Herb Stein famously noted that if something cannot go on forever, it will stop. Brazilian President Jair Bolsonaro is soon to discover that Stein’s law still applies, especially to the world of Brazil’s shaky public finances. And what a discovery it will be: His country’s unsustainable fiscal policy could roil the Brazilian currency market.
Even before Brazil was hit by the COVID-19 pandemic, its public finances were strained by years of profligacy and a weak economic recovery from a deep recession. By 2019, despite the Bolsonaro administration’s bold efforts to curb public pension expenditures, Brazil’s budget deficit remained stuck at more than 6 percent of GDP, resulting in a public-debt-to-GDP ratio of around 80 percent by the end of 2019—troublingly high for an emerging market economy.
The last thing that Brazil’s shaky public finances needed was a shock on the scale of the COVID-19 pandemic. Yet the shock came, and the government’s poor handling of the pandemic only exacerbated its effects. More than 150,000 Brazilians have died from the coronavirus while more than 5 million have been infected. During the first half of the year, Brazilian economic output declined by 7 percent—the largest economic contraction the country had experienced in 30 years.
The Brazilian government’s bold economic policy response to the pandemic further compromised its finances. According to the IMF, the fiscal and quasi-fiscal measures that Brazil adopted to support the economy amounted to a staggering 18 percent of GDP, which made it among the largest fiscal responses among the G-20 countries. Included in this response was an aid package to low-income families that has amounted to about 5 percent of GDP. All this spending bought Bolsonaro more approval points by mortgaging his country’s economic future.
The net effect is that while Brazil’s public finances may or may not have been sustainable before the pandemic, the response to COVID-19 has rendered them untenable. Brazil’s public-debt-to-GDP ratio will soon exceed 100 percent, and its budget deficit has ballooned to a level that will keep the public debt ratio rising into the foreseeable future. According to the IMF, Brazil’s government deficit excluding interest payments is unlikely to dip below 12 percent of GDP in 2020, even assuming that the country will not be hit by a second wave of the pandemic.
The precarious state of Brazil’s public finances has not been lost on the country’s foreign exchange market. Since the start of the year, the Brazilian real has lost around 25 percent of its value against the dollar, making it among the world’s worst performing currencies, as foreign exchange traders have begun to suspect that the poor state of the country’s public finances will lead to inflation.
In principle, the Brazilian government could try to slash public spending and hike taxes in an attempt to restore financial order. In practice, this is unlikely given that the country is fighting a deep recession, has very low interest rates, and has a currency under severe pressure.
Any attempt to reign in the budget deficit in those circumstances would risk deepening the recession. With interest rates at already low levels and with interest rate hikes likely needed to defend the currency, there would seem to be no room for further rate cuts to alleviate the sting of budget cuts.
Brazil has previously tried inflating away its debt. With the central bank now needing to print money to finance the government deficit, indications are it may try again. For Latin America’s largest economy, this is an expensive experiment to repeat.
One bright side, Brazil might serve as yet another cautionary tale for the United States as we risk losing control over our own public finances. Maybe then our economic policymakers might become less cavalier about the likely inflationary consequences of the sorry state of our own public finances.