Brazil's Corruption Scandal Isn't Its Biggest Problem

  • National debt growing at unprecedented rate as economy shrinks
  • Try cutting a budget in a falling economy -- hard to succeed

In Brazil, the push to oust President Dilma Rousseff has shifted, as often happens in politics, away from the corruption scandal that first landed her government in trouble. Impeachment calls are now focused on her handling of fiscal accounts, and that is perhaps fitting since few problems in Brazil rank higher than its exploding budget deficit.

At 536 billion reais ($141 billion), the gap has swollen to the equivalent of more than 9 percent of gross domestic product. It’s not just that the figure is the biggest in at least two decades; it’s how quickly it has grown as the country sinks into a protracted recession. Eighteen months ago, the deficit was 3 percent of GDP. So while no one is talking about default as a near-term concern -- and bond yields show no such jitters -- many do say that it’s helping fuel an inflation surge and could eventually push the country toward a full-blown debt crisis unless spending is reined in after a decade of largesse.

Caught in a grinding cycle of recession and eroding revenues, Brazil’s government finds itself in a damned-if-you-do-damned-if-you-don’t set of choices. In other words, while the country’s current debt dynamics look potentially unsustainable to UBS Securities LLC’s Geoffrey Dennis, he says that “if you try to cut a budget into a falling economy, chances are you’re not going to succeed.”

Rousseff started her second term this year vowing to regain investor confidence by shoring up public accounts. Instead, austerity measures caused Congress to rebel and her popularity to plummet. Investor and consumer confidence sank, and the recession deepened. Consumer prices are already soaring. They rose 9.9 percent in the past 12 months. That’s the fastest pace in over a decade.

The same accounting tricks the opposition says are reason enough to oust Rousseff add up to 57 billion reais the government now must repay state banks and other state entities, according to the congressional budget committee. Yet there is a long list of reasons for Brazil’s runaway budget deficit that go back years and include subsidized credits and tax breaks on everything from houses and cars to washing machines. In 2015 alone Brazil is forecast to lose 109.3 billion reais in revenue due to tax breaks implemented since 2010, according to the tax agency. Minimum wages increased 163 percent over the past decade, more than double the inflation rate, helping push up government pension payments, which are linked to it.

“The government explored every possible way to be irresponsible,” said John
Welch, macro strategist at Canadian Imperial Bank of Commerce. “It goes beyond a lack of foresight. It was plain old negligence.”

Plummeting Revenues

Political uncertainty over Rousseff’s future is exacerbating a post-commodity-boom recession, pushing business confidence to a record low and causing revenues to plummet. Plugging that gap would be a tall order for any government.

"Inaction due to the challenging political environment creates a negative feedback loop for the economy," Shelly Shetty, head of Latin America sovereigns for Fitch Ratings, said by e-mail. "Fiscal challenges will remain even if the political crisis is over."

Cutting spending is difficult and unpopular in any country but near impossible in Brazil. The government effectively has control over about 10 percent of its spending, with the rest earmarked for obligatory outlays, including social security spending, debt servicing and payroll, according to congressional budget experts. Appetite for more far-reaching measures to downsize the state and heighten competitiveness is virtually non-existent, says Nicholas Spiro, a managing director at Spiro Sovereign Strategy.

"There’s a sense of hopelessness," said Spiro. "It’s about the growing disillusion with the political class and the bleak prospects for reform."

Near-Record Reserves

Others push back on such pessimism, noting that, unlike the crisis of 2002 when the government was on the brink of default, it has a much sunnier balance sheet with near-record foreign reserves held by the central bank and lots of cash in the Treasury.

At almost $370 billion, Brazil’s international reserves are more than enough to cover a foreign debt of about $138 billion. So there is virtually no risk of a default, given the bulk of the debt is in local currency, and the country can print money to pay for it, said Jankiel Santos, chief economist at Haitong.

Still, to kick-start the economy and boost revenues, policy makers must slash interest rates to fuel consumption, not an option with near double-digit inflation. A 30 percent currency depreciation may boost exports, but these account for only about 12 percent of GDP.

The gross debt of Brazil’s public sector has ballooned to 66 percent of GDP from 52 percent when Rousseff took office in 2011. Not only is that larger than any of the other in the so-called BRICS or major Latin American economies but higher interest rates boost the cost of servicing the debt. That markets in Brazil have begun focusing on gross debt, rather than net debt, as is the norm across the globe, is in itself telling. The shift happened when investors started to worry that the government’s accounting techniques were distorting net debt calculations.

Brazil’s bond yields, while far from distressed levels, are climbing. The government’s benchmark 10-year dollar bonds yield over 6 percent today. A year ago, they were about 4 percent.

"The debt dynamics are deteriorating rapidly," said Dennis, who heads emerging-market strategy at UBS. "They become unstable at a much lower debt ratio than is the case in Europe."

The more the government owes, the more it needs to take out of its budget to pay for debt, fueling another vicious cycle. Brazil spent a record 511 billion reais in interest rate payments the past year. That is almost 20 times more than the budget assigned this year for Bolsa Familia, the government’s social flagship program.

“Brazil needs to realize its spending levels are not compatible with its revenues,” said Haitong’s Santos. “At the end of the day, it will need to print money, generating more inflation” if it doesn’t contain its deficit.

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