Brexit and Brazil

Written by Armando Castelar.

Late Thursday afternoon, a reporter called to ask what I thought would be the consequences of Brexit to Brazil. Other than some short-term volatility in asset prices, nothing significant should happen, I replied. Brazil is already in deep economic trouble, it got there by itself and whatever Brexit could add would not change things significantly. And, I added to myself, Brexit will not happen anyway. What a surprise when I woke up Friday morning to find out that the UK was leaving the EU!

Was I equally mistaken about the consequences of Brexit to Brazil? I don’t think so. As expected, on Friday the real dropped against the dollar, as did most other currencies, and the stock market plunged, like everywhere. However, Brexit didn’t change the fact that the outlook for the Brazilian economy depends more than anything on the government’s success to implement its fiscal agenda. With Brexit, Brazilian companies may find it even harder to roll over their foreign debts, which hasn’t been easy anyway. However, the real bad news of the week in this area was not Brexit, but the bankruptcy of Oi, Brazil’s largest telecom, with almost $ 20 bn in debt, half of which is owed to foreign bondholders. Nothing important should happen through the trade channel either. The UK accounts for just 1.5% of Brazil’s exports, which in turn add up to a modest 11% of GDP. For Brexit to impact Brazil through this channel it would have to severely harm the UK’s economy.[1]

What scares me about Brexit is what it says about the political risk of a slow-moving economy going through an era of technological change that has increased income inequality and alienated large segments of the working force. As noted in the FT, the “vote reflected a roar of rage from those who felt alienated from London and left behind by globalization.” Observe the contrast between prosperous London and Scotland, which backed REMAIN, and working-class towns, seaside resorts & rural England, which voted to  LEAVE (see figure below).

 UK Referendum

Source: Financial Times.

Brexit will embolden populist, divisive parties across Europe. It will also cause investors to reassess the odds of Donald Trump being elected president in the upcoming US election, another likely source of market turmoil this year. Things will be different after the vote in UK this week. Perhaps, very different. As Paul Davies remarked in the WSJ, the “biggest risk of Brexit is that it is a signpost along a road toward declining international trade, less free movement of capital and a continuing global economic cooling” (see here).

Why, I ask myself, did I fail to predict Brexit? Of course, the polls are partly to blame, for they indicated that Remain would win by a small but solid margin. However, that’s only part of the story. Probably equally important is that I preferred to view the evidence as I would like it to be: in favor of the Remain option. I wonder how much of that is also true of other things at stake in the world nowadays.

[1] The OECD estimates that Brexit will shave off 3 percent of UK GDP by 2020. Assuming an elasticity of 1 and that Brazilian exporters wouldn’t manage to send their goods elsewhere, this would reduced Brazil’s GDP by an estimated 0.005%.


German Bonds and Supernovas

Written by Armando Castelar.

This week, yields on 10-year German sovereign bonds, known as bunds, dropped below zero, following a path taken earlier by Japanese and Swiss sovereign bonds and adding to a pile of over $ 10 trillion in sovereign debt and roughly half a trillion dollars in corporate debt yielding a negative return. Yields in 30-year German bonds have followed in lockstep, dropping to a mere 0.55%.

Graph 1: Yields on 10- and 30-year German Bonds

Fig 1 German Bunds and Supernovas APC edits docx

Source: Bloomberg.

Why, I ask myself, do people invest in securities that yield negative carry? Why not just keep one’s savings in cash or deposited at a bank? In particular, why take so much duration risk for such a low or negative return? Indeed, it is easy to see that at the current juncture small increases in yields would be sufficient to produce huge capital losses. As Bill Gross tweeted last week, “global yields lowest in 500 years of recorded history … This is a supernova that will explode one day” (see also his June Outlook for a more elaborated analysis).

Over time, I have heard answers to this question combining four different arguments:

 i.         The world has embarked in a period of demographic transition and secular stagnation that will lead to rather low long-term growth. Interest rates have to fall in tandem, to reflect the lower demand for investment.

 ii.         Although nominal yields are negative, these bonds may yield positive real returns, as low global demand leads to deflation.

iii.         Investing on secure sovereign bonds at least guarantees the return of one’s capital, even if this requires sacrificing any return on your savings.

 iv.         Yields are negative because Central Banks have pushed them that way, in some cases through huge quantitative easing programs. This is the case of the Euro Area, where every month the ECB buys 80 billion euros in European sovereign bonds, 19 billion of which of bunds.

