The rekindling of recessionary fears across global markets in recent periods highlighted the notable risks inherent in the current global macro landscape and the speed with which deteriorating market sentiment can affect emerging markets. As markets gauge the moves from the Fed that is expected to finally start cutting rates in September, many developing economies would be well advised to focus on narrowing their fiscal gaps and keeping a lid on their public debt rather than setting high hopes on Fed decisions. In Latin America some of the largest economies in the region such as Brazil, Colombia and Argentina are striving to rein in fiscal deficits and arrest the growth in public debt dynamics. In most of these cases, including in the case of Brazil, cuts in fiscal spending will need to be complemented by a broader array of systemic measures that favour budget discipline, improved coordination between monetary and fiscal policy and adherence to economic policy rules.
The latest fiscal figures for July published by the Central Bank of Brazil show a primary deficit for the public sector of 21.3 billion reais, which is in line with the average monthly deficit in the past 12 months[1]. The primary deficit of the central government amounted to 8.6 billion reais, notably below the average for the past 12-month period, but the bulk of the deterioration in July came from the deficit of the regional budgets of 11 billion reais despite the surplus of more than 22 billion reais in the year up to July. As a result, the consolidated public sector nominal deficit increased to more than 10% of GDP compared to 9.9% of GDP in June 2024. According to Finance Minister Fernando Haddad the July fiscal figures were in line with this year’s target. The market took a more pessimistic view as the public sector primary deficit in July was notably higher than analysts’ expectations, with exchange depreciation after the release of July fiscal figures triggering forex interventions from Brazil’s Central Bank.
In the face of high budget gaps the Brazilian government has advanced the goal of eliminating the primary fiscal deficit (net of interest payments) by the end of this year, with the tolerance band of plus/minus 0.25% of GDP. The growing realization of the need for greater fiscal austerity has been reflected in recent statements by President Lula and the Chief of Staff Rui Costa. In particular, President Lula spoke out against new spending proposals and called on the government to focus on implementing the already announced spending commitments, while Rui Costa declared that budget cuts in Brazil were necessary in light of President’s commitment to fiscal responsibility[2]. In a sign of greater fiscal conservatism, Haddad noted that with signs of labour market overheating, there was a need to adjust social programs.
The key concern for the markets is that the persistence in Brazil’s fiscal deficits is feeding into higher debt levels. According to the figures of the Central Bank, the General Government Gross Debt (GGGD) – comprising the Federal government, INSS, and state and municipal governments – reached 77.8% of GDP (BRL 8.7 trillion) in June 2024, growing by 1.1 p.p. of GDP compared with May 2024 and marking a new two-year high. The Public Sector Net Debt (PSND) reached 62.2% of GDP (BRL 6.9 trillion) in June, also increasing compared to the preceding month.
The elevated levels of Brazil’s debt render the debt dynamics critical for financial markets in assessing the credibility of the country’s macroeconomic policy. Earlier this year the IMF’s debt sustainability analysis (DSA) pointed to continued growth in the debt-to GDP ratio with increases of 2 percentage points from 2023 to 2024 and 7.2 percentage points from 2023 to 2029[3]. At the same time the estimates of Brazil’s Central Bank suggest that debt dynamics is quite sensitive to interest rates, with a 1 percentage point decrease in the Selic rate generating a 0.4-0.5 percentage point reduction in the levels of Public Sector Net Debt (PSND) and General Government Gross Debt (GGGD). The conclusion then may be that “credibility effects” and the interaction between monetary and fiscal policy may prove crucial in attaining macroeconomic stability and, as argued by Finance Minister Haddad, balancing public accounts could make interest rates fall and spur growth in the country’s economy[4].
Source: Banco Central do Brasil
As the fiscal deficit in Brazil is yet to be brought down to sustainable levels, on the monetary policy side the Central Bank is hardening its rhetoric after keeping the benchmark Selic interest rate unchanged at 10.5% in July for the second time in a row. This is due to inflation accelerating since June 2024 after declines since 2022 – inflation is up from 4.2% in June to 4.5% in July – and the worsening inflation expectations (the market consensus expects an inflation rate of 4.25% in 2024 up by 0.25 percentage points from the start of July)[5]. Exchange rate volatility engendered by disappointing fiscal figures is certainly not helping to bring back inflation closer to the 3% target (albeit with a band of plus/minus 1.5 percentage points). The Brazilian currency is down nearly 14% so far in 2024- one of the worst results across major economies. The Central Bank is not excluding the possibility of a rate hike at the upcoming policy meeting on September 17-18 despite the Fed’s preparations to embark on lowering rates later this year.
