How Feasible Are Brazil’s New Fiscal Measures Given Ongoing Political Turmoil?

May 31, 2016 4:30 PM

Another week, another fallen minister. Interim President Michel Temer’s second full week in office began much like the first: A second key minister was caught on a wiretap allegedly plotting to obstruct the wide-ranging corruption probe that began with state oil giant Petrobras and has since engulfed much of the political system. This time the affected official was—and this is no joke—the Minister for Transparency. Last week, Temer’s Minister for Planning, one of his closest advisors and a key member of the new economic team, was pushed out for the same reason. Caught in the middle was the much-awaited announcement of measures to rescue the Brazilian economy from the abyss. A gaping budget deficit of over 3 percent of GDP projected for 2016, deteriorating debt dynamics, and a dramatic rise in the unemployment rate to 11 percent, are some of Brazil’s most challenging issues. The ongoing political crisis and setbacks to Temer’s nascent government may dent prospects that Brazil’s problems will finally face resolution.

Interim President Temer and Finance Minister Henrique Meirelles have recently announced a set of measures to begin the arduous process of addressing Brazil’s severe problems. While the proposals seemed underwhelming to many, both Temer and Meirelles emphasized that this is the first set of measures and that more will come in due course.

The announcements include the adoption of a ceiling on nominal expenditure growth; strict limits on subsidies; the extinction of Brazil’s sovereign wealth fund and the use of its remaining resources, less than 0.05 percent of GDP, for early repayment of loans from the Treasury to the state-owned public bank (equivalent to about 20 percent of total loans from the Treasury to the public bank made over the period 2005–10); measures to enhance governance in state-owned companies; and the passage of legislation that would remove from Petrobras the requirement that the embattled oil company maintain substantial stakes in Brazil’s pre-salt oil projects.

The most significant measure announced was the adoption of a ceiling on nominal expenditure growth. The idea of instituting brakes on expenditure growth has been around in Brazil since at least 2005, when then Finance Minister Antonio Palocci first proposed it, only to be mocked by Dilma Rousseff, former President Lula’s then Chief of Staff. She famously called the adoption of a ceiling on expenditure growth “rudimentary.” Interestingly, not long before the Senate vote that suspended her from office for 180 days pending an impeachment trial, President Rousseff was proposing a similar approach, which would have involved limiting nominal expenditure growth to the growth of nominal GDP.

The Meirelles-Temer proposal is more ambitious than that pursued by Rousseff. By establishing that expenditures cannot exceed the previous year’s inflation, the rule envisages a decline in the spending-to-GDP ratio as soon as growth turns positive. Currently, total government spending, including states, municipalities, and state-owned companies, amount to some 39 percent of GDP. Last year, while nominal GDP grew about 6 percent, total spending increased 12 percent, reflecting indexation mechanisms that automatically impact expenditures. The lack of ability to control spending due to perverse indexation mechanisms has been at the center of Brazil’s mounting fiscal problems.

The proposed ceiling on nominal expenditure growth would not only do away with perverse spending indexation but also align Brazil’s fiscal framework with global best practices. A recent study by the International Monetary Fund shows conclusive evidence that countries that adopt explicit rules for expenditure growth as a complement to their fiscal targets generally achieve better medium- and long-term fiscal results than those that do not. Moreover, the study shows expenditure rules induce greater policy countercyclicality, making countries more fiscally prudent when times are good, allowing them fiscal space to increase spending when times turn sour while respecting the ceiling. This suggests that the measure could be very positive for Brazil, which has suffered from years of profligacy and procyclical policymaking.

While an expenditure ceiling might have significant impact on Brazil’s medium-term fiscal prospects, the politics do not favor its approval. The measure would require constitutional amendments to remove the current indexation mechanisms. Approving constitutional amendments in Brazil requires three-fifths of both houses. While many political pundits believe Temer might have the necessary support in Congress, recent developments raise some important concerns. The two fallen ministers, more damaging revelations from the corruption investigations affecting other prominent politicians from Temer’s PMDB—Brazil’s largest political party—and low approval ratings for Temer himself all threaten the new economic program. Adopting a ceiling on expenditure growth would necessarily impact spending on health and education, as well as social security and other benefits, and would likely face fierce opposition from the Workers’ Party (PT) and its allies, as well as from the population more generally.

Expectations that a new Temer-led government would be able to lift Brazil from the doldrums were running high in the weeks prior to Rousseff’s suspension. Momentum has since subsided considerably, and some market analysts have begun to fear that plans to fix the country’s economic problems will go nowhere. Their fears are not unfounded.