A climate of uncertainty leading to opposite scenarios
Brazil is in the midst of a fiscal crisis that is still in latent state, and may or may not become an open crisis. In October a new president will be elected, and it is not known on what diagnosis the next government will base its economic policy actions, or if there will be sufficient congressional support to enact the reforms that are absolutely necessary.
If a reform of the pension system is approved that eliminates the spending growth (which currently gobbles up more than 50% of primary expenditures) due to the demographic dynamics, creating conditions to maintain the ceiling on growth of primary spending in real terms, combined with removal of tax breaks that cause forgone revenue, the risk of insolvency of the public debt would be eliminated. It is possible that due to the slow pace of cyclical recovery, sufficient primary surpluses would not be generated immediately, but there would be a perception that the correct path is being followed. In this case, the exchange rate would strengthen, partially offset by the appreciation of the dollar; the end of commodity ‘mini boom’; and the increase in the current account deficit caused by the expansion of imports derived from higher investments. Interest rates would decline at both the short and long ends of the yield curve. This, together with the reduction of risks, would stimulate fixed capital investments, boosting cyclical recovery, followed by stabilization of GDP growth around its potential rate, with inflation under control.
In the opposite scenario, the primary spending cap would be impossible to meet, and barring a large tax increase, with strong negative effects on production of goods and services, the public debt would continue to grow, maintaining the perception that the government is heading toward insolvency. At the limit, the country would converge to a fiscal dominance situation, in which monetary policy loses all effectiveness. Fiscal dominance is not an acute disease, like a speculative attack on a country’s reserves under fixed exchange rate regime. Rather, it is a degenerative disease, which leads to steady deterioration of the economic situation. What can be expected in this case is continuation of low investment rates and weak GDP growth, perhaps alternating with recessions, along with high unemployment, inflation and interest rates.
At this point it is impossible to attribute probabilities to these two extreme scenarios, as well as to possible intermediate cases.
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