1. We would like to thank staff for the report and the accompanying papers as well as for the fruitful interaction with the authorities during the visit to Brazil. The Article IV mission took place in the first fortnight of December 2014 – in the middle of a government transition – when many policy measures were still being formulated and the new economic team was not yet in office. In 2015, Brazil embarked on an ambitious economic consolidation program. Tight macroeconomic policy objectives were set to correct the deterioration of the fiscal and external positions that occurred especially in 2014 and steer inflation back to the midpoint of the target range. The authorities expect that this will lay the ground for a new cycle of growth and further rises in living standards, as fiscal and monetary indicators improve and market confidence builds up.
2. Economic activity will remain subdued in the near term, but the authorities foresee a recovery already in the fourth quarter of 2015. They expect the economy to gain more steam in 2016, as business and consumer confidence improve in response to the implementation of the adjustment program.
3. As indicated in paragraph 29 of the staff report, the Brazilian authorities disagree with staff’s growth forecasts for 2015 and 2016, which they consider to be overly pessimistic. Some of the assumptions behind staff’s projections seem exaggerated, such as the weight that appears to have been attributed to possible water and energy rationing and the impact of the reduction in investment by Petrobras, the state-controlled oil company. The tariff realignment should have an impact on the demand for energy, and recent rainfall has resulted in some increase in reservoir levels in the regions most affected by a severe drought. Staff’s projections are worse than current market readings: the most recent central bank’s survey of market expectations presents medians of -0.78 percent and 1.3 percent for GDP growth in 2015 and 2016, respectively.
4. Regarding Petrobras, it is important to note that the company is fundamentally sound. In 2014, Petrobras registered a record production of 2.67 Mbpd of oil and natural gas, with the new pre-salt production areas responding for about ¼ of total output. In 2015, the company is expected to benefit from higher production, larger refining capacity, higher domestic prices and lower import prices. The Brazilian securities and exchange commission (Comissão de Valores Mobiliários – CVM) is in dialogue with its counterparts abroad and Petrobras’ external auditors in order to accelerate the publication of an audited financial statement.
Fiscal and monetary policy objectives for 2015-2017
5. President Dilma Roussef was reelected in October 2014 and started her second mandate on January 1st, 2015. In December 2014, the economic team appointed to take office at the start of her new term announced some of its macroeconomic policy objectives. On the fiscal policy side, the goal is to reach a primary surplus of 1.2 percent of GDP in 2015 and at least 2.0 percent of GDP in 2016 and 2017. It was also announced that the Treasury would not provide new policy lending for public banks, which will help stabilize and subsequently reduce the gross public debt to GDP ratio. On the monetary policy front, end-2016 was established as the horizon for inflation to converge to the 4.5 percent midpoint of the target range.
6. Staff’s call for higher primary surplus targets and additional monetary policy tightening does not seem entirely persuasive. Planned fiscal consolidation is already very strong. The staff report itself estimates that the structural primary deficit of 0.6 percent of GDP in 2014 will be converted into a 2.5 percent surplus in 2016 – a swing of more than 3 percentage points of GDP in only two years (table 3). Staff’s estimate of the planned adjustment is even larger if policy lending is included in the calculation of the structural primary balance.1 Moreover, the central bank has already undertaken and is continuing to undertake significant monetary tightening. All this is being done in a scenario of weak growth.
7. The authorities are facing difficult trade-offs. Fiscal consolidation includes an adjustment of relative prices that is taking a toll on inflation in the short run. Exchange rate depreciation should benefit the current account balance but is also having an impact on inflation. Monetary tightening, in turn, implies a higher cost for servicing public debt, making the objective of reducing the public debt ratio more difficult. Despite these challenges, the authorities are forging ahead with their adjustment program.
8. The above mentioned objectives are already being translated into concrete measures, as shown in Box 4 of the staff report. Since the report was issued, one of the possible additional measures listed there is in the process of being submitted to Congress under urgency procedures. We refer to the reversal of payroll tax cuts, which is estimated to yield 0.4 percent of GDP savings per year.
9. The design of fiscal adjustment measures was guided by long-standing government goals. Thus, social spending is being preserved, in the pursuit of further gains in the reduction of poverty and social inequality. The authorities have also given attention to improving the balance between current expenditure and investment, with a view to increasing the share of investment in output and fostering long-term economic growth.
