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Brazil: 2016 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Brazil

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
November 2016
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Context: Deepest Recession in Decades

1. Brazil is still in the grip of a deep recession. Led by plummeting confidence that triggered sharp declines in investment and consumption, the contraction in output has been one of the largest in memory. Since the beginning of 2015, the unemployment rate has almost doubled and 2.7 million formal jobs have been lost; youth employment has been particularly hard hit (Box 1). Household income fell and inequality increased during the recession, bucking a decade-long trend.1

Brazil: Real GDP per Capita Growth (1902–2017)

(in yearly percentage change)

Sources: For 1902–1947. Haddad, C. “Crescimento do produto real no Brasil, 1900–1947”, R. bras. Econ., 1975. For 1947–2015, IBGE. For 2016–17, IMF Staff forecasts. Population data from IBGE’s decennial census with log-linear interpolation.

Box 1.Brazilian Unemployment in a Recessionary Environment

Labor market conditions deteriorated severely during the recession. Over the last eighteen months, unemployment rates reached levels last observed more than a decade ago.1 Overall, unemployment rates jumped from 6.5 percent in 2014Q4 to 11.3 percent in 2016Q2.

Brazil: Comparison of Different Unemployment Rate Measures

(In percent of labor force)

Sources: IBGE and IMF Staff estimates. 1/ From 2012Q1 onwards, series reflect official data from PNAD Contínua. Before that, data were backfitted using changes in interpolated annual PNAD data adjusted with seasonal factors from PME.

The increase in the youth unemployment rate was even sharper, rendering nearly 1 in every 4 Brazilian youngsters (18 to 24 years old) unemployed. Youth unemployment climbed from 14.1 percent in 2014Q4 to 24.5 percent in 2016Q2. There are significant differences between adult and youth labor dynamics. For adults (25 to 59 years old), the labor force has been growing at a steady pace, but since the end of 2014 the decline in employment growth has led to an increase in adult unemployment. By contrast, since early 2015 the youth labor force, which had been declining, has been rising again while youth employment has collapsed, causing youth unemployment rates to increase by more than 10 percent.

Brazil: Unemployment Rates1/

(In percent of labor force, by cohort)

Sources: IBGE and IMF Staff estimates. 1/ From 2012Q1 onwards, series reflect official data from PNAD Contínua. Before that, data were backfitted using changes in interpolated annual PNAD data adjusted with seasonal factors from PME.

Brazil: Decomposition of Changes in Adult (25- to 59-yo) Unemployment Rate

(In yearly percentage changes)

Sources: IBGE and IMF Staff estimates.

Brazil: Decomposition of Changes in Youth (18- to 24-yo) Unemployment Rate

(In yearly percentage changes)

Sources: IBGE and IMF Staff estimates.

The effects of the recession on youth employment are exacerbated by a high minimum wage. In Brazil, youth employment is significantly more sensitive to increases in the minimum wage (holding the average wage constant) than adult unemployment.2 Although real average earnings dropped by more than 4 percent year-over-year in 2016Q2, the real minimum wage increased, likely pricing younger workers out of the labor market.

Since the beginning of the recession the Brazilian economy lost 2.7 million formal jobs. Facing of decreasing industrial production, retail sales, and real wages, most sectors of the economy experienced negative job creation, but the bulk of the formal job destruction (about 1.8 million) has come from industry and construction.

Brazil: Net Formal Job Creation Since the Recession Began

(In million jobs)

Sources: Brazilian Ministry of Labor.

Brazil: Net Formal Job Creation and Economic Cycle

(In thousand jobs and year-on-year percentage change)

Sources: IBGE, Ministry of Labor, and WEO.

Formal job destruction is likely to continue for a few more quarters. The Brazilian formal job market is historically highly correlated with the business cycle. This suggests that, under Staffs forecast for Real GDP, cumulative formal job destruction during the recession can ammount to as much as 3.1 million jobs between 2014Q1 and 2017Q4.3

1 The analysis of market trends is complicated by changes in the measurement of unemployment. In 2016, the Brazilian government adopted a new official unemployment rate series, improving coverage of the underlying survey and reliability of the numbers. The previous official statistic for monthly unemployment rates came from PME (Pesquisa Mensal de Empregos), which covered 145 cities and fo cused on six metro areas. The new one comes from a PNAD-Contínua (Pesquisa Nacional por Amostra de Domicílios Contínua), which has a national coverage of 3500 cities. For methodological details, see IBGE (2015). “Nota Técnica: Principais diferenças metodológicas entre as pesquisas PME, PNAD e PNAD Cont ínua”. IMF Staff analysis uses structural trends in unemployment from a national-coverage survey (PNAD) and sea sonal factors from a metro-area survey (PME) to extend the new series backwards. The overall patterns of the old and new series, both actual and extended, are consistent.2 IMF, 2015, “Macroeconomic Implications of Minimum Wage Increases in Brazil,” Selected Issues Paper.3 We regress quarterly net formal job creation numbers (1999Q3–2016Q1) on year-on-year percent changes of real GDP (contemporaneous and two lags) and two lags of formal job creation. We then use IMF Staff forecasts to derive predicted values of future net job creation and cumulate the result from 2014Q1.

2. Domestic factors largely explain the deterioration in growth, although terms of trade changes and weak global demand also played an important role. Activity has contracted in 7 out of the 10 quarters through 2016Q2. The weakness reflects the confluence of long-standing domestic issues and other factors. In particular:

Brazil: Historical Decomposition of Real GDP Growth

(Deviation relative to the sample mean)

Source: Staff estimates. Historical decomposition from a SVAR model with four lags that includes a set of external variables US GDP, US CPI, US 10-year bond yield, Global EMBI Spread, Terms of Trade) and a set of domestic variables (CPI, policy rate, exchange rate, and GDP). All variables are specified in log changes and orthogonally identified in the order as listed above.

  • Investment contracted severely, reflecting a sustained period of deteriorating competitiveness and tighter financial conditions (evidenced in a retreat in real private credit during 2015–16), rising unit labor costs, worsening terms of trade, and a reassessment of Brazil’s future growth prospects (Box 2). The reassessment of prospects for export prices has caused drastic cuts in the expansion plans of the largest investor in the country, Petrobras (which is also dealing with the legacy of poor governance and high debt), and other large companies in the extractive sector. These firms have faced difficult financing conditions and have scaled down their traditional bond issuance abruptly, especially in 2015. The infrastructure concessions program has had difficulties making progress.

  • Consumption contracted as well, owing to deteriorating labor market conditions and a tightening of credit conditions (see Selected Issues Paper).

  • On the positive side, net exports have begun to support growth, reflecting both a demand-related contraction in imports and strong exports on the back of the depreciation of the real in 2015. Also, commodity export volumes expanded strongly owing to increases in capacity resulting from investment initiated during the boom years (e.g. in mining). However, the currency appreciation since March this year raises doubts about the momentum of net exports going forward.

  • A sharp realignment of regulated prices and monetary policy tightening also represented a drag on growth in 2015.

  • Fiscal policy was broadly neutral over 2015–16 (not counting the reduction in quasi-fiscal activity) despite cuts in discretionary spending introduced in early 2015. The government started 2015 promising rising fiscal surpluses, and took early adjustment measures, such as the discontinuation of policy lending to BNDES, the modification of some excesses in entitlement programs, and the realignment of electricity tariffs, which staved off the expected flow of subsidies to the sector. However, momentum was not sustained, and policies, including those originating in Congress, were at times expansionary. Policies under the new government have shifted focus toward the pursuit of medium-term reforms and away from meeting tight primary balance objectives in the near term.

  • Additional factors hampering growth related to uncertainty surrounding the political situation and the corruption probe at Petrobras. The corruption investigation has broadened to include more firms in the private sector and high-ranking politicians. Some of these effects are hard to disentangle from economic factors: for example, some large construction firms involved in corruption were banned from competing for new projects at Petrobras, but Petrobras has been cutting investment in any case in response to the new realities in the oil market.

Box 2.Investment and Growth Expectations

Investment has been particularly hard hit recently, falling by around 25 percent since the beginning of 2014. As a result, fixed capital formation in Brazil has fallen further behind other emerging economies.

Brazil: National Accounts Components

(Index, 2010Q1 = 100)

Sources: Haver Analytics and World Economic Outlook.

Brazil and EMs: Real Gross Fixed Capital Formation

(Index, 2000 = 100)

The recent worsening of the economic environment has contributed to a deterioration in medium-term growth expectations, but these have fallen by more, and for longer, than the recession can explain. Between 2002 and 2012, expectations of annual growth (3 years ahead) were broadly stable, averaging around 4 percent. Since then, growth expectations have deteriorated, falling to about 2 percent by end-2015. As of 2016Q2, the change in current conditions helps to explain roughly one quarter of the recent decrease in medium-term growth expectations, with the remainder of the decrease explained by other, ‘non-current’ factors. These factors in essence represent an autonomous reassessment of Brazil’s growth potential over the medium term, above and beyond the impact of contemporaneous growth.

Sources: IMF Staff estimates and Central Bank of Brazil.

1/ Estimated th rough regressions of end-of-year forecasts on forecast horizons and their squares and then using time varying parameters to fit a continuous series

2/ Current conditions include contemporaneous changes in GDP, regulated prices, terms of trade, and equity prices.

What explains the rapid drop in investment? Estimates suggest that developments hampering investment over this period include a rise in costs (chiefly a sharp increase in regulated prices, such as energy prices), falling terms of trade—impacting prospects for commodity exporters—and tighter financial conditions (through both higher real interest rates and lower equity prices).1 The “autonomous” part of the deterioration in the medium-term outlook for growth has been a significant drag to investment over the past 2 years, reducing investment by more than 10 percent since beginning of 2014.

Brazil: Decomposition of Gross Fixed Capital Formation Growth

(Quarter-on-quarter growth acumulated since 2014Q1, deviations from avg, all variables demeaned)

Source: IMF Staff estimates.

What does this imply for investment going forward? The results suggest that stabilization of regulated-price inflation, the terms of trade, equity prices, and real interest rates should improve both investment growth and growth expectations. In particular, the large, necessary, tariff increases of 2015 corrected past policy mistakes, and need not be repeated; subsequent increases can be more moderate and thus are not expected to represent large headwinds. Interest rates are expected to be eased as disinflation allows, also removing another important headwind. While stabilization of these factors is expected in the short term, reducing some of the drag on investment, the prospect of a return to investment growth crucially depends on an alleviation of other sources of weakness, such as a reduction in uncertainty related to the political situation, improvements in policy credibility, and addressing impediments to potential output. The analysis also suggests that if medium-term growth expectations remain subdued, the recovery in investment may be incomplete.

1 Results are from the joint estimation of two equations. The first regresses mid-term (3-years ahead) growth expectations on contemporaneous yearly percent changes in GDP, regulated prices, terms of trade, and equity prices. The second regresses quarterly changes in real gross fixed capital formation on lagged quarterly percent changes of regulated prices, terms of trade, real interest rates, equity prices and on the lagged residual of the first equation (i.e., the part of mid-term growth expectations which is orthogonal to current conditions). To account for correlation of residuals, Seemingly Unrelated Regressions is used, estimated with a two-step Generalized Least Squares method.

3. Tentative signs point to the end of recession. The rate of output contraction has slowed and the economy appears to have regained some footing, with industrial production and business confidence improving since early 2016. Indicators related to international trade and the labor market are also showing signs of stabilization, and staff’s financial conditions index (FCI), a leading indicator of real activity, has improved significantly since end-February 2016 (Figure 5).

Figure 1.Brazil: Recent Developments

Sources: Haver Analytics, IBGE; and Fund Staff estimates.

1/ Difference between the current rate and the 10-year average in percentage points.

Figure 2.Brazil: Inflation

Sources: Haver Analytics, IBGE, and Fund Staff estimates.

1/ Extended Consumer Price Index, Double Weighted (IPCA-DP).

Figure 3.Brazil: Macroeconomic Policies

Sources: Central Bank of Brazil, IBGE, Haver Analytics, and IMF Staff calculations.

Figure 4.Brazil: External Sector

Sources: Central Bank of Brazil, Haver Analytics, and Fund Staff calculations.

Figure 5.Brazil: Financial Sector Indicators

Sources: Central Bank of Brazil, Haver Analytics, Capital IQ, and IMF Staff estimates.

4. Inflation is normalizing slowly. The policy rate has been on hold for more than a year now. To prevent second round effects from the large increases in regulated prices and exchange rate depreciation, the monetary policy rate (SELIC) was hiked by 250 basis points to its current level of 14.25 percent between January 2015 and July 2015. The interest rate on subsidized loans (known as “TJLP”) was increased by 250 basis points to 7.5 percent between late 2014 and early 2016. Consistent with previous Staff advice, the central bank’s inflation tolerance range was reduced from 2.5 percent to 6.5 percent to 3 percent to 6 percent for 2017. However, headline and core inflation have been above the central target and around the upper limit of the central bank’s tolerance range for several years. In 2015, inflation spiked to 10.7 percent (e.o.p.), largely because of much needed relative-price adjustments (Box 3). But in 2016, some price increases have begun to moderate and 12-month inflation has fallen back to single digits. Yet, disinflation proceeded slowly due to inflation expectations that were higher than the target, and rising food prices owing in part to drought in the Northeast (Figure 2).

Box 3.Relative Price Realignment

Two sharp relative-price realignments occurred in 2015, contributing to a spike in inflation. Headline inflation rose to 10.7 in December 2015, more than 6 percent above the center of the central bank’s tolerance range. Regulated prices were a key contributor, rising by almost 18 percent over the year. Over this time, the exchange rate also depreciated by around 20 percent in real effective terms, putting further pressure on tradables’ prices.

Impact of Price Changes on Headline Inflation\1

(percent change in IPCA after one year)

Source: Staff Estimates.

/1 Estimated responses. 90 percent confidence bands. IPCA-weighted contributions to headline IPCA inflation. The direct regulated effect is the effect of the initial 10 percent rise in regulated prices; the indirect effect captures all subsequent changes in regulated pricesdue to second-round effects and inertia.

While boosting inflation in the short term, adjustments were necessary. In the several years prior to 2015, regulated prices had been contained by government policy, creating distortions, and contributing to rising inflation expectations. In the electricity sector, a policy to subsidize electricity prices was introduced in 2012, increasing demand despite early signs of drought, and driving companies to borrow to cover higher generation costs. In an attempt to protect consumers from rising international prices, Petrobras was directed to sell fuel at a loss from 2012 to early 2014, contributing to rising debt levels at the company and a deterioration in its share price. The recent increases in regulated prices have alleviated these distortions. Likewise, the depreciation of the currency has moved it towards levels more consistent with fundamentals, improving Brazil’s competitiveness.

The impact on inflation has been large and broad based.1 Regulated prices currently have a significant weight in Brazil’s CPI (around 25 percent of the basket), making the direct effect of regulated-price increases on inflation particularly large; the impact of an exchange rate depreciation is much smaller in comparison, but still significant. Many regulated goods and services are direct inputs into production (gasoline and electricity, e.g.), which leads to second-round effects that can broaden the impact of any price changes. Moreover, price- and wage-indexation perpetuate price shocks and spread their impact across the economy.

Headline Inflation and Contributions, based on 1999–2015 estimates /1

(percent year-over-year, deviation from center of tolerance range)

Source: Staff Estimates.

1/ Historical shock decompostion from a VAR estimated over the period 1999–2015. Direct regulated-price contributions are the IPCA-weighted contributions from regulated prices. Indirect contributions capture all other effects from regulated-price changes.

1 Estimates based on vector-autoregressive models estimated over two different monthly sample periods. The VARs include the output gap (HP-filtered BCB activity index) and monthly percent changes of: the real effective exchange rate; wholesale prices; regulated prices (IPCA); non-regulated prices (IPCA); and tradable prices (IPCA). Headline IPCA inflation is derived by weighting together each of the three subcomponents of the IPCA index. To identify the shocks, regulated-price inflation is assumed to be the most exogenous variable and the real exchange rate is assumed to be the most endogenous.

5. Fiscal policy outcomes have been disappointing. In 2015 the non-financial public sector primary deficit reached 1.9 percent of GDP (a far cry from the original target of a surplus of 1.2 percent of GDP), and the overall deficit was 10.4 percent of GDP. The key driver was a fall of 4.8 percent in real revenue collection,2 which was partially offset by a decline in real expenditures. Interest payments also increased substantially, including as a result of the FX swap program, which had losses of 1.5 percent of GDP. The targets for the 2016 primary balance were repeatedly revised, with a final large downward revision introduced mid-year. The new government reduced the 2016 federal primary balance target to -170 billion reais, or some -2.7 percent of GDP, reflecting the growth in items indexed to past inflation and the minimum wage and continuing revenue weakness. As of September 2016, meeting this target appeared feasible, but the outcome may depend on the yield of the repatriation tax. The strengthening of the currency has generated profits on the FX swaps in 2016, helping avoid an increase in the overall deficit. Financing the large deficits and falling maturities became significantly more expensive throughout 2015, with the rise in borrowing costs starting ahead of the loss of investment grade which took place between September and December 2015. But no difficulties arose in the placement of new debt, in part owing to the favorable composition of public debt by instrument and creditor (see Debt Sustainability Analysis (DSA) Annex and the Balance Sheet Analysis (BSA) matrix in Appendix III). Borrowing costs have fallen significantly in the course of 2016 with the change in government and the prospects of fiscal reforms. For example, the yield on the 5-year bond fell from 16.5 percent at end-December 2015 to 11.7 percent at end-September 2016.

