Brazil’s public debt has been declining over the past decade due to accelerated economic growth and large primary surpluses. Net public sector fell from more than 60% of GDP in 2002 to less than 37% of GDP in 2011. Leaving aside currency fluctuations, which materially impact the net debt ratio, the current fiscal stance, which targets a primary surplus of 3.1% of GDP, is compatible with a decline of the debt ratio of 1-2 ppt of GDP a year. Gross general government debt, the more widely used indicator for purposes of cross-country comparisons, remains relatively high, but this is largely due to the accumulation of FX reserves by the central bank and sizeable government lending to the government development bank.
The structure of public debt has been improving significantly. Treasury stress tests show that a shock similar to the one experienced in 2002, which it is worth noting is extremely unlikely to happen again given improved economic fundamentals, would result in a decline in net public sector debt due to the public-sector’s net long foreign-currency position. The debt structure is thus very resilient to market shocks. Fixed-rate and inflation-linked federal debt securities today account for 2/3 of outstanding debt securities. This helps match debt service and revenue flows much more closely in terms of their volatility than in the past. Meanwhile, net foreign-currency fell from 25% of GDP to a negative 10% of GDP (that is, FX reserves exceed outstanding foreign-currency-denominated/ -linked debt).
What about contingent liabilities? After all, Brazil got into trouble in the past because it had to bail out insolvent state banks. Brazilian net public sector debt excludes Petrobras and Eletrobras. It also excludes (partially) state-owned financial institutions (e.g. Banco do Brasil, BNDES, Caixa Econômica Federal). However, the state-owned financial institutions are well-capitalised and should be able to absorb any losses from potential over-lending without government help. Similarly, Petrobras and Eletrobras retain solid credit ratings. Last but not least, it is worth nothing that a tangible increase in gross general government would be unlikely to cause problems.
The government’s balance sheet would be solid enough to absorb the losses, although it is under no legal obligation to bail out partially state-owned entities. Naturally, in the case of state-owned financial institutions it would be extremely difficult to for the government not to come in and rescue the banks. Assuming, conservatively, a real interest rate of 6%, real GDP growth of 3%, we estimate that – taking into account the lower return on government assets (mainly FX reserves, loans to BNDES) relative to the cost of financing – general government debt could increase afford an increase of 20% of GDP without putting at risk solvency.
With government debt remaining on a downward trajectory, real interest rates have no doubt further to fall from current levels of 5-6%. Each 100bp decline allows the government to reduce its primary surplus by 0.4-0.5% of GDP. Compared to other Latin American governments (e.g. Mexico, Venezuela), Brazil is not very dependent on (direct) commodity-related revenues – it typically receives 0.2-0.3% of GDP in dividend payments. While a sustained downturn in commodity prices may have non-linear effects on government revenues, revenues seem to be experiencing a secular increase due to structural changes in the economy (e.g. increasing labour market formality, rising labour income). Even a sustained downturn in commodity prices should leave the government in a financially manageable situation. Last but not least, gross public sector borrowing requirements are very large for an emerging economy (20% of GDP in 2012), but this should pose little risk as long as the medium-term outlook is for a stable or declining debt ratio.
Over the medium- to long-term, rising social security and especially pension outlays will put pressure on the fiscal and debt outlook. As long as social security outlays are linked to the minimum wage and the minimum wage is adjusted in line with nominal GDP growth, this will be a problem. At the moment, the economy is growing reasonably rapidly and Brazil is in a demographic sweet spot (i.e. falling dependency ratio). Although is much better positioned than advanced economies as well as China and Russia, it too will be experiencing a dramatic rise in old-age dependency over the next few decades. The INSS, covering private-sector employees, registered a deficit of BRL 36.6 bn (or 0.9% of GDP) covering 29 m beneficiaries. By contrast, the RPPS, covering civil servants, ran a deficit of BR 56 bn (or 1.4% of GDP) and this deficit will rise dramatically as up to 40% of civil servants will be eligible for retirement four years from now. The (private-sector) social security deficit has been falling in recent years due to buoyant labour markets and increasing formalisation. However, the combination of a generous social security regime – Brazil already spends way more than other economies with a comparable level of per capita income and a, at the margin, rapidly changing demographic profile – will quickly turn into an increasingly important fiscal challenge over the medium term. Among the major emerging markets, Brazil´s estimated net present value of the increase in pension expenditure is almost 70% of GDP, similar to Turkey´s. Only Russia and the Ukraine, economies with incomparably worse demographic outlooks, are projected to experience larger increases.
The government is aware of this, which is why it is seeking approval from Congress for a complementary, capitalised pension scheme for civil servants. This is a first step. The political problem, of course, is that the losses are concentrated, while the benefits are not only more widely dispersed (e.g. fiscal sustainability), long-term and accruing to future generations (or people not yet eligible to vote). The longer the government leaves this issue unresolved, the politically stronger the so-called ´grey majority´ will become. A period of solid growth, economic stability, rising incomes and a politically less powerful ´grey minority’ should economically and politically be the most opportune moment to introduce such reforms. The problem is that the short-term political-electoral benefits of such a forward-looking reform are non-existent while the costs are potentially very real.
A rapidly rising (albeit from a low level) old-age dependency ratio combined with generous – relative to its per capita income – social security benefits will sooner or later force the government’s hand. Not only do large government transfers weigh on the national savings and investment rate as well as keep domestic interest rates very high. Large pension-related transfers will also slow Brazil´s economic ascent. What they say about China may equally apply to Brazil: The country of the future is running the risk of becoming old before it becomes rich.