Global Macro Outlook and Emerging and Developing Economies (2025)

The global macro cycle and especially the U.S. policy mix will prove to be a drag on emerging and developing economies, while the latter will remain at risk of experiencing further financial distress in the medium term, which, broadly speaking, will also raise the risk of domestic political instability. After more than a decade of ultra-low global interest rates and quantitative easing in the wake of the 2008 global financial crisis, significant flows of capital to emerging and developing economies. Low-income and lower-middle income economies have historically relied on official bilateral and multilateral financing, leading to Paris Club led restructuring. The tightening cycle was cut short by COVID-19, which lead for interest rates to effectively fall to zero and advanced (and even some non-advanced) central engaging in renewed quantitative easing, which effectively contributed to lowering long-term interest rates and support capital flows. The most recent tightening began in the wake of post-COVID-19 recovery, supply chain disruption, Ukraine energy shock and pent-up demand leading to most dramatic spike in inflation in more than forty years in advanced economies. As a consequence of economic shocks and higher borrowing costs, many especially developing economies experienced financial distress and several defaulted on their debt and/ or were forced to apply for IMF support. Sovereign distress, default and restructuring is only one variety of financial distress an economy can experience. Banking crises are another important source of financial instability. The past five years saw significant financial distress, particularly in low income countries, including several sovereign defaults. The economic shock related to COVID-19, higher U.S. interest rates and a stronger dollar led to financial distress in many developing economies, particularly in so-called frontier markets.

> In the past five years, the following countries have defaulted on and/ or were forced to restructure their sovereign international debt: Belize, Zambia, Ecuador, Argentina, Lebanon and Suriname. Argentina pre-emptively restructured its debt in 2020.

> According to the Bank of England default database, ten sovereigns accounted for 75% of the US-dollar value of debt currently in default globally (mainly Russia and Venezuela). the level of global public debt in default has averaged between 0.3% and 0.6% over the past decade, and currently stands at 0.5%.

The shift in U.S. economic policy will prove challenging for highly-indebted, low-income countries, as global interest rates will remain comparatively high, the dollar strong, the economic outlook (outside the United States) uncertain and the political-economic outlook fraught with risk. Adverse global economic and financial conditions, particularly in context of potentially inflationary and expansionary U.S. macroeconomic and trade policies, higher U.S. interest, rates, a stronger dollar, and lower dollar commodity prices could make things worse and lead to renewed financial, economic and domestic political distress in emerging and developing economies. An uncertain economic outlook in China due to structural and cyclical challenges as well as risks related to a conflictual U.S. economic policy toward Beijing has the potential to negatively impact low-income economies. Lower Chinese demand for commodities due to a move away from real-state and infrastructure-intensive growth and a reduced willingness to provide financing to low-income countries will negatively affect the economic and financial outlook. Emerging economies have generally solid economic fundamentals and sufficiently flexible policy regimes to limit the risk of a systemic financial crisis, including external debt defaults. Low-income countries have far greater financial vulnerabilities. Among emerging markets, Argentina, Ecuador as well as Pakistan face more significant financial challenges. But they also stand to benefit from IMF support, which means that if they follow IMF-prescribed policies in the context of an IMF program, they should be able to avoid another round of severe financial distress.

> The U.S. dollar on a trade-weighted basis. U.S. interest rate outlook has been revised upward in recent months in light of slow disinflation and risk of inflationary U.S. macroeconomic and trade policies. U.S. interest rates will decline only very modestly if all this year. Some market analysts even predict that the Federal Reserve may be forced to raise interest rates.

> Argentina, Ukraine, Egypt, Ecuador and Pakistan are the largest recipients of IMF loans, largely on account of their economic size. However, the bulk of countries receiving IMF support in the context of balance of payments problems is located sub-Saharan.

> Low-income, developing countries, including frontier markets, are most at risk of financial distress in light of significant bilateral and private external borrowing. Ghana and Zambia have just emerged from sovereign default. 

A significant number of mostly low-income countries (developing economies), as opposed to higher-middle income countries (or emerging economies) face various degrees of financial distress, including balance-of-payments problems, and are undergoing IMF-supervised economic adjustment. Short of a detailed economic, political and financial analysis of individual cases, sovereign credit ratings are an acceptable, if imperfect indicator of economic and financial risk in a country. However, they can and do sometimes miss risks, including non-sovereign financial risks. But broadly speaking, sovereign credit ratings (see table) seem strongly correlated with economic development and per capita income. Low-risk countries (rated A or higher) are largely advanced economies; the medium-risk category (rated BB or BBB) is dominated by emerging economies; the high-risk category consists mostly of low-income countries. A more fundamental reason why medium-term risk countries are less at risk than high-risk countries is their lower level of dollar-denominated risks, more independent central banks and more flexible exchange rates, which makes balance-of-payments more manageable. Often, they also benefit from a larger domestic investor base and stronger institutions. THis is not to suggest that countries like Brazil, Mexico, South Africa or Turkey will not face more challenging financial conditions, but they are unlikely to experience sovereign distress or external payments defaults in the next few years. 

> As of 2023, IMF estimated that share of developing economies in distress. It estimated that 25 percent of emerging and developing economies were at high risk and faced “default-like” spreads on their sovereign debt, meaning their ability to raise (or refinance) international debt was severely curtailed. About 15 percent of low-income countries were in debt distress, and an additional 45 percent are at high risk of debt distress. While some of these low-income countries are undergoing IMF-supervised definition and/ or have emerged from a debt restructuring, risks remain elevated, particularly in view of a worsening global macro environment. 

> A consequence of U.S. financial sanctions, Russia’s sovereign default (2022) was involuntary, while Ukraine’s default was largely the consequence of the war. Ukraine has successfully restructured (part?) of its private external debt, but not its official debt. 

