Mission Concluding Statement 

2. Fiscal sustainability is at risk . The end of an era of above-average growth, based on a consumption boom and high commodity prices, has exposed structural fiscal fault lines. The fiscal position, including at the subnational level, has reached its worst level in over two decades, reflecting the impact of the recession on top of adverse structural factors. The decline in potential growth and persistently high real interest rates have contributed to a significant worsening of the debt dynamics.

3. The government has committed to a much-needed agenda of fiscal and structural reforms . In particular, for 2017 and beyond, the government has proposed a cap on the growth in federal noninterest spending at the rate of consumer-price inflation in the previous year and announced plans for social security reform. The government has also initiated regulatory reforms in support of the concessions and privatization program, strengthened the governance framework for state owned enterprises, and hinted at further structural reforms. Major public enterprises and banks, notably Petrobras and BNDES, have been placed under new management. Markets have responded positively to decreasing uncertainty, further boosted by positive sentiment toward emerging economies.

II. Outlook

4. Growth should resume gradually in 2017. There are tentative signs that the recession is nearing its end. Staff project output growth of -3.3 percent in 2016 and about ½ percent in 2017. The projection is predicated on the assumption the fiscal spending cap and social security reform are approved in a reasonable timeframe, and the government will meet the proposed fiscal targets for 2016 and 2017. With these improvements on the fiscal front, and assuming uncertainty continues to decline, investment is projected to continue to recover, supporting a gradual return to positive sequential growth beginning in late 2016. A more rapid recovery in economic activity is hampered by excess corporate leverage, high unemployment, and weak balance sheets of households. Inflation is expected to gradually converge toward the midpoint of the target band. 

 
5. Downside risks continue to dominate the outlook, but some upside risks are emerging.

• The key domestic risk is that the government fails to deliver on the core of its fiscal consolidation strategy. Policy implementation challenges include navigating reforms through Congress in a tight time frame. If key reforms are watered down or get stalled in Congress, the boost to confidence will be short lived, and the recession may continue, putting further stress on income and balance sheets throughout the economy. In a similar vein, a re-intensification of political uncertainties will be a drag on growth.

• External risks relate to a more protracted period of slow growth in advanced and emerging economies, especially China, further declines in commodity prices, and tighter external financial conditions.

• But some upside risks have also emerged. Recent policy pronouncements have boosted confidence and asset prices. If this gathers further momentum, for example, because of a faster-than-expected approval of the spending cap and social security reform, it could facilitate a reduction in risk premia, triggering a more vigorous turnaround in investment (including as a result of M&A activity) and growth.

III. Policy Recommendations

6. The government’s focus on controlling the growth of fiscal spending is an imperative and is welcome. Unsustainable fiscal policies, driven by unfunded and increasingly onerous mandates on the expenditure side, ultimately increase borrowing costs for all agents in the economy and slow down economic growth, contributing, in turn, to a further worsening of the public debt dynamics. The approval and steadfast implementation of the spending cap could be a game changer—it would help improve the long-term trajectory of public spending and permit the stabilization and eventual reduction of public debt as a share of GDP.

7. Regaining fiscal sustainability requires addressing the structural drivers of public expenditure growth. Key areas to address include:

• Social security. It is important to move expeditiously on social security reform. The reform needs to be broad based, focusing on all of the main aspects of the system, including a modification of the rules governing retirement age, replacement rates at retirement, access to other benefits, duplication of benefits, and those affecting the annual growth of payments to beneficiaries. In the interest of fiscal prudence, as well as equity and fairness, the reform should also encompass the regimes for public sector employees at all levels of government. Given still high inequality and to mitigate the impact on the poor, a reform package should include provisions aimed at protecting the most vulnerable.

• Subnational governments. The upward trajectory of expenditures in many states, including some of the largest, needs to be contained through the adoption of a rule similar to the one proposed for the federal government. Enacting legislation enabling states to make difficult expenditure adjustments should be part of the strategy to help states regain control of their finances. A firm commitment by states to reform their finances and increase transparency in the reporting of expenditure is key.

