Mission Concluding Statement 

Brazil: Staff Concluding Statement of the 2019 Article IV Mission

May 24, 2019

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’). This mission was undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

A sluggish recovery is underway, constrained by subdued aggregate demand and lackluster productivity. A robust social security reform and additional fiscal measures are necessary to put public debt on a sustainable trajectory, thereby boosting investor confidence. The mission welcomes the government’s ambitious reform agenda which includes pension reform, privatization, trade openness, tax reform, and reducing state intervention in credit markets. These reforms are essential to boost potential growth. The monetary stance is appropriately supportive at present.

1. The recovery remains sluggish. After contracting by almost 7 percent during the 2015-16 recession, real GDP grew by only 1.1 percent per year in 2017 and 2018. Short-term indicators show that weakness persisted in Q1. Investment remains subdued, held back by large spare capacity and lingering uncertainty about the prospects for fiscal and structural reforms. Weak global growth and the recession in Argentina are holding back exports. Growth in 2019 is projected between 1 and 1.5 percent with significant downside risks. Conditional on the approval of a robust pension reform and favorable financial conditions, growth is expected to accelerate in 2020, supported by a recovery in private investment.

2. The fiscal stance was broadly neutral in 2018. In 2018, the nonfinancial public sector primary balance improved marginally to ˗1.7 percent of GDP and the structural fiscal stance was neutral. The current budget may entail a slight relaxation of the fiscal stance in 2019. Compliance with the expenditure ceiling in the following years depends on the approval of the pension reform and other consolidation measures.

3. Monetary policy is supportive. The central bank has held the policy rate at the historic low of 6.5 percent since March 2018, providing the economy with some monetary stimulus. Headline inflation is around the 4.25 inflation target for 2019, while core inflation is more muted. Inflation expectations are anchored around target.

4. Credit growth has been subdued. Lending by public banks has been declining, driven primarily by reduced funding available to BNDES development bank. Credit from private banks has grown instead at around 8 percent in real terms over the past year, leading to a moderate growth of overall bank lending. The reduction of the role of public banks in favor of market-based credit allocation is a welcome structural transformation. However, intermediation margins in the banking sector remain high, hindering credit demand and investment. The financial system is well capitalized.

5. Brazil’s external position remains strong. The current account deficit widened to 0.8 percent of GDP in 2018 and is projected to deteriorate to 1.5 percent of GDP in 2019 mostly because of one-off operations related to the energy sector and the recession in Argentina. However, Brazil’s external position is strong thanks to a large amount of reserves, a flexible exchange rate, and a contained current account deficit fully financed by large FDI inflows.

6. The improvement in social conditions has stalled in recent years. The unemployment rate declined only marginally in 2018, remaining high compared to pre-crisis levels, along with informal labor and underemployment. Despite the economic recovery, income inequality and the number of people living in poverty increased in 2017.

7. Domestic and external shocks could derail the recovery. The main domestic risk is the failure to approve a robust pension reform. In addition, other fiscal measures are necessary to comply with the expenditure ceiling and put debt on a sustainable trajectory.

Failure to undertake fiscal consolidation could undermine confidence and deter investment. External risks include a deepening of the recession in Argentina and global trade tensions.

Decisive Policy Action is Needed

8. Historically low growth, high public debt, and pervasive inequality call for a bold reform agenda. Since 1980, economic growth in Brazil has averaged 2.5 percent, well below peer countries. At 88 percent of GDP, public debt is one of the largest among emerging markets. Furthermore, debt continues to grow and is projected to peak only in 2024, conditional on continued fiscal consolidation. Despite remarkable improvements in previous years, inequality and poverty have increased since the 2015/16 recession and remain high by international standards. To tackle these challenges, the new government has rightly emphasized bold reforms with the overarching goals of unleashing growth potential and achieving fiscal consolidation, while its pension reform proposal would contribute to reducing inequalities.

Fiscal consolidation

9. Pension reform is the crucial step. The ambitious pension reform proposal under consideration by congress would stabilize pension spending over the next decade and make the system more equitable. To deliver the needed fiscal adjustment, Congress should preserve the proposed increase in retirement ages and decrease in the relatively high benefits, particularly for public sector employees.

