Itaú BBA - Spending ceiling may stabilize public debt below 80% of GDP

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Spending ceiling may stabilize public debt below 80% of GDP

June 20, 2016

The structural reform is capable to revert the deterioration of the public accounts

• As a strategy to reverse the fiscal imbalance, the government proposed a constitutional reform to limit the annual growth of federal spending to the previous year’s inflation.

• The measure represents a structural reform of the Brazilian economy that would be capable of reversing the deterioration of the public accounts.

• With a ceiling for spending growth, we estimate that public debt could stabilize below 80% of GDP and decline until 2025.

• By implying a better outlook for the trajectory of public spending, the reforms would create conditions for a cyclical recovery of the economy, with gains in confidence and interest-rate cuts. Real interest rates would have room to fall to historically low levels as public spending as a percentage of GDP declines. These implications for the overall balance of the economy are important, and allow public debt to stabilize before the primary surplus reaches the level that would stabilize it in the long run.

• For the spending ceiling to be viable, social security reform is essential.

I – A ceiling for spending growth

As a first step of the fiscal reform, the new economic team proposed a constitutional limit for total growth of federal primary expenditures. The proposal restricts total federal primary spending growth to the previous year’s inflation. Thus, spending would decline as a percentage of GDP as the economy resumes growth. The limit’s main merit would be to reopen discussions of the public budget, which is largely earmarked – 90% of expenses are considered mandatory. With the ceiling, if a given expenditure (e.g., social security) posts real increases, it would have to be offset by real declines in other expenditures.

The measure is important, given the continuous real increase in public spending seen over the last 20 years. Between 1998 and 2015, the central government’s primary spending grew by 6% per year on average in real terms, rising from 14.8% to 19.6% of GDP in the period. This was made possible by the rapid growth of federal tax revenues, reflecting tax increases, structural changes (such as the increase in labor-force formalization), increases in commodity prices and strong economic growth. These factors are unlikely to materialize again going forward, which reinforces the need to reduce spending and ease the public budget.

The limit will reduce spending as a percentage of GDP as the economy resumes growth. With total federal government spending close to 20% of GDP, for every 1% of economic growth, the federal primary expenditure reduces by about 0.2% of GDP per year. With growth at 4% per year for four years, for example, the primary expenditure would be 2.9% of GDP lower at the end of the four-year period. The fundamental change is to impose a countercyclical fiscal policy during economic expansion, when the political temptation to spend is heightened and long-term budgetary constraints are less evident.

II – Public debt dynamic with the spending ceiling

From a general equilibrium model, we simulate the fiscal trajectory, as well as the trajectory of other economic variables, with the spending limit[1].

We assume that the spending limit is implemented from 2017 onwards. We forecast a primary deficit of 2.4% of GDP in 2016 and 1.5% of GDP in 2017, which includes some other measures in addition to the spending limit[2]. From 2018 onward, we only assume the spending limit. We consider a primary result of zero for states, municipalities and state-owned companies throughout the simulation.

The main simulation results for the macroeconomic variables are:

1 - The economy undergoes a cyclical recovery between 2018 and 2020. We estimate an average GDP growth of 3.3% in the period.

2 - From 2020 onwards, GDP growth gradually returns to its potential (around 2.0%).

3 - The real interest rate declines while the spending limit is in force. We estimate an average real interest rate of 4.1% between 2017 and 2025.

Is it reasonable to expect a cyclical recovery and real interest-rate reduction with the approval of the spending ceiling? We believe that it is. The measure is a structural change that would bring a better outlook for the fiscal trajectory, generating a positive shock of expectations. This positive shock would be reinforced by the adoption of a social security reform, which is necessary to make the spending limit feasible (see discussion below). Additionally, with the reduction in public spending, the real interest rate would have room to fall, especially as public spending as a percentage of GDP declines. With all these effects, economic growth would be above potential for a few years, helping to close the output gap, which we currently estimate at around 6%. This recovery and the interest-rate cuts that would follow the adoption of reforms, as we discuss below, are important drivers for the improvement in debt dynamics over the coming years.

