While it appears the Brazilian recession may have hit bottom, with certain indicators such as industrial output showing nascent signs of recovery, strong economic recuperation will not occur until the government is able to show a credible movement towards a robust fiscal adjustment.

The initial crisis of confidence in the economy, and the consequent collapse in investment, was the result of a combination of poor economic management from Brasília and deteriorating global conditions for Brazil’s top exports.

The combination of these factors (with an emphasis on the former) led to a primary deficit in 2014, the first in more than a decade. In 2015, the government once again spent more than it brought in, and 2016 will likely see yet another record-setting primary deficit.

In the interim period (2013 through 2016), the country’s debt-to-GDP ratio is estimated to have climbed from 52% to above 70%. And while the government of Michel Temer has emphasized its commitment to realizing a robust fiscal adjustment by bringing primary spending under control, the outlook for 2017 onward remains unclear because of uncertain politics. To understand better the direction in which Brasília is going, companies should be aware of the five following factors related to Brazil’s fiscal adjustment.

1. Brazil’s fiscal adjustment has hardly begun: Despite having cut tens of billions from ministries such as education and healthcare in 2015, Brazil’s fiscal situation has only deteriorated further as revenues have fallen and overall spending has actually increased
2. To stabilize debt-to-GDP ratio, Brazil’s adjustment will need to be on the order of 5% of GDP: Indeed, it is estimated that the budget surplus that would stabilize the current debt-to-GDP ratio by allowing the government to make interest and amortization payments with excess revenue is equivalent to 2.5% of GDP. With the current deficit at approximately 2.5%, that means a needed adjustment or great proportions, or 5% of GDP
3. While spending cuts should lead the way, tax hikes are inevitable: Brazil must diminish the role of the state in the economy as the tax burden as a percentage of GDP already represents 35% (comparably to that seen in OECD markets). That said, considering the absolute size of the adjustment needed, new tax revenue is almost an unavoidable pursuit. In that case, while it is likely that the government lifts rates across the board while phasing out some exemptions, if revenues continue to fall, the reintroduction of the CPMF (an onerous financial transaction tax) is likely
4. Without pension reform nothing else matters: While the government is pursuing measures such as the creation of a spending ceiling, unless the country is able to address the unpayable obligations created by its pension system, no other reform will be sufficient to return the fiscal account to health. Spending on the pension payments now represents over half of federal spending and continues to climb, while other spending categories have stagnated
5. Brazil’s adjustment should be gradual and prolonged: Brazil cannot realize its necessary adjustment of 5% of GDP in one, or even two years. As the economy remains weak, either severely cutting spending or raising taxes significantly would suffocate any sort of recovery. Rather, the government must implement credible reforms that will allow for a gradual but prolonged adjustment.

FSG clients can read more about the fiscal adjustment and its significance B2G, B2C, and B2B sales by clicking here.

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