Fiscal Fragility and Concern Over the Road Ahead

BRAZIL ECONOMICS - Report 18 Jul 2022 by Affonso Pastore, Cristina Pinotti, Paula Magalhães and Diego Brandao

In the past 30 days, the Real has weakened from R$5.10/US$ to R$5.40/US$, once again placing it among the currencies that have depreciated the most in relation to the dollar. At the same time, the 10 year Brazilian CDS quotes – a traditional risk measure – have surpassed 400 points. Since the country has no problems related to the balance of payments, what this CDS movement indicates is the fiscal risk, which did not only rise due to the approval of a proposed constitutional amendment (PEC) authorizing an increase in primary spending of R$ 41.2 billion, motivated by the government’s reaction to the increased risk to the president’s reelection due to the “excessive increase of international oil prices”.

If the markets only assessed what seems fated to change in the immediate future, believing that the increase in expenditures would only be temporary, financed by extraordinary revenues, the prices of assets would not have reflected a perception of higher risk. However, the situation is very different. First of all, the extraordinary increase in revenues in the past 18 months has been largely due to the increase in the prices of crude oil and other commodities, and so far has been aided by the growth of Brazilian GDP “greater than expected”. Since commodities are priced, traded and financed in dollars, other than in very rare cases, their prices vary inversely with the dollar index. Additionally, the outlook is for severe global deceleration, with a reduction of oil prices.

This situation is aggravated by the rising probability that a recession in Brazil in 2023 will counteract the recent strong growth of revenues of the federal and state governments. Second, it would be naïve to imagine that with Brazil in recession, the presumed emergency aid of R$200 a month (increasing Auxilio Brasil to R$ 600) and the benefits now paid to those previously waiting to receive them will be cut. What is impending is thus a fiscal situation in which revenues will trend downward and supposedly temporary expenditures will become permanent. The current reaction of asset prices is only a first warning, which will be followed by others.

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