Brazil’s net public sector debt has been declining, more or less, continuously since 2002. Thanks to large primary surpluses and solid economic growth, net debt has declined from more than 63% of GDP in September 2002 to less than 40% of GDP in July 2011. Similarly, gross government debt declined by 20% of GDP, from a peak of 82% of GDP in September 2002 to 63% of GDP today. Meanwhile, gross domestic government debt has remained largely unchanged due to the sizeable domestic debt issuance necessary to finance public-sector assets accumulation.
The structure of public sector liabilities has improved tangibly over the past decade. Significantly, the public sector became a net foreign (currency) creditor in 2006. The share of both FX- and Selic-linked debt has diminished and the overall maturity structure has improved. As a result, were a financial shock equivalent to 2002 to occur today, the net debt ratio would fall by 3% of GDP rather than increase by 17% of GDP. Indeed, the debt ratio did decline during late 2008 on the back of a sharp currency depreciation. Gross financing requirements remain nonetheless large by international standards.
Net public debt will continue to decline over the short to medium-term. Under our baseline scenario, the ratio will decline by an average of 1.0-1.5% of GDP a year. Under an optimistic scenario – one where a tighter short-term fiscal policy combined with a medium-term adjustment reduces real interest rates materially – net debt could fall to as low as 20% of GDP by 2020. Such a scenario is, however, unlikely to materialise. By contrast, gross government will decline more slowly, depending on continued FX reserve accumulation and likely further lending to official banks by the Treasury.
It would be highly desirable to upgrade the present fiscal framework. Targeting primary surpluses was an appropriate policy when government solvency was at stake. With medium-term solvency not an issue anymore, it is time to “fine-tune” fiscal policy by shifting toward a structural (cyclically-adjusted) primary surplus target, or, even better, a structural nominal balance. This “upgrade” should be accompanied by broader structural reforms.
Brazil has come a very long way since 2002. Brazil suffered a series of major financial crises over the past three decades. Massive foreign borrowing in the 1970s followed by the so-called Volcker shock (read: high US interest rates and US recession) triggered a precipitous decline in commodity prices and eventually forced Brazil into external default. A great many stabilisation plans during the second half of the 1980s and early 1990s failed to bring spiralling inflation under control. After the real plan succeeded in doing so, Brazil suffered several subsequent balance-of-payments crises. In 1998-99, after a period of heightened global risk aversion following the Russian default, large-scale capital outflows forced Brazil off its crawling currency peg. A major contributor to and/or accelerator of both the 1998-99 and 2002 crisis were rising government debt and a debt structure, notably large shares of FX- and Selic-linked debt, that amplified financial shocks. Not only did the public debt structure make Brazil more vulnerable to both endogenous and exogenous shocks. But a high level of debt repeatedly forced the government into pro-cyclical fiscal and monetary tightening, exacerbating economic downturns.
Since the last major crisis in 2002, Brazil’s financial resilience has increased dramatically. The 2008 global crisis proved Brazil’s newfound financial resilience. Its solid external solvency and liquidity position (notably large FX reserves) was instrumental in allowing Brazil to weather the crisis – financially and economically – relatively unscathed. Lower public debt and a net foreign-currency creditor position at last severed the nefarious link between balance-of-payments-shocks-cum-currency-depreciation and public sector debt sustainability. It not only allowed the government to let fiscal stabilisers soften the economic downturn but it even allowed it to provide counter-cyclical fiscal and monetary stimulus. Thanks to the public sector’s and the economy’s net FCY creditor position, the government was also able to let the currency depreciate without triggering the systemic financial stress in the public, financial or corporate sectors related to FCY mismatches.