Although all these arguments make sense to me, I feel they miss one important element: many people invest in these bonds for they expect their yields to fall even further in the future, thus reaping significant capital gains. As shown below, as investors and the ECB flocked into German sovereign bonds, their prices went up. Anyone buying 30-year German bonds six months ago would have gained an annualized return of 47%. Not bad, right? Not bad at all.

Graph 2: Yields and prices of 30-year German bonds

Fig 2 German Bunds and Supernovas APC edits docx

Source: Bloomberg.

The problem, as I see it, is that this is a huge Ponzi scheme, which only yields significant returns while more money is flowing into these securities. One day someone will be left holding an enormous amount of negative yielding bonds that no one wants to buy. The losses will be huge: according to JP Morgan estimates reported at the Financial Times, if US Treasury yields go up by 1 percentage point, holders of US Treasuries would lose US$ 1 trillion. The same dynamic, if not quite the same magnitude, could be seen if German bund yields were to suddenly rise. More importantly, in a game of “Hot Potato,” who loses when the music stops? The person holding the potato, of course, but the whole regional or even global economy may also get burned. 


High Demand for Optimism

Written by Armando Castelar.

Yesterday, the Brazilian Institute of Economics (IBRE) held a seminar on Brazil’s Economic Outlook. What most impressed me in the presentations was the latent conflict between high hopes that the worst in the economy is behind us, with numbers that continue to show a daunting economic situation.[1] The surveys of business and consumer confidence illustrate this conflict: all improvements chronicled in recent months were due entirely to an upgrade in expectations about the future, with no significant progress in how firms and consumers assess the current situation.

The presentations revealed an external scenario with mixed impacts on the Brazilian economy. They stressed the importance of low growth in both global GDP and world trade, a factor that will weigh on the demand for Brazilian exports. On the other hand, they discarded major shocks coming from either higher interest rates in the US or a hard landing in China. Downside risks are apparently more concentrated in China, where expansionary fiscal and monetary policies produce ever less bang for the buck. In addition, risks are mounting around the vote on BREXIT (June 23) and the US presidential elections (November).

IBRE presented a favorable outlook for the external accounts, with a current account surplus in 2016 and a deficit next year, both of 0.1% of GDP. With net FDI inflows projected at 3% of GDP, and a Central Bank less willing to pile up foreign reserves, this should pressure the currency up. However, IBRE foresees the exchange rate at R$ 3.70/ US$ at the end of 2016 and R$ 3.85 / US$ a year later, on account of rising sovereign risk.

Whether the real strengthens or not will have direct implications for inflation and the degrees of freedom of Brazilian monetary policy. Here we see both good and bad news. Inflation will come down significantly in 2016, to an expected 7.1%, from 10.7% last year. However, in the base case scenario, it will reach 6.2% in 2017 and 5.7% in 2018, far from the target of 4.5%. Indeed, the seminar sent a clear message in this regard: if the Central Bank is serious about pursuing the inflation target, it will have limited room to lower the policy interest rate.

The most critical challenge the Central Bank will have to face is an adamant inflation in services, projected to come down to 7.4% this year, from 8.1% in 2015. This is surprisingly little disinflation considering that the unemployment rate should hit 12.3% by the end of this year and real labor earnings will likely drop 2.0%. IBRE expects unemployment to rise further in 2017. However, how much longer can unemployment remain at these record levels before the authorities are forced to provide some relief? In my view, this is will raise the temptation to let the real strengthen.

Much of the conflict between bulls and bears focus on how much GDP will grow next year. IBRE believes the economy is still going down and foresees a rather gradual recovery in GDP, which it expects will drop 0.1% in 2017. As I discussed in a previous post, bulls believe the economy has already hit bottom and predict an expansion between 2% and 3% next year.

A slow and lackluster recovery will make the fiscal problem Brazil currently faces even more worrisome. In IBRE’s scenario, the public sector debt will rise to 75.4% of GDP by the end of this year and 80.9% a year later. Higher growth would mitigate the problem, but it will not be sufficient to solve it.

The seminar revealed a great demand for optimism and widespread hope that the new administration will be able to put the economy back on track. The positive expectations about the future lay on sound foundations: a better economic team, a sounder diagnosis about the economy’s problems, and a more favorable attitude towards the private sector and international integration. It will be a great help if actual numbers reinforce these positive expectations.

Unfortunately, I myself believe that in a confrontation between optimism and hard numbers, it’s usually the high hopes that leave the arena bloodied. The positive initiatives the new administration has ventilated in the press are insufficient, on their own, to power an economic upturn. A sustained turnaround would require the government to secure congressional approval to measures that put stringent and sustained limits to the expansion of government expenditures. Otherwise, the honeymoon the new government currently enjoys may be short lived.

