I was speaking to a debt capital markets banker about Brazil’s recent international debt transaction – a re-tap of its 2047s. The obvious issue was that it came to market just one week after Standard & Poor’s downgraded the sovereign. But the banks – Citi, HSBC and Morgan Stanley – managed to tighten pricing down to 5.6% (after early guidance of 5.8% for $1 billion) and raise $1.5 billion.
International investors shrugged off the downgrade just as equity and FX investors had done the previous week. Why? Well, the reason for the downgrade were already known – the slippage of fiscal reform – and neither the banker nor I wanted to go down the path of this pensions conversation again.
Besides, he said, as far as international investors are concerned, the level of Brazilian foreign currency debt is dwarfed by its FX reserves, so there is no issue about the government being able to service coupons and maturities whatever mess it makes of the domestic accounts.
Another related and well-appreciated point, because finance officials regularly brief about it, is that in a stress test (ie depreciating FX), Brazil’s net public debt goes down because the country has large net FX reserves (assets), while liabilities are almost exclusively in local currency, the real. Local debt is R$3.37 trillion ($1.07 trillion) compared with foreign debt of R$121 billion.
Now it starts getting interesting. Because the corollary of this point is that the private sector faces the opposite situation.
The Brazilian government followed an aggressive policy of de-dollarization after the near-sovereign crisis of 2003, sparked by the 2002 devaluation, which was helped by the central bank’s decision to keep its policy rate high.
So, every time the real depreciates, the corporate sector, driven into dollar-denominated lending by the large differential in local and international rates, takes a hit that offsets what should be the positive factor of FX weakness, namely increased export competitiveness.
In short, the government’s switch to local debt increases the private sector’s reliance on foreign funding – and therefore weakens the transmission mechanism of competitiveness through changes in the exchange rate.
‘Fundamental flaw’
A new report by Standard & Poor’s points out Brazil’s fundamental monetary policy flaw. At the outset of the stability plan, the Plano Real, in the 1990s, interest rates were set at a high level to reduce inflation. This worked in the short term, mainly by creating currency stability. But without fiscal surpluses, it led to a rapid increase in M4 money supply.
As sovereign debt piled up, the central bank had no choice but to keep interest rates high because a reduction would have led to depreciation (carry investors would have run for the hills) and that would have spiked inflation.
Then, under Dilma Rousseff, the government added an expansion in credit supply directly from the budget, which it financed by more local debt issuance. When added to the primary fiscal deficit and interest expenditure, M4 exploded to over 20% growth a year, which kept inflation high and ultimately triggered the 2014/15 depreciation into a long-lasting recession.
Standard & Poor’s performed some econometric analysis that shows that a 10% increase in M4 leads to a 4% increase in the net exchange rate and a 4.5% lift in CPI inflation. It suggests that a 9% increase in M4 keeps inflation on target – especially in normal economic conditions.
It is not an accident that M4 growth is now below that 10% rate and inflation is also below its target rate. M4 growth is about 9%, and of that, six percentage points are linked to public debt service (the interest component of the fiscal deficit).
Clearly if six percentage points of M4 growth are due to paying interest on domestic debt, the key thing is to reduce that fiscal deficit.
And we are back to the pensions conversation.
But in the absence of reform, which is almost a given for now, all this has an important implication for monetary policy. Because what happens when inflation picks up with economic growth? Should the central bank increase rates again to nip that inflation in the bud or keep it low to support the economy?
Standard & Poor’s conclusion is that raising rates would not just kill off the recovery but also would not lower inflation as it would lead to an increase in M4 supply through increased interest payments.
The Brazilian government’s sensitivity to changes in the Selic (overnight) rate is horrible: it has high debt, at around 83% of GDP, and its average duration is very short; about one-third is linked to the overnight rate.
Unorthodox conclusion
Instead, the unorthodox conclusion is that the central bank should avoid raising rates and the treasury should issue dollar-linked debt.
After all, as the banker pointed out at the start of our conversation, Brazil’s public dollar debt is currently negligible and FX reserves are high. Absent a quick cut in the fiscal deficit, the government could at least avoid any further growth in local debt – and therefore M4 growth and inflation – by swapping into dollar debt (an added bonus would be lengthening average maturity).
That all seems logical. But in practice I would love to go to the roadshow that explained the rationale for a Brazilian dollar-debt-binge to investors along the lines of: “We need to increase dollar debt because our local debt burden is out of control and we can’t manage fiscal reform”.
Let’s see books upsize and prices tighten on the back of that kind of pitch.
