Brazil: 2017 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Brazil

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Brazil


2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Brazil

A Turning Point?

1. Brazil has experienced a long and deep recession. The recession has been marked by low levels of confidence and large declines in investment and private consumption. Since the end of 2014, real output has contracted by around 7 percent, around 3 million formal jobs have been lost, and the unemployment rate has more than doubled. The recession has had significant negative spillovers on Brazil’s closest regional trading partners, most notably Argentina.


Real GDP Growth and Contributions

(Annual percent change)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: IBGE and Fund staff estimates.

2. Domestic factors largely explain the recession, but terms of trade changes and global demand have also played a role. In particular:

  • Investment has fallen by around 30 percent since the beginning of 2014. The fall has been marked by a sustained period of low competitiveness, rising costs (e.g. energy and unit labor costs), worsening terms of trade, declining profitability, and tightening financial conditions. The decline has also been exacerbated by a generalized deterioration in future growth prospects, higher levels of corporate leverage, and rising economic policy uncertainty (Selected Issues Paper).

  • Consumption has also suffered a large contraction, amid a severe deterioration in labor market conditions, falling real income growth, and tightening financial conditions.

  • Net exports broadly supported growth over 2015, reflecting a sharp demand-related fall in imports and strong export growth amid exchange rate depreciation and the delayed effects of stronger investment and capacity in the commodity export sector (e.g. mining). However, the impetus to growth from exports seen in 2015 has waned, with exports contracting by almost 5 percent in the year to December 2016 (a pickup in export volumes was reported in 2017-Q1, but it does not alter the overall picture).

  • Additional factors that have hampered growth relate to continuing uncertainty surrounding the political situation and the government’s reform agenda, and the ongoing corruption probe (Box 1).


Corporate Sector Indicators


Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: Capital IQ and Fund staff estimates.

3. The economy appears to be nearing a turning point. After eight consecutive quarters of contraction, real GDP increased in 2017-Q1. The result was driven by net exports, largely a reflection of a positive supply shock to agricultural output; but domestic demand contracted again, making it difficult to call already the end of the recession. However, many of the factors that were hampering growth in the early phases of the recession (e.g. falling terms of trade, high inflation and tightening financial conditions) have normalized, and, in some cases, improved. Consumption should also get a modest boost from the release of funds in inactive mandatory savings accounts (FGTS).1 Corporate leverage has started to decline, albeit from a high level. So the economy seems poised to resume modest growth in the second half of the year.

Corruption Investigation and its Spillovers

The fight against corruption is reaching the upper echelons of the political class. The Lava Jato (car wash) investigation, which began in 2014, has revealed decades-long practices of corruption. A strong and independent judiciary has successfully pursued investigations and prosecutions, although some of its tactics have been controversial at times. Facilitated by the implementation of a new anti-corruption law and the introduction of plea-bargain agreements, and initially centered on oil giant Petrobras, the Lava Jato investigation and its offshoots expanded to all major construction firms, public works for the 2014 World Cup and the 2016 Olympics, the energy sector (dams and power plants), the meatpacking industry, defense contracts, pension funds, and BNDES, the development bank. In plea bargain arrangements with public prosecutors, business executives have implicated scores of politicians, many of whom enjoy parliamentary immunities. The Supreme Court has recently authorized investigations into one third of current cabinet members, one third of Senators, and one third of state Governors, as well as the President, leaders of Congress and of the main political parties. Several former presidents and presidential hopefuls for 2018 are also being investigated. The accusations have to be investigated before the individuals are charged and prosecuted.1 As the investigations unfold, more business executives and politicians may end up implicated.

The investigations are spilling over into other countries in the region. One focus of the investigation is Odebrecht, until recently South America’s largest construction conglomerate, with significant operations outside Brazil. The firm pleaded guilty and reached an agreement with prosecutors in Brazil, in the U.S. and Switzerland and agreed to pay a penalty of US$2½ billion. In the agreement, the firm implicated high-ranking current and former officials from 12 countries in the region in corruption in some 100 projects over the past 15 years. Investigations have started in several countries, and many projects involving the tainted companies, sometimes of macroeconomic importance, have been suspended or delayed.

The economic fallout from the corruption probe is counterbalanced by gains in transparency and improved governance. The investigation has undoubtedly raised uncertainties as a side effect, and dampened activity in the oil and gas and construction sectors. However, in its wake new reforms and initiatives are taking place that should bring institutional benefits to Brazil. The investigations have revealed easily abused procurement rules and other deficiencies in systems that should prevent or detect corruption. Thus, firms, including SOEs, are strengthening their governance frameworks, and the government is reviewing public procurement rules, with new players (including foreign ones) increasingly bidding for public projects. Going forward, fiscal, judicial and other legal reforms can help reduce the scope for corrupt practices and money laundering.

1 In the Lava Jato investigation 139 individuals have been sentenced in the first instance (as of May 2017), among whom there are only a handful of former politicians. The Supreme Court’s cases against over one hundred politicians with immunities have not resulted in any sentences yet.

4. Inflation has declined rapidly and the central bank is on an easing cycle. After almost 2 years of being above the ceiling of the central bank’s tolerance range of 6.5 percent, inflation has declined rapidly over the past year. The impact of large increases in regulated prices in 2015 has dissipated, while a widening output gap, an appreciating exchange rate, declining inflation expectations, and a favorable shock to food prices have combined to speed disinflation since late 2016 (Box 2 and Figure 2). The central bank began an easing cycle in September 2016, bringing the monetary policy rate (SELIC) down by a cumulative 400 bps to 10.25 percent as of June 2017. The reference rate for BNDES’ subsidized loans (known as “TJLP”) was also reduced by 50 basis points to 7.0 percent in late March. Most private forecasters see the SELIC below 9 percent by year’s end.

Figure 1.
Figure 1.

Brazil: Real Sector Developments

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.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 Developments

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

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

Headline Inflation and Contributions

(Annual percentage change)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: IBGE and Fund staff estimates.

5. The external position was on average broadly consistent with medium-term fundamentals and desirable policies in 2016. The recession has been a main driver of external adjustment (Appendix II). Reflecting weak investment and improving terms of trade, the current account deficit narrowed to 1.3 percent of GDP in 2016 (from 3.3 percent of GDP in 2015). On average in 2016, the external position was broadly consistent with medium-term fundamentals and desirable policies per the External Balance Assessment (EBA). The appreciation of the real effective exchange rate (REER) during 2016 reflected largely a return of market confidence in view of the reform agenda and a more general risk-on mode, and an improvement in the terms of trade (in the first quarter of 2017 the REER was 14 percent stronger than its average in 2016, but part of this appreciation was reversed following the start of the most recent political turmoil). The flexible exchange rate has been an important shock absorber. The BCB reduced the rollover rate of maturing FX swaps and auctioned reverse FX swaps, significantly reducing its net forward position to 1.4 percent of GDP from over 5 percent of GDP at end-2015. International reserves remained a source of strength, standing at US$365 billion, equivalent to 166 percent of the ARA metric.