[1] In what follows I sum up key points of the presentations done by Regis Bonelli, Jose Julio Senna, Livio Ribeiro, Aloisio Campelo, Salomao Quadros, Silvia Matos, Samuel Pessoa, Braulio Borges and myself. Julio Mereb, Bruno Ottoni and Vilma Pinto also contributed to build the outlook discussed herein.


Time to Buy Brazil? The Bearish Case

Written by Armando Castelar.

In a previous post I commented on the views of economists who are optimistic about the outlook of the Brazilian economy, foreseeing GDP growth in the 2% to 3% range already next year (see here). In this post I present the views of economists who remain bearish about the Brazilian economy in 2017.

The OECD economists are an example: in the first week of June they released their revised forecasts, which now foresee a GDP contraction of 1.7% next year, on top of a 4.3% drop in 2016. A week later, the World Bank followed suit, projecting a decline of 0.2% in next year’s GDP. Several Brazilian institutions also doubt that GDP may recover before 2018.

Bearish analysts question the strength of the arguments that support the optimistic view and point to other, less bright ones.

First, they are skeptical about political support to measures that actually tighten public sector spending, pointing to the vote in the Lower House in favor of substantially increasing salaries of civil servants. Indeed, this year the public sector’s primary expenditures should break another record. 

Moreover, they argue that, with the ongoing investigation of the corruption scandal in Petrobras, the political crisis may still be far from over, which will hamper support to harsh measures and affect confidence.

Second, inflation has proved to be much more resistant than earlier anticipated and it is not clear that it will converge to target if interest rates fall soon and substantially. In the last 12 months, prices went up 9.3%, more than their increase a year ago (8.5%). Despite rapidly rising unemployment, inflation in services has declined only marginally, from 8.2% to 7.5% in the same comparison.

Third, it is still far from certain that manufacturing has hit bottom and, if yes, how strong the recovery will be. In particular, if the real strengthens, helping to control inflation, it will stifle net exports. It is not very clear either how fast the new government will solve Petrobras’s financial problems, or launch new infrastructure projects.

In addition, there is much pessimism regarding the recovery of domestic consumption, and thus of sectors such as commerce and other services. Bearish economists point out that the labor market still has room to worsen: unemployment will move higher and real earnings will decline further. In addition, households and firms need to deleverage, meaning domestic credit will continue to contract, boding ill for sectors such as construction and financial intermediation.

Finally, there is a statistical issue: to expand 2% in 2017, after contracting 3.5% in 2016, GDP would have to grow at a seasonally adjusted annualized rate between 4% and 5% in the four quarters of next year. That is, the economy would have to accelerate quite substantially, which would require that confidence and interest rates move fast and substantially in the near future.

How do we balance the contrasting views of bullish and bearish economists about the Brazilian economy in 2017? In my next post I will give my answer to this question.


Time to Buy Brazil? The Bullish Case

Written by Armando Castelar.

The answer to the title’s question is a resounding yes, according to Mauricio Molan, chief economist of Santander Brasil (see here). He expects the economy to resume growth in the second semester of 2016 and to expand vigorously in 2017, when GDP will rise 2%, after printing a negative 3.7% in 2016. He is not alone in making this call: other well-regarded economists have also grown more optimistic lately, foreseeing expansions in the range of 2% to 3% next year.

The bullish view rests on three main pillars. First, Dilma Rousseff’s impeachment will put an end to the political crisis and facilitate the approval of reforms, notably concerning the fiscal accounts, as signaled by the strong support Congress has given so far to the Temer government. The new government also counts on a better economic team, which will boost credibility. These two factors will combine to raise business and consumer confidence from the record lows at which they now stand. Surveys of confidence already show that it is no longer declining. The rise in confidence, in turn, will lift investment and consumption, which will raise tax revenues, facilitating the fiscal adjustment process and further boosting confidence.

Second, the Central Bank is likely to lower the policy interest rate, by five percentage points or more until the end of 2017, further boosting domestic demand and lowering interest payments on the public sector debt. Bullish economists believe inflation will come down, nearing the inflation target (4.5%), due to the record recession of 2014-16, the higher credibility of the new Central Bank governor, and the appreciation of the real, on and in itself a factor that will improve confidence. They see the currency appreciating due to a balanced current account and the high volume of FDI, in a context in which the Central Bank is unwilling to further pile up international reserves.