> Ghana, Sri Lanka, Zambia have restructured their debt and continue to make progress on broader economic adjustment with fair prospect of regaining market access at the end of the IMF program. Argentina needs to secure an IMF agreement and move towards greater exchange rate flexibility to sustainably reestablish the equilibrium of its balance of payments. Lebanon and Venezuela (Republic and PDVSA) remain in default

An adverse macro environment and significant economic and financial vulnerabilities in low-income countries will keep the risk of political instability high, regardless of whether countries default and restructure their or avoid a debt restructuring but undergo significant policy adjustment. Domestic political instability often accompanies IMF programs, as policy adjustment and conditionality in the form of a tighter monetary policy, currency devaluation and fiscal adjustment, whether tax increases or expenditure, including subsidies cuts, prove deeply unpopular against the backdrop of initially often weak economic growth and high inflation. Opposition parties and where applicable coalition parties often have an incentive to criticize adjustment policies in view of the next elections, further fueling opposition to adjustment and their short-term economic costs. To the extent that IMF programs contain structural conditionality it may also require politically painful structural reform, such as the privatization of state assets and opposition from concentrated, well-organized and often politically influential domestic political interests. However, an external debt default is typically even more destabilizing, economically and politically, as it sharply limits a country’s access to external financing and forces a precipitous contraction of imports on the country as well as a lack of access to long-term financing of investment. Often, but not always, a default is accompanied by banking crises or domestic government debt crises. Governments tend to not to survive the economic turmoil in the wake of a disorderly default, but debtor governments and their creditors often kick the proverbial can down the road for too long and then get forced into an even more disruptive disorderly financial default rather than a pre-emptive debt restructuring against the backdrop of IMF support. This dynamic will also contribute to further financial distress, including sovereign debt crises and possibly defaults, in low-income countries in the next few years. But even if outright sovereign defaults can be avoided, increased financial distress will put increasing stress on many countries in the high-risk category.

> The potential for (very) adverse spill-over effects from financial distress in emerging and developing economies is very limited, particularly compared to the 1980s and 1990s, when defaults threatened to bring down the U.S. banking system or destabilize U.S. financial markets (e.g. Long-Term Capital Management). Today, the financial importance of non-advanced countries in financial distress is very limited. The systemic financial importance of the countries in the high-risk category is negligible (see table). 

> It took Zambia (2020-24) four years to restructure its debt. Ghana (2022-24) and Sri Lanka managed to do in in two years. While three countries hardly makes a large enough sample, it is possible that future debt restructuring will be completed less slowly, though much will in practice depend on how messy a default is and how willing debtors are to While the G20 Common Framework and Global Debt Roundtable have not delivered, debt restructurings seem to be completed less slowly in the context of non-Paris Club creditors like China 

Political Economy of Fiscal Reform in Brazil (2025)

Brazil’s economic growth has outperformed expectations post-COVID-19, but this improved economic performance is unlikely to be sustained over the medium term due to continued low savings and investment After years of economic underperformance following the car wash scandal, economic growth has outperformed market economists’ expectations. Brazil’s economic fundamentals are relatively sound in terms of its international financial position, commitment to a floating exchange rate regime and the government’s net foreign currency creditor position, all of which mitigate the risks of a balance-of-payments or sovereign external debt crisis. However, domestic government debt is high and fiscal deficits are high, raising concerns about the medium- and long-term outlook for debt sustainability, and hence economic growth.

> According to the IMF, real GDP grew by 3% annually in 2022 and 2023, and it is expected to expand another 3% in 2024, supported by strong domestic consumption, increased agricultural and hydrocarbon output and a less than anti-cyclical fiscal policy. Real GDP growth averaged 0.5% a year over the past decade. According to the World Bank, real GDP per capita growth averaged a negative 1.6% annually.

> The Brazilian public sector is net foreign-currency creditor. Less than 5% of Brazilian public debt is foreign-currency-linked. Brazil’s international financing requirements are low and the central bank sits on $350 billion of foreign-currency reserves, while the current account deficit is more than fully financed by net foreign direct investment flows.

> Compared to the other two large Latin American economies, Argentina and Mexico, Brazil compares favorably in terms of long-term economic growth. In the past thirty years, both Argentina and Mexico registered real GDP growth of 2%, compared to Brazil 2.4%. Over the past decade, Brazil grew 0.5% annually, compared to Mexico’s 1.5%, while Argentinian real GDP did not grow at all.

While Brazil’s international financial position is very manageable, a modest medium-term growth outlook and adverse fiscal dynamics represent will sooner or later force the government to pursue a much more restrictive fiscal policy. While such an adjustment is necessary to ensure medium- to long-term debt sustainability, if would also, if implemented forcefully, help free up resources to be invested in the economy to raise medium-term growth. But this is unlikely to happen on a meaningful scale, as the Lula government is struggling to implement more decisive short- and medium-term fiscal adjustment, particularly in view of the 2026 presidential elections. The government has reformed the fiscal framework, but is struggling to take more decisive actions aimed at a fiscal adjustment in the short term to help stabilize the debt-to-GDP ratio. The government has also failed to address longer-term fiscal concerns related to high levels of education, health and pension spending, which will sooner or later prove unsustainable. Significant reform remains unlikely in the next two years.

> In 2023, congress approved a constitutional amendment replacing the zero cap on growth in real federal spending, which had been in force since 2016, with a corridor for real spending growth tied to both revenues and the difference between projected and targeted primary fiscal balances. The amendment re-established floors for mandatory education and health as well as investment spending. While the reform committed the government to improving the primary balance from -0.5% of GDP in 2023 to 1% of GDP by 2026, these are indicative targets only and can be changed with a simple majority vote in congress. Mandatory spending increases mean that the government is constantly struggling to mobilize greater revenues, while it limits the amount of money that can be spent on investment.

> Absent reform, public pension spending is projected to increase from 12% of GDP in 2016t to 16% in 2025 to 26% in 2050. This is not sustainable. Pension reform in 1998, 2003 and 2012 were insufficient to significantly impact the path of future spending. Adjusted for age, Brazil has the largest pension expenditure in the world, according to the IMF.

