Lack of “deliveries” in fiscal area concerns, with pressure on exchange rates, interest rates

10/21/2024

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The anticipated cooling of economic activity after a surprising first semester is beginning to show in indicators, along with decreasing fiscal momentum. What could be seen as a relief and good news for inflation, however, is overshadowed by the growing deterioration of agents’ risk perception regarding the Brazilian fiscal scenario—a situation that pressures the exchange rates and the interest curve. In such a scenario, it is necessary to urgently “deliver” spending adjustment.

The October edition of the Fundação Getulio Vargas’s Brazilian Institute of Economics (Ibre-FGV)’s Macro Bulletin slightly revised the expectation for 2024 GDP growth from 2.9% to 3%. Following August data, the third quarter projection was adjusted from -0.1% to 0.1%, compared to the previous three months.

Annually adjusted, it is still a strong expansion of 3.2%, according to Silvia Matos, the survey coordinator. “Household consumption will likely remain very strong, we anticipate a year-on-year increase of 3.8%. Although the job market remains tight, the peak of fiscal stimulus is passing, along with the electoral cycle. It will eventually pressure down not only government consumption but also household consumption and investments in the third quarter,” she explained.

Ms. Matos notes that sectorial data from industry, services, and retail also point to accommodation, while confidence indicators suggest a cooling of business sentiment.

The Business Confidence Index (ICE) calculated by Ibre-FGV dropped 0.8 points, the first decline after six consecutive rises and only the second in 2024.

In terms of supply, the perspective is that the service sector should continue leading with a 0.4% increase compared to the previous quarter, followed by industry (0.3%), while agribusiness should see a 1% decline.

Except for the latter, these are more modest numbers than seen in the second quarter (1% and 1.8%, respectively).

On the supply side, a similar situation is seen. Two of the previous quarter’s drivers, household consumption is expected to slow from 1.3% to 0.2%, while government consumption goes from 1.3% to 0.5%. Ibre-FGV expects zero growth in gross fixed capital formation on a quarterly comparison. Meanwhile, exports could slow from 1.4% to 0.7%, and imports, from 7.6% to 0.4%.

“It will not be a sharp slowdown, the output gap will not return to negative, especially since we expect a resumption of activity in the first quarter of 2025,” Ms. Matos added. Ibre projects a 2% growth next year.

This scenario could help the inflation outlook but it has been pressured by two components. First, the severe drought and its impacts on food, as well as on energy tariffs. Economists André Braz and Mateus Dias note that farm products inflation rose by 8.4% in September, compared to a decrease of 6.9% a year earlier.

“This pressure is already felt by consumers, with food at home prices rising 6.1% in the last 12 months, against a drop of 0.78% in the same period of 2023,” the economists write. Given the change and maintenance of higher tariff flags, electricity has risen approximately 10% this year, adding 0.4 percentage points to the Extended Consumer Price Index (IPCA).

Ibre estimates the indicator to close 2024 at 4.7%—above the upper target pursued by the Central Bank, and to slow to 4.3% in 2025. In addition to the effects of the drought and strong activity, Ms. Matos highlights the sharp worsening of the fiscal perception, which has kept the exchange rate and interest curve high, a movement that pressures agents’ expectations about inflation and, consequently, the Central Bank.

“The inflationary situation worsens in the short term, so the Central Bank needs to act more decisively. With projections trending above the target this year, it’s hard to see the Selic policy interest rate falling next year,” Ms. Matos pointed out. “Even the international scenario may not help much, as was once expected. The Federal Reserve began its rate-cutting cycle with 0.5 percentage points but indicates it might opt for 0.25 points at the next meeting, or even pause it, amid issues around the U.S. elections. Trump has a rather protectionist agenda, which can be inflationary.”

The economist notes that, in Brazil, for a while, the market gave the benefit of the doubt to the fiscal framework. “Some had a very optimistic view. Now the market is waiting for some concrete measure of spending control.”

Ms. Matos regrets that, in Brazil, a severe worsening of the scenario is needed so that there is a favorable policy in tackling the fiscal issue. “We need to see a prospect that some positive primary result can be foreseen on the horizon, which has not yet occurred. The transition proposal to amend the Constitution (PEC) was approved at the end of 2022 without major disruptions—and it violated the Fiscal Responsibility Act by increasing recurrent spending by around 1% of GDP without saying how this would be financed. That 1% is exactly the current gap. Simply put, this issue remains hindering a scenario that could rather be much more positive, with growth slowing down slowly, a smaller interest rate hike.”

In this context, the proposal for income tax exemption for individuals earning up to R$5,000 could cause even more distress if it is compensated by applying a minimum tax of 12% to 15% on taxpayers with income exceeding R$ 1 million annually. “That is a way of re-taxing incomes that are currently exempt, such as profits and dividends and certain types of financial investments. According to Federal Revenue data, the top 0.01% of the Brazilian population with the highest income receives more than half of its income in the form of profits and dividends,” economist Manoel Pires wrote in the report. From a macroeconomic standpoint, however, “the redistributive change should produce an expansionary impact on aggregate demand. By taxing the richest to finance the relief of the lower-middle class, the proposal should stimulate consumption,” he warned.

Mr. Pires acknowledges that little is known about the measure. He considers its discussion inopportune at the moment, given its strong electoral impact and on public accounts. He adds that the biggest problem concerning the individuals’ income tax is not the exemption bracket, but its design.

“In a comparative study of 2023, published in the Fiscal Policy Observatory, it was found that, in Brazil, the deduction per dependent is very low compared to that of OECD countries. For example, a four-member—with three dependents—tends to have a much higher tax burden than a single-parent household with the same income,” Mr. Pires pointed out, noting that the latter has a much greater capacity to contribute. “Adjusting this type of inequality is more efficient and cheaper for the government.”

Another consequence of the overheated activity starts to appear in the external sector accounts: the current account deficit moving towards near 2.5% of GDP. Although exports remain strong, there was a significant increase in imports. Economist Livio Ribeiro points out that, although such a deficit does not pose a threat to the country’s external sustainability, “it will require more short-term capital, which could make the balance of payments results more unstable.”

*By Marcelo Osakabe — Sao Paulo

Source: Valor International

https://valorinternational.globo.com/