Currencies
Four Fall-Lines of Dominos: An Ordinal Ranking
May 06, 2008

By Stephen Jen & Luca Bindelli | London

Summary & Conclusions

In this note, we follow up on our framework of four possible ‘fall-lines’ of currency dominos by proposing an ordinal ranking of the vulnerability of currencies heading into this global slowdown.  We find that the NZD, AUD, CAD, ZAR and MEX are the lowest-ranking currencies, followed by TRY, CLP, ARS, GBP, and INR.  At the other end of the spectrum, CHF and HKD look best, followed by SGD, EUR and TWD. However, we believe that the EUR is so overvalued that it is vulnerable to downside surprises on growth.  These findings are broadly supportive of our tactical call to short CAD, short GBP, short NZD, and long CHF, SGD, and TWD.  

The Four Fall-Lines of Currency Dominos

In previous work (see Four Fall-Lines for the Dominos, March 13, 2008 and The Dollar Smile and the Fall Lines of Dominos, April 3, 2008), we suggested that, as the intensity of the financial crisis began to fade, the focus for currencies should shift to the economic fallout of a slowing US economy.  More specifically, we argued that, in anticipating how the various currency ‘dominos’ would fall, it might be useful to consider four possible ‘fall-lines’, which are not mutually-exclusive:

•           Fall-line 1.  C/A balances.  While C/A balances essentially reflect the underlying savings-investment balances of countries, and don’t need to be closed in steady state, in times of risk-aversion, they matter for currencies.  If we imagine a mild form of ‘global margin call’ as the world deleverages, the currencies of cash-rich countries should in theory be better positioned than those of cash-poor countries.  We will not repeat the chart we’ve shown in our earlier notes on the various countries’ C/A positions, but just note that countries are really spread out along this chart, with the likes of the ZAR, TRY, GBP, NZD and INR being the ‘losers’ and the CNY, SGD, GCC, CHF being the ‘winners’. 

•           Fall-line 2.  ‘Anglo’ financial, credit and housing cycle.   This is harder to measure quantitatively, but the idea is that the likes of the UK, NZ, Spain, Ireland and Australia, should, in theory, be more vulnerable than the likes of Germany and Japan. 

•           Fall-line 3.  Commodity prices.  Normally, a deceleration in global growth should lead to a weakening in commodity prices in general.  There may be powerful structural factors supporting commodity prices (e.g., possible changes in taste in emerging economies, the world may have entered ‘steep’ parts of the commodity supply curves, environmental policies), but commodity prices have risen so much recently that we believe there could be downside risks to them if the world’s demand growth slows enough in the coming months.  This means that currencies may be affected by the economies’ net commodity trade positions. 

•           Fall-line 4.  Trade exposure to US demand.  This is perhaps the most obvious channel through which a slowing US could affect currencies. 

A ‘Scorecard’

These four fall-lines are neither mutually-exclusive nor hard-linked to each other, either.  It is important to consider the possibility that different themes may dominate at different points in time.  Nevertheless, we propose a ‘scorecard’ that gives a summary ordinal ranking of currencies, to convey a general sense of vulnerability of selected currencies. 

For each ‘fall line’, we first rank the relevant characteristics of the economy in question, before assigning an ordinal ranking score.  For example, countries with the highest C/A deficit get a score of ‘-3’, while those with the highest C/A surplus get a score of ‘+3’.  A similar exercise is done for the other three ‘fall lines,’ though it was difficult to have a comprehensive set of scores for fall-line 2.  The four ordinal scores are then summed and the currencies re-ranked according to this summary measure. 

For the overall vulnerability index, CHF and HKD have the best overall ranking, followed by SGD, EUR, and TWD.  The C/A surpluses of both Switzerland and Hong Kong are large; they are also net commodity deficit economies, with a not very extreme trade exposure to the US.  Further, they don’t seem to have suffered from the ‘Anglo financial disease.’ 