> The IMF projects gross government debt to increase from 85% of GDP in 2023 to 95% of GDP by 2027, which represents a substantial increase. The IMF also forecasts the structural primary balance to improve by 0.5 percentage points of GDP annually, which will likely prove way too optimistic. It also forecast real economic growth of 2.4% annually, which is way above the ten- and twenty year average of 0.5% and 2.3%.

Structural economic reform necessary to accelerate medium- to long-term economic growth is always difficult, particularly so in Brazil. Brazilian presidents typically face an unwieldly congress in several ways. First, the president’s own party generally controls an often miniscule share of seats in the chamber and the senate, forcing the formation of often disparate “presidential coalitions”. Second, the number of congressional political parties and hence congressional fragmentation is high, which further weakens the cohesion of presidential coalitions. Third, party discipline in Brazil is very low, largely due to an electoral regime that weaken party-political control of candidates and favor personalistic policies. More recently, changes to the way budget policy is implemented further has further weakened the president’s ability to win congressional support for a cohesive, long-term economic reform agenda. Finally, many important economic reforms require amendments to the constitution and this require super-majorities to pass them. This is not impossible, but does make it more difficult to pass reform legislation than in other countries. If Brazil fails to implement major spending reform, particularly pension and social spending, it will sooner or later fail to comply with its new fiscal framework and government debt will inevitably become unsustainable. It also means that the government will fail to mobilize the fiscal space required to increase investment and support medium- to -long-term economic growth.

> Consisting of 82 members, the Senate has 11 different political parties and groups. The high degree of fragmentation tends to limit the size of presidential coalitions. The government coalition consists of 42 senators. Consisting of 513 member, the chamber of deputies has 16 different parties and political groups. The government coalition consists of 225 deputies, falling short of an absolute majority, hence requiring wide-ranging compromise with independents or the opposition to pass legislation.

> Members of the chamber of deputies are elected on the basis of open list proportional representation, which gives voters extensive influence over who they elect and weakens party political control over candidates, leading to personalistic and clientelist politics. The centrao, the broadly centrist group of members of congress that lack ideological conviction or cohesion and engage in clientelist politics, is a reflection of the open list proportional representation. Senators are elected on the basis of a plurality regime, but due to weak national political parties and the senatorial candidates’ need to maintain close ties with and rely on state governments and governors (and their political machines) to be elected, they are similarly independent from the parties they represent.

> The Brazilian constitution established extensive social and economic rights, which require constitutional majorities to be amended. This is possible, particularly as far as it concerns minor issues, but it is generally politically challenging due to 4/5 super-majorities in both chambers.

Despite a surprisingly strong growth performance, the medium-term outlook remains challenging, not least because sooner or later Brazil will need to overhaul public finances. Over the medium term, the government will need to implement a more forceful fiscal adjustment to prevent a further increase in government debt, not least given the large social and pension obligations. A future government will implement reform only gradually in terms of the politics and economics. Politically, radical reform is politically very unpopular as it affected “acquired rights”, which often are grandfathered in. Economically and financially, the effects of reform are limited in the sense that they typically seek to prevent a further rise of pension spending rather than a decline in a context where spending is set to increase due demographic dynamics. This will also mean that Brazil will continue to be characterized by a low, perhaps even falling savings rate, which will constrain domestic investment, particularly in public infrastructure, and future economic growth. Other structural reform, such as greater trade integration, may support higher medium-term growth, but progress will be slow, while the international trade environment is set to worsen in the next few years in the context of the U.S. presidential elections. With major structural reform unlikely before the 2026 elections, Brazil’s economic performance is likely peaking and will deteriorate as 2026 approaches and beyond.

> According to IBGE, Brazil’s population currently at 216 million is projected to peak at 220 million in 2041 in the context of a rapidly falling fertility rate (falling from 2.3 in 2000 to 1.6 in 2023, and projected to reach 1.4 by 2040). The old-age dependence ratio increased from 10 in 2010 to 15 in 2023 and is projected to 36% by 2050. Brazil’s working-age population is estimated to have peaked in 2021 as share of the total population.

> Trade integration, defined as exports and imports of goods and services, Brazil ranks 184 out of 195 countries. Agricultural product and fuels and mining account for 75% of total exports, only 25% manufacturing. China accounts for 26% of exports, followed by 15% for the EU and 11% for the U.S. China accounts for 23% of all imports, followed by the U.S. with 19% and the EU with 16%.

> Federal capital expenditure typically amounts to less than 1% of GDP and the public sector is net dis-saver, meaning most public sector net borrowing finances non-investment expenditure. Public sector dissaving is the major cause of a low domestic savings ratio of less than 15% of GDP, and hence low investment.

 

Brazil's Economic Performance Mean-Reverts (2024)

After years of economic stagnation and heightened political uncertainty, Brazil finds itself on a more stable and predictable economic path; however, the country’s medium-term economic growth will remain modest despite government efforts to accelerate it, including by developing the country’s abundant offshore oil reserves. Over the past decade, Brazil’s economy has largely stagnated. A decade ago, a major corruption scandal coincided with the end of a more than decades-long commodity boom, which weighed on investment and economic growth. This was followed by the COVID-19 pandemic, which caused a sharp recession. In economic terms, the past decade thus differed sharply from the Lula years (2003-10), which were characterized by solid economic growth and increased macroeconomic stability in the context of increasing commodity prices and stability-oriented macroeconomic policies. Absent renewed exogenous shocks and barring a major change in savings and investment, which is unlikely, Brazil’s economic growth rate will return to its long-term average and potential of 2.0% in the next few years. 

