Brazil’s economy policy team should go back to playing defense

This article originally appeared in The Brazilian Report (August 26, 2021).

In a country traditionally obsessed with “the beautiful game,” Brazil’s economic analysts frequently compare the Economy Minister’s role in the government to that of a goalkeeper in a football team. Even the best goalie in the world isn’t expected to score goals, but they are there to prevent opponents from scoring and defending against potentially embarrassing own goals.

The net, in this analogy, is the government budget and Brazil’s fiscal health. It is up to the Economy Minister to make sure that the endless list of politicians’ spending demands complies with existing budget laws, tax revenue estimates, and the market’s notion of debt sustainability.

However, when ruminating on the recent performance of Paulo Guedes, the mind wanders not to a solid goalkeeper, but to a flailing center-back — namely Brazil’s David Luiz, in the 7-1 semifinal thrashing at the hands of Germany in the 2014 World Cup. On that fateful day, the highly-rated player abandoned his defensive duties and simply roamed across the pitch, with movement patterns akin to that of a headless chicken. 

Interviewed live after the crushing defeat, he sobbed that he was only trying to “give some joy to [the Brazilian] people.”

In late May, off the back of surprisingly strong tax revenue figures — Brazil’s tax collection in Q1 2021 was 9.5 percent higher than the pre-pandemic Q1 2019 — Mr. Guedes told newspaper Folha de S. Paulo that it was time to strike. “We played defense for the first three years, controlling expenses. Now the election is coming? Let’s attack,” he declared.

“Attack,” in this sense, would consist of using the government’s newfound fiscal wiggle room to boost social spending and lift more citizens out of poverty. 

Bringing joy to the Brazilian people.

The Christmas present that was not to be

To Mr. Guedes credit, increasing cash transfers to poor families under the current constitutional spending cap seemed feasible at the time, as he stressed in that same interview. The government’s spending limit is updated yearly in accordance with the 12-month inflation rate in June, whereas most expenses linked to the minimum wage are adjusted for inflation in December. As consumer price indexes were expected to peak by the middle of the year, the difference between June and December would create some fiscal space that could be used to significantly increase cash transfers. 

The plan started to turn sour almost immediately. Inflation proved to be more persistent than previously thought, with manufacturing costs soaring across the world and local electricity prices hit hard by the dwindling levels of reservoirs at hydroelectric plants, a consequence of an unusually dry summer. 

The expected June-December inflation differential shrank to just 1 percentage point — down from around 2.8 percentage points by the end of May — erasing around BRL 20 billion (USD 3.82 billion) in potential expenses. 

Then, by July 30, the awaited fiscal space virtually vanished. The Supreme Court demanded that the government pay BRL 89 billion in registered warrants — known as precatórios — 63 percent more than the administration had budgeted for 2021. Mr. Guedes called the announcement a “meteor” and rushed to unveil a constitutional amendment proposal to set an annual limit on precatórios payments to preserve some room in next year’s budget. 

What followed was a surge of the market risk premium in Brazil, which had many root causes. First, the notion that the July 30 announcement was a bolt from the blue is disputed: the results of several court rulings that comprised the BRL 89 billion total were known for some time, and the Economy Ministry could have drawn up a plan to mitigate the financial hit. By receiving the bill with surprise, the government caused market confidence to decline. 

Perhaps more importantly, the constitutional amendment bill proposed by the Economy Ministry creates another — potentially larger — problem. The Economy Minister intends to earmark revenues from government asset sales and state-owned enterprise profits to speed up payments, excluding them from the calculation of the annual spending cap. 

Mr. Guedes himself suggested that excess revenues could be used to pay “social dividends” to the poor, also out of reach of current fiscal rules.

Spending cap controversy

To return to the football analogy, with the team’s leading center-back deciding to roam forward in attack while the team is taking a beating, the market feared a humiliating defeat. Limiting spending cap exceptions to a couple of specific expenses would be challenging. If part of precatórios payments and social spending can be treated as exceptions, then why not infrastructure investments and fuel subsidies?

The notion that there could be “excess revenues” while the country still runs primary budget deficits is also disturbing: part of the appeal of the spending cap is that, given growing government revenues, the fiscal consolidation process becomes automatic, as lower financing needs cannot be converted into new expenses. The entailing favorable debt dynamics helps contain market rates, creating a virtuous cycle of financing conditions.

It is fair to argue that the spending cap’s conditions may be too draconian, especially considering the quick recovery in tax revenue and the deep pandemic scars among Brazil’s poor. My take is that the market could be much less fixated on the importance of upholding the spending cap in its original conception if it was not for a broader issue of government credibility. 

President Jair Bolsonaro’s collapsing approval ratings and reelection prospects — following his disastrous management of the pandemic and continuous conflict with the Congress and Judiciary — are feeding a perception that the president and his allies could start taking increasingly desperate measures to boost the economy ahead of the October 2022 election. 

Mr. Guedes’s apparent lack of concern with the very basics of debt sustainability — extrapolating revenue increases and planning to spend ahead of them, instead of committing to a stable debt-to-GDP path — adds to that uncertainty.

With part of the team willing to take huge risks to try to get back on level terms, it would be prudent for the back line to simply resume playing defense and at least try to avoid a disaster. The recent strong deterioration in market perception and financial conditions is already jeopardizing next year’s growth and inflation prospects.

The rest of the team needs to realize soon that scoring own goals makes any win impossible.