At the bottom of the spectrum, NZD stands out as by far the lowest-ranking currency.  It has a large C/A deficit; it is a net commodity exporter; and it has a housing cycle that is roughly in line with that of the US (hence a score of ‘0’ for ‘fall-line 2’).  AUD and CAD also look pretty ugly in this table.  The de-merits of AUD are well-known, and Canada is super-exposed to US import demand.  GBP and INR look bad, though not as ugly as the commodity currencies.  ZAR and MEX also have low rankings. 

Currency Misalignments

It is important not to interpret these rankings literally.  ‘Mental adjustments’ to the results of our ordinal ranking need to be made, by considering the currency misalignments, market positioning and other factors.  To this end, we have included a column that shows the size of the currency misalignments using the current spot exchange rates.  For example, since EUR/USD is about 25% over-valued relative to our fair value framework, investors should not buy the EUR, despite its high ordinal ranking in our table.  SGD and TWD, on the other hand, look better positioned for out-performance among AXJ.  Similarly, NZD, AUD and GBP are all significantly over-valued, which should make it that much more compelling for investors to be cautious or outright bearish about these currencies, given their dismal ranking in our table.  CAD, on the other hand, looks a bit cheaper than NZD, AUD and GBP, and therefore could weaken by less.  Also, there is the consideration that Australia, for example, is a good ‘China Play’ and should enjoy some support from this status. 

Our Trade Recommendations

In any case, using this scorecard, we reiterate some of our currency calls:

1.         EUR/USD may have good reasons to be strong, but not this strong.   On our measures, the EUR does not appear to be that vulnerable.  However, as the global economy slows and as the financial conditions tighten in Euroland, we expect to see a material deceleration in the coming months.  Already, most sentiment surveys (soft data) are pointing toward weakness.  The ECB, however, is likely to treat the economy as ‘innocent until proven guilty’ and will likely refrain from cutting the refi rate unless ‘hard data’, such as industrial production and growth, start to show weakness.  In any case, the EUR is so over-valued that we believe it should trade down to 1.40 by year-end.  When this turn will take place, however, is a difficult call.  Our guess is that GBP/USD should head lower first, given that the reasons for this to happen are, to us, more compelling than EUR/USD trading lower, based on the data we have. 

2.         Look for TWD and SGD to out-perform.   In a separate note issued today, we have urged caution on short-USD/AXJ positions (see Dollar Smirks in Asia, May 1, 2008).   But among the AXJ currencies, we like TWD and SGD the best – a view validated by our scorecard. 

3.         Cautious and bearish on NZD, CAD, ZAR, GBP and INR.   The phase of the global business cycle we are about to see will not be friendly to these currencies, in our view, particularly if commodity prices start to decline, and more housing cycles in countries outside the US start to turn south.  We are relatively more constructive on AUD for the reasons highlighted in our previous research (see AUD: Liquidity, Coal, and Carry: Is Parity Within Reach, April 24, 2008).   New Zealand’s domestic cycle is turning, and we expect the first interest rate cut to come as early as September.  Being so exposed to demand from the US, we remain cautious on CAD.  If oil prices falter, CAD will lose another important leg of support.  India has ‘twin deficits’ and heavily depends on foreign capital inflows. 

Bottom Line

We believe investors should continue to focus on how the currency dominos will fall as the impact of the slowdown in the US economy starts to be felt in the rest of the world.  Sequencing is important, as not all currencies will be equally vulnerable or will weaken against the dollar at the same time.  We don’t like GBP, EUR, NZD, CAD, ZAR or INR.  We like SGD, TWD and the USD itself.

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Currencies
Dollar Smirks in Asia
May 06, 2008

By Stephen Jen & Charles St-Arnaud | London

Summary & Conclusions

We believe that the risks to USD/AXJ are likely to be skewed to the upside for the coming weeks. 

