Latin America Economics

Brazil: After pension reform, what next?

Latin America Economics Focus
Written by William Jackson

Brazil’s pension reform bill should help to stabilise the public finances and lift a dark cloud over the outlook. The government has a long to-do list of further fiscal reforms, although the political situation suggests that some of these will be delayed, diluted or abandoned. Either way, it looks like the good news on reform is already priced into local markets, and their outperformance will probably come to an end.

  • Brazil’s pension reform bill should help to stabilise the public finances and lift a dark cloud over the outlook. The government has a long to-do list of further fiscal reforms, although the political situation suggests that some of these will be delayed, diluted or abandoned. Either way, it looks like the good news on reform is already priced into local markets, and their outperformance will probably come to an end.
  • The pension bill is set for its final vote in the Senate today (having already been approved by the lower house), after which it will enter law. It needs to be approved by 49 senators (out of a total of 81). It passed the first vote in the Senate with a margin of 56 to 19, so it seems extremely likely that it will be approved.
  • The current pension system is extremely generous. Pension spending accounts for around 40% of total federal expenditure. Without any reform, we estimate that the public debt ratio would rise from about 80% of GDP now to around 140% by 2030. The current bill should save the government about 800bn reais over 10 years, helping to stabilise the debt ratio at about 95-100% of GDP by 2030.
  • Pension reform has clear long-term benefits for the economy. It should encourage households to raise precautionary savings, helping to increase Brazil’s extremely low domestic savings and investment rates, and raise potential growth. In the near-term, the benefits to the economy stem from the indirect effects on confidence and investment and from the fall in bond yields.
  • However, we think some of the near-term economic benefits are overstated. Widening bank spreads seem to be limiting the transmission from lower bond yields to credit growth. And there isn’t compelling evidence to suggest that there is pent-up investment that might be unleashed if confidence improves. For our part, we expect GDP growth to strengthen in 2020, but not due to pension reform.
  • There seems to be a general view that pension reform may help Brazil’s financial markets to continue to outperform. However, it looks like the approval of pension reform has been fully priced in since July, when it passed the first vote in the lower house of congress with a resounding majority. If anything, we think the conclusion of pension reform is likely to bring the outperformance of Brazilian assets to an end.
  • Indeed, there’s some evidence that this is already happening. The total returns on Brazilian dollar bonds and on equities (measured in dollar terms) between Jair Bolsonaro’s election victory last October and the first vote on pension reform in July were the best of any major EM. Optimism about pension reform seemed to shield Brazilian assets from external headwinds.
  • But since that first vote on pension reform, Brazilian assets’ performance has been middling to poor. They are no longer being supported by reform optimism. And there could be trouble on the horizon. With the global economy slowing, we think global risk appetite is likely to deteriorate in the coming months.
  • The government, to its credit, is not resting on its laurels with pension reform. Policymakers have outlined a series of other fiscal reforms which they intend to tackle once pension reform is completed. These would help to reduce the ‘Brazil cost’, improve the business environment, and boost productivity. One thing that seems clear at this stage, though, is that these reforms face more opposition than pension reform.
  • None of these next steps are likely to drive Brazil’s financial markets on a day-to-day basis in the way that pension reform has. But, by the same token, they won’t help to lift Brazilian assets further.

Brazil: After pension reform, what next?

The Brazilian government’s much-vaunted pension bill looks set to be passed into law in a vote later today, improving the long-term outlook for the public finances and lifting a dark cloud over the outlook for the economy.

In this Focus, we explain why pension reform is important. We then look at what it might mean for Brazil’s economy and financial markets, and finish by taking stock of the next steps in the government’s reform agenda.

Why does pension reform matter?

Brazil’s pension reform is set for its second and final vote in the Senate today. It needs to be approved by 49 senators (out of a total of 81). It passed its first vote in the Senate with a margin of 56 to 19, so it seems extremely likely that it will be approved.

We’ve written in detail about why pension reform matters in Brazil. (See here for example.) In short, the country’s pension system is currently very generous and pension expenditure accounts for around 40% of total federal spending. And pension contributions don’t match spending. With the population ageing, the gap between contributions and expenditure will only widen further.

Without any reform, we estimate that the public debt ratio would rise from about 80% of GDP now to around 140% by 2030. (See Chart 1.) That would not create an immediate fiscal crisis. Public debt is mainly denominated in reais and held domestically. But debt would be on an unsustainable upwards trajectory and problems would come to a head at some point over the coming years.

The most important aspects of the pension reform are that it raises minimum retirement ages and contribution rates, and reduces the generosity of pension incomes. The bill as it currently stands should save the government some 800bn reais over a ten-year period. This is significantly lower than the 1.2trn savings originally targeted. But it would still help to move the primary budget from deficit (of 1.4% of GDP) now to surplus (of about 1% of GDP by 2030). That, in turn, should help to stabilise the debt ratio, at around 95-100% of GDP. (See Chart 1.)

