Brazil state-level spending: How bad can it get?

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In 2014, state-level spending in Brazil represented 26 percent of total public spending, or approximately US$ 258 billion[i] (federal and municipal spending represented 58 percent and 16 percent respectively). Total state-level spending in Brazil then represented the equivalent of approximately one-half of Argentina’s GDP, an impressive figure.

However, 2015 has been unkind to Brazilian state governments. In the last month of 2015, the state of Rio de Janeiro was unable to adequately finance its healthcare system and was forced to declare a healthcare state of emergency, which triggered an injection of funding from the federal government. In the same month, the state of Rio Grande do Sul saw R$ 240 million in funds seized from its bank accounts by the federal treasury to cover arrears from the prior month.

The state government of Rio de Janeiro has since received assistance from the better-positioned municipal government of the city of Rio de Janeiro, but is clearly broke and will struggle mightily in the coming years to adequately fund even its central tasks such as healthcare, education, and the state employee pension system. Meanwhile, the government of Rio Grande do Sul has become the first state to implement its own fiscal responsibility law, and as such has constrained the hands of future governments to meaningfully expand fiscal outlays.

Looking at consolidated state fiscal accounts, the evolution of state income and state spending is alarming. Just since 2010, total state revenue has grown an average of just 2.4 percent (in real terms) while spending has grown by a more rapid four percent. Furthermore, through the first ten months of 2015, both revenue and spending have contracted with revenue falling nearly three times faster than spending. In an environment in which the federal government is restricting states (even those with the ability) to take on additional debt (in order to limit upward pressure on the consolidated public debt position that is already approaching the daunted 70 percent of GDP figure), states will need to continue to reduce spending or raise significant new revenue immediately.

 

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Drivers of state-level financial struggles

So what has happened? There are several factors responsible for the poor evolution of state finances in recent years. Shortly following the global recession of 2009, the federal government has allowed states to take on more debt, including debt denominated in foreign currency that was often unhedged.

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This new debt was in many cases taken on to maintain investment levels while state governments expanded current spending, including spending on personnel. Indeed, many states have been allowed to increase spending on personnel beyond the legal limit of 50 percent of total revenue by claiming deductions for certain categories of public servants and benefits, thus reducing the accounting total for this spending category.

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However, with their ability to take on new debt limited since 2014, and since it is nearly impossible to rapidly reduce personnel spending in the public sector, states have turned to cuts in investment outlays, which fell by more than 40 percent in the first ten months of 2015. At the same time, the increase in the debt load (including through depreciation of the real for states that had borrowed in foreign currencies) has led to larger interest and amortization payments, and has thus restricted states’ abilities to concentrate on other spending priorities such as infrastructure investment and improvements to basic social services.

Next, and more obvious, is the effect of a slowing economy on tax revenue. Both the ICMS collected by states and transfers from the federal government are significantly affected by slowdowns in economic activity (for a more detailed discussion on the role of federal transfers on subnational spending patterns, FSG clients can click here). Likewise, many state governments have lost revenue in recent years by conceding tax breaks in the continuous battle between states for private investment, which further cut into revenue. Finally, in the case of the main oil producing states (Rio de Janeiro and Espírito Santo), the steep fall in oil prices during the past 12 to 18 months have severely reduced the amount of royalties that these governments are able to collect. This last effect, of course, being one of the main drivers behind the fiscal crisis currently being experienced by the state of Rio de Janeiro.

How states are reacting?

States have and continue to attempt numerous policy changes in order to reduce spending and raise income:

  • 20 states have increased their ICMS tax on one or more commercialized goods
  • The states of Rio de Janeiro and Espírito Santo are lobbying to change rules in order to increase royalties paid by oil producers
  • Many states are renegotiating contracts with key suppliers, and notably the state of Sao Paulo has ordered its ministers to renegotiating contracts valued above R$750,000 for a wide range of operations
  • Numerous state governors have travelled to China to solicit finance for projects that have been stopped for a lack of funding (including roads and hydroelectric facilities)
  • State governors are lobbying the federal government to make further adjustments to the rules relating to debt payments by states to the federal government. Currently, these payments can reach up to ten percent of states total revenue
  • State governments are lobbying the federal government to pass legislation to require private health insurers to compensate states for services provided to their clients in state operated hospitals
  • State governors have, and are lobbying to again access judicial deposits (reserves held for paying compensation in legal processes against states) held by public financial institutions such as Banco do Brasil and Caixa

Prospects moving forward

There are of course several well-known measures not mentioned above that could potential ease the current financial pressure being felt by state governments. Such policies include reform of the ICMS tax and the reintroduction of the CPMF tax on financial transactions. While potential ICMS reform looks more likely, neither potential reform currently has the necessary political support in Congress to get off the ground. Likewise, the recent promulgation of a law permitting Brazilians to repatriate cash illegally held abroad will not benefit states, as all income from this measure will go to the federal government (currently estimated at R$ 21 billion in 2016).

Furthermore, the other measures being attempted are either improbable or will have a minimal effect. It has been argued that raising royalties on oil producing companies with global oil prices at their current level will only serve to put downward pressure on investment and output and thus will have a negligible effect on state revenue. In addition, in the case of renegotiating payment terms for debts owed to the federal government, proposed alterations would in fact weigh on the federal government’s final fiscal position, not only making changes difficult to pass but likely necessitating a deeper contraction of spending at the federal level.

Implications for multinationals

How are multinationals to interpret this quagmire? To begin, FSG believes that states’ spending power is unlikely to improve until the country returns to economic growth, which FSG is now projecting to occur only in 2018. Likewise, states’ increased debt levels and high spending on personnel mean that spending growth over the next five to ten years is likely to be suppressed while states continue to look to increase revenue (leading to a heavier tax burden) and reduce spending.

Companies should expect to continue to see smaller and more rigorous public tenders at the state level through at least 2018. In addition, FSG expects payment delays to extend through 2017 as private consumption continues to contract and thus tax revenue falls further. Those companies operating or selling into the healthcare or education spaces will likely experience the greatest difficulties, as most states have space to cut spending in both areas without falling below legal lower limits.

In this regard, companies should consider altering their value proposition when selling to state governments, emphasizing cost saving products and value-added services. Likewise, should the federal government loosen restrictions on new borrowing, companies will benefit more than ever from targeting states that are currently better positioned financially (see chart of state debt positions above).

Additionally, companies should consider targeting municipalities that have stronger financial positions than their state level counterparts (e.g. the municipality of Rio de Janeiro). As a matter of fact, FSG expects municipal spending to fall slower than spending at the state-level as the ruling PT party looks to boost the chances of its candidates in this October’s municipal elections.

With little prospect for significant new revenues at the state level, companies should be prepared for a sustained period of spending stagnation by Brazilian state governments, necessitating that even further attention be paid to subnational prioritization.


To learn more about how we can support your business needs in Brazil and tailor your strategy at the subnational level, contact us at info@frontierstrategygroup.com, or visit our website.

[i] At 2014 average BRL:USD exchange rate of 2.4

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