Brazil’s external-account indicators currently locate it among investment grade countries. Nonetheless, despite the fact that its fiscal behavior in terms of primary surpluses and public debt trajectory since the 2002 confidence crisis has surprised many skeptical analysts along the way, Brazil’s public debt-to-GDP level is still high as compared to peers. Therefore, the government’s defeat of the CPMF tax renewal at the Senate last December 12 constituted a major macroeconomic event, given that the fiscal revenue to be collected in the following years with that tax hitherto applied on monetary and financial transactions was expected to be around 1.4% of Brazil’s GDP.
The rejection of the CPMF renewal bill and the forthcoming fiscal policy’s reaction will bear consequences on the future of the Brazilian economy. While we wait until that reaction is made explicit in detail, let us explore a bit the backdrop in terms of debt dynamics against which it will be set.
It is worth recalling that, assuming away the emergence of “skeletons” in the wardrobe (i.e. hidden or hitherto unrecognized government liabilities), a public debt trajectory can in a simplified manner be defined as a race between, on the one hand, primary balances displayed by the public sector and, on the other, the impact exerted upon previous debt levels by the interest rate paid on that net debt, an impact in turn mitigated by the country’s pace of GDP growth:
d t = d t-1 [ (1+r) / (1+g )] – s t where:
d = net public debt-to-GDP ratio r = interest rate paid on the net public debt g = rate of GDP growth s = public sector primary surplus
Let us use the market expectations weekly collected by the Central Bank of Brazil as our benchmark. On the week prior to the Senate vote, “Mr(s). Market” was foreseeing things as follows:
Source: Central Bank of Brazil
Some remarks can then be made:
1. For a debt-to-GDP ratio of 43.42% in the beginning of 2008, one can obtain the primary surpluses required to keep it at that level, for each of all possible differentials between real interest rates and real growth rates, as shown in the straight line in the Chart below. Over time, the net debt-to-GDP ratio shrinks (expands) if the economy is to the left (right) of the line.
2. If one insert Mr(s). Market’s expectations on the simple debt-trajectory equation, one can infer that (s)he expects an implicit real interest to be paid on net debt somewhat above the real ex-ante Selic rate. More precisely, a primary surplus of 3.58% of GDP for 2008, combined with an increment of 4.39% in GDP, requires an implicit interest rate above the expected real Selic of 6.85% in order to lead to a decrease of net debt only to 41.75% at the end of the year. The same applies to the other two years.
Indeed, one can find several reasons why to expect a sluggish response of debt costs to the recent cycle of Selic rate cuts in a superb recent analysis by Eduardo Loyo and Claudio Ferraz, from UBS Pactual (UBS Investment Research – Latin American Economic Focus, 12/10/07). For instance, while the Selic-indexed portion of public debt has directly reflected the long series of rate cuts, it now comprises less than 40% of the total debt and the remainder still pays higher interest rates, particularly in the case of longer-term fixed notes. Furthermore, holding reserves (currently around 25% of the net debt) is costly, given the differential between the Selic and the US T-bills rates. The authors also refer to other components of the net debt that affect the wedge between the real costs of public debt and Selic rates, either downward (as the no-interest-paying monetary base that is added in Brazil’s official calculation of the net public debt) or upward (the resources of the “Workers’ Support Fund”- FAT – are lent at the official “Long-Term Interest Rate” – TJLP – currently set by the National Monetary Council at nominal 6.25%).
3. Point B in the Chart represents average market expectations regarding the debt dynamics as they were in the week prior to the CPMF dismissal. Assuming the same differential between implicit real interest rates and GDP growth, Points A and C show respectively the cases of maintenance of the primary surplus at 3.85% of GDP and of a reduction of 1.4 percentage points corresponding to the CPMF loss. One can notice that, in the latter case, the debt trajectory still keeps a downward trend but becomes susceptible to growth and interest rate shocks. No wonder Mr(s). Market reacted so well after President Lula declared that there would be no such a loosening in the primary surplus.
4. There are several reasons why one might expect a shift to the left of A in the case that the 3.85% surplus is preserved through cuts in recurrent expenditures. The balanced-budget multiplier associated to an equal decrease of scale in both tax revenues and government expenditures would imply lesser absorption growth, which in the current context of absorption running faster than domestic production might open space for new Selic rate cuts before they are currently been anticipated by Mr(s). Market.
5. The outcomes are less clear in other possible configurations of the government’s fiscal policy reaction: combining a lower primary surplus and/or a replacement of CPMF loss by hikes in other taxes that do not depend on Congress approval. Emy Shayo, from Bear Stearns (GEM Watch, “Measures to compensate for CPMF loss”, 12/14/07), has pointed out existing IOF (Tax on Financial Operations), IPI (Tax on Industrialized Products), and CSLL (Social Contribution on Net Income) as possible candidates. The net effect would depend on the net cost-push impacts of the new tax burden on inflation, as well as on the new distribution of purchasing power.
As a bottom line, it is fair to state that the government’s CPMF defeat at the Senate has not generated any imminent disaster after all, despite the weight of that now-defunct tax on recent government’s fiscal results. On the other hand, how more virtuous or fragile is the debt trajectory to become will hinge upon the nature of the government’s policy reaction.
I avail myself of the opportunity to wish you all – including Mr(s). Market – Happy Holidays!