In Brazil, know your problems before you solve them

The deterioration of the public accounts in Brazil in recent years is alarming. The primary fiscal results (before interest payments on debt) were rapidly heading toward negative territory even before the collapse of revenues due to the recession. The results have not only appeared worse because of the “creative accounting” to mask the real tragedy – they simply do not give a full picture of the scale of the fiscal risks facing the country.

The so-called contingent liabilities, or hidden debts, are also cause for growing concern by economic agents. These refer to the possibility of obligations resulting from past events whose existence will only be confirmed depending on the occurrence of future events, which for the most part are probable. Various contingent liabilities can have a significant effect on the public accounts in the coming years (or even decades). The primary deficits do not reflect the size of the fiscal risk. They are only the tip of the iceberg.

No estimates of the contingent liabilities exist. It will be an important mission of the next finance minister, whatever the political scenario, to estimate this liability and disclose it to society, giving transparency to the size of the hole, and also to propose strategies of face it.

Neither the political class nor society at large appears to understand the sheer size of the fiscal disaster and its consequences. There are those who believe the fiscal crisis is a result of the political crisis and the Lava Jato investigations. The fiscal crisis is the main cause of the economic crisis; these events are only aggravating elements. Much less well understood is that the fiscal problem reduces the country’s potential to grow and impairs or prevents the reduction of social inequality.

The social security system is a prime example of the contingent liabilities. Brazil’s system is simply too generous vis-à-vis the global experience and the country’s capacity to finance it. The aging of the population aggravates the situation. By 2030 the ratio between the elderly and working-age population will practically double, reaching about 20% versus the current 11%, according to the Finance Ministry. There are no updated estimates of the contingent liability represented by the social security system. An estimate by Professor Hélio Zylberstajn in 2005 indicated something like 2.5% of GDP to be paid in 50 years. This figure has likely risen in light of the population’s aging and the new benefits created in recent years, such as the special regime for micro-entrepreneurs.

The deficits of government-controlled companies might also require bailouts from the Treasury. Recently the Treasury injected R$1bn in Eletrobrás, by means of an advance on a future capital increase. Plans call for infusion of another R$6bn to increase the capitalization of the power distribution companies of the group. The company, which was hit hard by Provisional Measure 579 (which lowered electricity rates), and lost its investment grade rating, is suffering cash flow problems. Analysts talk of a need for capitalization in the range of R$1bn.

Petrobras is no different. In fact, their situation is worse. The company’s net debt now stands at 5.3 times EBITDA. To bring this ratio down to a more reasonable level, of 3.5, would require further capitalization of R$140bn, of which about R$60bn to R$80bn would come from the Treasury, according to analysts.

Uncertainty also exists around the future losses from bad loans on the books of public banks. These banks excessively increased their lending in recent years, to the point where their share in the total stock of credit is more than that of private banks. This stock, which was 19% of GDP at the start of 2011, is now more than 30% of GPD. Besides this, the forced reduction of interest rates (pre-fixed rates) and subsequent rise of the rates paid on funding due to the increase of the SELIC rate, generated a reduction of margins. The bill is now coming due, and at a bad time. The loan default rate is not that high, but it is rising, as is the proportion of loans in “pre-default” (15 to 90 days in arrears). Loans in arrears and default together account for nearly 7% of the loan book, against 4.9% at the start of 2014. These rates are only not higher because of an increase in renegotiation of debts, in a higher proportion than by private banks according to the Central Bank. And worse still, the public banks are more exposed to credit to government-controlled companies.

It’s true that the provisions of public banks have grown, but not at the same pace as default. The loan default coverage index is falling. In this respect, in the public sector, provision levels were 56% higher than the default rate at the end of 2015, versus 81% in the private sector.

There are no problems of solvency for now. The capitalization indexes and reserve requirements are at adequate levels. But some analysts question the impact of the Basel III timetable, which extends to 2019. They talk about capitalization needs of R$30bn for Caixa Econômica Federal and up to R$20bn for Banco do Brasil.

In the case of BNDES, there is an added element of concern. The loans from the Treasury now stand at 8.8% of GDP (R$524bn in December 2015) and the bank’s subsidies will cost another R$200bn (at present value) of the public purse up to 2060 (between 2008 and 2015, the cost was R$123bn), when the program ends, according to the National Treasury Secretariat (STN).

The renegotiation of the debts of state governments can generate a reduction of payments to the Treasury of R$45bn between 2016-18, while the stock of loans made by subnational governmental entities with Treasury guarantees is around R$150bn.

The bill appears to be endless. There is a R$16bn hole in the Worker Support Fund (FAT), which can put pressure on the budget in 2016; measures have recently been announced by the government that can compromise about R$60bn of liquidity of the FGTS; the value of net assets held by the pension funds of government companies has declined due to portfolio management mistakes; and state governments have been dipping into judicial guarantee accounts to pay current expenses.

Controversial court decisions also play a part, casting more doubt on the fiscal picture. An example of this is the injunction issued by the Supreme Court in favor of the Santa Catarina state government, allowing its debt service to be calculated at simple interest rather than compound interest. If this interpretation were extended to the debts of all the states, the cost could reach R$313bn according to the federal government.

The docket of matters to be judged by the Supreme Court includes economic plans (inflation adjustment of savings account deposits under past stabilization plans), which will have an impact on public banks, and the practice of using judicial guarantee accounts to pay expenses. In this respect, at least four laws are being challenged. Some state laws allow use of these deposits by state governments, including deposits by private parties.

It is essential that these costs be ascertained. The contingent liabilities are high and can harm future generations, and few people know the extent of this fiscal risk. Some progress has been made in recent years, with the determination by the Federal Audit Tribunal (TCU) regarding calculation of the subsidies from BNDES. But much still needs to be done to rescue transparency and fiscal discipline.

Americas Policy & Government

Zeina Latif is chief economist at XP Investments. She holds master and doctorate degrees in Economics at University of Sao Paulo (USP).

Previously she worked at Royal Bank of Scotland as senior economist for Latin America, and ING, ABN Amro and HSBC Asset as chief economist for Brazil.

She is columnist at the newspaper Estado de São Paulo and she is counselor at the Social and Economic Development Council of the Republic Presidency.

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