6. Many subnational governments have been crippled by a confluence of the recession and unsustainable expenditure mandates. The recession has caused states’ revenues from all sources to fall sharply in 2015–16, making financing of their rising mandatory spending, chiefly on salaries and retirement pensions, increasingly difficult (see Selected Issues Paper). Many states have raised tax rates and sold assets to cope with fiscal stress. Since late 2015, several states have been paying salaries late and/or have been using third-party funds held in escrow to make ends meet.3 Rio de Janeiro defaulted on federally guaranteed loans from IFIs in 2016, and obtained emergency federal transfers that helped it to host the Olympics (Box 4). The dire situation of the states is understated by fiscal statistics, which are compiled on a cash-basis (Table 3) and do not show all extra-budgetary operations and new arrears, and are subject to classification problems (the significance of data problems is illustrated by S&P’s recent decision to stop issuing ratings for Rio de Janeiro’s debt owing to data gaps). To provide states with relief, the federal government (the states’ main creditor) agreed to a temporary standstill in the servicing of federal loans, and many states are lobbying the federal government for additional support.

Table 1.Brazil: Selected Economic Indicators
I. Social and Demographic Indicators
Area (thousands of sq. km)8,512Health
Agricultural land (percent of land area)31.2Physician per 1000 people (2013)1.9
Hospital beds per 1000 people (2012)2.3
PopulationAccess to safe water (2015)98.1
Total (million) (est., 2015)204.5
Annual rate of growth (percent, 2015)0.8Education
Density (per sq. km.) (2012)24.0Adult illiteracy rate (2014)8.3
Unemployment rate (latest, 2016)11.6Net enrollment rates, percent in:
Primary education (2014)99
Population characteristics (2014)Secondary education (2014)84
Life expectancy at birth (years)75
Infant mortality (per thousand live births)14Poverty rate (in percent, 2013)15.1
Income distribution (2014)GDP, local currency (2015)R$5,904 billion
By highest 10 percent of households40.9GDP, dollars (2015)US$1,773 billion
By lowest 20 percent of households3.6GDP per capita (est., 2015)US$8,668
Gini coefficient (2014)51.8
Main export products: Airplanes, metallurgical products, soybeans, automobiles, electronic products, iron ore, coffee, and oil.
II. Economic Indicators
Proj
20142015201620172018201920202021
(Percentage change)
National accounts and prices
GDP at current prices7.03.84.46.66.97.27.17.1
GDP at constant prices0.1−3.8−3.30.51.52.02.02.0
Consumption1.3−3.4−4.1−0.40.60.81.01.1
Investment−5.6−22.6−11.34.65.17.16.15.5
Consumer prices (IPCA, end of period)6.410.77.25.04.84.54.54.5
(In percent of GDP)
Gross domestic investment21.019.218.418.919.420.120.721.3
Private sector18.617.317.017.417.918.719.219.7
Public sector2.41.91.41.51.61.51.51.6
Gross national savings16.715.917.617.417.718.319.019.5
Private sector20.224.126.525.324.223.923.823.7
Public sector−3.5−8.2−8.9−7.8−6.5−5.6−4.8−4.2
Public sector finances
Central government primary balance 1/−0.4−2.0−2.7−2.4−1.7−0.9−0.20.4
NFPS primary balance−0.6−1.9−2.7−2.3−1.3−0.50.10.8
NFPS cyclically adjusted primary balance−1.5−1.7−1.6−1.4−0.8−0.30.10.8
NFPS overall balance (including net policy lending)−7.0−10.4−10.5−9.5−8.2−7.2−6.2−5.9
Net public sector debt33.136.245.950.954.156.859.762.5
General Government gross debt, Authorities’ definition57.266.5
NFPS gross debt63.373.778.482.985.788.290.993.5
Of which: Foreign currency linked3.44.63.83.73.73.63.63.5
(Annual percentage change)
Money and credit
Base money 2/−4.58.44.56.76.97.27.17.1
Broad money 3/13.59.85.89.610.010.613.614.4
Bank loans to the private sector10.93.61.25.69.311.412.012.6
(In billions of U.S. dollars, unless otherwise specified)
Balance of payments
Trade balance−6.617.748.548.647.346.549.251.9
Exports224.1190.1197.6206.7210.9215.7224.8233.6
Imports230.7172.4149.1158.1163.6169.2175.7181.8
Current account−104.2−58.9−14.7−29.5−34.9−38.6−39.9−41.2
Capital account and financial account100.855.214.729.534.938.639.941.2
Foreign direct investment (net)70.961.661.856.753.150.849.247.7
Terms of trade (percentage change)−3.4−11.03.2−2.5−2.9−2.4−0.7−0.5
Merchandise exports (in US$, annual percentage change)−7.2−15.23.94.62.04.46.63.9
Merchandise imports (in US$, annual percentage change)−4.3−25.3−13.56.03.57.07.43.5
Total external debt (in percent of GDP)29.537.538.435.334.433.131.730.2
Memorandum items:
Current account (in percent of GDP)−4.3−3.3−0.8−1.5−1.7−1.8−1.8−1.8
Gross official reserves363.6356.5369.3369.3369.3369.3369.3369.3
REER (annual average in percent; appreciation +)−1.0−15.8
Sources: Central Bank of Brazil; Ministry of Finance; IPEA; and Fund staff estimates.

Includes the federal government, the central bank, and the social security system (INSS). Based on the 2016 draft budget, recent annoucements by the authorities, and staff projections.

Currency issued plus required and free reserves on demand deposits held at the central bank.

Base money plus demand, time and saving deposits.

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

Includes the federal government, the central bank, and the social security system (INSS). Based on the 2016 draft budget, recent annoucements by the authorities, and staff projections.

Currency issued plus required and free reserves on demand deposits held at the central bank.

Base money plus demand, time and saving deposits.

Table 2.Brazil: Balance of Payments(In billions of U.S. dollars, unless otherwise indicated)
Proj.
20142015201620172018201920202021
Current Account−104.2−58.9−14.7−29.5−34.9−38.6−39.9−41.2
Trade balance−6.617.748.548.647.346.549.251.9
Exports (fob)224.1190.1197.6206.7210.9215.7224.8233.6
Imports (fob)230.7172.4149.1158.1163.6169.2175.7181.8
Income, net−49.4−39.6−35.6−44.4−45.4−46.6−48.3−50.3
Capital and Financial Account100.855.214.729.534.938.639.941.2
Capital account0.20.40.40.40.40.40.40.4
Financial account 1/100.654.714.229.134.438.139.440.7
Direct investment, net70.961.661.856.753.150.849.247.7
Assets26.013.514.616.017.519.120.922.7
Liabilities96.975.176.472.770.670.070.170.4
Portfolio investment, net38.722.02.30.90.2−0.7−1.8−1.9
Financial Derivatives, net−1.6−3.40.40.40.40.40.40.4
Other investment, net3.4−23.9−37.3−28.9−19.3−12.4−8.4−5.4
Change in Reserve Assets, net−10.8−1.6−12.90.00.00.00.00.0
Errors and Omissions3.43.70.00.00.00.00.00.0
Memorandum Items:
Gross reserves (eop) 1/
In billions of U.S. dollars363.6356.5369.3369.3369.3369.3369.3369.3
Net international reserves (eop)
In billions of U.S. dollars363.6357.7370.6370.6370.6370.6370.6370.6
In percent of short-term debt (residual maturity)234.7242.8269.6263.6259.5256.7256.7254.9
Current account (in percent of GDP)−4.3−3.3−0.8−1.5−1.7−1.8−1.8−1.8
Trade balance (in percent of GDP)−0.31.02.72.52.32.22.22.2
Merchandise exports (in percent of GDP)9.310.711.210.610.410.210.110.1
Merchandise imports (in percent of GDP)9.59.78.48.18.08.07.97.8
Export volume (yoy change, in percent)−0.38.15.43.33.63.73.63.5
Import volume (yoy change, in percent)−0.1−13.5−8.83.92.62.32.72.9
Export price index (yoy change, in percent)−5.3−21.6−1.41.2−1.5−1.40.60.4
Import price index (yoy change, in percent)−2.0−11.9−4.43.81.51.11.40.8
Terms of trade (yoy change, in percent)−3.4−11.03.2−2.5−2.9−2.4−0.7−0.5
Oil price (Brent blend; US$ per barrel)96.250.843.050.653.154.456.357.6
Nominal exchange rate (R/US$, annual average)2.353.33
REER (annual average in percent; appreciation +)−1.0−15.8
GDP in billions of U.S. dollars2,4171,7731,7691,9572,0322,1222,2182,319
Sources: Central Bank of Brazil; and Fund staff estimates and projections.

Historical numbers include valuation changes.

Sources: Central Bank of Brazil; and Fund staff estimates and projections.

Historical numbers include valuation changes.

Table 3.Brazil: Main Fiscal Aggregates(In percent of GDP, unless otherwise indicated)
Proj.
20142015201620172018201920202021
FEDERAL GOVERNMENT1/
Nonfinancial revenue21.520.820.221.021.421.721.921.9
Revenue administered by SRF13.212.912.312.712.913.113.213.2
PIT2.62.52.32.42.52.62.62.6
CIT4.03.53.33.53.53.63.63.6
Indirect Taxes5.86.05.85.96.06.06.16.1
Trade taxes0.60.70.70.70.70.70.70.7
Other0.20.20.20.20.20.20.20.2
Social security contributions5.95.85.75.75.75.85.85.8
Other revenue2.42.12.22.62.82.82.82.9
Total primary expenditure21.822.822.923.423.122.622.121.5
Current expenditures20.521.822.322.622.422.222.122.1
Personnel3.94.04.24.44.34.24.14.0
Transfers3.73.73.43.53.43.33.33.2
Pension benefits6.97.48.58.78.99.19.49.6
Other6.06.76.26.05.85.65.35.2
Capital expenditures1.41.00.70.80.90.91.01.0
Expenditure reforms to meet Spending Cap Rule−0.2−0.5−1.0−1.6
Primary balance−0.4−2.0−2.7−2.4−1.7−0.9−0.20.4
Borrowing requirement4.88.78.87.86.75.74.84.1
STATES AND MUNICIPALITIES
Nonfinancial revenue10.810.710.510.510.610.610.610.6
Own revenues8.08.28.18.18.08.07.97.9
Indirect taxes6.56.66.56.46.46.46.36.3
Other1.51.61.61.61.61.61.61.6
Transfers from the federal government2.72.52.42.52.62.62.72.7
Total primary expenditure11.010.610.510.510.310.310.410.3
Current expenditures10.09.79.89.89.99.99.99.8
Personnel4.94.94.95.05.05.15.04.9
Other5.14.84.94.94.94.84.84.9
Capital expenditures and other1.00.90.70.70.70.60.60.5
Expenditure reforms to meet the primary surplus target−0.1−0.1−0.2−0.30.00.0
Primary balance of municipalities0.10.10.00.00.00.00.10.2
Primary balance−0.10.10.00.00.30.30.20.4
Borrowing requirement1.11.61.61.61.41.41.31.6
PUBLIC ENTERPRISES
Federal enterprises
Nonfinancial revenue0.70.70.70.70.70.70.70.7
Expenditures0.80.70.70.70.70.70.70.7
Personnel0.20.20.20.20.20.20.20.2
Other current expenditures0.40.30.30.30.30.30.30.3
Capital expenditures0.20.20.20.20.20.20.20.2
State and municipal enterprises
Primary balance0.00.00.00.00.00.00.00.0
Primary balance−0.10.00.00.00.00.00.00.0
Borrowing requirement0.10.10.10.10.10.10.10.1
NON FINANCIAL PUBLIC SECTOR
Primary balance−0.6−1.9−2.7−2.3−1.3−0.50.10.8
Primary balance (Authorities’ target)−2.6−2.1−0.90.2
Overall balance−6.0−10.4−10.5−9.5−8.2−7.2−6.2−5.9
Overall balance including policy lending−7.0−10.4−10.5−9.5−8.2−7.2−6.2−5.9
Structural primary balance 2/−1.3−1.4−1.6−1.4−0.9−0.4−0.10.6
Structural primary balance including policy lending−2.3−1.4−1.6−1.4−0.9−0.4−0.10.6
Memorandum items:
Additional adjustment to meet Authorities’ target−0.1−0.1−0.5−0.7−1.0−1.6
Public Investment Pilot Expenditure0.00.00.00.00.00.00.00.0
Growth Acceleration Program1.01.01.01.01.01.01.01.0
Transfers to SWF0.00.00.00.00.00.00.00.0
Loans to public financial institutions 3/1.00.00.00.00.00.00.00.0
NFPS net interest expenditure5.58.57.87.26.96.76.36.7
Net central government debt 4/22.425.434.839.041.543.746.047.9
Net public sector debt 4/33.136.245.950.954.156.859.762.5
Gross public sector debt63.373.778.482.985.788.290.993.5
General Government Debt, Authorities’ Definition57.266.5
Nominal GDP (million Brazilian reais)5,687,3105,904,3326,166,1266,575,6817,028,7927,533,8158,066,7648,640,597
Sources: Central Bank of Brazil; Ministry of Finance; Ministry of Planning and the Budget; and Fund staff estimates.

Comprises the central administration; the Central Bank of Brazil; and the social security system.

Structural primary balance adjusts for output gap and one-off measures.

Policy lending to BNDES and others.

Includes assets, which mainly comprise international reserves, financial assets of public enterprises, and assets of the federal labor fund (FAT).

Sources: Central Bank of Brazil; Ministry of Finance; Ministry of Planning and the Budget; and Fund staff estimates.

Comprises the central administration; the Central Bank of Brazil; and the social security system.

Structural primary balance adjusts for output gap and one-off measures.

Policy lending to BNDES and others.

Includes assets, which mainly comprise international reserves, financial assets of public enterprises, and assets of the federal labor fund (FAT).

Box 4.Fiscal Crisis in Rio de Janeiro

The state of Rio de Janeiro epitomizes the subnational fiscal crisis in Brazil. In July 2016, Rio de Janeiro declared a “state of calamity” over public finances and received a R$2.9 billion transfer from the federal government to guarantee the payment of security forces during the Olympic Games. This episode put the state on the spotlight and increased the media attention towards a subnational fiscal crisis that affects some of the largest states in the country. At the end of 2015, Rio Grande do Sul had already breached the debt limit established by the Fiscal Responsibility Law (at 200 percent of net current revenues) and Rio de Janeiro and Minas Gerais were rapidly approaching the limit. A number of states have been able to avert such rapid deterioration of public finances and find themselves in better fiscal shape.

Rio de Janeiro has been running arrears due to cash shortages. In 2015, faced with falling revenues and a federally-imposed tight credit constraint, Rio de Janeiro prioritized its payroll. Like other states, it obtained cash-flow relief from the suspension of debt service payments to the Federal government in 2016, but this was not enough. Cash shortages led Rio to increase payment deferrals and Despesas de Exercicios Anteriores (DEAs), which are exceptional expenditures not included in the budget and postponed to the following year. These payment delays included electricity, water, gas, phone, security and cleaning services. In 2015, 24 states accumulated R$15.4 billion (0.3 percent of Brazil’s GDP) in DEAs (an increase of 44 percent from 2014), and Rio de Janeiro was the state with the largest increase (185 percent). Rio de Janeiro also failed to service debt to international financial institutions, triggering federal guarantees. By August 2016, Rio de Janeiro accumulated a 4-month delay in transferring to commercial banks the amounts withheld from state employees’ paychecks to service their personal loans. In response, banks stopped payroll loans to state government employees in Rio de Janeiro.

The fiscal crisis in Rio de Janeiro stems largely from structural fiscal imbalances. The decline in revenues in Rio de Janeiro has both a cyclical component (the recession reduced tax collection, especially from ICMS) and a structural component (the oil price slump which dramatically reduced revenues from royalties and accentuated recessionary conditions in Rio de Janeiro, where Petrobras is headquartered and was building a large petrochemical complex, now cancelled). The increase in expenditures is also structural in nature and has been building up over a long period of time. In 2015, payroll expenditures (R$17 billion) and pensions for inactive workers and retirees (R$11 billion) represented 32 and 20 percent of total primary expenditures respectively. Between 2009 and 2015 these two expenditures increased 70 percent in real terms, driven largely by salary increases, putting Rio de Janeiro in the leading position in this spending category (see Selected Issues Paper). While its economy was growing and oil was booming Rio de Janeiro managed to keep up with this structural increase in spending, but as soon as the downturn hit the region, the decline in revenue made it very hard to finance its spending: in 2016 monthly payments of both salaries and pensions consumed 90 percent of monthly revenues.

