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Macro Vision
June 20, 2016
Spending ceiling may stabilize public debt below 80%
of GDP
• 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.
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Macro Vision – June 20, 2016
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
1
economic variables, with the spending limit .
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
2
spending limit . 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.
Spending ceiling: zero primary result in 2020 and
onward improvement until 2025
21%
5%
% of GDP
20%
4%
19%
3%
18%
2%
17%
1%
16%
0%
15%
14%
13%
-1%
Central government net tax revenues
Central government primary expenditure
Consolidated primary result (rhs)
12%
-2%
-3%
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
Source: National Treasury, Itaú
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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Macro Vision – June 20, 2016
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.
Spending ceiling may revert public
debt upward trend
85%
% of GDP
80%
80%
75%
70%
77%
General government
gross debt
65%
60%
55%
50%
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
Source: Central Bank, Itaú
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:
(
)
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.
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Macro Vision – June 20, 2016
Favorable cyclical effect helps to
improve the public debt dynamic
10%
Contribution to the annual increase in gross public
debt - % of GDP
8%
Primary result
Real interest rate - GDP
Other factors
Total debt delta
6%
4%
2%
0%
-2%
-4%
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
Source: Central Bank, Itaú
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.
Without a reform, social security would
represent a large part in the budget and make
the spending ceiling unviable
100%
90%
80%
% of central government primary expenditure
Social Security expenditure
70%
60%
50%
40%
65%
30%
20%
40%
50%
10%
0%
2016
2020
Source: National Treasury, Itaú
Pedro Schneider
Julia Gottlieb
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2025
Macro Vision – June 20, 2016
Macro Research – Itaú
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