The Brazilian economy is booming. Foreign and domestic investor confidence is high. The new government confidently projects real GDP to expand at an average annual rate of 6% over the next four years, underpinned by rising public and private-sector investment. This compares with an actual average growth rate of 2.3% under Cardoso (1995-2002) and 4.1% under Lula (2003-2010).
A widening current account deficit has in the meantime made Brazil more sensitive to a precipitous decline in commodity prices, while the recent surge in capital inflows has made it similarly sensitive to a reflow of foreign capital. If it were not for a further projected rise in commodity prices, Brazil would be registering a trade deficit this year for the first time in a decade on the back of an appreciated exchange rate and burgeoning domestic demand.
The value of non-manufacturing exports as a share of total exports has risen to 60% against 40% a decade ago. Brazil has also absorbed large foreign capital inflows since Q1 2009. Capital inflows doubled from USD 85 bn in 2009 to USD 165 bn in 2010 (or a massive 7% of GDP). The stock of foreign portfolio holdings has tripled over the past two years and now amounts to USD 360 bn (or 15% of GDP). It is hence not difficult to see how Brazil has become more sensitive to a combined current and capital account shock.
Thanks to strong fundamentals such a shock would, similar to 2008, not jeopardise Brazil’s overall economic stability, for its aggregate balance sheet remains strong. In terms of external liquidity and solvency, Brazil’s position is very solid. While some of the recent capital inflows are potentially fickle, any currency depreciation resulting from a balance-of-payments shock would prove self-limiting given that an increasing share of nonresident claims are denominated in local currency. Last but not least, the systemically important bank sector carries a manageable FX exposure, both on-balance-sheet and off-balance-sheet.
In terms of government finances, Brazil is similarly well-positioned. The public sector is a net foreign-currency creditor to the tune of 10% of GDP. Currency depreciation thus results in a decline in the debt-to-GDP ratio. Public debt has also become less sensitive to a sudden rise in interest rates, while interest rate volatility has declined. Moreover, the government does not directly depend on commodity revenues, other than by way of (limited) dividend payments. Compared to many other commodity-exporting countries, Brazil’s fiscal vulnerability is very low.
That said, the government should raise the primary surplus more aggressively, preferably via a reduction of current expenditure. This would not only be desirable in terms of dealing with capital inflows, currency appreciation, monetary policy and economic over-heating. It would also provide the government with greater fiscal space, should the knock-on effect of a terms-of-trade shock on the government’s fiscal position be larger than expected.
In this regard, the Dilma government has made a decent start by resisting demands for a greater increase in the minimum wage, to which a significant share of primary expenditure is indexed. Last month, the government also announced a reduction in planned current expenditure for 2011. Even if the government succeeds in implementing the cuts, primary expenditure would still rise more than 3% in real terms. However, given the backward-looking adjustment of the minimum wage, current expenditure is set to jump significantly next year. It would therefore be preferable to introduce a fiscal rule aimed at containing or, even better, reducing primary current expenditure over the medium term by, for instance, indexing its increase to be less than the rate of GDP growth. “Discretionary” fiscal cuts should be replaced by a medium-term, rules-based adjustment. As the Brazilian budget is characterised by extensive revenue earmarking and expenditure rigidity, such a rule might require “flanking” reforms.
Such a proposal was put forward by FM Palocci under Lula I. If this is politically not feasible, the government could consider switching from a “primary surplus” to a “structural primary surplus” target (that is, surplus adjusted for the economic cycle and, if necessary, the volatility of commodity-related revenue). Targeting the structural balance would help reduce the pro-cyclicality of Brazil’s fiscal policy. The government might even consider targeting a structural nominal deficit given the continued decline in interest rate volatility. However, given the medium-term trend towards rising primary current expenditure and the need for extensive public investment in the run-up to the 2014 World Cup and 2016 Olympics, it might be preferable to adopt a rule aimed at a reduction of current expenditure rather than a rule that might end up constraining the growth in public investment.