Brazil: BCB seizes the initiative Global Economic Outlook, Q2 2017

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​Dubbed a key driver of global growth only a few years ago, Brazil has since faced a staggering reversal of fortune. Encouragingly, the central bank has come to the rescue, even as the government tries to get public finances back to health.

Introduction

On April 12, Banco Central do Brasil’s (BCB’s) rate-setting committee cut the benchmark Selic rate by 100 basis points (bps) to 11.25 percent, the lowest rate since November 2014.1 BCB’s move was not a surprise given that inflation has been dipping toward the midpoint of the central bank’s 3.0–6.0 percent range. Also, due to severe contraction in GDP in 2015 and 2016, the economy requires a strong dose of monetary easing. Fiscal stimulus would have helped, but Brazil’s public finances are in poor shape. The fiscal deficit is high (8.9 percent of GDP in 2016), and government debt as a share of GDP has shot up by 14.8 percentage points since September 2015.2

Encouragingly, the government is aware of the fiscal challenges and appears determined to reverse course. It capped real government spending and is also trying to reform pensions, which arguably pose the biggest threat to state finances in the medium to long term.3 While bond markets have rewarded the government by dragging yields lower, pushing through pension reforms won’t be easy in the face of strong public resentment and the president’s declining popularity.4 A lot will depend on the government’s ability to convince legislators and the public about the benefits of fiscal sustainability.

Pushing through pension reforms won’t be easy in the face of strong public resentment and the president’s declining popularity.

BCB reversing course—and rightly so

Since it cut rates for the first time in four years in October 2016, BCB has been on an easing spree, pushing down the Selic rate by a total of 300 bps in eight months. Downward price pressures have aided BCB in its monetary easing spree. Headline inflation fell to 4.8 percent year over year in February from 5.4 percent the month before (figure 1). In fact, when inflation fell to 5.4 percent in January, it was the first time since February 2014 that the figure had dipped below the upper limit (6.0 percent) of BCB’s target range.

Headline inflation is edging down toward the midpoint of BCB’s target range

BCB’s current monetary stance is likely geared to counter multiple challenges, the first of which is to revive economic activity. Brazil has been going through one of the deepest downturns in recent memory. Economic contraction continued into Q4 2016, with real GDP (seasonally adjusted) declining 0.9 percent quarter over quarter, thereby bringing down annual GDP in 2016 by 3.6 percent. In 2015, the economy had contracted 3.8 percent. Since Q1 2014, real GDP has contracted 9.0 percent (figure 2)—a staggering reversal of fortune for an economy that until a few years ago was dubbed as one of the key drivers of global growth. Unfortunately, the scenario for growth is still uncertain, with key indicators conveying mixed signals so far this year. While consumer and business sentiment have been edging up, retail sales and industrial production have barely grown.5

GDP and GFCF have contracted sharply in recent times

The second challenge is that gross fixed capital formation (GFCF) has contracted every quarter, bar one, since Q3 2013. BCB will be keen to revive private sector investments, which are critical not only for economic recovery in the short term but also to boost productivity in the medium to long term. According to Oxford Economics, average annual potential GDP growth over 2016–25 is expected to be about 1.6 percent, with total factor productivity rising 0.3 percent on average per year during that period.6 Both figures are lower than the corresponding ones for 2006–15 (potential GDP growth: 2.9 percent; total factor productivity: 0.8 percent).7 Pushing up productivity is essential for an economy likely to host an aging population in the future.8

Third, BCB’s rate cuts aim to bring down debt-servicing costs for households. Household debt in Brazil as a share of personal disposable income went up an estimated 11.2 percentage points between 2008 and 2016. Within this period, the Selic rate went up about 250 bps, with a large jump (700 bps) occurring between March 2013 and July 2015. With households already under pressure from a slowing economy and high unemployment (13.2 percent in February9), BCB hopes that reducing debt repayment costs will keep repayments going, which should also ease some pressure off banks and financial institutions.

Finally, loosening monetary policy keeps the pressure on government bond yields, which have been declining due to short- and long-term positive measures by the government to tackle poor fiscal health. For example, the 10-year Treasury yield has declined more than 550 bps since January 2016, reversing partially from a rise of more than 680 bps between May 2013 and January 2016 (figure 3). The decline in government bond yields, in turn, has pushed down the government’s debt-servicing cost, thereby aiding fiscal balances: The fiscal deficit declined to 8.9 percent in 2016 from 10.2 percent in 2015. BCB would want that trend to continue, although much depends on the government’s success in pushing reforms.

While consumer and business sentiment have been edging up, retail sales and industrial production have barely grown.

Bond yields have been going down since early 2016

BCB’s rate moves reflect increasing confidence in the real

In 2015, the Brazilian real fell about 16.0 percent against the US dollar, one of the worst performances by an emerging-market currency that year. Things have changed since then, with the real gaining against the greenback by 15.5 percent last year and gaining ground in 2017 as well (figure 4). This is despite three cuts in the Selic rate (by a total of 300 bps) between October 2016 and the latest rate cut on April 12. The currency’s gain primarily reflects a revival of confidence in the economy, albeit a nascent one, due to improving external balances, greater confidence in the central bank, and fiscal prudence.10

Should BCB be worried about the impact of the rising interest rate differential with the United States, where the Federal Reserve (Fed) is poised to raise rates again this year? It likely would not be. Markets may have already priced in three rate hikes by the Fed (amounting to 75 bps) this year, and a fourth hike is also likely.11 At the same time, markets also expect BCB to continue monetary easing, emboldened by declining inflation, and it is likely that BCB will cut rates by an additional 100–150 bps this year. It is no wonder, then, that the real has continued its gains. While a more aggressive monetary easing stance may put downward pressure on the currency, it is likely that such a trend would benefit exports, which in turn would benefit the real over the medium term.

Should BCB be worried about the impact of the rising interest rate differential with the United States, where the Federal Reserve is poised to raise rates again this year?

Brazil’s currency bounced back last year after weakening in 2015

Much rests on the fiscal side

Declining bond yields and a rise in the currency translate to nothing less than a vote of confidence in the economy. The government can take some credit for this. Its move to cap real government spending for the next 20 years is a positive step.12 Recent ventures in the public-private partnership space to boost infrastructure are another.13 The government also reacted swiftly to stem the controversy over tainted beef exports:14 Negotiations and reassurances at the highest level—including dining over steak with foreign diplomats—helped persuade key Brazilian meat importers such as China to lift the cap on exports.15

The same skills need to be replicated for pushing through other reforms. The government appears determined to reform reforms, including raising the retirement age to 65 years from the current average of 54 years; and modifying the relationship between pension payments, the last-drawn salary, and the number of years worked.16 For now, the government appears to have the numbers in the legislature to enact these changes. What may queer the pitch, though, is public protests against pension reforms, which, in turn, may force legislators to ask for a watered-down version. That would be unfortunate, given that pension reforms are critical for fiscal sustainability. According to the Economist, at the current pace, government spending on pensions could spike to about 20.0 percent of GDP by 2060 from the current 12.0 percent.17 The current corruption investigations that have ensnared senior politicians across the political aisle may also hinder getting reforms approved by the legislature.18

To further muddle matters, the government has limited time on its hands, as new presidential elections are due in October next year. Any such hiccups may dent the tide of rising confidence. Worse, it could end up delaying a return to investment-grade ratings and long-term productivity growth. Any dithering on reforms is thus perilous.