Brazil: Staff Concluding Statement of the 2016 Article IV Mission
IMF News, September 29, 2016
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- Published: September 29, 2016
I. Context and Recent Developments
- Brazil is in a deep recession with multiple causes: policy failures on long-standing structural problems; declining terms of trade; tight financing conditions; steep increases in electricity tariffs; a corruption scandal; and a political crisis leading to heightened uncertainty.
- The recession has caused a large contraction of output, a massive toll on employment, and slowed progress on reducing social inequalities.
- Inflation has exceeded the top end of the target band since 2015, with disinflation proceeding slowly despite a large output gap.
- Fiscal sustainability is at risk:
- Fiscal position, including at the subnational level, is at its worst level in over two decades.
- Decline in potential growth and persistently high real interest rates have worsened debt dynamics.
- Government policy actions and reforms:
- Proposed cap on the growth in federal noninterest spending at the rate of consumer-price inflation in the previous year.
- Announced plans for social security reform.
- Regulatory reforms to support concessions and privatization program; strengthened governance for state-owned enterprises.
- Major public enterprises and banks, notably Petrobras and BNDES, placed under new management.
- Markets have responded positively to decreasing uncertainty and improved sentiment toward emerging economies.
II. Outlook
- Growth projections:
- Output growth projected at -3.3 percent in 2016.
- Output growth projected at about ½ percent in 2017.
- Projection contingent on approval of the fiscal spending cap and social security reform in a reasonable timeframe and meeting proposed fiscal targets for 2016 and 2017.
- Recovery dynamics:
- Investment projected to recover if uncertainty continues to decline, supporting gradual return to positive sequential growth beginning in late 2016.
- Recovery impeded by excess corporate leverage, high unemployment, and weak household balance sheets.
- Inflation expected to gradually converge toward the midpoint of the target band.
- Risks to the outlook:
- Downside risks dominate: failure to deliver core fiscal consolidation; reforms watered down or stalled in Congress; re-intensification of political uncertainties; protracted slow growth externally (especially China); further commodity price declines; tighter external financial conditions.
- Upside risks: recent policy pronouncements boosting confidence and asset prices; faster-than-expected approval of spending cap and social security reform could reduce risk premia and trigger stronger investment and growth (including via M&A activity).
III. Policy Recommendations — Fiscal
- Core recommendation:
- Controlling the growth of fiscal spending is imperative; approval and steadfast implementation of the spending cap could be a game changer for long-term public spending trajectory and permit stabilization and eventual reduction of public debt as a share of GDP.
- Address structural drivers of public expenditure growth — key areas:
- Social security:
- Move expeditiously on broad-based reform covering retirement age rules, replacement rates, access to benefits, duplication of benefits, annual growth of payments, and regimes for public sector employees at all levels.
- Include provisions to protect the most vulnerable given high inequality.
- Subnational governments:
- Contain upward expenditure trajectories in many states through adoption of a rule similar to the federal proposal.
- Enact enabling legislation for states to make difficult expenditure adjustments; increase transparency in expenditure reporting.
- Fiscal framework:
- Strengthen the medium-term fiscal framework; reduce budgetary rigidities (including tax earmarking); increase flexibility in composition of spending.
- Recommended consolidation of Petrobras and Eletrobras into non-financial public sector statistics (without including them in fiscal targets calculation) to improve transparency and fiscal risk management.
- Minimum wage and indexation:
- Revise the formula for minimum wage revisions and the link between social benefits and the minimum wage to address medium-term fiscal pressures; revise the minimum wage formula to better reflect productivity improvements.
- Spending efficiency:
- The spending cap will require government agencies to make better use of resources to prevent declines in service quality.
- Fiscal consolidation timing and composition:
- Consolidation based solely on the spending cap would take several years to stabilize public debt and carries risks: public sector debt as a ratio of GDP would continue to grow for a number of years before peaking and declining gradually; overall deficit would remain high for an extended period, crowding out private agents.
- Merit in a more frontloaded consolidation:
- Possible objective: reach a primary balance of around 3½ percent of GDP over the next 5 years, which would stabilize debt by 2021.
- Consider a combination of expenditure and revenue measures; measures could be designed to take effect once economic growth has firmed up to mitigate short-run output costs.
IV. Policy Recommendations — Monetary, Exchange Rate, Financial Sector
- Monetary policy:
- Should remain tight until inflation expectations converge more clearly toward the center of the target band.
- Current monetary policy settings considered broadly appropriate given inflation expectations.
- Tangible progress on public finance sustainability would allow more room for monetary easing to support recovery.
- Exchange rate and FX intervention:
- Exchange rate should remain the first line of defense against shocks.
- Foreign exchange intervention should be limited to episodes of clear market disruption and high volatility; reserve buffers should be preserved.
- Support continuation of central bank policy of reducing the net notional value of FX swaps; use of reverse FX swaps is a useful supplementary tool.
- Banking sector resilience and safety nets:
- Banking system largely sound but profitability and asset quality affected by recession.
- Mission welcomes moderation in growth of credit by public banks; plans to reduce direct financing of large corporations with market access; intentions of largest public banks to strengthen capital positions.
- Recommendations:
- Improve financial safety nets: strengthen procedures for use of the deposit insurance fund; enhance central bank emergency liquidity assistance; modernize the resolution regime.
- Put in place frameworks for identifying, preparing for, and responding to future risks involving all financial regulators.
- Strengthen private insolvency frameworks to expedite bankruptcy and reduce default losses for banks.
V. Policy Recommendations — Structural Reforms and Governance
- Structural reforms to hasten and strengthen recovery:
- Infrastructure bottlenecks:
- Implement announced enhancements and regulatory reforms to make concessions program more attractive while maintaining governance and program design standards.
- Opening of the economy:
- Reduce tariffs and nontariff barriers, revise domestic content requirements, and pursue free-trade negotiations outside Mercosur to boost competition, efficiency, and growth.
- Efficient allocation of savings:
- Review credit earmarking rules and other distortions to channel national savings to their most productive uses.
- Labor reform:
- Facilitate productive employment and reduce incentives for informality to promote job creation, investment, and growth.
- Tax reform:
- Simplify the State Tax on the Circulation of Goods and Services (ICMS).
- Consolidate PIS/CONFIS and IPI and replace them with a true federal VAT to reduce cost of doing business.
- Transparency, anti-corruption and anti-money laundering:
- Effective implementation of these measures would enhance predictability for businesses and perceptions of fairness.
- Government commitments cited:
- Make public procurement data open by default.
- Implement recent legislation on conflict of interest.
- Strengthen whistleblowing mechanisms.
IMF Staff Concluding Statement, September 29, 2016.