As a slowing US starts to compromise growth in Asia, we expect the AXJ (Asia ex-Japan) currencies to experience some weakness against the dollar.  When confronted with the choice between growth and inflation, most of Asia will choose to protect growth.  As a result, the structural descent in USD/AXJ will likely be temporarily interrupted.  For short-term players, this may be time to consider putting on tactical long-USD/Asia positions.  For longer-term players, we advise patience in re-establishing short-USD/Asia positions.  We stress that this is the first time in a long while that we are recommending that investors unwind short USD/Asia positions.  Among the AXJ currencies, we continue to believe that the ‘Greater Chinese’ currencies (TWD, SGD and CNY) are likely to outperform most other currencies.  Having said this, we believe that the pace of decline in USD/CNY will decelerate, and underperform the NDF; the risks of a maxi-step revaluation in the CNY are extremely low, in our view. 

Evolving Economic Fundamentals

Our structural view on the AXJ currencies should be familiar to regular readers of our work, that they are in the middle of a long-term structural ascent against the dollar as well as the euro.  However, in the coming two quarters or so, we suspect USD/AXJ may actually have more upside than downside risks.  There are several reasons behind this tactical view of ours. 

1.         Asian policymakers almost always put growth before inflation.  When growth is robust, Asian central banks talk about inflation.  But when growth decelerates, policies will be deployed to deal with this risk, regardless of inflation.  The distinction between the ‘dual-minded’ Fed and a ‘single-minded’ ECB is well-understood, but Asian central banks on the whole place even greater emphasis on growth and jobs than the Fed, as most of AXJ has a ‘tiered mandate’ with growth being more important than inflation.  This is mainly due to historical and structural reasons.  Historically, Asian countries have not suffered from sustained inflationary problems, unlike LatAm economies.  For example, during 1985-2007, inflation averaged 4.4% in Korea, 1.9% in Taiwan, 1.3% in Singapore and 2.6% in Malaysia.  Inflation in Indonesia and the Philippines has been relatively higher (averaging 10.8% and 8.1% during the past two decades).  Nevertheless, inflation rates in Asia have been significantly lower than in Latin American countries (301.1% in Argentina and 489.9% in Brazil during the same period).  In addition, structurally, workers’ bargaining power in Asia is even less than that in the US.  As long as unemployment is rising, there will be no wage inflation in Asia.  Thus, as AXJ economies start to decelerate, the policymakers will likely significantly slow down the pace of the appreciation of their currencies or reverse this long-standing trend altogether. (In this discussion about an impending growth deceleration in Asia, I stress that I still hold the view that Asia will only partially re-couple to the US.  The partial decoupling (or growth divergence) view is likely to be correct, but as long as growth slows, there will be policy reactions in Asia, in my view.)    

2.         It is the second derivative of CPI that matters.  CPI could be relatively high these days.  But as long as CPI inflation starts to decline, even it remains high, policies will turn.  In China, this is especially important.  If we see inflation decelerating sequentially every quarter this year, which is possible as the global economy slows and commodity prices have already experienced sharp increases in 1Q of this year, policies will turn much less hawkish.  While my colleague Qing Wang has argued that the PBoC will likely halt further interest rate hikes, I have been arguing that the pace of USD/CNY appreciation will decelerate.  In any case, the key here is that the second derivative of CPI turns negative. 

3.         USD/CNY to slow down.  Even though I have argued, in the past two years, that the CNY would appreciate strongly, so far this year, I have highlighted the risk of a deceleration in the rate of appreciation of the CNY: a negative demand shock from a slowing US should, in theory, be met with an exchange rate, not an interest rate, response.  This appears to be what Beijing has begun to do.  Further, the gradual CNY appreciation policy has its own problems.  The steady down-trend in USD/CNY has imbued in investors’ minds that further CNY appreciation is a certainty.  One-way bets on the CNY, in my view, were a key reason why, out of the US$460 billion of China’s balance of payments (BoP) surplus in 2007, trade only explained US$260 billion, with the rest being net capital inflows.  Strong expectations of further CNY appreciation have themselves led to large BoP surpluses, growth in high powered money, and ultimately inflation.  In other words, while the ‘end’ (the ultimate policy objective) of achieving a more sustainable C/A balance makes sense as a partial solution to the inflation problem in China, the ‘means’ of moving toward that objective through gradual and steady CNY appreciation is itself inflationary.  As external demand weakens, China’s C/A surplus will naturally decline, obviating the need for rapid CNY appreciation.  On the inflation front, diluting the expectation of certain CNY appreciation should help contain some inflationary pressures, contrary to popular belief.  (Many somehow have the view that a strong currency is good for keeping inflation low.  This is broadly correct, but more nuanced than many may think.  To keep imported price inflation contained, the currency would need to appreciate continuously.  This nuance applies to the argument about using a strong EUR to stem inflationary pressures in Europe.  Unless the EUR continues to appreciate indefinitely, it will not be a durable solution to the imported inflation problem in Europe.)   

