BRAZIL

Brazil had a fragile pre-pandemic fiscal outlook, although the pro-business reforms pipeline was encouraging. However, the pandemic shock halted the already sluggish growth and reform momentum. Brazil's fiscal response was extremely ambitious and effective, but it put public finances on an even more unsustainable path.

Brazil’s economy contracted less than that of peers in 2020 (-4.4% vs. -6.8% on average in Latin America). Indeed, ~USD110 in emergency monthly government payments were sent to around 67 million Brazilians (almost a third of the population) and were extended (albeit reduced by half in September) until the end of 2020. Those transfers were so effective that they actually reduced the poverty rate in Brazil. Brazil spent 8.6% of GDP in discretionary measures and, in total, more than what the pension reform voted in 2019 was aiming to save across 10 years (~USD200bn).

The mismanagement of Brazil’s second wave of the pandemic will alter the Q1 2021 economic performance. In fact, one in three Covid-19-related deaths now occur in Brazil, and states undertake different decentralized responses in absence of a nationally mandated lockdown. In addition, the slow start of the vaccination rollout (although it will pick up pace), inflation pressures and political and social risk put the recovery at risk, and should create some stress on the currency, raising borrowing costs for companies and leading to double digit insolvency growth. We expect +2.8% GDP growth in 2021 and +2.3% in 2022.

With inflation running at 5.2% in February, the 3.75% central bank target was exceeded and expectations of future inflation rose, prompting the central bank to hike the policy interest rate even more than expected in March (by 75bps to 2.75%). The central bank’s stance remains accommodative as estimates for the neutral interest rate in Brazil hover around 5-6% (and the rate was at more than 14% in 2015, not so long ago!). We expect at least an additional 75bps rate cut at the next central bank meeting, but probably more in the second half of this year to tame inflation pressures and reassure markets anticipating a US interest rate hike. This shows the solidity of the monetary policy framework reinforced by the recently voted central bank independence law. Yet this also shows monetary stimulus will progressively be withdrawn as soon as this year, in contrast to most economies in the world. This also explains why the Brazilian recovery should remain fragile this year.

Good policy orientation, but interventionism and political risk in general are blurring pro-business signals

The orientation of the economically liberal government and center-right leaning momentum in Congress has allowed the implementation of several pro-business “quick win” policies since Bolsonaro’s inauguration, in addition to a flagship pension reform. While Congress and the finance minister have reaffirmed their will to vote fiscal and administrative reforms in 2021, the prospects of the 2022 presidential and legislative election mean ambitious reforms will be more difficult to pass. Our baseline scenario is that the economic team will be able to pass a limited fiscal reform to anchor market expectations and buy Brazil some time, but certainly not reverse the course of unsustainable debt accumulation.

Moreover, former president Lula running in 2022 (not a certainty yet, but the likelihood is high) also makes it less likely for Bolsonaro to adopt stark austerity measures as Bolsonaro’s populist roots will be exacerbated: we expect the president will want to pull the rug out from under Lula and his left-leaning ideology by continuing to spend and abandon fiscal rigor. Bolsonaro’s interventionism is already back under the spotlight. During a recent congressional vote on an emergency bill to contain public expenditure through freezing salaries and delaying promotions in the civil service, Bolsonaro managed to have the police exempted from the measure. The same happened when truck drivers threatened a national strike over fuel prices; Bolsonaro dismissed the CEO of state oil company Petrobras. This was followed by an announcement that he also intended to intervene in the setting of electricity prices.

Upside risks do exist: the acceleration of vaccination could lead the country to lift restrictions in April 2021 and could boost business and consumer confidence.  The urgency of the post-crisis situation could also lead to political consensus on key reforms (tax reform, business environment…), which could restore confidence and create opportunities. - April 2021