BRAZIL MEMO: MANAGING EXPECTATIONS

CARLOS GERALDO LANGONI

November 30th, 2020

• The proximity of an effective vaccine and the resurgence of Covid-19 have brought about asymmetrical expectations in Europe, the US, and Brazil. Uncertainties prevail regarding which measures will be taken in order to cope with the harsh social and economic impact of the pandemic and to speed up the ensuing recovery.

• The ideal solution for Brazil would be to revise subsidies and tax exemptions and impose a trigger mechanism on mandatory expenditures. This would flag to the market that the Administration is adamant on opposing any economic unorthodoxy.

• In an environment of floating exchange rates, the external adjustment is endogenous and requires no government intervention. On the domestic front, the fragility of the labor market – unemployment and informality - plays a crucial role in defining the contours of new social policies.

The world is experiencing curious asymmetrical expectations: the imminent availability of efficient vaccines increases the appetite for global risk.

On the other hand, the intensity of the 2nd wave in both Europe and the US - where claims for unemployment benefits skyrocketed - threatens the world economy as it attempts to rebound.

Scenario:

The IMF implicitly recognizes this dichotomy by endorsing a gradual withdrawal of economic stimuli and a focus on green and digital infrastructure.

Brazil is also experiencing this paradox: several sectors reveal signs of a V-shaped recovery. The challenge lies in transforming this recovery into sustainable expansion.

There are still considerable uncertainties regarding post-pandemic fiscal architecture, particularly how to reconcile plans to expand measures for social support with primary deficits. The consolidated Central Government deficit accumulated over a period of 12 months reached R$ 726 billion or 9.8% of GDP, which is clearly unsustainable.

The decline in the Getulio Vargas Foundation's November confidence indices of key economic sectors such as trade and construction reflects the above uncertainties.

Ideally, the Administration would have to revise subsidies and tax exemptions, the annual amount of which is in the order of R$ 307 billion, which are spent in programs of dubious allocative efficiency, with regressive impact on income distribution.

The above adjustment would be effective in conjunction with the reinforcement of triggers that impose caps on mandatory spending in order to preserve the expenditure ceiling. It would be an objective way to renounce the fatal temptation of unorthodoxy, while leveraging a new wave of private investments.

Congress is sending signs that it would adopt an intermediary solution: new taxes would be accepted within the principle of compensation for lost revenue.

The rapporteur of the bill establishing a new tax on goods and services, which would unify five taxes, is inclined to include dividend taxation on the agenda. So far so good - it would be a counterpoint to the reduction in corporate income tax. What makes no sense is the progressive taxation on wealth and inheritance, which would discourage long-term savings and cause massive capital flight.

External Accounts:

In contrast, external adjustment, in a floating exchange rate environment, is endogenousand requires no authorization from Congress. The current account deficit in October maintained a systematic downward trend with the 12-month rate reaching 1.04% of GDP.

It is a result from the combination of significant trade surpluses and an improvement in the balance of services. The inflow of external capital invested in portfolio draws attention: with negative real interest rates, foreign capital is mainly channeled to variable income securities, which represents a bet on the rapid recovery of the private sector.

Long-term foreign direct investment is decelerating as expected, following the global trend observed in all emerging markets.

Notwithstanding, long-term FDI remains at comfortable levels (2.96% of GDP) regarding the financing of external deficit. The return of long-term FDI to the level of US$ 80 billion per year will be “the proof of the pudding” in order to attest to the consistency of post-pandemic macroeconomic policy.

Employment:

The level of fragility in the labor market is decisive in defining whether populist pressures will be reinforced or moderated. According to the General Registry of the Admitted and Lai-Off Workers (Caged, the acronym in Portuguese) 395 thousand formal jobs were created, indicating a growth trend in employment levels in relation to the last few months.

This improvement has not sufficed to reverse the systematic rise in the unemployment rate, which reached a record level of 14.6% in the moving quarter that ended in October. Informality also remains high (38.4% of the employed population).

Experience suggests that only sustained growth led by the private sector will be able to alter this situation. There are no magic solutions.

In short, asymmetrical expectations prevail both at the global and domestic level. The inconsistent fiscal architecture continues to fuel uncertainty, in contrast to the successful external adjustment.

The critical trend of unemployment and informality may exert political pressure in favor of new measures for social support.