When will Brazil return to investment grade status?

Friday, May 5, 2017

The approval in Brazil of an unpopular pension reform is considered crucial to restore the health of public finances, investor confidence, and economic growth.

As President Michel​ Temer and his government is pushing hard for the reform, the entire political class is beginning to think about the general elections that Brazil will hold in October next year.

The government, which is facing strong opposition from many Brazilians, has made changes to the bill's original draft. Originally, the government was planning to establish a minimum retirement age of 65 years for men and women. But it later amended it to 65 years for men and 62 for women. It also increased the minimum contribution period for retirement benefits to 25 years from 15 years currently.

BNamericas talked to Banco Votorantim's chief economist Roberto Padovani about the challenges the pension reform is facing and the chances of Brazil obtaining investment grade status again, among other key issues.

BNamericas: How do you view the pension reform proposed by the Brazilian government and the changes that it has implemented recently in an effort to obtain the green light from the congress?

Padovani: The pension reform is positive as it is a step towards the reduction of government spending, but it is still not enough. The government, as a strategy, presented an ambitious agenda already knowing that the negotiations could dehydrate, to a certain point, the pension reform.

Those [changes] are within the acceptable range.

I think it is possible to see even more changes, but the more important points should not change, such as setting a minimum age for retirement for men and women. The bottom line is that with the approval of the pension reform we are taking a step to reduce [government] deficits."

BNamericas: Is the pension reform enough for Brazil to guarantee a sustainable economic expansion and reach, once again, investment grade status from international rating agencies?

Padovani: It is not. In terms of the pension system, at some point in the near future, we need to evaluate a way to un-link the retirement benefits from the increase in the minimum wage.

To reach investment grade again, Brazil needs to complete three phases.

The first one is very important and includes reforms of the [government] spending structure, and the control of its spending.

The second is to guarantee an economic recovery, with GDP growth, which is likely to be seen more clearly next year.

The third one, which is no less important, is the reduction of political risks. I believe those three phases will be completed in 2019, after the presidential election at the end of 2018.

BNamericas: So, with those three phases completed, when would Brazil be able to obtain investment grade status?

Padovani: With all the three phases advancing as I described, I believe it is possible, it is realistic, to expect investment grade status at the end of 2019, or the beginning of 2020.

BNamericas: What happens if the pension reform is not approved or a 'softer' than expected reform is approved?

Padovani: If it [congress] does not approve the reform, the government's spending ceiling will not be realized and the economy will be more vulnerable to external shocks.

This would lead to pressure on inflation expectations and expectations for the general economy, as it would signal a lack of fiscal control. The central bank would have much less room to cut interest rates and the ability of companies to invest would decrease.

We would [also] see an increase in social and political tensions. This would in turn create a vicious circle, fueling uncertainty and economic crisis. We would enter a negative spiral, similar to what we had in 2015 and 2016.

The dollar could reach 4 reais quickly and that would limit the chance of the benchmark interest rate [the Selic rate] reaching the single-digit area - and it would stay at around 10%.

As for GDP, all the expectations about a recover this year and in 2018 would disappear and the most likely scenario is for another recession this year and zero growth next year.

BNamericas: How could President Temer's low approval ratings affect the progress of the pension reform?

Padovani: The international experience shows that deep reforms took place during crisis. The cost of a non-action is much higher than to implement a [unpopular] reform.

The model that should be adopted in the reforms in Brazil should not be measured by government approval, as Brazil is a country with a crisis.

The government's bet is that the reform agenda will allow for a reduction of interest rates and boost economic growth next year.

It is true that people can get fed up with reformist governments if they reduce their rights, but the resumption of economic growth would have positive social effects.

The trend for 2018's [elections] already signals [substantial] votes for non-establishment candidates. If you add zero economic growth to this equation, then the political establishment has no chance. The government is [therefore] betting on economic growth for next year.

In my opinion, Temer is not worried about being elected [next year], he only wants to preserve himself after the [presidential] term. He wants to keep his power of influence and this will only happen if the economy grows again.

About Roberto Padovani

Roberto Padovani has been with Banco Votorantim since 2011. Before Votorantim, Padovani was chief strategist in Latin America for WestLB and a partner at local consultant group Tendencias Consultoria.