As Brazilians shift their attention away from the country’s woes to the 2016 Olympics in Rio de Janeiro, interim president Michel Temer and his economic team will likely receive a two-week respite from growing criticism. Unfortunately, questions and uncertainties will resume in earnest as soon as the closing ceremony is over. Policy priorities include passing urgent fiscal measures to restore debt sustainability, addressing worsening finances, reducing domestic interest rates, and formulating a coherent strategy to privatize state assets. The government also needs to reshape Brazil’s public banks, particularly the development bank BNDES, as well as decide whether the public mortgage lender, whose balance sheet has ballooned over the last several years as loan delinquencies rise, needs cash injections or a recapitalization from the government. Even if many of these reforms are not carried out as intended, the Central Bank should consider reducing interest rates sooner than it has so far indicated.
Brazil is facing its second consecutive year of falling GDP, marking the country’s worst recession on record. The International Monetary Fund (IMF) and the Brazilian authorities have recently revised GDP projections to a contraction of 3.3 percent in 2016, a lesser decline than previous estimates. For 2017, the IMF projects growth of only 0.5 percent, while some market participants believe activity could expand by as much as 2 percent.
No Clear Source of Growth
These expectations, however, are based more on wishful thinking than reality. The reality is that it is difficult to envision where growth would come from. Household debt remains high, unemployment is on the rise—11.6 million Brazilians are jobless, and layoffs have not abated—and although inflation has declined somewhat, household budgets remain tight due to steadfast prices combined with falling wages. Investment also shows little hope of recovering: Public investment is now constrained by the need to rein in expenditures, while private investment continues to suffer because of a climate of uncertainty—especially political uncertainty—and high interest rates. An export-driven recovery is also unlikely. While exports have rebounded somewhat thanks to recent exchange rate devaluations, Brazil’s overall lack of competitiveness and adverse trends in global trade constraint its exports.
Signs of Progress
To be sure, Brazil has made significant advances since the start of the year. On the political front, the process to impeach President Dilma Rousseff has advanced within the established parameters set by the country’s constitution, avoiding a severe institutional crisis, despite misinterpretations that a “coup” has been staged by current interim president Temer—Rousseff’s former vice-president—and his party, the Brazilian Democratic Movement Party (PMDB), a former ally of the Worker’s Party (PT). The corruption investigations have ensnared a number of politicians and businessmen and have thus strengthened the rule of law in Brazil. Since becoming Brazil’s interim president in May, Temer has promoted a major overhaul not only of the economic team, but also of the boards of both BNDES and Petrobras, the oil company. Petrobras’ shares have since rebounded, and there are growing expectations that BNDES will undergo major reforms to its lending practices as well as see a substantial reduction in its balance sheet.
Temer’s new finance minister and economic team have also announced a series of key fiscal measures, which include the creation of a ceiling on expenditure growth, social security reform, and other efforts to contain spending. Market participants received these announcements with great optimism, and Brazilian assets have since rebounded on the expectation that the economy is on the mend.
Dysfunctional Politics Impede Fiscal Policy
However, a series of setbacks suggests greater caution, and after the Olympics are over—which will likely coincide with Rousseff’s definitive removal from office—reality will sink in. Fiscal policy challenges in a still dysfunctional political environment have surfaced recently. To date, Temer has been unable to pass constitutional amendments that would make the proposed expenditure ceiling viable and effective. The interim president has also conceded to pressures to increase public servants’ wages and salaries, and has received sharp backlash on his social security reform proposals, all of which are paramount to restoring medium-term fiscal sustainability.
Moreover, a recent plan to provide states with debt relief—especially Rio de Janeiro, whose finances have been stretched beyond the limit by the Olympics, and Brazil’s largest state, São Paulo—has come under harsh criticism. Initially, the government had proposed providing debt relief in exchange for states’ agreements to include key spending items under the expenditure ceiling that Congress would approve. Recently, this proviso has been relaxed, meaning that states may end up getting the full relief without any obligation to constrain future spending. It is not clear how much the deal with the states will ultimately cost the budget, but the cost is now likely to exceed the amounts previously estimated by the Finance Ministry and incorporated in the fiscal targets for 2016 and 2017—both are equivalent to deficits of just under 2 percent of GDP.
Monetary Policy: Greater Confidence in the Central Bank
The government’s proposed fiscal and social security reform agenda, as well as its plans to privatize state assets to improve economic efficiency and create additional budget revenues, have been well received and are certainly steps in the right direction. However, little attention has been given to the role of monetary policy. Under new leadership, the Central Bank has recently decided to maintain interest rates at 14.25 percent annually, in view of the uncertainties that still plague the economy, especially on the fiscal front. However, given improved market conditions, driven by investors' blank confidence check to the new Central Bank team, inflation expectations have come down substantially. As a result, taking into account 12-month expectations, real interest rates have recently risen to a whopping 9 percent from about 6.5 percent at the beginning of the year. Such a sharp tightening of monetary conditions in the midst of an ongoing recession suggests that holding interest rates constant may no longer be the right policy for Brazil. Reducing interest rates sooner rather than waiting for the government and Congress on fiscal measures, may do much to alleviate household and corporate indebtedness, as well as the government’s own interest bill, equivalent to some 8 percent of GDP. By lowering interest rates, the Central Bank would also help reduce investment costs if inflation expectations remain subdued.
Inflation expectations are not likely to deteriorate if the Central Bank were bolder on interest rates. On the one hand, the continuing recession would limit perceptions that inflation is likely to rise in the future, much as it is already doing now. On the other, given the market confidence in the new economic team and the perception that this Central Bank is not politically influenced—unlike perceptions that prevailed under Dilma’s leadership—investors would likely view an interest rate reduction with greater trust. Finally, recent Central Bank surveys show many market participants are already expecting an imminent reduction in interest rates anyway. Thus, if the Central Bank steers monetary policy on a different course, the chances of a swifter recovery could rise, setting in motion fundamentals that would actually justify current optimism. Hurdles would still remain, but their height would be lowered to conform to Brazil’s current disadvantages.