6. Brazil has continued to attract sizable capital flows but their composition has changed. Net direct investment fully financed the current deficit in 2016, partly supported by intercompany loans. Net portfolio debt liabilities, having accounted for more than 1 percent of GDP in previous years, turned to net outflows despite improving market sentiment toward the government’s reform agenda, as evidenced by the evolution of market spreads. In fact, the share of government debt held by nonresidents declined steadily over the course of 2016 from 19 percent to 14 percent.

Drivers of Disinflation

Inflation has declined markedly over the past year. After peaking at 10.7 percent in December 2015, annual IPCA inflation ended 2016 at 6.3 percent, within the target band. The large increase in regulated prices, that resulted from a much-needed adjustment in energy prices in 2015, had a particularly large impact on electricity and fuel prices in the housing and transport sectors, but also contributed to rising production costs in other sectors of the economy. The effect of these increases began to wane in early 2016, but inflation was slow to fall due to a sharp increase in food prices in early 2016 that resulted from adverse growing conditions for key crops (notably, black beans). The effect of food price shocks began to dissipate over the latter part of 2016 and inflation has experienced a large and broad-based decline.


Headline Inflation and Contributions

(Percent year-over-year)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Fund staff estimates.

What are the key macroeconomic drivers of the decline in inflation?1 A decomposition of annual inflation into contributions from several key variables suggests that declining regulated-price inflation was a key contributor to the overall decline in inflation over the past year. However, more recently, the effects of weak demand and appreciation of the exchange rate have also been increasingly exerting downward pressure on inflation. These disinflationary effects have been offset somewhat by inflation inertia (resulting from price and wage indexation to past inflation) and other shocks, including food-price shocks in the early part of 2016.


Headline Inflation and Macroeconomic Contributions

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

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Fund staff estimates.

Disinflationary pressures are expected to continue in the near term. Demand is expected to remain weak for some time and will continue to exert downward pressure on inflation. Likewise, regulated-price inflation and food-price inflation are expected to remain subdued, consistent with relatively stable international energy prices and the exchange rate, and favorable weather conditions for agricultural production in late 2016.

1 Based on OLS estimation of a simple Phillips curve: πt=0.34πt14+0.34yt+0.05Zt+0.34πt14+ϵt, where πt is quarterly IPCA inflation (annualized), πt14 is lagged annual inflation (inertia), yt is the output gap (output), Zt is annual growth in the real-effective exchange rate (exchange rate), and πtr is quarterly IPCA regulated-price inflation (annualized; a proxy for energy prices), and ϵt represents all other shocks. All inflation rates are expressed as deviations from the inflation target and the other variables are demeaned. The estimation sample is 1999Q4 to 2017Q1. All coefficients are statistically significant at the 1 percent level using HAC standard errors. The adjusted R-squared is 0.7.

7. Financial markets have been impacted by domestic risks. The authorities have had some success in pursuing their ambitious reform agenda over the past year and have enjoyed broad-based market support. The real apreciated by around 8 percent against the U.S. dollar over the year to December 2016, and by around 7 percent in real effective terms. The domestic government 10-year yield declined by around 400 basis points to 10 percent in the year to early May 2017. More recently, a sharp increase in uncertainty related to the political situation sparked doubts about the government’s ability to deliver on its reform agenda and prompted a rapid repricing of risk. Over the course of one day (May 18), 5- and 10-year sovereign yields rose by around 150 basis points, and the stock market and exchange rate against the U.S. dollar lost almost 10 percent of their values. The stock exchange’s automatic circuit breakers were triggered, and the authorities stepped in to mitigate market volatility. The Central Bank provided an exchange rate hedge through FX swaps, and the Treasury implemented a series of extraordinary buy and sell auctions to provide liquidity and pricing information to investors. Asset prices have since stabilized, albeit at lower levels than in early May, and uncertainty remains high.

8. The credit cycle downturn has deepened, but financial conditions have eased. Private sector credit, a lagging variable in the cycle, has continued to decelerate, reflecting both low demand and still tight underwriting standards. A factor affecting both supply and demand was the investigation of construction companies involved in the corruption scandal, which were traditionally large users of BNDES credit. However, demand and supply indicators of credit and new loans have picked up since late-2016, potentially signaling the end of the negative credit dynamics. Moreover, staff’s financial conditions index, a leading indicator of the cycle, has been loosening for several quarters now.


Financial Conditions Index

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Fund staff estimates.

9. The banking sector’s health has strengthened. Profits before taxes surged due to high interest margins and lower funding costs. To limit increases in non-performing loans, banks have continued renegotiating the terms of loans and writing off delinquent loans. Capital ratios increased on the back of a decline in private banks’ risk-weighted assets and higher unrealized gains on fixed income securities. However, capital ratios of public banks, much lower than private banks’, continued declining because of higher Basel III deductions (Figure 5). Liquidity improved as withdrawals of saving deposits stopped and banks’ holdings of liquid assets increased. Overall external funding exposure and net open positions remained low.

Figure 3.
Figure 3.

Brazil: Macroeconomic Policies

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: Central Bank of Brazil, IBGE, Haver Analytics, and Fund staff calculations.
Figure 4.
Figure 4.

Brazil: External Sector Developments

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: Central Bank of Brazil; Haver Analytics; and Fund staff calculations.
Figure 5.
Figure 5.

Brazil: Financial Sector Developments

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: Central Bank of Brazil, KMV, and Fund staff calculations.

Brazil: Bankruptcy Protection Applications Index

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

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Serasa.

10. Nonfinancial corporate and household balance sheets have begun to improve. Households’ debt-to-disposable income ratio is edging down, mainly due to lower non-mortgage debt, while debt-service-to-income ratios have declined owing to accelerated principal repayments on outstanding loans. Corporate bankruptcy protection applications have begun to fall. Leverage, however, continues to be high in the corporate and household sectors, and warrants continued monitoring, including because of its adverse effect on the pace of the economic recovery. Petrobras has made progress on asset sales and improved its management practices, enhancing efficiency and lowering costs. The company’s EBITDA margin is at its highest level in several years, thanks in part to a change in its domestic pricing policy towards ensuring at least a small premium over import parity prices. While debt maturing over 2017 and 2018 remains high at nearly US$20 billion, its debt amortization schedule has improved.


Brazil: Household Indebtedness

(Percent of disposable income)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Banco Central do Brasil.

