Brazil: Staff Report for the 2014 Article IV Consultation

This 2014 Article IV Consultation highlights that Brazil’s growth has decelerated in recent years. The boost from decade-old reforms, expanding labor income, and favorable external conditions, which enabled consumption and credit-led growth and underpinned sustained poverty reduction, has lost steam. Investment has been sluggish, reflecting eroding competitiveness, a worsening business environment, and lower commodity prices. The IMF staff projects negative output growth of 1 percent in 2015, with some drag from tighter fiscal and monetary policies and from the cuts in investment by Petrobras, adding to the downward momentum in activity carried over from 2014.


This 2014 Article IV Consultation highlights that Brazil’s growth has decelerated in recent years. The boost from decade-old reforms, expanding labor income, and favorable external conditions, which enabled consumption and credit-led growth and underpinned sustained poverty reduction, has lost steam. Investment has been sluggish, reflecting eroding competitiveness, a worsening business environment, and lower commodity prices. The IMF staff projects negative output growth of 1 percent in 2015, with some drag from tighter fiscal and monetary policies and from the cuts in investment by Petrobras, adding to the downward momentum in activity carried over from 2014.

Context: Disappointing Growth

1. Brazil’s growth has persistently decelerated in recent years. The impulse from decade-old reforms, expanding labor income, and favorable external conditions, which enabled a consumption and credit-led growth, has lost steam. A major expansion in the operations of the national development bank, BNDES, in the last few years has failed to boost investment, which has been sluggish since 2011 because the economy has lost competitiveness, the business environment has worsened and commodity prices have fallen from record highs. Moreover, structural sources of pressure on fiscal spending have necessitated a high tax burden. At the same time, unwarranted microeconomic interventions have contributed to reduced dynamism and increased financial stress in key sectors. For instance, in the energy sector, instead of promoting measures to increase efficiency, the government introduced a policy to subsidize electricity prices in 2012, increasing demand despite early signs of drought and driving electricity companies to borrow to cover increased generation costs in the expectation of future government compensation. Likewise, a high regulatory burden slowed implementation of the infrastructure investment program, especially in its initial phases.


Brazil: Revisions in Growth Forecasts

(In annual percentage change, per vintage)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: WEO and Fund staff estimates.

2. The economy stalled in 2014. Activity contracted in the third quarter of 2013 and in the first two quarters of 2014. A confluence of external and, more importantly, domestic factors helps explain the recent moderation in activity.

  • Weak investment in recent quarters reflects tighter financial conditions, and, more importantly, policy drift and uncertainty, including in the run up to the presidential elections. Business confidence has dropped to historical lows.

  • Consumption has also moderated notwithstanding strong wage increases, as job creation has halted and financial conditions have tightened, affecting household income and consumer confidence, which is now below levels seen during the global financial crisis.

  • At the margin, additional headwinds in 2014 came from the ongoing drought and the World Cup—which caused a reduction in working days and provided a space for public demonstrations which impacted confidence.


Brazil: Historical Decomposition of Real GDP Growth

(Deviation relative to the sample mean)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

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, Brazil EMBI Spread, Terms of Trade) and a set of domestic variables (CPI, policy rate, exchange rate, and GDP). All variables are specified in y-o-y percentage changes and orthogonally identified in the order listed above.

3. Poverty, inequality, and unemployment have been on a declining trend for more than a decade, thanks in part to effective social policies, but further progress will depend crucially on strong and sustained economic growth. Over the last 12–15 years, millions of families have been lifted from poverty owing to social policy interventions and buoyant real increases in the minimum wage (Box 1). Income inequality has also declined, and access to education and health has broadened. Over that period, relatively strong growth helped unemployment fall to historically low levels, although most recent declines are largely explained by declining labor force participation rather than job creation (Box 2). Further improvements in living standards hinge on securing strong, balanced, and durable growth, to ensure continuing employment growth and sustained funding for essential social programs.

Bolsa Família and Brasil sem Miséria: The End of Extreme Poverty in Brazil1

Bolsa Família (BF), the conditional cash transfer program created in 2003, is the flagship of Brazil’s social programs. Eligibility is determined by household income per capita. Conditionality includes mandatory enrollment and minimum school attendance for children and adolescents, vaccination and good nutrition for young children, and pre- and postnatal care for women, among others. Building on the success of BF, the government launched Brasil sem Miséria in 2011 to overcome extreme poverty. This program goes beyond income transfers and promotes educational qualification, integration in the labor market, and improved access to public services.

A wide reach at a low fiscal cost. BF has expanded from initially 3.6 to 14.0 million families (end-2014), reaching nearly 50 million people or ¼ of the population. Despite its wide reach, its fiscal cost is less than 0.6 percent of GDP per year; the average monthly transfer per family was R$169 (US$65) at end-2014.

Poverty mapping and coordination within the government were strengthened concomitantly. The government has actively worked to identify eligible households. At the same time, a unified registry of beneficiaries was created for monitoring recipient families.

Social outcomes have improved significantly. An estimated 22 million people were lifted from extreme income poverty alone since the 2011 expansion of the program, and extreme poverty has reached historically low levels. The impact of BF on the well-being of beneficiaries goes well beyond income support. Participants have higher school attendance rates, higher school progression and lower grade repetition. Concerning health, low birth weight, infant mortality, and malnutrition and diarrhea have fallen among participants, while breastfeeding and vaccination rates have increased. In addition, by targeting women as cash recipients, BF strengthened women’s financial independence.


Fiscal Cost and Reach of Bolsa Familia

(percent of GDP and million of households)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: Ministry of Social Development, IMF Staff estimates.

Brazil: Extreme poverty

(share of population living under the respective povery line)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: Ministry of Social Development, IMF Staff estimates.
1 Prepared by Flavia Barbosa.

Labor Market Dynamics1

Brazil has seen a substantial reduction in unemployment during the past decade; but recent declines mask a weakening of the labor market. The unemployment rate2 reached a record low of 4.5 percent in mid-2014, down from 11.7 percent in 2002, and stands currently at 5.4 percent (January 2015). The most recent declines in unemployment, however, reflect a contraction in the labor force, which masks a halt in employment growth amidst a slowdown in economic activity.


GDP and the Unemployment Rate

(In percentage change and percent)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001


Employment and Labor Force

(Year on year percentage change)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Job creation has slowed sharply. Net employment in the industry and construction sectors has contracted since early-2014. The creation of jobs in the service and the commerce sectors—though still positive—has weakened at the margin on the back of moderating consumption.


Net Job Creation by Sector

(in thousand jobs)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Labor force participation declined from late 2012, but has increased again more recently. Labor force participation rates fell across all age groups. The fall was especially strong for those aged 18–24 years, as Government scholarship financing programs (such as FIES and ProUni) have offered young people the opportunity to access higher education and therefore delay entrance in the labor market. Social programs and policies—such as Minha Casa Minha Vida, and the minimum old age pension—have boosted household’s cash and non-cash income, which might have affected reservation wages. However, more recently, participation started again to increase.


