1. I thank staff for the set of reports, the high-quality analytical work and the valuable engagement with the Brazilian authorities.
Recent economic developments
2. In mid-2014 Brazil entered its worst recorded recession, accumulating a GDP contraction of 8 percent in the nine quarters through the second quarter of 2016. As is often the case, such a decline in economic activity resulted from a combination of factors. In addition to external factors affecting commodity prices and unleashing important headwinds, policy missteps, in particular on the fiscal front, contributed to eroding confidence in the policy framework. Moreover, political uncertainty coupled with the shrinking of Petrobras further impinged upon investment, which fell dramatically in the last two years. The collapse in aggregate demand led to extensive job losses in the period and a steep rise in unemployment.
3. The new administration, which took office on an interim basis this May and was confirmed only in September, has shown strong commitment to sound macroeconomic policies and has galvanized broad support in Congress to cope with the challenging economic situation.
4. At this point, the Brazilian economy shows signs that activity is stabilizing, albeit still tentatively. Short-term indicators are currently uneven, in line with what is expected in such transitional periods. As political uncertainty dissipates, business and consumer confidence have rebounded. It is expected, however, that labor market softening will continue in the coming quarters, before stabilizing in 2017. Nevertheless, market participants are now more optimistic with regard to GDP growth, as the forecast for 2017 was revised upwards to 1.2 percent, compared to 0.3 percent six months ago.
Economic policy priorities
5. The authorities are fully aware of the severity of the situation and the sheer dimension of the challenges ahead, and concur with staff that growth will more likely resume gradually. They are nevertheless working consistently on different fronts to create the conditions to ensure a stronger and sustainable rebound in growth. In this regard, they have devised and are implementing a combination of actions to restore the credibility of the macroeconomic policy framework, while proceeding with productivity enhancing structural reforms.
6. A paramount goal within this approach is to undertake the needed measures to restore confidence through first stabilizing gross public debt and then subsequently reducing it. Considering that unsustainable long-term expenditure mandates have been a major source of fiscal imbalances, the new administration has set out a fiscal consolidation strategy based on initially curbing the real growth of public spending and then promoting a parametric reform of the pension system. This approach is key towards reestablishing confidence in the fiscal policy framework, helping inflation to converge to the target and creating an opportunity for rebalancing the policy mix. Such a combination of lower inflation and real interest rates as well as reduced uncertainty regarding fiscal sustainability will be crucial to reignite investment in a more vigorous way than currently anticipated.
7. Within this course of action, important progress has already been made in a relatively short period. These include a constitutional amendment that was approved in August to de-earmark a larger share of the budget, which also encompasses subnational entities and facilitates fiscal adjustment; another constitutional amendment freezing federal spending in real terms has been approved by an overwhelming majority in the lower house, before proceeding to the Senate; the Court of Accounts is expected to rule soon in favor of the legality of the early repayment of BNDES – the state-owned development bank – loans from the Treasury, giving the green light for an agreement that may reduce the gross public debt by R$100 billion (about 1.6 percent of GDP) in the next three years; and tax revenues from the new law for the repatriation of undeclared assets are expected to reach R$50 billion (the exact figure will be known in the next few days). Additionally, a constitutional amendment establishing new parameters for the social security system, to promote its sustainability over the long term is set to be sent to Congress by the end of this year.
8. The Brazilian authorities consider that the key fiscal measures, namely, the spending cap and the social security reform, are the game changers to restore debt sustainability and confidence in the economy. So far the strategy is advancing as envisaged and Congress has sent clear signals that it is willing to step up and approve these politically harsh, but necessary measures.
9. With the ongoing progress in the fiscal front, and with inflation expectations for 2017 having come down swiftly in the past six months from 6 to 5 percent and well anchored at the target thereafter, the Monetary Policy Committee (Copom) cut the Selic rate by 25 basis points in its last meeting, on October 19th. Monetary policy remains tight, with high real interest rates. However, as stated by the Central Bank of Brazil (BCB), the gradual and moderate flexibilization of the monetary stance is consistent with the convergence of inflation to the target. Going forward, the magnitude and speed of monetary flexibilization will depend on the level of confidence in the convergence of inflation within the relevant period for monetary policy. Incoming data, in particular, the behavior of those inflation items that are more responsive to monetary policy and economic activity, and the pace of implementation of reforms will be key for such development. Within the outlined strategy, a stronger fiscal stance and a rebalanced monetary policy will provide a mix consistent with the macroeconomic goals that are more conducive to sustainable growth resumption, based on reduced uncertainty, diminished crowding out, and lower financing costs.