10. But additional measures beyond the pension reform are needed to comply with the expenditure ceiling and stabilize debt . The government should preserve a neutral fiscal stance in 2019. Furthermore, to comply with the constitutional expenditure ceiling in outer years, the government should lower the public wage bill (which would also make earnings more equitable relative to private employees) and reduce other current expenditures, including by limiting minimum wage increases to cost of living adjustments since they also affect the growth of pensions and other benefits. Given the high level of debt, windfall revenue from oil—including proceeds from the upcoming Transfer of Rights transaction—should be used exclusively to lower debt. While pursuing fiscal consolidation, it is critical to protect effective social programs, including Bolsa Familia, and support public investment, both essential for sustained and inclusive growth.

11. The overly complicated and distortive tax system should be reformed . An ambitious tax reform is necessary to eliminate multiple indirect taxes by moving toward a single broad-based VAT, harmonize the fragmented federal and state tax regimes, and remove distortionary and costly tax exemptions. Efforts to strengthen revenue administration should continue.

12. The fiscal framework should be enhanced. To ensure the quality of fiscal adjustment, the authorities should address budget rigidities, including revenue earmarking, mandatory expenditure, and the indexation of key spending items. In addition, to facilitate the prolonged adjustment implied by the expenditure ceiling, the government should move toward a medium-term budget framework.

13. Fiscal risks for some states loom large. Governors of seven states have declared a state of calamity facing severe fiscal challenges. Of these, Rio de Janeiro has negotiated a fiscal recovery program with the federal government. Other states might also receive temporary relief if they implement fiscal consolidation measures under a program being considered by the authorities. But deeper structural measures, including pension and tax reforms, are essential to restore the medium-term sustainability of subnational governments.

Monetary policy

14. The monetary stance should remain accommodative, given the large output gap and anchored inflation expectations . The monetary stance is appropriately supportive at present. In the future, to the extent that fiscal consolidation is contractionary, there is scope to loosen further monetary policy provided inflation expectations remain well anchored. The recent bill on the relationship between the Treasury and the Central Bank enhances the institutional framework and is welcome. Enshrining central bank independence into law would further improve the inflation-targeting regime.

15. A flexible exchange rate remains important to absorb shocks. Intervention in the foreign exchange market should be used only to address disruptive market volatility. International reserves continue to provide a buffer against external shocks and should be preserved.

16. Further steps should be taken to enhance oversight of the banking sector. While there has been progress towards many of the 2018 FSAP recommendations, the authorities should build on recent efforts to further enhance the prudential, crisis management, safety net, and macroprudential frameworks. The regulatory and supervisory approach to credit risk should be upgraded further with regards to related party exposures and transactions, country and transfer risk, and restructured loans. A new financial resolution regime in line with the FSAP recommendations should be put in place promptly. The deposit guarantee fund should be brought into the public sector and the process for providing emergency liquidity assistance should be tightened. Efforts to create a multi-agency committee with explicit mandates for macroprudential policy and crisis management should be completed.

Structural reforms

17. Structural reforms are necessary to boost productivity. The government has rightly identified reducing the footprint of the state in the economy as a priority, by pursuing privatization, reducing state intervention in credit markets, lowering trade barriers, tackling corruption, and simplifying taxation.

18. The government is working on an ambitious privatization program. While privatization may provide some helpful one-off revenue, its main benefit will come by the improvement in productivity in some key sectors, including infrastructure and energy.

Privatized companies may also increase investment without using limited public resources.

19. Reforms are needed to improve bank intermediation efficiency. Firms and households face an unduly high cost of borrowing due to banks’ large credit losses, high operating costs, and lack of competition. A proposed corporate bankruptcy law would reduce delinquency costs for banks. Efforts to reduce the role of public banks and directed lending in credit markets should continue. Actions are needed to facilitate client mobility and financial product cost transparency. The recent approval of a credit registry law (cadastro positivo) is a step in the right direction.

20. Trade liberalization is essential to improve competitiveness. Brazil remains one of the most closed economies in the world to trade. After some trade liberalization in the early 1990s, tariffs have not changed much and nontariff barriers are high. In this context, plans to lower import barriers are welcome. Prospective OECD accession is an opportunity to foster trade integration. But trade liberalization should be pursued in any case.

21. The effective implementation of anti-money laundering and anti-corruption measures remains critically important. The government continues to pursue significant money laundering and corruption cases and has submitted proposals to improve the legal framework. Authorities are encouraged to continue focusing on preventive measures, effective enforcement, and long-term legislative improvements. In addition, authorities are urged to expedite the completion of the national anti-money laundering risk assessment.

The mission is grateful to the authorities and other counterparts for excellent discussions.