Structural fiscal reforms are required to solve the fiscal crisis. Despite the savings from the federal debt rescheduling program (equivalent to R$2.5 billion) and a large number of ad-hoc measures, the state still faces a gap in its finances of R$16 billion in 2016 (2.4 percent of the state’s GDP and ¼ percent of Brazil’s GDP). Structural fiscal reforms are urgently needed. The subnational fiscal crisis requires a reform of public employment rules and a pension reform at the national level to alleviate the pressure coming from growing mandatory expenditures. In Rio de Janeiro and possibly some other states, new sources of recurrent revenue also need to be considered.

7. Financial markets have been volatile. Major market movements through the last 12–18 months can often be traced to political and policy shocks, such as the successive loosening of fiscal targets and the impeachment of President Rousseff. The real depreciated by around 50 percent against the U.S. dollar over the year to December 2015, and by around 20 percent in real effective terms. Over the same period, stock prices lost 10 percent of their value and domestic government bond yields rose by more than 300 basis points. Over the course of 2016, these indicators have regained lost ground amid expectations of improved economic policies and growth prospects, and a more generalized reduction in risk aversion among global investors. This has been reflected in a sharp reversal in the FCI in 2016Q2, and in renewed bond placements abroad by corporates.

8. The central bank has intervened in the foreign exchange market less frequently than in the past. Intervention in 2015 was appropriately limited to containing short-term excessive volatility, broadly symmetric, and continued to rely on the use of FX swaps and, to a lesser extent, FX repos. Taking advantage of the market rally that began in March 2016, the central bank has lowered the net notional value of outstanding FX swaps to about US$32 billion (from a high of about US$110 billion) by issuing reverse swaps and not rolling over maturing swaps.

9. The external position has improved (Appendix II). The current account deficit narrowed from 4.3 percent of GDP in 2014 to 3.3 percent in 2015, but Brazil’s external position remained moderately weaker than the level consistent with fundamentals according to the External Balance Assessment (EBA). Due to the depreciation in the second half of 2015, the real effective exchange rate was only slightly overvalued at the beginning of 2016 but given the currency appreciation this year, earlier competitiveness gains have been eroded. The real depreciation in 2015 was reflected largely in improvements in the current account in 2016 owing to lagged effects on exports (Appendix III).

10. International reserves remain a source of strength and capital flows are stable, although their composition has changed. At US$365 billion, reserves are above the IMF’s adequacy metric. Over 2015–2016, equity liability flows (both direct investment and portfolio accounts) remained strong as foreign investors pursued private equity deals made attractive by the weaker real. But debt liability flows fell sharply, especially in 2015, reflecting the hardening of market access for Petrobras and other large corporations. Net direct investment fully financed the current account deficit in both 2015 and 2016. After rising sharply over 2014, the share of intercompany loans in direct investment liability flows fell to about 25 percent in 2015 as proceeds from overseas borrowing by foreign incorporated subsidiaries of Brazilian parent companies, notably Petrobras, dropped sharply (Appendix III). Net portfolio debt liabilities fell to close to zero in 2015 from 1 percent of GDP in previous years. So far in 2016, firms have enjoyed greater market access relative to 2015 and FDI has remained strong, including as a result of intercompany loans by foreign companies to their Brazilian subsidiaries, but portfolio flows have remained subdued.

11. Brazil is in the downturn phase of the financial cycle, which warrants enhanced monitoring. Corporates are significantly bank dependent, and the expansion of bank credit for many years contributed to rising leveraging among firms (see Appendix III, where balance sheet matrices for 2007 and 2014 are analyzed). The credit cycle has turned, however, as banks (increasingly including public banks) have been slowing credit supply while leveraged corporations and households face unfavorable income prospects. In fact, contracting domestic demand and a negative output gap have been reflected in a reduction in demand for credit, including for subsidized lending extended by BNDES. Facing withdrawals of savings deposits in 2015, Caixa Economica reduced the supply of mortgages by tightening LTV requirements. The LTVs were reversed in 2016 as the bank compensated for lower deposits with alternative, albeit more expensive, funding sources.4 Nominal credit growth was negative (-0.6 percent year over year) in August 2016, for the first time since 2002, reflecting a decline in demand, tighter underwriting standards, and the authorities’ decision to reduce the rate of expansion of public banks. Until about Q1–2016, financial conditions (measured by the FCI) had been tightening amid higher foreign funding costs, monetary policy tightening and the depreciation of the real (see Selected Issues Paper).5 Since March, however, the FCI reversed course with the prospects of government change.

12. Macro-prudential policies have been used appropriately. The central bank relaxed reserve requirements on deposits for small- and medium-sized banks in an effort to support liquidity and bolster certain types of loan (housing, agricultural and infrastructure). This move was consistent with macro-prudential principles, as it helped soften a declining credit cycle and alleviate liquidity risks, and reversed the previous tightening of reserve requirements.

13. After deteriorating in 2015, the health of the banking sector improved in the first half of 2016 as shocks to funding dissipated. In particular:

  • Solvency. The system-wide capital ratios fell in 2015, but have since increased and are well above the regulatory minima. However, capital ratios of public banks, which are much lower than those of private banks, have continued to drop mainly due to higher Basel III deductions from capital. In an effort to bolster capital ratios, the two largest public banks have already cut dividends and are planning to sell assets, including by issuing initial public offerings of part of their operations. The decrease in capital in 2015 largely reflects higher unrealized losses on fixed income securities, an expansion of balance sheets from exchange rate depreciation, and a significant increase in deferred tax assets following an increase in the tax rate. The increase in capital ratios of private banks in 2016 was mainly driven by reduction of balance sheets (also due to exchange rate appreciation) and higher unrealized gains on fixed income securities as government yields plunged following the government change.

  • Liquidity. Liquidity risk increased in 2015 due to withdrawals of funding, especially saving deposits. This partly reflects a search for yield through the purchase of mutual funds shares and banks’ deposits-like instruments. However, the overall funding profile of the system remains strong and improved in the first half of 2016 as banks increased holdings of liquid assets in an environment of low credit supply. External funding exposures are low (at around 12 percent of total funding) and foreign exchange risks are largely hedged.

  • Profitability. While banks’ net income after taxes increased in 2015 reflecting higher tax credits and higher deferred tax assets following the tax change, net income before taxes dropped significantly in 2015, owing to a spike in provisions for loan losses and higher funding costs following the sovereign downgrade. On the other hand, net incomes after taxes fell in the first half of 2016 pushing profitability indicators below 2015 levels. However, profits before taxes surged significantly during the first half of 2016 primarily due to higher spreads as a result of higher credit risk. The poor performance of the stocks, especially Petrobras shares, has impacted BNDES’ equity portfolio with the damage being recognized in its mid-2016 income statement.

  • Asset quality. Banks’ non-performing loans (NPLs) have gradually increased over 2015 and reached 3.6 percent of total loans in July 2016 (4.1 percent if restructured loans are added to the stock of NPLs). To further limit increases in NPLs, banks have been renegotiating the terms of some loans and writing-off delinquent loans. Banks have remained well provisioned with loan loss reserves covering 150 percent of NPLs.

  • Nonfinancial corporations are vulnerable. Brazilian firms stand out in the region for their high leverage and interest servicing, and for more pronounced declines in profitability. While the depreciation of the real increased leverage, the impact on profitability and capital has so far been mitigated by widespread hedging and the recent appreciation of the real. The corruption scandal at Petrobras and credit ratings downgrades hampered access to foreign credit for many Brazilian corporates, motivating some large firms, including Petrobras, to develop deleveraging strategies in the last 12–18 months. While market access has improved in 2016 for some firms, many corporations remain under pressure, as revealed, for example, by the rise in bankruptcy protection applications and the rising share of larger firms in these processes. In fact, one of Brazil’s largest telecommunications companies, Oi, filed for bankruptcy protection on US$19 billion of debt in June, contributing to a spike in provisioning.6

Brazil: Bankruptcy Protection Applications Index

(12-month rolling average; higher means more applications)

Sources: Serasa.

Nonfinancial Corporates: Brazil and LA4

(Chile, Colombia, Mexico, and Peru)

Sources: Bloomberg and IMF Staff calculations. Approximately 250 firms for Brazil and 350 firms for LA4. Leverage: total debt to total equity (percent); profitability: return on equity (percent, 4-quarter average); interest coverage: EBITDA/total interest (ratio, 4-quarter average); liquidity: cash ratio (cash and equivalents over current liabilities), 4-quarter average).

14. Household debt has begun to edge down, and service costs have stabilized at a high level. Household debt-to-disposable income has fallen over the course of 2016 reflecting both demand and supply factors; the share of mortgage debt has increased to one third, but underwriting standards, including mortgage LTVs, have tightened. The household debt service-to-income ratio has been broadly stable at 22 percent for more than a year, with rising interest costs largely offsetting lower principal payments as a share of income.

Brazil: Household Indebtedness

(in percent of disposable income)

Source: Central Bank of Brazil.

15. The change in government has brought a change in the design and orientation of several key policies.

  • The government has sent to Congress a constitutional amendment limiting the growth in federal noninterest spending to the rate of consumer price inflation of the previous year for the next 20 years, with an opportunity for a revision in the tenth year.7 This reform seeks to overcome the effect of political fragmentation on Brazil’s budgetary process by imposing a hard budget constraint at the constitutional level.8 Also, the government has accepted a large primary deficit in 2016, and proposed a primary balance target for 2017 in line with the operation of the expenditure ceiling. The proposed 2017 budget also includes some ½ percent of GDP in one-off revenues from the auctioning of concessions and asset sales. Under these policies, there would still be significant real spending growth in 2017 (if inflation falls, as expected); the harder part of the adjustment would start in 2018, once inflation has broadly stabilized, preventing further real growth in spending. The government has also announced a reform of the social security system, much needed in its own right and also necessary to make the expenditure limit viable.

  • Against the background of a marked drop in interest rate futures, the Central Bank has made a return of inflation to the central target by end-2017 a priority, and indicated that an easing of policies can be considered once visible progress in fiscal reforms has been secured. The BCB has also stepped up its communication practices and the new government announced the intention to grant the central bank operational autonomy through a constitutional amendment that provides immunity to board members from lower-court prosecution, while removing the ministerial status that is now conferred on the BCB governor.

  • The infrastructure concessions program has had difficulties gaining momentum in an environment marked by uncertainty, low growth, and tight financing conditions, especially for large construction companies implicated in the Petrobras corruption scandal. However, a newly announced institutional framework and forthcoming changes in regulatory agencies may stimulate a pick-up in private sector participation (see Appendix III).

16. While recent corruption investigations signal a welcome move towards greater transparency, they have also added to political and economic uncertainty. The authorities have been implementing strong mechanisms to oversee public expenditure and recover losses to the state due to budgetary irregularities. This has been notably achieved through the work of the Federal Court of Accounts, the Federal Public Prosecutors Office, the Financial Intelligence Unit and the ENCCLA9. Steps taken to strengthen the anti-corruption (AC) and anti-money laundering (AML) frameworks, such as the revisions to the AML Law in 2012, and the 2013 AC law have provided additional tools to investigate and prosecute corruption. Nevertheless, high-level enforcement actions have added uncertainty to the existing negative impact that large-scale corruption has on investment, growth, and political stability.

Outlook and Risks

A. Returning to Growth

17. Activity is expected to start to recover gradually, but will remain weak for a prolonged period. The near-term outlook is for a gradual recovery to start in the second half of 2016, assuming that political uncertainty diminishes and that other downward economic shocks (such as the large administered-price adjustments of 2015 and the major investment cuts by Petrobras) run their course. A sharper recovery is difficult because of the excess leverage and slack among firms, and weakened income and balance sheets of households. Monetary policy is expected to remain relatively tight and credit growth is projected to fall further as a share of GDP in 2017. While deteriorating economic conditions are expected to affect the quality of banks’ assets, the largest banks have enough capital to absorb possible losses (see Selected Issues Paper). The baseline assumes that the proposed fiscal target for 2016 will be met, and that the authorities’ proposed structural reforms on the public expenditure side will be approved and implemented. Over the medium term, inflation is expected to slowly converge toward the target midpoint as output growth reaches its potential rate of 2 percent (which does not assume the adoption of any major structural reforms on the supply side beyond the implementation of the authorities’ infrastructure concession program); the current account deficit is expected to stabilize around 2 percent of GDP. Credit is expected to recover broadly in line with activity, albeit with a lag (the credit to GDP ratio will begin to edge up in 2018).10 In this context, BNDES is expected to rely on its own balance sheet and to prioritize lending for infrastructure. The health of the banking sector is expected to improve as the economy picks up and funding costs decline. Government spending is assumed to continue growing in real terms in the near term, albeit at reduced rates, consistent with the gradual tightening implicit in the expenditure ceiling. The gradual recovery of growth will have positive spillovers on other economies in the region, notably those of Brazil’s Mercosur partners.

Scenario: Baseline
201620172018201920202021
Growth, %−3.30.51.52.02.02.0
Inflation (GDP deflator), %8.06.15.35.15.05.0
Primary Balance, % GDP−2.7−2.3−1.3−0.50.10.8
Gross Debt, % GDP78.482.985.788.290.993.5

18. Downside risks continue to dominate the outlook, but upside risks are emerging (Appendix I).

  • A key domestic risk is that the new government fails to deliver on its fiscal consolidation strategy and provide a durable boost to confidence. Re-intensification of political uncertainties (e.g., as a result of developments in the corruption probe) could also exacerbate downside risks resulting in a “sudden stop” of capital inflows, a sharp asset price adjustment and widening of credit spreads, and a defensive tightening of the monetary policy stance. In this financial stress scenario, higher risk premia would also trigger losses on fixed income securities for banks, while a “double dip” recession could further impact private agents with weakened balance sheets, resulting in larger loan losses and capital shortfalls for some banks; this would further dampen credit supply and economic activity, and damage the fiscal position with recapitalization costs and the realization of deferred tax credits (see Selected Issues Paper). 11 Petrobras’ balance sheet may be subject to risks from unfunded contingent liabilities, as is the case for other SOEs, (Eletrobras and Caixa Economica).

  • External downside risks relate to a protracted period of slower growth in advanced and emerging economies, especially China, further declines in export commodity prices, and tighter financial conditions.

  • Upside risks have also emerged. Recent policy pronouncements have boosted confidence and asset prices which, if sustained, could foster a sharper turnaround in investment and growth. Faster-than-envisaged progress in the approval of the authority’s fiscal reform agenda could spark a more vigorous recovery in sentiment, boosting foreign interest in Brazil in the context of an external environment marked by low interest rates. This would result in stronger investment and growth in Brazil, although a possible surge in capital flows may pose challenges, notably for sectors that have benefitted from the recent currency depreciation.

19. The authorities have been responsive to some of Staff’s past recommendations. In particular, monetary policy was tightened in 2015, and the National Monetary Council narrowed the inflation tolerance range from 4.5 percent +/- 2 percent to 4.5 percent +/- 1.5 percent for 2017, and raised the long-term lending rate (TJLP) from 5.5 to 7.5 percent over the past year and a half. The net FX swaps position was also lowered significantly over the past year, in line with Staff’s advice. The ongoing push for reforms that address structural sources of fiscal pressure, including the announced plans of the government to pursue social security reform, are also consistent with past advice from Staff.

Policy Discussions

Policymaking in recent years has failed to address long-standing structural problems and proved counterproductive, contributing to an erosion of policy credibility and worsening growth prospects. Greater progress at addressing medium-term structural issues—particularly pertaining to the fiscal framework, at both national and subnational levels—would go a long way toward restoring policy credibility and boosting confidence, necessary for the return to strong, inclusive, and sustainable growth. Early implementation of key measures would also help moderate inflation expectations and facilitate an easing of monetary policy. Given the current environment and risks, the resilience of the banking sector should be bolstered and efforts to boost infrastructure investment scaled up.

A. Restoring Credibility Through Fiscal Sustainability

20. The government’s focus on controlling fiscal spending growth is an imperative and welcome. Unsustainable fiscal dynamics are being driven by unfunded and increasingly onerous mandates on the expenditure side, which increase government financing needs, raise borrowing costs for all agents in the economy, and slow down economic growth, contributing, in turn, to a further worsening of the public debt dynamics. The approval and steadfast implementation of the spending cap could be a game changer—it would help improve the long term trajectory of public spending and permit the stabilization and eventual reduction of public debt as a share of GDP. In addition to the spending cap, the draft budget law before Congress contains a series of one-off revenues arising from the granting of concessions and the sale of some assets. Together with revenue projections based on the authorities’ macroeconomic assumptions, this yields a primary balance target (floor) of -2.1 percent of GDP for 2017.