11. Public debt ratios have risen sharply. NFPS debt rose from 72.5 percent of GDP to 78.3 percent between 2015 and 2016, with primary balances of −1.9 and −2.5 percent of GDP, and overall balances of −10.3 and −9.1 percent of GDP in those two years. The deficits in the primary balance have been largely the result of trend increases in mandatory spending and a sharp cyclical revenue downturn, while high borrowing costs and the contraction in output have delivered adverse debt dynamics. Along the way, the composition of spending has worsened, with rising current outlays and stagnant investment. Improving fiscal balances remains essential to ensure fiscal sustainability (see the accompanying Debt Sustainability Analysis).

12. Some subnational governments’ finances are highly stressed (Box 3). States’ fiscal positions have deteriorated due to the combination of revenue shortfalls, especially marked in oil producing states such as Rio de Janeiro, and steep wage bill and pension spending increases in the last several years. While similar in nature, the severity of fiscal problems differs widely from state to state. The federal government has negotiated consolidation measures in exchange for debt rescheduling and loan guarantees with Rio de Janeiro and Rio Grande do Sul (two states facing serious difficulties), and the overall framework has received congressional approval.

Rio de Janeiro and Rio Grande do Sul—The Tale of Two Financially Troubled States

Rio de Janeiro (RJ) and Rio Grande do Sul (RS) are two of the states showing the most extreme fiscal distress.


Rio de Janeiro: Overall Balance, 2008–19

(Constant R$ billion)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Ministry of Finance.

Rio de Janeiro

The situation in RJ is dire. RJ has been affected by the combination of fast expenditure increases for many years, a sudden reduction in revenues arising from the recession, and the sharp contraction in royalty revenue as world oil prices fell. Today, RJ struggles to stay current with payments to its creditors, its employees, its pensioners, and its providers. By the end of 2016, RJ accumulated an estimated financing gap of R$26 billion in 2017 (3.7 percent of the state’s GDP and 0.4 percent of Brazil’s GDP).

More than one rescue package will likely be needed to stabilize RJ’s finances. The 3-year rescue package agreed in January between RJ and the federal government (FG), includes measures to cover a fiscal gap of R$26 billion in 2017, including an increase of R$1.2 billion in revenues, cuts in discretionary spending of R$9 billion, and an increase in pension contributions worth R$3.2 billion. In addition, RJ will not have to service its debt to the FG (R$6.2 billion) in 2017, and the FG will guarantee a bank loan against future privatizations (R$3.4 billion). While this package will help RJ deal with its cash pressures in 2017, additional measures will be needed to finance large expected deficits in 2018 and 2019. Absent reforms to curb the structural growth of salaries and pensions, a large fiscal gap will remain and a new package will be needed in 2020.

Rio Grande do Sul

High spending on pensions and personnel have become structural problems in RS. Booming spending on social security is the main obstacle for the sustainability of public finances in RS. The ratio of retirees and other beneficiaries to active employees is already very high at 1.3; and the projected deficit of the pension system for 2017 is estimated at R$9 billion. The unfavorable trend has also affected the quality of public services, as teachers and public servants are rushing to retire early given the uncertainty over the pension reform.

RS launched austerity measures earlier than other states. Facing a R$25 billion deficit projected for 2017–19, the RS government launched a first package of adjustment measures early in 2015, followed by additional measures in 2016. Administrative spending was cut by 20 percent, 9 out of 29 ministries were closed, and 9 foundations were terminated. RS also approved a ceiling on government spending on wages, capped at 70 percent of revenue. In relation to pensions, a ceiling on the value of benefits that can be cumulated was introduced, and a new complementary system was created for civil servants joining from 2015 onwards, implying full capitalization above a certain salary threshold. Benefits from this reform, however, will only be felt 20 years from now.

Revenue measures have also been part of the adjustment process. The list includes an increase in the inheritance tax, a hike of the state consumption tax (ICMS), and increases in telecom, fuel, electricity and alcohol taxes. The contributions to the pension system paid by the employees were also increased from 13.25 to 14 percent and the local authorities stepped up efforts to collect one-off revenues, recalled fiscal incentives, and encouraged early repayment of tax debt.

A short-term rescue package could stabilize the ongoing fiscal crisis in RS but structural measures will be necessary for medium-term sustainability. To close the R$9 billion financing gap in 2017, the rescue package being negotiated between the FG and RS will involve a mix of financing and belt-tightening measures. This package will probably include an extension of the grace period on debt-service to the FG for another 3 years, generating about R$4 billion in (temporary) savings. The rest should come from loans with federal-guarantees against a future sale of assets, mainly SOEs in the energy sector (electricity, mining, water and gas). But structural fiscal reforms will be needed to ensure long-term sustainability. While the increase in the contribution rate was useful, it will not be sufficient to guarantee pension system sustainability. The minimum retirement age proposed for the FG level, if approved, should be extended to military and security personnel at state level to provide fuller relief. However, legislation to alter the structure of teachers’ careers and introduce longer contribution periods before retirement is also necessary.

Policy is Heading in the Right Direction

13. Various aspects of Brazil’s policy framework have been strengthened or have improvements in prospect,2 including:

  • Expenditure Cap. In December 2016, Congress passed a constitutional amendment imposing a ceiling on federal noninterest spending; this ceiling will be indexed to the rate of consumer price inflation of the previous year (measured in June). The reform includes provisions that would trigger a series of corrective measures in case of breach of the rule. This rule will be in effect for 20 years, with an opportunity to modify the ceiling’s indexation mechanism after the first 9 years.3 This ceiling lays the basis for gradually exiting a period marked by primary fiscal deficits and very large increases in public debt. With this constitutional limit, noninterest expenditure will decline as a share of GDP in the medium term as long as nominal GDP growth exceeds consumer price inflation.

  • Fiscal Sustainability. The government aims to restore fiscal sustainability by gradually bringing primary balances toward surplus territory, with the support of the constitutional expenditure ceiling and social security reform. For 2017, the authorities aim to bring the primary deficit to −2.1 percent of GDP. They have introduced adjustment measures of 0.9 percent of GDP, including cuts in discretionary spending of 2/3 percent of GDP and a partial roll-back of payroll tax exemptions. Other measures under consideration include selected privatization operations, such as the sale of Caixa’s lottery and insurance businesses. For 2018, the primary balance target improves slightly to −1.8 percent of GDP.

  • Monetary Policy. Communications from the central bank have become more transparent, putting more emphasis on the balance of risks and providing more guidance on the monetary policy stance. The tolerance range for inflation was narrowed for 2017 and 2018.

  • Credit Markets. The role of subsidized credit is being reduced. In particular, the government has announced the gradual phase out of the TJLP, a subsidized interest rate fixed by the National Monetary Council, and its replacement with the TLP, a market-linked interest rate. The role of the BNDES is being adjusted in line with this new policy direction.

  • Labor Market. A draft labor reform in Congress would give priority to firm/union agreements over legislation in selected aspects of labor relations, and increase the scope for part-time employment. A recently approved law allows an unrestricted outsourcing of labor, including that related to firms’ core activities (Box 4).

