Fiscal Challenges
August 25, 2009
By Marcelo Carvalho | Sao Paulo
Brazil's recent fiscal deterioration pales in comparison to trends seen elsewhere in the global economy lately. So, why worry? Brazil's near-term fiscal picture looks comfortably manageable, but observers might start to wonder about the longer-term fiscal outlook if the recent acceleration in federal spending and aggressive credit expansion by public banks become a permanent feature of Brazil's fiscal landscape.
Rising federal spending weakens the fiscal balance. Brazil's budget balance is worsening. Brazil's headline fiscal concept is the so-called public sector ‘primary' balance, which excludes the burden of interest payments. Brazilians call the ‘nominal' deficit what elsewhere is often known as the budget balance. While Brazil runs a primary surplus, it faces a nominal deficit. Both measures have weakened lately. The primary surplus declined to 2.0% of GDP in the 12 months through June, from 3.7% at the end of 2008, or a peak of 4.3% last October. This is also below the 2.5% target for calendar 2009 as a whole. In other words, Brazil's primary surplus has weakened by about 2 percentage points in less than a year - this is a fairly fast pace of deterioration by Brazil's standards. The burden of fiscal interest payments has come down, to 5.3% of GDP in the 12 months through June, from 5.7% of GDP at the end of 2008. But declining interest rates are not enough to fully offset the shrinking primary surplus, and the nominal deficit has thus worsened to 3.2% of GDP by mid-2009, from 2.0% at end-2008, or from a record low of 1.3% last October.
The federal government is driving most of the recent fiscal deterioration - numbers at the local government level or at state-owned enterprises have not changed much. By contrast, fiscal worsening at the federal level accounts for 85% of the fiscal worsening seen in the first half of the year.
Rising spending accounts for about two-thirds of the fiscal worsening at the federal level so far this year, though revenues have weakened too. Federal revenues have suffered on the back of the economic downturn and discretionary tax breaks, such as a temporary reduction in the IPI tax on automobiles and white-line goods. For its part, federal spending had already been trending higher over the last several years, but has accelerated significantly so far this year.
Why Worry?
Brazil's fiscal deterioration appears very mild by recent (much looser) international standards. According to a recent IMF study, Brazil's fiscal stimulus represents only about 0.7% of its GDP, much smaller that the average fiscal expansion seen in other G-20 economies. So, why worry?
Two issues may raise questions about Brazil's current fiscal strategy: fiscal spending and public sector banks. The first issue is that the recent rise in spending inspires caution, given its composition (see below), accelerated pace and possibly permanent nature. The second issue is the potential quasi-fiscal costs associated with the current aggressive expansion of credit by public sector banks. The IMF's measure of fiscal stimulus mentioned above captures neither of these issues, as it essentially measures temporary tax cuts recently introduced in Brazil.
Indeed, the recent rise in fiscal spending can raise three concerns. First, its composition does not appear ideal from the point of view of stimulating Brazil's growth potential. Indeed, despite Brazil's widely recognized infrastructure needs, federal investment is just about a meager 1% of GDP. Instead, rising federal spending is concentrated in non-investment areas. Social security expenses continue their secular upward march, magnified by generous discretionary annual hikes in the minimum wage, which serves as a floor for social security outlays. Running expenses have climbed steadily over the last several years too. But perhaps the most eye-catching recent development is the sudden acceleration in personnel expenses, after years of stability as a share of GDP.
In fact, the second concern on fiscal spending is its recent accelerated pace. Left unchecked, the recent pace of spending would require a matching accelerated pace of revenue expansion in order to keep the primary surplus intact.
A third concern is the potential permanency of higher spending, given its asymmetric nature. Federal expenditures have risen in areas which seem hard to quickly unwind - for instance, public sector wages and hiring. A temporary increase in fiscal spending is understandable as a policy response to a recessionary environment. But the picture could start to change if temporary fiscal support morphs into permanently higher spending. Brazil's recent fiscal policy is sometimes described as a counter-cyclical response to the growth downturn. However, counter-cyclical policies have to be temporary, leaning against the cycle in both directions. Recent temporary tax breaks seem to fit the description. But it remains to be seen whether fiscal authorities will cut spending as the economy recovers. The risk is that Brazil ends up with a hard-to-unwind, permanent rise in spending.