Real GDP growth in Brazil averaged 2.5% over the past four decades, but only 0.6% in the past decade. The ten-year average is inconsistent with Brazil’s medium-term growth potential of 1.5-2.5% on account of its investment levels. In 2023, real GDP growth is forecast to have increased nearly 3%, though this level of growth will be unsustainable due to continued low investment. Brazil ‘s savings ratio is a mere 14% of GDP and its investment ratio 16% of GDP. This is low by international standards and helps explain Brazil’s modest economic growth compared to many of its emerging economy peers. Historically, such a low investment rate is consistent with real GDP growth rate of around 2%.

Brazil’s economic outlook is stable, but its growth potential will remain modest. The risk of serious macroeconomic instability is low. Although Brazil’s has a high level of government debt and large public sector deficits, the bulk of government debt is denominated in local currency and the public sector is net foreign currency creditor, which sharply limits the economy’s vulnerability to external shocks. Moreover, Brazil continues to run trade surpluses and modest current account deficits, which are easily financed by non-debt foreign direct investment inflows. A flexible exchange rate, combined with an independent central bank, allows Brazil to absorb even severe external shocks. In the medium term, Brazil’s greatest economic challenge are a high level of government debt and limited economic growth. But the government has committed to eliminate the primary deficit, which has helped maintain investor confidence in the short term. Medium- to long-term, however, the government needs to make a greater effort if the debt-to-GDP ratio is to be stabilized. As long as the real interest rate exceeds the real growth rate of the economy, the government will need to run primary surpluses, sooner or later. Although the Lula government has loosed some of the restrictions that were meant to curtail real public sector expenditure, the risk of a fiscal crisis will remain manageable in the near-term, as public debt will increase only gradually over the medium term. Five-year sovereign credit default spreads, an important measure of sovereign default risk, are trading at less than 150 basis points, pointing to a very low level of sovereign default risk.

Institutionally, the Brazilian state has proven resilient in the face of political polarization, but resilience and stability also mean inertia in terms of economic reform, particularly in the context of an improving economic outlook through productivity-improving structural reform. An independent judiciary and a strong, or at least obstructive congress limit the Brazil’s ability to generate radical policy change. But the relative stability of the institutional framework is also responsible for the relative policy and reform inertia. While large-scale reform is difficult in all political systems, it is particularly difficult in Brazil due to the high number of veto players. Congress is highly fragmented and party discipline is low. Ideology barely matters, and presidents need to carefully build diverse and heterogenous presidential majorities, which limits the president’s ability to implement wide-ranging reform due to the need to reconcile politically divergent interests. The constitution is very detailed and many important economic reforms require super-majorities in both houses of congress, which are difficult to construct. The judiciary is very independent and both willing and able to constrain government action. In addition to institutional constraints, the relatively stable economic outlook also militates against growth-enhancing structural reform. Significant economic reform typically occurs during times of significant economic stability or after devastating economic crises. Relative economic stability limits the incentives of the government to pursue wide-ranging economic reform, often leading it prioritize smaller, less significant reform. Instead, the Lula government relies on fiscal spending to accelerate economic growth. But this will sooner or later run into the budget constraint and will do little to increase productivity, judging by the success of similar growth programs under the previous Lula and Dilma governments.

The government’s plan to develop its energy exports is welcome, which would boost export revenues, but it will not fundamentally alter the economy’s medium-term growth outlook. Even if the government succeeds in implanting its energy plan, the boost to medium-term economic growth will be limited, if welcome. First of all, the government would need to convert higher export revenues into savings and investment. But political-electoral pressures makes it likely that at least part of the windfall will be consumed. Second, not the entire increase in domestic oil and energy production will translate into increased net exports. Third, even though Brazil may become the fifth-largest oil exporter a decade from now, oil exports as a share of GDP will remain small compared to other major oil exporters, which will limit the impact of expanding production, exports and higher prices on Brazil’s medium-term economic outlook. In addition, increased government investment focused on other sectors, which often revives projects abandoned more than a decade ago under a similar growth program, will only boost aggregate investment marginally. Therefore, Brazil’s long-term economic growth will be highly unlikely to exceed 3% over the medium term, and this assumes that the underlying growth potential will not deteriorate in the next few years. But higher economic growth will help keep a lid on public debt, provided the government manages to eliminate the primary fiscal deficit. But it will be insufficient to raise aggregate investment to a level where it would make a significant difference to the medium-term economic growth outlook.

(Conditional) Economic Convergence? Not in the Americas (2024)

Argentina, Brazil and Mexico should have grown much faster than the United States in the past few decades. They didn't. Admittedly, per capita growth or per capita income as a share of US income would be better measures to capture income convergence. Yet, it is remarkable that the United States whose per capita income is 3-4 times higher than in Argentina, Brazil and Mexico managed to generate faster growth than in the three largest Latin American economies. That's why they call it "conditional (!) income convergence."

Argentina, Brazil and Mexico have very different economic characteristics and they differ widely in terms of their financial strength as well as their approaches to economic policy and international trade integration. Remarkably, their long-term growth performance has not differed much. In the past four decades, real GDP growth has averaged 2.0%, 2.5% and 2.1% in Argentina, Brazil and Mexico, respectively. Ten-year average growth differs a little more, but not dramatically so. It was zero, 0.6% and 1.5%, respectively. This is quite remarkable given the vastly different economic trajectories and different approaches to economic policy and international economic integration taken in the three countries.

 

The composition of GDP in the three countries is very comparable in terms of primary, secondary and tertiary sectors. The service center represents 50-60% of GDP in all three countries. Mexico’s agricultural sector is slightly smaller than in in Argentina and Brazil, but not considerably so. Manufacturing exports account for 14%, 25% and 77% of total exports in Argentina, Brazil and Mexico, respectively. Not surprisingly, Mexico’s terms-of-trade have been far less volatile than Argentina’s or Brazil’s. Yet, the three countries’ economic performance has been very similar.

