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Brazil: Staff Report for the 2014 Article IV Consultation—Debt Sustainabilityanalysis1

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
May 2015
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Public Debt Sustainability Analysis

Gross debt of the nonfinancial public sector (NFPS) has remained high in recent years, reaching 71 percent of GDP in 2014, whereas net debt has declined by 13 percentage points of GDP in the last decade to 37.6 percent of GDP in 2014. The debt maturity profile and composition have improved over time, but spreads on government bonds remain somewhat elevated and external financing requirements are large. Primary surpluses around 1.6 percent of GDP (excluding interest revenue) are needed simply to keep gross debt from growing as a ratio to GDP, and larger primary balances will be needed to put the gross debt-to-GDP ratio on a downward path. In the baseline scenario, which is consistent with the government’s announced targets for 2015–17, gross debt decreases by 2.2 percentage points to 68.8 percent of GDP by 2020. The trajectory of gross debt is sensitive to growth and fiscal policy underperformance given the pressure arising from high borrowing costs.

A. Background

Debt coverage. Brazil’s gross debt statistics cover the NFPS, defined to exclude Petrobras and Eletrobras and consolidate the Sovereign Wealth Fund. The NFPS debt includes Treasury securities on the central bank’s balance sheet, including those not used under repurchase agreements. At end-2014, the gross debt amounted to 71 percent of GDP.2 The (consolidated) public sector has a large stock of assets, amounting to 39.1 percent of GDP in 2014, which include 19.4 percent of GDP in international reserves. Although net debt reported by the government corresponds to the public sector, defined to include the central bank, in this Debt Sustainability Analysis (DSA) we use net debt of the NFPS to maintain consistency. Non-financial public sector assets amount to 32.5 percent of GDP (see Box). Brazil’s debt is reported at nominal value.3

Debt profile. Brazil’s Federal government (FG) domestic tradable securities account for 92 percent of total NFPS gross debt in 2014, of which 2/3 were held by the public.4 Active debt management in recent years has improved the profile of these instruments, which now display longer maturities, of about 4.4 years on average, up from less than 3 years in 2008. Still, a large share of domestic tradable securities, nearly 25 percent of total, matures within 1 year.5 The government has the objective of raising average maturity to 5.5 years and bringing total short term debt (on both original and residual maturity basis) down toward 20 percent of all debt. Fixed-rate and inflation-linked domestic bonds have gradually replaced foreign-currency linked instruments and floating-rate bonds. Zero-coupon bonds with original maturities over one year constitute slightly more than half of FG domestic tradable securities held by the public, or 21.7 percent of GDP. Foreign holding of domestic debt has increased and amounted to 17 percent of total at end-2014.

Composition of Tradable Domestic Debt in Public Hands

(Percent)

Sources: Central Bank; Ministry of Finance: and Fund staff estimates.

In addition to tradable securities, other NFPS debt consist of liabilities issued by SOEs and subnational governments, as well as direct bank lending to the FG. Foreign currency denominated debt of the NFPS accounted for only 5 percent of the total in 2014, representing slightly more than 4 percent of GDP. Gross financing needs have tended to be high, above 15 percent of GDP. However, this figure overstates rollover risk, as a large fraction of the federal government debt (about 20 percent of GDP, with a maturity profile in line with that of overall debt) is held by the central bank, which follows a policy of automatic rollover of its holdings of government securities.

Box.Non-Financial Public Sector Debt and Assets

Although gross non-financial public sector (NFPS) debt has declined only marginally over the past decade, net debt has been on a mostly downward path. Brazil has made important strides in improving the debt profile, now displaying longer maturities, lower foreign exposure, and a higher share of fixed-rate instruments. Yet, while gross debt has hovered above 65 percent of GDP over the past decade, net debt was reduced significantly, supported by strong accumulation of assets. What lies behind this evolution of assets and liabilities?

Gross and Net NFPS Debt

(Percent of GDP)

Sources: Central Bank; Ministry of Finance: and Fund staff estimates.

Lending through development banks and sterilization of capital inflows have been the main drivers of the widening wedge between gross and net debt. The build-up of assets has reflected the countercyclical policy followed in response to the global crisis, which was based on lending through development banks. In addition, sterilization of large foreign inflows that has resulted in an increase in international reserves has had as a counterpart growing Treasury cash holdings at the central bank (TSA). The TSA balances hit 11.9 percent of GDP in 2014 (compared to 7.1 percent in 2003) while credit to public financial institutions, mainly the national development bank (BNDES), increased from 0.5 percent of GDP before the global crisis to 10.8 percent of GDP in 2014. In addition, a large share of assets of the Workers’ Assistance Fund (FAT)—now amounting to 4 percent of GDP, are mainly invested in the BNDES since, by its constitution, at least 40 percent of FAT’s annual revenues must be transferred to finance programs promoting economic development.1 Other assets include hybrid instruments of capital and debt (1.1 percent of GDP) and investment in funds and programs (2.8 percent of GDP) while the remaining share encompasses tax float, pension fund assets, and sight deposits of subnational governments. (This last group of assets has remained broadly stable during the period.) What are the risk and liquidity profiles of the NFPS’ assets and what is their economic value?

