Brazil’s Exploding Debt-to-GDP Is Going to Become a Problem Soon

Jonathan Levin JonathanJLevin

Ye Xie xieyebloomberg
June 2, 2016 — 10:00 PM BRTUpdated on June 3, 2016 — 2:27 PM BRT
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Reining in Brazil’s mammoth budget is no small feat, no matter how good you are.
Cut discretionary spending, and risk blowback from an already frustrated electorate. Raise taxes, you could exacerbate the nation’s crushing recession. Privatize government companies? Beware the wrath of the unions. Shrink social security? It’ll take decades to manifest itself on the nation’s balance sheet. And that doesn’t even start to address Brazil’s massive interest tab.
That’s the harsh reality facing Acting President Michel Temer, 75, who took over three weeks ago for Dilma Rousseff as she awaits an impeachment trial. His economic cabinet — dubbed the “dream team” by Goldman Sachs Group Inc. — takes over a crisis-torn country with a public-sector debt burden that climbed 9 percentage points last year alone to 67 percent of gross domestic product. And liabilities keep mounting fast. The budget gap is now the biggest among all countries in the G-20 except Saudi Arabia, equal to more than 10 percent of GDP.
“I’m very skeptical that they can pull this off,” said Desmond Lachman, a former International Monetary Fund director. “You’re having to do this whole exercise with a very weak economy, and there’s a risk that you push this economy down even more. If the politics are very difficult now, how much more difficult are they going to be in a few month’s time if the economy keeps sliding?”
Gross debt-to-GDP, while still at manageable levels for now, is on course to top 80 percent within two years, according to Lachman, now a resident fellow at the American Enterprise Institute in Washington. That would exceed the threshold that Bank of International Settlements economists have said hobbles growth. It also raises concerns about fiscal sustainability in a country that missed foreign debt payments in the 1980s and sought an IMF bailout in 2002.
There are key differences this time around — the country now holds a lot more dollars that it can use in an emergency and it primarily owes money to local, rather than foreign, investors — but another full-blown crisis still may be looming, Lachman said.
For a BI Economics overview of Brazil’s government spending, click here.
In the well-worn Titanic analogy of slow-moving sovereign debt meltdowns, Temer still has time to help Brazil dodge the iceberg. But the deep recession makes that harder by the day. Unemployment is at its highest since at least 2012, central bankers are hamstrung by a 9.3 percent inflation rate and history hasn’t been kind to developing nations with disproportionately large debt loads. The crowding-out effect, whereby the government exhausts the economy’s lending capacity and drives up interest rates, has a way of squelching private investment and undermining growth.
“Economies really suffer” when emerging-market governments accumulate too much debt, said Koon Chow, a London-based strategist at Union Bancaire Privee, which oversees $112 billion in assets. “They tend to have more turmoil and asset prices are more volatile.”
The exploding debt load, political challenges and gloomy economic outlook all add up to a tough road ahead for Temer. That’s left many long-time Brazil watchers scratching their heads as investors frantically bid up asset prices this year on speculation he can quickly turn around Latin America’s biggest economy. The currency is up 12 percent this year and the Ibovespa equity index has surged 30 percent in dollar terms. The cost of hedging against non-payment on Brazilian dollar debt has plummeted more than 150 basis points to 341 basis points. The real jumped 1.7 percent Friday to 3.5322 per dollar as of 1:23 p.m. in New York.
To bulls out there like Jan Dehn, the head of research at Ashmore Group Plc, there’s plenty more money to be made. “The political transformation in Brazil is creating huge investment opportunities,” he said from London.
To Lachman, that feels like wishful thinking. “Markets are getting ahead of themselves,” he said. “You’re not going to find a silver bullet.”
Quicktake: Brazil’s Highs and Lows
Temer’s options are limited. Even if his team can muster political support for spending cuts in Congress — something the Rousseff administration failed to do — it’ll be restricted by a budget in which only about a fifth of expenditures are discretionary, according to Bloomberg Intelligence calculations. Of the biggest mandatory outlays, social security benefits take up 38 percent of the budget and payrolls are 20 percent. Subsidies and unemployment insurance represent 5 percent each.
The discretionary spending line item is problematic, too. Health and education spending are both based on constitutionally defined rules, limiting the cuts that can be made. Among the few expenses that are truly discretionary are infrastructure-type investments and Bolsa Familia, the government’s signature poverty-alleviation program, said Marco Maciel, Bloomberg Intelligence’s economist in Brazil.
Raising taxes is an option, but that risks driving Brazil even deeper into its worst-in-a-century recession. The economy is projected to shrink 3.8 percent this year. Boosting income taxes isn’t ideal — workers are already struggling enough, Maciel said. Higher levies on financial transactions, tobacco, fuel and beverages could add 33 billion reais ($9.2 billion) in real annual revenue, but that’s still less than a fifth of the 170.5 billion primary deficit approved by lawmakers in May.
Privatizing state-owned companies could help bring down the debt, and it would leave fewer state enterprises to potentially seek a bailout down the line, but unions are bound to put up a fight, said Alberto Ramos, the Goldman Sachs economist responsible for the dream-team coinage.
“You need to secure political support — you need to actually convince society that this is needed,” Ramos said. Can it be done? “We don’t know,” he said.