• Fiscal framework. Strengthening the medium-term fiscal framework, reducing budgetary rigidities (including of tax earmarking), and increasing the flexibility of the composition of spending would increase the effectiveness and credibility of the spending cap. To increase transparency and the management of fiscal risks, it is recommended to consolidate Petrobras and Eletrobras into non-financial public sector statistics (without including them in the calculation of the fiscal targets).

• Minimum wage and indexation. The formula for minimum wage revisions affects the growth of pensions and other benefits, and is therefore a major source of fiscal pressure over the medium term. The link between social benefits and the minimum wage merits revision, while the minimum wage formula should be revised to better reflect improvements in productivity.

• Spending efficiency. The spending cap will make it imperative for government agencies to make better use of resources to prevent a decline in the quality of their services.

8. Fiscal consolidation based solely on the spending cap would take several years to stabilize public debt, and carries attendant risks . In such a scenario, public sector debt as a ratio of GDP will still continue to grow for a number of years, before peaking and beginning to decline gradually. The overall deficit would also remain high for an extended period, during which the government would continue to crowd out private agents from scarce funding.

9. Thus, there is merit in a more frontloaded consolidation. The exact moment when debt peaks will be affected by the rate of growth of the economy and real interest rates in coming years, and also by the trajectory of primary balances, over which the government has more control. A possible objective could be to reach a primary balance of around 3½ percent of GDP over the next 5 years, which would stabilize debt by 2021. A combination of expenditure and revenue measures could be considered to this end. Given concerns over the short run impact on output of faster consolidation, these measures could be designed to come into effect once economic growth has firmed up.

10. Monetary policy should remain tight until inflation expectations converge more clearly toward the center of the target band. Staff considers current monetary policy settings as broadly appropriate given inflation expectations. Tangible progress on restoring the sustainability of public finances would allow more room for monetary easing to support the recovery.

11. The exchange rate should remain the first line of defense against shocks. Intervention in foreign exchange markets should remain limited to episodes of clear market disruption and high volatility, and reserve buffers should be preserved. Under the baseline, staff sees merit in the continuation of the central bank’s policy of reducing the net notional value of FX swaps. The use of reverse FX swaps is also a good tool for this purpose, supplementing the reduction in rollover rates of FX swaps.

12. The resilience and efficiency of the banking sector should be bolstered. The health of the banking system remains largely sound, although the recession has affected profitability and asset quality. The mission welcomes the moderation in the growth rate of credit by public banks, their 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. To make the banking sector more resilient to shocks, financial safety nets should be improved by strengthening the procedures for use of the deposit insurance fund, enhancing the central bank’s emergency liquidity assistance, and modernizing the resolution regime. Frameworks to identify, prepare for, and respond to future risks, involving all financial regulators, should be put in place expeditiously. The authorities are also urged to follow through on their plans to strengthen private insolvency frameworks, with the aim of expediting the bankruptcy process and reducing default losses incurred by banks.

13. Well-designed and properly sequenced structural reforms can hasten the return to growth and strengthen it over the medium term. Some of the key areas to consider include:

• Infrastructure bottlenecks. Following through on recently announced enhancements and regulatory reforms would help make the concessions program more attractive to investors, while maintaining high standards of governance and program design.

• Opening of the economy . Reductions in tariffs and nontariff barriers, including a revision of the policy on domestic content requirements, and pursuing free-trade negotiations outside Mercosur, would help boost competition, efficiency, and growth over the medium term.

• Efficient allocation of savings . A review of credit earmarking rules and other distortions would be advisable to ensure that national savings go to their most productive uses.

• Labor reform . Reforms aimed at facilitating productive employment and reducing incentives for informality would promote job-creation, investment, and growth.

• Tax reform . One important way to reduce the cost of doing business would be to simplify the State Tax on the Circulation of Goods and Services (ICMS). PIS/CONFIS and IPI should also be consolidated and replaced with a true federal VAT.

14. The effective implementation of transparency, anti-corruption and anti-money laundering measures would contribute to enhancing predictability for businesses and ensuring a greater perception of fairness. The government’s commitment to make data on public procurement open by default, implement the recent legislation on conflict of interest, and strengthen whistleblowing mechanisms will go a long way towards increasing transparency.

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