  • Other Reforms. Petrobras is continuing its turnaround based on a cutback of expansion plans, a selective divestment strategy, and a new pricing policy for domestic products guided by import parity. Reforms to improve regulation, the business environment, and to lower red tape have also been announced. The government is standardizing foreign trade procedures, simplifying tax refunds and payments of labor and tax obligations, and improving the positive credit registry. Improvements in the bankruptcy procedure (a new law) will empower creditors, incentivize extrajudicial recovery, and strengthen acquirers’ rights (Selected Issues Paper). In addition to the expanded list of infrastructure projects, the government announced changes to concession rules and the role of regulatory agencies.4 Under the infrastructure concessions program, four airport concessions were auctioned off to foreign bidders.

Labor Regulation and the Proposed Reform

Labor reform discussions in Congress center on a proposed reform to labor relations. The draft law (6787/16) gives agreements reached between workers’ representatives and employers precedence over labor legislation in about a dozen areas concerning working day and salary. It regulates the workers’ representation at the firm level, while introducing flexibility with respect to industrywide legal regulations. The legislation would be made more flexible by allowing companies and employees to negotiate the weekly work schedule within certain limits, enabling workers to take annual leave in up to three installments, and broadening the modalities for part-time employment, among other issues. The new provisions could facilitate an increase of temporary work and may also help increase labor force participation. However, it is less clear what the ultimate effect on aggregate employment will be.

The reform also discourages excessive litigation. The backlog of pending cases before labor courts is very high by international standards, and lower courts’ decisions are often unpredictable. The reform aims at reducing the judicialization of labor relations, inter alia, by regulating how much the losing party should pay for litigation costs. The reforms, however, do not reduce employment protection, which is high in Brazilian law, nor do they change the minimum wage indexation formula.


Employment Protection Legislation Index, 2013: Temporary Contracts

(Scale 0–6, from least to most restrictive)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: OECD and EPL database.

The outsourcing framework is also being modified. Previously an area ruled only by jurisprudence, a new (recently enacted) law now defines the scope for outsourcing of activities. This law allows firms to outsource any activity, including core ones. The law does not require that outsourced jobs have the same benefits as those that remain on payroll, even if the jobs are equivalent.

Outlook and Risks

14. A subdued recovery is expected, although this baseline is subject to an elevated degree of uncertainty brought about by the difficult political situation. Real economic growth is expected to turn positive in 2017, helped by a recovery in the terms of trade, a generally supportive external financial environment for emerging markets, stronger agricultural production as a result of favorable weather conditions, a boost to consumer spending from households’ withdrawals of FGTS accounts, and monetary policy easing.

  • Staff project output growth of 0.3 percent in 2017 (with positive quarterly growth offsetting the negative carryover from 2016) and 1.3 percent in 2018. A more rapid recovery seems unlikely in the near term, given still high levels of government, corporate, and household leverage, significant excess capacity, high unemployment, and a resurgence of political uncertainty.

  • Credit is expected to recover broadly in line with activity, albeit with a lag, and over the medium term to grow again as a ratio to GDP as financial deepening resumes. Banks are expected to maintain high profitability as their funding costs continue to fall, despite pressures on asset quality.

  • Inflation is expected to undershoot the midpoint of the target band in 2017 and 2018, reflecting excess supply conditions and moderate food-price inflation. Unemployment is projected to peak in late 2017 as job creation lags growth. In this context, youth unemployment of about 25 percent is especially worrisome.

  • The baseline assumes that the governments’ proposed pension reform is delayed some months as a result of the political crisis, but is ultimately approved without major additional dilution, and the constitutional expenditure cap is observed.

  • The current account deficit is expected to stabilize at around 2 percent of GDP as demand recovers. The resumption of growth in Brazil will have beneficial spillovers on the economies of its Mercosur partners.

15. Brazil has limited space for a growth-supportive fiscal expansion, as evidenced by the DSA. The level and trajectory of debt and gross financing needs raise significant risks. In the baseline scenario, involving implementation of reforms already underway, debt keeps rising to about 92½ percent of GDP in 2022/2023, and only starts declining in 2024.


Baseline with Expenditure Rule


Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: Fund staff estimates.

16. Risks are dominated by political factors, including uncertainty on the continuity of the government and its policies (Appendix I).

  • A major domestic risk relates to political instability and spillovers from the corruption investigations, as illustrated by the current turmoil, and renewed policy uncertainty in 2018 as general elections approach. If corruption investigations spread to the financial sector, for example, banks could face liquidity pressures (as illustrated by the experience of BTG Pactual in late 2015). This could spark a sharp tightening of financial conditions that could delay the recovery.

  • A key domestic policy risk in the near term is a failure to enact social security reform, or considerable additional dilution of this reform in Congress, possibly resulting from new political developments. This failure would put the fiscal consolidation at risk and could prompt another round of sovereign downgrades. In the near term, markets would react negatively and confidence gains would be reversed, tipping the economy back into recession. Lack of reform would also raise the need for additional fiscal measures to finance growing expenditure pressures over time, ultimately resulting in a rising tax burden, with adverse implications for medium term growth.

Scenario: No Consolidation

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  • The key external risk emanates from a significant slowdown in China and persistent slow growth in major advanced economies. A slowdown in China could depress commodity prices and prompt a repricing of risk in global financial markets, with negative implications for Brazil. Similarly, persistent slow growth in major advanced economies would be a serious drag on prospects for Brazil. In addition, a shift in U.S. policies could lead to a further strengthening of the U.S. dollar and/or higher dollar interest rates, which could ultimately hamper the recovery in domestic expenditure. The various domestic downside risks could combine and feed on each other, especially if they were to coincide with the materialization of external risks.

  • There are upside risks as well. Agricultural output in 2017 could prove stronger than expected; households could consume more of the proceeds from their FGTS accounts than currently envisaged; and domestic demand could be stronger if monetary easing spurs faster deleveraging by households and firms. But these upside factors are unlikely to be sustained if political uncertainty remains elevated.

Policy Discussions

The authorities’ policy efforts are appropriately focused on an ambitious strategy of reform in the fiscal sector, aimed at securing the sustainability of the public finances and social security. The pace of fiscal adjustment should, however, quicken when economic recovery strengthens on a sustainable basis, anchored by greater clarity on the measures that will help deliver the adjustment. Monetary policy can turn accommodative given the slack in the economy and the ongoing process of disinflation. Structural reforms are needed to support strong and inclusive growth over the medium term. Corruption has proven costly for Brazil; going forward, improving governance, increasing transparency and strengthening institutional frameworks will help secure strong, durable and inclusive growth.