Brazil has come a long way indeed in terms of public sector debt sustainability, that is, solvency, liquidity and sensitivity to shocks. First, public debt is at very manageable levels. In net terms, public debt amounts to slightly less than 40% of GDP, compared to more than 60% in 2002. Second, its dependence on private foreign financing, whether international bond markets or foreign buying of domestically issued debt, is small to negligible. FCY-denominated/ -linked debt amounts to less than 3% of GDP. Non-resident holdings of domestic LCY debt amounts to a relatively modest 5% of GDP. Third, the aggregate (public- and private-sector) external balance sheet has removed the long-standing “fear of floating”. Thus a flexible exchange rate allows Brazil to absorb external shocks more easily than in the late 1990s and early 2000s when policy-makers were frequently forced to respond to external shocks with massive monetary tightening in an attempt to limit excessive currency depreciation, which, in turn, was threatening to further undermine debt sustainability. Today, a 10% nominal depreciation reduces the net public sector debt ratio by 1% of GDP. At the height of the global financial crisis in late 2008, net public sector debt had dropped by a full 5% of GDP, largely as a result of the public sector’s net FCY creditor position. In short, Brazil’s public debt position is quite solid.
Gross government debt vs. net public sector debt. After repeated financial crises in the 1990s and early 2000s, Brazil managed to put its fiscal house in order and reduce the public debt burden thanks to large primary surpluses and improved economic growth – and despite very, very high real interest rates of 10% or more. Brazil traditionally uses the public sector (PS) primary surplus to measure its fiscal effort. Following the return to low inflation during the second half of the 1990s, the public sector’s fiscal position deteriorated sharply due to a declining “inflation tax”. The primary balance was raised significantly in the wake of the 1998-99 financial crisis and again in the wake of the 2002 capital account crisis. The fiscal adjustment during the first year of the Lula administration was decisive in that it led to a near-continuous decline in net public debt, thus putting government debt dynamics on an unambiguously sustainable path.
Net public sector debt spiked to 63% of GDP in September 2002 at the height of the balance-of-payments crisis, mainly on account of sharply depreciated BRL and, somewhat less so, a widening fiscal deficit. Almost 50% of the public debt was linked to or denominated in foreign-currency or linked to the Selic rate (if one accounts for central bank swaps). Since then, debt has been gradually declining and today stands at just below 40% of GDP. The ratio even dipped to below 36% of GDP at the height of the 2008 financial crisis when – thanks to the public sector’s long FCY creditor position – the sharp devaluation of the BRL led to an improvement in the net public sector debt position.
Under the more widely used gross general government (GG) debt concept, which covers the federal government, states and municipalities, Brazil’s debt – under the “new” definition – has fluctuated in the 55-60% of GDP range since 2007. The “new” gross government debt definition as opposed to the conventional “old” definition only counts debt held by the public (including repos) as government debt, while federal debt securities held by the central bank are not counted as debt. Under the “old” definition, which counts central bank holdings of government debt as GG debt, this ratio declined from more than 80% of GDP in 2002 to 62% of GDP in July 2011.
Not only has gross government debt (under the new definition) remained largely unchanged, fluctuating in the 55-60% of GDP range since late-2006, but domestic debt has actually risen during this period from 51% of GDP to 54% of GDP. This happened in spite of, by Brazilian standards, strong economic growth, averaging 4.5% in real terms. The unchanged debt ratio is almost entirely attributable to the accumulation of assets financed by domestic debt issuance. Loans to the financial public sector (mainly: BNDES) and central bank foreign reserve assets account for the lion’s share of asset accumulation. Credit to public-sector banks increased from 0.5% of GDP at end-2006 to 7.3% of GDP in August 2011. During the same period, the stock of FX reserves grew from 8% to 15% of GDP. In dollar terms, the BCB accumulated more than USD 270 bn in additional FX reserves since 2007. Roughly speaking, leaving aside the question whether it has been financed by repos or Treasury issuance and excluding the “carrying costs”, this added 7% of GDP worth of debt to the gross domestic debt stock. All other things equal, gross domestic government debt would be roughly 15% of GDP lower than it is today, had the government not extended loans to official banks and not accumulated FX reserves since 2007. In other words, gross domestic GG debt would be closer to 40% of GDP had no further asset accumulation taken place.