21. Credible implementation of the spending cap, and more generally restoring sustainability of the public sector finances, requires addressing the structural drivers of public expenditure growth and increasing flexibility in the allocation of public monies. The main areas for reform include:

  • Social security. The success of the expenditure rule would depend on reforming the social security system—which is necessary in its own right, and would be a priority even in the absence of a spending cap. Pension and other benefits represent nearly one half of federal noninterest spending and at least 13 percent of states’ noninterest spending. These outlays have strong real growth momentum as a result of demographic trends and benefit indexation rules (see Selected Issues Paper). The reform of the pension system should be comprehensive, bearing upon the rules governing retirement age, replacement rates at retirement, the growth of benefits post-retirement, and the duplication of benefits. The retirement benefits system has been providing support for persons who should instead be covered by targeted social assistance programs; these programs should be ready to step in as the retirement system is reformed. Bringing civil servants’ pension schemes closer to that of the private sector would be fiscally prudent and also fair and equitable.

  • Ending revenue earmarking. Revenue earmarking needs to be eliminated to create the flexibility in the allocation of budgetary resources the expenditure cap will demand. In this context, an important feature of the expenditure cap legislation is that it aims to remove the obligation to dedicate an increasing share of net federal revenues to spending in education and health. This provision will need to be supplemented with measures to control the growth of spending per capita on public health, which is set to rise as Brazil’s population ages (see Selected Issues Paper).

  • Containing payroll growth. Payrolls represent a large share of spending, especially in subnational governments. Ensuring prudent hiring and remuneration decisions will be essential. In this context, reforms to make exit from civil service feasible and to rationalize automatic career progression are also needed.

  • Subnational governments: Strengthening institutional relationships across levels of government and enacting legislation enabling states to make difficult expenditure adjustments should be part of the strategy to help states regain control of their finances. The recommendations on social security and payroll control apply fully to the case of states. A firm commitment by states to increasing transparency is also key.

  • Minimum wage and indexation. The current formula for minimum wage revisions affects the growth in pension and other benefits, and is thus a source of fiscal pressure over the medium term. Severing the automatic link between benefit payments and the minimum wage is advisable, as would be limiting minimum wage increases to cost of living adjustments.

  • Spending efficiency and composition. The spending cap will make it imperative for government agencies to make better use of their resources to prevent a decline in the quality of their services. Also, decisions over the composition of expenditure should preserve programs with a positive impact on growth, including investment, and social safety nets for the most vulnerable members of society.

22. By itself, the expenditure cap could take several years to stabilize and reduce debt. As designed, the cap would give the government one and possibly two more years of positive real spending growth, before freezing real spending when inflation stabilizes. In staff’s baseline scenario, the expenditure cap is implemented fully and one-off revenues like those in the 2017 budget proposal are assumed to be collected each year. Given staff’s macroeconomic assumptions, this policy combination would keep the overall deficit high for many years, during which the government would continue to crowd out private agents from scarce funding (Tables 1 and 3, and DSA). Public debt (GFSM definition) would reach 93.5 percent of GDP in 2021, and would peak around two years later before beginning to decline.

23. Against this backdrop, a more frontloaded adjustment which results in a faster regeneration of the currently exhausted fiscal space has merit. The eventual trajectory of debt ratios will depend on the evolution of growth, real interest rates, and primary balances—with the last of these elements being most closely under the government’s influence. Frontloading fiscal consolidation may be a headwind to growth in the near term, but it can boost confidence and reduce pressures on funding markets, bolstering growth in subsequent years.12 Staff’s recommendation is to gradually raise the primary balance to about 3 percent of GDP by 2021; with this, public debt would start declining from a peak of 86 percent of GDP already in that year (see DSA). Beyond that point, the primary surplus would have to remain at a similarly high level for debt ratios and borrowing costs to decrease to more comfortable levels. The additional adjustment, which would rise gradually, would require a mixture of efforts to undershoot the spending cap and mobilize quick-acting revenue gains, over-performing on the government’s own primary balance targets by 0.3 percent of GDP in 2017 and 2018, and by larger margins in subsequent years (text table). Moreover, these efforts may be even more urgent if one-off revenues cannot be sustained at the 2017 level going forward. Some revenue measures should be temporary, remaining in effect only while debt is still rising, and could include, in addition to asset sales, increases in fuels taxes (CIDE) and federal turnover taxes (PIS/COFINS), an increase in the IOF tax on new loans, and the rollback of payroll tax cuts and other tax expenditures (including the SIMPLES program). Expenditure measures should include the extension of the spending cap to subnational entities, and an additional reduction of inefficient discretionary expenditures. Given concerns over the short run effects on output of adjustment, these actions should proceed as economic growth firms up.

Scenario: Debt Reduction Begins by 2021
201620172018201920202021
Growth−3.30.21.52.22.52.2
Inflation (GDP deflator), %86.15.35.155
Primary Balance, % GDP
Authorities’ Target−2.6−2.1−0.90.2
IMF Baseline−2.7−2.3−1.3−0.50.10.8
IMF Recommended Path−1.8−0.60.72.03.0
Measures Required, % GDP0.50.71.21.92.2
Revenues0.30.50.81.01.0
Expenditures0.20.20.40.91.2
Gross Debt, % GDP78.482.884.785.785.885.5

B. Monetary and Financial Stability Policy

24. The stance of monetary policy should remain unchanged until inflation is more certain to converge to the central target. In the current context, marked by uncertainty about the output gap, approval of key reforms, and related movements in the exchange rate, maintaining current monetary policy settings would be broadly appropriate. The spike in inflation caused by regulated-price and exchange-rate adjustments over 2015, as well as inflation persistence related to the more recent drought-related food price shock, are expected to wane soon, while the effects of weak demand and the recent exchange rate appreciation are expected to increasingly put downward pressure on inflation. This would allow an easing cycle to begin in 2017. Nevertheless, there is a risk that second-round effects of high inflation in 2015 contribute to an increase in inflation persistence. Monetary policy should, therefore, remain tight until inflation expectations settle closer to the midpoint of the central bank’s tolerance range. In this context, tangible progress in fiscal adjustment and reforms would create space for easing monetary policy. The intention to strengthen the inflation targeting framework by enhancing the autonomy of the central bank and improved central bank communication are welcome. These steps will boost institutional credibility and may contribute to faster disinflation (see Selected Issues Paper).

25. The exchange rate should remain the key external adjustment variable. Intervention should remain limited to episodes of disorderly market conditions. Reserve buffers should be preserved, resisting pressures to use them for ad-hoc purposes or for defending the currency in the event of sustained capital outflows (see RAM). Continuing gradually to reduce the net notional value of FX swaps, including by issuance of reverse FX swaps, is advisable. If improved market sentiment from the swift implementation of structural reforms or more generally as foreign investors search for yield in an environment of low interest rates leads to increased capital inflows with potentially unwarranted appreciation, the options available would be to tighten fiscal policy (as in Staff’s recommended path, for example, provided growth remains positive), issue more reverse FX swaps (involving some fiscal cost), further reserve accumulation (with higher sterilization costs), and an easing of the policy rate while raising the TJLP (with tradeoffs concerning the disinflation effort).

26. While the health of the banking system remains largely sound, the resilience of the banking sector should be bolstered. The health of the banking system remains largely sound, although the recession has affected profitability and asset quality. The mission welcomes the moderation in the growth rate of credit by public banks, their plans to reduce direct financing of large corporations with market access, reducing credit market distortions, and the intention of the two largest public banks to strengthen their capital position. To make the banking sector more resilient to shocks, financial safety nets should be improved by strengthening the procedures for use of the deposit insurance fund (for example, by securing adequate funding for the fund), enhancing the central bank’s emergency liquidity assistance, and modernizing the resolution regime. To strengthen transparency and accountability and reinforce the authorities’ ability to identify and respond to future risks, an explicit mandate with clear responsibilities should be given to a committee comprising all financial regulators, the deposit Guarantee Fund, and the Ministry of finance, for macro-prudential oversight. Also, a mandate should be given to a separate entity that should set up a coordination framework to support timely and effective decision-making in a crisis situation, and periodically test the capacity of the authorities to respond to crisis scenarios. The authorities are also urged to follow through on their plans to strengthen private insolvency frameworks, with the aim of expediting the bankruptcy process and reducing default losses incurred by creditors. Risks arising from high private sector leverage underscore the need for continued vigilance and close monitoring of the health of the corporate sector and its links to the banking sector.

C. Policies to Boost Potential Growth

27. Structural reforms targeted at reducing costs of doing business, enhancing efficiency, and fostering investment are essential to strengthen growth over the medium term. While some of these reforms are difficult politically, they come at very little economic cost and would hasten a return to growth and bolster it beyond the current projection of 2 percent over the medium term—although quantifying the precise impact on growth of these reforms is difficult. Key areas to consider are:

  • Infrastructure bottlenecks. The infrastructure concessions program is critical to alleviating supply-side constraints and boosting competitiveness. Following through on recently announced enhancements and regulatory reforms would help make the program more attractive to investors, while maintaining high standards of governance and program design.

  • Tax reform. Brazil’s tax system is complex and burdensome. One important way to reduce the cost of doing business would be to simplify the federal PIS/COFINS and the State Tax on the Circulation of Goods and Services (ICMS).13

  • Opening the economy. Tariffs and nontariff-barrier reductions, a revision of the policy on domestic content requirements, and pursuing free-trade negotiations outside Mercosur would help increase competition and efficiency.

  • Efficient allocation of savings. A review of credit earmarking rules and other distortions would be advisable to ensure that national savings go to their most productive uses.

  • Labor reform. Reforms aimed at facilitating productive employment and reducing incentives for informality would promote job-creation, investment, and growth. Reforms should be mindful of first-time entrants in the labor market, a segment composed largely of young people and relatively sensitive to cyclical fluctuations. The moderation of the minimum wage indexation rule, proposed earlier on fiscal grounds, would also contribute to restoring youth employment.

28. Fiscal statistics should be made more comprehensive. In particular:

  • A full balance sheet for general government should be published. Although balance sheets are published by the federal and other governments, the published balance sheet for general government includes only debt and financial assets. Among the missing items are accounts payable, including floating debt (restos a pagar), and liabilities related to civil servants’ pensions.

  • Given the importance of state-owned enterprises and public banks in the analysis of fiscal policy, the government should also publish fiscal statistics for the entire nonfinancial public sector (i.e., including Eletrobras and Petrobras) and for the entire public sector (including BNDES, Caixa Econômica Federal, and Banco do Brasil). However, these entities should not be included in the calculation of fiscal targets (as including them would introduce new distortions).

  • Strengthening fiscal transparency in states’ fiscal reporting (including by adopting standard accounting practices) and timely monitoring and enforcement of fiscal rules are key challenges.

29. The effective implementation of transparency, anti-corruption and AML measures would contribute to enhancing predictability for businesses and ensure a greater perception of fairness. Authorities’ commitments to make data on public procurement open by default, implement the recent legislation on conflict of interest, and strengthen whistleblowing mechanisms should be implemented. To further strengthen the effectiveness of the anti-corruption and AML frameworks, the authorities should eliminate regulations that provide opportunities for bribes. Additionally, the authorities aim to improve access to and sharing of banking and fiscal information, and prevent the abuse of appeal provisions and statutes of limitations in legal proceedings, in line with Supreme Court jurisprudence. Authorities should also strengthen provisional measures and confiscation, effectively pursue a larger number of significant corruption, money laundering and illicit enrichment cases, and enhance the AML/CFT supervision of banks’ obligations regarding politically exposed persons.

Authorities’ Views

30. The authorities see evidence that economic activity has stabilized recently. They indicated that growth is likely to turn positive in the fourth quarter of this year, driven by rising confidence and a recovery in investment. The authorities agreed with staff that the weak labor market is likely to hamper the recovery in private consumption. Nevertheless, they were more optimistic than staff about the prospects for investment, especially if deleveraging is accelerated through equity issuance and M&A activity. In their view, swift passage of the two main fiscal reforms would provide additional support for the recovery. Thus, the Ministry of Finance projects GDP growth of 1.6 percent in 2017 and 2.5 in 2018, and considers that there is the potential for upside surprises.

31. The authorities were also positive on Brazil’s medium-term growth prospects, subject to steady progress with a deliberate sequence of reforms. They are of the view that the recently revamped infrastructure concession framework and the associated regulatory changes would facilitate private sector participation in the existing pipeline of priority investment projects, helping raise potential growth over the medium term. They also indicated that their agenda included a number of structural reforms, such as tax simplification, labor reform, and negotiation of new international trade agreements. However, they explained that these reforms would most likely wait till after key fiscal reforms are secured.

32. The authorities stressed that regaining control of public expenditure must be at the front and center of the fiscal reform strategy. They explained that expenditure growth has structural causes, and that their proposed constitutional amendment (which they see as having a high probability of approval) would help address these problems at the root. The cap would force Congress to make tough choices in the annual budget. They also see the expenditure cap as a commitment device that would support the negotiation and approval of other necessary reforms in the fiscal area, including the social security reform.

33. The authorities agreed with staff that fiscal consolidation would need to go beyond the expenditure cap, but stressed the need to tackle challenges in a sequence. They noted that a stronger macroeconomic environment will contribute to the stabilization and eventual reduction in debt. They indicated also that the government would aim to accelerate the reduction of gross debt through asset sales and other operations, including the negotiation of an early repayment of debt by BNDES, amounting to R$100 billion over three years. They noted that additional measures, including rolling back tax exemptions, could be considered once the expenditure ceiling was approved, the social security reform was well advanced, and the recovery in economic activity had started. Tax measures would also be considered if the primary balance target for 2017 were at some point to appear at risk (they felt confident that the 2016 target would be met, noting the expected contribution from the repatriation tax).

34. The authorities concurred that pension and social benefits reforms are urgent, but will involve difficult negotiations. The authorities see the current juncture as a historical opportunity to push for a reform that can stabilize the trajectory of the finances of the social security for the next three decades or so. They felt that the discussion of retirement age increases was mature, but other aspects of the social security system would need to be reformed as well. They indicated that Brazil’s finances preempted consideration of reforms based on the adoption of a defined contribution scheme as a main pillar. They explained that the reform they envisage would aim to cover the various key parameters of the system, and reach a variety of participants in the system (including contributors and beneficiaries, and people in various age and employment groups) to distribute the effects of the reforms broadly. They stressed that the reform would respect constitutional constraints and rights. They finally noted that the final form of the reform, including its transitional clauses, would reflect the outcome of ongoing discussions with many stakeholders and the congress.

35. The authorities were concerned with fiscal problems in many subnational governments, and elaborated on their strategy to help them. The authorities agreed that stress in the finances of many states reflects both cyclical and structural factors. They also acknowledged that the steps taken so far, largely involving rescheduling of debt service payments to the national treasury, are insufficient to deal with the most difficult cases. They see the need to include states in key structural reforms (such as social security reform and the expenditure cap) and to promote national reforms that can enable states to address their employment and employee remuneration problems. They underscored that greater transparency in the disclosure of state government finances is necessary to better diagnose the specific situation of each state (they vary significantly) and for monitoring purposes. The National Treasury is also organizing missions to those states experiencing the most severe strains to help them devise programs to address both their immediate needs and their structural problems.

36. The central bank emphasized that ensuring convergence of inflation to the target in the relevant horizon for monetary policy was a priority. The relevant horizon involves the years for which the National Monetary Council (CMN) has set targets, including 2017. They noted that disinflation is ongoing, but its pace is still uncertain. Their models had been pointing to falling inflation over the projection horizon; but inflation has shown persistence, partly due to successive food-price shocks and perhaps also due to inertial mechanisms. They also explained that the start of an easing cycle would depend on factors that allow the Monetary Policy Committee (COPOM) to have greater confidence in meeting the inflation targets. They emphasized the following factors: limited persistence of the effects of food-price shocks, an appropriate pace of disinflation of the components that are most sensitive to monetary policy and economic activity, and a reduction in uncertainty regarding the approval and implementation of fiscal reforms. Additionally, the authorities agreed that the monetary policy framework could be improved in a number of ways, some of them under consideration, including bolstering central bank autonomy, and increasing the effectiveness of monetary policy by changing various credit policies that involve earmarking and credit subsidies.

37. The central bank’s views on foreign exchange interventions are broadly consistent with those of staff. They thought that the exchange rate has proven to be good shock absorber and that their interventions through FX swaps and repos have preserved the direction of movements determined by the market while smoothing excess volatility. They noted that the FX swaps also have a strong macro-prudential component, inasmuch as they shelter corporates, and consequently their creditors, against adverse exchange rate movements. They also stated that, as the end of the current benign period for emerging market economies approaches, there will be less room to reduce the stock of FX swaps. The authorities did not rule out future interventions using different instruments, only if needed and when market conditions allow.

