Mission Concluding Statement 

Brazil: Staff Concluding Statement of the 2020 Article IV Mission

October 5, 2020

Washington, DC:

Pre-Covid: A Slow Recovery but Promising Outlook

1. Brazil was struggling to kickstart its economy after the severe 2015-16 recession . GDP growth during 2017-19 was disappointingly low , marking the slowest recovery on record for Brazil and among the 10 percent weakest recoveries around the world in the last 50 years.

2. But good policies had positioned the economy to take off in 2020 . The government embraced an ambitious reform agenda to put fiscal finances on a sustainable footing. A landmark pension reform was passed in October 2019 that stabilized pension spending as a share of GDP, and draft legislations were submitted to Congress to control government spending, improve tax efficiency and decentralize fiscal resources. These measures combined with the adoption of the constitutional expenditure ceiling in 2016 and reduction in state bank lending, improved Brazil’s fiscal outlook considerably and precipitated a fall in the sovereign risk premium. With core inflation below target, this enabled the Central Bank (BCB) to gradually cut the policy rate to a record low of 4.25 percent by early 2020. The historically low interest rate environment triggered a structural transformation of financial markets, ushering in a new class of retail investors and deepening capital markets.

The Covid-19 Shock: Impact and Policy Response

3. As in most countries around the world, the COVID-19 pandemic has upended the lives and livelihoods of Brazilians. More than140,000 Brazilians have died and 4.8 million have been infected, making Brazil one of the hardest hit countries in the world. New cases and fatalities have declined but remain at high levels while insufficient testing hampers a full assessment of the scale of the health crisis. Many Brazilians also lost their jobs or saw their working hours significantly reduced as the pandemic shut down key sectors of the economy. Overall, economic activity contracted by 7 percent in the first half of 2020, the largest contraction in 30 years.

• Almost 12 million jobs were lost between February and July, of which over 7 million were from the informal sector. The unemployment rate rose by about 2 percentage points to 13.8 percent, but this small increase masks the fact that 11 million workers (over 10 percent of the workforce) left the labor force altogether.

• Households at the lowest income decile were most affected by the overall loss in labor income—losing 30.2 percent of their monthly income—while women, who were more likely to be employed in the service sector, suffered a big decline in hours worked (36.2 percent versus 27 percent for men).

4. Amid the spike in global risk aversion, Brazil suffered large capital outflows. Portfolio outflows amounted to US$32 billion in March and April, sharply accelerating a trend of outflows over 2015-19 which totaled around US$47 billion. Financial flows have since stabilized and international reserves have recovered to end-2019 levels, but the Real remains much weaker than at the start of the year and non-resident portfolio outflows have not yet reversed.

5. The government’s response was swift and substantial. In late March, Congress declared a state of public calamity to pave the way for fiscal and quasi-fiscal measures amounting to 18 percent of GDP. Despite already high public debt, the policy response was among the largest for G20 countries and raised the primary fiscal deficit to 12 percent of GDP. An important element of the government support was in the form of cash transfers ( Auxílio Emergencial or Emergency Aid). The authorities also increased health spending, provided vital financial support to subnational governments, extended government-backed credit lines to small businesses, and introduced employment retention schemes.

6. The BCB eased monetary and financial policy. The BCB cut the policy rate by 225 bps in quick succession to 2 percent, sold US$38 billion in the spot and derivatives market as the exchange rate came under pressure during March and April, and announced extensive liquidity and capital relief measures. To expand the BCB’s crisis-fighting toolkit, Congress passed legislation allowing the BCB to purchase public and private assets for financial stability purposes while a state of public calamity is in force, an option that has not yet been used.

7. The strong policy response averted a deeper economic downturn, stabilized financial markets, and cushioned the effects of the pandemic on the poor and vulnerable .

• The Emergency Aid proved crucial in supporting the livelihoods of informal workers and poor households, lifting the income of an estimated 23 million individuals—10 percent of the total population—above the extreme poverty line. But the extension of the aid to 67.7 million individuals meant that the average fiscal costs for nine months will reach around 4.6 percent of GDP. At close to 10 times the annual cost of the well regarded Bolsa Familia program the Emergency Aid was large given the available fiscal space .

