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

The economy is still in its deepest recession in decades, partly the result of the failure of past policies. The recession has been aggravated by a political crisis, which had, until recently, paralyzed policymaking and further damaged confidence. President Rousseff was impeached for responsibility crimes related to fiscal practices on August 31, and the government that took office in May will remain in charge until January 1st, 2019. Markets have responded positively to the new government's reform agenda, bolstering asset prices and confidence and helping the country ride a positive wave of sentiment toward emerging economies. However, while some high-frequency indicators suggest the recession may be nearing its end, the implementation of much-needed reforms to durably restore policy credibility is subject to risks.


The economy is still in its deepest recession in decades, partly the result of the failure of past policies. The recession has been aggravated by a political crisis, which had, until recently, paralyzed policymaking and further damaged confidence. President Rousseff was impeached for responsibility crimes related to fiscal practices on August 31, and the government that took office in May will remain in charge until January 1st, 2019. Markets have responded positively to the new government's reform agenda, bolstering asset prices and confidence and helping the country ride a positive wave of sentiment toward emerging economies. However, while some high-frequency indicators suggest the recession may be nearing its end, the implementation of much-needed reforms to durably restore policy credibility is subject to risks.

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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.

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: IBGE and IMF Staff estimates.

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

(In yearly percentage changes)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Brazilian Ministry of Labor.

Brazil: Net Formal Job Creation and Economic Cycle

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

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.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, 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.

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Haver Analytics and World Economic Outlook.

Brazil and EMs: Real Gross Fixed Capital Formation

(Index, 2000 = 100)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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 series2/ 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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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.
Figure 1.

Brazil: Recent Developments

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Haver Analytics, IBGE; and Fund Staff estimates.1/ Difference between the current rate and the 10-year average in percentage points.
Figure 2.
Figure 2.

Brazil: Inflation

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Haver Analytics, IBGE, and Fund Staff estimates.1/ Extended Consumer Price Index, Double Weighted (IPCA-DP).
Figure 3.
Figure 3.

Brazil: Macroeconomic Policies

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Central Bank of Brazil, IBGE, Haver Analytics, and IMF Staff calculations.
Figure 4.
Figure 4.

Brazil: External Sector

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Central Bank of Brazil, Haver Analytics, and Fund Staff calculations.
Figure 5.
Figure 5.

Brazil: Financial Sector Indicators

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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).

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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

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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 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)

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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 Aggregates

(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.

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).

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

Sources: Serasa.

Nonfinancial Corporates: Brazil and LA4

(Chile, Colombia, Mexico, and Peru)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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)

Citation: IMF Staff Country Reports 2016, 348; 10.5089/9781475553192.002.A001

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

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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

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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)

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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.

Table 5.

Brazil: Medium-Term Macroeconomic Framework, Balance of Payments, and External Debt

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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.