4.         A maxi-step revaluation of CNY makes theoretical sense, but not practical sense.   Regarding potential for any big one-off CNY revaluations, we do not believe such a policy would make practical sense.  Theoretically, to avoid the catch-22 situation mentioned above, that a gradual CNY appreciation would be inflationary, Beijing could, over a long holiday period, surprise the market with a step revaluation, depriving the market of an opportunity to build on their long-CNY positions.  Indeed, some well-respected scholars in China, including Prof. Yu Yong-ding, have been proponents of this idea.  However, there are some practical issues.  First, in an environment of growth deceleration, it is very unlikely that Beijing would do something so dramatic and risky.  Second, to make this work, the size of the revaluation will need to be so big that most speculators and investors no longer expect further CNY appreciation.  The problem is that nobody knows where that level should be.  10, 15, even 20% might not be big enough (we suspect few investors would believe that a 15% CNY revaluation against the dollar would materially affect China’s C/A balance),  but a 35 or 40% revaluation would be totally out of the question, from a political perspective, in our view. (The conceptual distinction between ‘fair value’ and ‘equilibrium value’ of exchange rates matters here.  By ‘fair value’, often people have in mind the value of USD/CNY that is consistent with the relative economic fundamentals.  On the other hand, by ‘equilibrium value’, they have in mind the value of USD/CNY that would help narrow China’s balance of payments.  On the latter measure, USD/CNY would need to fall by a massive amount to satisfy speculators.)   

5.         HKD peg here to stay; RUB and GCC more interesting targets.  Of all the countries that have confronted the ‘impossible trinity’ – i.e., the policy ‘trilemma’ of maintaining an independent monetary policy, preserving a currency peg and keeping the capital account open, the HKD peg is the least likely to break.  We have long argued against betting on the HKD’s LERS (linked exchange rate system) being dismantled in the foreseeable future.  As the US slowdown starts to affect Asia, however marginally, the pressures on the HKD peg will abate, regardless of the inflation trend in Hong Kong.  Relative to the HKD peg, we believe long RUB is a much more interesting trade.  Inflation in Russia reached 13.3% in March and is heading into the 15-20% zone, which should turn inflation into a political problem in Moscow.  The de facto basket peg of RUB that has been in place since last summer will be pressured.  With a positive carry on the USD-RUB trade, we believe it makes much more sense to focus on the RUB than on the HKD.  Also, with crude oil above US$100 a barrel, some GCC pegs, such as Qatar (whose inflation has most likely already entered the 15-20% zone), are also much more vulnerable than the HKD peg, in our view. 

6.         The Fed and the Asian currencies.  If we look at the last two rounds of Fed rate cuts – the early-1990s (the FFR was 9.75% in April 1989 and 3.00% by September 1992) and early-2000s (the FFR was 6.50% in December 2000 and 1.00% by June 2003), we see that, in both episodes, the unweighted average USD/AXJ rose during the US slowdown and FFR rate cuts.  This, in fact, is the essence of the ‘Dollar Smile’ theme, whereby a US slowdown hurts other currencies more than the dollar.  Exhibit 1 shows that as the Fed eased into the past two recessions, USD/AXJ rose materially, and declined only when the Fed began to tighten.