Participation Rate by Age Group

(percent points, dec 2012=100)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

There is insufficient data to determine whether the most recent movement has cyclical causes, or reflects a correction of what might have been an excessive reaction of participation to the factors mentioned earlier.

Wage pressures remain strong. Real wages have continued to expand above productivity, reflecting in part strong increases in the minimum wage. While some formal sector workers receive exactly one minimum wage, others are also affected. More recently, low labor-force participation has also contributed to the pressure on wages.


Wage and Labor Productivity Growth

(index, 2004 = 100)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: Fund staff estimates and Haver Analytics

Unemployment is likely to increase due to continued weak economic activity and recovering participation. The participation rate already started to increase, causing the unemployment rate to increase in 2014Q3. If the participation rate were to return to its 2008-2014 average of 56.8 percent, the unemployment rate could rise to 6.5 percent, other things constant.

1 Prepared by Fabian Lipinsky.2 The source for employment, unemployment, labor force and participation data used in the text and charts is, unless where otherwise explicitly stated, the monthly employment survey of the national statistics office (PME/IBGE). Real GDP data is reported by the quarterly national accounts, also by IBGE. All data were seasonally adjusted.

4. Inflation and inflation expectations remain above the central target. For several years, headline and core inflation have been near the upper-edge of the 2.5 to 6.5 percent inflation tolerance band, owing in part to sustained wage cost pressures, lingering indexation practices, and, more recently, the ongoing drought. In turn, longer-term inflation expectations have risen on average. Moreover, modest increases in regulated energy and fuel prices helped hold back overall inflation. However, overdue adjustments are underway. In particular, Petrobras raised gasoline and diesel prices in November 2014, and electricity tariffs increased in January 2015, when a new system of color “flags” was introduced to signal when generation costs are especially high; tariffs are expected to increase further. In parallel, tighter financial conditions and the still negative output gap have led to a moderation in the rate of growth of market-determined prices, although new inflation pressures are emerging from the nominal depreciation of the currency.

5. Financial markets have been volatile, contributing to reduce confidence. Brazilian asset prices were among the hardest hit following the Fed’s “taper” announcement in May 2013. Volatility rose again in the run-up to the October 2014 elections as well as amidst the Russian ruble depreciation in November. During 2014, both the Bovespa stock exchange index and the exchange rate against the U.S. dollar fell by about 7 percent and 14 percent, respectively. The resulting uncertainty has contributed to lower confidence and higher financing costs, reinforcing other headwinds for activity.

6. Petrobras, the state-controlled oil major, faces unprecedented difficulties because of external and internal factors. Petrobras’ credit rating has been downgraded (one rating agency now classifies it as high yield) and its share price has recently reached multi-year lows. For several years, the slide reflected an expensive domestic content policy for its procurement and persistent delays in domestic product price increases, which amounted to a quasi-fiscal subsidy financed by the company. These policies reduced cashflow from operations, pushing Petrobras into a debt-based strategy to finance its expansion plans. In the closing months of 2014, however, Petrobras’ difficulties intensified under the combined pressure of diminished oil price prospects and serious governance problems that cut the company’s access to external finance (Box 3). Petrobras is at present relying on its cash buffers to finance its expansion projects, and has announced a cut in its capital expenditure program for 2015 (estimated to be a 20 percent reduction), a decision that will bear upon the company’s future production and export plans, and for the economy as a whole because Petrobras accounts for about 10 percent of investment in Brazil. Petrobras, which is excluded from the definition of the public sector for the purposes of the fiscal responsibility law, has become a source of fiscal risk.


Petrobras’ financial situation has worsened. The recent sharp decline in international oil prices has improved the profitability of downstream operations after several years of losses, but prospects of a sustained period of lower prices and the ongoing corruption investigation are casting a shadow over Petrobras. By end-2014, Petrobras’ equity price had fallen by more than 80 percent in U.S. dollar terms over 5 years and its debt levels had increased to be the highest in the industry.


Petrobras: Net Income from the Downstream Segment

(in billions of U.S. dollars, per year)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Source: Petrobras

Investment plans may need to be further revisited. According to the 2014–18 business plan, production growth is projected to rise to 3.2 million barrels a day in 2018 (from around 2 million barrels a day in 2013), contingent on capital expenditures of around US$221 billion over 2014–18. However, since formulating this plan, international oil prices have effectively halved, nearing breakeven estimates under the current tax regime. In late January, the company announced a cut in capital expenditure of 20 percent in 2015 reflecting its need to conserve cash and diminished prospects for oil prices. Further revisions to the plan may be needed.


Oil Industry: Leverage Ratios, 2014Q2/Q3

(Gross debt to earnings or assets ratios, larger = worse 1/)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Source: Economatica1/ Gross debt includes total interest-bearing liabilities.2/ EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization -a cashflow measure. The ratios represent how many years it would take for a company to repay its debt with all its cashflow if earnings and debt are held otherwise constant.

Access to necessary financing at a sufficiently low cost is a key risk. Financing has become more difficult across the oil industry, with Petrobras’ difficulties exacerbated by idiosyncratic factors. Delays in the release of financial statements for the third quarter of 2014 closed access to international markets in early 2015. Uncertainty over asset write-downs has kept the auditor from signing off Petrobras’ financial statements. Also, opportunities to secure financing from state-owned banks are limited by already-large exposures to the company. Petrobras had a large cash cushion going into 2015 but needs to regain access to funding to continue expanding beyond 2015.

Adverse spillovers from the corruption probe could be large. The probe involves several of the largest construction companies in Brazil. At present, 27 such companies have been banned from engaging in new contracts with Petrobras. As already seen in one case (OAS), these companies may face difficulties securing financing, possibly impacting their suppliers and creditors (although any impact on banks appears moderate at this point). Perhaps the most important risk is a prolonged period of insufficient access to markets by Petrobras. Such a situation could necessitate financial support from the government—directly and/or indirectly—putting the government’s debt reduction objectives under stress.

1 Prepared by Troy Matheson (WHD).

7. The central bank has intervened in the foreign exchange market, with the aim of limiting volatility by meeting the demand for hedging. In response to a surge in exchange rate volatility following the Fed’s taper announcement, the central bank launched a program of pre-announced intervention starting in August 2013. Rather than selling dollars from its reserves in the spot market, the central bank has been selling hedging instruments settled in local currency (“FX swaps”).1 The intervention program has been renewed three times since its inception, and is currently in effect through end-March 2015; the amount auctioned daily (excluding rollovers) has been reduced in two steps and is now one fifth of its initial size. Intervention helped tame the real’s volatility in the second half of 2013 and early 2014. However, the second extension of the program in June 2014 occurred at a time of relatively low global volatility. The notional amount of outstanding FX swaps at end-2014 was US$110 billion, exceeding short-term external debt on a residual maturity basis.