Third, net exports will continue to expand strongly. There is much optimism regarding a recovery in manufacturing, thanks to a decline in inventories, higher exports and the substitution of imports. Moreover, demand for export commodities has increased in recent months, with substantial price rises, benefiting agriculture and mining. Furthermore, there is the expectation that investment in the oil and infrastructure sectors will expand, with the new management teams in Petrobras and BNDES, as well as due to changes in legislation to make regulation in these sectors more market friendly.

However, not all economists are so optimistic about the outlook for the Brazilian economy in 2017. As I will show in my next post, the bearish case rests on arguments as sound as those put forward by bullish economists that lead to totally different forecasts.


What Are the Credit Rating Agencies Saying About Brazil?

Written by Armando Castelar.

On February 24, 2016, Moody’s stripped Brazil of its cherished investment grade (here), following similar moves by S&P and Fitch. Like the other two agencies, Moody’s sent a strong message: it reduced the credit rating by two notches at once, for foreign and local currency issues, and kept a negative outlook.

The core reason for the downgrade is straightforward: the government has run a large budget deficit and has failed to put forward a credible plan to cut it down. Together with poor GDP performance, this has caused a huge buildup in the public debt, from 51.7% of GDP in 2013 to 66.2% of GDP in 2015. In the most likely scenario, the public debt will surpass 80% of GDP at some moment in 2017-18. At this level, it will become extremely complicated to stabilize the dynamics of the public sector accounts, as interest payments on the debt will feed back into the budget deficit and raise financing requirements.

A key element in this analysis is the assessment that the government will be unable to approve fiscal and structural reforms to change that dynamics within the horizon covered by the ratings (2016-18). According to Moody’s, this includes “to raise the minimum retirement age, improve fiscal flexibility, and reduce revenue earmarking”, in addition to reducing “mandatory growth in various spending categories despite weak revenue performance”. The three credit rating agencies blame the failure to move ahead with such an agenda on political gridlock in Congress; in particular, on the unwillingness of Congressmen to pass unpopular reforms.

I beg to disagree. The real constraint, in my view, lies elsewhere. What has paralyzed the reform agenda is the Rousseff’s government opposition to them and its unwillingness to make the sacrifice to share the political burden with Congress. Suffice it to say that in other crises Congress has supported presidents proposing equally unpopular reforms, and most reforms that Rousseff has sent to Congress have been approved

Instead, the government’s strategy lies in raising the tax burden (think CPMF) to keep popular expenditures on the rise, without letting the deficit rise too fast. Meanwhile, it tries to appease the market by paying lip service to reforms that are supposed to kick in only in future administrations (see here), while renewing broken promises of fiscal austerity. So far, this strategy has worked well and the government has had no problems meeting its large financing needs. If all works according to plan, it will leave the time bomb of the rising public debt for the next administration to disarm.

I like to compare reports issued by credit rating agencies to medical examination reports: they are important and informative, but what matters at the end of the day is how well the patient is. Now we have three expert examiners judging the Brazilian economy to be in very poor health. It is scary that knowing this the patient insists on keeping on with its unhealthy ways.


Back to Reality: The Numbers Don’t Lie

Written by Armando Castelar.

With the end of Carnival, this week in Brazil one gets a sense that the year is finally speeding up: more cars on the street, congressmen bickering about who will be party leader, the Supreme Court finally moving forward with pending cases ... It was also a busy week regarding economic surveys and studies. The story they tell is not a pretty one.

On Thursday, the Central Bank released its estimate for the IBC-BR -- a monthly indicator the monetary authority uses to track the level of economic activity -- in December 2015. Although the IBC-BR does not intend to replicate the official GDP, it is a good proxy for it (Figure 1). Based on a simple regression between the two indicators (more detail here), we infer that in the fourth quarter of 2015 GDP contracted 4.8% YoY and 0.4% QoQ (seasonally adjusted). This translates into a 3.6% contraction of GDP in 2015. This is slightly better than the median financial market forecast (-3.8%) and our own prediction at IBRE (-3.7%).

Figure 1: YoY Variation of Quarterly IBC-BR and GDP (%)

20160221 Figure 1

Sources: IBGE and Central Bank.

Also on Thursday, the OECD released its Interim Economic Outlook for the world economy, cutting down global growth forecasts. In the report, it significantly slashed its projections for Brazil’s GDP, which it now predicts will contract by 4.0% in 2016 and stagnate in 2017, after declining 3.8% in 2015. These compare to the IMF’s forecasts of negative growth of 3.5% in 2016 and also zero change in 2017. If the OECD is right, per capita GDP will have dropped a total 10.5% in 2014-17, going back to the level first reached in 2008!