38. The authorities emphasized the resilience of the banking system and the demonstrated effectiveness of their tools for monitoring and management of risks. The authorities acknowledged staff’s concern about the health of the corporate sector, but noted that they are monitoring the system closely and that banks remain well capitalized and have significantly increased provisions for corporate exposures. The authorities indicated that they already have a comprehensive and timely stress testing framework, which they will continue to enhance, consistent with the staff’s recommendations, such as the “bottom-up” approach. They also expect that the new resolution framework, consistent with the FSB’s key attributes of effective resolution regimes, will include the backstop for the deposit insurance fund from the central bank, and will be implemented in 2017. The authorities agreed that providing mandates for macro-prudential oversight and crisis management with clear objectives and division of responsibilities would enhance implementation of macro-prudential policies and crisis preparedness. They also noted that there is no room for easing of macro-prudential policies as most of tools are, or were already loosened up to the micro-prudential limits.

39. The authorities acknowledged the need to open up the economy and improve the business environment. They saw merit in reducing tariffs and domestic content requirements and committed to pursuing free-trade negotiations outside Mercosur to help increase competition and efficiency. They agreed that increasing labor market flexibility by allowing collective agreements to stand above general regulations would foster investment and promote economic activity in general. While some actions on the structural front are already ongoing, legal reforms will need to be taken up after higher priority reforms are concluded.

Staff Appraisal

40. Brazil must revamp its policy framework to restore fiscal sustainability, rein in inflation, and open up the economy, in the context of a still uncertain recovery from a prolonged recession. Policymaking in recent years has failed to tackle long-standing structural problems and proven to be counterproductive, contributing to the erosion of policy credibility and a large contraction of output. Fiscal sustainability is at risk.

41. Efforts aimed at capping the growth of fiscal spending and reforming the social security system are well founded steps to restore fiscal sustainability; but more will be required to address budgetary rigidities. The approval and steadfast implementation of the spending cap would help improve the long-term trajectory of public spending and permit the stabilization and eventual reduction of public debt as a share of GDP. Similarly, putting the social security system on a sound footing for future generations is a key part of restoring fiscal sustainability and preserving the social contract. The credibility of reforms will be bolstered if attention is also placed on the link between minimum wage indexation and benefit payments, revenue earmarking, and rigidities and lack of transparency in subnational budgets.

42. To guard against risks emanating from prolonged fiscal adjustment, there is merit in considering a more frontloaded consolidation strategy once growth has firmed up. Through a combination of expenditure and revenue measures, the government can contain the growth in public debt and reverse the trajectory of public debt earlier. This would alleviate the onerous burden of high borrowing costs on the private sector, and enable a more rapid and sustainable recovery. Revenue measures can begin once economic growth is underway, and some of them should be temporary.

43. Monetary policy should remain on hold until inflation expectations converge more clearly toward the central target. Staff considers current monetary policy settings as broadly appropriate given inflation expectations and remaining uncertainties. Tangible progress on restoring the sustainability of public finances would create room for easing monetary policy earlier than envisaged.

44. Staff welcomes the use of the exchange rate as the first line of defense against shocks. Intervention in foreign exchange markets should remain limited to episodes of disorderly market conditions, and reserve buffers should be preserved. Staff sees merit in the continuation of the central bank’s policy to reduce the net notional value of FX swaps.

45. The resilience of the banking sector should be bolstered. Although the recession took a toll on asset quality and profitability, the health of the banking system remains largely sound. Looking ahead, to make the banking sector even more robust, financial safety nets should be improved by strengthening the procedures for use of the deposit insurance fund, enhancing the central bank’s emergency liquidity assistance, and modernizing the resolution regime. Private insolvency frameworks should be improved, and frameworks to identify, prepare for, and respond to future risks should be put in place. Staff welcomes the ongoing work to strengthen the stress testing framework used by the central bank.

46. Well-designed and properly sequenced structural reforms can hasten the return to growth and strengthen it over the medium term. Staff encourages the authorities to follow through on various plans to strengthen the supply side of the economy, increase efficiency and productivity, and to further implement transparency, anti-corruption and AML measures. Without these reforms, potential growth is likely to remain underwhelming.

47. It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

Table 4.Brazil: Depository Corporations and Monetary Aggregates(End of period, in billions of reais)
201020112012201320142015
I. Central Bank
Net foreign assets474.6653.8756.9834.5958.91,376.9
Net international reserves473.2659.7762.5840.7965.81,392.2
Other foreign assets (net)1.5−5.9−5.6−6.2−6.9−15.4
Net domestic assets55.9−66.1−248.9−259.9−410.4−782.5
Net claims on public sector292.7176.4276.7266.0415.4242.6
Net credit to other depository corporations−227.4−288.6−474.1−479.0−764.3−882.9
Other items (net)9.4−46.251.546.961.5142.2
Base money530.6587.7508.0574.6548.5594.4
Currency issued151.1162.8187.4204.1220.9225.5
Liabilities to other depository corporations379.4424.9320.0369.0325.7368.4
Reserve deposits55.751.545.945.542.729.8
Liabilities to other sectors0.00.00.61.51.90.6
II. Depository Corporations 1/
Net foreign assets378.0488.5527.5638.2734.71,089.4
Net international reserves473.2659.7762.5840.7965.81,392.2
Other foreign assets (net)−95.2−171.2−235.0−202.5−231.2−302.9
Net domestic assets2,210.72,579.43,028.23,234.53,662.03,738.1
Net claims on public sector1,225.71,210.11,368.61,346.11,488.81,628.2
Credit to other financial corporations294.2342.7383.7431.6496.1526.0
Credit to private sector2,050.42,541.73,010.23,424.53,815.84,006.6
Of which: loans to private sector661.0817.0966.81,126.61,264.61,505.9
Other items (net)1,418.31,585.01,838.22,100.12,315.72,680.9
Capital613.2631.2793.4791.6857.9855.4
Other liabilities excluded from broad money805.1953.81,044.91,308.51,457.91,825.6
Broad money (M2)2/2,588.73,067.93,555.73,872.74,396.74,827.5
Currency in circulation121.7131.4149.6163.9178.3185.3
Demand deposits165.2159.8182.3189.8183.9160.9
Quasi-money liabilities2,301.82,776.73,223.83,519.04,034.64,481.3
(Ratio)
Multiplier (M2/base money)4.95.27.06.78.08.1
(In percent of GDP)
Base money13.713.410.610.810.310.5
Broad money (M2)66.670.174.072.882.784.9
M3 3/65.669.373.271.981.283.7
M4 4/78.281.285.482.893.997.7
Financial sector credit to the private sector52.858.162.664.471.870.4
Of which: bank credit40.643.345.747.652.851.1
Memorandum item:
GDP (in billions of national currency)3,8864,3744,8065,3165,3165,687
Sources: Central Bank of Brazil; and Fund staff estimates.

Includes the Central Bank of Brazil, commercial banks, multiple banks, financial (money market) investment funds, Banco do Brasil, Federal Savings Bank, state savings bank, investment banks, National Bank for Economic and Social Development (BNDES), state development banks, finance and investment companies, housing credit companies, and mortgage companies.

M2 includes the liabilities to other financial corporations, state and municipal governments, nonfinancial public enterprises, other nonfinanical corporations, and other resident sectors.

Authorities’ definition. M3 comprises M2 plus shares in financial investment funds and the net position of the securities used in their purchase agreements transactions with money holding sectors.

Authorities’ definition. M4 comprises M3 plus federal, state, and municipal liquid securities held by the public.

Sources: Central Bank of Brazil; and Fund staff estimates.

Includes the Central Bank of Brazil, commercial banks, multiple banks, financial (money market) investment funds, Banco do Brasil, Federal Savings Bank, state savings bank, investment banks, National Bank for Economic and Social Development (BNDES), state development banks, finance and investment companies, housing credit companies, and mortgage companies.

M2 includes the liabilities to other financial corporations, state and municipal governments, nonfinancial public enterprises, other nonfinanical corporations, and other resident sectors.

Authorities’ definition. M3 comprises M2 plus shares in financial investment funds and the net position of the securities used in their purchase agreements transactions with money holding sectors.

Authorities’ definition. M4 comprises M3 plus federal, state, and municipal liquid securities held by the public.

Table 5.Brazil: Medium-Term Macroeconomic Framework, Balance of Payments, and External Debt
Proj.
20142015201620172018201920202021
MACROECONOMIC FRAMEWORKIn percent of GDP, unless otherwise specified
GDP growth at constant prices (in percent)0.1−3.8−3.30.51.52.02.02.0
Consumer prices (IPCA, end of period, in percent)6.410.77.25.04.84.54.54.5
Gross domestic investment21.019.218.418.919.420.120.721.3
Private sector18.617.317.017.417.918.719.219.7
Public sector2.41.91.41.51.61.51.51.6
Gross domestic savings16.715.917.617.417.718.319.019.5
Private sector20.224.126.525.324.223.923.823.7
Public sector−3.5−8.2−8.9−7.8−6.5−5.6−4.8−4.2
External current account balance−4.3−3.3−0.8−1.5−1.7−1.8−1.8−1.8
Central government primary balance−0.4−2.0−2.7−2.5−1.8−1.2−0.9−0.8
Consolidated non-financial public sector
Primary balance−0.6−1.9−2.7−2.3−1.3−0.50.10.8
Overall balance−6.0−10.3−10.5−9.5−8.2−7.2−6.2−5.9
Public sector net debt 1/33.136.245.950.954.156.859.762.5
General Government gross debt, authorities’ definition57.266.5
NFPS gross debt 2/63.373.778.482.985.788.290.993.5
EXTERNAL DEBT3/4/In billions of U.S. Dollars
Total external debt712.7665.1680.1691.0698.3702.7703.3700.0
Medium- and long-term654.9614.0629.4640.7648.3653.0653.9651.2
Nonfinancial public sector231.9192.9191.1189.7188.6187.5186.0184.2
Public sector banks70.768.768.067.567.166.766.265.6
Private sector410.1403.6421.0433.7442.6448.5451.1450.2
Short-term57.851.150.750.350.049.749.348.8
Medium- and long-term external debt service88.3115.8115.1104.5108.3111.2113.2114.6
Amortization70.797.196.286.890.392.894.695.9
Interest17.618.718.917.718.118.418.618.7
In percent of GDP
Total external debt29.537.538.435.334.433.131.730.2
Medium- and long-term27.134.635.632.731.930.829.528.1
Nonfinancial public sector9.610.910.89.79.38.88.47.9
Public sector banks2.93.93.83.53.33.13.02.8
Private sector17.022.823.822.221.821.120.319.4
Short-term2.42.92.92.62.52.32.22.1
In percent of gross international reserves
Medium- and long-term external debt service24.332.531.228.329.330.130.631.0
Amortization19.527.226.023.524.425.125.626.0
Interest4.85.25.14.84.95.05.05.1
Short-term debt15.914.313.713.613.513.513.413.2
MEMORANDUM ITEMS:
Gross reserves (eop) 4/
In billions of U.S. dollars363.6356.5369.3369.3369.3369.3369.3369.3
In percent of external short-term debt629.2697.0728.8734.2738.6743.0748.8756.1
In months of prospective GNFS imports191.2180.4178.7175.1171.2164.3158.1
Short-term debt in percent of total external debt8.17.77.57.37.27.17.07.0
Intercompany debt (in billions of U.S. dollars)207.8205.7224.9239.1249.1256.2260.2261.2
In percent of GDP8.611.612.712.212.312.111.711.3
GDP (billion US$)2,4171,7731,7691,9572,0322,1222,2182,319
Sources: Central Bank of Brazil; and Fund staff estimates and projections.

Includes assets, which mainly comprise international reserves, outstanding liabilities of public financial institutions to the Treasury, financial assets of public enterprises, and assets of the federal labor fund (FAT).

Gross non financial public sector debt consolidates debt of public enterprises with that of general government. Unlike the authorities’ definition, gross general government debt comprises treasury bills at the central bank’s balance sheet not used under repurchase agreements.

Includes intercompany debt.

Historical numbers include valuation changes.

Sources: Central Bank of Brazil; and Fund staff estimates and projections.

Includes assets, which mainly comprise international reserves, outstanding liabilities of public financial institutions to the Treasury, financial assets of public enterprises, and assets of the federal labor fund (FAT).

Gross non financial public sector debt consolidates debt of public enterprises with that of general government. Unlike the authorities’ definition, gross general government debt comprises treasury bills at the central bank’s balance sheet not used under repurchase agreements.

Includes intercompany debt.

Historical numbers include valuation changes.

Table 6.Brazil: External Vulnerability(In billions of U.S. dollars, unless otherwise indicated)
Proj.
2010201120122013201420152016
Trade
Exports of GNFS (12-month percent change, US$)29.126.1−3.9−0.5−5.6−15.23.9
Imports of GNFS (12-month percent change, US$)39.824.00.67.1−2.1−23.7−12.9
Terms of trade (12-month percent change)16.07.8−5.8−2.0−3.4−11.03.2
Current account
Current account−75.8−77.0−74.2−74.8−104.2−58.9−14.7
In percent of GDP−3.4−2.9−3.0−3.0−4.3−3.3−0.8
Capital and financial account76.379.574.273.0100.855.214.7
Capital Account0.20.30.20.30.20.40.4
Financial Account76.079.274.072.7100.654.714.2
Portfolio investment (net)66.941.215.832.838.722.02.3
Foreign direct investment (net)61.785.181.454.270.961.661.8
Of which: intercompany loans (net)23.231.522.139.738.319.520.0
Short-term external liabilities of commercial banks46.034.329.229.349.442.742.4
External debt
Total external debt 1/452.8516.0570.8621.4712.7665.1680.1
In percent of gross reserves156.9146.6153.0173.2196.0186.6184.1
Amortization of external MLT debt (in percent of GNFS exports)21.713.720.324.731.651.148.7
External interest payments (in percent of GNFS exports)7.16.17.47.37.89.89.6
Reserves
Gross reserves288.6352.0373.1358.8363.6356.5369.3
In months of prospective GNFS imports15.218.818.618.725.328.728.0
In percent of broad money (M2)11.111.510.59.38.37.47.2
In percent of short-term external debt502.6875.41,142.51,096.1629.2697.0728.8
In percent of IMF metric131.8150.6157.6154.9148.6154.1158.4
Exchange rate
Exchange rate (R$/US$, period average)1.761.671.952.162.353.33
REER (annual average in percent; appreciation +)13.43.5−10.0−5.6−1.0−15.8
Sources: Central Bank of Brazil; Bloomberg; and Fund staff estimates.

Includes intercompany loans.

Sources: Central Bank of Brazil; Bloomberg; and Fund staff estimates.

Includes intercompany loans.