8. Despite weakening domestic demand, the current account deficit reached 4.2 percent of GDP in 2014 from 2.4 percent of GDP in 2012.2 The deterioration reflects worsening terms of trade, a drop in exports to Argentina, and an increase in fuel imports necessitated by the drought. The recent depreciation against the U.S. dollar, arising in part from general dollar strength, has not translated one-for-one into gains against competitors in global markets. Moreover, persistently high unit labor costs continue to dampen competitiveness.

9. As a result, the external position is weaker than desirable, with the real still overvalued. Staff estimates that in 2014 the current account was weaker than its level implied by fundamentals and desirable policy settings and the real was stronger than indicated by fundamentals by about 10-20 percent on average during the year. This assessment is derived using methodologies that estimate the deviation of the current account from norms based on country-specific fundamentals, and identify the correction in the real exchange rate that could close this gap (Appendix I). By December 2014, the real had depreciated by 6 percent in real effective terms relative to its 2014 average, implying a corresponding reduction in the degree of overvaluation.3


Brazil: Nominal and Real Effective Exchange Rates

(Indices, Jan-2013 = 100; positive changes represent depreciation) 1/

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Source: Bloomberg, Haver Analytics and Fund staff estimates.1/ Monthly averages. Data for the exchange rate and nominal effective exchange rate for February 2015 corresponds to the latest observation by mid-February.

10. International reserves are high and capital flows have remained stable. FDI financed more than 70 percent of the current account deficit in 2014, with intercompany loans accounting for about 60 percent of total FDI.4 Portfolio inflows have been buoyant since 2013, as the central bank tightened monetary policy and rolled back CFMs on capital inflows (the IOF). At about US$362 billion, gross international reserves (cash concept) are well above the IMF’s reserve adequacy metric and other standard benchmarks.

11. The banking system’s soundness indicators remain favorable, but sustained low growth and the transition to a low credit growth environment could put bank balance sheets under pressure. Recently, credit growth has decelerated from high rates to 11.3 percent y/y in 2014, driven by a slowdown in credit expansion by public banks, while private bank credit continued to expand at a moderate pace. Real growth in home prices has also slowed down to about 1 percent as of November 2014.

  • Total and Tier 1 capital ratios remain well above the regulatory minimum at 16.5 and 13.1 percent, respectively, in the third quarter of 2014 (broadly in line with fully-loaded Basel III basis). Banks are also well provisioned (170 percent of nonperforming loans), and liquidity risk for the system as a whole is low.5 Banks continue to rely mainly on domestic funding sources, with the ratio of foreign funding to total funding at less than 10 percent.

  • Household and corporate leverage have increased in recent years, to a large degree as a result of increased borrowing from banks. The rising proportion of mortgages in household borrowing has lengthened average maturities, containing the growth in debt service. Corporate bond issuance has become increasingly important, including overseas borrowing, raising FX exposure but also allowing firms to access credit at longer maturities and lower rates. Leverage-already high by international standards-has edged up without translating into higher capital outlays as firms built cash cushions instead of augmenting their capital stock. In the case of commodity exporters, the decline in commodities is also contributing to raising leveraging by reducing free cashflow and equity growth. While FX debt accounts for about 30 percent of the total, it is largely hedged.6

  • Against this backdrop, tepid growth, possibly rising unemployment, exchange rate depreciation and tighter financial conditions ahead will likely put strains on private sector balance sheets. Indeed, there are emerging signs of balance sheet pressures. While the overall NPL ratio remains stable at about 3 percent, weak activity has already caused an uptick in NPL ratios for some segments of consumer and corporate loans, such as overdraft, credit card, working capital, and SME loans, particularly by public banks (Appendix II). These segments have, however, been the ones leading the recent deceleration in credit growth in public banks.


Household Indebtedness

(In percent of disposable income)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: Central Bank of Brazil and Fund staff calculation.

12. The macroeconomic policy mix from mid-2013 through 2014 lacked consistency, undermining credibility.

  • The fiscal stance turned expansionary. In 2013, the nonfinancial public sector (NFPS) primary balance declined to 1.9 percent of GDP, undershooting its 2.3 percent target. Coming on top of tax breaks introduced over 2012 and 2013, slowing revenue and rapid real expenditure growth (arising in part from structural sources of fiscal pressure such as mandatory minimum spending and minimum benefit rules, and wide-ranging earmarking) brought the primary fiscal balance of the NFPS to -0.6 percent of GDP in 2014, despite one-off measures of about ½ percent of GDP. Policy lending to BNDES edged back up in 2014, including a transfer of 0.6 percent of GDP in December, further raising government borrowing. As a result, gross and net public debt increased respectively to 71 and 37 percent of GDP. In 2014, the net interest bill of the nonfinancial public sector was 6 percent of GDP, exceeding the typical volume of spending in education, for example. Declining growth and poor fiscal performance affected Brazil’s sovereign credit rating. Standard & Poor’s cut Brazil’s credit rating to BBB- in March 2014, its first downgrade since July 2002. In September 2014, Moody’s revised Brazil’s sovereign rating outlook to negative.

  • Monetary policy has, however, maintained a tightening bias. In view of persistent inflation pressures, and largely in contrast with the fiscal policy stance, the monetary policy rate (SELIC) was hiked by 375 basis points to 11 percent between April 2013 and April 2014. Policy tightening paused from May through September. But between October 2014 and January 2015, the SELIC was increased by another 125 basis points to prevent second round effects from currency depreciation and the anticipated increases in regulated prices. At times, lending by public banks has been at odds with the thrust of monetary policy, diminishing the latter’s effectiveness.

  • Macro-prudential policies broadly responded to changes in risks along the credit cycle, but in some instances seemed to go against the grain of monetary policy. In September 2013, the central bank introduced limits on loan-to-value (LTV) ratios for mortgages to prevent potential future vulnerabilities.7 In July and August 2014, reserve and capital requirements were selectively loosened. The first of these actions aimed at containing liquidity risk in some segments of the banking system. But the second one largely aimed at boosting certain types of consumer loans, notwithstanding the tightening bias of monetary policy and an uptick in delinquencies of unsecured personal loans.8

13. Over December 2014-January 2015, a new economic team was brought on board with a mandate to strengthen macroeconomic policies and restore credibility. The team announced an ambitious fiscal adjustment strategy to bring the primary surplus to 1.2 percent of GDP in 2015 and to at least 2 percent of GDP in 2016 and 2017. This strategy, together with the ending of policy lending from the treasury to public banks, aims to stabilize and then reduce gross public debt. The economic team also set the objective of reaching the 4.5 percent inflation target by end-2016. Early measures and announcements include the 125 bps increase in SELIC mentioned above; an increase in the interest rate on subsidized loans (known as “TJLP”); a series of adjustment measures on the fiscal side worth about 0.9 percent of GDP in 2015, notably a tightening of eligibility for unemployment benefits, salary bonuses, and survivor pensions, and the reintroduction of the tax on fuels (Box 4).9

14. While efforts to alleviate supply-side constraints and boost the economy’s productive capacity have continued, long-standing obstacles to business and intra- and international trade remain unaddressed.