10. Meanwhile, in its pursuit to continuously enhance policy credibility and help the disinflationary process, the BCB undertook measures to sharpen transparency and policy communication. The government is also considering ways to strengthen the de jure autonomy of the monetary authority.
11. Sustainable economic growth is the crucial precondition for overcoming the current challenges of the Brazilian economy. A cyclical rebound may be amplified by the measures mentioned above, but in order to ensure higher potential growth, a robust structural agenda needs to be implemented. With that in mind, the government is pursuing different avenues. One important strand relates to the changes being introduced in the framework for privatization and concessions to make them more appealing. Such an initiative will simultaneously help balance fiscal accounts and boost productivity, by removing bottlenecks and bringing new players to the ground. In addition, Petrobras is currently streamlining its activities, having also been exempted from the requirement to participate in all pre-salt oil exploitation projects. Moreover, in order to facilitate private participation in the provision of public services, a new framework for sanitation companies is being designed, while Infraero – the state-owned airport company – is no longer required to be a mandatory partner in the concession of airports.
12. The authorities are conscious of the fact that microeconomic reforms are also crucial for boosting productivity and long term economic growth, as well as increasing Brazil’s competitiveness in a more open economy. In this regard, an agenda to foster a better legal and infra-legal regulatory framework to improve the business climate and stimulate investment is being developed. Some of the main goals are to enhance governance in SOEs, increase the autonomy of regulatory agencies, prioritize evaluation of results over procedures, and update the bankruptcy law. Last but not least, the administration is encouraging BNDES to focus on infrastructure investment. The authorities believe that a better business climate and a clearer design of infrastructure concessions and privatizations will stimulate investments and unleash productive forces in the economy. Moreover, recent corruption probes will lay the groundwork for a new, improved and more transparent relationship between government and the private sector, with potential efficiency gains for the economy.
Financial system soundness and the external sector
13. The Brazilian financial system has recently been through a real life stress test and so far has passed with flying colors. In the last three years, the decline in economic growth, the sharp depreciation of the Brazilian real (BRL), the hike in domestic interest rate and the fall in real household income, reached extraordinary levels. Even considering that economic recovery is still needed to ease the pressure and strengthen profitability of the system, deleveraging and absorption of shocks proceeded without any systemic event. Brazilian banks are well provisioned and capitalized, and the regulatory and supervisory framework proved to be robust. Furthermore, BCB’s FX swap program (non-deliverable future instruments settled in BRL) provided a valuable additional supply of hedge, which allowed the exchange rate to float widely without causing disruptive financial distress. The overall fiscal impact of the FX swap program has been contained, as the large profits of the program in the first ten months of 2016 made up for more than 80 percent of the losses incurred in 2015.
14. Throughout this period of economic and political turbulence, high levels of international reserves played a major role in providing stability to the Brazilian economy. A large current account deficit and spikes in risk aversion leading to intense volatility of capital flows did not trigger any mistrust about the ability of Brazil to meet its foreign exchange commitments1. The floating exchange rate regime worked effectively as the first line of defense to absorb external shocks and promote a swift adjustment in the current account. The FX swap program was instrumental for corporate and financial sectors to assimilate sharp exchange rate movements. In addition, during this period there were no episodes of capital flight and foreign direct investment remained a reliable source of external finance. Looking forward, the authorities foresee a healthier performance of the current account as the economy recovers, while exchange rate flexibility and a sound financial system will continue to be vital for sustainable growth in Brazil.
The fiscal situation of States and Municipalities
15. The economic downturn also affected the public finance of subnational governments, especially those whose revenues are more dependent on commodity prices. Consequently, all levels of government, including states and municipalities, reduced spending to partially accommodate for falling fiscal revenues. However, budget rigidities have constrained the extent of that adjustment, and achieving sustainability is still challenging for states. In this regard, while attention is required for necessary structural reforms, the temporary relief granted by the federal government provided needed space for the adjustment to follow its course. More importantly, the social security reform to be proposed by the federal government should help states tackle increasing pension expenditures.
16. Strengthening controls, closer monitoring by the National Treasury, and full enforcement of the Fiscal Responsibility Law together with improvements in the efficiency in public spending and enhancement of fiscal transparency will help bring subnational governments to a sounder fiscal footing. Yet again, growth will be decisive for restoring fiscal sustainability, particularly for states, whose revenues are more responsive to the economic cycle.
The Selected Issues Paper on Effectiveness of Interventions in Brazil, prepared by Christian Saborowski, demonstrates that convertibility risk has been negligible in the Brazilian foreign exchange market.