Another issue to watch on the fiscal front is the quasi-fiscal stimulus put in place through aggressive credit expansion by public sector banks. Perhaps less obvious or immediate, this could prove to be a relevant fiscal concern over time. Public sector banks have been lending aggressively so far this year, including the national development bank (BNDES), well ahead of private sector banks (see "Brazil: The Credit Channel", EM Economist, August 7, 2009). In 1H09, public sector banks have increased their lending by almost two percentage points of GDP, accounting for about three-quarters of the total credit extension in Brazil during that period, boosting their share in the system to 39%.
Quasi-fiscal policies can entail fiscal costs. Pushing public sector banks to lend aggressively can help to stimulate the economy in the near term. But it may also imply eventual fiscal costs if loans turn bad, and end up requiring capital injections from the Treasury later down the road. In turn, subsidized lending from BNDES is not costless. When the Treasury issues debt to fund subsidized loans via the BNDES, the public sector's gross debt increases, its net debt remains unchanged (the BNDES is not considered public sector for the sake of the fiscal accounts), but the effective burden of interest payments rises, given the negative interest rate differential for the Treasury.
Fiscal policy has implications for monetary policy too. The looser fiscal policy gets, the relatively tighter monetary policy has to be, for a given overall policy stance. Given the still relatively high level of interest rates in Brazil by international standards, Brazil could benefit from some policy rebalancing - tighter fiscal policy could open room for a relatively looser monetary stance over time. In the near term, by contrast, one risk is that fiscal expansion in 2010 could end up working to accelerate the start of the eventual monetary tightening cycle.
Near-Term Fiscal Scenarios
It will not be easy to meet the official fiscal targets without resorting to some accounting devices this year and next. In our computations, the primary fiscal surplus looks likely to worsen from 3.7% of GDP last year to around 1% of GDP (a bit below the 1% mark this year, and slightly above 1% next year). A rebounding economy and the unwinding of tax breaks will support tax revenues, but fiscal spending will rise too. The official fiscal target looks for a primary surplus of 2.5% of GDP in 2009 and 3.3% in 2010.
But with the primary surplus likely to fall below those marks, the authorities may resort to two accounting mechanisms that can improve the headline number by about 1% of GDP - drawing from the so-called sovereign wealth fund (0.5% of GDP), and using the investment pilot program (0.6% of GDP), which essentially means not computing as fiscal spending some public investment. It would not surprise us if next year's 3.3% primary fiscal target itself is eventually lowered too, as already happened in April with the 2009 target.
Lower average interest rates should help to reduce the burden of interest payments this year and next. But the overall nominal budget deficit still worsens from 2% of GDP last year to almost 4% of GDP this year, before an improvement to about 3% of GDP next year. Again, accounting mechanisms that boost the primary result would also automatically improve the nominal deficit too.
Real GDP growth and the pace of spending matter. Our base case scenario assumes real GDP growth of 3.5% next year. It also assumes that the speed of increase in fiscal spending slows back to the average pace seen over the last several years. To be sure, growth helps. If real GDP growth recovers to the 4.0-5.0% range next year, fiscal balances would improve by about 0.5% of GDP, relative to the base case, on the back of higher tax revenues. But there are downside risks too. If fiscal spending continues to expand at the accelerated pace seen in 1H09, then next year's fiscal balance could worsen by more than 1.5% of GDP, relative to our base case scenario.
Beyond the near-term fiscal outlook, the longer-term sustainability of Brazil's broader current fiscal strategy looks questionable - relying on a steadily rising tax burden in order to compensate for steadily rising fiscal spending (as a share of GDP) does not seem to be a strategy that can be sustained indefinitely, without entailing an undesired crowding out of the private sector. In other words, Brazil would benefit from a fiscal ‘exit strategy' from the current approach of steadily rising taxes and spending.
The good news is that fiscal solvency is not at stake. We look for the net debt/GDP ratio to stay mostly in the 40-45% range over the next year-and-a-half, although that ratio is sensitive to currency moves too. A simple medium-term exercise illustrates that Brazil's debt dynamics look comfortable under most scenarios. With solvency concerns far removed, the fiscal authorities can now focus on making sure that the public sector boosts its ability to save and invest, enhances its efficiency, avoids crowding out the private sector, and contributes to improve Brazil's monetary-fiscal policy mix. It would be a shame if instead Brazil ends up with just steadily higher fiscal spending, a rising tax burden and increasing quasi-fiscal contingent liabilities.
Bottom Line
Brazil's recent fiscal deterioration pales in comparison to trends seen elsewhere in the global economy lately. So, why worry? Brazil's near-term fiscal picture looks comfortably manageable, but observers might start to wonder about the longer-term fiscal outlook if the recent acceleration in federal spending and aggressive credit expansion by public banks become a permanent feature of Brazil's fiscal landscape.