This week IBGE released two surveys that showed a mixed impact of the fall in economic activity on the labor market. On Friday, the Continuous National Household Survey (PNAD-C) showed that, on average, in Sep-Nov/15 the unemployment rate climbed to 9.0%, up from 6.5% a year before. The survey reinforced two stylized facts about the reaction of the labor market to Brazil’s great recession that will probably extend into 2016:

[1] The number of unemployed is quickly increasing: YoY, a rise of 41.5%, or 2.7 million more people. Yet, employment levels have barely changed: YoY, employment fell 0.6%, with the elimination of 0.5 million jobs. Thus, unemployment is going up because more people are entering the labor force. Although to some extent counterintuitive – why look for a job exactly when it has become harder to find one? – this behavior is consistent with the hypothesis that high levels of household debt and stagnant incomes are pressuring households to seek other sources of income to make ends meet.

[2] The mean quality of jobs has deteriorated, although with only a modest impact on average real earnings: these declined 1.3% for all workers, with a 1.6% contraction for those in the private sector. Focusing on the latter, we see two different stories unfolding. On the one hand, there was a 3.1% YoY (-1.1 million jobs) fall in the number of formal employees, who, however, managed to protect their earnings from inflation (a +0.3% real gain YoY). On the other hand, the number of workers self-employed or in domestic help jobs soared by 4.3% (+ 1.1 million jobs), while their real earnings contracted 5.1% YoY.

Although representative of the overall labor market, the PNAD-C dates back to only 2012, so it does not allow for longer-term comparisons. Also last week, though, IBGE released the Survey on Industrial Employment and Salaries (PIMES), which goes back to late 2000. The PIMES makes clear that, for industry at least, the blunt of the adjustment in the formal labor market has fallen on declining employment and hours worked, with still relatively minor impact on real earnings per hour (Figure 2).

Figure 2: Index numbers for hours paid and real hourly wages in industry

20160221 Figure 2
(12-month moving average, Dec 2001 = 100)

Source: IBGE.

A busy week would not be complete without news on the challenging fiscal front. Indeed, on Thursday S&P downgraded Brazil’s credit rating one more notch below investment grade, keeping a negative outlook. On Friday the government announced a number of initiatives in fiscal policy, the most noteworthy of which was asking Congress to allow for the federal government to run a primary (i.e., before interest payments) budget deficit of 1.0% of GDP in 2016, down from its previous target of a 0.5% of GDP surplus. Do not be surprised if this target is revised south at least once more this year.

The shows of smoke and mirrors that usually accompany the announcement of new policy measures will do little to stem Brazil’s downward spiral, as highlighted by S&P’s decision this week. Moreover, the longer the government takes to act, the more physical and human capital will be destroyed, further complicating an eventual economic recovery, when it comes. We can only hope that, without the distraction of vacations and carnival, Brazilians will start to demand better policies from the government.


Rousseff’s social security reform: Bait and switch?

Written by Armando Castelar.

At the start of 2016, President Dilma Rousseff announced a two-pronged strategy to deal with Brazil’s deteriorating public sector accounts: in the long term, curb government spending through social security reform; meanwhile, balance the public sector accounts by raising taxes.

The announcement had a target audience: the majority of the Brazilian population, in Congress and outside, that opposes further tax increases and wants the government to balance its books by cutting spending. To them, Rousseff offered her bargain: raise taxes until the end of her term -- in particular, by approving the highly unpopular financial transaction tax (CPMF) – and she will in turn fix the social security system, even if this means alienating the political forces that still support the Workers’ Party (to which she and former president Lula belong). Should society accept her bargain?

It is crucial that social security reform is again under consideration. Generous retirement rules and a demographic transition that is outpacing that in developed economies have led to a rapid rise in social security expenditures, which in turn has contributed to push public sector spending up and jeopardize the fiscal balance. It will be virtually impossible to consolidate Brazil’s public sector accounts without making the rules of Brazil’s social security system less generous.

Brazil has two main public social security systems: one for civil servants and another for workers in the private sector. The latter is managed by the INSS (National Institute of Social Security). For the last two decades, most of the pressure on the fiscal accounts has come from the INSS: between 1997 and 2015, INSS outlays expanded at a whopping 6.4% per year in real terms, on average, climbing from 4.9% to 7.4% of GDP (Figure 1).

Two leading factors explain the steep rise in INSS outlays: the rapid expansion in the number of beneficiaries and the large increase in the mean value of the benefits paid to them. The Ministry of Social Security does not report the number of beneficiaries. We can, though, approximate its dynamics by that of the number of benefits INSS has paid: the same beneficiary can received more than one benefit (e.g., his or her own pension, plus the retirement benefits of a deceased spouse). The numbers are revealing. Considering only the month of December of each year, in 2000-15 the number of INSS benefits went up by an average 3.5% per year, while the mean benefit value rose 2.1% per year (Figure 2).