Table 7.Brazil: Financial Soundness Indicators, 2010–16(In percent, unless otherwise indicated)
2010201120122013201420152016q1
Total banking system
Capital Adequacy
Regulatory capital to risk-weighted assets16.916.316.416.116.716.416.2
Regulatory Tier 1 capital to risk-weighted assets13.712.911.912.613.012.712.8
Capital to assets10.310.110.19.39.08.59.0
Gross asset position in financial derivatives to capital8.87.47.89.611.829.624.5
Gross liability position in financial derivatives to capital10.68.09.310.913.835.626.3
Asset Quality
Nonperforming loans to total gross loans3.13.53.42.92.93.33.6
Provisions to Nonperforming loans164.8151.6148.7161.2155.8154.4148.2
Earnings and Profitability
Return on assets1.91.71.41.41.31.51.4
Return on equity16.816.112.913.013.115.414.4
Liquidity
Liquidity assets to short-term liabilities185.3178.6191.8158.0202.2190.0195.2
Liquidity assets to total assets12.011.714.910.912.011.612.7
Net open position in foreign exchange to capital1.10.2−0.60.40.30.5−0.5
External funding to total funding7.39.29.38.59.413.012.1
Public banks
Capital Adequacy
Regulatory capital to risk-weighted assets15.114.314.514.916.215.515.3
Regulatory Tier 1 capital to risk-weighted assets10.79.89.411.311.811.010.8
Capital to assets6.86.76.35.65.14.74.9
Gross asset position in financial derivatives to capital1.10.81.01.73.18.24.8
Gross liability position in financial derivatives to capital3.92.12.13.02.53.22.7
Asset Quality
Nonperforming loans to total gross loans2.01.91.81.92.02.53.0
Provisions to Nonperforming loans209.6214.2203.3181.1164.0157.8137.3
Earnings and Profitability
Return on assets1.81.71.51.51.11.00.8
Return on equity22.921.018.718.113.814.412.0
Liquidity
Liquidity assets to short-term liabilities214.4201.1282.1214.1209.6196.0195.0
Liquidity assets to total assets13.412.914.210.510.29.710.3
Net open position in foreign exchange to capital1.64.30.01.42.2−1.2−3.5
External funding to total funding2.63.24.44.34.67.56.8
Private banks (domestic and foreign)
Capital Adequacy
Regulatory capital to risk-weighted assets17.717.317.416.816.916.816.8
Regulatory Tier 1 capital to risk-weighted assets15.014.313.213.313.713.613.9
Capital to assets12.211.912.511.811.610.911.7
Gross asset position in financial derivatives to capital11.19.49.912.214.435.830.1
Gross liability position in financial derivatives to capital12.69.811.613.517.344.933.1
Asset Quality
Nonperforming loans to total gross loans3.94.64.93.83.74.24.4
Provisions to Nonperforming loans149.0133.4131.6151.7151.0152.2154.9
Earnings and Profitability
Return on assets2.01.71.31.31.51.81.7
Return on equity14.914.410.810.812.815.815.3
Liquidity
Liquidity assets to short-term liabilities170.9166.8162.4135.3198.5187.2195.3
Liquidity assets to total assets11.211.115.411.213.312.914.3
Net open position in foreign exchange to capital1.0−1.1−0.80.1−0.31.00.3
External funding to total funding9.812.612.511.813.417.716.4
Sources: Central Bank of Brazil; and Fund staff calculation.
Sources: Central Bank of Brazil; and Fund staff calculation.
Table 8.Brazil: Brazil External Debt Sustainability Framework, 2013–21(In percent of GDP, unless otherwise indicated)
Proj.Debt-stabilizing non-interest current account 6/
201320142015201620172018201920202021
Baseline: External debt25.229.537.538.435.334433.131.730.2−3.1
Change in external debt2.04.38.00.9−3.1−0.9−1.2−1.4−1.5
Identified external debt-creating flows (4+8+9)1.52.58.5−0.9−1.2−1.2−1.2−1.2−1.3
Current account deficit, excluding interest payments2.33.62.3−0.20.60.81.01.01.0
Deficit in balance of goods and services1.92.31.1−1.2−0.8−0.5−0.4−0.4−0.5
Exports11.310.912.613.212.412.212.011.911.9
Imports13.213.213.712.011.711.711.611.511.4
Net non-debt creating capital inflows (negative)−1.1−1.8−2.9−2.9−2.5−2.4−2.3−2.4−2.5
Net foreign direct investment, equity0.61.32.42.32.12.02.02.01.9
Net portfolio investment, equity0.50.50.60.50.40.30.30.40.5
Automatic debt dynamics 1/0.20.79.22.30.70.40.20.20.2
Denominator: 1+g+r+gr1.01.00.71.01.11.01.01.01.0
Contribution from nominal interest rate0.70.71.11.00.90.90.90.80.8
Contribution from real GDP growth−0.70.01.51.2−0.2−0.5−0.6−0.6−0.6
Contribution from price and exchange rate changes 2/0.20.06.6
Residual, incl. change in gross foreign assets (2–3) 3/0.51.8−0.51.8−2.00.2−0.1−0.2−0.2
External debt-to-exports ratio (in percent)222.3269.9297.1292.3283.8281.1276.6265.6254.4
Gross external financing need (in billions of US dollars) 4/167.2207.7213.8162.0167.0175.4181.4184.2186.4
in percent of GDP6.88.612.19.08.48.58.48.17.9
Scenario with key variables at their historical averages 5/38.438.036.935.634.232.7−3.3
Key Macroeconomic Assumptions Underlying Baseline
Real GDP growth (in percent)3.00.1−3.8−3.30.51.52.02.02.0
Exchange rate appreciation (US dollar value of local currency, change in percent)−9.4−8.3−29.4−4.43.7−2.8−2.6−2.4−2.4
GDP deflator (change in domestic currency)7.46.98.010.26.15.35.15.05.0
GDP deflator in US dollars (change in percent)−2.7−2.0−23.75.310.12.32.42.52.5
Nominal external interest rate (in percent)3.12.82.62.82.62.62.62.62.7
Growth of exports (US dollar terms, in percent)−0.5−5.6−15.23.94.62.02.34.23.9
Growth of imports (US dollar terms, in percent)7.1−2.1−23.7−12.97.94.13.43.73.3
Current account balance, excluding interest payments−2.3−3.6−2.30.2−0.6−0.8−1.0−1.0−1.0
Net non-debt creating capital inflows1.11.82.92.92.52.42.32.42.5
B. Bound Tests
B1. Nominal interest rate is at historical average plus one standard deviation38.435.635.034.032.931.7−2.9
B2. Real GDP growth is at historical average minus one standard deviations38.435.935.534.833.932.7−2.8
B3. Non-interest current account is at historical average minus one standard deviations38.436.336.235.935.434.7−3.2
B4. Combination of B1-B3 using 1/2 standard deviation shocks38.436.336.235.935.334.6−2.8
B5. One time 30 percent real depreciation in 200638.453.351.849.947.845.4−4.9

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate,

e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate,

e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure 6.Brazil: External Debt Sustainability: Bound Tests 1/2/

(External debt in percent of GDP)

Sources: International Monetary Fund, Country desk data, and staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent occurs in 2016.

Appendix I. Risk Assessment Matrix
Brazil: Risk Assessment Matrix
Nature/Source of ThreatLikelihoodExpected Impact on EconomyPolicy Responses
Failing to pass the proposed spending cap and failing to pass the measures necessary to maintain the cap over the medium termMH. Fiscal balances would continue to disappoint and fail to stabilize debt. Further loss of confidence would lower investment and growth. Inflationary pressures would remain elevated. Corporates could be vulnerable to capital flow reversals, exchange rate depreciation and higher funding costs. The strains would worsen if banking system soundness deteriorated owing to an increase in NPLs and funding costs and losses on government bonds’ holdings.Strong fiscal adjustment to restore credibility in the fiscal framework and to ensure debt stabilizes. Focus efforts on boosting competitiveness and productivity.
Broadening of the corruption scandalMH. Prolonged uncertainty would further hamper investment, confidence and growth. A more persistent increase in unemployment increases the threat of social unrest. And there is further damage to the credibility of the policy framework.Greater efforts to ensure policy credibility. Monetary policy should ensure inflation expectations remain firmly within the tolerance range and exchange rate intervention should be limited to clear cases of market disruption. Fiscal policy should forge ahead with efforts to ensure medium-term debt sustainability.
Protracted period of low growthMM. Continuous employment destruction leading to a deterioration of households’ balance sheet and income resulting in a rise in delinquencies on consumer loans. Lower corporate profits may expose some highly leveraged corporates. Increased financial vulnerabilities among banks with portfolio concentrated in households and corporate loans. Potential knock on effects on public finances. For example, Caixa extends housing loans to low-income families with a government guarantee.Monitor for signs of emerging domestic financial and corporate vulnerabilities and strengthen safety nets. Smooth out the employment loss by relying on strategies such as reduced hours.
External Risks
Sharp rise in risk premia with flight to safety: Investors withdraw from specific risk asset classes as they reassess underlying economic and financial risks in large economies, or respond to unanticipated Fed tightening, and increases in U.S. term premia, with poor market liquidity amplifying volatility. Safe haven currencies—especially the US dollar—surge creates balance sheet strains for FX debtors.MH. Increasing Brazil’s risk premiums, pressures on the real and reversal of capital flows. Increasing yields in domestic bond markets and higher funding costs for corporates and banks. In particular corporates lacking FX hedging could be exposed.The flexible exchange rate remains an important shock absorber. Recourse to FX intervention if FX volatility becomes excessive. Provide FX liquidity and support individual banks if dollar shortages appear. May also need to tighten fiscal policy to further strengthen policy credibility and avoid sell-offs of Brazilian domestic bonds. Capital flow management measures could be envisaged on a temporary basis but only in crisis type circumstances.
Structurally weak growth in key advanced and emerging economies: Weak demand, low productivity growth, and persistently low inflation from a failure to fully address crisis legacies and undertake structural reforms, leading to lower medium-term path of potential growth (the Euro area, Japan, and the United States) and exacerbating legacy financial imbalances especially among banks (the Euro area) (high likelihood). Tighter financial conditions and insufficient reforms undermine medium-term growth in emerging markets (medium likelihood).H/MH/M. Worsening current account deficit and weaker growth. Highly indebted corporates could see their profits decline. A sharp decline in commodity prices would have a direct impact on the exporting sector.Use the exchange rate as first shock absorbers. Limited room for monetary and/or fiscal policy stimulus to smooth shock. Instead, prioritize structural reforms to boost potential growth.
Persistently lower energy prices, triggered by supply factors reversing more gradually than expected.LM. Mild favorable impact on the trade balance in the short-term, but worsening current account in the medium term, when Brazil is expected to become a net oil exporter. Petrobras could see a decline in the value of its assets and face an increase in borrowing costs, causing delays in on-going investment plans and affecting plans to develop new fields. Banks could face losses on exposures to oil sector.The requirement for Petrobras’s participating in new oil developments should be eased. Domestic pricing policies should ensure Petrobras obtains an adequate return. Tighten governance in the company and enforce strict criteria on capital projects to avoid unnecessary losses.
1 The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. “Short term” and “medium term” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.
Appendix II. External Sector Assessment 2015
Brazil: External Sector Assessment 2015Overall Assessment
Foreign asset and liability position and trajectoryBackground. Brazil’s NIIP improved to -27 percent of GDP in 2015 reflecting in part the real’s depreciation. It is projected to remain broadly unchanged over the medium term. 1/ DI accounts for close to half of liabilities (which are 69.7 percent of GDP). Of concern is the rise in external debt since the global financial crisis (to some 350 percent of exports)

Assessment. The NIIP is comparable to that of Brazil’s peers, but the shift in composition of liabilities toward external debt over the last several years is a concern.
Overall Assessment

The external position of Brazil in 2015 was moderately weaker than the level consistent with medium-term fundamentals and desirable policy settings. The subsequent appreciation of the REER as of June 2016 suggests that the REER remains above the level suggested by fundamentals and desirable policies. The current account-to-GDP ratio will likely improve further in 2016 amid subdued domestic demand and the delayed impact of the 2015 depreciation, and despite further worsening of Brazil’s ToT.

Potential Policy Responses

Efforts to raise national savings are needed to provide room for a sustainable expansion in investment. Fiscal consolidation, including from social security reform, should contribute to shifting the structure of spending away from consumption. Structural reforms to reduce the cost of doing business would also help strengthen competitiveness. Foreign exchange intervention, including through the use of derivatives, can be appropriate to punctually alleviate disorderly market conditions in the foreign exchange market. The authorities should aim to preserve their foreign reserve buffers.
Current accountBackground. The current account deficit adjusted sharply in 2015 owing to the real’s depreciation and the drop in domestic demand, despite the ToT deterioration. 2/ The deficit fell from 4.3 percent of GDP in 2014 to 3.3 percent in 2015 against a broadly neutral structural fiscal stance. 3/ The deterioration in prices for Brazil’s major commodity exports reduced export values by around 1.5 percent of GDP. The CA is projected to improve in 2016 and going forward due to the delayed impact from the depreciation and the slow recovery in demand, even without closing all policy gaps (e.g. fiscal). Brazil’s ToT are expected to weaken further under the baseline and remain a downside risk. 4/ However, a larger-than-expected recovery in private demand could widen the deficit unless public savings strengthen. The development of Brazil’s off-shore oil potential is no longer projected to contribute significantly to the external adjustment as investment in expansion has been cut back. 5/

Assessment. Staff estimates that the CA norm is consistent with fundamentals and desirable policy settings range from 0.25 to -1.5 percent of GDP. 6/ With a cyclically adjusted CA of -2.8 percent, the 2015 CA gap ranged between -1.3 and -3.1 percent of GDP, wider than the EBA gap estimate of 0.1 percent.
Real exchange rateBackground. The REER on average depreciated by 15 percent between 2014 and 2015. After some oscillations, by June 2016, it was some 6 percent above its average 2015 level. The annual average ULC based REER also depreciated by some 15 percent between 2014 and 2015, due to both labor shedding and improvements in cost competitiveness. The nominal exchange rate has been sensitive to political developments and global trends in 2016.

Assessment. Staff’s assessment is that the real was on average some 5–15 percent above the level implied by fundamentals and desirable policy settings in 2015. 6/
Capital and financial accounts: flows and policy measuresBackground. Brazil continues to attract sizable capital flows but their composition changed in 2015. Equity liability flows remained strong while debt liability flows fell sharply. Net DI fully financed the CA deficit (DI liabilities totaled 4.3 percent of GDP). The share of intercompany loans in DI liabilities dropped sharply. 7/ Net portfolio debt liabilities, having accounted for more than 1 percent of GDP in previous years, fell to close to zero reflecting downgrades of Brazil’s sovereign credit rating and associated corporate downgrades. Interest differentials will continue to attract inflows, but the recession and growing vulnerabilities are expected to weaken investor interest.

Assessment. While the composition of flows has a favorable risk profile, there is a risk that outflows may increase amid the prolonged recession and growing domestic risks. The currently higher appetite for equity over debt investments may reflect a combination of the depreciation and investors taking a longer-term view.
FX intervention and reserves levelBackground. Brazil has a floating exchange rate. Since mid-2011, reserves have remained broadly stable. The preannounced intervention program the central bank initiated in 2013 ended in March 2015. Intervention in 2015 continued to rely on the use of FX swaps and FX repos but was symmetric over the course of the year and generally more limited compared to previous years. 8/ During the market turmoil in September, the authorities reacted to excessive volatility largely by providing FX liquidity through FX repos. In March and April of 2016, as the currency strengthened, the BCB reduced the rollover rate of maturing FX swaps and started auctioning reverse FX swaps, significantly reducing its net forward position to some $62 billion as of early June. Brazil’s gross reserves remained broadly constant in 2015, at $358 billion, some 20 percent of GDP and 200 percent of short term debt at remaining maturity.

Assessment. The flexible exchange rate has been an important shock absorber. Reserves are adequate relative to various criteria including the IMF’s composite reserve adequacy metric (185 percent). While Brazil’s reserve holdings in principle provide some space to intervene, the authorities should aim to retain these buffers and their net creditor position in foreign exchange. Staff would advise only punctually alleviating disorderly market conditions as needed.
Technical Background Notes1/ The projection takes valuation effects into account.

2/ Import volumes fell by 15 percent in 2015 due to both import compression and the real’s depreciation (between a third and a half of the fall in import demand is attributable to the depreciation). Export volumes rose by 8 percent, but the bulk of the impact of the 2015 depreciation in expected to materialize in 2016, especially for manufacturing exports.

3/ While the cyclically adjusted overall balance would signal a significantly expansionary fiscal stance in 2015, a structural perspective (excluding e.g. BCB losses on FX swaps and the net settlement of previously unreported commitments to public banks) suggests a broadly neutral stance.

4/ At 19 percent of the total, China remains Brazil’s most important export destination and accounts for the bulk of Brazil’s major commodity exports

5/ Brazil currently features a small oil balance deficit; in the short run, falling oil prices thus strengthen the current account ceteris paribus while they may depress the outlook for oil production in the medium term.

6/ Staff’s assessment centers on the current account norm. Estimates suggest a current account norm between -2.7 percent (EBA current account approach) and -1.2 percent (NIIP-stabilizing approach). Staff’s assessment of a current account norm range from 0.25 to -1.5 percent (higher than in previous years due to the significant downward revision in the growth outlook) reflects low potential growth, commodity price downside risks, and the objective of avoiding a deterioration in the NIIP over the medium term, and facilitates expenditure switching away from consumption and towards investment. In contrast, EBA REER level and index approaches suggest that the real was undervalued by 2–19 percent on average in 2015.

7/ The strong decline in proceeds from overseas borrowing by foreign incorporated subsidiaries of Brazilian parent companies—chiefly Petrobras—illustrates that the risk profile of these flows is more similar to portfolio debt flows than to other types of DI liabilities.

8/ In the Brazilian FX repo, the Central Bank sells dollars with the commitment to repurchase them at a predetermined future date. That is, the Central Bank retains a long dollar position following execution of the repo. In the Brazilian FX swap, the Central Bank enters into a contract whereby it agrees to pay the onshore dollar rate on a given notional value plus the variation in the exchange rate, and to receive the SELIC rate on the BRL equivalent (at the moment of initiation) of the given notional value. The net value of these payments is redeemed in local currency. Under this mechanism, the Central bank pays the holder if the BRL depreciates by more than the difference between the SELIC rate and the onshore dollar rate, and receives payment from the holder in the opposite case. This instrument provides hedging to agents with prospective hard currency needs.
Appendix III. Selected Topics1

A. Update on the Infrastructure Program

1. Have infrastructure pressures subsided in the wake of the recession in Brazil? Slowing consumption of energy services by the corporate sector and lower traffic demand are providing some relief to the electricity sector and congested roads. However, from a medium-term perspective, making gains in spatial and social integration by expanding the transport network and improving access to basic infrastructure services in an equitable way remains paramount for Brazil’s development

2. In the years ahead, Brazil will have to “do more with less”, by leveraging private finance, optimizing costs and eliminating inefficiencies in service provision. There are few possibilities available for scaling up infrastructure investment over the near- and medium-term, given a constrained public sector resource envelope and strained private sector balance sheets. While reform needs are numerous, the focus should be on scaling up efforts to boost private sector participation in investment financing, improving investment returns, and increasing efficiency. Projects with private participation should also have transparent accounting practices that recognize contingent liabilities that could impact the public finances.