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Review and Preview
August 25, 2009
By Ted Wieseman | New York
As we move through the worst of the summer doldrums, Treasuries ended up little changed the past week amid minimal trading volumes, as a Friday sell-off, which followed a surprisingly strong existing home sales report and a fourth-straight gain in stocks that took them to a new high for the year after a significant sell-off Monday briefly interrupted the five-month long surge, reversed decent gains seen through the first part of the week. Stock moves largely dictated Treasury trading, and aside from the sell-off in response to the home sales strength, there wasn't much reaction to a light economic calendar. Other data were somewhat mixed, but the ongoing rebound in 3Q growth is expected to be manufacturing, and especially autos, focused, and this continued to be confirmed both in data reports and company-level news. The early manufacturing surveys for August from the New York and Philadelphia Fed Districts both showed major improvement, with the upside in the underlying activity gauges suggesting that the national ISM will probably move into growth territory above the 50 boom/bust line this month for the first time since the beginning of 2008 just as the recession was starting. And GM's updated assembly schedules, with huge sequential increases in production in both 3Q and 4Q, confirm expectations that there will not be any sudden reversal of the huge rebound in auto sector output in 3Q that is expected to drive most of the expected +3.9% gain in 3Q GDP (which we boosted slightly on the week from +3.7% as a result of the existing home sales numbers). The planned surge in auto output, which is poised to add more than 3 points to 3Q GDP and potentially another half-point or more to 4Q, comes as huge demand for cash-for-clunker trade-ins continued to drive auto inventories to new lows even as production has been sharply boosted already. A recent stream of erroneous press reports claiming fading effectiveness of cash-for-clunkers incentives was definitively refuted by the Transportation Department's announcement that the additional US$2 billion in money recently added to the initial US$1 billion for the program has already been almost exhausted, necessitating that the program end imminently. Based on this news, we now expect that August motor vehicle sales will surge another 43% on top of July's 16% gain to a 16 million unit annual rate, which would be the best month since November 2007. On the somewhat softer side, however, the labor market improvement appears to be coming along much more gradually as productivity is seeing a cyclical spike, with the latest claims figures suggesting that August payrolls will probably post a drop in line with July's -247,000, which had marked a major moderation in job losses from the prior few quarters.
On the week, benchmark Treasury yields were not much changed, on net ending a period of major volatility that included a huge rally the prior week that followed a major sell-off two weeks back. Small short-end losses and small long-end gains, however, flattened the curve moderately on the week. The 2-year yield rose 3bp to 1.08%, 3-year 2bp to 1.63%, 5-year 5bp to 2.55% and 7-year 3bp to 3.19%, while the 10-year was flat at 3.55%, and the 30-year rallied 4bp to 4.36%. The mild underperformance on the curve by the 2-year, 5-year and 7-year came ahead of heavy supply in these issues in the coming week. The stabilization on the week in nominals did not carry over into TIPS, where a big rally led to another major weekly move in inflation breakevens, this time to the upside as oil prices surged, with October oil up over US$4 a barrel to US$73.89, a high for the front month since last October. The 5-year TIPS yield fell 18bp to 1.15%, 10-year 17bp to 1.66% and 20-year 8bp to 2.14%, reversing some of what had been a major prior flattening in the real yield curve. These gains left the benchmark 10-year inflation breakeven up 17bp at 1.90%, reversing part of a 29bp decline the prior week. After returning to near 4.5% after a big recovery the prior week, MBS yields weren't much changed through the week. With only a few notable brief swings in either direction, current coupon mortgage yields have mostly held quite close to 4.5% for a solid two months now, which has kept 30-year mortgage rates near 5.25%. This is up about 50bp from the late March to late May period when MBS yields were consistently near 4% and 30-year mortgage rates at record lows near 4.75%, but evidently the current level of rates is still low enough (and the stability is also no doubt helpful) to be supportive of a gradual pick-up in housing market activity. Swap spreads widened somewhat on the week, with the benchmark 5-year and 10-year spreads both up about 4bp to 42.5bp and 26.5bp. There were some bouts of mortgage-related paying when origination activity accelerated in response to the rally in mortgage yields from the highs on August 7 near 4.8% down back to 4.5% by mid-month. Trends in interbank rates markets were also somewhat mixed. Spot 3-month Libor after a minor hiccup Monday resumed setting daily record lows Tuesday, sinking to 0.39% Friday, a nearly 4bp drop on the week. The spot 3-month Libor/OIS spread sank about 5bp to only 20bp, extending the run of new lows since the financial turmoil began two years ago. We had figured that the improvement would stall around 25bp, but it keeps moving closer by the day to pre-crisis norms near 10bp. Futures markets believe that we're near the low, however. The forward Libor/fed funds spread to mid-September declined a few basis points on the week, but at 22bp is a bit above the spot spread, and further widening is priced in beyond that. Forward Libor/OIS spreads to December, March, June and next September were up about 3-5bp on the week into the 35-40bp range, though this upside relative to longer-dated forwards suggesting a new equilibrium around 25bp is partly a cyclical reflection of the rate hikes priced in over the course of 2010.