Chart 1: General Government Gross Debt
(% of GDP, National Definition)

Sources: BCB, Treasury, Capital Economics

What does it mean for the economy?

The pension reform bill has some clear long-term benefits for the economy. It should encourage households to raise precautionary savings, helping to increase Brazil’s extremely low domestic savings rate. That would provide a larger pool of resources to fund investment, which is also low by international standards. (See Chart 2.) This in turn should lift productivity and potential GDP growth, which probably now sits at around 2.5% a year.

Chart 2: Investment Rate (% of GDP, 2018)

Source: IMF

The more immediate economic benefits arise from the indirect effects on confidence and bond yields, which have come down significantly ever since Jair Bolsonaro looked set to win the presidency last year. (See Chart 3.) That was, in part, due to a marked decline in expectations for the Selic interest rate over the maturity of these bonds, but also a reduction in Brazil’s country risk premium – both of which were driven by pension reform.

Chart 3: Local Currency Government
Bond Yields (%)

Source: Refinitiv

However, we think some of the near-term economic benefits of pension reform have been overstated. For one thing, widening bank spreads seem to be dampening the transmission mechanism from lower bond yields to credit growth. (See here.)

Some have suggested that pension reform – and fading concerns about a fiscal crisis – could raise business confidence and unleash pent-up investment. There’s probably something to this. But the limited data available since pension reform passed the first vote in congress in early July don’t provide much evidence to suggest this is happening.

Net foreign direct investment inflows in July and August were broadly in line with the same period in 2018. And capital goods production, a proxy for investment, fell in m/m terms in both July and August. More fundamentally, the large output gap suggests that there is probably limited desire by firms to invest. (See here.)

Instead, the main beneficiary so far from pension reform seems to be the government. Lower interest rates have helped to cut the state’s interest payments to fall by about 1% of GDP since last September. This accounts for all the improvement in the public sector net borrowing requirement over this period. However, with the budget deficit still above 6% of GDP it doesn’t provide scope to ease on austerity.

For our part, we expect that GDP growth will strengthen in 2020. But that has much more to do with lower inflation and the boost to households’ incomes, and an improvement in the oil and iron ore sectors, than to the government’s reform agenda. We are forecasting GDP growth of just 2.0% next year and 1.8% in 2021. (See our latest Latin America Outlook.)

What does it mean for financial markets?

The passage of pension reform is almost certainly already priced in. It has looked likely to be approved ever since it passed a first vote in the lower house of congress in early July with a resounding majority.

There seems to be a general view that pension reform may help Brazil’s financial markets to continue to fare well. But, if anything, we think the passage of pension reform is likely to bring the outperformance of Brazil’s financial markets to an end.

The ‘Bolsonaro boost’ to Brazil’s financial markets that started just before the first round of the presidential election in October last year helped to shield Brazilian assets from external turbulence. For example, even though the MSCI EM equity index fell over the final quarter of 2018, the MSCI Brazil index rose (in local currency and US dollar terms). And Brazilian equities came through this May’s turbulence in EM financial markets relatively unscathed. Overall, this Bolsonaro boost may have boosted the dollar level of Brazilian equities by as much as 30%. (See Chart 4.)

Chart 4: MSCI Equity Indices ($US Terms)

Sources: Refinitiv, Capital Economics

However, it looks like the shine is already starting to come off the country’s financial markets. The total return on Brazilian equities (again measured in US dollar terms) and dollar bonds between the presidential election and the first vote on pension reform (on 10th July) were among the best of any major EM. Since then, however, the total returns of Brazilian equities have been the worst among major EMs and the performance of dollar bonds has been middling at best. (See Charts 5 & 6.)

Chart 5: Total Return on MSCI Equity Indices
(%, US$ Terms)

Sources: Refinitiv, Capital Economics

Chart 6: Total Return on JP Morgan EMBI Indices (%)

Sources: Refinitiv, Capital Economics

With pension reform now priced in, Brazilian assets are no longer likely to ride out shifts in global investor sentiment. Given our view that the coming months will be a difficult environment for risky assets, that points to falls in the real, a decline in equity prices and widening credit spreads over the next few months.

We expect that the real will weaken to 4.30/$ by the end of this year (from 4.10/$ now) and only stage a modest recovery in 2020, to 4.25/$. That would make it an underperformer among EM currencies. Meanwhile, we think the Bovespa equity index will end the year at 93,000 (12% lower than its current level of 106,000), before rising to 104,000 in 2020. That performance is roughly in line with our expectations for other EM stock markets.

What are the next steps?

