Brazil: Staff Report for the 2018 Article IV Consultation—Debt Sustainability Analysis

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Brazil

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Brazil

Background

1. Definitions and coverage. The gross debt statistics of Brazil cover the non-financial public sector (NFPS), excluding the state-owned enterprises (SOEs) Petrobras and Eletrobras, and consolidate the Sovereign Wealth Fund. Following the GFSM 2014 manual, the NFPS debt includes all Treasury securities on the Central Bank’s (BCB) balance sheet.2 At end-2017, gross debt amounted to 84 percent of GDP. As reported by the government, net debt corresponds to the entire public sector, consolidating the BCB. The consolidated public sector has a large stock of assets, equal to 34.3 of GDP in 2017, which include international reserves amounting to 18.9 of GDP. Brazil’s debt is reported at nominal value.3

2. Debt profile. Federal government (FG) domestic tradable securities account for 92 percent of total NFPS gross debt, of which close to 2/3 is held by the public and the rest is held by the BCB.4 Nearly 1/3 of FG domestic tradable securities are fixed income securities, 1/3 are linked to inflation, and 1/3 are linked to the SELIC rate. Zero coupon bonds with original maturities over one year constitute slightly more than half of FG domestic tradable securities held by the public. About 17 percent of FG domestic tradable securities will mature in 2018. Foreign currency denominated NFPS debt accounted for only 4.3 percent of GDP. Gross financing needs have been consistently above 15 percent of GDP; however, a large fraction of the federal government debt (about 33 percent of total) is held by BCB, following a policy of automatic rollover.

3. Debt developments. At the end-2017, Brazil’s NFPS gross debt amounted to 84 percent of GDP, 5.5 percentage points higher than a year before. Public sector net debt amounted to 51.6 percent of GDP. A primary deficit of 1.7 percent of GDP and net interest payments of 6.1 percent of GDP contributed to the increase in gross debt. Net interest payments were slightly lower than the value recorded in 2016 (6.5 percent of GDP), reflecting declining premia and lower Selic. Average maturity of FG securities edged down slightly to 4.3 from 4.5 years in 2016. In September and October 2017, the national development bank (BNDES) repaid R$50 billion in outstanding government securities to the Treasury, which resulted in the proportional decline in NFPS assets of 0.7 percent of GDP. An additional repayment of 130bn reais in 2018 is mandated and will contribute to lowering the stock of gross debt of up to 2 percent of GDP.

A03ufig1

Baseline with Expenditure Rule

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Sources: Fund Staff estimates.

Baseline and Realism of Projections

4. Macroeconomic assumptions. The projections assume real GDP growth of 1.8 percent in 2018, and a gradual return to potential growth of 2.2 percent by 2020. The primary balance moves into positive territory in 2022 (0.1 percent of GDP) and the cumulative adjustment is of about 3 percentage points of GDP during 2018–23. Nominal interest rates on new borrowing are between 6.6 and 10.7 percent over the projection horizon, bringing the effective interest rate to about 8.9 percent on average.5 The baseline scenario assumes limited structural reforms and favorable external conditions. Gross debt remains on an upward trajectory, reaching 95.6 percent of GDP by 2023. If the expenditure cap remains in place until 2027, and the primary balance follows the same consolidation path, debt peaks in 2023 and starts falling in 2024. The timing of the debt peak is sensitive to variation in assumptions about the real interest rate and growth over the projection horizon. The debt stabilizing primary balance in the baseline scenario is 1.1 percent of GDP (excluding interest revenue).6

Large Fiscal Effort to Stabilize the Debt Ratio

A primary surplus of about one percent of GDP is needed to stabilize the gross debt-to-GDP at 95.6 percent in 2023. The table below reports the debt-stabilizing primary balance (DSPB) required to stabilize the gross debt-to-GDP at 95.6 percent for various combinations of real growth and real interest rates.1 Under the baseline scenario of 2.2 percent growth and 8.6 percent nominal effective interest rate in 2023, the DSPB is 1.1 percent of GDP. A lower primary surplus can only be sustained along higher real growth or lower real interest rates (or both), as shown in the shaded area in the table.

A03ufig2

Debt Stabilizing Primary Balance in 2023

(At 95.6 percent of GDP)

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Sources: IMF Staff calculations.

An adverse shock that pushes growth down or real interest rates up will require even higher DSPB. In an event that real growth falls (below 2 percent) and interest rates increase (above 8 percent), the primary surplus required to stabilize the debt-to-GDP level becomes large, above 2.0 percent of GDP and above.

1 The debt stabilizing primary balance is calculated using the formula: pb=d(1+g)(1+π)[iπ(1+g)g]intrev, where pb is the primary balance, d is gross debt in percent of GDP, i is the effective nominal interest rate, π is the inflation rate, g is real GDP growth, and intjrev is revenue from interest.

5. Debt profile risks. The stock of debt and the gross financing needs are high and volatile, mainly because of the repayment schedule of existing zero-coupon bonds. GFN breach the high-risk threshold of 15 percent of GDP through most of the projection period (Figure 1). This indicator, however, overstates the financing needs for two reasons. First, the actual rollover risk is overstated because of the BCB’s automatic debt roll over policy. Gross financing needs would be about 30 percent lower on average excluding rollover of BCB held bonds. Second, the interest on existing FG securities reported in the authorities’ overall fiscal balance (and used in the DSA) includes accrued interest, in line with the reporting of debt at nominal value. This concept overstates the government’s need for borrowing from markets in the early projection years by about 2 percent of GDP relative to cash interest. Nevertheless, debt sustainability risks are large.