  • On the one hand, the government has focused on its program of concessions to involve the private sector in key infrastructure projects in transportation (roads and airports), energy transmission and generation, and telecommunications, increasing the program’s flexibility over time to overcome difficulties attracting investor interest. Similarly, in the oil sector, a consortium of Petrobras and international companies were given the rights to explore the Libra pre-salt field, potentially one of the world’s largest

  • On the other hand, structural impediments to growth remain rampant In particular, Brazil remains a relatively closed economy compared to its peers, with limited integration into global value chains; the tax system is uncommonly complex and unit labor costs are high; despite recent initiatives, Brazil’s infrastructure and competitiveness indicators have deteriorated in relation to its competitors; and while Brazil has maintained its average applied Most-Favored Nation (MFN) tariff at an elevated level of around 10 percent, several of its peers, such as China and Mexico, have cut taxes on imports and built a large network of preferential trade agreements (Box 5).


Brazil and Competitors: Competitiveness Indicators, 2011-2014

(Rank out of 144 countries; 1 = best, 144 = worst)

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: World Economic Forum Competitiveness Report 2010/11 and 2014/15.1/ Trade competitors: Argentina, Australia, Canada, China, India, Kazakhstan, Mexico, Russian Federation, South Africa, and United States.

Fiscal Policy Measures1

The new economic team has announced several measures to strengthen the fiscal balances; but additional measures will be needed to ensure the attainment of the primary surplus targets set for 2015 and 2016–17. On the expenditure side, the government announced (i) reduced benefits and tighter eligibility criteria for survivor pensions, unemployment and sickness benefits, and salary bonuses for private employees with low earnings, and (ii) the elimination of electricity subsidies (supported by tariff adjustments). The government estimates these measures will yield about 0.5 percent of GDP savings in 2015. In addition, it introduced tight provisional limits on certain discretionary current spending in its continuing resolution for the initial months of 2015; but this measure will be superseded by the changes to the 2015 budget. On the revenue side, taxes were raised on fuels, household credit operations, car sales, imports, and cosmetics, and a planned revision of PIT brackets was vetoed by the President (yielding 0.4 percent of GDP in total). Furthermore, the decision of halting the Treasury transfers to BNDES, tightening the rates of some subsidized loans, and raising the TJLP will lower the net interest bill. Further efforts are necessary to achieve the government’s proposed targets for 2015 because the starting point, given by the 2014 fiscal outcome, is a primary deficit of 0.6 even after some extraordinary revenue is taken into account, and because revenues in 2015 will tend to weaken as a result of the contraction in activity.2 Possible additional measures are indicated in the Table below.

Possible Additional Fiscal Consoditated Measures, Estimated Savings in 2015-19

(Percent of GDP, annualized)

article image
Source: Staff estimates based on data from Federal Tax Admnistration and National Treasury.

Refers to measures implemented since 2010. Estimates are based on the 2014 cost of such measures.

Includes federal tax exemptions over basic consumption basket, and IPI reductions (except on cars, which is already in place since January 2015).

Excludes also the impact of exclusion of the ICMS from the PIS/Cofins tax base on imports, since compensatory measures were already announced.

Implementation in January 2016.

Achieved through removal of budget rigidities and lower revenue earmarking. Expenditure cuts assumed to be phased in gradually, starting in 2015.

In general, fiscal adjustment should fall preferentially on current spending; on the revenue side, the rolling-back of temporary tax breaks would be useful. Curtailing expenditures will bring a lower drag on economic activity than increasing taxes would (see Selected Issues Paper). Given the size of the needed adjustment, however, revenue effort will also be required. The tax exemptions introduced in 2012–13 represent a sacrifice of revenues of 2 percent of GDP; however, they have been largely unsuccessful, and have in fact created new distortions in the treatment of different industries.

A further consideration is to favor adjustment strategies that address sources of long-term fiscal pressure. Spending related to ageing population groups is expected to rise by 3 percent of GDP in the coming 15 years. Structural budgetary reforms that reduce the complex structure of revenue earmarking and mandatory growth requirements for major spending lines, such as health or education, would have long term benefits in terms of increased policy flexibility. About 90 percent of the budget is predetermined at the general government level.3 The value of the minimum pension is indexed to the minimum wage, which grows roughly at the same rate as the tax base; such indexation makes therefore no allowance for the trend increase in the number of beneficiaries, making this system a permanent source of fiscal pressure.

1 Prepared by Joana Pereira (FAD).2 The estimated yield of measures excludes announcements made after February 25.3 Details discussed in the Selected Issues Paper for the 2005 and 2011 Article IV Reports.

Outlook and Risks

15. The pace of economic activity will remain subdued in the near term. Staff projects real GDP to contract by 1.0 percent in 2015 and to grow again by 0.9 percent in 2016.

  • This projection assumes that policy implementation is in line with recent pronouncements, the infrastructure concessions program functions broadly as programmed, and pre-committed Petrobras’ investment projects in the oil sector—as they stand after the cuts announced in late January—proceed largely as planned. The cuts in investment by Petrobras enter the projection with a relatively large multiplier to incorporate collateral effects on Petrobras’ contractors and suppliers. Following a prolonged period of low rainfall and diminished reservoir levels in key regions, the specter of water and electricity rationing is already affecting business and consumer confidence.

  • Staff estimates that the planned fiscal consolidation in 2015 would be a modest drag on growth, although the adverse impact should be increasingly mitigated by the favorable effect that the adoption of concrete measures and successful adjustment will have on credibility and confidence. Judicious deployment of the large transfer of loanable resources to BNDES in December 2014 should provide some support in 2015; fiscal drag in 2016 is expected to be lower, as some of the additional consolidation should come the from full-year effect of measures adopted in 2015, and thus already internalized in economic agents’ decision making.

  • Consistent with the policy announcements, staff assumes that policy lending will stop. Staff also expects some moderate additional tightening in the SELIC and the TJLP in 2015, with the monetary policy stance remaining tight until inflation approaches the 4.5 percent target (although, with the hump in regulated-price inflation behind, policy could ease at the margin in 2016).

  • Investment is projected to contract for a second year running in 2015, reaching its lowest point since 2009, primarily as a result of the change in Petrobras’s expansion plans. Investment growth is projected to recover gradually, especially in the latter part of 2015 as policy uncertainty abates and markets gain confidence in the government’s reform agenda. The recovery in investment in 2016 also assumes that Petrobras will secure reaccess to financing from capital markets.

  • Private consumption growth is projected to stay flat in 2015, reflecting tight financial conditions and some rise in unemployment, while government consumption is assumed to contract as part of fiscal consolidation. Private consumption is projected to regain some strength in 2016, including as a result of investment-related employment and improved confidence. Net exports should make a modest contribution to growth reflecting in part the weaker real, despite a challenging external environment.

