IMF Executive Board Concludes 2016 Article IV Consultation with 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.

Abstract

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.

On October 31, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Brazil.

The government that took office in May 2016 has announced a series of measures to address long standing fiscal imbalances and budget rigidities. A strong push to implement the proposed measures on the expenditure side would go a long way towards restoring policy credibility and market confidence with positive effects on investment and growth. Early implementation of key fiscal policy measures would also help moderate inflation expectations and facilitate monetary policy easing.

Brazil is poised to emerge from a deep recession. The economy has contracted markedly in 2015 and 2016, reflecting mostly long-standing domestic issues, although terms of trade changes and weak global demand also played an important role. Tighter financial conditions and slowing credit and uncertainty surrounding the political scene have been the main factors behind the declining investment and consumption, and the ratcheting unemployment. A sharp realignment of regulated prices and monetary policy tightening also represented a drag on growth.

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. Monetary policy has correspondingly remained at its current tight level for over a year. But in 2016, some price increases have begun to moderate although disinflation proceeded slowly due to above target, albeit declining, inflation expectations and rising food prices.

The central bank has intervened in the foreign exchange market less frequently than in the past and broadly symmetrically, limiting corrective action to containing short-term excessive volatility. Taking advantage of the market rally started in March 2016, the central bank has lowered the net notional value of outstanding FX swaps to about US$35 billion (from a high of about US$110 billion) by issuing reverse swaps and failing to roll over maturing swaps.

International reserves are above most IMF adequacy and other standard indicators and FDI fully financed the current account deficit which narrowed from 4.3 percent of GDP in 2014 to 3.3 percent in 2015. Brazil’s external position remained, however, moderately weaker than the level consistent with fundamentals reflecting the recent reversal of exchange rate depreciation that occurred in 2015.

The health of the banking sector deteriorated somewhat but remains solid: the system wide capital ratios fell in 2015, but remain well above the regulatory minima; liquidity risk increased in 2015, but the overall funding profile of the system remained strong; external funding exposures are low and foreign exchange risks are largely hedged; profitability declined owing to a spike in provisions for loan losses and higher funding costs; non-performing loans (NPLs) have gradually increased, but remain moderate at 4.1 percent. Banks have remained well provisioned with loan loss reserves covering 150 percent of NPLs. However, nonfinancial corporates are leveraged and vulnerable.

Fiscal outcomes have been disappointing. In 2015 the non-financial public sector primary deficit reached 1.9 percent of GDP and the overall deficit was 10.4 percent of GDP. The primary deficit in 2016 is expected to reach 2.7 percent of GDP, and the overall balance would be close to that observed in 2015.

Since May 2016, the government announced a series of measures to strengthen macro policies and restore credibility. Notably, 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. The government has also announced a reform of the social security system, needed in its own right and also necessary to make the expenditure limit viable.

Fund staff expects activity to start to recover gradually, but remain weak for a prolonged period. Staff project output growth of -3.3 percent in 2016 and about ½ percent in 2017. The projection is predicated on the assumption the fiscal spending cap and social security reform are approved in a reasonable timeframe, and the government will meet the proposed fiscal targets for 2016 and 2017. With these improvements on the fiscal front, and assuming uncertainty continues to decline, investment is projected to continue to recover, supporting a gradual return to positive sequential growth beginning in late 2016. The outlook is subject to downside risks, including the re-intensification of political uncertainties (e.g., as a result of developments in the corruption probe) and risks related to a protracted period of slower growth in advanced and emerging economies, especially China, further declines in export commodity prices, and tighter financial conditions.

Executive Board Assessment2

Executive Directors agreed that Brazil’s difficult economic situation had resulted from several factors, including past policy missteps, policy uncertainty, and external shocks. The recession has lowered growth, raised unemployment, and undermined public and private balance sheets. However, the economy appeared to be stabilizing and near term prospects were for a gradual resumption of economic growth. Looking forward, Directors strongly emphasized the need for fiscal consolidation to ensure macroeconomic stability and comprehensive structural reforms to raise potential growth.

Directors welcomed the authorities’ announced fiscal strategy noting that it had helped boost confidence and market sentiment. They supported the focus on controlling expenditure growth, including through the proposed federal spending cap. This expenditure restraint may need to be complemented with revenue measures to achieve fiscal targets if revenue collections disappoint in the future. Most directors noted the potential positive effects of a front loaded fiscal consolidation strategy on borrowing costs, savings, confidence, debt sustainability and medium term growth. While recognizing the necessity of consolidation measures, a number of other Directors cautioned against more front loaded measures until growth is on a strong recovery path.

Directors underlined the need for reform of social security schemes, including those for civil servants at all levels of government, in view of unfavorable demographic trends and large actuarial imbalances. They emphasized the centrality of this reform for the viability of the federal spending cap. Directors also expressed concern over subnational finances, and encouraged the authorities to continue to develop durable solutions in coordination with the states.

Directors noted that monetary policy had been appropriately calibrated, with the tight stance of the last two years warranted by strong inflation pressures. While conditions for a gradual easing cycle are taking shape now, with inflation expectations converging toward the target, Directors recommended that monetary policy should remain relatively tight until more tangible progress in fiscal adjustment and reforms is made and inflation expectations move closer to the central bank’s inflation target. Directors welcomed the intention to strengthen Brazil’s inflation targeting framework by enhancing the central bank’s autonomy and improving its communications.

Directors underscored that the floating exchange rate system and reserve buffers were two main sources of strength for Brazil and should be preserved. They welcomed the reduction in foreign exchange intervention, and recommended that market intervention be limited to smoothing excessive volatility.

Directors highlighted that the financial system has remained sound amidst the recession and low credit growth and see scope for making the financial system even more robust by enhancing the financial safety net. Directors underscored the need for continued vigilance and close monitoring of the health of the corporate sector and its links to the banking sector.

Directors strongly recommended that the authorities step up their structural reforms efforts to raise long term growth, including in the areas of tax policy, labor markets, and infrastructure. They also underscored the importance of trade reforms to increase competitiveness and efficiency.

Directors commended Brazil for the effective implementation of AML/CFT measures and encouraged the authorities to pursue further reforms. They noted the need for strengthened reporting of fiscal statistics of SOEs, public banks, and states’ finances, and encouraged the authorities to monitor and enforce subnational fiscal rules.

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 the 2016 draft budget, recent announcements 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.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.