Figure 1: Expenditures with private sector social security system (INSS),
in constant R$ of 2005 and % GDP

                         Source: Ministry of Finance.


Figure 2: Number and mean value of benefits paid by the INSS in December (billion benefits and constant R$ of Dec 2015)

                         Source: Social Security Statistical Bulletin (Ministry of Social Security).

The growing number of benefits is consistent with the rapid expansion of the population aged 60 or more, the main clientele of the INSS. In 2000-15, the number of Brazilians in that age bracket grew, on average, 3.5% per year. This compares to average annual expansions of 1.1% for the overall population and 1.5% for the working age population (15-59-year-olds).

In turn, the mean benefit value went up due to the rise in the real value of the minimum wage: as of December 2015, two out of every three benefits paid by the INSS amounted to exactly one minimum wage. And, in 2000-15, the government raised the minimum wage by an annual average of 4.6%, on top of the increase in consumer prices. This compares to an expansion of 1.5% per annum in per capita GDP.

Absent reforms, social security spending will continue to climb ahead of GDP:

      1.     The government projects that over the next ten years the number of Brazilians aged 60 or more will expand 4.0% per year (0.7% for the overall population).

    2.     Current legislation determines that the minimum wage will rise each year according to the inflation rate in the previous year, plus the rise in GDP two years before, if this was positive, or zero, otherwise.

    3.     Assuming that GDP will fall 3% in 2016, stagnate in 2017 and grow 2% per year in the following eight years, we should expect INSS outlays to reach 10% of GDP by 2025!

Thus, to be meaningful, Rousseff’s reform will have to significantly slow down the rise in the number and mean value of benefits. And the new rules need to kick in relatively fast, before the INSS becomes overwhelmed by unmanageable liabilities, which will then take decades to go away.

Rousseff and her cabinet have been rather vague about the content and timeframe of the reform she has in mind (see, in particular, the interview by Miguel Rosseto, minister of Social Security, to Valor Econômico). So far, the two most positive ideas raised by government officials include:

 (i)            Establish a minimum retirement age, which could eventually become the same for men and women. Currently, the mean retirement age in Brazil is 58 years, so presumably the legal minimum age would be set at or above 60.

 (ii)          Unify all the existing social security systems, setting equal rules for civil servants and private sector workers and for urban and rural workers.

On the other hand, the government has also made clear that:

(iii)        Eliminating the link between the minimum wage and the value of social security benefits is off the table.

(iv)          There will be a lengthy transition period both to start implementing the new rules and then before they become fully effective. Tentative dates would be 2027, to start changing the rules, and 2040, to complete the transition process.

(v)            There is no consensus within the government about what should be in the reform proposal. This will only emerge after extensive negotiations within the working group created with this purpose, which consists of government officials and representatives of labor unions, business organizations and civil society.

$1(vi)          The government hopes to reach a consensus with all key players on a reform proposal by mid-2016. Yet, if it does not, it will go on negotiating until a consensus emerges.

This is a clear recipe for failure. The ideas raised so far fall seriously short of what is needed to prevent an explosion in social security expenses. The level of government commitment is extremely low. The suggested timeframe means changes will only come when it is too late.

Such working procedures and the lack of clarity and commitment make clear that the government likely intends little beyond offering bait to incentivize the approval of higher taxes. More likely than not—and the government’s track record in this area is very telling—it will abandon any intention to meaningfully change the social security system as soon as it gets its side of the bargain. Congress and society in general should not accept these nonsensical negotiation terms.


Putting a Price Tag on the Cost of Loan Subsidies

Written by Armando Castelar.

Brazil is in the middle of its worst fiscal crisis in decades. In 2015, the primary budget deficit (i.e., before interest payments)peaked at 1.9% of GDP, while the overall deficit reached 10.3% of GDP. Market analysts project equally scary deficits for this and the next years, the financing of which will raise the public debt to an eye-watering 82.1% of GDP at the end of 2017, up from 66.2% in 2015 and 51.7% in 2013.

The explosive dynamics of the public sector accounts is the main reason for Brazil’s deep economic crisis, which will cause GDP to contract by about 8% in 2015-16. Although fiscal adjustment is essential, disagreement about how to reduce the budget deficit has delayed significant action in this front. The private sector wants the government to cut expenditures, arguing that the tax burden is already too high. The government, in turn, has reacted by raising taxes and asking Congress to create yet new taxes. In particular, it argues that there is little scope to lower expenditures, for most of them are either earmarked (e.g., for education and health) or obligatory (personnel, social security benefits etc.). Indeed, the government says, cutting expenditures is not only difficult, but also unfair, for it would require cutting down on social programs, thus disproportionately affecting the poor.