• The employment retention schemes helped protect formal jobs . The program subsidizes workers for temporary reductions in hours and is estimated to have saved up to 10 million jobs at a cost of around 0.4 percent of GDP between April and September. Government-backed credit lines to SMEs also helped save 2 million jobs.

• Liquidity support and capital relief measures preserved the proper functioning of domestic financial markets and supported credit intermediation. Private sector credit growth picked up and reached 10 percent between March and July, as non-financial corporates ramped up demand for working capital to manage their cash-flow challenges.

Outlook and Risks

8. The economy is projected to shrink by 5.8 percent in 2020, followed by a partial recovery to 2.8 percent in 2021 . With the Emergency Aid cut by half for the last four months of the year, private consumption is expected to recover only modestly in the second half of 2020 and expand slowly through 2021 due to the lingering effects of the health crisis and the withdrawal of fiscal support. The drawdown of household savings accumulated during 2020 (household time deposits surged by over 60 percent y-o-y as of August) will smooth consumption during the first quarter of 2021, and as in many countries, investment will be hampered by idle capacity and high uncertainty about growth prospects. The current account is projected to post a small surplus of 0.3 percent of GDP in 2020 amid a sharp contraction in imports and to balance in 2021 as external demand picks up.

9. With the sharp increase in the primary fiscal deficit, gross public debt is projected to jump to around 100 percent of GDP in 2020 and remain high over the medium-term . Gross financing needs of 29 percent of GDP in 2020 are being met through a combination of domestic issuances and the use of liquid assets (Treasury deposits at the BCB). The record low SELIC, combined with the recent shortening in average debt maturities, has allowed the government to reduce its borrowing costs to historically low levels (5 percent relative to a high of close to 15 percent in late 2016). However, Brazil currently faces a very steep local currency yield curve, highlighting market concerns over fiscal sustainability.

10. Risks are exceptionally high and multifaceted. While there are upside risks—the recession could turn out to be less severe or the recovery more robust than projected—the downside risks are significant. These could include a second wave of the pandemic, long-term scarring from a protracted recession, and vulnerability to confidence shocks given Brazil’s high level of public debt. Nevertheless, sizable international reserves, a resilient banking system, and a low share of public FX debt are important strengths. International reserves are about 150 percent of the IMF’s benchmark (ARA) metric and 250 percent of external debt, providing a comfortable cushion against external shocks.

Near-Term Policy Priorities: Saving Lives and Livelihoods

11. The authorities’ steadfast commitment to the expenditure ceiling is welcome. With public debt rising to 100 percent of GDP, preserving the constitutional expenditure ceiling as a fiscal anchor is essential to support market confidence and keep the sovereign risk premium contained. Substantial fiscal consolidation is required to close the primary deficit, which the mission projects as necessary to stabilize public debt over the medium-term.

12. If health, economic, and social conditions were to turn out worse than the authorities expect, they should be prepared to provide additional fiscal support . While some recent indicators are encouraging and the authorities expect a strong rebound next year, it may take time for employment, incomes, and poverty to return to pre-Covid levels. There is an unusually high degree of uncertainty over how the pandemic will evolve and the expiry of fiscal support at the end of the year will add pressure on the already-wide output gap.

13. Swiftly implementing structural reforms that lock in medium-term consolidation will be essential to mitigate the risk of undesirable debt dynamics. Without unequivocal evidence that the expenditure ceiling will be preserved, any additional spending could erode market confidence and increase interest rates. Fiscal structural reforms should focus on reducing mandatory spending and budget rigidities, strengthening the social safety net, and revamping the tax system:

• Reducing mandatory spending and budget rigidities . The pandemic has brought into sharp focus the critical need to free up fiscal space for discretionary spending, which is currently limited to less than 7 percent of the Federal Budget (1.5 percent of GDP). This could be achieved with an overhaul of the civil service career structures to reduce the heavy burden of wages and pensions, reducing earmarking, and de-linking social benefits from minimum wage increases. These measures could at a minimum release one percent of GDP annually for discretionary spending. In addition, the subnational pension schemes should be reformed in line with the new provisions for federal government employees and state personnel spending should be reduced to comply with the limits established by the Fiscal Responsibility Law.