The main simulation results for the fiscal variables are:

1 - The primary spending recedes from 19.4% of GDP in 2017 to 17.8% of GDP in 2020 and 15.8% of GDP in 2025.

2 - The primary result equals zero in 2020 (see chart above) and reaches a surplus of 1.9% of GDP in 2025.

3 - Gross debt would stabilize at around 80% of GDP until 2020 and decline until 2025 (see chart). The improved dynamics occur even before the primary surplus reaches the level that stabilizes debt in the long run.

In order to understand how the public debt stabilization takes place, we break down the factors that determine its evolution. The change in public debt (Δb) is determined by the difference (r-g) between the real interest rate (r) and GDP growth (g), the primary surplus (s) and other factors (e), such as currency swaps, fiscal skeletons, asset sales and rebates, according to the following simplified equation:

∆b= (r - g)* b - s + e

Between 2014 and 2015, gross debt increased by 14.6% of GDP, with negative contributions from all factors (see chart). The difference between the real interest rate and GDP growth contributed 5.7%; the primary deficit’s contribution was 2.2%, while other factors such as losses on currency swaps contributed 6.7%.

Between 2016 and 2017, the deterioration in the primary deficit and in the growth-interest rate differential is the main factor raising debt by 9.4% of GDP. Other factors such as the reversal of part of the loss on FX swaps will likely contribute to a decline in debt growth.

Between 2018 and 2020, the cyclical recovery significantly reduces the growth/interest-rate ratio and allows debt to start stabilizing at a level close to 80% of GDP (see chart). The difference between real interest rates and economic growth drops to an average of 1.2%, compared to 6.6% between 2014 and 2017. This reduction and the gradual decline of the primary deficit start to stabilize gross debt.

Between 2021 and 2025, gross debt starts declining as a percentage of GDP. The spending ceiling continues to reduce public spending as a percentage of GDP, keeping real interest rates at low levels. GDP growth gradually converges toward its potential rate of 2%. Thus, the difference between the interest rate and growth starts going up, but maintaining reduced levels. The primary result turns positive, but is likely to still be below 2.5% of GDP, a level that we estimate as necessary to keep debt at a balanced level. Nonetheless, gross debt already starts declining.

Skeletons are a risk to this simulation. We don’t consider any payment of contingent liabilities such as an eventual capitalization in state-owned companies. In case of any payment of fiscal skeletons in the period, there would be no change in the public debt trend, but only a parallel increase in the debt level.

III – Is a spending limit feasible?

The social security reform is essential. Expenditures related to social security will increase in real terms over the coming years due to growth in the number of beneficiaries and the minimum wage adjustment rule. Thus, to maintain total spending constant in real terms, as provided in the rule that limits spending growth, the remaining expenses have to grow below inflation. Without the social security reform, we estimate that this expenditure, which in 2016 represents 40% of total spending (8% of GDP), would correspond to 50% of costs (9% of GDP) in 2020 and 65% of spending (10% of GDP) in 2025 (see chart). A social security reform, which increases the minimum age and unlinks the benefits from the minimum wage, would decrease the pace of real increases of this expense, reducing the need for cuts in the rest of the budget.

Pedro Schneider
Julia Gottlieb

[1] The results presented from 2018 onward are a simulation that takes into account the approval of the spending limit and may differ from official forecasts released by Itaú in other reports.

[2] Our forecast for 2016 is higher by 0.2% of GDP compared to the fiscal target of -2.6% of GDP, reflecting a better scenario for economic activity (-3.5%) than is forecasted in the target (-3.8%) and extraordinary revenues. In 2017, we consider reduction efforts of 0.2% of GDP in spending and a revenue increase of 0.8% of GDP.


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