The Fiscal Challenge: Reforms, Risks and Monetary Consequences
The Central Bank has been expressing concern regarding the next monetary policy movements. Might there be an effective lower bound (ELB) for the basic interest rate in Brazil, as is the case of other emerging countries? Will the path of the primary results and gross debt alter the risk premiums and thus the slope of the yield curve? The objective of this Special Report is to formulate scenarios about the evolution of the fiscal risks and their effects on monetary policy. We examine two types of reforms: those that alter the growth of potential GDP and favor a lower equilibrium real interest rate; and those that act on the primary expenditures and results of the central government.
In the first group, the standout is tax reform, in which case we examine the proposal that would contribute to increase productivity, contained in Proposed Constitutional Amendment 45 (PEC-45), which includes ICMS reform but appears to be off the government’s radar screen. Since ICMS creates the greatest distortions (fiscal war among the states, penalization of exports), and since correction of these distortions depends on economic opening for international trade, there is little hope that reforms will be enacted that alter productivity and growth of potential GDP.
The second group contains reforms that affect growth of spending. What could be done regarding the pension system has already been accomplished, so what remains now is administrative reform, for which there is little government appetite. There are also weak perspectives for cuts in spending on health and education, and risks exist that an attempt to regroup transfers to the neediest people will increase total spending.
When questioned about the monetary policy scenario in 2020, the Central Bank’s directors start from the assumption that the government will continue pursuing an agenda of reforms that in the least will enable compliance with the spending cap. This is an important supposition, but it depends on the decision of the government to execute the reforms necessary to allow achieving at least this objective. If the monetary authorities are correct in their hypotheses, the risk premiums will decline, with a reduction of the effective lower bound of the interest rate and of the risk premiums, causing the slope of the yield curve to decline and keeping open the transmission channel of the capital market. We do not doubt they have their reasons to formulate these hypotheses, but our obligation is to warn about the contrary case.
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