit. This not only forced firms that did not have (political) access to the subsidized rate to have to borrow at rates above the average, but it also made monetary policy significantly less effective at fighting inflation.

The signals are that the government wants to return to this type of financial segmentation and repression under the guise of increased investment. But evidence over the years shows that firms with access to these priority rates merely change the disposition of their liabilities and enjoy much higher margins. Meanwhile those that do not have access are rationed out of the credit market.

Does more subsidized credit increase investment? Chart 5 plots investment and savings rates against the share of subsidized credit in total credit. Clearly, the crowding-out effects of subsidized credit outweigh any positive affects of subsidized credit on investment. Moreover, it crowds out private savings as well as large corporations with access to subsidized credit reduce retained earnings.

Market Implications: More debt, Higher Market Interest Rates

The market has shown volatility around these developments but no real trend. USD/BRL has traded in 5.0-5.5 range with a slight bias to fall. Our model has consistently produced a fair value of 4.6. Theoretically, an expansive fiscal policy leads to a stronger real exchange and nominal exchange rate with inflation falling and no fiscal panic. However, election and fiscal rule uncertainty and the constant attacks on the BCB by the new administration have kept USD/BRL elevated.

The same is true for monetary policy and the DI curve. Under usual circumstances, the BCB would have already started cutting the SELIC, but the attacks on BCB independence and the lack of a credible fiscal plan has kept the COPOM on hold. The DI market was discounting a significant fall in the SELIC rate with the forward curve showing significant inversion until 2026 and thereafter a significant steepening.

The CDS market has shown a mild tendency to fall. But with CDS spreads at 226bps, the market is still discounting a relatively high 13.9% probability of default for the next five years. We expect that as fiscal numbers start coming, fundamentals will grow into these high nominal prices, and we expect upside for USD/BRL, DI, and CDS. In the meantime, we would invest in rates up to two years and floaters. It is too early to look at inflation-linked.

Conclusions: The Fight for Fiscal Solvency Is Over

All signs point to a dramatic deterioration in Brazilian public sector finances over the next 12 months. The new ‘Fiscal Framework’ is a poor substitute for the spending cap. Some argue that the spending cap was already violated. This is true but in the context of a pandemic-induced crisis. Once past that crisis, the government quickly regained the upper hand on spending and enjoyed a strong recovery in revenues as the economy rebounded.

The only hope is that Congress modifies the fiscal scheme to make it more binding. The Brazilian Congress has leant conservative on fiscal issues since 2016, but these same politicians approved the huge increase in spending at end-2022. I think we are headed for another pain trade like 2013-2016 that culminated in President Dilma’s impeachment. The difference this time is the increased speed in implementing unsound fiscal policies.

Citations

Lisboa, Marcos and Marcos Mendes: ‘Regra fiscal: novas considerações,’ Brazil Journal, 2 April 2023.

Lisboa, Marcos, Marcos Mendes, Marília Taveira, Cristiano de Souza, and Rogério Nagamine Costanz (2023): ‘O Algoritmo do Gasto: O Impacto das Despesa Obrigatórias no Arcabouço Fiscal,’ Moneograph, Insper, April.

Ministerio da Fazenda: ‘Arcabouço Fiscal,’ presentation 30 March 2023.

[1] See Ministerio da Fazenda: ‘Arcabouço Fiscal,’ presentation 30 March 2023. Marcos Lisboa e Marcos Mendes: ‘Regra fiscal: novas considerações,’ Brazil Journal, 2 April 2023 provide a good summary.

[2] Several categories of expenditure are excluded from this spending cap, e.g., FUNDEB and the nursing wage floor as per the existing spending cap.

John H. Welch is currently Executive Director at the Brazilian American Chamber of commerce. He is also the Farrell Family Liberty Fellow in Economics at the King’s College in New York. At chamber, Dr. Welch coordinates a team of six colleagues in creating content driven events, including webinars, seminars, and the Person of the Year awards dinner.

Photo Credit: depositphotos.com

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