A. Policies to Ensure Fiscal Sustainability

17. The decision to address spending pressures is welcome, and is a key element of the medium term fiscal strategy. The government aims to restore fiscal sustainability by controlling spending growth and gradually increasing primary balances over the next several years. (In fact, their framework has both a spending cap and primary balance objectives.) Staff projects the NFPS primary balance returning to surplus in 2021 (official fiscal targets see a primary surplus in 2020). Improving primary balances, in combination with a return to growth and a fall in real interest rates from the heights of recent years, would contribute to a gradual stabilization of the trajectory of public debt.

18. An ambitious social security reform bill is being discussed in Congress. This reform is needed to ensure the long-term viability of the social security system. It would also be important in supporting compliance with the expenditure ceiling because social security spending exceeds 40 percent of federal government primary spending. The reform would also help tackle fiscal pressures in states, given high pension spending at the subnational level.5 The reform is crucial due to the system’s large and rising cash and actuarial imbalances arising from increasing dependency and replacement ratios. The linchpin of the proposed reform is a higher mandatory retirement age (with some transition rules) and an effective reduction in replacement ratios. The government’s initial reform proposal aimed to stabilize social security spending as a percent of GDP for the next decade at least, implying savings of some 2 percent of GDP a year by 2026 relative to a no-reform scenario. Moreover, by unifying the rules governing the public and private pension systems, it would reduce inequalities arising from the relatively large benefits granted by some of the schemes for government employees, who already command a premium on their salaries (Selected Issues Paper). The version of the reform negotiated in Congress retains the most important elements of the original proposal, and is estimated by the government to generate 75 percent of the savings intended in the original proposal over its first 10 years. Given the negotiated transition rules, the amounts saved would gradually rise over time; in 2022, for example, the reform would save 0.7 percent of GDP relative to no-reform projections. However, the approval of the reform has been delayed and remains at risk in the current political environment.


Pension Expenditure

(2014 or latest avalable estimate)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: World Development Indicators and Fund Staff estimates based on a sample of about 100 countries.

19. The government faces challenges meeting its fiscal targets in the near term. Expenditure containment measures will likely be needed in 2018 if, as widely expected, CPI inflation comes in well below 4 percent in June 2017 (this parameter defines the 2018 expenditure ceiling; see Table 3). Quick yielding measures for 2018 could include a hiring freeze and a reduction in financial and credit subsidies, in addition to the start of pension reform. Given continuing weakness in revenue (Box 5), efforts are also likely to be needed to meet primary balance targets in 2017 and 2018, which currently depend on deep cuts in discretionary spending and one-off revenues. Revenues could be mobilized through asset sales (already under consideration for 2017) and by rolling back tax breaks.

Table 1.

Brazil: Selected Economic Indicators, 2015–22

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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 2017 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.

Q1 2017 only.

Table 2.

Brazil: Balance of Payments, 2015–22

(In billions of U.S. dollars, unless otherwise indicated)

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

Historical numbers include valuation changes.

Table 3.

Brazil: Main Fiscal Indicators, 2015–22

(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 and the social security system.

Total primary expenditure is the sum of current (on trend) plus capital (on trend) expenditures, minus unallocated cuts to meet the ceiling.

Excluding Petrobras and Eletrobras.

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

The ceiling excludes from total primary expenditures of the federal government in constitutional fund for Brasilia DF, extraordinary credit,; electoral lawsuits, complement to Fundeb, and equity increases in public companies.

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).

20. Medium-term consolidation will demand intense fiscal effort. Under current plans and policies, primary balances will improve relatively slowly and the public debt-to-GDP ratio would only begin to decline many years from now, posing significant risks, especially if the economic environment turns less favorable. This underscores the importance of speeding up fiscal consolidation, beyond what is currently planned, when growth strengthens on a sustainable basis; predicated on a firm return to growth in 2018, additional measures of the order of 1–2 percent of GDP introduced over time would make sure the debt-GDP ratio starts declining already in 2020 and peaks 9 points of GDP below the peak in the baseline projection. Moderate and well-chosen revenue measures would be useful to accelerate the fiscal adjustment, including the rollback of the remaining payroll tax exemptions. Other fiscal measures that should be considered by the current and any future government include:

  • Medium-term fiscal planning. A rolling medium-term fiscal framework would be useful to clarify and update the governments’ goals for debt stabilization.

  • Mandatory spending. Although essential, social security reform will not be enough to meet the expenditure ceiling over the next several years (Table 3), as its full benefits will be felt over longer horizons. Additional measures should include a change in the minimum wage indexation formula, which is a key driver of social security and other benefit spending, and the revision of allowances for civil servants. Going forward, wage increases for civil servants above inflation should be avoided. A medium-term budget framework would support policy credibility through the identification of expenditure policies that could be rolled out over time to keep the budget consistent with the ceiling without the need for triggering the automatic corrective spending cuts foreseen in the constitution.

  • Subnational finances. The new framework to provide temporary debt relief to states in crisis in exchange for their implementing a series of fiscal measures is a step in the right direction. However, in the worst-hit states, this framework will likely fall short of restoring sustainability. Hence, it will be necessary to continue to work toward pension reform, wage restraint, and ambitious deficit reduction objectives at the subnational level. Also, efforts to increase fiscal transparency in subnational governments, such as the use by all states of common accounting standards as currently planned, need to continue, while close attention is needed in monitoring municipal finances.

  • Other reforms. The creation in 2016 of the Independent Fiscal Institution (IFI), attached to the Senate, is an important step to promote fiscal transparency and enhance the debate on fiscal policy in Congress and society. At all levels of government, the improvement of fiscal forecasts would strengthen the budget process. Even with the new DRU, large budget rigidities, including revenue earmarking and high mandatory spending, remain in place and need to be addressed with a sense of urgency.

Scenario: Recommended

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Tax Revenues and the Economic Cycle

Tax revenues contracted more than GDP during the recent economic recession. Tax elasticities have fallen below 1 after the financial crisis according to some (Ribeiro, 2016). A possible explanation is a high dependence of tax revenues on wages and sales, which have shrunk disproportionally during the recession (Goldfajn, 2016). Compliance issues have contributed to tax revenue contraction beyond what can be explained by the decline in the GDP during the crisis (Brondolo, 2009). Will tax revenues return to their pre-crisis level when the economy rebounds, and how fast?


Tax Collection and Real GDP Growth


Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Ministry of Finance; and Fund Staff estimates

The experience of other countries provides evidence of incomplete recovery of tax revenue ratios in the first two years following a crisis. In a panel of 78 countries over 1997–2014, 32 episodes of cumulative real GDP contractions of at least 2 percent over two consecutive years associated with declining revenues-to-GDP were identified. The average cumulative GDP contraction in the sample was 5.3 percent over the crisis period, while the average decline in the tax revenue ratio was about 1.6 percentage points of GDP. In the first year of the recovery, tax revenue-to-GDP climbed back to the pre-crisis level in only a few countries. The average gap compared to the pre-crisis level of taxes amounted to 1.3 percentage points of GDP. In the second year after the crisis, the distance to the pre-crisis tax revenue ratios was smaller, although still negative in the large majority of cases (0.7 percentage points of GDP).