Assets of the NFPS

(Percent of GDP)

Sources: Central Bank; Ministry of Finance: and Fund staff estimates.

There is no risk associated with TSA balances and their liquidity is high;2 in the case of loans to BNDES, their liquidity and risk are low, but so is their economic value. The BNDES extends through direct credit one third of its resources to large and highly competitive foreign and domestic companies, mainly operating in the area of infrastructure, industry, and services, which must meet stringent eligibility criteria. BNDES also on-lends government resources through other major public and private banks, which channel credit and bear the risk of such lending operations. The repayment profile of BNDES loans is very favorable, with terms as long as 40 years, and grace periods of up to 20 years for the principal repayment and 5 years for interest. The interest rates BNDE charges on its loans are linked to the long-term interest rate (the TJLP), set by the National Monetary Council, which has been around 5–6 percent in since 2009. Reflecting attractiveness of BNDES loans to firms and high loan portfolio quality, historical default rates on BNDES loans have been below 3 percent and NPLs have more recently been near 0. From the government’s perspective, despite the low risk profile of its loans to BNDES, their liquidity is by construction low because these loans are not in the form of a negotiable security. Their economic value is below their book value because the government borrows at the SELIC rate and earns the TJLP on its loans to BNDES.3 Thus, the grant element implicit in government loans to BNDES is about 52 percent. The NPV of the stock of credit to BNDES, calculated with the government’s borrowing cos as the discount factor, was below 4 percent of GDP at end-2014, less than half its nominal value.

General Government Credit to BNDES

(Percent of GDP)

Sources: Central Bank; Ministry of Finance: and Fund staff estimates.

There may be scope for achieving a better balance between gross debt and assets in the near future. Because assets have low liquidity or value (loans to BNDES) or must be maintained at reasonable precautionary levels (cash), gross debt remains the most useful indicator; thus, lowering the gross debt ratio is an important policy objective. Transfers from the Federal Government to BNDES are expected to stop, although BNDES will remain involved in funding of investment, including in infrastructure, by recycling its funds, and fostering capital market development including through guarantees. However, a sustained decline in gross debt will in any case have to be based on ambitious primary surpluses.

1 The NFPS includes the FAT. Because there is no pre-defined amortization schedule, FAT’s claims on BNDS can be considered as quasi-equity.2 Moreover, the TSA is remunerated at an average rate interest paid by the federal government securities in the central bank’s portfolio, about 10–11 percent during the same period.3 BNDES is subject to Basel III requirements as other financial institutions in Brazil.

B. Baseline Scenario

Macroeconomic assumptions. The projections assume a real GDP contraction of -1 percent in 2015, a slight recovery in 2016, and a gradual return to potential growth of 2.5 percent by the end of the projection horizon. The assumed fiscal adjustment brings the primary balance to 2.5 percent of GDP by 2018, which implies an improvement of 3.1 percentage points of GDP during 2015–18. Policy lending is projected to stop from 2015. The nominal interest rates on new borrowing are between 11 and 13 percent over 2015–20, bringing the effective interest rate below 12 percent on average.6 The DSA also assumes that deposits are made into the TSA held at the Central Bank to keep its balances constant at 11.9 percent of GDP (the latest observation) throughout the projection period. The baseline scenario assumes policy strengthening and implementation of the infrastructure concessions program, but otherwise limited structural reforms and a modest world output recovery. In this baseline, gross debt increases to 72 percent of GDP in 2015 before it declines to 68.8 percent of GDP in 2020. Gross financing needs are projected to remain above the high risk threshold of 15 percent of GDP on average over the medium term. The primary balance required to stabilize debt in the baseline scenario is 1.6 percent of GDP (excluding interest revenue).7

Past forecast errors. There is no evidence of a systematic projection bias in the baseline assumptions that would undermine the assessment of sustainability and the projected fiscal adjustment is in line with other countries’ experiences. The median forecast error for GDP growth and the primary balance is below 1 percent and in line with other countries’ forecast errors.

