Global Insight Perspective

Significance

The federal government's primary surplus narrowed substantially in May, which brings fresh concern about the ability of the Lula administration to meet this year's fiscal goals. However, cumulative results over the first five months of the year remain solid.

Implications

A softening economy and increasing political uncertainty will make the government's fiscal conditions more challenging in the second half of the year. A populist approach boosting public spending beyond reasonable levels could erase any improvement made over the last three years.

Outlook

Global Insight expects the central government's fiscal results to continue deteriorating over the remainder of 2005. However, we still expect the government to meet its fiscal targets for the year, since these targets anticipated deteriorating economic conditions.

Consolidated Public-Sector Primary Surplus Reaches 6.6% of GDP in First Five Months of 2005

Brazil's central government's primary surplus (which excludes interest expenses) reached 2.2 billion reais (US$927.1 million) in May, down from 4.7 billion reais one year ago. This decline was mostly the result of a narrower primary surplus by the federal government, which resulted from a combination of accelerating government spending and stagnant revenues. The other two entities that form the central government, the central bank and social security, showed similar results from one year earlier. On the positive side, the state and local regional governments showed increased primary surplus in May. Meanwhile, state-owned enterprises reached a primary surplus of 1.4 billion reais in May, compared with a deficit of 0.734 billion reais one year earlier. The consolidated public-sector primary surplus reached 6.3 billion reais in May, up slightly from 5.84 billion reais one year earlier. This slight improvement was more than offset by a 29% increase in interest expenses. As a result, Brazil's consolidated fiscal deficit (including interest expenses) widened from 4.8 billion reais in May 2004 to 7.4 billion reais one year later.

Despite May's overall deterioration, Brazil's fiscal accounts over the first five months of 2005 still appear relatively strong. The primary surplus of the consolidated public sector, which consists of the central and regional governments and state-owned enterprises, reached 6.6% of GDP over the first five months of the year, compared with 5.6% one year earlier. The central government reached a primary surplus equivalent to 4.48% of GDP over this period. Meanwhile, the regional government and state-owned enterprises reached primary surpluses of 1.57% and 0.52%, respectively. On the negative side, interest expenses reached the equivalent of 8.47% of GDP in the first five months of 2005, up from 7.66% one year earlier. As a result, Brazil's consolidated public-sector fiscal deficit totalled the equivalent of 1.9% of GDP over this period, up slightly from 2.02% one year earlier.

Outlook and Implications

May's fiscal figures show some worrying signs. As expected, interest expenses have increased in recent months amid higher interest rates, especially with respect to Brazil's domestic debt. Total interest expenses will continue to increase compared with 2004 levels, even after the central bank stops raising its benchmark Selic rate. However, May's figures show an even more worrying sign in that the federal government's primary surplus is shrinking because of an acceleration in spending and stagnant revenues. We expect this trend to intensify during the remainder of 2005 as the government aims to improve its public image, which has been badly damaged by recent corruption scandals. We also expect tax collection to suffer because of a softening economy. On the positive side, the regional government and public enterprises continue to improve their fiscal situation, which partially offsets the central government's deteriorating fiscal performance.

Despite May's disappointing figures, Brazil's public sector remains in strong shape when compared with this year's targets. Nevertheless, the fiscal sector could deteriorate faster than expected in the second half of the year if the government chooses to boost public spending beyond its capabilities in an attempt to re-energize the economy and improve its acceptance level. Such a populist approach could eliminate most of the improvements achieved by the Lula administration over the last few years, which would hurt business confidence and the economy later on. Unfortunately, this risk will likely increase with time as we approach next year?s presidential elections.