10. In order to ensure that limits on discretionary expenditures will be observed in 2015, the government preventively set lower ceilings for these expenditures until the approval by Congress of the Annual Budget Law. The Federal Government also established an inter-ministerial working group to monitor and evaluate public spending.
11. Fiscal consolidation at the sub-national level will be pursued through enhanced control procedures. This will include a review of regulations, a tightening of the criteria for authorization for new domestic borrowing, and stricter limitations on the granting of warranties on external loans. Moreover, revenues from the Imposto sobre Circulação de Mercadorias e Serviços (ICMS), which is collected by state governments, are expected to increase due to the recent realignment of energy and fuel prices.
12. Staff estimates that the gross public debt to GDP ratio will rise slightly in 2015 and gradually decline as of 2016 (table 3). It should be noted, however, that there is a significant difference between the Fund’s and the authorities’ definitions of gross public debt. The former includes in gross public debt all treasury securities held by the Central Bank of Brazil (BCB). The latter excludes the treasury securities that are held by the BCB and only accounts for those held by the public – including as collateral for BCB’s liquidity-mopping repos. The authorities’ definition is widely used by financial markets, including major international banks, and by the three largest rating agencies in their debt sustainability analyses.
13. As can be seen from table 3 of the staff report, the divergence between the two definitions is far from negligible. Under the Fund’s approach, the ratio of gross public debt to GDP was nearly 7 percentage points higher in 2014. The Fund’s methodology also leads to an overestimation of gross financing needs, as the rollover risk of securities held by the BCB is insignificant – something that staff now recognizes. Despite this recognition, the debt sustainability analysis is entirely based on the Fund’s inappropriate definition of gross public debt.
Monetary policy and FX swaps
14. The BCB is determined to bring inflation back to the 4.5 percent midpoint of the target range by the end of 2016. After having raised the policy rate by 375 basis points from April 2013 to April 2014, the BCB resumed monetary tightening last October, increasing the policy rate by a further 175 basis points, totaling a 550 basis-point increase. This will help cope with the second-order effects on inflation arising from two important adjustments in relative prices currently underway: i) the realignment of tradables prices vis-à-vis those of non-tradables; and ii) the realignment of administered vis-à-vis market-based prices.
15. The authorities have stressed that the floating exchange rate regime remains the first line of defense. The exchange rate has moved in response to changing fundamentals and external shocks. A FX swap program was put in place in August 2013 to mitigate financial risks arising from monetary policy normalization in the U.S. and has helped preserve financial stability by allowing economic agents to hedge their foreign exchange positions. As they are settled in local currency, the FX swaps do not compromise or commit international reserves. The BCB considers that the notional value of FX swap contracts outstanding is broadly in line with the hedging needs of the private sector. As indicated in the staff report, the latest extension of the FX swap program on a reduced scale and for a shorter period is consistent with this view.
16. Staff’s argument that the swap program, by lowering the cost of hedging, encouraged excessive risk taking is debatable. Actually, lower costs facilitate access to hedging and therefore a reduction and a better distribution of risks.
17. Data in table 6 of the staff report indicate that the Brazilian financial system has ample liquidity, is well-provisioned and holds adequate capital levels. Financial sector regulation and supervision are recognized to be strong, both in terms of on-site and off-site monitoring.
18. The BCB is confident that credit expansion in recent years did not create fragilities in the banking system. Staff’s assessment of the risk of deterioration of banks’ balance sheets in a scenario of low growth seems exaggerated. We note that stress tests conducted by the central bank with extreme scenarios proposed by staff only pointed out to some – yet limited – need for additional capital.
19. Staff emphasizes the need for close monitoring of the health of bank balance sheets in response to evolving economic conditions without sufficiently recognizing the extent to which the BCB is able to exercise its supervisory mandate. In particular, the BCB’s credit registry system tracks 99 percent of banking credit, allowing for early identification of asset quality deterioration, an aspect that the staff report should have taken into account.
20. The level of non-performing loans (NPLs) in the banking system as a whole remains low. The ratio of NPLs to total loans has been stable at less than 3 percent since 2013. At 2.1 percent as of September 2014, the NPL ratio of public banks continues to be significantly lower than that of private banks (table 6).
