Credit rating agency says that if fiscal performance is weak during strong economic growth, it may deteriorate further during an unexpected slowdown
09/27/2024
Shelly Shetty — Photo: Claudio Belli/Valor
Despite Brazil’s surprising economic growth this year, the country’s fiscal performance has been “weaker than anticipated,” maintaining high uncertainty regarding public finances, according to Fitch Ratings. “Economic outperformance may partly result from the loose fiscal position. If fiscal performance is weak when growth is strong, it could deteriorate further in an unexpected slowdown. Uncertain consolidation prospects are therefore a key macroeconomic vulnerability constraining Brazil’s ‘BB’/Stable sovereign rating.”
In a commentary released Thursday, signed by analysts Todd Martinez, Shelly Shetty, and Mark Brown, Fitch noted that the Lula administration is aiming for gradual fiscal consolidation after allowing the deficit to increase last year to accommodate a rise in social spending. However, the analysts pointed out that the government faces challenges both in significantly boosting revenues and in controlling expenditures.
The agency highlighted that the government projects a primary deficit of 0.6% of GDP this year, which would be the maximum allowed under the fiscal framework and zero-deficit target, with a tolerance range of plus or minus 0.25% of GDP. However, this projection does not account for certain expenses, such as those related to flooding in Rio Grande do Sul. Fitch stated that it expects the government to achieve this target, “but it would not be an auspicious start to the consolidation process.”
Fitch analysts emphasized that the main revenue-enhancing measures are either temporary or have uncertain outcomes, specifically mentioning revenues from dispute settlements under the Administrative Council for Economic Defense (CARF). Moreover, they regarded the government’s contemplated measures to offset revenue shortfalls, such as using idle bank deposits and increasing dividends from the Brazilian Development Bank (BNDES), as “improvisational measures.” “Such improvisational measures show a commitment to fiscal targets but do not offer structural fiscal improvements,” the agency said.
Meanwhile, Fitch noted that controlling expenditures has proven to be a “challenging” process, particularly with higher-than-expected pension costs. Additionally, the agency warned that indexing and tying expenditures to specific revenues would “keep pressure on social expenditures in the next few years, requiring a further squeeze of discretionary spending to compensate that could eventually become unviable.” Thus, the agency acknowledged the government’s initiative to combat fraud in social programs but stressed that “political appetite for changes that deliver major relief remains unclear.”
In its updated projections, Fitch now expects a 2.8% growth rate for this year. Regarding public finances, the agency predicts a primary deficit of 1% of GDP in 2025, higher than the previous forecast of 0.7%. “This would exceed the maximum 0.6% allowed by the fiscal rule,” it warned. Furthermore, interest costs are expected to rise due to the Central Bank initiating a mini-cycle of monetary tightening. “This will lift interest payments immediately, given a high share (45%) of floating-rate debt.”
Fitch forecasts that economic growth will slow to 2% starting in 2025. In this context, the agency projects that debt will reach 77.8% of GDP this year and 83.9% of GDP by 2026. “This is faster than previously forecast, widening the gap to the ‘BB’ category median of 55%,” the Fitch analysts remarked.
Market participants are already working with real rate of 5%
12/13/2022
As discussions about public spending move forward with the Transition PEC (proposal to amend the Constitution), the worsening perception of fiscal risk and the possibility of increased subsidized loans via state-owned banks have put pressure on the neutral rate of interest, the one that neither speeds nor slows economic growth. The international landscape is not helpful either, with tighter monetary conditions in the major economies, which props up the feeling that the local interest rate will remain at higher levels in the future.
The lower levels of neutral rates of interest have been left behind. Before the pandemic, the Central Bank and the market worked in their scenarios with a neutral rate of interest of around 3% in real terms. In June, the monetary authority started to adopt in its scenarios a neutral real rate of 4%, but in the last few weeks the market has been working with even higher numbers –some institutions have already put in their scenarios a neutral rate of interest of 5%.
In the Banco Original’s calculations, which consider the difference between the key interest rate Selic and the IPCA (Brazil’s official inflation index) estimated by the Focus (Central Bank’s weekly survey with economists) for a three-year period ahead, the neutral rate of interest implicit in the expectations of market economists is 4.9% in real terms. The environment with a higher neutral rate makes it clear that, in the market’s view, even if the Selic does not rise above the current level of 13.75% per year, it will not fall as much as was expected months ago. This is linked to recent scenarios of market participants who have raised projections for the Selic in 2023 and 2024.
Fernando Genta — Foto: Silvia Zamboni/Valor
This is the case of XP Asset Management, whose central scenario includes a neutral real interest rate of 5%, with an upward bias, said chief economist Fernando Genta. For him, the signs of neutral rate of interest hike are “unequivocal” and Brazil is likely to transition to a new macroeconomic balance of higher public spending, higher interest rates, faster inflation, and some increase in the tax burden.