Although pension reform is the most pressing fiscal issue in Brazil, it is not the only one. Even after pension reform, the budget deficit will still be large (perhaps at 4% of GDP, even by 2030) and the debt ratio high (100% of GDP by 2030). Meanwhile, the tax system is extremely complex, public expenditure is skewed towards current spending and generally regressive, and mandatory spending places constrictions on a large portion of the budget.

To its credit, the government is not resting on its laurels with pension reform. Economy Minister Paulo Guedes will reportedly set out the government’s priorities after the pension reform bill is passed.

A so-called “parallel” constitutional amendment will be presented in the Senate on Wednesday, containing some of the more contentious parts of pension reform that were deliberately omitted from the current bill. This aims to extend the reform to state and municipal pension systems.

The government is also aiming to simplify the tax system, get more control over mandatory expenditure as part of a modification of the “golden rule”, and amend the administrative system. The government is also in the process of selling state assets. (See Table 1 for more details. This focuses on fiscal reforms. Other reforms such as trade liberalisation and making the central bank independent are also under discussion. For more on these, see here and here.)

The economic benefits of these fiscal reforms would, as with pension reform, mainly materialise over the longer term. Reforming the tax system, for example, would help to reduce the ‘Brazil cost’, improve the business environment and raise investment. Meanwhile, modifying the golden rule and reforming the administrative system would give the government much more flexibility when it comes to budgeting, reducing the risk of a future fiscal mess.

But while the agenda is ambitious, one point that seems clear at this stage is that the politics of reform are likely to become more difficult from here on. (See here.) First, there seems to be more opposition across various levels of government to the next stage of reforms than to pension reform.

Second, further policies don’t seem to be viewed with the same kind of urgency as pension reform. It was perhaps easier to pass pension reform given that the looming fiscal problem was clear. But, with this seemingly avoided for now, some parties in congress are now suggesting that the thrust of fiscal policy should shift towards supporting the economy rather than balancing the books.

And finally, the Bolsonaro government’s ability to muster support for reforms may start to waver. The president has recently faced internal strife within his own party. And polling by Datafolha suggests that Brazilians’ approval of his administration seems to be waning, which may weaken the president’s political capital. This may help to explain why some of the government’s proposals (such as to the tax system) seem to be behind schedule and why the government’s priorities appear to be in constant flux. The upshot is that it looks like many of these reforms will be delayed, diluted or abandoned.

We doubt that any of the next steps in the government’s reform agenda will carry the same weight in financial markets as pension reform did. So progress (or a lack of) in these areas are unlikely to drive day-to-day moves in Brazilian equities, bonds, or the currency. But, by the same token, progress in these areas won’t help to lift Brazilian assets like pension reform did.

And backsliding in these areas could still have negative repercussions for investors. For one thing, a stalled reform programme could prompt the (long-rumoured) resignation of Economy Minister Paulo Guedes, who is widely seen as carrying the flame for reforms within the executive branch.

What’s more, a failure to push through reforms might prompt the central bank to bring its easing cycle to a halt. Admittedly, inflation is likely to remain below target over the coming few years and won’t be an impediment to further cuts in the Selic rate. (See Chart 7.) However, with policymakers making clear that reforms are one of the key factors that determine the scope for easing, it would be harder to justify cuts if reforms face delays. This is one reason why we think the current scale of rate cuts priced into financial markets over the coming months looks excessive. (See here.)

Chart 7: Consumer Prices (% y/y)

Sources: Refinitiv, Capital Economics

Table 1: Selected Planned Fiscal Reforms

Area

Details

Fiscal council

Government has talked of establishing a body containing the president and other senior figures to oversee the budget of all levels of government.

Parallel pension reform

Aims to extend the current reform to state and municipal pension systems. A constitutional amendment has already been prepared. But this is likely to prove more contentious than the original pension reform bill.

Tax reform

Government wants to simplify the tax system. There are two constitutional amendments already in congress, but legislators are waiting for a proposal from the government. The general aim is to replace the multitude of indirect taxes with one VAT-type tax, cutting firms’ tax compliance costs.

Federative pact

Delegate some federal spending and revenue decisions to states and municipalities. Reform plans have faced pushback from some state governors.

Administrative reform

Would allow the government to have greater control over public sector salaries.

The ‘golden rule’

Golden rule prevents government from borrowing to finance current spending. Government is seeking more control over mandatory expenditure.

Privatisations

Government wants to reduce holdings of state assets. But sales of some of the government’s larges stakes – in Petrobras, Banco do Brasil and Caixa – don’t (yet) appear to be on the agenda.

Transfer of rights

Government has settled a dispute with Petrobras, allowing an auction of oil prospecting rights this year, which will raise one-off funds of 100bn reais.

Sources: Various


William Jackson, Chief Emerging Markets Economist, +44 20 7808 4054, william.jackson@capitaleconomics.com