Gordian Knot: Why Brazil’s Recession Could Last Until 2018

Bankrupt states, fiscal crises at all levels of government, rampant corruption scandals, a reform effort that has no immediate effect on Brazil's fiscal woes, and a resurgence of political turmoil. Six months into the Michel Temer administration, Brazil's Gordian Knot seems to only get worse, as argued in previous posts. While markets rallied and euphoria soared some months ago, there were clear signs that the political crisis would rear its head once again and that the economy was far from staging the expected recovery. This prognosis has now come to pass, with a remarkable twist: Rather than providing support, Brazil's central bank is actually making a bad situation worse.

Brazilian states are gripped by a mounting fiscal crisis that looks unsolvable in the short term. A toxic combination of falling revenues and growing expenditures—in 2015, 15 out of the 27 Brazilian states breached the limit of personnel expenditures to current net revenues established by the Fiscal Responsibility Law—have placed many states on the brink of calamity. Some states such as Rio de Janeiro have been postponing expenditures and payments, including those to public servants, others have slashed investment, affecting their capacity to contribute to Brazil's recovery.

In the past, subnational fiscal crises resulted in bailouts by the federal government and increased scrutiny on state finances, culminating in limits introduced under Brazil's Fiscal Responsibility Law, enacted in 2000. Under the 2001 law, states started to need federal government approval for all new external credit lines. The Fiscal Responsibility Law also established that net state debts could not exceed 200 percent of net current revenues, and debt service could not rise above 11.5 percent of net current revenues¹. Large states such as Rio de Janeiro, Minas Gerais, and Rio Grande do Sul are currently in breach of these limits due to several factors, including a relaxation of these constraints under the Rousseff administration.

In view of the federal government's own mounting debt problems, it is in no position to provide states with a bailout. Moreover, any plan to rein in spending and raise revenues would do little to resolve the situation in the short term in view of very high stocks of debt. The calamitous state of subnational finances in Brazil therefore raises the specter of social unrest as the population is faced with severe cuts in public services, particularly health, education, and security. Rio de Janeiro has already seen a significant spike in crime rates since the Olympic Games in August.

At the same time, the government is grappling with new corruption scandals, now affecting Temer's inner circle, and looming revelations from the ever-widening corruption probe. Temer's chief political articulator, Minister Geddel Vieira, has recently resigned over revelations of bribery and abuse of power. He is the sixth minister to fall in a span of six months—an embarrassing rate of one felled minister per month for the Temer administration. Depositions from Odebrecht executives under a far-reaching plea bargain agreement are expected to further damage Temer's cabinet, as well as a number of members of Congress. The latest round of problems has weakened the president's hand at a delicate moment, when the government was preparing to approve a contentious ceiling on government spending, and to formulate a comprehensive social security reform without which the spending cap will be useless—Brazil's rampant spending growth over the past several years has resulted largely from runaway pensions and other benefits. As the administration itself recognizes, even if these reforms are ultimately approved, they have no immediate impact on fiscal trajectories—their combined effect on the debt-to-GDP ratio would only start to appear within five to six years of their implementation.

Meanwhile, economic indicators have continued to show the depth of Brazil's crisis. Tax revenues continue to drop, monthly GDP indicators are still falling, unemployment keeps climbing. It has thus become more likely that Brazil will not only fail to stage the expected recovery in 2017, but might even see another year of recession, albeit one that is far from the horrid output figures recorded in 2015 and 2016.

In the absence of any possible fiscal action to alleviate the recession, the central bank, faced with falling inflation and inflation expectations, should sense an urgent need to support growth and jobs with more aggressive actions.  Instead, the Brazilian monetary authority kicked off a timid cycle of interest rate reductions in October, lowering the policy rate by 25 basis points to 14 percent. In the meantime, however, both inflation and inflation expectations have fallen faster, leading to a substantial tightening of monetary conditions. As 12-month inflation expectations have dropped to 5 percent, real interest rates have widened to 9 percent, adding to the burden of overly indebted sectors—companies and the public sector alike—and thereby hurting the prospects for a recovery.

Brazil's central bank cannot and should not be Alexander the Great to Brazil's Gordian Knot. But that does not mean the proper policy response is to be overly cautious, aggravating an already historic economic slump.