Mexico’s economy is also far more open than Argentina’s and Brazil’s. Exports account for 40% of GDP, compared to 20% in Brazil and less than 20% in Argentina. Mexico’s exports are far more geographically concentrated. Around 4/5 of Mexican exports go to the United States. Only 2% of Mexican exports to go to China. By contrast, a full 25% of Brazilian exports go to China, which is Brazil’s largest trade partner. Less than 10% of Argentinian exports go to China, which is Argentina’s third-largest trading partner after Brazil and the EU.

Last but certainly not least, all three countries differ in terms of their overall financial stability. Mexico is rated investment, Brazil sub-investment grade, and Argentina teeters on the verge of yet another default. Remarkably, the three countries’ long-term economic performance is almost impossible to distinguish, even though Mexico has by and large pursued Washington Consensus types policies, while Argentina’s economic policy has swing form orthodox to heterodox, to put it politely. And yet, their long-term economic performance has been virtually identical. Possible explanation? Similar investment ratio. Implication? Economic policies should be geared toward raising investment as well as productivity.

Advanced economies > Latin America .... (2019)

Latin America seems to be experiencing increasing political and economic instability. Governments in Bolivia, Chile and Ecuador have been rocked by protests. The Bolivian president has just been chased out of the country. In Argentina, economic populists defeated the economically relatively orthodox government of President Macri at the ballot box. The release of former President Lula in Brazil may lead to increasing polarization by paving another presidential run in 2022. Venezuela is in the midst of a major humanitarian crisis. Venezuela is also in default on its external debt and the new government in Argentina will have little choice but to restructure or at least reschedule its external liabilities. In Mexico, the second-largest regional economy after Brazil, AMLO, the country's left-wing president, is pursuing a less market-friendly policy than his predecessor. Last but not least, many of the smaller Central American and Caribbean economies have also been struggling with low economic growth and rising debt as well as occasional civil unrest (Nicaragua). Some countries even managed to default on their debt more than once in the past decade (Belize, Jamaica). The economic outlook for the region ranges from disappointing to dismal. This is all the more remarkable given the relatively favourable global economic backdrop. 

Economic growth has been disappointing. If the IMF’s forecasts are to be believed, five-year average real GDP growth in the region reached a mere 1.0% last year. It is set to fall to 0.6% this year. This compares poorly even to the performance of an advanced economies whose growth rate averaged 2.1%. Five-year average real GDP growth in both Argentina and Brazil has actually been negative, while in Chile, Colombia and Mexico it amounted to 2.0-2.5%. Only Peru will manage to eke out economic growth of slightly more than 3%, down from an average of 7% at the beginning of the decade. Last but not least, Venezuela’s economy is collapsing.

Source: IMF

Not only is Latin America doing poorly compared to the rest of the world. The region is also faring poorly compared to its past economic performance. Throughout much of the past decade, Latin America was riding high on the back of a commodity boom and, generally speaking, improved macroeconomic policies. Today it is difficult to see what could help lift the region out economic stagnation. Add to this the Eichengreenian middle-income trap and worsening demographics and the region’s growth rate will remain stuck around 2-3% over the medium term - at best. Downside risks abound. For a start, there is a risk then that low growth will lead to a further increase in political instability, less or no economic reform and continued economic stagnation. It is not difficult to see how this could quickly turn into a vicious political-economic cycle.

Source: IMF

The global macro backdrop is unlikely to improve. The US and European economies have slowed down. The US-China trade conflict continues to weigh on global trade and investor confidence. Advanced economies’ manufacturing sectors are in the doldrums and their fiscal and monetary policy space, though it varies somewhat, is generally limited. Advanced economies’ interest rates are already very low and it is unlikely that further Fed rate cuts would lead to a significant increase of capital flows to Latin America given worsening global sentiment and increasing risk aversion. Furthermore, China’s structural shift away from investment-intensive to greater consumption-led economic growth means that another commodity super-cycle is unlikely to come to Latin America’s rescue. In short, global economic growth has likely peaked. Even if a broader downturn can be avoided, it is difficult to see any upside as far as Latin America growth is concerned.

The outlook for growth-enhancing economic is far from encouraging. In countries like Argentina and Mexico, left-wing and populist presidents are unlikely to pursue major structural reform. Rising public discontent and increased political polarisation will make it harder to implement many of the reforms necessary to reinvigorate economic growth in absence of favorable global economic conditions. True, Brazil just passed an important pension reform. While undoubtedly welcome, it is worth remembering that the reform will only help avoid medium-term public-sector insolvency. Little has so far been done to reduce the infamous custo Brasil and address Brazil’s low productivity and dilapidated infrastructure. Moreover, the release from prison of former President Lula risks increasing political polarizationm, while the prospect of the left returning to power after the next presidential elections in 2022 will do little to lift the economy’s ‘animal spirits’. This will likely be true even if Bolosnaro surprises and manages to push through further structural reform through congress. Venezuela may prove a bright spot, but only if the Maduro government is replaced and a new Venezuelan government quickly resolves its external debt problems. Even then, necessary economic adjustment may prove more contentious, and the political transition more acrimonious, than many markets analysts anticipate. In short, the outlook for growth-enhancing structural economic reform in the region’s three largest economies, Argentina, Brazil and Mexico, which account for 2/3 of regional, is somewhere between modest (Brazil) and poor (Argentina, Mexico). The fact that economic fundamentals remain relatively sound in Chile, Colombia and Peru in spite of elevated but generally manageable political risks does not alter the fact the outlook for Latin America as a whole will remain poor.