16. Growth should gradually rise over the medium term, but its long term potential will depend on addressing structural constraints. Under a scenario of macroeconomic policy strengthening and implementation of the infrastructure concessions program, but otherwise limited structural reforms, potential growth is projected to reach 2.5 percent by 2020. Despite some expected further weakening in commodity prices, the current account is projected to improve modestly on higher oil production and the more depreciated level of the real, although offshore oil exploration plans are assumed to be scaled down at the margin given the diminished prospects for world oil prices.

Trade Restrictiveness1

Brazil stands out among its peers for its low degree of integration to global trade. With just above 20 percent of GDP in 2013, Brazil’s goods trade is about half the size of that in Peru, Russia, India and China and about a third of the size of trade in Chile and Mexico. Brazil shows the smallest volume of trade in goods and services relative to GDP among the LA5 and BRICS. Brazilian companies are less integrated into global value chains than those in most emerging market peers.2


Trade openness outcome indicators

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001


Goods trade vs. trade restrictiveness

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Brazil’s relatively restrictive system of trade taxes partly explains the low trade integration. As a founding member of MERCOSUR, Brazil shares a common external tariff with other members, subject to exceptions. Its applied MFN customs tariff is entirely ad valorem, with rates ranging from zero to 55 percent. Goods imports face a weighted average applied MFN tariff of around 10 percent according to the WTO, the highest among LA5 and BRICS peers. Moreover, Brazil’s network of preferential trade agreements covers a relatively small share of world trade compared to its peers.3 Besides customs tariffs, imports are subject to a complex system of internal taxes.4

Trading across borders is also hindered by significant behind-the-border constraints. The World Bank’s Doing Business indicators rank Brazil 123rd out of 189 countries in terms of ‘trading across borders’. Brazil stands out in terms of the cost of importing and exporting as the well as the number of documents needed to export/import. The authorities recently introduced procedures, such streamlining customs, aiming at reducing bureaucratic hurdles to trade.

Reducing trade barriers and behind-the-border constraints should be a priority. Reducing the level and complexity of the system of trade taxes—including by extending the network of preferential trade agreements—should boost trade volumes and growth, especially when paired with the push towards trade facilitation. Domestic content restrictions could be eased to promote Brazil’s inclusion in global value chains.


Doing business: trading across borders, overall Rank in 2014

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

1 Prepared by Christian Saborowski.2 See WTO World Trade Report 2014.3 MERCOSUR has preferential trade agreements with India and Israel, and three further agreements pending entry into force. Negotiations aimed at creating a free trade agreement with the EU are ongoing.4 See 2013 WTO Trade Policy Review for Brazil. Import taxes are also the most restrictive among peers when measured according to the World Bank’s overall trade restrictiveness index (OTRI) which takes into account non-tariff measures.

17. Inflation is expected to fall only gradually. Inflation is expected to converge toward the 4.5 percent target over the medium term as a result of tight monetary policies, although the rate of convergence will be affected by the necessary adjustments in regulated prices, high inflation expectations, and lingering indexation, including in wages.

18. Risks to the outlook are significantly tilted to the downside (Appendix III).

  • A key domestic risk to activity is that investment, including in the areas of oil production and infrastructure concessions, may be further hampered by the probe into corruption at Petrobras, which involves several of the largest construction companies in the country. Insufficient access to funding by these companies can result in adverse spillovers to their creditors, although the impact on banks would likely be moderate. Prolonged insufficient access to markets by Petrobras itself is a risk to the fiscal adjustment strategy. More generally, there is a risk that the fiscal targets for 2015–16 may not be met. This could undermine market confidence, with implications for growth, debt outcomes, and potentially for Brazil’s sovereign rating (Brazil is only one or two downgrades away from losing investment grade, depending on which rating agency one looks at). In turn, this could result in a sell-off of government debt by nonresidents, which could also cause stress in those financial institutions with large exposures to government securities, and affect capital flows to other emerging markets as well. Following a prolonged period of low rainfall and falling reservoir levels in key regions, water and electricity rationing has emerged as a key risk to growth in the near term. Continued low rainfall could result in tightened supply constraints, especially in the Southeast of the country, where a large fraction of GDP originates.

  • External downside risks stem from the increase in financial volatility, as well as from further declines in commodity prices. An abrupt surge in global financial market volatility could increase Brazil’s risk premium, exert pressure on the real (in addition to that coming from the U.S. dollar strengthening), and pose a challenge in financing Brazil’s large current account deficit. The impact on balance sheets should be contained as corporate exposures to foreign exchange risk are largely hedged. A protracted period of slower growth in advanced and emerging economies could weaken exports. A combination of a weaker real and slow growth would put pressure on private sector balance sheets. Further declines in export commodity prices—such as iron ore and soy beans—resulting from a slowdown in China also remains a key vulnerability. A further decline in oil prices, while a boon in the near term, could affect adversely Petrobras’ development plans of high-cost deep-sea oil, as well as prospects for growth and the current account over the medium term, when Brazil is expected to become a net oil exporter. Conversely, a sharp rise in oil prices, as would result from a geopolitical shock, would put pressure on the current account and on Petrobras’ cashflow in the near term.

  • Deeper downside risks to growth involve a combination of external shocks that are amplified by domestic vulnerabilities. In this environment there is a high probability of a sovereign credit downgrade. Such a scenario would see a larger rise in unemployment, with a likely worsening of social indicators, a sell-off of government debt, and negative repercussions for the financial sector, with adverse spillovers for other countries in the region.

19. Policies implemented in 2014 were partially in line with previous Fund advice. At the conclusion of the 2013 Article IV Consultation with Brazil, IMF Executive Directors welcomed the initiation of the monetary tightening cycle and recommended that monetary policy remained geared at containing inflationary pressures and anchoring inflation expectations. In addition, Directors highlighted the importance of adhering to a primary surplus target that placed public debt on a downward path, while also recommending a gradual reduction of policy lending. The continuation of monetary policy tightening since April 2013, with the goal of containing inflation pressures, took the policy rate to 11.75 percent by December, up from 7.25 percent before the start of the tightening cycle. However, in the fiscal policy area, performance deteriorated, with the primary balance slipping into deficit and policy lending edging back up, resulting in an increase in public debt in 2014.

Policy Discussions

Brazil is in a very tough spot, and policymakers face difficult policy choices that will test the grit and determination of the new government. Economic activity continues to contract with significant downside risks, even as inflation remains above target. There appears to be a limited role for demand support, both because there are emerging supply constraints and there is little policy space, underscoring the need to boost the economy’s productivity capacity through supply-side reforms. But this will take time. A key imperative in the near term is to bolster policy credibility, notably through front-loaded fiscal adjustment and monetary tightening, since this is important to boost confidence and, in turn, private demand that would anchor strong and sustainable growth over the medium-term. Adjustment will not be easy; however, any compromise on policy effort could jeopardize medium-term prospects without yielding any significant benefit in the short-term.