Luckily, the Ministry of Finance (MoF) has just released a study that allows for a more nuanced view of this debate by highlighting an often underappreciated source of government outlays: loans by Brazil’s National Development Bank, BNDES.[1] The study puts a price tag on the cost of two of the three main types of subsidies firms received when they borrow from BNDES. In the study’s parlance, these comprise:

1.   Credit or implicit subsidies. These type 1 subsidies derive from the difference between the interest rate the government pays when borrowing from the market and the rate it charges on loans extended to BNDES, which are then used to fund the bank’s own lending. Those subsidies have risen significantly since 2009, as the Treasury rapidly expand the value of loans to the bank, which reached R$ 523.9 billion at the end of 2015 (Figure 1). In present value terms, those subsidies added R$ 114.8 billion to the government’s outlays in 2008-15 and the MoF estimates that they will it cost the taxpayer an additional R$ 175.0 billion in 2016-60. Overall, they amount to roughly 4.9% of GDP, almost seven times the annual revenue estimated for the financial transaction tax (CPMF) the government is trying to create. About 70% of these subsidies will be disbursed, in present value terms, in 2010-20, when they will average 0.31% of GDP per year.

Figure 1: Treasury loans to BNDES (R$ mn)

Source: Central Bank.

BNDES was not alone in operating this type of quasi-fiscal instrument: the Treasury also lent Type 1 funds at subsidized rates to Banco do Brasil (BB) and Caixa Econômica Federal (CEF), two other state-owned banks. BB focuses on agriculture, while CEF favors loans to housing and infrastructure. The Treasury loans extended to these banks, though, were substantially smaller; overall, I estimate a ballpark figure of 0.4% of GDP for the corresponding subsidies for the overall period, in present value terms.

2.  Financial or explicit subsidies. These type 2 subsidies result from the difference between the interest rate BNDES charges for especially favored loans, extended through the Program to Sustain Investment (PSI), and the cost of these loans to the bank, including fund and operational costs and a profit margin. The Treasury directly pays for those subsidies, through transfers to BNDES, the reason why the MoF labels them “explicit”. The PSI started in 2009, with an authorization for BNDES to extend PSI loans of up to R$ 43 billion, but this ceiling rapidly climbed, reaching R$ 452 billion in 2015. In present value terms, those subsidies cost the taxpayer R$ 46.7 billion in 2009-15 and, according to MoF estimates, the Treasury will pay an additional R$ 25.1 billion in 2016-41. Overall, the government will spend 1.2% of GDP to fund those subsidies. In present value terms, the Treasury will disburse 95% of those subsidies in 2010-20, when they will average 0.11% of GDP per year.

Large firms receive most subsidies channeled through BNDES. For instance, the top 1% of the borrowers who benefitted from the PSI in 2009-14 accounted for 53% of the program’s loan value and probably an even larger share of the subsidies (see here). BNDES reckons this distribution is similar to that of its overall lending (see here) so the distribution of type 1 subsidies follows an analogous pattern.

Although a recent addition in the case of BNDES, there is a long history of type 2 subsidies being channeled through other state-owned banks. Thus, a substantial share of the loans that BB extends to the agricultural sector carry below-market interest rates. The Treasury then compensates BB through an annual transfer of budgetary resources. In 2013-15, annual loan subsidies to the agricultural sector amounted on average to R$ 8.8 billion (0.15% of GDP per year). The distribution of those subsidies across farmers is also concentrated on the top ones. Moreover, it is not clear why they are necessary, considering Brazil’s comparative advantage in agriculture.

There is a third type of subsidy, unaccounted for in the MoF calculations: roughly, 27% of BNDES’s overall funding comes from taxes, through the FAT (Worker’s Support Fund). These funds cost to BNDES the same as the loans provided by the Treasury and amount to 40% of their value. Differently from the Treasury loans, though, BNDES does not need to pay them back to the FAT, barring critical circumstances, so the present value of the implied subsidies per R$ is proportionately larger.

A similar mechanism generates funding for loan subsidies channeled through CEF. CEF manages the FGTS, a fund to which workers compulsorily contribute with 8.25% of their monthly salaries, and to which they have access when fired from a job, retiring, getting married or falling seriously sick. The FGTS pays a negative real return (see here). CEF then transforms the negative return subtracted from the workers’ savings to its clients in the form of below market interest rates. This is a loan subsidy in the sense that the workers are unwittingly subsidizing CEF programs by accepting a negative real return for their retirement and unemployment savings.