There are drawbacks to public sector asset accumulation. The accumulation of public sector assets financed by public sector liabilities is worth having a closer look at. As regards FX reserve accumulation, the marginal economic and financial benefits of accumulation are, initially, significant in terms of lowering risk premia and foreign borrowing costs, including those of the private sector, and in terms of reducing economic and financial volatility (susceptibility to both endogenous and exogenous shocks). However, leaving aside the gains and losses resulting from currency depreciation/appreciation, the public sector incurs a financial loss. The interest rate paid on the domestic liabilities issued to finance FX reserve accumulation is greater than the interest received on its FX assets. The so-called “negative carry” is greater than 1,100 bp at the moment (roughly: Fed funds rate minus Selic). The public sector incurs losses, leaving aside currency-valuation-related gains or losses, worth 1.0-1.5% of GDP every year. Again, this can be considered an insurance premium paid to protect the economy against disruptive shocks and an indirect subsidy to the private sector in terms of cheaper external borrowing.
Similarly, as regards lending to public banks, the Treasury lends at TJLP (taxa de juros de longo prazo or long-term interest rate) but has to finance the loan at roughly Selic, resulting in a negative run rate of currently more than 500 bp. This roughly translates into a loss of more than 0.3% of GDP (roughly: 500 bp x 7% of GDP). The TCU federal watchdog has recently put the fiscal cost at 0.35% of GDP. True, to the extent that BNDES makes a profit by lending at a rate higher than TLJP and, ultimately, pays dividends to the Treasury, the effective loss (assuming zero credit losses incurred by BNDES) will be slightly smaller. Again, this holds in strictly financial terms and does not take into account the non-financial benefits in terms of broader, generally difficult-to-quantify growth and development objectives.
That said, in terms of FX reserves, the public sector looks “over-hedged”. The public-sector is a net foreign (currency) creditor to the tune of 10-12% of GDP. Foreign gross GG debt currently amounts to a mere 2.4% of GDP. This strongly suggests that the additional economic and financial benefit derived from additional FX reserve accumulation does not compensate for its fiscal costs. (This suggests that continued FX reserve accumulation is driven by other concerns.) A similar argument applies to the accumulation of Treasury claims on public-sector banks. Initially being a response to the credit crunch in 2008, public-sector-backed lending represented an economically and politically opportune way to support growth in the context of a severe credit crunch. Today the continued increase in lending comes at a tangible fiscal cost and it is arguable whether the non-financial benefits resulting from it offset the financial losses incurred by the Treasury. It would seem more sensible for official banks to raise the needed financing in the market rather than rely on the Treasury for funding.
Where one stands on this issue is largely determined by one’s assessment of the economic, non-financial benefits relative to the financial losses of both FX reserve accumulation and BNDES lending. It is incontrovertible, however, that this policy causes non-negligible financial costs and may even raise medium-term fiscal risks. The Treasury runs some (admittedly limited) credit risk on its loans. The BNDES loan portfolio is of relatively high credit quality.
But in a severe economic scenario, it would nonetheless likely suffer losses, which could indirectly impact the Treasury. While the public sector does not run credit risk on its FX holdings, currency appreciation does lead to accounting losses. On the flipside, of course, currency depreciation results in valuation gains. All told, too narrow a focus on direct financial costs and potential losses overlooks the potential “opportunity costs” of asset accumulation. By preventing a more sustained decline in domestic debt, this policy helps keep domestic interest rates at a level higher than under a scenario where (external) asset accumulation had not taken place.
Again, the stock of federal debt securities held by the public would be closer to 40% of GDP rather than the 53% of GDP, had the central bank stopped accumulating FX reserves in 2007 and the Treasury not extended financing to BNDES. A faster decline in domestic interest rates would not only have created “fiscal space”, enabling the government, if necessary, to respond to an economic slowdown forcefully. It would also have allowed for a decline in gross and net interest payments and, under the assumption that the government had refrained from increasing current expenditure, for higher public investment or more rapid deficit reduction. In addition to narrowing the “carry” differential and thus further reducing opportunity costs, it should also have led to less severe currency appreciation pressure earlier in the year.