Bottom Line

For the first time in close to two years, we are recommending that investors be cautious about short-USD/AXJ positions.  As the negative impact of a slowing US starts to show up in data on Asia, policymakers in Asia will almost certainly choose to protect growth, even if inflation remains high.  On inflation, it is important to remember that it is the second derivative of prices that matters, not how high the inflation rate is.  In this light, the slowdown in USD/CNY’s downtrend, which we had argued earlier this year would take place, makes perfect sense.  Betting against the HKD peg now makes even less sense.

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Brazil
Investment Grade, Why Worry?
May 06, 2008

By Marcelo Carvalho | Sao Paulo

Brazil’s investment grade is deserved, and reflects significant accomplishments. However, like graduation day, it should mark a starting point, not the final destination. There is still plenty of room for improvement on the structural reforms. The fiscal framework is a good example here. It is easy to see why no one cares about the fiscal numbers these days. But underlying structural challenges remain.

A Well Deserved Stamp of Approval

Graduation day is a major symbolic milestone. Standard & Poor’s upgraded Brazil’s long-term sovereign currency rating one notch to BBB- last week, with a stable outlook. Such graduation is a long-waited, major symbolic achievement. It marks a milestone in Brazil's economic history. S&P's statement highlighted the strength of Brazil's institutions and policy framework. It is only natural that observers will now expect other rating agencies to eventually upgrade Brazil too. Fitch and Moody's currently rate Brazil one notch below investment grade, with a stable outlook. Moody’s seems reluctant to act soon, but Fitch has indicated that Brazil’s rating is under active review. 

Timing was unexpectedly early. A long-awaited upgrade has been in the pipeline for awhile. But observers were getting used to the idea that an actual move was getting pushed for 2H08, or maybe next year. S&P did a good job in keeping its cards close to its chest. Few investors appeared to be positioned for an upgrade right now.

Investment grade is deserved. Several of Brazil's macroeconomic indicators have already been consistent with those seen in investment grade emerging markets. In particular, Brazil has accumulated reserves massively and bought back external debt, thus ‘buying’ its way into investment grade, so to speak.

Market implications are positive. The near-term market reaction is clear. Brazil's asset prices have rallied across the board, including sovereign debt spreads, the currency, local bonds and the stock market. Some pullback later on, after initial overshooting, cannot be ruled out. But there is little doubt that investment grade can provide an important support for investor sentiment on Brazil. One standard argument is that investment grade puts Brazil on the radar screen of a broader universe of international investors. Financing costs for the sovereign as well as for Brazilian companies should decline.

Investment grade is good news for the currency. There is little reason anymore for much further central bank intervention in the foreign exchange market in order to accumulate foreign reserves for the sake of rating upgrades. And the recent upgrade promises to lure more capital flows into Brazil, although no sudden deluge should be expected. In all, the currency should benefit. The real could well test new highs in the near term, in our view.

While we remain concerned that a widening current account balance will eventually call into question the long-term strength of the real, we are revising our end-2008 currency forecast to 1.70 versus our 1.90 forecast that we established last month (see “Brazil: Take a Hike”, EM Economist, April 18, 2008). Currency strength might help inflation prospects, but it is not likely to stop the central bank from hiking further. A question remains: how would the finance ministry eventually respond to currency appreciation? Here, no immediate action seems likely, but underlying policy tensions appear to linger.

Starting Point, Not Final Destination

It is easy to get carried away with optimism around investment grade. Don’t get us wrong: investment grade is a major symbolic accomplishment, and it reflects significant macroeconomic improvement over the years. Still, investment grade should be seen as a starting point, not a final destination. It would be sad if the rating upgrade led to investor or policy complacency. Fundamentals are consistent with investment grade status. However, sovereign rating reflects just a narrow concept: willingness and ability to pay debt. That is different from the much broader notion of ‘country risk’. Indeed, there is a long agenda of micro-economic challenges yet to be addressed. It would be best if investment grade encouraged the authorities to resume the structural reforms necessary to consolidate and further strengthen Brazil's fundamentals.

