Fitch: Brazil's Budget Freeze Highlights Effort and Challenges

Brazil's announcement of an approximately BRL69.9bn budget freeze highlights both the increased willingness of policymakers to tackle fiscal imbalances and the challenge they face in doing so, Fitch Ratings says. The budgetary freeze announced recently focused on discretionary expenditures, including capital investment. Implementation challenges remain and Fitch will monitor how effective the spending freezes will be in terms of achieving the government's fiscal goals.

The government had previously estimated that the budget freeze would be roughly BRL60bn as it aims to lift the primary surplus to BRL66.3bn this year, using both spending and revenue measures. But a bigger freeze does not imply larger or faster consolidation. Rather, it acknowledges that hitting existing fiscal targets will demand extra effort as economic contraction dents revenue performance. Year-to-date fiscal performance continues to reflect the adverse impact of a weak economy on revenues. We forecast Brazilian GDP to contract by 1% this year with risks skewed to the downside due to weak confidence, negative spillovers from the Petrobras corruption investigations, policy tightening, and difficult external conditions including lower commodity prices.

An effective spending freeze will help fiscal consolidation after the country recorded a primary deficit (and a general government fiscal deficit of 6.5% of GDP) last year thanks to weak revenue performance and a strong increase in spending (particularly discretionary spending). The planned freeze demonstrates the authorities' commitment to the front-loaded macroeconomic adjustment programme adopted after President Rousseff's election to a second term.

The targeted fiscal consolidation may face challenges, however. Political support for consolidation may wane as austerity measures bite. Coalition politics can be cumbersome and Congress could dilute fiscal measures. Some dilution has already been observed in fiscal measures (such as the unemployment insurance and limiting the reductions to survivors' benefits and disability) approved by the Brazilian Lower House, which are still pending approval in Senate.

Recession, revenue weakness, and rising interest costs present risks to consolidation. We forecast deficits averaging 5% of GDP in 2015-2016. This would slow, but not stabilise, the increase in general government debt to GDP ratio in 2015-2016.
Nevertheless, tighter fiscal and monetary policy could gradually improve policy credibility, confidence, and investment prospects, paving the way for a subdued economic recovery from 2016. Cumulative rate hikes of 225bp since October appear to be slightly improving the inflation expectations for next year. The Central Bank of Brazil raised the Selic rate by 50bs to 13.25% on 29 April and has allowed the real to depreciate. Winding down the quasi-fiscal stimulus through public-sector lending should also strengthen the effectiveness of monetary policy.

Weak economic performance, fiscal deterioration, and rising government debt were among the drivers of our revision of the Outlook on Brazil's 'BBB' sovereign rating to Negative from Stable last month. Continued economic underperformance, difficulty in consolidating fiscal accounts, and reduced confidence in the capacity of the government to sustain the currently underway fiscal and macroeconomic adjustment process could be negative for the ratings. On the other hand, improved policy credibility that restores confidence and promotes growth, a reduction in macroeconomic imbalances, and fiscal consolidation that improves the government debt trajectory would be credit-positive.