The debt structure has improved tangibly. An improving outlook for public sector solvency and lower, but still very high (real) interest rates have also allowed the authorities to improve the debt structure and reduce the risks attached to it. As mentioned above, the vulnerability to exchange rate and interest rate shocks has diminished dramatically. In 2004, 1/4 of all federal public debt securities outstanding3 was FCY-linked or -denominated, rendering the debt vulnerable to exchange rate shocks. A very considerable 1/2 was linked to the Selic rate. By 2011, the debt structure had improved very dramatically. Today FX debt is only 4% of the total debt stock, while Selic-linked debt amounts to 1/3 of the total. This, as pointed out several times already, renders public debt significantly less susceptible to currency and interest-rate shocks, as the 2008 crisis demonstrated. Moreover, more than 40% of all domestic debt securities were maturing over the next 12 months in December 2002, or 17% of GDP. Today, less than 23% of all securities will mature over the course of the next 12 months, or less than 11% of GDP. This is still higher than the government’s deposits with the central bank and is high by emerging markets standards. But roll-over risk has undoubtedly declined over the past decade, even if gross financing requirements remain comparatively high.
In terms of the holders of government debt, a little more than 10% of total government debt securities are held by non-residents, and the vast bulk consists of holdings of LCY-denominated debt, whether domestic or external. This significantly improves the risk features from the creditor’s point of view by transferring FCY-related risks to the investor. Before 2005, there were, admittedly, next to no nonresident holdings of domestic government debt. But given that foreigners are predominantly invested in longer-term and/or fixed-rate instruments, financial risks from the Treasury’s point of view are low. By comparison, non-residents hold 50% of both German and US government debt securities (held by the public) due to their reserve currency status.
The structure of foreign government debt also improved. On the back of FX reserve accumulation, the public sector became a net foreign (-currency) creditor in 2006. Brasilia retired its IMF debt in 2005, repaid its Paris Club debt in 2006 and it pre-paid World Bank debt in 2009. Today the bulk of government debt is owed by the federal government in the form of international bonds. (It is worth mentioning that 10% of international bonds are denominated in BRL.) Starting in 2006, the Treasury has also been repurchasing international bonds.
Long story short. Not only has net public sector and, to a lesser extent, gross GG debt declined in recent years. But the risk profile of the debt has also improved markedly in terms of susceptibility to financial markets shocks. The 2003 fiscal adjustment unambiguously re-established public sector solvency and it subsequently allowed a tangible improvement in the debt structure. Were a financial shock equivalent to 2002 to occur today, the net debt ratio would fall by 3% of GDP rather than increase by 17% of GDP. It is worth pointing out, however, that, by the standards of the more advanced emerging markets, gross government financing requirements remain significant and the maturity of the domestic debt stock is of relatively short duration.
Net financing requirements (or fiscal deficits) have been on a declining path since 2003. The 2003 fiscal adjustment raised the primary surplus4 to 4.25% of GDP (pre-upward revision of GDP). Primary surpluses averaged 3.5 % of GDP in 2003-07 (following GDP revision). Thanks to sustained primary surpluses, declining inflation and accelerating economic growth, the nominal fiscal deficit fell from more than 5% of GDP in 2003 to a low of 1.3% of GDP in late 2008, before widening again in the wake of the 2009 economic downturn. The deficit will settle at 2-3% of GDP this year, subject to the authorities meeting their announced primary surplus target. The authorities project the nominal deficit to fall to zero within the next few years. This looks unlikely unless a very significant decline in net interest payments occurs. And this looks unlikely given continued low G3 rates and continued high domestic interest rates, the recent Selic rate cut notwithstanding. Declining deficits and the improved government solvency they imply were instrumental in lowering nominal and real interest rates. Although real interest rates remain very high by international standards, they are far below the levels seen during the second half of the 1990s and the first half of the 2000s.