21. The current account deficit has widened and is expected to have reached 4.2 percent of GDP in 2014, compared to 3.6 percent in 20132. Brazil’s attractiveness to foreign investors, however, remains strong. Foreign direct investment (FDI) in 2014 surpassed USD 60 billion, enough to cover more than ¾ of the current account deficit. Brazil accounted for 4.4 percent of global FDI inflows and ranked among the top five FDI host economies in UNCTAD’s 2014 World Investment Report. The BCB expects FDI flows to remain broadly stable in 2015, around USD 65 billion.
22. The rise in the current account deficit is in part due to exogenous factors, such as a worsening in the terms of trade and a reduction in demand from important trading partners. The ongoing realignment of the exchange rate, with further real effective exchange rate depreciation in late 2014 and early 2015, will help reduce the current account deficit going forward. Moreover, the authorities expect that the recovery in the U.S. will have a positive impact on Brazilian exports.
23. Brazil’s foreign reserves are one of the country’s main strengths, a point perhaps insufficiently stressed by staff. Reserves closed 2014 at USD 364 billion, the equivalent of 377 percent of short-term debt at residual maturity and more than 15 months of prospective imports of goods and non factor services (table 5 of the staff report). Nonetheless, the high level of reserves is not taken into account in staff’s analysis of external risks; it is not even mentioned in the report’s Risk Assessment Matrix (Appendix III).
24. Brazil’s investment program covers three key areas: (i) removal of regulatory obstacles to investment, especially to infrastructure investment; (ii) adoption of coordinated policy measures for increasing competiveness; and (iii) improvement of labor force skills and promotion of innovation in order to boost productivity and lift potential growth.
25. For each of these areas, specific measures have been planned to address Brazil’s policy gaps and challenges. Those measures include: i) an infrastructure investment package of USD 40 billion in the form of concessions and public-private partnerships already negotiated, and projects in the pipeline totaling USD 110 billion; ii) a new regulatory framework for small and medium enterprises to reduce red tape and improve their access to capital markets and export credit; iii) trade facilitation through the integration of all foreign trade procedures under a new single window system; and iv) implementation of the National Education Plan and the National Program of Knowledge Platforms. New investment instruments have been developed to facilitate private sector participation in infrastructure projects, such as the infrastructure debentures (fixed-income securities linked to infrastructure projects). As of December 2014, the outstanding volume of these debentures surpassed 15 billion reais, with maturities ranging from 5 to 17 years.
26. In 2014, Brazil’s social programs continued to advance firmly in line with their main objectives: universal coverage of social protection through the application of well-defined criteria; economic inclusion of the poorest; and reduction of income, gender, color, and regional inequality.
27. The main instrument to achieve these objectives has been Bolsa Familia (BF), the conditional cash transfer program created in 2003. In 2011, the target of overcoming extreme poverty in Brazil started to be more directly addressed with the creation of the Brasil Sem Miséria social program.
28. Box 1 of the staff report provides a useful summary of the two programs, but we add further information to emphasize some of their most important features:
Close attention is given to efficient program implementation. In spite of its wide scope – currently reaching 54 million people or 14 million families – BF’s budget, at around 0.5 percent of GDP, is relatively low, and administrative costs represent less than 5 percent of the total.
Program monitoring is strong. Around 1.3 million people were excluded from BF in 2014 (an election year), either for not having fulfilled the requirement for biannual update of their data; for not having continued to meet the conditionalities (regularly checked against information provided by the educational and health systems); or for no longer meeting the revenue criterion (monitored through cross-checking of data with several other official databases).
BF’s national reach is ensured by the participation of all states and municipalities, which has also been key to the development of the Single Registry of Social Programs of the Federal Government. This centralized database, in turn, has provided support for several initiatives under Brasil sem Miséria, such as the enrollment of 1.8 million people in the professional training program Pronatec and the formalization of 1.2 million micro-entrepreneurs, in addition to far-reaching initiatives for the improvement of water and energy supply, prevention and the treatment of the most common diseases among children, and the expansion of day care, which now reaches 700 thousand children registered in BF.
29. As a result of these concerted actions, the rate of chronic poverty in Brazil has fallen from 1.8 percent of the population in 2011 to 1.1 percent in 2014; and the country has left the map of world hunger of the Food and Agriculture Organization of the United Nations.
The structural primary balance including policy lending is estimated to rise from a deficit of 1.7 percent of GDP in 2014 to a 2.5 percent surplus in 2016 (table 3).
It should be noted, however, that part of the increase in the current account deficit as a proportion of GDP reflects the impact of exchange rate depreciation on GDP expressed in dollar terms.