Press Release No. 15/167

Press Release: IMF Executive Board Concludes 2014 Article IV Consultation with Brazil

April 10, 2015

The Executive Board of the International Monetary Fund (IMF) concluded the Article IV Consultation¹ with Brazil on March 16, 2015.

Starting in 2015, the new government has been introducing a series of measures to strengthen macroeconomic policies and restore credibility following a period in which Brazil’s growth has surprised on the downside. Determined implementation of these measures should help restore confidence and foster a recovery in growth and investment in due course.

Brazil’s growth has decelerated in recent years.² The boost from decade-old reforms, expanding labor income, and favorable external conditions, which enabled consumption and credit-led growth and underpinned sustained poverty reduction, has lost steam. Investment has been sluggish, reflecting eroding competitiveness, a worsening business environment, and lower commodity prices. Consumption has also moderated despite strong wage increases, as job creation has halted and financial conditions have tightened, affecting household income and consumer confidence.

In recent years, headline and core inflation have been near the upper-edge of the inflation tolerance band, owing in part to sustained wage cost pressures, lingering indexation practices, and, more recently, the ongoing drought. In turn, longer-term inflation expectations rose since 2011, although they have edged down since end-2014. Meanwhile, modest increases in regulated energy and fuel prices helped hold back overall inflation for some time. But overdue adjustments in regulated prices are now underway, while inflation in market-determined prices is moderating reflecting tighter financial conditions and subdued economic activity. New inflation pressures are emerging from the Real’s nominal depreciation.

The central bank hiked the monetary policy rate 375 basis points to 11 percent between April 2013 and April 2014. Policy tightening paused from May through September 2014. Between October 2014 and March 2015, the rate was again increased by a cumulative 175 basis points to prevent second round effects from currency depreciation and the anticipated increases in regulated prices.

Despite weakening domestic demand, the current account deficit reached 4.2 percent of GDP in 2014, up from 2.4 percent of GDP in 2012. The deterioration reflects worsening terms of trade, a drop in exports to Argentina, and an increase in fuel imports necessitated by the drought. The recent depreciation against the U.S. dollar, arising in part from general dollar strength, has not translated one-for-one into gains against competitors in global markets. Moreover, persistently high unit labor costs continue to dampen competitiveness. As a result, the external position is weaker than desirable, with the real still overvalued at end-2014.

International reserves are high and capital flows have remained stable. FDI financed more than 70 percent of the current account deficit in 2014, and portfolio inflows have been buoyant. At about US$362 billion, gross international reserves (cash concept) are well above the IMF’s reserve adequacy metric and other standard benchmarks.

The banking system’s soundness indicators remain favorable. Although private sector leverage and past expansion of public bank lending are potential sources of stress, banks’ indicators are encouraging, showing adequate levels of capitalization and provisioning as confirmed by stress tests.

In 2013, the non-financial public sector primary balance declined to 1.9 percent of GDP, undershooting its 2.3 percent target despite one-off revenue measures. Coming on top of tax breaks introduced over 2012-2013, rapid real expenditure growth and slowing revenues brought the primary fiscal balance of the nonfinancial public sector to -0.6 percent of GDP in 2014, despite one-off measures of about ½ percent of GDP. Policy lending to public banks also edged back up. As a result, nonfinancial public sector gross debt increased to 71 percent of GDP. Declining growth and weak fiscal performance affected Brazil’s sovereign credit rating in 2014. Standard & Poor’s cut Brazil’s credit rating to BBB- in March 2014, its first downgrade since July 2002. In September 2014, Moody’s revised Brazil’s sovereign rating outlook to negative.

Since January 2015, the government began introducing a series of important measures to strengthen macroeconomic policies and restore credibility. The linchpin of the new strategy is an ambitious fiscal adjustment to bring the primary surplus of the nonfinancial public sector to 1.2 percent of GDP in 2015 and to at least 2 percent of GDP in 2016 and 2017. The measures aim first to stabilize nonfinancial public sector gross debt and then put it in a downward trajectory.

Fund staff projects negative output growth of 1 percent in 2015, with some drag from tighter fiscal and monetary policies and from the cuts in investment by Petrobras adding to the downward momentum in activity carried over from 2014. Successful implementation of the fiscal adjustment strategy and other policy actions should contribute to strengthen confidence and help reinvigorate investment in the latter part of 2015, providing the basis for a return to positive growth in 2016. The outlook is subject to significant downward risks, including drought-induced rationing of energy and water, the possible fallout from the Petrobras case, and a more adverse international environment.

Executive Board Assessment³

Executive Directors underlined the success of the Brazilian authorities in reducing unemployment, poverty, and inequality in recent years. Directors noted that stalling growth, high inflation, and deteriorating public finances pose difficult challenges, while external downside risks also weigh on the outlook. In this context, they emphasized the need to further strengthen policy credibility and market confidence, boost investment and competitiveness, and reinforce the foundation for strong, balanced, and sustainable growth.

Directors welcomed the newly announced fiscal strategy, which includes targets for 2015−17, the decision to end policy lending to public banks, and the emphasis on reducing gross debt ratios. They stressed that achieving the budget targets would require ambitious, front-loaded measures. They supported the focus on cuts in current expenditures and tax exemptions to make room for priority spending on investment and social programs. Many Directors pointed to the benefits of targeting a higher primary surplus over the next two years in further strengthening policy credibility and the fiscal position, although some cautioned about the growth impact of such adjustment. Directors saw a need for continued fiscal reforms to reduce budget rigidities, simplify the tax system, and address structural sources of fiscal pressure more broadly, including the pension and wage indexation systems.

Directors encouraged strengthened governance frameworks in state-owned enterprises. They considered it an immediate priority to address the problems at the state-owned oil company and welcomed the authorities’ commitment to find a swift resolution.

Directors generally agreed that monetary policy should remain tight. They welcomed the authorities’ commitment to the announced inflation target and their readiness to take additional action so as not to jeopardize that target. Directors recommended further efforts to improve monetary policy transmission and the inflation targeting framework over time.

Directors noted that Brazil’s flexible exchange rate has an important role to play as the main shock absorber. They welcomed the recent scale-down of the foreign exchange intervention program and recommended that its use remain limited to smoothing out excessive volatility, thereby allowing a further depreciation of the exchange rate in line with fundamentals and promoting external competitiveness.

Directors recognized the soundness of the banking system, with adequate capital buffers, provisioning, and liquidity. They stressed the importance of monitoring banks’ balance sheets and corporate leverage in the current low-growth environment. Enhanced bank supervision, including for public banks, as well as targeted microprudential measures, would help mitigate potential risks. Directors were encouraged by the significant progress being made in implementing key recommendations of the Financial Sector Assessment Program.

Directors considered supply-side reforms as critical for boosting the economy’s productive capacity and growth potential. They recommended that priority be placed on infrastructure investment and initiatives to enhance tax efficiency, improve the business climate, and foster international trade. Prioritization of reforms and greater private sector participation will be key to success.