After a rough start to the week on Monday, risk markets managed a solid recovery over the rest of the week to leave equity and credit markets back in rally mode after the prior week's interruption of the prior long run of gains. Stocks managed a bigger and more persistent rally after the Monday losses than credit, with the S&P 500 gaining 2.2% for the week and reaching another new high for the year at Friday's close. The energy sector did particularly well, with about a 5% gain, but gains were broadly based, with financials, industrials, materials, consumer discretionary, consumer staples, utilities and healthcare all posting gains that weren't far from the overall market's 2% increase. A strong end to the week allowed investment grade credit to post small net gains on the week, with the IG CDX index trading 3bp tighter at 114bp late Friday, unlike stocks, still somewhat worse than the year's best level of 105bp reached August 7. Lower-quality credit similarly posted a relatively small net improvement, thanks to a strong end to the week, with the high yield CDX index jumping 1 1/8 points Friday after having been 4bp wider at Thursday's close at 836 and the leveraged loan LCDX index jumping a point Friday after having been 10bp wider at 714bp at Thursday's close. The HY CDX and LCDX index both closed out the week around 65bp wider than the early August tights for the year. It was a mixed week for the commercial mortgage CMBX market. The AAA index fell 1.61 points to 76.77, as investors were not too excited by the amount of loans requested at the second round of TALF lending for CMBS (which only lends against AAA paper). The program again failed to spark any new CMBS issuance, and while there was a pick-up in borrowing to buy legacy CMBS from the meager US$0.7 billion in July, the US$2.3 billion requested this month was not too impressive. Lower-rated CMBX indices, on the other hand, did manage to rebound strongly off a bad start to the week and end stronger, with the junior AAA up a point to 42.06 and the AA and A up moderately as well. The subprime ABX market showed marginal upside, with the AAA index up a tenth of a point to 26.85. halting a substantial pullback over the prior couple of weeks from the 31.18 close at the end of July. There was some horrible data about mortgage delinquencies and foreclosures released by the Mortgage Bankers' Association during the week, with subprime credit problems becoming even more severe into 2Q, but apparently this was already in the price.
Existing home sales surged 7.2% in July to a 5.24 million unit annual rate, a two-year high after a 21% rebound from the January low. The National Association of Realtors said that nearly a third of July's sales were distressed sales, the same as in June, though somewhat improved from the early spring. This continued to pressure prices, with the median sales price down 2% in July for a 15%Y plunge. Record foreclosure rates also stymied progress in getting inventories under control. The number of homes for sale at month-end rose 7.3%, leaving the supply unchanged at 9.4 months, well above more balanced levels around six months. Housing construction also continued to stabilize, a near-term positive for growth but not helpful in getting inventories of unsold homes down quickly. Housing starts dipped 1% in July to a 581,000 unit annual rate. All of the weakness was accounted for by a 13% drop in multi-family starts to a record-low 91,000 on an over-supply of condos and apartments and a drying up of commercial real estate financing. Single-family starts, on the other hand, gained 2% to 491,000 and are now up 37% from the record low hit early in the year, though to a still severely depressed level from a longer-term perspective. Incorporating these latest housing figures, we now see 3Q residential investment on pace for about a 1% rise, up from our prior -5% forecast, which boosted our GDP forecast to +3.9% from +3.7%. If residential investment does rise slightly this quarter, it would end an incredible run of 14 straight quarterly declines that cumulated to a 57% collapse. Although the recent stabilization in starts indicates that new homebuilding activity is flattening out, homes under construction and housing completions continue to fall as they catch up with the prior plunge in starts, so new homebuilding activity will probably be down again in 3Q, though at a much slower pace than seen in some time. Instead, all of the upside we see in residential investment in 3Q should come from a surge in the broker commissions component, which has become a more important share of total residential spending as homebuilding has collapsed.