Many Latin American countries arguably continue to be plagued by their colonial past, paternalistic-corporatist state structures and an over-reliance on commodity exports (North, Summerhill & Weingast 1999; Rodrik, Subramanian & Trebbi 2002). Government-owned companies continue to play an important economic role and often offer opportunities for corruption and mismanagement. The rent-seeking of various politically influential economic and societal groups causes economic inefficiencies. The continued dependence on commodity exports renders Latin American economies vulnerable to repeated terms-of-trade shocks. The legacy of an inward-looking development strategy has not been completely overcome and many economies have failed to integrate themselves into global supply chains - Mexico and several Central American economies excepted. While some countries have made some progress with respect to several of these challenges (Chile, Colombia, Peru), others have been less successful (Argentina, Brazil, Venezuela). It is therefore not very surprising that Argentina is due for another external debt restructuring and Venezuela is in default. Neither Brazil nor Mexico is at risk of a near-term external payments default. However, their sovereign credit profile has weakened in the past few years due to rising public debt. Once one realises that the deterioration in economic fundamentals has taken place against the backdrop of solid global economic growth and record-low global interest rates, it is worth asking two questions. What will happen to the region’s economic outlook, should advanced economies experience a further slowdown or even a recession? How will a further deterioration of regional economic conditions affect political stability, more broadly, including the ability of the various governments to pursue stability-oriented economic policies?

Brazil - The political economy of low economic growth (2014)

Brazilian economic growth has been disappointing of late. At the end of Lula II, the seven-year real GDP growth had crept up to 4%. By 2015, seven-year growth will have declined to its multi-decade average of 2.6%. Put differently, under Lula I and II (2003-10), real GDP growth averaged 4%, significantly higher than the 2.3% registered under Cardoso I and II (1995-2002). (This does not mean that the Lula governments can take all the credit. After all, it was the Cardoso reforms that laid the foundation for subsequent accelerated economic growth, helped by rising commodity prices and moderate-to-low global interest rates.)

If current forecasts are correct, economic growth will average around 2% under Dilma I (2011-14). Admittedly, Brazil is not the only EM to experience a broader decline in trend growth. India, Russia, Turkey, even China, have seen lower growth in recent years, compared to the 2003-10 period. Nonetheless, real GDP growth of 2% is very low even by EM standards. This raises the question why the government has not taken more aggressive measures to lift economic growth. 

Source: IMF

The government did, of course, react to slowing growth. However, the Dilma government has focused more on demand than supply side measures. This has proven to be a mistake, for it resulted in higher inflation and larger (quasi) fiscal deficits, while it failed to prevent a decline in the economic growth rate. It is tempting to argue that, absent these measures, economic growth would have been even weaker still. However, higher inflation points to supply side constraints rather than a lack of demand. Under Dilma I, inflation has been 120bps higher (6% vs 4.8%) and real GDP growth has been 250bps (2.1% vs 4.6%) lower than under Lula II.

While the demand-side-oriented policy response to the global financial crisis in 2008-09 was completely appropriate, the continuation of relatively loose monetary and fiscal policies, including quasi-fiscal expansion through public-sector bank lending, failed to address the real problem: growing supply-side constraints. Basically, Brazil’s output gap closed quickly post-crisis due to a tight labour market and insufficient investment. If anything, the gradual erosion of the macroeconomic policy regime (higher inflation, larger fiscal deficits) may have helped undermine policy credibility in the eyes of the (real economy) private sector. While tax cuts and energy price reductions, for instance, were meant to make the economy more competitive, they were largely interpreted as lacking credibility and as unsustainable over the medium term given their fiscal costs. In this context, the government investment programme (PAC-2) and concession sales, which have been slow to take off mainly due to squabbles over rates of return, has thus far proven too little too late.

So what are the chances that Brazil will see a policy shift over the next year? In the past, severe financial crises spurred reform efforts. Hyper-inflation led to plano real under then FM Cardoso, admittedly after repeated failures to defeat inflation over the previous decade. The banking crisis in the mid-nineties led to large-scale bank restructuring and regulatory reform. The financial crisis of 1998-99 led to the adoption of the Fiscal Responsibility Law. Last but not least, the balance-of-payments crisis of 2002 led the Lula government to convert to fiscal discipline and an orthodox monetary policy. 

Today Brazil is not at risk of an imminent crisis. In the worst-case scenario, it will be stuck with a 2.5% growth rate. Unfortunately, low economic growth appears to be a politically stable equilibrium in the short-term. Unemployment is at record-lows, real incomes continue to rise and a large number of people continue to move into an expanding middle class. This has allowed the president to maintain a dominant lead in the polls and this makes a meaningful shift in policy before the October elections extremely unlikely. 

The relevant question to ask is how sustainable this equilibrium is over the medium term. If real GDP growth continues to trend lower, an uptick in unemployment looks quite possible given continued labour force growth. A sustained slowdown in income growth might also affect government popularity. Equally important, dissatisfaction with public services and an inadequate infrastructure is on the rise. Dilma’s approval ratings hit all-time lows during last year’s protests. This might give the next government sufficient political incentives to more aggressively focus on supply-side-oriented reforms and infrastructure investment (including concessions).

In short- to medium-term, a variety of supply side reforms (e.g. labour market, minimum wage, foreign trade) and an acceleration of public investment and concessions sales would help raise the growth potential and might also help address public discontent. Sooner rather than later, however, the government will have to slow down the growth of current expenditure (mainly transfers) to below the rate of GDP growth in order to increase domestic savings and the economy’s capacity to finance higher domestic investment. Politically, this appears unpalatable, not least becase inter-temporal trade-offs are typically solved in favour of limiting near-term political costs rather than long-term economic benefits. In Brazil, as in most democracies with competitive elections, short-term political expediency tends to outweigh longer-term economic rationality. 

A more orthodox policy might go some way in restoring confidence. (Presidential candidate Eduardo Campos has talked about the need for a more orthodox monetary and fiscal policy.) Broader structural reforms aimed at raising total factor productivity are also highly desirable. But unless the adjustment takes place in the context of slowing down the growth of current expenditure, it is likely to negatively impact public investment. This makes the government understandably reluctant to do what is necessary to live up to its recently re-affirmed commitment to fiscal discipline. Sooner or later, the government will have to accept that it needs to slow down the growth of current expenditure if domestic savings and investment are to rise sustainably. 

