It went down to the wire, but the stadiums are complete, the brand-new metro line is up and running, and the 2016 Olympic Games in Rio de Janeiro are officially underway. When it comes to the Brazilian economy, on the other hand, there is still more work to be done. While there has been some progress in resolving the political uncertainty dogging the country, the fiscal consolidation that needs to happen for the sake of Brazil’s longer-term economic health still seems to be far off.
Legislators won’t vote on the matter until the end of August, but President Dilma Rousseff’s temporary replacement, Vice President Michael Temer, has already replaced the entire presidential cabinet and installed a new economic team. And that, say Brazil economists on Credit Suisse’s Global Markets team, has been enough to buoy business and consumer confidence.
Partly as a result of the newfound confidence, the Bank’s economists have increased their forecast for 2016 GDP growth from -4.2 percent to -3.5 percent, with a return to positive growth expected in 2017. Still, with government spending rising and tax revenues in decline, Credit Suisse’s economists are predicting a 2016 primary deficit (not counting interest payments) of 1.9 percent of GDP. If no fiscal reforms are passed, the deficit could reach 2.6 percent of GDP in 2017. Add Brazil’s hefty interest payments into the mix, and the fiscal deficit is likely to remain significantly high, at around 6.5 percent in 2016 and 8.4 percent in 2017. Running persistent deficits is an excellent way to rack up debt, and Credit Suisse expects gross debt to hit almost 80 percent of GDP in 2018, up from 52 percent in 2013.
A recent analysis by economists on the Global Markets team concluded that the deteriorating fiscal situation in Brazil has probably made the recession deeper than it otherwise may have been, and that correcting it is the key to healthier growth patterns moving forward. The economists analyzed 103 fiscal consolidations around the globe—defined as instances in which a country’s primary balance improved by 2 percentage points or more for two consecutive years or by 3 percentage points for three or more years in a row—over the past 35 years. Successful consolidations—those in which debt levels kept falling two years after the fiscal adjustment was over—were positive for growth, while those that failed to reduce debt levels resulted in declining GDP growth.
It’s one thing to know that a country should take steps to improve its fiscal situation in a way that lasts long after the emergency measures are over. It’s quite another thing to know exactly how to do it. Credit Suisse divided the consolidations that successfully reduced debt levels into two groups: those that focused primarily on cutting spending and those that relied more heavily on raising taxes. Both methods restored GDP growth, which tended to fall in the five years prior to a fiscal consolidation, back to pre-crisis levels while also increasing aggregate investment.
(While it may not seem obvious that cutting government spending can have the effect of increasing GDP growth, the Bank’s analysts point out that in emerging economies in particular, the threat of potential fiscal insolvency can have disproportionate effects on both business and consumer confidence. In such circumstances, improving a country’s fiscal situation can have an outsize effect on growth and consumption—even when it involves cutting spending.)
The decline in gross debt happened faster with less coincident inflation when the government placed a greater emphasis on cutting spending than on hiking taxes. Keeping inflation in check is a high priority in Brazil, as prices are on track to increase 7.4 percent in 2016—an improvement from the 10.7 percent inflation rate of 2015, but still much higher than the 6.5 percent target set by the Central Bank of Brazil.
Based on their analysis, the Global Markets economists conclude that Brazil would be best served by placing more emphasis on slashing budgets than on boosting revenues. In particular, they note that Brazil’s current subsidies and early retirement ages are too generous for a country with its “standard of development,” taking up more than 12 percent of GDP. The economists even propose a specific road map for cost-cutting: In successful consolidations, the level of public investment as a percentage of GDP tended to stay stable, while the heaviest swing of the ax was reserved for cuts to social security expenditures.
But will Brazil actually make the reforms it needs? A great deal of fiscal spending is indexed either to government revenues, past inflation, or GDP, and Congress would have to pass several different measures to make significant cuts. To that end, the government should send to Congress various reform measures, including social security, tax and labor marketreforms as well as the already proposed cap on inflation-indexed spending growth. But the Bank’s economists nevertheless see “a significant risk” of the unpopular measures failing in the legislature. Building an Olympic Village is quite the accomplishment. Rebuilding an entire economy won’t be so easy.