The New Finance Minister’s Task: Mission Impossible

BRAZIL ECONOMICS - Report 26 Jan 2016 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

The new finance minister takes office with the simultaneous mission of pursuing the fiscal adjustment and stimulating the economy, pulling it from a long and deep recession. He is faced with a veritable mission impossible. Due to lack of conviction and political support, he’s unlikely to propose, much less win approval of, the necessary reforms. Due to the explosive growth of the gross debt in relation to GDP, he cannot use countercyclical fiscal policies, and given the high inflation, he cannot count on help from the Central Bank through interest rate cuts.

The debt/GDP ratio will continue growing unsustainably, putting pressure on the CDS quotations and the exchange rate, where depreciation increases net exports and stimulates aggregate demand. But the depreciation comes mainly from the increase of risks, which generates contagion in firms’ cost of capital, sharply reducing the stimulus to fixed capital investments, which acts in the opposite direction, prolonging the recession. In the past few months the yields of Brazilian corporate bonds in the secondary market have grown substantially, a movement that can be blamed on the contagion from the fiscal deterioration, indicating that the cost of capital will remain high for an extended period.

So far the government has not given any signs it intends to resort more clearly to populism. The risk, however, is that it will tire of the inefficacy of more timid measures and succumb to the temptation to use countercyclical fiscal and monetary stimuli more aggressively. This is not what the new finance minister’s pronouncements have indicated, but we know he is one of the mentors of the “new matrix” and that the political pressures on the government of which he is part are huge. Therefore, it’s not possible to discard the possibility of a shift toward greater expansionism, and nothing in the behavior of asset prices indicates the marked disagrees with this proposition.

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