As Brazil enters the recovery phase, a cautious approach to revenue projections is warranted in the years ahead. While in a small number of countries tax revenue ratios have surpassed pre-crisis levels rapidly, country-specific circumstances and changes in tax policies and administration may have played a role. In most cases, incomplete and delayed recoveries in tax ratios may have stemmed from lags in collections due to tax credits accumulated during the downturn, structural changes in the economy affecting the tax base, and changes in the external environment.


1st Year Post Recession: Revenue-to-GDP Gap

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Sources: WEO and Fund staff estimates.
Sources: Goldfajn, I., 2016, “Tax Revenues in Brazil Declining Faster than GDP,” Itaú Op-ed, February 11, 2016; (ITAU) Ribeiro, L., 2016, “Nota Tecnica Sobre Arrecadacao e Atividade Economica,” FGV-IBRE, Janeiro 2016 (IBRE); Brondolo, J., 2009, “Collecting Taxes During an Economic Crisis,” IMF Staff Position Note, SPN/9/17 (IMF).

B. Policies to Consolidate Disinflation Gains and Credibility

21. The current pace of monetary easing is broadly appropriate. While there is significant uncertainty about the level of the “neutral” interest rate (Box 6), significant excess supply and below-target inflation expectations suggest an accommodative policy stance is warranted to mitigate risks of undershooting the central target for too long.6 Calibrating the pace of reduction in policy rates in the present environment of heightened uncertainty is unusually challenging. The central bank should continue to reassess the pace and extent of the easing cycle considering the evolution of inflation and expectations, market signals, external conditions, and the prospects for the success of fiscal reforms.

22. There remains scope to improve the central bank’s credibility. In the context of falling inflation, the possibility of lowering the inflation target for 2019 is being debated. This would bring the inflation target closer in line with targets observed internationally. Nevertheless, when considering this move, policymakers should take into account that adopting a substantially lower target could reduce the space for monetary easing in the period ahead. Notwithstanding any changes to the inflation target, there is still room to improve the inflation targeting framework. This includes the specification of a well-defined, medium-term target, strengthening the Central Bank’s independence, and the publication and discussion of fully endogenous inflation and policy rate projections (Selected Issues Paper).

23. The exchange rate should remain the main external adjustment variable. Brazil’s substantial international reserves are a source of strength. Intervention, including through foreign-exchange swaps, should remain limited to addressing disorderly market conditions, such as those observed in mid-May. Brazil’s comfortable reserve holdings could in principle provide space to intervene, and much discussion has been devoted at various points in time to ideas such as selling reserves to buy back public debt. However, given the limited cost of holding reserves, and the small stock effects of operations of that type that can be undertaken without risking market scares, the authorities should resist again any future pressures to use reserves for ad-hoc purposes such as financing public investment or repaying public debt.

C. Policies to Strengthen the Financial System’s Resilience

24. The banking sector has weathered the recession well, and ongoing efforts to bolster its resilience should continue. Banking sector soundness indicators improved in 2016 as shocks to funding dissipated, interest margins rose, and non-performing loans moderated. From a structural perspective, it would be important to conclude actions aimed at strengthening financial safety nets further by enhancing the central bank’s ability to provide emergency liquidity assistance and implementing the new resolution regime for banks. These steps would strengthen the authorities’ capacity to deal with liquidity and solvency shocks. As recommended in the previous Financial Sector Assessment Program (FSAP), a committee with an explicit mandate for systemic risk monitoring should be established, and a mandate should be given to a separate entity to set up a crisis management framework. Banks that consistently fail the stress tests performed by the Central Bank should be required to raise additional capital or, if they are state-owned, they should be recapitalized or allowed to retain profits to boost their capital (this is not expected to be a significant source of fiscal risk).

The Neutral Real Interest Rate

The neutral real interest rate is always important but always uncertain. It is the real interest rate consistent with an economy’s long-run equilibrium, when inflation is at target and the effects of all other cyclical shocks have past. As such, the neutral interest rate is of great importance when formulating monetary policy decisions, governing the policy stance in the short term and determining the appropriate level of interest rates over the long term. It is also an important determinant of government debt dynamics over the long term and thus fiscal policy decisions. Unfortunately, the neutral real interest rate is unobservable and notoriously difficult to estimate in real time. For example, estimates of the neutral real interest rate for Brazil based on a variety of time-series and economic models exhibit a large degree of dispersion, ranging from around 3 percent to around 9 percent. A medium-term equilibrium real rate around 5.5 percent was consistent with the sovereign yield curve observed during much of 2017-H1, right up to the mid-May rise in market volatility.


Real Interest Rate and Estimates of the Neutral Real Interest Rate 1/


Citation: IMF Staff Country Reports 2017, 215; 10.5089/9781484309896.002.A001

Source: Fund estimates.1/ The real rate is the Selic less 12-month ahead inflation expectations from the Focus survey. The medium-sized model is a semi-structural New Keynesian model. The small model is similar to Laubach and Williams (2003) (the median and 10th and 90th percentiles are displayed). HP filter is the trend real rate estimated using a standard HP filter. HP filter* is the trend real rate estimated with a larger-than-standard smoothing parameter (10,000).

Brazil’s central bank has recently emphasized heightened uncertainty about the neutral interest rate. In recent communications, the central bank has noted that the magnitude and pace of the monetary easing cycle currently underway is conditional on estimates of the structural (neutral) interest rate and that greater progress on fiscal reform could increase the scope for monetary easing (Selected Issues Paper). Intuitively, improving the fiscal policy framework could contribute to a reduction in risk associated with Brazil and eventually lead to reduction in interest rates over time.

Given heightened uncertainty, the central bank should closely monitor and reassess its estimates of neutral real interest rates as the easing cycle progresses. Over time, underestimating/overestimating the level of neutral real interest rates will cause the policy stance to be tighter/looser than intended and eventually lead to unexpectedly low/high inflation and inflation expectations. Thus, to avoid policy reversals, careful monitoring of inflation developments is warranted.

Neutral Real Interest Rates Implied by Covered Interest Parity 1/

(Annual percent)

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Source: Fund estimates.

Staff’s assessment is that Brazil’s real-effective-exchange rate is overvalued by around 10–15 percent. Assuming this overvaluation is corrected gradually over a 5-year period and the U.S. real interest rate settles somewhere between 2–3 percent, Brazil’s real neutral rate would be somewhere between 5–7 percent, according to covered interest parity. Note: A risk premium is added, based on the average spread between the overnight dollar rate in Brazil and the LIBOR.