In view of the above macroeconomic developments, there is a range of measures that could be undertaken by Brazil’s government to stabilize the fiscal dynamics. One possibility is to target higher tax receipts – in fact recent statements from the Deputy Finance Minister Dario Durigan suggest that taxes may be introduced on big tech in Brazil. Ad hoc tax increases or new taxes on corporates may prove self-defeating however as the tax base could shrink and business activity quickly may well prioritize locations with a more favourable tax regime. The bulk of the fiscal adjustment will need to be borne on the expenditure side and this seems to be the focus of the markets in gauging the credibility of Brazil’s fiscal policy.
In pursuing the path of cutting outlays, the government will need to optimize the composition of fiscal spending – a factor that will largely determine the success of its fiscal adjustment measures. In other words, while the quantitative scale of the fiscal adjustment matters, the qualitative element of the composition of spending cuts may prove to be no less important. There may hence be a need to conduct an inventory of the efficiency of state programs and projects in order to determine the segments of inefficiencies whose reduction would not adversely affect growth.
Existing academic literature suggests that the composition of fiscal spending is key in the success of fiscal adjustments[6] and consolidations based on spending cuts is more likely to enhance growth than tax-based measures[7]. Across various expenditure categories social programs (as stated by President Lula) will need to be largely protected, with more of the onus of adjustment falling then on categories such as red tape/bureaucracy and inefficient infrastructure projects. These measures will need to be coordinated with the adjustments in spending at the regional level and combined with well-targeted optimization of existing tax breaks and state benefits.
More broadly, however, the attitude of the markets will be affected not only by the incoming stats on Brazil’s primary fiscal balance and expenditure cuts, but also by some of the key underlying themes related to Brazil’s budget process. The latter relates to issues such as the commitment of the authorities to fiscal targets/fiscal rules and the coordination of fiscal and monetary policy between the Central Bank and the government. Another systemic credibility factor concerns the relations between the government and the Congress. The stance of the legislature will be crucial in allowing the government to implement some of the key priority policies designed to rein in the fiscal deficit.
Overall, the current dynamics in Brazil’s fiscal-monetary mix characterized by fiscal deficits exerting pressure on the exchange rate as well as stoking inflation and higher interest rates could result in a vicious circle leading to higher debt levels. Under these circumstances, a best-case scenario would be an “expansionary fiscal consolidation”, whereby the authorities deliver consistent fiscal performance of lower budget deficits that reduces the pressure from the markets and creates scope for the monetary authorities to start cutting rates. The positive “credibility effect” could then deliver improved growth performance via lower rates and higher investment, with the appreciation of the exchange rate also having scope under this scenario to deliver its anti-inflationary impulse.
An “expansionary fiscal consolidation” would not be altogether impossible – there is evidence of such scenarios playing out with positive growth effects precisely in periods when so much is riding on credibility issues being effectively addressed by the government through fiscal adjustment. One such example is the Danish fiscal consolidation of the early 1980s that was followed by an expansion in output on the back of the decline in interest rates and improved credibility in the authorities’ policy stance[8]. Supportive monetary and structural policies (including via trade liberalization) in such episodes are also key in keeping a lid on inflation and public debt levels, while creating space for economic growth.
And while technically the government may deliver improvements in the monthly streams of figures on the country’s fiscal balances, the systemic issues of its coordination/relations with the monetary authorities and the legislature will be a more difficult matter to resolve in the near term and hence likely an ongoing concern for the financial markets. As is all too often the case across EM, there is not much leeway and time for the policy-makers in Brazil to deliver the hard decisions given the policy coordination difficulties and the nearing of the October municipal elections.
[1] https://www.bcb.gov.br/en/statistics/fiscalstatistics
[2] https://www.yahoo.com/news/budget-cuts-brazil-necessary-lula-131344168.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAEnqDnWSwRqE2DPbBbe2ubLFH6E5UXQgckk_sYUneNsDtIWlsEPUwkSIyVFD8Bzj59T8TgfKs7-ShyNs6eZ_Ne_aO9CSC0l25T5NgrmJXKVl6Nlm46kBjfz_3RkjBnHnSPlgyr6jf7Qe0ExfJgCGzDsSjwmQDLcDScYeutte5n2L
[3] https://valorinternational.globo.com/economy/news/2024/04/18/imf-projects-increase-in-brazils-gross-debt-at-least-until-2029.ghtml; https://www.imf.org/en/Publications/CR/Issues/2024/07/11/Brazil-2024-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-551705
[4] https://www.xm.com/research/markets/forex/reuters/fiscal-expansion-not-good-for-brazil-at-the-moment-haddad-says-53879656
[5] https://brazilian.report/liveblog/politics-insider/2024/08/26/inflation-expectation-rise-year-end/
[6] https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp675.pdf
[7] https://www.ifo.de/DocDL/dicereport204-data4.pdf
[8]https://journals.sagepub.com/doi/abs/10.1177/109114219902700604?download=true&journalCode=pfrb
Yaroslav Lissovolik, Founder, BRICS+ Analytics
Image by JoeBamz via Pixabay