The government is often criticised for frequent changes to the way in which it calculates the primary balance. It is fair to say that the changes thus far do not jeopardize government solvency. That said, the authorities do keep changing the way in which they measure the deficit and this certainly reduces transparency, unnecessarily so.
First, in 2006 the IMF and the authorities agreed to allow to “abate” from the primary surplus a pre-determined amount for purposes of growth-enhancing public investment. This possibility was introduced
for purposes of IMF conditionality. If the government failed to meet the surplus target, it was allowed to subtract a pre-agreed amount of generally 0.25-0.75% of GDP without being considered in violation of its fiscal targets, provided it managed to implement the pre-agreed investments. Actually, this “abatement” was only used in 2009 and 2010 when the government had trouble meeting its primary surplus due, first, to the economic downturn and, then, to pre-electoral surge in public spending. The 2012 LDO, for instance, allows the government to “deduct” a portion (BRL 40.6 bn or 1% of 2011 GDP) of PAC investments from the primary surplus target.
Second, and more controversially, the government booked the Petrobras capitalisation worth 1% of GDP as revenue. In this asset-liability transaction Petrobras received the rights to explore oil (from the government) and the Treasury (via the BNDES and BSF) received shares and booked them as counting against its primary surplus target. Clearly, this has no impact on the underlying fiscal stance of the public sector and only helps embellish the reported 2010 deficit and thus bring it closer to the (revised) 2.5% of GDP target.
Third, the government has also resorted to using so-called “restos a pagar” (“leftovers to be paid”) to embellish fiscal outcomes. As the primary surplus in Brazil is still calculated on a cash basis, that is, expenditure is only appropriated when paid for, not when it is effectively executed, the primary balance may be raised in any given year by simply postponing the payment of expenditures. This has helped inflate primary surpluses somewhat on several occasions.
Fourth, the authorities excluded Petrobras, and later Electrobras, from the public sector debt definition. This is legitimate to the extent that, while the government is a majority shareholder, it is not on the hook for its debt. That said, it would be difficult to envision a scenario where Petrobras were to get into financial difficulties and the government would not bail it out.
Fifth, in 2008 the authorities transferred 0.5% of GDP worth of primary surplus to capitalise the newly-created sovereign wealth fund (BSB). Whatever the merits of the sovereign wealth fund, which are somewhat questionable, this arguably reduces the transparency of fiscal policy and public debt. The funds were ultimately invested in Banco do Brasil and Petrobras shares. Last but not least, it is worth noting that in terms of accounting Treasury lending to the BNDES helps embellish fiscal outcomes. The PS primary surplus does not take into account interest paid (on securities issued to provide loans to BNDES) or received (sub-market TJLP received on loans from BNDES), but it does include dividend payments received from the BNDES. This embellishes the primary surplus performance, while adding to the overall balance.
Overall, the various changes diminish transparency. At this point, none of these changes poses a risk to fiscal sustainability and continued debt reduction. While in some cases good arguments no doubt exist (excl. Petrobras from PS), in others the reasons are less convincing. Above all, these changes are unnecessary. Analysts do their own calculations adjusting their figures for the changes introduced by the Treasury. These changes only serve to reduce transparency. Moreover, if the government is confronted with a sharp economic slowdown (2009), nobody expects it to meet its primary surplus target. On the other hand, if the government is at risk of missing its target during an economic upswing (2010), changing the rules will fool nobody. The government would be better off modifying its fiscal rules by upgrading its target from a headline primary surplus target to a cyclically-adjusted target in the first place.