Even on the macro front, there is still plenty of room for improvement on the structural reforms. At the end, the ultimate goal is to promote the conditions that allow faster, sustainable potential growth. These include: boosting infrastructure, investing in human capital and building a regulatory framework that encourages competition and fosters private sector entrepreneurship. Investment grade by itself does little to change these conditions. In our view, a key structural chink in Brazil’s macroeconomic armor is its fiscal framework.

It Is Mostly Fiscal

It is easy to see why no one cares about the fiscal accounts in Brazil these days. After all, a significant primary surplus remains in place. The public sector debt to GDP ratio has drifted lower for years. And, despite the end of the CPMF tax last December, federal tax revenues during 1Q08 jumped 13% over a year ago in real terms − that is, above inflation. In fact, the primary surplus during 1Q was so large that it allowed a surplus also in the nominal balance (including the burden of interest payments), for the first time in recent history. Why worry now?

The emperor’s new clothes might become more visibly transparent if the macro cyclical landscape changes. The rising tide of global abundance over the last several years lifted many boats in the emerging world, spurring domestic growth and boosting fiscal balances in many places.

Indeed, Brazil’s fiscal accounts are ill prepared for a cyclical downturn. Brazil has followed pro-cyclical fiscal policies, maintaining a stable primary surplus by spending away a rising tax burden, amid strong domestic growth. The problem with pro-cyclical policies is that they feel great in the upswing, but can prove regrettably painful in the downturn. In fact, while concerns about structural fiscal challenges tend to move to the backburner in the good days, they risk coming back to haunt us in more challenging times.

A tougher environment for the fiscal accounts might lie ahead. First, as monetary policy tightens, the fiscal burden of interest payments increases. About a third of the federal domestic debt is linked to the overnight policy rate. Besides, about 30% of the domestic debt stock is due within the next 12 months (about half of which are fixed-rate bills), and will need to be rolled over at higher interest rates. In all, the Treasury estimates that a 100bp rate hike entails a direct fiscal cost of almost R$6 billion over a year. A full cycle of 200bp thus would cost some R$12 billion over a year − that means about 0.5% of GDP, or almost 2% of total federal revenues.

Second, as the economy slows under rising interest rates, the tax revenue picture could change. That is especially true if we are right that the economy will end 2008 softer than it started the year, with sub-par growth in 2009. Preliminary estimates suggest that a slowdown in industrial production to about half the 6% average growth pace seen last year might sap revenue earnings, perhaps to the tune of some 0.5% of GDP.

Taxes and Death

How would the authorities respond in case the fiscal picture begins to turn less bright? One possibility is simply to do nothing, and just let the fiscal balances deteriorate. A temptation here is to resort to the so-called Pilot Investment Program, an arrangement agreed with the IMF many years back. In this scheme, under certain conditions, some public expenses classified as investment would not officially count as primary spending. The headlined fiscal figures would thus look better, possibly by as much as 0.5% of GDP. However, analysts would quickly see through such arrangement as essentially an accounting trick.

Fiscal adjustment would require either higher revenues or lower spending. There is convincing international empirical evidence suggesting that sustainable fiscal adjustments tend to rely on spending cuts − rather than on tax increases. The composition of Brazil’s fiscal performance over the last many years therefore looks worrisome, as it has counted on a steadily rising tax burden at the same time that spending keeps climbing. In Brazil’s case, going ahead, neither accelerating revenue growth nor slashing fiscal spending would be easy policies to quickly implement.

First, the tax burden is already too high for lasting health. Brazil’s tax burden has marched up systematically over the last decade or two, increasing from about 25% of GDP in the 1980s to 35% of GDP last year. This is high by international standards, once adjusted for the country’s per capita income. Brazil is an outlier: it is a Latin country that taxes almost like Europe – without the provision of public goods seen in the old continent. The average tax burden elsewhere in Latin America is close to 20%. Given Brazil’s per capita income, its tax burden should be about 25%, if it were to fit a simple cross-country regression. No wonder thus public sentiment in Brazil by now has firmly turned against higher taxes. The government’s defeat in congress on the CPMF tax renewal last year testifies this new public attitude. Therefore, reliance on a steadily rising tax burden may prove an increasingly difficult proposition.

