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Summary
- Brazil’s fiscal health continues to deteriorate at break-neck speed.
- The government has abandoned the original, extremely relaxed fiscal targets, and the market is catching on.
- The Banco Central do Brazil has lowered the SELIC policy rate 300bps since it started easing but has already turned more cautious in discourse if not yet action.
- Now the only thing keeping Brazilian inflation in check is the central bank, and current President Roberto Campos Neto may leave the bank before his term finishes at the end of 2024.
Market Implications
- As in 2010-2016, the continuation of these policies should result in slower growth and recession, higher inflation, higher local interest rates and spread widening in Brazil’s Sovereign bond.
- All are already occurring.
- We still like to hold shorter-term duration positions until maturity and look to shift to inflation-linked assets in mid-2024.
Fiscal Situation Continues to Deteriorate Quickly
The Lula administration’s Fiscal Framework has not worked. As we anticipated, the government had no intention of keeping to the fiscal straight and narrow. Now, it has all but discarded any pretext for fiscal adjustment after abandoning the much-revised primary balance target of 0.0% of GDP for 2024 and revising down the forecast for 2025 to 0.25% (0.5% before) and 0.5% in 2026.
None of these primary surpluses will cause the debt-GDP ratio to stop growing. But these targets depend on a significant increase in taxes, which I doubt will take place. As I argued in May 2023, running after increased government spending by increasing tax revenue is not a viable strategy.
Brazil’s fiscal accounts have deteriorated in line with my prior forecasts (Chart 1).
Government Finance Minister Haddad and Planning Minister Simone Tebet have admitted that the gross public sector debt-GDP ratio will continue to grow until 2027 before inflecting downward from a peak of 79.7%. My forecasts do not go out that far, and they are lower than the government’s projections because I forecast higher inflation than they do (Chart 2). I think the increase in public sector deficits will translate into higher inflation after the coming changes at the Banco Central do Brasil (BCB). This is just as harmful for macroeconomic performance.
Moreover, the government has orchestrated a large increase in subsidized credit (Chart 3). Although the subsidy is lower than in the past – excluding the Temer and Bolsonaro Administrations – it is growing (Chart 4). And subsidized credit is growing with it.
As happened before, especially after the 2008-09 GFC when the government ramped up subsidized loans through the state banks, the increase is crowding out private lending. And it is causing saving and investment to fall significantly as a percent of GDP. The more recent Temer and Bolsonaro administrations dialed back this lending and lowered the implicit subsidy, and savings and investment recovered.
This is the genius of what I called the coming ‘Recessflation’: the expansion of fiscal deficits and subsidized lending will damage investment spending and savings. Growth in Brazil’s economy now comes only from consumption and government spending with a little help from net exports. The situation is unsustainable, and we expect signs of recession will only continue to grow.
Changes at BCB: Lower Credibility and Higher USD/BRL
BCB started easing in September 2023, reducing the SELIC policy rate from 13.75% to the current 10.75%, or a decline of 300bps. We had argued the BCB had created around 350bps easing space, but the quick deterioration of the fiscal situation and worsening prospect of adjustment has fed into inflation (and exchange rate) expectations.
Nontraded goods prices are still high and well above the target (Chart 5). Tradable goods prices have kept headline and core inflation lower. But that could change, especially with the recent increase in oil prices. News agencies report that the average price of diesel fuel is 15%, and gasoline is 21% below international equivalent prices. Any correction will cause tradable goods inflation to rise. If the government keeps the price there, we may see large lines for fuel, especially among truckers.
The BCB board has signaled discomfort with this evolution of prices and now with the fiscal situation. We think this has consumed at least half of the remaining 150bps of easing space, and I now expect only 75bps of further easing, and for BCB to lower the current 50bps pace to 25bps at the 7 May 2024 meeting.
In Chart 6 we show a 2-10% range for the Taylor Rule depending on the estimated neutral real interest rate. The reduction of 300 basis points and a lagging TLP (Long Run Rate charged by the state banks, which is now below the SELIC) has brought the average base rate to well inside band of Taylor Rules.
Our best guess is that monetary policy is closer to neutral than to tight. Again, to its great credit, the BCB is the most effective central bank in the world to combat inflation following the pandemic. The problem for the pace and size of future easing is the continued large fiscal deterioration.
To make matters worse, BCB President Robert Campos Neto’s term ends at the end of 2024. He has signaled he might leave before then. The prospects for a new president equal to the task are dim. The fall in credibility of the government’s fiscal stance and monetary stability signal an inflection point for USD/BRL. Instead of downward pressure, we expect upward pressure that has already started.
Market Implication 1: USD/BRL Now with Significant upside
With mild and controllable fiscal easing and continued tight monetary policy, we now expect upward pressure on USD/BRL – but no real trend. USD/BRL had traded in a 4.7-5.0 range with no trend. Our model had consistently produced a fair value below the spot rate for the last four years. Now, the equilibrium rate is above the spot (Chart7).
Theoretically, an expansive fiscal policy leads to a stronger real exchange and nominal exchange rate with inflation falling and no fiscal panic. However, the continued deterioration in new fiscal accounts, the consequent plunge in credibility, the recent monetary easing, and the resuscitation of attacks on the BCB by the administration have kept USD/BRL elevated.
Moreover, loose fiscal policies and easing monetary policies have led to a decline in foreign exchange reserves (Chart 8). This also reflects a large decline in foreign direct investment (FDI) over the last 12 months of 34%. Foreign multinationals are not reinvesting remitted profits, which is also reflected in a 14.6% 12-month decline in imports, mostly capital goods. Brazil’s external position is strong but weakening on the margins, and this is also reflected in USD/BRL. The cause? I think it is the fall in policy credibility.
Market Implication 2: Local Rates Finally Adjusting
Brazil’s most local rate curve has finally started to reflect more realism. That is that loose fiscal policy will put upward pressure on inflation and restrain the BCB’s penchant to ease. As we wrote in September 2023, ‘under usual circumstances, the BCB would have already cut the SELIC significantly.’ But markets have finally woken up to the fact that the so-called fiscal framework is no framework at all and will not constrain government deficits. An exacerbation of these fears caused DI rates to back up (Chart 9). The market is no longer discounting any easing, and the curve has steepened on the short end beyond 2026.
Conclusions: ‘Funny How Falling Feels Now Like Falling’[1]
The dramatic deterioration we expected in Brazilian public sector finances was even more dramatic and faster than we expected. Certainly, the market and market analysts have only slowly adapted.
The fall in credibility should continue at almost panic pace. Market nervousness should grow as we approach the end of BCB President Roberto Campos Neto’s term. The incoming yet-to-be-named BCB president may try to force the SELIC down below 9% in H1 2025, but that implies higher inflation and continuing chaos in a government already moving into crisis mode.
We like to buy USD/BRL on dips (5.05-5.10, although it may not return to those levels). We like to hold paper (LTN or DI) that matures in 2026 and reinvest the proceeds at maturity in inflation-linked NTN-B or in anything that follows USD/BRL.
Finally, we expect little movement in Brazil Global Bonds or CDS as the reserve position, although marginally weaker, is still very strong. Brazil 5-year CDS spreads have widened from 125bps in early market to 166bps over similar duration US Treasury bonds (Chart 10). Assuming a 25% recovery value, this implies probability of default in five years of 11%. We expect these spreads to continue to widen.
[1] A play on the refrain from song “Fallin’ and Flyin’” written and performed by Colin Farrel and Jeff Bridges in the Oscar winning Film “Crazy Heart”, 2009.