How will government debt evolve over the next few years? A back-of-the-envelope calculation suggests that the net debt ratio will continue to decline for the foreseeable future. An average real interest rate of 6% and a real GDP growth rate of 4% require a primary balance of only 0.8% of GDP to stabilise the debt ratio at its current level of 40% of GDP. The current primary surplus target is 3.2% of GDP. On current trends, net public sector debt will fall to 30% of GDP by 2017. This assumes an unchanged primary surplus, annual real GDP growth of 4% and average real interest rates of 5%. It also assumes an unchanged real exchange rate. This looks like a slightly optimistic scenario given considerable short-term infrastructure investment needs (World Cup 2014, Olympics 2016) and the political temptation to reduce the primary surplus as debt moves towards the 30% mark. Nonetheless, even under a more adverse scenario, net public debt would continue to decline. The key question is whether the authorities will be able to resist political pressures for greater spending (and a lower primary surplus) as the net debt ratio continues to fall.
Back-of-the-envelope calculations, while simple, overestimate the speed at which the net debt ratio will decline. Applying the average Selic rate to the net debt stock (or even its LCY component) underestimates interest payments. The average weighted interest rate paid on the net debt stock can be derived from the net debt composition. The PS pays an average effective nominal interest rate higher than Selic. Here is why. The PS receives (roughly) TLJP on its BNDES loans, while paying Selic. Leaving aside exchange rate changes, the public sector also faces a negative carry on its FX reserve holdings. On the other hand, 4.7% of GDP worth of debt is interest-free (monetary base). Adding all up results in an effective nominal interest rate about 200 bp higher than Selic, assuming a largely unchanged asset and liability structure and an unchanged real effective exchange rate.
In order to estimate the path of gross domestic government debt, it is necessary to make further assumptions pertaining to public sector asset accumulation, including its effect on real interest rates. Our
projections suggest that net public sector debt will fall below 30% of GDP by 2017. The evolution of gross GG debt will critically depend on the pace of FX reserve accumulation and further Treasury lending to the BNDES. We expect the pace of both FX reserve accumulation and (more so) Treasury lending to the BNDES to slow over the next few years. Assuming a nominal deficit of 2% and nominal GDP growth of 10% and PS asset accumulation worth 4% of GDP, we project gross GG debt (old definition) to decline to 46% of GDP by 2020. Assuming an unchanged fiscal stance, net debt could fall to as low as 25% of GDP by 2020. By comparison, the IMF projects gross GG debt (old definition) to fall from currently 67% of GDP to 57% of GDP by 2016 and net PS debt to fall to 33% of GDP by 2016 (vs our forecast of 31% of GDP).
Why are real interest rates stubbornly high? Debt dynamics will critically depend on real interest rate dynamics. This raises the (perennial) question as to why real interest rates are so high.5 Economic theory (let’s call it ex-post rationalisation) points to national savings that are very low or, which is the same, a national propensity to consume that is very high. If this is so, the solution would consist in a reduction in government consumption (and transfers). A credible medium-term adjustment combined with more immediate fiscal tightening should go a long way in reducing interest rates. Another explanation is to do with the reduced, but still considerable indexation of government debt and its relatively short maturity (for a non-reserve currency country). Practically, pushing out maturities against the backdrop of high real interest rates is financially costly. A fiscal adjustment would seem to be a promising avenue to lower interest rates in the wake of which maturities could be pushed out and debt de-indexed. The problem is perhaps not so much the size of the government deficit, which is relatively modest, but the structure of government spending and the residual risk attached to re-financing.