Staff Views

Fiscal policy

20. An ambitious and front-loaded fiscal adjustment effort, embedded in a realistic medium-term fiscal plan, is imperative for reducing public debt and bolstering policy credibility. Fiscal policy decisions confront two conflicting objectives: supporting demand and boosting policy credibility. On the one hand, in the context of weakening activity, fiscal policy could be used to bolster demand. On the other hand, however, policy drift and the loss of credibility in policy frameworks in recent years, reflected in plummeting consumer and business confidence, would put a premium on ambitious and front-loaded fiscal adjustment that would anchor strong and sustainable growth over the medium-term, notwithstanding the growth dampening effect such adjustment would have in the near-term. Since current growth woes in Brazil largely reflect supply-side constraints, as evident from limited slack, inflation being at the top end of the band, and the growing need to conserve water and energy, staff is of the view that fiscal policy actions should be geared toward restoring policy credibility.

  • Given the weak underlying fiscal position in 2014, rising public debt and deterioration of fiscal policy credibility over the last years, the announced fiscal target for 2015 of a primary surplus of 1.2 percent of GDP for the NFPS is appropriate. However, while the measures announced so far are welcome, additional effort (estimated at 1.2-1.4 percent of GDP, including to offset cyclical effects on revenue from the contraction in 2015) will be needed to meet the target. Additional expenditure containment is expected to be included in the revised 2015 budget (Box 4).

  • Going beyond 2015, the new government’s target of 2.0 percent of GDP for the primary surplus would begin to reduce public debt in the central macroeconomic scenario; but increasing that target by ½ percent of GDP would help put public debt on a more firmly downward path by reducing the interest bill faster and increasing resilience to shocks and potential fiscal risks.

  • From the perspective of the overall fiscal adjustment strategy, tilting the adjustment towards expenditure consolidation may help limit the drag on economic activity, but preserving and even increasing capital spending would be important (Selected Issues Paper). That said, given the size of the required adjustment, revenue measures are also necessary in the short run. To this end, beyond the measures already announced, consideration should be given to a fuller rollback of tax exemptions, as enlarging the tax base this way supports revenues, reduces distortions, and promotes horizontal equity. Going forward, addressing budget rigidities and ageing-related spending pressures is crucial to reduce debt and build fiscal space (Box 4). To the extent that structural fiscal measures that address key sources of long term fiscal pressure can be adopted early (such as the link between benefits and minimum wages), a more gradual adjustment path could be compatible with strengthening sustainability and credibility; but absent such reforms, adherence to the announced primary surplus objectives would remain key.

  • Furthermore, anchoring fiscal policies and targets in a medium-term framework would improve fiscal predictability. Staff sees merit in such an institutional framework as well as on publishing a debt-sustainability analysis. Moreover, an independent fiscal council would provide further support to transparency and accountability.

21. The commitment to end policy lending to the development bank and more generally to correct relative prices and reduce subsidies is welcome, and should bolster fiscal credibility. The decision to stop policy lending to BNDES starting this year is bold and will alleviate pressures on the fiscal position, while reducing financial distortions. The discontinuation of general subsidies to electricity, underpinned by tariff increases, is a positive step both for fiscal and economic efficiency reasons. The current context of low international oil prices provides a window of opportunity for recouping the downstream losses incurred by Petrobras in past years, and later for introducing formula-based mechanisms to adjust domestic prices regularly in line with the evolution of import parity benchmarks and reasonable domestic margins. More generally, adopting market-related pricing formulas for administered prices would help preserve the integrity of the balance sheets of large state-owned enterprises and reduce future fiscal risks.

22. Improving transparency of the fiscal accounts and reviewing the strength of governance frameworks in state-owned enterprises (SOEs) is critical. Full disclosure of the underlying fiscal position would boost confidence and help communicate the need for adjustment. The irregularities uncovered in Petrobras point to the need to review and strengthen internal and external oversight mechanisms in Petrobras and possibly in other SOEs, a task of the highest priority. The recent appointment of a director for governance in Petrobras is a positive initial step. Strong governance and close oversight of parastatals is also key for containing fiscal risks.

Monetary and financial sector policies

23. Bringing inflation to target by 2016 will likely require some further tightening of monetary policy in 2015. While moderate economic activity and planned fiscal consolidation, together with recent increases in the SELIC, should help reduce inflation, the required re-alignment of regulated prices and recent currency depreciation will necessitate monetary policy maintaining a tightening bias to mitigate the second-round effects on other prices and wages.

24. The renewed emphasis in communication on the 4.5 percent inflation target and the readiness to use the policy instruments to prevent second round effects from the ongoing correction of relative prices will bolster the credibility of the monetary framework.

  • Beyond the immediate, strengthening the inflation targeting framework would improve the effectiveness of monetary policy. In particular, the accountability and autonomy of the central bank could be enhanced by narrowing the tolerance band around the 4.5 percent target and giving a specific term of office to the central bank’s top management, as recommended by the 2002 and 2012 FSAPs (Appendix IV).

  • The widespread use of subsidized lending weakens monetary policy transmission and distorts credit markets. Introducing a direct link between the policy rate (SELIC) and the subsidized lending rate (TJLP) would increase the effectiveness of monetary policy. Reducing the gap between the SELIC and the TJLP—675 bps after the recent 50 bps TLJP hike—would also lower the recurrent fiscal cost arising from the cumulative stock of policy lending by government.

25. The exchange rate should remain the main shock absorber in the face of external shocks, with intervention in foreign exchange market being limited to dealing with excessive volatility. The pre-announced intervention program has helped reduce volatility and pre-empted pressures in the spot market at critical times by providing hedging options for economic agents with exchange rate exposures. However, by reducing the cost of hedging, the program may have encouraged excessive risk taking by the private sector; and, while the flexible exchange rate has remained the main shock absorber, prolonged intervention may have slowed the convergence of the exchange rate needed to restore competitiveness. For these reasons, staff considers the reduction in size and duration of the intervention program announced in December 2014 as a positive development. Going forward, the central bank should refrain from extending the intervention program further and, as conditions permit, continue to use the leeway provided by the calendar of rollovers of maturing swaps to temper the stock of swaps outstanding, with the goals of preserving and increasing policy space and supporting convergence of the exchange rate to levels in line with fundamentals.

26. Banking system soundness indicators are encouraging, but private sector leverage and the rapid past expansion of public banks are potential sources of stress requiring vigilance.

  • The central bank ran stress tests with scenarios constructed by staff, and the overall outcome was within the parameters of the stress tests published in the central bank’s own September 2014 Financial Stability Report—that is, in a high stress scenario, some banks would become noncompliant with capital requirements, but the capital shortfall would be small, less than 0.5 percent of regulatory capital, given existing provisions.10

  • This said, risks could arise from high private sector leverage and growing FX exposure in an environment of sustained low growth and possibly rising unemployment. The increase in delinquencies of high-risk loans by public banks could generate a demand for additional capital if loan defaults increase, but, more importantly, underscores the need for greater vigilance and close monitoring of the health of bank balance sheets in response to evolving economic conditions.