One might think that such a policy shift may become less costly in political terms once income growth slows, unemployment rises and public dissatisfaction with a poor infrastructure increases. Unfortunately, the government will likely seek avoid such an adjustment and the concomitant political costs by allowing the fiscal deficit to widen. In other words, there is for now a way for the government to have its cake and eat it. In terms of fostering higher long-term growth, this is a sub-optimal policy and it will likely be insufficient to lift real GDP growth above 3%. A credible, longer-term fiscal adjustment aimed at raising government savings (aka limiting the growth of current expenditure) and flanked by accompanying supply side reforms is necessary to raise domestic investment, increase productivity and lift the growth potential back to where it was during Lula I and II.

Demographic change and government debt sustainability in Brazil (2013)

Brazilian government debt has been declining over the past decade, falling from more than 60% of GDP in 2002 to 35% of GDP today. The current fiscal stance is compatible with a decline of the debt ratio of 1-2 percentage points a year. Gross general government debt, the more widely used indicator for purposes of cross-country comparisons, remains relatively high. But this is to a large extent due to the accumulation of FX reserves by the central bank and sizeable government lending to the state development bank. 

Moreover, even a tangible increase in gross general government debt would be unlikely to cause problems. Assuming, very conservatively, a real interest rate of 7%, real GDP growth of 3%, and taking into account the lower financial return on government assets (mainly FX reserves, loans to BNDES) relative to their financing costs, general government debt could increase by 20-30% of GDP from current levels without jeopardising public-sector solvency. With government debt on a downward trajectory, however, the equilibrium real interest rate is not likely to rise back to its historical average – and each 100bp decline allows the government to reduce its primary surplus by an additional 0.4-0.5% of GDP. 

Over the medium to long term, rising social security and health outlays on the back of aging demographics will put pressure on the evolution of public finances. The combination of a generous social security regime – Brazil spends way more as a share of GDP than other economies with a comparable level of per capita income and is experiencing, at the margin, a more rapid change of its demographic profile – may turn into an increasingly important fiscal challenge over the medium to long term. The net present value of the increase in pension and health-related expenditure exceeds 100% of GDP in Brazil. A rapidly rising (albeit from a low level) old-age dependency ratio combined with generous social security benefits will sooner or later force the government’s hand. 

Source: IMF

Sovereign balance sheets in Brazil and Turkey (2013)

In the early 2000s, both Brazil and Turkey experienced severe financial crises. Currency depreciation and public sector solvency concerns in the context of significant liability dollarisation pushed both countries to the verge of default. Luckily, both countries embarked upon successful IMF-supervised economic adjustment programme under new governments and experienced a decade of solid economic growth. Coincidentally (maybe) both countries have recently been experiencing wide-spread popular protests, albeit for a variety of different reasons. Arguably, the economic stabilisation of the past decade and the emergence of a politically vocal middle class have played a role here. But this is a separate topic. Let’s focus on economics.

The combination of fiscal adjustment and growth acceleration underpinned improving government solvency. In Brazil, net public sector debt has fallen from more than 60% of GDP in 2002 to 35% of GDP today. Gross general government debt - the more widely used indicator for purposes of cross-country comparisons - remains relatively elevated at 69% of GDP. The more limited decline of gross debt is to some extent due to central bank’s sterilised FX intervention and accumulation policy as well as sizeable off-balance financial transactions in the guise of lending to public sector banks. In Turkey, net general government debt has fallen a little faster than in Brazil, decreasing from 70% of GDP in 2002 to less than 30% of GDP today. Gross general government debt has fallen by much more than in Brazil and today stands at around 36% of GDP.

Both sovereigns have successfully reduced their (net) foreign-currency (FCY) exposure. At end-2012, Brazil’s sovereign net FCY creditor position was 14.2% of GDP, compared to Turkey’s 1.7% of GDP. Both countries have largely eliminated domestically-issued FCY(-linked), while a decade ago, 30-40% of domestically-issued government debt in both countries was linked to the exchange rate. In Brazil, the general government domestic debt is 55.8% of GDP, compared to total debt of 58.7% in 2012. By comparison, Turkey’s domestic debt amounts to 28.4% of GDP, compared to a total of 37.6% of GDP. The Brazilian central bank holds FCY assets worth 14% of GDP, roughly the same as in Turkey, translating into net FCY creditor  position in both cases.

A sovereign net FCY creditor position means that, unlike a decade ago, exchange depreciation leads to a decline – rather than a significant rise – in the net debt-to-GDP ratio. Accumulating large FX reserves does come at a direct financial cost, however. First of all, the central bank typically sells government bonds from its portfolio to absorb the additional liquidity created by FX purchases, thus effectively financing lower-yielding FCY-denominated assets by way of higher-yielding local-currency (LCY) government debt. Moreover, to the extent that a currency is undervalued in real terms, reducing net FCY debt deprives the sovereign of the opportunity to reduce the LCY value of FCY liabilities by way of real currency appreciation. Last but not least, the resulting larger stock of domestic LCY debt will tend to help keep domestic interest rates high. 

On the flipside, a large net FCY creditor position (aka large FX reserves) provides the authorities with more ammunition to intervene in the FX market and provide FCY funding to domestic financial institutions and corporates in case of a “sudden shock” (e.g. Brazil in 2008-09). Brazil certainly has a much a more favourable external liquidity position than Turkey. It may be worth noting that the CBRT’s net international FX reserves amount to less than half its reported reserves after adjusting for domestic banks’ FX deposits with the central bank. In practice, this may not make a significant difference, but in this respect Brazil’s position is more favourable, too.

While both the Turkish government and the banking sector can sustain even a large exchange rate shock, limited FCY liquidity means that the impact in terms of higher interest rates, lower local liquidity and economic growth will be much more significant than in Brazil. It is no coincidence that Turkish real GDP declined dramatically in late 2008 and early 2009, while the Brazilian economy only registered a very mild decline in output. Turkey is no doubt more exposed to a sudden stop, and while the government and the banking sector seem well-positioned to withstand significant exchange rate depreciation, the authorities have significantly less scope to soften the impact of such a shock as far as external liquidity is concerned. 