Tax exemptions on interest income accruing from certain savings instruments make possible a fourth type of loan subsidy. The most traditional of these instruments is the “Caderneta de Poupança”, a simple savings account that pays a monthly interest rate of 0.5%, plus a base rate, the TR, which also indexes the FGTS. In 2015, the TR was 1.8% and the annual return for the Caderneta added 8.1%. The government exempts this return from income and other taxes. Had the government levied a 15% tax on this income, it would have collected R$ 1.7 billion in 2015. So this loan subsidizes citizens’ savings – theoretically a noble and worthwhile policy—but the flip side of this tax exemption is the obligation of financial institutions to use the majority of the funds deposited on those savings accounts to finance agriculture (BB) and housing (all other banks). More recently, the government extended this privilege to other financial instruments (e.g. CRIs, LCIs, CRAs, LCAs, and infrastructure debentures). Financial institutions have to use the money raised through the sale of these securities to finance housing, agriculture or infrastructure.

A fifth type of loan subsidy comes from public sector guarantees on certain credit operations. This is the case, for instance, of the CCR (Convênio de Crédito Recíproco), an agreement through which central banks guarantee export credit operations across Latin American countries that are members of LAIA (Latin American Integration Association).

Governments in most countries provide one type or the other of loan subsidies to its firms and households. In this regard, there is nothing unique about Brazil. Still, it is remarkable that Brazilian taxpayers spend so much money with such unclear goals, in a regressive fashion, and with absolutely no formal assessment of its impact. At a time when the fiscal cost of such subsidies is rising so dramatically, it makes sense to reassess their utility and check how much bang taxpayers are really getting for their buck spent on loan subsidies.

[1] The Valor Econômico newspaper was the first to report on the study, on February 10, 2016 (see here).


Three questions about the CPMF

Written by Armando Castelar.

Tiradentes, Brazil’s national hero, was executed and had his dead body cut into pieces by the Portuguese crown for opposing a hike in taxes. The year was 1792. Fast forward 223 years and Brazil is again divided over a government’s attempt to further raise the tax burden. The government wants to implement a new tax, the CPMF, of 0.2%, on top of all financial transactions. The government estimates the CPMF can generate R$ 32 billion in revenues per year.

Congress is discussing whether to approve the constitutional amendment creating the CPMF. The issue has generated a heated debate in the press and among economists. Some see it as the least bad option to fix the chaotic situation of the public sector accounts (see here). That is also the government’s view (see here). Yet, three questions about the CPMF linger without answer:

     ·  The government argues that it is near its limit on what it can discretionarily cut in primary expenditures (all but financial expenses), citing the earmarking of revenues to specific areas or programs as the key restraint. But if the constitution can be changed to raise taxes, why not change it to undo the earmarking and cut inefficient government expenditures?

      ·  Why not fix the budget by cutting financial expenses the government controls? So far the government has spent R$ 102 billion to benefit firms unhedged against the exchange rate devaluation. The 2016 budget foresees expenditures of R$ 38 billion on interest subsidies to firms borrowing on one of the credit programs extended by the national development bank. Other credit subsidies to agriculture, industry and construction will consume even more. Considering that Brazil already has a very large state, the size of which has expanded dramatically over the last three decades, why not seize the opportunity to cut back on some of these financial subsidy programs?

   · How can one be sure that even with the CPMF there will not be another fiscal crisis in a couple years? The government talks about the rise in taxes as providing a bridge, but it doesn’t say what is on the other side of the bridge. Public sector expenditures have risen continuously over the years, lately on account of rising subsidies and social security expenditures, but nothing is being proposed to stop that process. Moreover, former president Lula, who carries enormous influence over the government and will be a presidential candidate in 2018, has repeatedly spoken against the fiscal adjustment and in favor of expanding public sector expenditures. What certainty can there be that the CPMF collections will not be squandered in another binge of inefficient spending?

As the death of Tiradentes, a dentist and army officer, illustrates, the debate over taxes is seldom a technical matter, but one that hinges on the nature of the society and economic model we want. Yet, so much taxpayer money is wasted on inefficient and regressive government programs, that the case for further raising taxes is weak also on technical grounds. Brazil already has one of the largest tax burdens in the world, higher than the OECD average. It has not served Brazil well, either in generating growth, offering appropriate public services or improving income distribution (see here). Something has to be done to cut the budget deficit, but creating yet another tax is not the best option.