Policies to bolster the economy’s productive potential

27. Broad-ranging structural reforms are critical for improving the economy’s productive capacity, notably by reducing the cost of doing business and fostering investment, and to anchor strong, sustained, and balanced growth. Prioritization of these reforms and getting an early start is essential. Reforms should include:

  • Addressing infrastructure bottlenecks. The infrastructure concessions program is critical for boosting medium-term growth, and should be implemented with greater vigor, notably by assessing factors that have impeded greater private sector participation. In particular, consideration should be given to increasing the program’s scope and size, given the significance of infrastructure bottlenecks, while observing high standards of governance and program design, including regarding transfer of risks, to minimize fiscal risks and attract private sector participation. Tilting the composition of public expenditure away from current spending would also free resources for public investment, including in infrastructure.

  • Tax reforms. Brazil’s tax system is extremely complex and burdensome, especially with regard to distortionary indirect taxes. In particular, a simplification of the State Tax on the Circulation of Goods and Services (ICMS) would be an important way to reduce the cost of doing business.

  • Opening the economy. Brazil’s trade to GDP ratio is one of the lowest among emerging markets. Reducing applied MFN customs tariffs; continuing trade facilitation efforts; lifting domestic content requirements; and pursuing preferential trade agreements would help increase competition and the efficiency of the economy.

  • Improving resource allocation. The banking system’s ability to allocate resources efficiently can be improved by reducing the share of earmarked credit. Focusing public banks’ activities on missing markets, such as providing guarantees for concessions, would improve the allocation of limited financing. Similarly, reducing budget earmarking would release fiscal space and improve the allocation of limited fiscal resources.

  • Pension reform. Reforming the pension system (beyond the announced tightening of survivor benefits) would mitigate foreseeable fiscal pressures. It could also boost savings, much-needed for funding investment. Revising the indexation of certain benefits, including pensions, to the minimum wage would also help raise public saving.

  • Revising the minimum wage indexation formula, so that it better reflects productivity gains. The trade-off between employment and high real wage growth would likely reassert itself in a low-economic growth environment (see Selected Issues Paper). The large and sustained rise in unit labor costs has contributed to the erosion of competitiveness. The current formula for minimum wage, by affecting the growth in pension and other benefits, is also a source of fiscal pressure. A reform of the minimum wage indexation formula is critical, but will likely require extensive consultation among stakeholders. Hence, efforts should begin early and in earnest to develop a broad-based consensus in favor of reform.


G-20 Saving, Invesment, and Growth, 2011-14

(In percent of GDP) 1/

Citation: IMF Staff Country Reports 2015, 121; 10.5089/9781484380758.002.A001

Sources: WEO and Fund staff estimates.1/ Average since 2011. Size of bubbles reflects growth of GDP per capita.

Authorities’ Views

28. The authorities agreed that 2015 will be a difficult transition year, but are determined to strengthen policies. They expect activity particularly in the first half of the year to be subdued, but anticipate a recovery in investment in the second half of the year on the premise that a strengthening of macroeconomic policy will help restore credibility and boost market confidence. Over the year, they see consumption remaining subdued given the drag from tighter fiscal and monetary policies. The authorities expressed in strong terms the commitment of the government to the objectives for fiscal and monetary policy that have been set for the next three years, which they see as providing the necessary foundation for the government’s actions to continue improving the living standards of the population. Concerning risks of fallout from the Petrobras probe, the authorities stressed that the investigation was following its course, and that the police and judicial authorities were fulfilling their functions within the framework of the law, illustrating the strength of Brazil’s institutions. They also noted that the company is sound, and that the new management that took the helm at Petrobras in February is working closely with the independent auditor to find a prompt resolution to the question of the markdown of assets, which would permit Petrobras to issue audited accounts.

29. The authorities, however, do not concur with staff forecasts, which they consider to be very pessimistic. According to the authorities, staff forecasts for 2015 overstate the impact of fiscal adjustment on public consumption, which is implicitly expected to decline by 6.9 percent, and hence on aggregate demand. They note that the worst decline of this aggregate demand component in more than two decades (1996-2013) was only -1.8 percent in 1996. In addition, contrary to staff’s forecast for private consumption growth to be flat, the authorities consider that there are still factors in place that would point to a small positive growth, such as projected real wage and credit growth. The authorities also note that estimates of the output gap may not be entirely consistent with the rest of the forecast.

30. The authorities emphasized their strong commitment to delivering the announced primary surplus target of 1.2 percent of GDP in 2015 and at least 2.0 percent of GDP in 2016 and 2017, with no new policy lending by government to the development bank. They further reiterated the link between these fiscal targets and their focus on the stabilization and subsequent reduction of gross debt. They indicated that their commitment to follow through with the consolidation process without delay was demonstrated by the measures announced since the turn of the year.

31. The authorities indicated that, within the existing constraints, they would seek to minimize the impact on activity of their fiscal adjustment. They explained that the situation was not one of crisis, and so they could implement the full adjustment over two years. They further indicated that fiscal adjustment will have to rely on both expenditure cuts and revenue measures, taking care to avoid cuts in key spending items (such as high-value capital and social spending) and increases in distortionary taxes. The authorities reiterated that they do not plan to continue the Treasury funding for public banks in the form of policy lending. Other costly subsidies are also being revised, notably those to energy, where revisions are already being implemented.

32. While authorities agreed that fiscal policies should aim at ensuring long-term sustainability and be fully transparent, they did not see a strong case for introducing a medium term fiscal framework beyond that provided by the three-year Budgetary Directives Law.

33. The authorities emphasized that ensuring inflation convergence to the 4.5 percent target by the end of 2016 is the key priority for monetary policy. The central bank noted that the monetary policy stance had been adjusted over the past year-and-a-half in line with the evolving inflation outlook, most recently to support a process of relative price adjustment that will contribute to reduce vulnerabilities, while preventing relative price adjustments from affecting general inflation. Moreover, they stressed that, although the headline inflation rate had remained broadly stable during 2014, this masked a gradual improvement in its composition, with a progressively decelerating rate of inflation in freely determined prices offsetting a rise in the inflation of monitored prices. The authorities agreed that the TJLP gap relative to SELIC should narrow over time.

34. The authorities argued that their foreign exchange intervention program has aimed at, and has helped preserve, financial stability, and has had no undesirable side-effects. In particular, they stated that the program had not encouraged overseas borrowing by corporates, and stressed, instead, that the program had prevented capital outflows during episodes of high volatility. The central bank argued that, in addition, the FX swaps helped reduce the cost of carrying international reserves, and that, being settled in local currency, they did not compromise or commit international reserves. They also remarked that the exchange rate had continued, and would continue, to move in response to changing fundamentals and external shocks. Taking all of these factors into account, the authorities indicated that at present the notional value of the hedging contracts outstanding is broadly in line with the economy’s hedging needs. The latest extension of the intervention program on a reduced scale and for a shorter period than previous extensions is consistent with this view. Concerning staff’s assessment of Brazil’s external position, the authorities saw the current account in 2014 as weaker than expected, reflecting in part the drop in key export prices; but they noted that it was still mostly FDI-financed, and that the deficit should narrow over the medium term as a result of ongoing adjustments in relative prices and increases in Brazil’s oil exports.