• Strengthening the social safety net. The authorities should holistically review existing social assistance programs with the aim to eliminate those that are inefficient and regressive. This should save at least 0.3 percent of GDP under the expenditure ceiling to fund an expanded Bolsa Familia program, on a permanent basis, while preserving efficient targeting.

• Revamping the tax system . A simplification of indirect taxes, reduction of payroll costs and tax expenditures, and more progressive labor and capital income taxation are needed to improve the business environment, reduce resource misallocation, and tackle income inequality. Implicit and explicit fiscal incentives are approaching 5 percent of GDP and provide an important source of revenues to improve the primary balance and reduce debt.

14. With the substantial withdrawal of fiscal stimulus in 2021, monetary policy carries the burden of supporting the economy. The current 2 percent policy rate corresponds to a negative real rate, which is strongly expansionary. There is room to cut the policy rate further if inflation and inflation expectations remain below target. Possible implications for capital outflows and financial stability risks should be carefully monitored. As a complement, continued use of forward guidance to signal that the policy rate would stay low for longer, conditional on maintaining a sound fiscal regime, could have an expansionary effect without risks to financial stability. The temporary reduction in the reserve requirement ratio could also be made permanent to reduce banks’ liquidity costs, thus helping to narrow borrowing spreads and increase the flow of credit to firms and households. Should downside risks materialize after conventional monetary policy has been exhausted, the BCB has the option to use QE. The BCB has built its reputation over the years as a credible institution, and the approval of formal Central Bank independence would further strengthen the integrity of the monetary framework.

15. The Brazilian banking system remains resilient but continued close surveillance and bank-by-bank monitoring is warranted. Results from solvency stress tests suggest that the banking system will remain resilient to the COVID-19 shock, and banks have been conservative and forward looking in increasing provisions. The existing flexibility of the regulatory framework should be used to weather the short-term impact of COVID-19 without diluting prudential standards or accounting requirements. If needed, banks should draw down on their capital conservation buffer to absorb the impact of any losses. In a situation in which system-wide liquidity pressure prevails, banks should also be encouraged to use their stock of high quality liquid assets by allowing the liquidity coverage ratio to fall below 100 percent and the BCB could provide additional liquidity by, for example, expanding the collateral base of its lending facilities.

16. The authorities must move ahead with structural reforms to raise potential growth and improve the standard of living for all Brazilians. The pandemic has added to Brazil’s growth challenge. To create jobs and lift the poor above the poverty line, structural reforms to make the Brazilian economy more competitive, open to business and trade, and attractive to investment are essential. The BCB is charging ahead with the BC# Agenda to improve market efficiency and reduce the cost of credit, an important part of banking sector reforms needed to raise productivity growth. Nevertheless, a renewed push to pass legislation for a comprehensive tax reform, finalize trade agreements with the EU and other trading partners, conclude the GPA with the WTO, and accelerate the pace of new concessions and privatizations, is still needed to bring productivity gains to the economy. The newly approved sanitation and sewage bill is highly welcomed and should spur a pipeline of critical infrastructure projects and investments going forward.

17. The authorities should continue to prioritize the fight against corruption and money laundering (ML) and prevent legal and institutional setbacks . Ensuring the capacity of competent authorities to independently and effectively investigate and prosecute corruption and financial crimes, without undue influence, are fundamental aspects of international standards and of any effective anticorruption and AML/CFT frameworks. Preparations for the upcoming FATF/GAFILAT AML/CFT assessment are underway, notably a national risk assessment and AML/CFT risk-based financial supervision. There is also a legislative initiative to amend the AML/CFT law, which should involve all relevant stakeholders to ensure FATF compliance. As in other countries, the COVID-19 pandemic has increased corruption and money laundering risks, notably those associated with procurement fraud and corruption. The authorities have already taken prevention and transparency efforts to mitigate risks. Additional useful measures would be to enhance the sharing of beneficial ownership information, and to strengthen the frameworks for asset disclosures, lobbying and whistleblower protection.

The IMF team is grateful to the authorities and private sector counterparts for their collaboration and high-quality discussions.