Realism of projections. Brazil’s projected fiscal adjustment (an improvement of about 3 percentage point in the cyclically-adjusted primary balance/GDP over the medium term) is ambitious, but it appears achievable. The magnitude of adjustment is also in line with other countries’ experiences, with a 3-year adjustment in cyclically-adjusted primary balance at the 20 percentile among all surveillance countries.8

C. Shocks and Stress Tests

  • Growth shock. The impact on the debt-to-GDP ratio of the 1 standard deviation shock (2.6 percent) to real GDP growth is large. Over 2016-17, real GDP growth rates become negative while inflation declines by 150 bps in each year. The primary balance worsens before recovering in 2018; interest rates increase by 55 bps for each percentage point decline in output growth. In this scenario, gross debt increases above 81.5 percent of GDP by 2019 and stabilizes at 81.1 percent in 2020 while gross financing needs reach almost 23 percent of GDP.

  • Primary balance and real interest rate shocks. In the primary balance shock consolidation is delayed by one year. In the interest rate shock borrowing costs increase by 200 bps in the first projection year and remain the same over the medium term. The impact of these shocks on debt and gross financing needs is modest, pushing up debt-to-GDP by 2 percentage points above the baseline in 2020.

  • Combined macro-fiscal shock and contingent liabilities shocks. The macro-fiscal shock combines the growth and interest rates shock and a primary balance shock as in the standard examples above, together with the real exchange rate shock consistent with a maximum movement of the real exchange rate over the past 10 years and a pass-through coefficient of 0.25. The contingent liability shock simulates a loss of 10 percent of banking system assets, in line with the experience with past banking crises in other countries, and assumption of contingent liabilities by the public sector. The latter results in a primary deficit of -3.6 percent of GDP in 2016 and a 1 standard deviation shock to GDP growth in 2016 and 2017. The effect of these shocks on debt ratios and gross financing needs is large and reflects in particular the sensitivity of debt to growth shocks, which make the largest contribution to the change in the debt path. Debt-to-GDP reaches about 85 percent by 2020 in both shocks.

  • Heat map. In addition to the vulnerabilities from shocks discussed above, the heat map suggests that the premium asked by the market on government borrowing, the reliance on external financing, and the share of short-term debt are all high pointing to risks to the debt profile. As noted earlier, however, the gross financing need indicator overstates actual rollover risk as a result of the policy of continuous rollover maintained by the Central Bank, which holds a significant amount of FG bonds.

Figure 1.Brazil: Public Sector Debt Sustainability Analysis (DSA)—Baseline Scenario

(Percent of GDP unless otherwise indicated)

Source: IMF staff.

1/ Public sector is defined as non-financial public sector.

2/ Based on available data.

3/ Long-term bond spread over U.S. bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year. Up to 2020, the primary balance shown is a non-interest balance, with interest income showing in the residual, but from 2021 onwards interest income counts toward the required primary balance.

Figure 2.Brazil: Public DSA—Composition of Public Debt and Alternative Scenarios

Source: IMF staff.

Figure 3.Brazil: Public DSA—Realism of Baseline Assumptions

Source: IMF Staff.

1/ Platted distribution includes surveillance countries, percentile rank refers to all countries.

2/ Projections made in the spring WE0 vintage of the preceding year.

3/ Not applicable for Brazil.

4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 50 percent of GDP, Percent of sample on vertical axis.

Figure 4.Brazil: Public DSA—Stress Tests

Source: IMF staff.

Figure 5.Brazil: Public DSA—Risk Assessment

Source: IMF staff.

1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.

3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are:

200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.

4/ Long-term bond spread over U.S. bonds, an average over the last 3 months, 25-Oct-14 through 23-Jan-15.

5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.

The analysis of public debt sustainability is based on the framework developed for market access countries. See Staff Guidance Note for Public Debt Sustainability Analysis in Market Access Countries, IMF, May 2013.

The national definition of gross debt includes the stock of Treasury securities used for monetary policy purposes by the central bank (those pledged as security in reverse repo operations), but excludes the rest of the government securities held by the central bank. According to the national definition, gross debt of the general government amounted to 64.2 percent of GDP at end-2014.

The nominal value is calculated by discounting future interest and principal payments at the existing contractual interest rate(s), and generally differs from face value.

The rest is held by the central bank on its balance sheet. The central bank uses over half of its holdings as security in liquidity-draining operations with the banking system.

This is broadly a recurring situation. At original maturity, short-term debt is very small, amounting some 2 percent of total NFPS debt.

Interest rates on new borrowing are projected to behave in line with the latest yield curve of each instrument augmented for the change in the DI curve.

The debt stabilizing primary balance shown on the right-most column of the table on “Contributions to changes in public debt” in the Baseline Scenario (3.1 percent of GDP) corresponds to a concept of the primary balance that includes interest revenue. The definition of the primary balance as a non-interest concept is customary in Brazil and corresponds to 1.6 percent of GDP quoted in the main text.

The interaction between growth and inflation are Brazil-specific and were estimated through a macro-model by desks. The estimates of the fiscal multipliers and persistence are part of the 2015 Article IV Selected Issues Paper. The fiscal multiplier and the persistence are estimated at 0.3 percent.

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