One-off Improvement in 2021
Fiscal revenues have been much better than expected at the start of the year. 2021 total revenues will probably close the year roughly 18% higher than what was expected a year ago, partly due to high inflation and commodity prices. The 2021 primary deficit of the central government should be roughly BRL 85bn or 1% of the GDP, less than half of the deficit that was expected a year ago. The primary balance of the public sector as a whole may actually be slightly positive due to the good performance of local governments. In this environment, the much higher nominal GDP will mean debt to GDP declines to around 82%, from almost 89% in 2020.
The so-called “Precatorio PEC” opened up some BRL 110bn extra space within the ceiling for 2022, to accommodate “Auxilio Brazil” and other expenses. The PEC is a constitutional amendment that changed the way the spending ceiling is calculated and created a sub-ceiling for the payment of court orders. This begs the question of what does the spending cap really mean if it can be tweaked and dodged at any time.
With the PEC out of the way, the 2022 budget was finally approved on December 21. Despite some corrections in the right direction, the macroeconomic assumptions remain optimistic, with GDP assumed at 2.1% and inflation at 4.7%, too high and too low compared to both our estimates and the market consensus. 2022 will probably see the public sector primary balance return to the negative territory, but the deficit will likely be smaller than 1% of GDP. However, amid a much tighter monetary policy and fiscal concerns shifting the yield curve upwards, debt service will increase. Debt to GDP will thus likely increase to 85%, despite high inflation increasing the denominator. How bad is this? Bad—indebtedness is much higher than most EM peers and countries rated similarly to Brazil. That said, it is not as bad as most had expected shortly after the initial hit of the pandemic.
Large Financing Needs Meet by Domestic Investors
Although Brazil’s rollover risk is high with a short average maturity of 3.9 years, funding the large government needs is not an issue. Moreover, the public debt liquidity reserve (debt cushion) can almost entirely cover the debt maturing in the next 12 months that is held by the public. Debt is overwhelmingly held by domestic holders, but if a confidence shock was to happen, the Central Bank can serve as a lender of last resort as 95% of Brazil’s federal public debt is BRL-denominated.
The Snowball Effect
Although no solvency issues are foreseen in the near term, Brazil’s debt is not sustainable. Reforms to reduce public spending and enhance productivity need to be done (which will not happen before the October 2022 elections). Otherwise, in an environment of structurally low economic growth, a sustained and sizable fiscal tightening will be needed to stabilize the debt. A scenario where fiscal tightening keeps being delayed with 1% of GDP primary deficits, 1.7% GDP growth, and 4% neutral policy rate is not hard to imagine. Such a scenario would increase the gross debt to GDP ratio by 10ppts by 2025 (Figure 1). Indeed, a pessimistic but realistic scenario where GDP grows 1% and primary deficits average 2% would take indebtedness to over 120% of GDP by 2030.