New Perspectives and Old Risks

The deterioration of the international scenario combined with larger fiscal deficits will probably jeopardize Brazilian economic policy until the 2014 elections.

The international economic scenario has changed significantly. Last month, FED’s chairman, Ben Bernanke, has announced that QE3 will be gradually discontinued until 2015 (the famous, maybe now, infamous, “taper”), if the economy continues to recover as forecasted, with further decreases on the unemployment rate. Although Bernanke intended to calm down the market, the effects of the announcement on international financial markets were enormous, with huge shifts from funds of long-term bonds to short term ones and from emerging economies to central ones. Currencies and stock markets in emerging economies fell abruptly. Another factor increasing uncertainty is the likely replacement of Bernanke in the near future.

For Brazil, equally or even more important than the future of American economy is the behavior of the Chinese one. Commodities prices closely follow the Chinese growth. Recently, the Chinese central bank (PBOC), facing markets’ generalized fall and threat of banks’ crash, ended up reversing restrictive measures of monetary policy previousy undertaken to discourage excessive domestic credit expansion outside banks (shadow banking system). There is great uncertainty about the speed the Chinese dynamo will keep on growing. These determinants of the external scenario will decisively influence capital flows and prices of Brazilian financial assets: stocks, currency and interest rates.

Simultaneously to the deterioration in the external front, a wave of popular protests unexpectedly emerged in Brazil. Among the immediate effects of the protests, Brazilian political cards have been reshuffled, making next year’s presidential elections way more uncertain and competitive. President Dilma Roussef approval ratings felt from 57% to 30%!

Overwhelmingly, Brazilians hope that the protests will eventually lead to a more efficient use of our tax reais, but there is a risk of more populism and a deterioration in fiscal imbalance. Even though the first of the five pacts proposed by President Dilma Roussef in response to the streets’ demands is about achieving fiscal balance to fight inflation, she is probably merely paying lip service to fiscal rectitude in order to appease financial markets.

Interesting interviews published in the business newspaper Valor Econômico (June 26) about the effects of the protests on economic policy confront an orthodox and a heterodox perspectives. The heterodox one, probably closer to the government’s perspective, makes it clear that public spending should rise, in an attempt to preserve the low unemployment rate and the resulting electoral support.  The tax relief policies on public transportation, together with other taxes exemptions and outlays already promised, represent a relevant final cost. The most likely outcome is that they will not be compensated by cuts on unnecessary expenses, but, instead, will raise the fiscal deficit (the properly measured one, excluding accounting gimmicks).

Corroborating such forecast, two measures undertaken at the end of June already showed that the pact for fiscal balance has had little or no effect. The first of them was that, instead of meeting the previously announced deadlines, the Finance Minister, Guido Mantega, has partially renewed the tax relief policy on electrical appliances, which was supposed to expire by the end of June. It has become a habit of the Minister, when pressured by sectors’ lobbies, not to comply with the schedules he had previously announced. The second measure, much more important, was the change made in BNDES’s (National Economic and Social Development Bank) statute in order to allow the expansion of a very harmful accounting trick. This accounting gimmick amounts to generate illusive primary revenues out of subsidized loans from the Brazilian Treasury to BNDES. With the subsidy, not explicitly accounted for in the budget, BNDES runs profits and distributes dividends to the Brazilian Treasury. These dividends are accounted for as primary revenues, unduly increasing the primary surplus.

Therefore, it is only natural to assume that the government’s answers to the protests should increase the government deficit. There will be two main consequences: more inflation and more government debt.

On its Inflation Report, published at the end of June, the Brazilian Central Bank (BCB) shows worrying inflation projections, admitting that even under the market forecasted future interest raise increases, CPI inflation will not be brought back to its target (4.5%) over the next two years. Moreover, even the BCB’s new forecasts are excessively optimistic, because they assume that the primary fiscal surplus target will be fully met and  that the exchange rate will remain around R$ 2,10/US$, which today seems rather unrealistic. The risk of higher inflation, including the one of crossing the target band’s upper limit (6.5%), has clearly risen.

However, as stated in the already mentioned interview, heterodox economists see inflation as a minor risk, as they believe that it will bring gains on growth and employment. Leniency towards inflation is a path that has already cost Brazil a great deal, and that should clearly be avoided.

To sum up, the external scenario has worsened and the answers to the protests will probably involve more government spending, instead of improving much needed efficiency. Those two vectors represent additional risks to the Brazilian economy, making it more likely that economic policy will deteriorate even further, especially fiscal policy, until 2014 election. The positive side is that, now, it seems more likely that this picture may change after the presidential elections.

Marcio Garcia