Conversations with Brazil’s bankers tend to reveal two things.
The first is that they think that current valuations and forecasts for growth (and therefore the positive expectations for capital markets and banking generally) price in the expectation that whoever is elected president next year will make swingeing fiscal cuts to control the rapid accumulation of government debt. That basically means pensions reform plus other less important cuts to compulsory spending.
The second is that they are, by and large, fine with that.
“Whoever wins will have no choice but to pick up pensions reform and pass it,” says the consensus. “If they don’t, they will quickly run into the debt ceiling (passed last year) and will have no money for health, education, for anything.”
The work has been done, the consensus adds, “it’s just a simple case of picking up the reforms, diluting some of the provisions back into an effective state and spending some of whoever’s newly minted political capital in grasping the fiscal nettle.”
The government’s initial proposal submitted in January this year would have created fiscal savings worth 2% of GDP annually over 10 years. This has subsequently been watered down to 1.2% of GDP over the same time period, and it would be likely watered down further to around 1% of GDP if it were to be passed under president Michel Temer’s administration – meaning the next president would have to pass further reforms anyway.
“Even Lula would pass it,” say most.
It is strange how many bankers paint Lula da Silva as a very bad thing for the markets given his metamorphosis into a cuddly, pro-banker politician last time he took his Workers Party into the Planalto. This time there would be differences, but essentially Lula understood the need to work with the markets rather than against them to underpin his broader agenda.
Back to bankers’ belief in the inevitability of effective fiscal reform: it is a logical supposition and, sure, it could happen.
But consider the following scenario. President whoever wins on October 28, 2018 and inherits an economy that is set to record 3% growth for 2017. And next year’s projections (pricing in that fiscal reform) say things will be better.
Government revenues are up and the interest rate paid on new government debt is less than half what it was a couple of years ago.
The potential fiscal cliff and debt explosion facing Brazil means that the next president should take the necessary action. But, then again, so should this government
Maybe, president whoever thinks, these pensions, expensive though they clearly are, can be trimmed a bit rather than receiving a proper cut. A trim makes pensions look better for international investors but does not upset the locals (on probably the most sensitive social issue anywhere in the world).
But the consensus shrugs off the possibility of such a scenario: “No, because that’s the genius of the debt ceiling – president whoever would quickly hit that obstacle.”
But the next president could decide to change those limits.
It would be difficult and require three-fifths of congress. But that is not impossible.
And depending on what the new president really wants to focus on, maybe they feel it would be better to horse-trade the ceiling limits away than alienate a massive swathe of voters in year one.
Or maybe, given the improving revenues, the next president is inclined to reform pensions but has other priorities first and moves pensions onto year two’s to-do list. And then year three. And then it is election time again.
This scenario has clearly got Moody’s spooked by the growing certainty that this government, which has the mind to reform pensions if it could just stop stepping into debilitating scandals, will pass the reform forward to the next government.
It is pretty scary from a rating agency’s perspective: without serious reform, social security expenditures will jump to 9.6% of GDP in 2025 from around 8% in 2017.
That highlights the speed that liabilities will get out of hand if not addressed quickly.
In the same period, social security would reach two-thirds of all government spending – up from an already hefty 50% today (emerging markets aren’t supposed to be handing out so much on social payments after all).
Investment – currently a paltry 1% of government spending – would have to shrink even though emerging markets are supposed to be catching up with developed markets by investing in infrastructure.
So, up to a point, the consensus is correct: the potential fiscal cliff and debt explosion facing Brazil means that the next president should take the necessary action. But, then again, so should this government. It was even trying to, but politics got in the way.
The problem is that politics often does – especially in Brazil.