  • Securing financing: the government has granted tax benefits for fixed income products created specifically to finance infrastructure investments in 2012. Since then, the importance of infrastructure bonds has grown: 78 infrastructure bonds (totaling R$15.7 billion) associated with projects authorized by the ministries were issued. Over the coming months Brazil will issue a new debenture model featuring income tax incentives, payment of interest throughout the existence of the project, and premium quality guarantee on the debt principal. The government will continue to work with the Inter-American Development Bank Group and the CAF, which have programs to help finance new infrastructure concessions through local financial partners. The CAF program is based on another smaller scale fund created in Colombia to finance the highway concession program. These initiatives are important steps in the right direction, which will have to be accompanied by other measures to improve the attractiveness of projects.

  • Ensuring cost recovery: underpricing of infrastructure services leads to excess utilization and low revenues, constraining private sector returns and shrinking resources needed for maintenance and new investments. A thorough review of tariff-setting principles might reveal areas for improvement.

  • Improving allocative and productive efficiency: Brazil is one of the leading Latin American (LA) countries in terms of operational maturity for project management and institutional framework, and lags behind other large LA economies only in terms of investment climate. However, across all countries, the entire infrastructure investment process, from planning and project selection to contracting, monitoring and evaluation, often can be strengthened by aligning priorities, streamlining processes, and optimizing financial costs.

3. The new Investment Partnership Program (PPI), created in May, changed the institutional framework for the implementation of public infrastructure through partnership agreements between the state and the private sector. The projects will include pre-salt area bidding, energy and sanitation assets, as well as roads, railway, ports and, airports, some of them already included in previous concession programs. Some of the changes introduced in the Investments Partnerships Program (PPI) are:

  • increasing the time between the public notice and the auction to 100 days, to encourage the participation of medium-sized and foreign companies;

  • calls for tenders can only be announced after preliminary environmental licensing;

  • internal rates of return used in the old model will be abandoned;

  • bridge loans, previously extended by public and private-sector banks to allow the beginning of investments in the concession until the final long-term loan is approved, will be replaced by guarantees provided by banks or through bonds which would be valid until the concession has its own cash flow (typically 5–7 years), which will serve as collateral to the securities.

4. The government has created a Council of the Investment Partnership Program (CIPP) in the Presidency and an infrastructure support fund. The CIPP is in charge of monitoring implementation of the PPI program, formulating policy recommendations and providing guidance to agencies, entities and the federal public administration. The members of the Council with voting rights include the Executive Secretary of the Secretariat of the Investment Partnership Program of the Presidency, which will also act as Executive Secretary of the Council; the Chief Minister of the Civil House; Ministers of Finance, Planning, Development and Management, Transport, Ports and Civil Aviation and the Environment; President of the National Bank for Economic and Social Development (BNDES) and the President of Caixa Economica Federal. The infrastructure fund will support infrastructure partnerships and will be managed by the BNDES which will be in charge of providing specialized professional services for structuring investment partnerships and privatization contracts.

5. The changes in the institutional framework for regulatory agencies, for which congressional approval is pending, are expected to contribute to greater stability and professionalism in regulation. The proposal seeks to strengthen the autonomy of the agencies and standardize aspects of management, organization, governance and social control. The regulatory agencies will have an independent budget, and the selection of nominees to compose their management boards will be more rigorous, in order to shield regulatory agencies from political interference and other forms of capture. Also, deadlines will be set for appointment of new directors, to avoid prolonged periods with vacant positions.

Table 1.Public Investment Pipeline.
ProjectsAuction Period
Highways:
BR-364/365/GO/MG2017, 2nd semester
BR-101/116/290/386/RS2017, 2nd semester
Airports:
Salgado Filho2017, February
Deputado Luís Eduardo Magalhães2017, February
Hercílio Luz2017, February
Pinto Martins2017, February
Port terminals:
Santarém (STM 04 e 05)2017, May
Trigo do Rio de Janeiro2017, May
Railroads:
EF-151 SP/MG/GO/TO - Norte-Sul2017, 2nd semester
EF-170 MT/PA - Ferrogrão2017, 2nd semester
EF-334/BA2017, 2nd semester
Source: Casa Civil.
Source: Casa Civil.

B. Financial Linkages Across Economic Sectors in Brazil—The BSA Matrix

6. The Balance Sheet Analysis (BSA) is an important tool for the assessment of macro-financial linkages in an economy. Balance sheets carry information on stocks and can throw light on the state and vulnerabilities of corporates, households and government. At the sectoral level, balance sheet matrices show aggregate exposures, exposures to other sectors, and to the rest of the world, revealing the degree of interconnectedness of the economy, which is important for the propagation of shocks.

7. The BSA matrix is constructed using several data sources including the MFS, the IIP, and the GFSM among others. The central government, the state governments and the budgetary public companies (excluding Petrobras and Eletrobras — the largest state-controlled companies in Brazil) are grouped into the government sector.2 NFCs, typically considered “the Private Sector”, include also some nonfinancial corporates in the Public Sector. The BSA matrices for the years 2007 and 2014 allow the comparison of recent estimates with the last “pre-crisis” year. (The way to read these matrices can be illustrated with the top, leftmost entries of Table 1. The central bank held government bonds worth 20 percent of GDP in 2014, while the government deposits at the central bank totaled 12 percent of GDP.)

Table 1.Brazil: Intersectoral Asset and Liability Positions, end-2014(Percent of GDP)
Issuer of liability (debtor)Public SectorFinancial SectorNonfinancial Private SectorRest of the World
Holder of liability (creditor)GovernmentCentral BankOther Depository Corporations and BNDESOther Financial CorporationsNonfinancial CorporatesHouseholdsNonresidents
AssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNet
Government
Total20127331220212−1100000010010
In domestic currency20127331220212−11000000707
In foreign currency000000000000000303
Central Bank
Total1220−720119000000000017−17
In domestic currency1220−720120000000000000
In foreign currency000000000000000017−17
Oth. Dep. Corporations
Total1233−20120−1989−154459252321147
In domestic currency1233−20120−2089−154441025232101
In foreign currency00000000011−10001046
Oth. Fin Corporations
Total1221100098105−411011000
In domestic currency1221100098105−411011000
In foreign currency000000000000000000
Nonfinancial Corporates
Total0000004554−9504511636
In domestic currency0000004454−10504401624
In foreign currency00000011100011011
Households
Total0000002325−2011−11000
In domestic currency0000002325−2011−11000
In foreign currency000000000000000
Nonresidents
Total011−1117017411−70001651−36000
In domestic currency07−700001−10001640−24000
In foreign currency03−317017410−6000011−11000
Total3765−2838335135112231533−1870101−31362413733736
In domestic currency3762−242033−13129101291533−187089−19362412481633
In foreign currency03−318017611−6000113−1200025213

8. Brazil’s BSA presents some limitations, which are mainly due to data gaps.3 No data are available for the relationship between Nonfinancial corporate (NFC) sector and Households (HH) sectors and there is also no information about the maturity structure of assets and liabilities. Moreover, focusing on aggregate sectoral exposures, the BSA analysis ignores potential within-sector risks and specific linkages among sectors. For instance, although overall exposure of the Financial Sector to households may be contained, certain banks specializing in mortgage lending to a segment of population with lower income may be at higher risk during periods of growth slowdown.4

9. A useful complement to the BSA is the network map. The network map offers a graphical representation of the size and direction of sectoral interlinkages, pointing to possible areas that may benefit from in-depth analysis. The nodes in the network map in Figure 1 represent the total size of the sector’s liability exposure, while the links between the nodes outline the direction and size of the gross exposure. For example, the size of NFCs liabilities to Nonresidents was 51 percent of GDP in 2014, as in the BSA matrix in Table 1, and it is represented as a gross arrow going from the NFC to the Nonresident sector. The small figure on the left separates the linkages from the NFC sector to other economic sectors.

Figure 1.Intersectoral Gross Liabilities Network Map, 2014

(Percent of GDP)

10. The BSA matrices and the network map (Tables 1, 2 and Figures 1, 2) show the system’s increasing depth and connectedness. Gross assets of all sectors at end-2014 amounted to 416 percent of GDP, against 341 percent of GDP in 2007. Other financial institutions (OFIs) in particular have become more important over time, in terms of size and connectedness. Almost two thirds of the growth of total assets could be ascribed to the expansion of ODCs’ assets against the private nonfinancial sector. ODCs and NFCs are the largest issuers of gross liabilities in the system. However, while declining somewhat since 2007, the government’s net liability position remains the most dominant.

Table 2.Brazil: Intersectoral Asset and Liability Positions, end-2007(Percent of GDP)
Issuer of liability (debtor)Public SectorFinancial SectorNonfinancial Private SectorRest of the World
Holder of liability (creditor)GovernmentCentral BankOther Depository Corporations and BNDESOther Financial CorporationsNonfinancial CorporatesHouseholdsNonresidents
AssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNet
Government
Total13.310.23.138.53.135.42.713.5−10.80.00.00.00.00.00.05.70.25.5
In domestic currency13.210.23.138.53.135.42.713.5−10.80.00.00.00.00.00.05.70.25.5
In foreign currency0.10.00.10.00.00.00.00.00.00.00.00.00.00.00.00.00.00.0
Central Bank
Total10.213.3−3.112.01.011.00.00.00.00.40.00.40.00.00.01.112.8−11.7
In domestic currency10.213.2−3.112.01.011.00.00.00.00.40.00.40.00.00.00.00.00.0
In foreign currency0.00.1−0.10.00.00.00.00.00.00.00.00.00.00.00.01.112.8−11.7
Oth. Dep. Corporations
Total3.138.5−35.41.012.0−11.012.07.54.545.627.518.118.313.54.87.53.04.4
In domestic currency3.138.5−35.41.012.0−11.011.97.44.545.226.219.118.313.54.80.90.00.9
In foreign currency0.00.00.00.00.00.00.20.20.00.41.3−0.90.00.00.06.53.03.5
Oth. Fin Corporations
Total13.52.710.80.00.00.07.512.0−4.50.610.2−9.612.60.612.00.00.00.0
In domestic currency13.52.710.80.00.00.07.411.9−4.50.610.2−9.612.60.612.00.00.00.0
In foreign currency0.00.00.00.00.00.00.20.20.00.00.00.00.00.00.00.00.00.0
Nonfinancial Corporates
Total0.00.00.00.00.4−0.427.545.6−18.110.20.69.657.110.646.5
In domestic currency0.00.00.00.00.4−0.426.245.2−19.110.20.69.648.310.637.7
In foreign currency0.00.00.00.00.00.01.30.40.90.00.00.08.80.08.8
Households
Total0.00.00.00.00.00.013.518.3−4.80.612.6−12.00.00.00.0
In domestic currency0.00.00.00.00.00.013.518.3−4.80.612.6−12.00.00.00.0
In foreign currency0.00.00.00.00.00.00.00.00.00.00.00.00.00.00.0
Nonresidents
Total0.25.7−5.512.81.111.73.07.5−4.40.00.00.010.657.1−46.50.00.00.0
In domestic currency0.25.7−5.50.00.00.00.00.9−0.90.00.00.010.648.3−37.70.00.00.0
In foreign currency0.00.00.012.81.111.73.06.5−3.50.00.00.00.08.8−8.80.00.00.0
Total27.060.2−33.227.123.63.4102.087.514.625.634.3−8.757.294.7−37.630.914.116.871.326.644.8
In domestic currency27.060.1−33.114.222.6−8.497.580.417.225.434.1−8.856.884.7−27.930.914.116.854.910.844.1
In foreign currency0.00.1−0.112.91.111.84.57.1−2.60.20.20.00.410.1−9.70.00.00.016.415.80.6

Figure 2.Gross Claims and Liabilities to Other Sectors, 2007–15

(Percent of GDP)

Sources: Banco Central do Brasil and Tesouro Nacional; based on MFS, IIP and debt statistics.

11. Foreign currency exposure of NFCs increased on account of higher external borrowing. The Central Bank accounts for a sizeable amount of reserves, but the public sector’s foreign currency assets and liabilities as a share of total system’s assets and liabilities are limited. ODCs’ gross foreign currency liabilities to Nonresidents have increased but the net currency exposures remain modest. The highest exposure is seen in the NFC sector, where foreign bond issuance picked up in recent years. The oil company Petrobras alone had about US$130 million alone in foreign debt at end-2014.

12. Exposure to the Nonresident sector increased. The government became more reliant on financing from abroad, and NFCs’ net liabilities to Nonresidents appear to have increased too. This may understate the growth of external borrowing of this sector to the extent that a part of offshore bond issuances by foreign incorporated subsidiaries of Brazilian parent companies are not repatriated through intercompany loans.

13. While those sectors which were net debtors in 2007 remained net debtors through 2014, some changes in net liability positions since the global crisis are notable. The net liability position of ODCs and NFCs improved (Table 1, Appendix I), but the net position of Other financial corporations (OFC)s and that of the HHs sector worsened. The net liability position of the Public Sector (the government and the Central Bank) improved albeit marginally. While the extent of these changes is small relative to those seen in the U.S. balance sheets over the same period, they are notable considering the initial depth of the financial sector in Brazil and the strength of sectoral inter-linkages.

14. Government policies have contributed to some changes in the liability positions described above over the period 2007–14. First, the pickup of government liabilities to the Central Bank reflects the issuance, in 2010, of securities, which the Central Bank uses for monetary policy purposes.5 In fact, the growth of Central Bank liabilities to ODCs in Figure 2 reflect the increasing role of repo operations in liquidity management. Second, the government also made a deliberate transfer of securities, in the aftermath of the crisis and over the following years, to public banks to support countercyclical fiscal stimulus. This increased banks’ holding of government paper but also allowed banks to step up lending, thus contributing to financial deepening. Indeed, Caixa stepped up mortgage lending to HHs, while the BNDES increased lending to businesses. ODCs (excluding BNDES) fund their lending activity manly through domestic deposits (64.4 percent of GDP), with loan to deposit ratio amounting to over 99 percent in 2014. Their strong liquidity position up to 2014 was made possible also by increased NFCs cash holdings, the counterparty of which is higher company debt.

15. Developments in 2015 altered the size of some intersectoral exposures in the BSA matrix. Reflecting a high overall deficit, Government liabilities increased by 10 percentage points of GDP. About 16 percent of gross debt was held by non-residents and 25 percent by financial institutions. Because of the steep depreciation of the real, Central Banks’ foreign assets increased by 3 percentage points to 24 percent of GDP. Total net liabilities of ODCs improved by 2 percentage points of GDP. Yet, their net exposure to NFCs’ increased by almost 6 percentage points of GDP and net liabilities to the Public sector decreased by a similar amount due to their higher holdings of government securities. Net liabilities to Nonresidents remained broadly unchanged. Issuances of debt instruments by the NFC sector foreign slowed down because of weak demand and amounted to 2.5 percent of GDP (of which 2 percent of GDP were domestic). The direction of overall net sectoral interlinkages in the BSA remained unchanged.

