Pandemic, Fiscal Risk and Yield Curve

BRAZIL ECONOMICS - Report 22 Feb 2021 by Affonso Pastore, Cristina Pinotti and Paula Magalhães

With the vaccination program progressing at a snail’s pace and the spontaneous reaction of society to the increasing death toll, increasing the voluntary social distancing, GDP will almost surely shrink in the first quarter this year. The inevitable prolongation of some type of emergency relief and the increased spending on health, together with the decline of tax receipts, will raise the primary deficit and the public debt. Therefore, even if the spending cap is honored (because a supplementary credit will be authorized for “extraordinary expenditures”, which will not be counted for the effect of the ceiling), the fiscal situation is fated to worsen. In parallel, in January and February the yield curve once again shifted upward, with the 10-year interest rate reaching 8%. However, due to the action of the Treasury, which has preferred to redeem bonds with longer maturities and replace them with instruments with shorter maturities, there has been a greater increase of the short end of the curve, with terms of up to one year. This is one of the reasons (the other being the expectation that the Central Bank will soon raise the SELIC rate) why, despite the worsening fiscal risk, the slope of the yield curve defined by the difference between the one- and ten-year rates has declined. According to the official “accounting rule” applicable to the expenditures mentioned above (the extraordinary spending is not computed for the purpose of the spending cap), the ceiling imposed by the Constitution will be met in 2021. And due to the rule on its adjustment in 2022 inflation measured by the 12 months INPC in June 2021), it might also be satisfied that year as well. Why considering the compliance with the spending cap have the risk premiums not fallen? The reason is the government’s political inability to win approval of reforms to assure fiscal consolidation. The government is supported in the Chamber of Deputies by enough deputies to block the impeachment proceedings against Bolsonaro, but insufficient to approve unpopular reforms that would resolve the fiscal problem.

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