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The risks of Brazil ignoring its public spending cap

. Sep 30, 2020
The risks of Brazil ignoring its public spending cap Photo: André Nery/Shutterstock

The year 2020 was one of great expectations, not only for the Brazilian economy — but for the global financial landscape. Macroeconomic data corroborated growth expectations, GDP forecasts were promising, retail results enjoyed an upward trend, and inflation was under control. However, Brazil inherited an eye-watering debt-to-GDP ratio, which only got worse during the Covid-19 pandemic. The national debt to GDP ratio — already high at 75 percent — became desperate, with the expectation of hitting 100 percent.

Besides crashing into the Brazilian economy like a wrecking ball,

the pandemic certainly created a feeling of mistrust among investors with regard to the country&#8217;s public spending cap. Brazil has a severe flaw in its constitution, by which spending on personnel — the second-highest <a href="https://brazilian.report/newsletters/brazil-daily/2020/09/01/breaking-down-brazil-2021-budget/">public sector expense</a>, behind pensions — cannot be decreased. In fact, this expenditure has to be adjusted for inflation on a yearly basis, causing a direct impact on the spending ceiling.</p> <p>Furthermore, the government&#8217;s public service reform, submitted to Congress, would only affect employees who enter civil service after the constitutional changes are approved. In other words, it would spark no effect, as existing obligations will continue to raise public spending. Beyond this, the reform proposal would not even apply to politicians, judges, members of high courts, prosecutors, and military servants.</p> <h2>Brazil an ugly duckling for international investors</h2> <p>Brazil&#8217;s image on the international market is very poor indeed. This can be seen by the outflow of foreign capital from the Brazilian stock exchange — BRL 87 billion (USD 15.5 billion) has left this year alone. While these political uncertainties and compliance with the public spending ceiling continue, Brazil&#8217;s reputation on the world stage is unlikely to improve. However, this flow of funds could be reverted into a potential increase in interest rates and the risk premium.</p> <p>Mirroring this landscape, the world&#8217;s major credit rating agencies have maintained Brazil&#8217;s sovereign rating but altered their outlook from &#8220;stable&#8221; to &#8220;negative.&#8221; While ultraliberal Economy Minister Paulo Guedes has said he will adhere to the public spending cap, President Jair Bolsonaro has mentioned the possibility of breaking through the ceiling on a number of occasions, increasing uncertainty.</p> <p>If Brazil were to breach its public spending rules, ratings agencies could lower the country&#8217;s sovereign credit rating, which would cause huge losses for Brazil&#8217;s image abroad and scare off foreign investors even more.&nbsp;</p> <h2>Public spending issues: domestic factors</h2> <p>Macroeconomics also have to be taken into account. Ignoring fiscal policy would lead to an increase in inflation, the further weakening of the Brazilian Real, higher interest rates, and more unemployment. As this situation could turn into a vicious cycle, it is likely that the recession would become even more severe.</p> <p>Elsewhere, there is the matter of the government&#8217;s coronavirus emergency salary. The plan to pay the unemployed and informal workers a monthly sum of BRL 600 (USD 106) set the administration back BRL 50 billion a month. The program was extended until the end of the year, but payments have been cut to BRL 300. The emergency aid certainly propped up Brazil&#8217;s GDP in the second quarter — avoiding a bigger dive than the -9.7 percent registered by the government — but it has aggravated the country&#8217;s fiscal outlook.</p> <div class="flourish-embed flourish-chart" data-src="visualisation/3883119" data-url="https://flo.uri.sh/visualisation/3883119/embed" aria-label=""><script src="https://public.flourish.studio/resources/embed.js"></script></div> <p>As seen in the chart above, <a href="https://www.investing.com/rates-bonds/brazil-cds-5-years-usd-historical-data">Brazil&#8217;s Credit Default Swap</a> — or CDS, measuring the likelihood of a default on public debt — reached 91.8 points in February 2020, but now stands at around 227 points.</p> <p>Therefore, so that Brazil may improve its national debt to GDP ratio, authorities must focus on reducing debt and mitigating the country&#8217;s problems in honoring its payments by way of public service and tax reforms, and implementing a sweeping program of privatizations. This will give the country more control over its spending, increasing tax revenue, and allowing funds to be invested in health, education, and infrastructure.

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Marco Harbich

Marco Harbich, CFP, holds a Master's degree in finance. He is CEO and CIO at NEO Finanças Pessoais, and a professor at Mackenzie Presbyterian University, in São Paulo

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