Finessing Brazil’s fiscal balance

Brazilians driven to exasperation by the politicians and technocrats running the country often refer to the capital Brasília as Fantasy Island. There, officials isolated in the sweltering central plains often seem utterly out of touch with the grim realities of daily life in the big cities where most Brazilians live. The same used to be said of the government’s financial team – the central bank and finance ministry. Not only were they far from the business centers in São Paulo and Rio de Janeiro, but few had any experience of life in the markets. Most were academics or bureaucrats.

The central bank, at least is changing. Armínio Fraga, its president and a former Wall Street fund manager, has assembled a team of bright young former investment bankers who, until their recruitment into the public sector two years ago, made a living in the financial markets.

Yet the government continues sinking into debt at a remarkable rate. This year’s budget deficit is forecast at 7% of GDP and the federal government is borrowing such fabulous amounts of money that it is steadily crowding out the private sector. Pedro Malan, the finance minister, says that a good chunk of the increase has come from recognizing previously undocumented debt and has cut spending in the wake of the Argentine crisis. “It is wrong to say the increase in debt is a result of the government’s spending policy,” Malan says, adding that 40% of the increase in debt was due to recognizing existing government debt.

Brazil’s debt stands at $247.6 billion, with the country’s debt-to-GDP ratio at just over 50% this year, up from 29% in 1994. In August, the government had to ask the International Monetary Fund for a further $15 billion in loans to help insulate Brazil from the effects of Argentina’s collapse. The rising debt level, the rising cost of servicing this debt and the deal with the IMF all threaten to become political footballs as the country begins campaigning for the October 2002 elections against a backdrop of a sharp economic slowdown. “You are taking the country to the brink of bankruptcy. I don’t understand how the government is going to pay this debt,” warns Senator Ademir Andrade of the Brazilian Socialist Party.

Looking Long Term
Daniel Gleizer, head of the central bank’s international department (see interview, page 11) says the government is trying to maintain a primary budget surplus. “Concerns over debt dynamics are a concern of foreigners,” he says. “Brazilian treasurers do not fear this. Debt dynamics are important as an indicator of the public sector’s solvency and this is a long-term question. What you have got to show is that there is a long-term tendency of stability or decline in debt levels.” Temporary shifts caused by fluctuations in the exchange or interest rates only matter to the extent that they affect the debt stock in real terms, he argues.

In the first half of this year, the consolidated public sector’s primary surplus – before interest payments – was R$30.42 billion ($12.17 billion), or 5.2% of GDP. This was 40% more than the target the government had agreed with the IMF. However, including interest charges, the government ran a deficit of R$28.8 billion, which is equivalent to 4.9% of GDP. The federal government’s interest bill alone came to R$59.2 billion between January and June, or 10% of GDP. The interest burden has increased sharply: in the first half of last year, the government paid out the equivalent of 7.8% of GDP.

Prior to the 1999 currency devaluation, government debt had an average life of 11 months. The government has since then aggressively pushed for longer-term maturities, extending the average life of debt to 30 months. However, half the debt it issues is indexed to the short-term Selic rate and one-quarter is tied to the exchange rate. About 10% is indexed to the inflation rate. Fixed-rate local debt accounts for only 15% of total debt stock. The country’s debt profile is 80% internal debt and 20% external debt. The government continues to actively re-profile its external debt, through secondary market exchanges of its Brady debt stock.

Interest rates at home have moved up sharply and the pace of the real’s decline has picked up. It has lost nearly a quarter of its value this year. Brazilian bonds are priced at nearly 1,000 basis points over US Treasurys, due mainly to contagion from Argentina. This spread is substantially higher than Peru, Colombia and Venezuela. The central bank began raising its Selic benchmark interest rate in March and has kept raising it steadily all year. Although at nearly 19% in nominal terms, the Selic is still a hefty burden.

Ilan Goldfajn, head of research at the central bank, and Gleizer himself both argue that short-term shifts in the exchange rate and in interest rates are offset over time by inflation and GDP growth patterns. It is the debt’s growth trend and the real-as opposed to nominal-level of the debt that really matter, they argue. Even so, since government domestic debt is mainly short-dated and indexed to the exchange rate and short-term interest rates, the immediate impact of a weakening currency and monetary tightening is dramatic: between May and June, the debt rose by 1% of GDP.

The broader economic context is disheartening. The crisis in Argentina, a downturn in the global economy and Brazil’s power shortages have all conspired to cut economic growth sharply. Forecasts at the beginning of the year called for GDP expansion of 4.5% to 5% and inflation of about 4% to 5%. Now, economists expect growth of about 2% to 2.5% and inflation of 6% or higher.

The government is attempting to be as responsible as it can in managing its finances, attempting to push out the maturity of its bonds as it struggles to build a local currency yield curve. It raises most of its fresh financing locally, partly because the international capital markets remain closed, partly out of a conscious decision to fund as much debt in local currency as possible and partly out of a sense of mission to build a modern debt capital market in Brazil.

This marks a considerable shift in attitude. Until recently, officialdom saw the accumulation of liquidity in Brazil – which has never suffered disastrous outflows of capital flight – as a captive source of financing for the government’s gaping budget deficits and never gave much thought to developing a sophisticated local financial market.

The government has attempted to reduce whenever possible issuance of inflation- and dollar-indexed debt and tried to issue more fixed-rate paper. The central bank, which manages the government’s finances as well as running monetary policy on a semi-independent basis, is also attempting to extend maturities and build out a real yield curve to further strengthen the local debt capital markets.

Exploiting Opportunities
Gleizer, the central bank’s international director, says he intends to continually exploit opportunities to manage the republic’s liabilities as actively as possible, using exchanges, buy-backs and other instruments to reduce the debt or reshape its profile.

However, the deepening crisis in Argentina has concentrated liquidity in the short end of the yield curve as nervousness over the structure of the domestic debt increased. Very few international appear to be convinced by Goldfajn’s arguments or by claims by government officials that Brazilian investors in the local markets have agreed to roll over federal debt without great difficulty, even at the height of major crises. Fears of a government default during the 1999 real crisis were unfounded, although the Selic interest rate exceeded 40%. However, the approach of the elections is now becoming a matter of concern and investors are demanding a premium for taking paper that matures after 2002, when the new government is to be sworn in.

Richard Madigan, director at Offitbank, comments that “Brazil, because of the strength and depth of its local bank, pension and mutual fund industries, does not have and has not had a problem rolling over its domestic debt stock. Rather, the issue has been its vulnerability to the fiscal impact from the cost of that debt-as we again see pressures mounting this year on Brazil’s nominal fiscal deficit.”

Brazilian governments have rarely if ever placed much importance on fiscal responsibility. The government has enacted a fiscal responsibility law which imposes limits on indebtedness and includes ceilings on certain types of spending, such as on personnel.

The legislation comes into force gradually and so President Fernando Henrique Cardoso, who signed the law, will largely escape its strictures. If the law works and rolls back the public sector, or at least limits its hunger for capital, this alone would be a vital step toward easing crowding-out, bringing interest rates down and allowing maturities to grow.