35. The authorities acknowledged staff’s concerns over the recent rapid expansion of public banks’ balance sheets, but remarked that the pace had moderated significantly and that the NPL ratios in these institutions had remained low. The authorities stressed, furthermore, that the asset quality deterioration was mainly concentrated in non-core segments of these banks’ loans, and that the banks were well provisioned for possible loan losses.

36. The authorities reiterated their commitment to advance the implementation of financial reforms. The authorities started to phase-in the implementation of Basel III capital requirement from October 2013.11 Brazilian banks have progressed well towards the fully-fledged implementation of Basel III, which according to authorities’ estimates would require additional capital for only a few banks and be equivalent to 0.3 percent of regulatory capital in the system until 2019. The authorities noted that further progress has been made since the 2013 Article IV consultation in implementing key recommendations from the 2012 FSAP Update, including the introduction of a new framework for Emergency Liquidity Assistance (ELA), and the approval of the updated bylaws of the deposit insurance fund (FGC).

37. The authorities agreed that addressing the infrastructure gaps is essential to boost potential growth and that further domestic private sector participation is needed, given limited fiscal space. They pointed to the recent success of their infrastructure concession program in attracting investors when auctioning the concessions of ports, roads and airports. They added that public banks are expected to continue to play a role in the financing of infrastructure, and that new options to mobilize private financing from capital markets were also under consideration.

38. The authorities agreed that structural reforms would help boost Brazil’s potential growth, but remarked that in some cases improvements in fiscal transfer programs (such as better targeting and reduction in abuses) provided incentives for higher labor productivity equivalent to reforms.

  • The authorities see great potential benefits from a simplification of the ICMS. However, they indicated that this reform would need time as it involves complex negotiations with state governments and the Senate. The simplification of the PIS/COFINS is also receiving consideration, as is the expansion of SIMPLES, the tax regime that applies to most small enterprises, so it includes some medium-sized enterprises as well.

  • The authorities agreed that promoting a more open economy would be beneficial, and highlighted recently introduced procedures for trade facilitation, including in customs, aimed at reducing bureaucratic hurdles to trade.

  • The authorities argued that modifying the minimum wage indexation formula was not a pressing need, as the current formula would imply modest increases in the real value of the minimum wage in the next few years, and it had proved a factor of stability in the last two years.

Staff Appraisal

39. The Brazilian economy faces serious challenges in the context of stalling growth and high inflation. The new government must strengthen macro-financial policies and institutions to restore credibility, and use its political capital to embark on much-needed structural reforms that would improve competitiveness and put the economy on a strong and sustainable medium-term growth path.

40. The announced fiscal targets for 2015–17 are welcome, but implementation will be crucial for bolstering market sentiment. An ambitious and front-loaded fiscal consolidation is required for reducing public debt and restoring policy credibility. For these reasons, staff welcomes the government’s primary fiscal targets for 2015–17, the authorities’ decision to end policy lending, and the emphasis on reducing gross debt. The recent announcements of a series of expenditure and revenue measures have sent an important signal of the authorities’ commitment to their policy strategy. Given the weak underlying fiscal position in 2014, the fiscal target of 1.2 percent of GDP for 2015 is appropriate, but further measures will be needed to meet this target. However, starting in 2016, aiming for a primary surplus above the minimum objective of 2.0 percent of GDP in 2016–17 would bolster fiscal sustainability, lower vulnerability to shocks, help reduce the interest bill faster, and strengthen policy credibility. A more gradual path for fiscal consolidation than the one announced should only be considered in the context that reforms addressing structural sources of fiscal pressure are brought forward and pursued with vigor. Moreover, anchoring fiscal targets in an effective medium-term fiscal framework would improve the predictability of fiscal policy.

41. Improving transparency of public finances is critical. Full disclosure of the underlying fiscal position would boost confidence and help communicate the need for adjustment. The weakening of Petrobras’ financial position poses a risk to the public finances and to the company’s investment plans. In this context, staff welcomes the ongoing investigation, and encourages the authorities to take steps to limit any economic fallout from the probe and to prevent future instances of procurement fraud and corruption.

42. Monetary policy has been appropriately tightened, but bringing inflation to target within the next two years will likely require some further tightening in the near term. While moderate economic activity and planned fiscal consolidation should help reduce inflation, the required re-alignment of relative prices, and the persistent cost-push arising from wage negotiations, will necessitate monetary policy maintaining a tightening bias to deliver a significant reduction in overall inflation by end-2016. Moreover, if currency weakness or the correction of regulated prices were to fuel inflation expectations, monetary policy would need to be further tightened.

43. Staff welcomes the recent scale down of the foreign exchange intervention program. Within the context of the flexible exchange rate regime, intervention can be useful when faced with episodes of excessive volatility, as was the case when the current intervention program was introduced. However, the continuous operation of the program could delay convergence of the exchange rate to a more competitive value. In this context, the recent reduction in the scale of the program should moderate its side effects, and consideration should be given to not renewing the program further.

44. Close monitoring and prudential measures could help deal with latent risks in private sector balance sheets, including banks and corporates. In the current low growth environment, there is a risk of deterioration in the quality of assets on banks’ balance sheets, especially commercial loans to SMEs and non-housing consumer loans. Enhanced supervision and the pursuit of targeted microprudential measures would help reduce such risks. Staff welcomes the enhanced on- and off-site supervision of public banks by the central bank. Public banks should also be encouraged to bolster their capital positions, including by retained earnings. Rising corporate leverage, including through overseas borrowing, should be carefully monitored. It is important to continue assessing whether corporates are adequately hedged.

45. Structural reforms are critical for improving the economy’s productive capacity and to anchor strong, sustained, and balanced growth over the medium term. Prioritizing these reforms and getting an early start would be essential. Staff welcomes the emphasis placed on the implementation of the infrastructure concessions program, and the intention to address tax inefficiencies related to the ICMS and foster a more open economy in particular. It will be essential to follow through with these efforts, and to consider other areas of reform as well.

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

Table 1.

Brazil: Selected Economic and Social Indicators

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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 2015 draft budget, recent announcements by the authorities, and staff projections. Assumes no policy change.

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)

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

Historical numbers include valuation changes.

Table 3.

Brazil: Main Fiscal Indicators

(In percent of GDP, unless otherwise indicated)

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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.

Excludes proceeds from privatization.

Includes unallocated fiscal consolidation measures in 2015-20

Policy lending to BNDES and other public financial institutions.

Structural primary balance adjusts for output gap and one-off measures in 2009 and 2010 (sale of Eletrobras debt and Petrobras operation).

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.

Table 4.

Brazil: Depository Corporations and Monetary Aggregates

(End of period, in billions of reais)

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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.

As of November 2014.