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…time to upgrade the fiscal policy targets

The Brazilian economy is booming, but it has also become more sensitive to a combined current and capital account shock. Thanks to strong fundamentals such a shock would, similar to 2008, not jeopardise Brazil’s overall economic stability. Nonetheless, Brazil should think about moving towards rules-based, medium-term fiscal policy adjustment, preferably focussed on containing current expenditure. This would, at the margin, help deal with persistent currency appreciation pressures and create greater “fiscal space” in the event of a balance-of-payments shock.

The Brazilian economy is booming. Foreign and domestic investor confidence is high. The new government confidently projects real GDP to expand at an average annual rate of 6% over the next four years, underpinned by rising public and private-sector investment. This compares with an actual average growth rate of 2.3% under Cardoso (1995-2002) and 4.1% under Lula (2003-2010).

A widening current account deficit has in the meantime made Brazil more sensitive to a precipitous decline in commodity prices, while the recent surge in capital inflows has made it similarly sensitive to a reflow of foreign capital. If it were not for a further projected rise in commodity prices, Brazil would be registering a trade deficit this year for the first time in a decade on the back of an appreciated exchange rate and burgeoning domestic demand.

The value of non-manufacturing exports as a share of total exports has risen to 60% against 40% a decade ago. Brazil has also absorbed large foreign capital inflows since Q1 2009. Capital inflows doubled from USD 85 bn in 2009 to USD 165 bn in 2010 (or a massive 7% of GDP). The stock of foreign portfolio holdings has tripled over the past two years and now amounts to USD 360 bn (or 15% of GDP). It is hence not difficult to see how Brazil has become more sensitive to a combined current and capital account shock.

Thanks to strong fundamentals such a shock would, similar to 2008, not jeopardise Brazil’s overall economic stability, for its aggregate balance sheet remains strong. In terms of external liquidity and solvency, Brazil’s position is very solid (chart). While some of the recent capital inflows are potentially fickle, any currency depreciation resulting from a balance-of-payments shock would prove self-limiting given that an increasing share of non-resident claims are denominated in local currency. Last but not least, the systemically important bank sector carries a manageable FX exposure, both on-balance-sheet and off-balance-sheet.

In terms of government finances, Brazil is similarly well-positioned. The public sector is a net foreign-currency creditor to the tune of 10% of GDP. Currency depreciation thus results in a decline in the debt-to-GDP ratio. Public debt has also become less sensitive to a sudden rise in interest rates, while interest rate volatility has declined. Moreover, the government does not directly depend on commodity revenues, other than by way of (limited) dividend payments. Compared to many other commodity-exporting countries, Brazil’s fiscal vulnerability is very low.

That said, the government should raise the primary surplus more aggressively, preferably via a reduction of current expenditure. This would not only be desirable in terms of dealing with capital inflows, currency appreciation, monetary policy and economic over-heating. It would also provide the government with greater fiscal space, should the knock-on effect of a terms-of-trade shock on the government’s fiscal position be larger than expected.

Such a proposal was put forward by FM Palocci under Lula I. If this is politically not feasible, the government could consider switching from a “primary surplus” to a “structural primary surplus” target (that is, surplus adjusted for the economic cycle and, if necessary, the volatility of commodity-related revenue). Targeting the structural balance would help reduce the pro-cyclicality of Brazil’s fiscal policy. The government might even consider targeting a structural nominal deficit given the continued decline in interest rate volatility. However, given the medium-term trend towards rising primary current expenditure and the need for extensive public investment in the run-up to the 2014 World Cup and 2016 Olympics, it might be preferable to adopt a rule aimed at a reduction of current expenditure rather than a rule that might end up constraining the growth in public investment.

With the help of a credible, rules-based, medium-term fiscal policy adjustment, Brazil would be able to bring about a further structural downward shift in domestic real interest rates and a concomitant rise in domestic investment. This would not only help boost Brazil’s long-term economic growth. It would also help to reduce currency appreciation pressure or make a strong currency valuation more manageable over the medium term thanks to resulting productivity gains. Last but not least, it would provide the government with greater “fiscal space”, should a terms-of-trade shock end up having a greater-than-expected impact on the government’s fiscal position.