25. Efforts to reduce distortions in credit markets are welcome. Replacing the TJLP with a market-determined rate, linked to government bond yields as currently scheduled, will contribute to phasing out credit subsidies and improving monetary policy transmission. Efficiencies will also be gained by revising the earmarking of saving deposits for mortgages and agriculture credit, as is under discussion. The Central Bank’s plans to promote the reduction of banking sector spreads, including by simplifying reserve requirements, implementing a positive credit bureau, and establishing a centralized market for receivables are welcome. A reform of the bankruptcy framework is underway; its early conclusion would help expedite the bankruptcy process and reduce creditors’ default losses, which should in turn facilitate the financing of capital investment.

D. Policies to Strengthen Medium-Term Growth

26. Convergence of per capita income between Brazil and advanced economies has stalled in recent years, largely reflecting Brazil’s relatively weak productivity performance. Over the last 10 years, annual labor productivity growth in Brazil has averaged about 1 percent, considerably below the growth rates experienced by other countries at a similar stage of development.7 Recent policy efforts will increase labor market flexibility, but even after the reforms the labor market would remain highly regulated relative to other emerging markets. The economy is relatively closed, with average tariff rates above those of peers and relatively high non-tariff barriers, including onerous domestic content requirements, which limits the productivity-enhancing effects of trade. Other constraints that hamper productivity and growth in Brazil include a highly complex tax system and inadequate infrastructure, particularly in the area of transport.

27. Structural reforms targeted at reducing the costs of doing business, enhancing efficiency, and fostering investment are essential to raise potential growth over the medium-term. The policies that can be pursued at present are conditioned by the need to respect tight fiscal constraints and to avoid interfering with the exit from recession and aggravating already high unemployment. The government’s productivity agenda includes the revision of local content rules, trade facilitation, and steps to reduce red tape. Other key areas are:

  • Opening the economy. Reducing tariffs, especially on capital goods, and eliminating non-tariff barriers to trade, including frequent resort to anti-dumping, would enhance efficiency and boost potential growth (see Selected Issues Paper). Likewise, pursuing free-trade negotiations would help increase competition and foster productivity gains.

  • Tax reform. The authorities should move forward with plans to simplify the federal tax system, beginning with the PIS/COFINS, which has a complex base, and continue to work toward harmonizing federal and state tax regimes, with a view to reducing taxpayer compliance costs, which are very high in Brazil, and improving resource allocation and productivity (see Selected Issues Paper).

  • Labor market. Ongoing reforms to increase labor market flexibility and reduce excess litigation in labor courts are welcome. The flexibility can reduce labor market informality among the poor; still, the potential impact on formal labor market duality needs to be watched. Adaptations in the tax code may be needed to limit adverse side effects on fiscal revenue.8 Other reforms, pertaining, for example, to labor protection regulations, can be considered once the economy is on a stronger footing and should be accompanied by policies to support individuals going through unemployment.

  • Infrastructure bottlenecks. The infrastructure concessions program is critical to alleviate supply-side constraints limiting medium term growth and boost competitiveness.9 Ongoing efforts to make the program more attractive to investors while maintaining high standards of governance and program design are welcome. A successful concessions program will, additionally, have a positive effect on the pace of the recovery.

28. Improving governance, increasing transparency and strengthening institutional frameworks is needed to help secure strong, durable and inclusive growth in Brazil. Historically, corruption has been facilitated by a lack of transparency, notably regarding beneficial ownership of companies and public procurement, and weaknesses in interagency information sharing, international cooperation, and criminal justice. However, efforts to pursue significant corruption and money laundering cases have become more successful following recent legal reforms such the anti-corruption law and the introduction of plea bargains in 2013 (Box 1). Ongoing work to update the definition of politically-exposed persons (PEPs) should make it more difficult to hide illicit assets. The use of transparency measures such as the Transparency Portal to prevent corruption is also to be commended. Going forward, authorities are encouraged, inter alia, to:

  • Continue pursuing significant corruption and money laundering cases, and work with the legislature to adopt relevant pending reforms to further strengthen the anti-corruption and anti-money laundering framework. This includes strengthening whistleblower mechanisms, provisional measures and confiscation, and the prevention of abuse of appeal provisions and statutes of limitations in legal proceedings.

  • To make it more difficult to hide illicit assets, follow-up on existing ENCCLA (National Strategy Against Corruption and Money Laundering) action items regarding (i) interagency sharing of tax and banking information, including to prevent abuse of tax-repatriation provisions for money laundering, (ii) the effective implementation of beneficial ownership requirements, and (iii) the enactment of international cooperation tools to facilitate detection and repatriation of funds channeled abroad.

  • Continue to populate the Transparency Portal, and similar publicly accessible websites such as Compras Governamentais (“Government Purchases”) and the Brazilian open data portal, with data that assist to prevent and disclose corruption (including data related to public procurement, budgets and expenditures).

Authorities’ Views

29. The authorities see evidence that economic growth has resumed. They indicated that growth has turned positive in the first quarter of 2017, helped by strong agricultural production. The authorities generally agreed with staff that the weak labor market is likely to slow the recovery in private consumption, although increased access to FGTS will provide a one-off boost to private spending. They were optimistic about the prospects for investment, citing its behavior following previous recessions in Brazil and the ongoing monetary easing cycle. The Ministry of Finance projects growth of 0.5 percent in 2017 and 2.5 percent in 2018. In their view, passage of pension reform is likely and could provide significant upside risks to the recovery. Moreover, while recognizing the increase in uncertainty in recent weeks, they stressed their belief that the program of structural reforms was likely to be carried forward under the most probable scenario.

30. The authorities emphasized that social security reform is a crucial step towards ensuring fiscal sustainability. They explained that the negotiations in Congress had preserved the bulk of the savings anticipated in the initial formulation of the reform, and had enshrined principles that would underpin a more sustainable social security system, including a minimum retirement age. They also stressed that this reform would be an increasingly important factor in the effort to comply with the federal spending ceiling. Nevertheless, they agreed that further mandatory spending cuts, including the reform of military pensions, would be needed to ensure the ceiling is observed over the medium term. They noted that it would be premature to focus on identifying and enacting specific additional measures before the social security reform is approved. In fact, a large part of this work would have to be carried out by the next government, which would have the duty of issuing a multi-year fiscal plan for the 2019–22 period. That said, the authorities indicated that they are working on the design of a new medium-term fiscal framework.

31. While noting that a faster fiscal consolidation would be desirable if the economy recovers strongly, the authorities acknowledged fiscal space is limited and that further measures may be necessary to observe their primary balance objectives in the near term. The authorities noted that the delay in the recovery had necessitated a downward adjustment of revenue projections for 2017 and 2018. In turn, this called for the identification of measures to ensure the 2017 primary balance target is attained, and for a revision of the 2018 target. They stressed that to generate savings cutting discretionary spending would not be enough. Thus, they were cutting back on new hiring, reducing some mandatory spending, for example, by preventing abuses in the sickness support program, and going through a review of spending programs to identify additional savings. While observing that some one-off revenues could be mobilized, they explained that it would be harder to increase recurrent revenues, given the already high tax ratio in Brazil. Recurrent revenue measures could be considered if needed to meet primary balance targets, and provided they did not introduce new distortions. Additionally, some savings in the interest bill (with no impact on the primary balance, but with beneficial effects on the trajectory of debt) would come from declining subsidies to BNDES as the TJLP is gradually phased out and replaced with the market-linked TLP. The authorities highlighted that the new fiscal recovery regime for the states would create incentives for those in financial trouble to undertake significant fiscal adjustment and increase transparency.