“With the prospect of higher public spending, the Focus survey is likely to show upward revisions in the Selic projections, with no downward revisions in inflation expectations. This combination of more interest and inflation expected, for an extended period, is interpreted by the model as an increase in neutral rates of interest,” said Mr. Genta, who was assistant secretary of the Ministry of Economy between 2017 and 2018.
The most recent discussions about possible changes to the Long-Term Rate (TLP) also interfere with the sense of a higher neutral rate of interest. Rumors that former Minister Aloizio Mercadante may take over the Brazilian Development Bank (BNDES) in the next administration gained steam Monday and impacted long-term interest rates substantially. The interbank deposit (DI) rate for January 2027 rose to 13.05% from 12.865%; while the DI for January 2029 climbed to 13.1% from 12.9%.
Last week, Mr. Mercadante criticized what he considers an excessive transfer of profit from the BNDES to the National Treasury, advocated the bank’s role as a booster of industry and guarantor of long-term loans and, internally, also discussed ways to rebuild the bank’s funding system and change the TLP. The presidential transition team’s view is that, besides being excessively high, the TLP is inflexible and, thus, inefficient.
In Mr. Genta’s view, the recent discussion about changes in the TLP moves in the direction of a higher neutral rate of interest, since, in case of reversal and return to the previous scenario, the power of monetary policy would be weakened. “As you increase the percentage of credit not impacted by monetary policy, you need a higher interest rate to achieve the same impact on inflation. It may sound semantic, but I think this is more a reduction in the power of monetary policy per se rather than a rise in the neutral rate of interest. But both things go together,” he said.
Banks such as Credit Suisse and Citi are also working in their scenarios with a neutral real interest rate of 5%. Santander embeds in its scenarios a neutral rate of interest of 4%, but stressed that this variable shows some tendency to the upside.
“Our calculations, which are based on the real yield curve and smooth market moves, the neutral rate of interest is actually moving towards 5%. We are not incorporating this into our scenario yet; we are waiting for fiscal decisions and signals about economic policy,” said Mauricio Oreng, Santander’s head of economic research. While uncertainty is high, he said, “in fact, there is a preliminary indication that the neutral rate of interest may be going to 5%.”
“All else constant, a higher neutral rate of interest also means that the neutral primary result gets higher,” said Mr. Oreng, as he points to the fiscal challenges ahead. “And we are also seeing a scenario where international interest is higher. For a few years ahead we will be working with a higher interest rate abroad. The environment with Fed funds at 5% is quite different from what we expected before.”
When evaluating the recent history of the neutral rate of interest, Mr. Oreng recalled that, after Congress passed the pension reform and TLP was put in place, the risk premiums of Brazilian assets fell to “very low” levels, which led the market to project a neutral rate of interest of 3%. “However, the evolution of the post-pension reform scenario, with new discussions of the fiscal framework and spending above the cap, led to a higher neutral rate of interest scenario. If we excluded the pension reform, our interest rate would be at an even higher level.”
The baseline scenario of Apex Capital’s chief economist Alexandre Bassoli includes the neutral rate of interest at 5% in real terms. “The trend has been upward since the pandemic. The estimates of the Central Bank itself, which used to be 3%, went to 4%. There is a global component because clearly there is a trend of a significant increase in interest rates in the world, but there is also a local component, which is the issue of the risk premium, which is related mainly to fiscal uncertainty.”
Mr. Bassoli points out that the spending cap brought predictability to public spending and increased the confidence of economic agents. “It is unclear what kind of regime may come to be adopted, but if the adoption of the cap contributed to reduce the neutral rate of interest, the extinction of the cap increases the rate.”
Original’s chief economist Marco Antonio Caruso observed the same. “If you have a federal administration willing to reduce public savings, there is, in theory, less availability of funds, and this helps you to have a higher neutral rate. Brazil has a high debt – almost 20% above its emerging peers – and the signaling of an increase in this debt causes risk premiums to rise. This also brings a higher neutral rate of interest,” said Mr. Caruso.
Since the neutral interest rate is an unobservable variable, according to Mr. Caruso, the evidence of a higher neutral rate of interest may show up in the economy through slower disinflationary processes and higher nominal rates for longer periods.
Mr. Caruso also draws attention to the recent discussion on the resumption of the Long-Term Interest Rate (TJLP). “BNDES used to offer subsidized loans to large companies, in relevant volumes. You end up making a large part of the economy’s credit unresponsive to monetary policy. If this scenario comes back, it would also require a structurally higher interest rate over time,” the economist said.
Cautious messages about the resumption of subsidized interest rates have even been sent by Central Bank authorities, especially by the monetary authority’s president, Roberto Campos Neto, in recent events. But despite the discussion being on the rise among market players in recent months, Mr. Caruso does not believe there will be any sharp change in the neutral rate of interest in the Central Bank’s next communications.
“The Central Bank is a ‘taker’ of fiscal information and cannot assume things that are not yet materialized. And it would be strange. Nature does not make jumps. It is difficult for the Central Bank to indicate that it has a high conviction that an unobservable variable went to 5% from 4% overnight. I think it would be a longer and more discussed process,” he said.
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