6. Past forecast error. Forecast errors for GDP growth are larger than those in surveillance countries reflecting the fact that Brazil underwent its largest recession in a century during 2015–16.

7. Realism of projections. Brazil’s projected fiscal adjustment (an improvement of about 1.4 percentage points in the cyclically-adjusted primary balance/GDP over the medium term) is in line with other surveillance countries’ experience. Moreover, the projected path of the fiscal adjustment is based on the expenditure rule, which is a constitutional norm.

Shocks and Stress Tests

8. Primary balance shock. In the primary balance shock scenario, consolidation efforts are deferred and the expenditure cap is abandoned starting in 2019. The primary balance deteriorates cumulatively by 8 percentage points of GDP over the period 2019–23 compared to the baseline. All other variables are kept at baseline levels to isolate the impact of the shock. Under this scenario, gross debt-to-GDP increases to 104.2 percent (8.6 percentage points above the baseline) in 2023, while gross financing needs reach 31.7 percent of GDP.

9. Growth shock. Under the growth shock scenario, real output growth is reduced by one standard deviation (3.5 percent) for two consecutive periods starting in 2019. Over the period 2019–20, real GDP contracts by a cumulative 2.3 percent. All other variables are kept at baseline levels. Under this scenario, gross debt-to-GDP reaches 102.4 percent, with gross financing needs standing at 29.6 percent.

10. Real interest rate and real exchange rate shocks. In the real interest rate shock scenario, the real interest rate is increased by 400bps over the period 2019–23. In the real exchange rate shock scenario, the real exchange rate depreciates by 26 percent (maximum movement over the past 10 years) in 2019, and it remains at this level until the end of the projection period. The impact of these shocks on debt and gross financing needs is modest, pushing debt-to-GDP by 5 and 0.7 percentage points above the baseline in 2023, respectively.

11. Combined macro-fiscal shock. The macro-fiscal shock combines the real growth, interest rate, exchange rate and the primary balance shocks as described above. The impact of the macro-fiscal shock on gross debt-to-GDP is large. The gross debt-to-GDP ratio reaches 117.5 percent by 2023, 21.9 percent above the baseline, with gross financing needs peaking at 34.9 percent of GDP.

12. Stronger growth. In this scenario, the output gap is closing faster as growth is on average 1.5 percentage point higher in each projection year compared to the baseline. The ensuing stronger primary surpluses are a consequence of higher revenues and unchanged expenditure projections. Gross debt-to-GDP declines by about 20 percentage points of GDP by 2023. The underlying assumption in this scenario is that the authorities comply with expenditure ceiling using high-quality measures. In this scenario, also a strong fiscal framework would be adopted.

Figure 1.
Figure 1.

Brazil: Public DSA—Risk Assessment

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.3/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are:200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 1 5 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.4/ Long-term bond spread over U.S. bonds, an average over the last 3 months, 02-Jan-18 through 02-Apr-18.5/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.
Figure 2.
Figure 2.

Brazil: Public DSA—Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Source : IMF Staff.1/ Plotted distribution includes surveillance countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Not applicable for Brazil.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.▯
Figure 3.
Figure 3.

Brazil: Public Sector Debt Sustainability Analysis (DSA)—Baseline Scenario

(Percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Source: IMF staff.1 / Public sector is defined as non-financial public sector.2/ Based on available data.3/ Long-term bond spread over U.S. bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r - π(1 + g) - g + ae(1 + r)]/(1 + g + π + gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1 +g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1 + r).8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ “Interest revenue” is a reconciliation series calculated as a difference between the gross interest of the NFPS and the net interest of the PS. This concept is used to maintain consistency between the fiscal accounts, in which the net interest used to compute the overall balance includes also the net interst bill of the BCB, and gross interest of the NFPS in the DSA.10/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year. Up to 2023, the primary balance is a non-interest balance, with interest income showing in the residual. From 2024 onwards interest income counts toward the required primary balance.
Figure 4.
Figure 4.

Brazil: Public DSA—Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Source: IMF staff.
Figure 5.
Figure 5.

Brazil: Public DSA—Stress Tests

Citation: IMF Staff Country Reports 2018, 253; 10.5089/9781484372449.002.A003

Source: IMF staff.

1

The analysis of public debt sustainability is based on the framework developed for market access countries. See Staff Guidance Note for Public Debt Sustainability Analysis in Market Access Countries, IMF, May 2013.

2

In contrast, the authorities’ definition of gross debt includes the stock of Treasury securities used for monetary policy purposes by the BCB (those pledged as security in reverse repo operations), but excludes the rest of the government securities held by the BCB. Thus, per the national definition, gross debt of the general government amounted to 74 percent of GDP at end-2017.

3

The nominal value is calculated as the PDV of future interest and principal payments at the security’s contractual interest rate(s), and generally differs from face value.

4

The BCB uses about ¾ of its holdings as security in liquidity-draining operations with the banking system.

5

Interest rates on new borrowing are derived by applying the expectations hypothesis of the term structure of interest rates to the Brazilian yield curve as of April 2018.

6

The debt stabilizing primary balance shown on the right-most column of the table on “Contributions to changes in public debt” in the Baseline Scenario (1.3 percent of GDP) corresponds to a concept of the primary balance that includes interest revenue. The definition of the primary balance as a non-interest concept is customary in Brazil and corresponds to 1.1 percent of GDP quoted in the main text.

Brazil: 2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Brazil
Author: International Monetary Fund. Western Hemisphere Dept.