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Oxford Analytica Daily Brief

Fiscal deterioration threatens Brazilian economy


Monday, November 4 2013
The public sector recorded a primary deficit of 2.3% of estimated monthly GDP in
September, the Central Bank reported on October 31. This result, which lowered the yearto-date primary surplus to 1.28% of GDP, came as the government finds itself under fire for
its fiscal performance. Since June, Standard & Poor's and Moody's lowered their outlook
on Brazilian sovereign debt -- to which both assign their second-lowest investment grade
rating -- and last month, both the IMF and OECD criticised the government's fiscal
policies. Government spending, at some 40% of GDP, is close to levels seen in advanced
economies despite the country's generally poor public services.

What next
The combination of low growth with a deteriorating fiscal position makes a sovereign debt
downgrade increasingly likely in 2014. This could inflict significant damage on the real
economy -- particularly if Brazil loses its investment grade in concert with an end to US
quantitative easing. Regardless whether this threat materialises, the government taking
office in 2015 will face strong pressure to address fiscal imbalances. In the longer term,
only politically costly reforms can put public finances on a sustainable path.
Analysis
Brazil's 'full' target for the 2013 primary surplus for the entire public sector (including the
federal and regional governments) was set at 155.9 billion reais (69.0 billion dollars) or
some 3.2% of GDP. However, as in previous years, this was lowered (by 45 billion reais)
to discount from the calculation resources dedicated to the Growth Acceleration Plan
investment programme and a series a tax cuts -- even if only the latter cost 58.1 billion
reais in lost revenues in the January-September period.

Dilma Rousseff reacts during a meeting


in Brasilia (Reuters// Ueslei Marcelino)

Impact
Gross debt, at just under 60%
of GDP, is relatively high for
an emerging market.
With lower primary surpluses
and the recent monetary
tightening, spending on debt
service will tend to increase.
Yet the bulk of debt is in
national currency and there is
no solvency risk.
As in 2012, 'creative
accounting' may be used to
improve this year's fiscal
result.
A sharp economic
deterioration in 2014 would be
the main threat to President
Dilma Rousseff's re-election.

The resulting new target, of 110.9 billion reais (2.3% of GDP), is now almost certainly out
of reach, since in the three initial quarters the public sector saved only 40.6% of that
amount. Traditionally, the federal government has made an additional fiscal effort to offset
poorer performance by states and cities. However, after September's results were
announced, Brasilia simply pledged to achieve the federal target of 73 billion reais, thus
quietly dismissing its policy objective for the wider public sector.

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Oxford Analytica Daily Brief


Fiscal deterioration threatens Brazilian economy

Nevertheless, the federal government may struggle to hit even this revised target:

40.6%
In the year through September, it saved only 26.5 billion dollars, meaning it would have
to achieve a primary surplus of 46.5 billion in the last quarter.
For that, it counts on one-off sources of revenue, notably the 15 billion real signing
bonus that the winning consortium in the recent auction to explore the Libra pre-salt oil
field will have to pay (see BRAZIL: Libra auction may add to Petrobras problems October 16, 2013), as well as an amount of up to 12 billion reais mainly from a
programme to refinance overdue taxes.
This would still mean another 19.47 billion reais would have to be saved, which seems
ambitious given weak economic performance -- although dividends from public-sector
companies could total up to 7.5 billion reais in the last quarter.
Public banks
In the three initial quarters, federal government spending was up 13.5% year on year in
nominal terms, increasing faster than revenue, which rose 8.0% over the same period -helping explain the poor fiscal result.
Yet a significant reason why Brazil has in recent years been unable to repeat the fiscal
performance it achieved up to 2008 is the role that public sector banks, especially the
National Development Bank (BNDES), have played in the post-Lehman economy. To keep
credit flowing to companies as private banks took a more cautious approach, the Treasury
stepped up its subsidised loans to the BNDES, which will reach 320.25 billion reais by the
end of this year. In an attempt to address the impact of this on public finances, the
government -- apart from announcing earlier this year an end to the BNDES-supported
policy to create 'national champions' -- recently has:
pledged to reduce loans to the BNDES, eventually ending them altogether;
promised that the BNDES will now narrow its focus, favouring especially important
infrastructure projects; and
suggested that BNDES Participacoes, the bank's subsidiary that buys stakes in private
sector companies, could sell equity to raise resources.
Yet such changes could be risky. The participation of public sector banks in credit
markets has increased from one-third to half of outstanding loans between 2008 and now. If
private sector banks maintain their cautious approach, less ambition from public-sector
banks could further undermine an economy that is already struggling to gain momentum
(see BRAZIL: No rapid economic upturn on the cards - August 22, 2013).

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No duplication or transmission is permitted without the written consent of Oxford Analytica
Contact us: T +44 1865 261600 (North America 1 800 965 7666) or oxan.to/contact

Share of 2013 primary surplus


target achieved in JanuarySeptember

Oxford Analytica Daily Brief


Fiscal deterioration threatens Brazilian economy

Looming downgrade?
With a tax burden which last year reached a record 36.27% of GDP, raising taxes is not a
viable option for improving fiscal performance. Furthermore, a number of factors suggest
that next year will see little improvement, increasing the possibility of a rating downgrade:
Politics
General elections in the last quarter do not augur fiscal restraint during the year. Moreover,
there is increasing pressure for public service improvements in the wake of the recent
massive street protests (see BRAZIL: 'Anti-system' protests raise populism risk - June 24,
2013).
Changed budget act?
Congress is currently discussing a government-proposed budget bill according to which
Brasilia would no longer be obliged to save additional resources to compensate for lower
primary surpluses than required from states and cities -- formalising what, in practice, is
set to happen this year already.
Regional debt
Congress is also discussing a bill adopting a lower index to correct the value of the debt of
cities and states with the federal government, as well as reducing the stock of this debt.
While this would increase the ability of regional governments to invest, it would also open
the door for them to spend more. Moreover, the move raises concerns over adherence to
the Fiscal Responsibility Act, which forbids the refinancing of such debt.
Structural issues
Beyond 2014 results, some fundamental problems affect Brazil's longer-term fiscal outlook.
Fiscal-monetary trap
The combination of high spending, protectionism and low productivity generates inflation,
leading to high interest rates. These discourage private investment and increase spending
on debt servicing, which in turn leaves fewer resources for public investment and requires
high taxes, fuelling a vicious circle.
Budget straitjacket
With legislation earmarking some 90% of the federal budget, the government has very
limited room for manoeuvre to trim and restructure its spending. As a result, fiscal balance
requires low government investment, which in turn undermines potential growth.
Furthermore, Brazil's population is ageing fast, and, without further reform, an overgenerous
pensions system will threaten the country's long-term fiscal sustainability (see BRAZIL:
Ageing population raises pension, labour fears - October 22, 2013).

Oxford Analytica 2015. All rights reserved


No duplication or transmission is permitted without the written consent of Oxford Analytica
Contact us: T +44 1865 261600 (North America 1 800 965 7666) or oxan.to/contact

The pension systems clouds


the long-term fiscal outlook