Balance Sheets Matrix, Data Sources and Notes

Table 3.Brazil: Change in Gross Intersectoral Asset and Liability Positions(Change 2007–14, percent of GDP)
Issuer of liability (debtor)Public SectorFinancial SectorNonfinancial Private SectorRest of the World
Holder of liability (creditor)GovernmentCentral BankOther Depository Corporations and BNDESOther Financial CorporationsNonfinancial CorporatesHouseholdsNonresidents
AssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNetAssetsLiabilitiesNet
Government
Total6.32.14.2−5.69.4−15.0−1.0−1.10.10.00.00.00.00.00.04.5−0.14.6
In domestic currency6.42.14.3−5.69.4−15.0−1.0−1.10.10.00.00.00.00.00.01.7−0.11.8
In foreign currency−0.10.0−0.10.00.00.00.00.00.00.00.00.00.00.00.03.40.03.4
Central Bank
Total2.16.3−4.28.20.08.20.00.00.0−0.20.0−0.20.00.00.0−0.94.3−5.2
In domestic currency2.16.4−4.38.2−0.58.60.00.00.0−0.20.0−0.20.00.00.00.00.00.0
In foreign currency0.0−0.10.10.00.5−0.50.00.00.00.00.00.00.00.00.0−0.94.3−5.2
Oth. Dep. Corporations
Total9.4−5.615.00.08.2−8.2−4.01.2−5.28.817.9−9.16.79.8−3.13.41.22.1
In domestic currency9.4−5.615.0−0.58.2−8.6−3.91.3−5.28.517.9−9.46.79.8−3.10.00.00.0
In foreign currency0.00.00.00.50.00.5−0.1−0.10.00.3−0.10.30.00.00.03.31.22.1
Oth. Fin Corporations
Total−1.1−1.0−0.10.00.00.01.2−4.05.2−0.3−5.65.3−1.4−0.2−1.10.00.1−0.1
In domestic currency−1.1−1.0−0.10.00.00.01.3−3.95.2−0.3−5.65.3−1.4−0.2−1.20.00.00.0
In foreign currency0.00.00.00.00.00.0−0.1−0.10.00.00.00.00.00.00.00.00.1−0.1
NFCs
Total0.00.00.00.0−0.20.217.98.89.1−5.6−0.3−5.3−5.85.0−10.8
In domestic currency0.00.00.00.0−0.20.217.98.59.4−5.6−0.3−5.3−8.45.0−13.4
In foreign currency0.00.00.00.00.00.0−0.10.3−0.30.00.00.02.60.02.6
HHs
Total0.00.00.00.00.00.09.86.73.1−0.2−1.41.10.00.00.0
In domestic currency0.00.00.00.00.00.09.86.73.1−0.2−1.41.20.00.00.0
In foreign currency0.00.00.00.00.00.00.00.00.00.00.00.00.00.00.0
External
Total−0.15.1−5.24.3−0.95.21.23.4−2.10.10.00.15.0−5.810.80.00.00.0
In domestic currency−0.11.7−1.80.00.00.00.00.00.00.00.00.05.0−8.413.40.00.00.0
In foreign currency0.03.4−3.44.3−0.95.21.23.3−2.10.10.00.10.02.6−2.60.00.00.0
Total10.34.85.510.69.31.332.724.28.5−10.7−1.5−9.113.36.56.85.39.6−4.31.910.6−8.7
In domestic currency10.31.58.85.910.2−4.331.620.311.3−10.6−1.4−9.213.13.99.15.39.6−4.3−6.64.9−11.5
In foreign currency0.03.3−3.34.7−0.95.61.14.0−2.90.0−0.10.10.32.5−2.30.00.00.08.55.62.8

Standard Data Sources for the BSA

Central Bank of Brazil

Ministry of Industry, Commerce and Tourism, Secretariat of Foreign Commerce (SECEX)

Brazilian Institute of Statistics and Geography (IBGE)

Central Bank:

Consists of the Central Bank of Brazil (CBB) only.

Beginning in July 2007, data are based on a standardized report form (SRF) for central banks, which accords with the concepts and definitions of the IMF’s Monetary and Financial Statistics Manual (MFSM), 2000. Departures from the MFSM methodology are explained below. Securities lending backed by securities is treated as a transaction and included in Other Items (Net) rather than recorded off-balance sheet. Loans to financial corporations in liquidation are valued at market price rather than at nominal value. For December 2001 through June 2007, data in the SRF format are compiled from pre-SRF data, which are not fully based on the MFSM methodology. Departures from the MFSM methodology are explained below. Financial assets and liabilities for which economic sectorization is unavailable are allocated to the economic sector having the largest volume of transactions in the category. Foreign Assets are partly calculated using balance of payments data rather than entirely calculated from the balance sheet of the BCB. Shares and Other Equity includes some provisions for losses. Accounts receivable and payable are included in Other Items (Net) rather than in the CBB’s claims on or liabilities to the corresponding economic sectors. Securities lending backed by securities is treated as a transaction and included in Other Items (Net) rather than recorded off-balance sheet. Some securities other than shares issued by the central government are valued at acquisition cost rather than at current market price or fair value. Loans to financial corporations in liquidation are valued at market price rather than at nominal value.

Other Depository Corporations:

Comprises commercial banks, Bank of Brazil; multiple banks; Federal Savings Bank; investment banks; National Bank for Economic and Social Development (BNDES); development banks; finance and investment companies; housing credit companies, mortgage companies; money market financial investment funds; and savings, loans, and credit cooperatives. Beginning in December 2004, data are based on a standardized report form (SRF) for other depository corporations, which accords with the concepts and definitions of the Monetary and Financial Statistics Manual (MFSM). For other depository corporations in Brazil, departures from the MFSM methodology are explained below. Some data for other depository corporations were not directly distinguished from data for other financial corporations, in which case separation is derived by using counterparty records with residual amounts allocated to the private sector. For December 2001 through November 2004, coverage of other depository corporations excludes credit cooperatives. Data in the SRF format are compiled from pre-SRF data, which are not fully based on the MFSM methodology. Departures from the MFSM methodology are explained below. Financial assets and liabilities for which economic sectorization is unavailable are allocated to the economic sector having the largest volume of transactions in the category. Though some data for other depository corporations were not directly distinguished from data for other financial corporations, separation of the data was based on the characteristics of the financial asset or liability. Loans to other financial corporations are included in Other Items (Net). Loans include some loans from other depository corporations. Claims on Other Financial Corporations includes debentures issued by other nonfinancial corporations. Other Deposits Included in Broad Money includes some deposits of other depository corporations. Deposits Excluded from Broad Money includes other deposits of other financial corporations and nonresidents. Shares and Other Equity includes provisions for loan losses. Some financial derivatives and accounts receivable and payable are included in Other Items (Net) rather than in the other depository corporations’ claims on or liabilities to the corresponding economic sectors.

Other Financial Corporations:

Comprises leasing companies, stock brokerage houses, distributor companies, and fostering agencies. Beginning in December 2006, includes closed pension funds, non-money market financial investment funds, microfinance societies, and exchange banks. Data exclude insurance corporations, open pension funds, capitalization funds, and exchange houses.

Data are based on a standardized report form (SRF) for other financial corporations, which accords with the concepts and definitions of the Monetary and Financial Statistics Manual (MFSM). For other financial corporations in Brazil, departures from the MFSM methodology are explained below. Data for the closed pension funds are available only on a quarterly basis. Data for the intervening months and the two months after the latest quarter are estimated by carrying forward the data for the last month of the previous quarter. Some data for other depository corporations were not directly distinguished from data for other financial corporations, in which case separation is derived by using counterparty records with residual amounts allocated to the private sector. For December 2001 through November 2006, data in the SRF format are compiled from pre-SRF data, which are not fully based on the MFSM methodology. For other financial corporations in the Brazil, departures from the MFSM methodology are explained below. Financial assets and liabilities for which financial instrument breakdown is unavailable are allocated to the financial instrument having the largest volume of transactions in the category. Though some data for other financial corporations were not directly distinguished from data for other depository corporations, separation of the data was based on the characteristics of the financial asset or liability. Claims on Depository Corporations includes some deposits with other financial corporations and shares and other equity issued by other financial corporations and private sector. Shares and Other Equity includes provisions for loan losses. Some financial derivatives and accounts receivable and payable are included in Other Items (Net) rather than in the other financial corporations’ claims on or liabilities to the corresponding economic sectors.

Nonresident sector:

The total liabilities to NFCs according to the IIP include some OFC liabilities, which are not captured as OFCs in the MFS due to incomplete coverage. In addition, the total IIP number is adjusted by the difference between MFS and IIP in ODC external liabilities, which is due to MMFs being included as “other sectors” in the IIP total.

Government Finance:

Operations Statement data are from the Central Bank and Ministry of Finance. The Central Bank of Brazil revised the data series for financial data (flows and stocks), correcting some classification and consolidation problems. In the Balance Sheet, beginning December 2006 onwards, the Central/General Government Gross Debt excludes the Central Government securities that are under the Central Bank’s outright ownership. The financial asset “currency and deposits” was corrected by the same amount. (For additional information on this methodological break, please consult the note published by the Central Bank of Brazil in http://www.bcb.gov.br/ftp/notaecon/ni200802pfi.zip.)

C. The Impact of Political Fragmentation on Public Debt

16. Fiscal policy is the area of macroeconomic policy most directly intertwined with politics. The reason is that fiscal policy is mostly about redistribution across individuals, regions and generations: the core of political conflict. The common consensus among economists is that there are increasing marginal costs of public deficit and debt. This raises the question of why countries still spend beyond their means and risk not being able to cope with their financial situation by accumulating long-term and excessive public debt. The political economy literature in this field emphasizes the need to take into account the role that political factors have on fiscal policy. There are two distorting political forces affecting policy choice. First, the incumbents desire to retain power, which could lead to opportunistic behavior and the strategic use of debt. Second, the degree of polarization in a society gives rise to a degree of social and ideological conflict that reflects in the degree of government fragmentation and puts pressure fiscal policy (Mulas-Granados, 2006; Alesina and Passalacqua, 2015).

17. Political fragmentation is a key source of fiscal pressure, debt accumulation and delayed stabilization. Two alternative theories predict that political fragmentation is associated with higher deficits and debt. The common pool theory predicts that as the number of parties in government grows the pressure on deficits and debt increases, because each party serves its own privileged group while only facing part of the associated tax burdens (Weingast, Shepsle and Johnsen, 1981). The veto players’ theory predicts that when the number of players increase and their ideological distance grows, policy changes become more difficult to pass, making public debt reductions more unlikely (Tsebelis, 2002). A wide body of empirical research using data from advanced economies has demonstrated these theories are correct: minority governments, divided legislatures, coalition and multiparty cabinets, with a large number of ministers, are all associated with higher deficits and debt. More recent evidence from a sample of 92 advanced, emerging and developing economies from 1975 to 2015 shows that traditional indicators of political fragmentation (from both common pool and veto player theories) are associated with average increases in public debt (Crivelli, Gupta and Mulas-Granados, 2016).

18. Brazil has traditionally had a very fragmented political system. When compared with a sample containing a large number of countries Brazil shows on average a higher level of political fragmentation, a lower margin of parliamentary majorities, a higher ideological polarization, and a higher number of spending ministries. In addition, Brazil has a larger number of veto player’s than the average, and confronts an aging population, a growing unemployment rate and higher social unrest (measured by the number of strikes). These are all indicators that tend to put pressure on public spending and to be associated with public debt accumulation.

Political Fragmentation, 1975–2015

(Common Pool Indicators)

Political Fragmentation, 1975–2015

(Veto Players Indicators)

19. Institutional frameworks that reinforce the medium-term perspective and centralize budget commitments help eliminate the effects of political fragmentation on public accounts. Strong budget rules and budget institutions help shield the budget from electoral pressures and reduce the effect of political fragmentation on deficits and debt. In the presence of divided cabinets, a strong coordinating role for the Ministry of Finance, is associated with less fiscal profligacy and declining public debt (Hallerberg and Von Hagen, 1997; Von Hagen, Hallett and Strauch, 2001).

D. Composition of Direct Investment Liabilities

20. Direct investment (DI) has contributed to Brazil’s external resilience in recent years. Net DI (flows) amounted to some 3 percent on average since 2010 while DI liabilities reached about 4 percent of GDP. This compares to a current account deficit of some 3.3 percent over the same period. Given their favorable risk profile, sustained large FDI flows into Brazil represent a factor of strength.

Breakdown of DI liabilities ($ Billions)

21. The breakdown of DI liabilities reveals an important development. The share of intercompany loans in the total increased significantly during the post-2008 period, amounting to around half of DI liabilities in 2013/14. Loans by foreign incorporated subsidiaries to Brazilian parent companies, such as Petrobras, drove the uptick. The more traditional type of loans from a foreign parent to a domestic subsidiary has often been judged to have a similar risk profile to DI equity investments. In contrast, intercompany loans from the subsidiary to the parent may have a risk profile more similar to portfolio debt flows because they reflect the proceeds from offshore bond issuances by the foreign incorporated subsidiaries.

Outstanding Stocks of Offshore Issuance by Foreign Incorporated Subsidiaries

Percent of GDP

22. Offshore issuances by foreign incorporated subsidiaries of domestic corporates have gained prominence during the post-crisis period. Brazil is among a number of EMs in which the outstanding stock of such issuances increased dramatically in recent years (to some 7 percent of GDP in 2014). To the extent that the parent is a non-financial corporate, the repatriation of proceeds from such issuances would show up in DI debt liabilities of domestic parent companies in the balance of payments. In the case of Brazil, parent companies indeed appear to have been repatriating the bulk of the proceeds, as indicated by the close correlation between issuances and the relevant DI component. Importantly, the dramatic decline of both series in 2015, reflecting largely Petrobras’ temporary loss of market access, illustrates the risk profile of such flows, distinguishing them from other, less risky types of DI liabilities.

DI liabilities and Offshore Issuance by Foreign Incorporated Subsidiary

E. Trade Response to the Real Effective Exchange Rate Change

23. The link between the exchange rate and export volumes has weakened over time with the declining share of manufactured goods in the export basket. A structural VAR analysis based on a model including the REER, trade volumes and the terms of trade (using first differenced quarterly data since 1990) suggests that imports respond strongly to real depreciations within the same year of the relative price change, while exports respond with a delay of one to two years. The response of imports to REER changes appears to be rather immediate and sizable at about 0.45. There is no evidence that a change in the REER affects import volumes later than 4 quarters out. The elasticity of manufacturing exports to a REER change is -0.45, with the bulk of the response materializing one year after the price change. Semi-manufactured and basic products show smaller elasticities, which operate with longer lags. This is intuitive given that commodities’ supply tends to be inelastic. Importantly, this also implies that the aggregate export elasticity has fallen over time as the share of manufacturing in total exports declined from 59 percent in 2000 to 38 percent in 2015. The current aggregate elasticity of about 0.4 would have been closer to 0.5 in 2000.

Trade Volume Elasticities

24. Estimated trade elasticities are used to assess staff’s trade projections. We compare our projections to those that would have been obtained had the REER remained constant at its end-2013 with the value of other variables, including the terms of trade, evolving as in the baseline. Import decline in 2015 following the dramatic REER depreciation in the same year is sizeable. Exports, in turn, show a delayed response that only fully materializes by 2017. The total effect of movements in the REER between 2013 and 2020 is projected to amount to 35 billion US dollars, about evenly split between exports and imports. Using the estimated trade elasticities, the analysis indicates that staff’s trade balance forecast would have remained closer to zero throughout the medium term in the absence of the currency depreciation, all else constant.

Trade Balance Projection (in $billion)

References

Based on unofficial estimates produced by Fundação Getulio Vargas with data from official household surveys.

The settlement of irregular obligations to public banks carried over from 2014 (the so-called “pedaladas”) contributed as well. The incurrence of these irregular obligations was one of the reasons for the impeachment of President Rousseff.

These are the “judicial deposits” constituted by private parties with disputes against the states (or against other private parties) awaiting resolution by the courts. The temporary use of these resources has been allowed by law, but the funds will need to be made up.

These changes were corporate decisions by Caixa, and thus are not considered macro-prudential policy actions. Caixa is the dominant player in the residential mortgage market.

Financial, credit, and business cycles are estimated using a variety of commonly-used statistical methods and a semi-structural model of the Brazilian economy (see Selected Issues Paper). In the model-based approach financial, credit, and business cycles are jointly estimated and can be projected in a consistent way. Staff’s baseline output and credit forecasts benefit from this approach.

The Portuguese term is recuperacão judicial which could also be translated as “court-approved reorganization.”

The reform, with minor changes, passed its first vote in the lower house on October 10. It still needs another vote in that house and two votes in the Senate.

See Appendix III for a general discussion of political fragmentation and its interaction with government finance.

Estratégia Nacional de Combate à Corrupção e à Lavagem de Dinheiro (ENCCLA).

As noted in the Selected Issues Paper, output has a stronger impact on credit than credit has on output.

These results, obtained independently by Staff, are broadly consistent with the results of the central bank’s own stress test published in their April and September 2016 Financial Stability Reports. In the SIP it is also noted that a sharp slowdown in credit can be harmful to growth. Such a situation could be provoked, for example, by a greater need to strengthen balance sheets as buffers reach critical levels in a financial stress scenario.

In the period 1999–2014, fiscal multipliers in Brazil were around 0.3–0.5 percent (Selected Issues Paper for the 2014 Article IV Consultation). The text table reflects this adverse effect on growth in 2017, but assumes that tailwinds from faster restoration of fiscal sustainability will more than offset this “multiplier” effect in the following years, with this boost tapering toward the end of the projection period. The scenario does not assume additional supply side structural reforms that would lead to a permanently higher rate of real GDP growth.

The PIS/COFINS is an indirect levy earmarked for the funding of social security, and is thus considered a “contribution” instead of a tax.

1 Prepared by Flavia Barbosa, Izabela Karpowicz, Carlos Mulas Granados, and Christian Saborowski.

2 This is not an important shortcoming, given limited exposures to other economic sectors.

3 For an in-depth discussion of BSA matrix data gaps refer to “Balance Sheet Analysis in Fund Surveillance,” Policy Paper and Reference Note, International Monetary Fund.

4 The BSA matrix does not include insurance companies or asset managers, which are large players in Brazil.

5 Government assets at the central bank are the TSA deposits used for precautionary policy and for the repayment of short-term debt obligations.

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