View of Rio de Janeiro, Brazil: Latin America's largest economy is still in its deepest recession in decades (photo: Chris Bradley)

Fiscal Discipline Critical to Restoring Growth in Brazil

November 15, 2016

  • Brazil appears to be exiting from a deep recession
  • Growth projected to resume only gradually
  • Long-term fiscal sustainability must be restored

While there are signs that the recession is nearing its end, Brazil’s economic prospects hinge on the new government’s ability to implement ambitious structural reforms to restore fiscal sustainability, the IMF said in its annual review on the state of the Brazilian economy.

According to the report, Latin America’s largest economy has suffered its deepest recession in decades. Since the beginning of 2015, the unemployment rate has doubled to more than 11 percent and 2.7 million formal jobs have been lost.

A gradual recovery is expected to start in the second half of 2016, assuming that reforms continue, political uncertainty diminishes, and that other economic shocks run their course. The IMF projects output growth of -3.3 percent in 2016 and 0.5 percent in 2017.

The IMF said that risks continue to dominate the outlook, but positive signs are emerging. A key domestic risk is that the new government fails to deliver on its fiscal consolidation strategy and provide a lasting boost to confidence. External risks include an extended period of slower growth in advanced and emerging economies, especially China, further declines in export commodity prices, and tighter financial conditions.

Faster-than-expected progress on the reform agenda represents an upside risk that could spark a more vigorous recovery in investment, boosting foreign interest in Brazil, even as global interest rates remain low.

Restoring credibility through fiscal sustainability

In recent years, policies have failed to address long-standing structural problems and often proved counterproductive. In this context, the IMF report welcomes the new government’s focus to control fiscal spending growth by imposing a cap on spending in real terms and reforming the social security system. Approval and successful implementation of the spending cap would be a game-changer for Brazil, the report said.

Other measures to contain spending include improving the allocation of public funds, ending revenue earmarking, and containing payroll growth. An emerging priority is expenditure control at the regional level.

The spending cap by itself would take several years to stabilize and begin to reduce public debt. Given the risks associated with such a prolonged period of fiscal adjustment, the IMF called for more measures to speed up fiscal consolidation, and for greater efforts to boost potential output growth over the medium term (see box).

Priorities for boosting potential growth

The IMF recommends the following policy actions to lower the cost of doing business, enhance efficiency, and strengthen medium-term growth:

• Make the infrastructure concessions program more attractive to boost investment and competitiveness.

• Reduce the cost of doing business by simplifying the tax code.

• Reduce tariffs and non-tariff trade barriers, revising domestic content requirements, and pursuing free-trade negotiations outside Mercosur.

• Improve the allocation of savings by reviewing credit earmarking rules and other distortions.

• Facilitate productive employment and reduce incentives for informality to promote job creation, investment, and growth.

Monetary policy can lend a hand

Inflation has been above the central bank’s target for the past several years. But given the uncertainty about the output gap, approval of key reforms, and related movements in the exchange rate, the IMF argued that maintaining current monetary policy settings would be broadly appropriate. Tangible progress on fiscal consolidation would allow more room for monetary easing to support the recovery and help moderate inflation.

The IMF said it welcomed the government’s intention to strengthen the inflation targeting framework by enhancing the independence of the central bank and improving central bank communication. These steps will help boost institutional credibility.

The report also welcomed the use of exchange rate flexibility as the first line of defense against shocks. Intervention in foreign exchange markets should remain limited to episodes of disorderly market conditions, and reserve buffers should be preserved.

Protecting the financial system

While the Brazilian banking system remains largely sound, the resilience of the sector should be reinforced. The IMF said it welcomes the moderation in the growth rate of credit by public banks, the plans to reduce direct financing of large corporations with market access, and the intention of the two largest public banks to strengthen their capital position. Enhanced monitoring and improved financial safety nets would also help strengthen the banking sector.