Early indications for the key round of initial August data were somewhat mixed but positive overall. The headline sentiment gauges in the Empire State and Philly Fed surveys both surged well into positive territory, and while the levels of the underlying activity details weren't as robust, the sequential improvement was just as strong. On an ISM-comparable weighted average basis, the Empire rose to 48.7 from 44.5 and the Philly to 48.5 from 43.7. Our initial forecast for the national ISM is for an increase to 51.0 from 48.9, which would be the first outcome above the 50-breakeven level since January 2008. Also very positive were reports from the government and automakers on just how strong the cash-for-clunkers program has continued to run. With the additional money allocated to the program expected to be exhausted soon, it appears that cash-for-clunkers trade-in sales probably reached close to 600,000 units in August, or about 6-7 million units on a seasonally adjusted annual rate basis. On top of the depressed recent underlying trend in sales, this suggests that the sales pace for the month could have surged all the way to 16 million from 11.2 million in July and only 9.5 million in the first half of the year. Note also that while non-auto retail sales are likely to remain weak, there will likely be at least some temporary upside in August chain store sales relative to recent awful numbers, as a later start to the beginning of school and resulting shifting of a number of state sales tax holidays appears to have shifted some demand in the important back-to-school shopping season into August from July. Against these positive signs, improvement in the labor market appears to have temporarily stalled after the big moderation in job losses seen in July. The latest weekly claims report showed both the 4-week average of initial claims and continuing claims little changed moving into the survey period for the August employment report compared to the July survey week after a major prior improvement. As a result, our preliminary forecast is for a 250,000 drop in non-farm payrolls in August, the same as in July. And we expect the unemployment rate to move a bit higher again after the surprising decline in July that resulted from a drop in the labor force that more than offset continuing declines in employment.
The calendar is a lot busier in the coming week, but it seems likely that trading conditions will be at least as thin as the dead-quiet past week, since undoubtedly large numbers of market participants will be out on summer vacations. The most recent rounds of supply have been taken down without any problems after repeated difficulties earlier in the year, but it's possible that thinly staffed desks at dealers and investment firms could make the latest flood of supply - US$42 billion 2s Tuesday, US$39 billion 5s Wednesday and US$28 billion 7s Thursday - a bit trickier. The economic data calendar is fairly busy, though the next major run of numbers won't be until the following week, when we get the initial run of key reports for August. Releases due out in the coming week include consumer confidence Tuesday, durable goods and new home sales Wednesday, revised GDP Thursday and personal income Friday:
* We expect the Conference Board's measure of consumer confidence to rise to 48.0 in August. The University of Michigan sentiment gauge posted a surprising dip in early August. However, we look for a slight uptick in the Conference Board measure, reflecting the recent euphoria in financial markets and the lagged impact of lower gasoline prices. Also, note that one of the major differences between the two surveys is the greater weight placed on labor market conditions in the Conference Board survey. Thus, news that the unemployment rate registered a slight decline in July could help to bolster this measure of confidence a bit.
* We forecast a 3.7% gain in July durable goods orders. Sharp gains in the volatile aircraft and motor vehicle categories are expected to lead to big jump in overall order volumes in July. Meanwhile, the key core category - non-defense capital goods excluding aircraft - is expected to post a modest gain, providing further evidence of some underlying improvement in bookings. Finally, shipments are expected to post a healthy gain, while inventories are likely to register another sizeable decline.
* We expect July new home sales to rise to a 400,000 unit annual rate. Although mortgage rates have risen from their lows of a few months ago, the homebuilder sentiment survey continues to show signs of a modest recovery from the extremely depressed levels seen late last year and earlier this year. So, we look for another 4% gain in sales of newly constructed residences.
* We expect 2Q GDP growth to be adjusted down a bit to -1.5%. A significant downward revision to the already sizeable negative contribution from inventories should more than offset an upward adjustment to net exports, leaving overall GDP about a half percentage point below the originally reported reading of -1.0%.
* We look for 0.3% gains in both personal income and spending in July. The employment report showed the first increase in aggregate weekly payrolls since last August. So personal income appears poised for a modest rise. Meanwhile, a sharp jump in vehicle sales should more than offset a dip in retail control, leading to a similar-sized gain in overall consumption. The personal savings rate is expected to hold steady in July following some big swings over the course of prior months that were tied to a special one-time stimulus payment. Finally, our translation of the CPI data points to a +0.10% outcome for the core PCE price index, which implies a dip to +1.4%Y.
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