The First Steps of the Adjustment

BRAZIL ECONOMICS - Report 13 Jun 2016 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

To achieve renewed growth while keeping inflation under control, Brazil needs various reforms, but by far the most important is in the fiscal area, to produce a return of primary surpluses large enough to lower the debt/GDP ratio. To start this adjustment, the government has chosen to avoid an immediate increase in the tax burden (for lack of political support), instead proposing a rule lasting several years on adjustment of the nominal value of expenses. If the government succeeds in a comprehensive program, the primary deficits will decline and be succeeded by surpluses, but the pace of this adjustment will be slow, which means that the debt/GDP ratio will continue rising for several years.

Within the mechanics proposed for the adjustment, how much the primary deficits decline will depend on how strong GDP growth is. However, although the recession is nearing its end, we do not forecast conditions for GDP to grow by more than 2.5% a year in the coming years.

Monetary policy will likely contribute to renewed growth, due to the expectation of an intense easing cycle. This does not derive from abandonment of the inflation target. Instead, it comes from a set of circumstances that allow the SELIC rate to be lowered while the Central Bank maintains its commitment to reach the central target of 4.5%. The reasons are varied: the severity of the recession and consequent increase in unemployment; the strong contractionary component that will come from the intensity of the fiscal adjustment; and the total obstruction of the credit channel, due to the excessive indebtedness of households and businesses.

If the fiscal adjustment succeeds, this will trigger a new round of increasing demand for Brazilian assets, working to strengthen the real. In this case, instead of counteracting the appreciation by stepping up repurchases of forex swaps, the best policy will be to reduce the interest rate. This will promote faster growth, helping the fiscal adjustment.

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