Brazil’s economic fundamentals have improved beyond recognition since 2002. In addition to a dramatic improvement in its external financial position, Brazil has succeeded in lowering its public debt substantially. Net public sector debt has declined from over 60% of GDP in 2002 to just below 40% of GDP today. On current trends, net debt will fall below 30% of GDP by 2017, and assuming the government maintains large primary surpluses, as low as 25% of GDP by 2020. Gross general government (GG) debt declined much less, falling from 77% of GDP in 2002 to 63% of GDP today – and domestic GG debt has actually increased since 2002, rising from 57% to 60% of GDP (under the traditional GG concept). This is largely due to the tangible accumulation of assets financed by domestic debt issuance (e.g. loans to official financial institutions, FX reserves).
The debt structure has improved tangibly. External surpluses combined with aggressive FX reserve accumulation has transformed the public sector into net foreign (currency) creditor, effectively severing the link between currency depreciation and government solvency, which came close to pushing Brazil into default more than once in the late 1990s and early 2000s. The fiscal deficit is currently running at just below 2% of GDP. The authorities project the deficit to decline to zero within the next 24 months or so. But this looks too optimistic, unless the primary surplus is raised or net interest payments decline dramatically (which is unlikely). More realistically, the deficit will remain in the 1-2% of GDP range over the next few years. Leaving aside accounting changes, the authorities have, by and large, met their pre-announced fiscal targets in the past few years. Although debt has been on a downward trajectory (and will remain so), real interest rates have remained stubbornly by international standards.
Why are real interest rates so high? Various explanations have been put forward. First, the real interest rate is the rate that balances the supply of (including foreign) and demand for savings (investment). A high real interest rate points to a low savings or a high investment ratio (or both). As the sole explanation, this appears unsatisfactory. Other countries have very similar savings and investment ratios, but much lower real interest rates (e.g. Mexico). Second, high real interest rates also imply a very high propensity to consume and very high discount rates, which could be the result of past events, especially in the 1980s and early 1990s (e.g. hyperinflation, freeze of private financial assets under Collor). Third, real interest rates may reflect a high (government) risk premium. True, debt is on a downward path, the fiscal deficit is small and the government is credibly committed to fiscal discipline. That said, at almost 20% of GDP, gross financing requirements remain very high and the government is typically characterised by a negative savings ratio. All these factors combine to keep interest rates shy high.
In this context a comparison with Turkey is instructive. Both Brazil and Turkey experienced very severe financial crises in the early 2000s, received large IMF bail-outs, underwent macroeconomic adjustment and experienced a period of sustained high real interest rates in the wake of the crisis. But Turkey’s gross and net debt declined much more rapidly than Brazil’s thanks to a tighter fiscal stance and higher economic growth. Turkish growth was 1/3 higher than Brazil (5.1% vs. 3.9%) in 2002-10. Moreover, Turkey implemented an important and much more wide-ranging pension reform than Brazil, resulting in a much improved long-term fiscal outlook. Last but not least, a less aggressive accumulation of public sector assets in the case of Turkey also allowed for a more rapid in gross domestic (LCY) debt.
In the wake of the sharp economic downturn following the global financial crisis, the CBRT aggressively cut interest rates, bringing the real ex ante rate to zero. The current level of real interest rates is unlikely to be sustainable, if inflation is to be kept within the target range, but it may have demonstrated (in the eyes of Brazilian policymakers) that aggressive interest rate cuts can move real interest rates from a “bad” to a “good” equilibrium. This is speculation, of course, but circumstantial evidence point this way. After all, Turkey is running a very large current account deficit (almost 10% of GDP) whose financing is of poor quality (limited long-term flows). Its external liquidity indicators are much weaker than Brazil’s. By comparison, Brazil has a much more modest current account deficit is fully financed by FDI inflows. Public debt is declining in both countries, yet real ex-ante interest rates are around 6-7% compared in Brazil compared with around zero in Turkey.
It is questionable that policy rate cuts will succeed in a secular decline real interest rates, unless Brazil is willing to accept structurally higher inflation. Real interest rates are a reflection of economic fundamentals and thus the continued decline in public debt ratios will help reduce the real interest rate. Brazilian real interest rates have been trending, albeit it more slowly than Turkish ones. This is due to the relatively slower reduction in Brazilian debt, especially gross debt. If government debt continues to trend down, as is very likely, Brazilian real interest rates will fall to below 3% before too long. Having shed the “country of the future (and always will be)” image, Brazil will then finally have become a “normal” country in financial terms, too.
