Brazil set to pass critical credit reform

By:
Rob Dwyer
Published on:

State bank BNDES’ benchmark rate set to be replaced; implicit subsidies have been a significant fiscal drain

The Brazilian government is expected to secure its reform to BNDES financing with the approval of a new benchmark rate called TLP before the legislation ‘expires’ on 6 September.

Lucas Aragao, partner and director at Arko Advice, a political risk consultant in Brasilia, says the proposals faced stiff opposition in the committee stage but now that the bill has moved to the floor of the Congress he expects the government to be able to secure a vote and win approval for the reform (with a simple majority) before the early-September deadline.

Despite Standard & Poor’s citing the reform as a critical step to prevent a further sovereign downgrade, the business community reportedly lobbied hard against the changes.

“[Because of the bill’s inbuilt expiry date] timing was key for the TLP reform and so the key issue was getting the bill out of the committee stage where it faced very heavy lobbying from the productive sector,” says Aragao, who adds that the committee’s chairman was seeking to kill the bill because, as a member of former President Rousseff’s Workers Party, he is ideologically aligned against the current administration.

“There is a huge battle in Brazil between the productive sector – by which I mean the large companies that have for many years benefited from below market interest rates from BNDES – and the markets,” says Aragao.

brazil bndes chart 400pxThe TLP would replace the TLJP as the benchmark interest rate used by BNDES for nearly all of its financing. The transition would apply only to new credit extended after 1 January 2018 and the new benchmark, which will be the five-year NTN-B (inflation-linked) bond yield, would have a five-year adjustment mechanism to smooth the transition.

BNDES is slowly lowering its financial participation in the country’s credit markets but is still a significant player as it provides 19% of all credit in Brazil. The move away from TLJP, which is set by a committee at rates significantly below those paid by the government, would cut one major fiscal subsidy. 

Today the TLJP rate is 7.5% and the country’s base interest rate, Selic, is 13%. According to government data between 2007 and 2016 this implicit subsidy accounted for R$231 billion – or 32% of total subsidies granted in this period. In 2016 alone the cost of this implicit subsidy reached $78 billion.

The government says that cutting the cost of subsidizing BNDES lending is a key part of its plan to contain burgeoning fiscal deficits: the government’s running 12 month financial deficit (including interest payments) hit 9.5% in June and in August the government announced looser primary fiscal targets for 2017 and 2018 as it struggles to contain spending and has been disappointed by revenues.

Major reform

Standard & Poor’s maintains a negative outlook on Brazil and in its most recent report explicitly cited the TLP as one of the two major reforms it was monitoring (the other being pensions reform).

The monetary policy committee of Brazil’s central bank, COPOM, also referenced the TLP reform in the minutes of its latest meeting as the change would have a significant impact on monetary policy.

The subsidized TLJP (part of a large block of ‘earmarked’ credit, which now accounts for nearly 50% of the credit market) limits monetary policy transmission and leads to artificially higher policy rates – and therefore also free market rates. While there are other earmarked credit rates in the economy the interest rate differential with the TLJP is the highest. On average the TLJP has been 650bp lower than Selic, peaking at 1000bp in 2005. It is also the largest – accounting for nearly one-fifth of all credit.

As well as potentially leading to misallocation of credit resources by limiting the market mechanism it requires the central bank to lift Selic higher than it would otherwise have to when trying to cool the economy.

Bank of America Merrill Lynch modelled the impact on Selic if the gap between the BNDES financing rate and Selic was eliminated. The banks’ economists say the country’s neutral real interest rate would be almost 100bp lower and the prospect of its reform has led the bank’s leading Brazil economist, David Beker to alter his predictions for this cutting cycle: “Forecasting the policy rate accounting for the TLJP [reform] is relevant … if this distortion is reduced results suggest total easing cycle could reach 600bp, ie 475bp cuts still left.”

Beker is therefore forecasting Selic at 8.25% in 2018 against 9.75% previously. The reform is being watched closely by the markets and other economists would likely follow suit if the legislation is passed.

Despite the clear financial benefits to the macroeconomic environment of the reform the large companies that have benefited from the TLJP rates fought hard to maintain their subsidies.

“Brazil’s productive sector doesn’t protect the interest of the private sector in general,” says Aragao. “For example, FIESP, Sao Paulo’s business federation, protests against tax increases and interest rate hikes but when Dilma [Rousseff] was giving away free money from BNDES with subsidized interest rate it was first in the line. These companies don’t really care about the fiscal adjustment unless it is for them.”