Interestingly, Brazil’s significantly more favourable FCY position does not translate into lower sovereign risk as reflected in CDS spreads. Curiously, as of early July Brazilian 5Y CDS spreads traded at 195 bp versus 180 bps in Turkey. Naturally, Turkey’s gross and, less so, net public sector debt is lower than Brazil’s. But its external position, if not vulnerable, is undoubtedly more sensitive to an external shock than Brazil’s. It looks as if the benefits Brazil derives from a large sovereign FCY creditor position in terms of markets’ perception of sovereign risk are at best very limited compared to Turkey, while it undoubtedly translates into higher (quasi-) fiscal costs. Nominal and real interest rates in Brazil remain significantly higher than in Turkey. That said, large FCY holdings do make Brazil less susceptible to a sudden stop than Turkey. Think of greater quasi-fiscal costs as an insurance premium.

Time for China to become more Brazilian (2013)

What could China possibly learn from Brazil, economically? After all, real GDP growth in Brazil averaged 2.75% annually over the past three decades, compared to 10% in China. Moreover, Brazil’s consumption-oriented growth model is about to exhaust itself, while China’s investment-focussed strategy continues to generate high, if somewhat diminished economic growth. Factor in the social, environmental and political consequences and it becomes clear that China’s growth model needs to change as well. Therefore: Brazil would be well-advised to become more “Chinese” in terms of savings and investment behaviour, while China would benefit from becoming more “Brazilian” in terms of consuming more (saving less).

Brazil’s economic growth has disappointed in the past couple of years. After increasing more than 7% in 2010, real GDP growth decelerated to 2.7% and 0.9% in 2011 and 2012, respectively. Even if real GDP growth recovers to slightly more than 3% this year, it will be below the 4% growth level Brazil got accustomed to over the past decade. While economic growth has disappointed, household consumption has remained resilient due to rising incomes, tight labour markets and the greater availability of household credit. Investment growth, by contrast, has been very weak, especially in the manufacturing sector. This is largely due to rising labour costs, a strong currency and a lack of productivity-enhancing structural reform. Brazil may be showing symptoms of Dutch disease.

The combination of strong consumption and relatively weak investment growth will sooner rather than later force the authorities to choose between higher inflation and lower growth – if this has not already happened. For now, the president continues to benefit from high approval ratings, recent protests notwithstanding, against the backdrop of a strong labour market, rising household incomes and expanding consumption. But the government seems to have realised that greater investment is necessary to keep employment and income growth going over the medium term. The government has been seeking to expand lending by public-sector banks, accelerate public-sector investment, reduce labour and production costs through tax cuts and exemptions and create and/or offer more favourable conditions for/to private investment in infrastructure projects (e.g. sales of infrastructure concessions). Unfortunately, this has thus far failed to trigger a rise in domestic investment.

Chinese GDP growth has slowed down from more than 10% a year to a still high 8% or so. Nonetheless, capital-intensive growth is having an increasingly adverse ecological impact. Investment-led combined with export-oriented growth makes the economy more vulnerable to exogenous shocks and creates incentives to engage in potentially risky quasi-fiscal stimulus policies (2008-09). Last but not least, more service-sector and consumption-oriented growth would be more employment intensive. As such, the political incentives to modify the growth strategy certainly exist, and they are growing larger.

Admittedly, Chinese household consumption is growing rapidly, but so is GDP, while household income remains very small as a share of GDP. Savings remain high across the government, corporate and household sector. Household savings are high in part due to an under-developed social security regime, creating significant incentives to accumulate precautionary savings. Household incomes are weighed down by extra-low returns on household assets due to financial repression. By contrast, corporate savings and investment are high due to a favourable tax and dividend regime as well as an undervalued exchange rate and cheap credit, favouring investment in the export-oriented, capital-intensive manufacturing sector. China has taken measures to raise domestic consumption, mainly by expanding social welfare coverage, providing tax incentives and gradually appreciating the exchange rate. Plans to liberalise interest rates, thus boosting household incomes and raising the cost of capital, and to raise corporate dividend pay-outs are also in the works, amongst others.

Source: IMF

The structural differences between Brazil and China have thus remained very striking. In Brazil, the household sector has limited incentives to generate precautionary savings. An extensive social security and pension regime incentivises households to consume rather than save. In China, the household sector faces the opposite problem: the social welfare regime is not very extensive. In Brazil, the corporate sector is facing very high borrowing costs (in part due to low domestic savings), which limits profitability. In China, the corporate sector has access to very cheap funding due to high savings and financial repression. In Brazil, the exchange rate is overvalued, limiting the incentives to invest in export-oriented industries, while in China the exchange rate - at least until recently - had been undervalued, favouring investment in the export-oriented manufacturing sector. The list goes on.

Policy-makers in both countries have acknowledged the need to adjust their economic strategies; and the political incentives to adapt their respective models do exist, too. Both governments have taken a number of measures in the past few years, but respective consumption/ savings patterns have changed only little in the past few years. Chinese savings have declined a little, but investment is actually higher today than it was before 2008-09. (While the combination of higher investment and somewhat lower savings/ higher consumption has helped narrow the politically-contentious external surplus, it has made the economy even more dependent on investment.) Admittedly, neither Brazil nor China has taken overly aggressive measures to achieve their respective objectives. But savings, consumption and investment patterns perhaps only change slowly.

Perhaps fundamental factors such as demographic trends and cultural or historically-inherited attitudes (e.g. hyper-inflation) are also at work. This does not mean that government policies will not have any effects – only that they need to be pursued more forcefully if Brazil and China are to shift their economic growth models towards greater investment and greater consumption, respectively.

Brazil – Contingent public sector liabilities (2012)

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.