Comparing Brazil to Turkey is instructive. Brazil’s domestic LCY debt has increased as a share of GDP. It is therefore not entirely surprising that nominal and real interest rates on BRL debt have declined more slowly than the decline in the net debt ratio and the narrowing of the fiscal deficit might suggest. Brazil’s experience differs sharply from Turkey’s. Turkey similarly experienced a major financial and public debt crisis in the early 2000s. Thanks to a tight(er) fiscal policy and higher economic growth, it managed to bring down public debt more aggressively than Brazil. Crucially, Turkey reduced its net public sector debt to 30% of GDP from 70% in 2001, compared to Brazil where the comparable ratio declined from more than 60% of GDP to just below 40% of GDP. More importantly, Turkey’s TRY debt is relatively low at around 30% of GDP compared with more than 50% of GDP in Brazil. Real ex-ante interest rates are currently zero, compared with around 7% in Brazil. Zero real interest rates are probably not consistent with 5% inflation in Turkey, but the equilibrium real interest rate is no doubt significantly lower than in Brazil. A cursory comparison suggests that Brazil should make a greater effort to reduce its net public debt, ideally via a reduction in gross domestic BRL debt. A glance at GG gross interest payments shows that the savings potential stemming from lower interest rates is enormous.
Fiscal reforms would accelerate decline in real rates. While short- to medium-term debt sustainability is not a problem, the government nonetheless ought to implement wide-ranging reforms in order to create fiscal space and to reduce real interest rates more aggressively. It would be desirable to introduce a “structural” primary surplus rule, which could/should – once the indexation of government debt and annual financing requirements have declined further – be upgraded to a nominal balance target. During the first half of the 2000s, the government committed itself to a primary surplus due to the large share of indexed debt, which made interest payments difficult to predict and nominal deficit target difficult to meet due to the unpredictability of interest payments in any given year. It would be desirable to move towards a cyclically-adjusted primary balance target, allowing for tangible short-term deviations from its medium-term target.6 This would also make it unnecessary to resort to accounting changes in an attempt to embellish fiscal outcomes (in the short term). It would also prevent Brazil from being forced to pursue pro-cyclical fiscal policies.
From a more short-term and real interest rate perspective, the government should raise the primary surplus more aggressively by reducing current spending as a share of GDP. Federal primary spending has been rising inexorably over the past decade. In the short term, this may not even require large-scale, big-ticket reforms like social security and pension. However, politically, it is difficult to sell a tighter policy when debt is already declining and solvency concerns are not an issue. The government seems to have finally come round to this view. It remains to be seen if the government is able to meet its recently announced enhanced primary surplus target given the rise in the minimum wage, related fiscal spending and significant pressure to raise public sector wages. The need to raise investment spending won’t help, either, from a short-term adjustment perspective.
Brazil should also implement a medium- and long-term adjustment. Medium- and long-term adjustment would require relatively wide-ranging and politically difficult reforms. For example, both revenue and expenditure are very rigid (“earmarking”). The World Bank7 estimates that only 10% of expenditure and 20% of revenue are “free” (that is, not linked or earmarked). Much of the expenditure is indexed to the minimum wage, introducing a further element of rigidity. Brazil will face medium- and long-term spending pressure arising from social security and pension obligations. The political challenge is to muster the will to put forward reforms and win the large constitutional majorities necessary for their adoption. Sooner or later, these reforms will have to be introduced due to the projected rise in social security payments.
Brazil needs to accelerate the reduction in the public debt ratio, including the stock of domestic debt, in order to reduce interest rates. This will ultimately require both shorter-term fiscal adjustment and longer-term structural reforms. Gross domestic debt of no more than 40% of GDP would be highly desirable. This would roughly translate into a net debt level of 25%, deemed absolutely safe. This is where Brazil is headed in the short- and medium-term. It would nonetheless be highly desirable to accelerate this process. Real interest rate would adjust more quickly to levels seen in economies with similar public debt, investment and savings characteristics (e.g. Mexico), that is, real interest rates of no more than 2-3%, compared with 6-9% today. There is little reason to expect that Brazilian interest rates would be any higher provided it manages to reduce debt, improve the debt structure and in addition implement reasonable medium-term fiscal reforms aimed at both limiting long-term spending commitments and reducing government current spending.8 Brazil has shaken off its “country of the future (and always will be)” image. A further fiscal adjustment resulting in accelerated debt reduction and lower interest rates would at last make Brazil a “normal” country.