32. The Central Bank indicated that there was still room for the easing cycle to continue. They noted that disinflation, although led by favorable food price trends, is broad-based, and reflects significant excess capacity in the economy and subdued inflation expectations. In this context, monetary policy could adopt an expansionary stance, implying further cuts in the policy interest rate. They stressed, however, that there is some uncertainty attached to the estimation of the equilibrium real interest rate, which defines a neutral stance. They noted that the evolution of this rate depended on continued progress on fiscal reform, which would for that reason be an important determinant of the pace and extent of the easing cycle. Additionally, the authorities noted that they were working to improve the monetary policy framework, including gradually replacing the TJLP with the TLP, among other actions. The National Monetary Council will decide on the 2019 inflation target at the end of June.

33. The authorities agreed that the flexible exchange rate is a key shock absorber, and emphasized that interventions through FX swaps and FX repos have aimed at smoothing excess volatility during episodes of market stress. They added that interventions had not affected the direction of movements determined by the market. In that connection, they broadly agreed with staff’s assessment of the external position and noted that the real appreciation observed through 2016 and early 2017 was consistent with improving fundamentals. They emphasized that high international reserves, together with their policy of reducing the stock of swaps during last year, placed them in a strong position to face new shocks, as evidenced by their ability to respond to turmoil in the exchange market in mid-May.

34. The authorities emphasized that the resilience of the banking system has been proven in the recession. Furthermore, new legislation is being drafted to strengthen further the effectiveness of the framework for monitoring and managing risks. The authorities expect that the new resolution framework, consistent with the FSB’s key attributes of effective resolution regimes, will be enacted this year. Several other improvements in the framework are being implemented under the BC+ agenda.

35. The authorities acknowledged the need to improve the business environment and enhance competitiveness, and are confident that ongoing and planned actions can boost potential growth. They are of the view that the recently revamped infrastructure concession framework and the associated regulatory changes would facilitate private sector participation in priority investment projects. They also noted that domestic-content rules had already been relaxed in the oil and gas sector, and that additional reforms of similar rules were planned for BNDES’ lending and government procurement. They saw merit in reducing tariffs and in pursuing new free-trade negotiations to help increase competition and efficiency. The authorities also plan to undertake a simplification of indirect federal taxes (PIS-COFINS), which are exceedingly complex, affecting compliance costs. Labor reforms (some of which are still before Congress) would reduce costly litigation and facilitate formalization of labor, and a new bankruptcy framework would support the financing of investment by enhancing creditor rights. While some of these initiatives are ongoing, some will require legal reforms that would need to be taken up after social security and labor reforms are concluded. Based on these reforms, the authorities hold a positive view on the medium-term prospects for growth.

36. The authorities agreed that transparency and anti-corruption measures are an important part of the effort to improve long-term prospects for Brazil. They noted their efforts to pursue significant corruption and money laundering cases, and the creation of the Transparency Portal, which would be useful in the prevention of corruption. They stressed their intention to continue to strengthen governance and transparency.

Staff Appraisal

37. Brazil must forge ahead with its reform agenda in the context of an uncertain environment. Fiscal sustainability has not yet been secured, and Brazil has limited fiscal space for an expansionist policy. The government’s policy efforts are appropriately focused on an ambitious strategy of consolidation and reform in the fiscal sector, aimed at securing the sustainability of the public finances and social security. However, the pace of fiscal adjustment under current plans is relatively moderate, allowing debt ratios to remain high for a prolonged period. This underscores the importance of speeding up fiscal consolidation, beyond what is currently planned, when growth strengthens on a sustainable basis.

38. Social security reform is key for fiscal as well as social reasons. This reform is essential to ensure that the core of Brazil’s social protection system can remain viable in the long term. Also, social security reform is an important element in the strategy to restore fiscal sustainability, and more concretely, to meet the constitutional ceiling on expenditure. It is of vital importance that Congress approves this reform.

39. Additional expenditure and revenue measures should be considered by the current and any future government. Social security reform will not be enough to ensure that the expenditure limit is met over the medium term. The authorities are encouraged to introduce a rolling medium-term fiscal framework to further clarify the governments’ goals for debt stabilization, as well as a medium-term budget framework, which would support policy credibility by identifying expenditure measures and policies to keep the budget consistent with the ceiling in coming years. Moderate and well-chosen revenue measures would also be useful to accelerate the fiscal adjustment.

40. The current pace of monetary easing is broadly appropriate. Significant excess supply and below-target inflation expectations suggest an accommodative policy stance is warranted. The pace and extent of the easing cycle should be reassessed considering the evolution of inflation and expectations, market signals, external conditions, and prospects for fiscal reforms.

41. Staff welcomes the use of the exchange rate as the first line of defense against shocks. Brazil’s external position in 2016 was on average broadly consistent with medium-term fundamentals and desirable policies. Brazil’s substantial international reserves are a source of strength. Intervention in foreign exchange markets should remain limited to episodes of disorderly market conditions, and reserve buffers should be preserved.

42. Efforts to bolster the resilience of the financial sector should continue. It is important to conclude actions aimed at strengthening financial safety nets further by enhancing the central bank’s ability to provide emergency liquidity assistance and implementing the new resolution regime for banks. A committee with an explicit mandate for systemic risk monitoring should be set up. A mandate should also be given to a separate entity to set up a crisis management framework. Banks that consistently fail the stress tests performed by the Central Bank should be required to raise additional capital or, if they are state-owned, they should be recapitalized.

43. Structural reforms targeted at enhancing efficiency and fostering investment are essential to raise potential growth over the medium term. Staff encourages the authorities to follow through on their plans to strengthen the supply side of the economy to increase efficiency and productivity. Improving the allocation of scarce resources by the financial system through the reduction of subsidized credit and the reform of BNDES are also important elements in this drive. Without such measures, medium-term growth could disappoint.

44. Ongoing efforts to combat corruption are of the highest importance. Corrupt practices undermine economic and political institutions. Corruption has caused the country to go through a protracted period of elevated uncertainty, affecting economic activity and reducing the ability of consumers and firms to plan for the future. It is vital for Brazil to strengthen governance and further implement transparency, anti-corruption and AML measures.

45. 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, 2011–16

(In billions of reais, end-of-period)

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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, 2014–22

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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.