Second, perverse budgetary rigidities limit the scope for quick spending cuts, in light of mandatory spending rules and revenue earmarking. In fact, many spending decisions face an asymmetry: it is easy to increase expenses, but hard to cut them back, for legal as well as for political reasons. The minimum wage is a good example. It faces a ratchet effect. Because the floor for social security outlays is linked to the minimum wage, a decision to increase the minimum wage sets a new, permanently higher burden for the social security accounts. To complicate matters further, recent signals from Brasília suggest a policy inclination towards fiscal prodigality, not frugality. And the apparent slowdown in the pace of spending growth in 1Q had a lot to do with the simple fact that congress has not yet approved the 2008 budget. Lack of budget approval constrains expenses, but only temporarily.

All that Glitters Is Not Gold

The decline in the debt to GDP ratio could have been faster. A declining debt-to-GDP ratio is proof that fiscal policies in Brazil have been sufficiently tight in recent years, right? Look again. We suspect that this might be a misleading benchmark. An alternative measure of success is what the numbers would have looked like under a more prudent framework. Let us provide a simple counterfactual exercise. Assume fiscal spending in recent years was held stable as a share of GDP at the levels seen back in 2003. Note we are not assuming an outright spending cut at all. Just increase expenses in line with the economy. All else equal, the cumulative benefit from a resulting larger primary surplus would have shrunk the debt-to-GDP ratio to under 20%, as opposed to the actual figure a bit above 40% we have now.

Why Worry Now?

A cyclical downturn might eventually rekindle concerns about the remaining structural challenges. Current fiscal trends in Brazil are not sustainable, to put it bluntly. Maintaining a primary surplus amid rising spending by steadily increasing the tax burden is not a strategy that can be sustained indefinitely. A rising tax burden eventually hits a limit – either economic or political. Global growth bonanza in recent years may have helped to mask underlying structural fiscal issues. But a prospective cyclical downturn can serve as a timely reminder: structural reforms are needed in order to put Brazil’s fiscal accounts on long-term sustained footing.

Four main areas for fiscal reform come to mind. First: increase budget flexibility. Budget rigidities in the form of mandatory expenses and revenue earmarking constrain the room for maneuver in the event of adverse developments.

Second, improve Brazil’s fiscal framework, which is currently bad for growth. A heavy tax burden and a cumbersome tax system, besides weak public investment in infrastructure, are no doubt a drag on the private sector’s ability to grow faster.

Third, rebalance the policy mix. Brazil’s current policy mix − with rising fiscal spending and world-high interest rates − is suboptimal. Tighter fiscal policies could go a long way in paving the road for structurally lower real interest rates over time.

Fourth, address social security trends. The underlying structure of the social security system is probably the Achilles’ heel facing Brazil’s long-term fiscal prospects. Besides global demographic trends that turn against pay-as-you-go systems, Brazil’s social security has its own idiosyncratic challenges. In the scheme for private sector employees, relatively low retirement age requirements and the link to the minimum wage complicate matters. In the system for public sector employees, generous rules for retirement bloat expenses. In both cases, the long-term viability of the current system is questionable.

Sadly, recent years have been a missed opportunity for fiscal reform. It is a shame. Global abundance over the last years provided sunny skies for Brazil to fix its fiscal roof. Being forced to get it done under the rain could prove a much less pleasant experience. Investment grade now offers a new opportunity for resumed reforming effort. It would be unfortunate if instead it ends up becoming a curse in disguise, by encouraging policy complacency.

Bottom Line

Investment grade is great news. But it is a starting point, not a final destination. There is still plenty of room for micro and macro structural reforms. In particular, few care about fiscal matters these days. But questions remain about the long-term sustainability of Brazil’s fiscal framework.

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