Brazil’s spending cap is finished. Where to tie up Ulysses now?

This article originally appeared in The Brazilian Report (October 22, 2021).

Instituted in 2016 as a new and powerful anchor for the country’s fiscal accounts following years of largesse, Brazil’s federal spending cap is dead. And, ironically, it was dismantled on the watch of an orthodox, pro-market, right-wing Economy minister, who has failed in his attempts to convince elites that it would be possible to grant a “waiver” to boost social spending without jeopardizing the current legal framework.

Meanwhile, the government’s congressional coalition is preparing a constitutional amendment bill which, in practice, frees up around BRL 80 billion (USD 14 billion, or just under 1 percent of Brazil’s GDP) to be spent in 2022 — on top of the Executive’s budget proposal submitted in August.

This fiscal wiggle room relates to the government’s registered warrants, known in Brazil as precatórios. Lawmakers’ proposal is to cap the total repayments the government will be forced to make next year, as well as remove these payments from federal spending ceiling rules.

The money freed up from this piece of budget juggling would largely be used to boost cash transfers to poor families — with President Bolsonaro concerned about his dipping popularity figures — and to keep around BRL 20 billion in parliamentary grants, funds used by lawmakers to finance projects in their constituencies.

Laws can only go so far

The spending cap will be joining a list of 11 other nominally active fiscal rules determining how the government can spend and issue debt. The list is compiled by the Senate’s Independent Fiscal Institution, Brazil’s equivalent of the U.S. Congressional Budget Office. In practice, no laws have been strong enough to withstand the cocktail of a weak president, an extremely fragmented parliament, and endless demand for increased public spending.

When there is a perceived necessity to spend more, creative legislative solutions arise to bypass the rules and render them ineffective.

Before being buried, however, the federal spending cap will have accomplished a significant feat: barring 2020 and pandemic-related spending, inflation-adjusted federal government primary spending has been mostly unchanged since 2014.

The cap imposed a high cost on politicians willing to break it, forcing them to modify the constitution and facing the wrath of financial markets. Its collapse is evidence of how desperate politicians are to distribute more money to the destitute, whether that be for noble reasons or for cynical electioneering.

Where does the government go from here?

This article was written as Brazilian markets entered a tailspin, trying to set a new risk premia level embedded in bonds, equities, and the currency. It is still unclear how the newly presented constitutional amendment bill will be altered by members of Congress, but the initial values endorsed by the government can now only go higher.

With no clear idea of how much will be eventually spent in 2022 and beyond — nobody believes that whatever amount is granted “temporarily” will be revoked under the next government — market analysts have a hard time agreeing on an expected debt-to-GDP path.

The vicious cycle of weakening currency, higher inflation risk, and higher rates adds to the perception that, in the future, the government will have to resort to printing money to pay its debts. With no credible fiscal anchor in place, credit rating agencies could downgrade Brazil, further worsening investors’ perception.

Looking at the figures involved and the global backdrop, it is hard to escape the conclusion — in the words of my boss — that Brazil is drowning itself in a shallow bathtub. Financial conditions remain loose for most emerging countries, which will be able to finish this year accommodating substantially higher inflation (compared to pre-pandemic levels) under lower policy rates.

The extra spending next year is likely to add less than one percentage point of GDP to the primary deficit target proposed in the budget draft – the country would still probably deliver a smaller deficit than this year’s (around 1.6 percent of GDP). Primary spending is likely to remain stable at around 18.5 percent of GDP, its lowest since 2014.

Meanwhile, the debt/GDP ratio is expected to increase by a couple percentage points but will remain below its 2020 peak.

Guedes out?

The key to stabilize markets is signalling a credible debt path. The future dynamics are more important than the starting point. Economists often liken monetary and fiscal rules to the Ulysses pact, a reference to the mythological hero who asked his crew to tie him to his boat’s mast so he could not jump into the sea, tempted by seductive sirens. Brazil’s mast has been destroyed, so an alternative must be found.

The obvious candidate is next year’s primary deficit target: the Economy Minister must set a new, credible one as soon as possible, drawing a line for Congress, other cabinet ministers, and the president. Paulo Guedes needs to use whatever is left of his reputation to make it clear that he and his team will not tolerate open-ended spending. However, as I finish revising this article, four of his deputies — including the undersecretary responsible for budgeting — tendered their resignation.

A changing of the guard in the Economy Ministry could help, but Brazil is seeing itself reliving a famous anecdote told by dictatorship-era President Castello Branco — and recounted many times by legendary journalist Elio Gaspari. Mocked for his low popularity, Mr. Castello Branco would tell the story of a dreadful tenor being booed off stage by an angry crowd. “Just wait for the baritone,” said the singer.

Whereas it is hard to imagine Brazil’s next president being worse than Jair Bolsonaro, finding a reasonable successor to Paulo Guedes in current circumstances would be some feat — especially when the crazy conductors will still be running the political show.