Brazil: Fiscal Framework Sent to Congress
Final text of the new Fiscal Framework was sent to Congress. As with its predecessor there are several breaches by which expenditures could be raise beyond the 70% growth revenue limit. We find that the rule would allow debt/gdp to be stabilized on 84% and its results would not be so different from the Expenditure Ceiling. However, it is most important to see whether the government sticks with the proposed rule avoiding using its breaches.
The Brazilian Government has sent to the Congress the final text of the New Fiscal Framework (here). The measure would restrict the growth to 70% for Revenue Growth, set bands for the primary target and in case the primary target is above the stipulated, the government could use the extra revenues to finance investments. The text clarifies that the non-recurrent revenues will be left out of the calculus to limit expenditure growth. Additionally, similar to the Expenditure Ceiling, there have been several expenditures that will not be restricted to revenue growth, mostly related to expenditures that have linked revenues to their execution. However, non-financial state owned enterprises are also left out as so is the Extraordinary Credit. Additionally, in case the government is not able to stick with the primary target bands, the expenditure limit for the following year would come down to 50% of the revenue growth. The law is set to be valid from 2024.
Is that Different from the Expenditure Ceilling?
There are several similarities with the expenditure ceiling, especially on how to limit the expenditure growth. The biggest is that similar expenditures have been left out of the rule, and the escape expenditure, “Extraordinary Credits” is kept. Those are expenditures not predicted by Annual Budgetary Law and could be approved with support of the both houses. Another difference is that expenditures that use external financing such as international co-operations will not be submitted to the expenditure rule, differently from the expenditure ceiling.
Government officials have showed their desire to reduce the fiscal deficit to zero in 2024. This measure would imply cutting expenditures in 2023 and 2024, while GDP would grow at 2.5% in 2023 and 2024. We believe neither of these two hypotheses are feasible. In our simulations, the fiscal deficit would be 0.9% of GDP in 2023, 0.7% in 2024 moving to a gradual reduction in the next year, and reaching zero in 2028, after Lula’s third mandate is over. Interestingly, if we impose the expenditure ceiling rule from 2024 and on, the results would be pretty similar with the rule proposed by the government.
Figure 1: Fiscal Result Forecast
Source: Tesouro Nacional and Continuum Economics
Debt Sustainability
By applying a standard Debt sustainability analysis, we construct three scenarios for the debt/gdp ratio. Scenario 1 is our baseline and its main assumption is that growth is in accordance with our forecast and Brazilian Central Bank (BCB) is able to control inflation, allowing interest rates to fall. In Scenario 3 we use the same assumptions of the Brazilian government and the Debt/GDP ratio presents a descending trajectory. In Scenario 2 growth is lower, reflecting on lower revenues, and due to the incapacity of the government to cut expenditures the fiscal rule would be abandoned reflecting on higher fiscal deficits. Additionally, BCB independency is damaged reflecting higher borrowing costs for the government. In this case, the debt/GDP ratio would be unsustainable and present an explosive path.
Figure 2: Debt/GDP Forecast
Source: Continuum Economics
More Important than the Rule is Complying with it
Recent research by the Brookings Institute (here) have analysed the two disinflation episodes that occurred in 2002 and 2016. On both occasions, it was important that not only the Central Bank raises rates but also that government apply a credible fiscal policy which guarantees debt sustainability. Government officials have sent mixed messages to the market. On one side President Lula has been advocating against the Expenditure Ceiling Rule and advocating more expenditures to sustain growth. On the other side Finance Minister Fernando Haddad is advocating for controlling expenditures and pursuing a zero deficit policy. We believe that this dissonance in the communication is what drives the fear that Lula’s third mandate will not seek sustainable policies. We believe the fiscal rule will pass smoothly in the Congress but as we stated there are several breaches by which government could raise expenditures above the set limit. The first year of its implementation in 2024 will be key to show market participants that the government will pursue a sustainable fiscal policy.