Brazil’s states are now in hock to federal banks to the tune of $35b.
Brazil’s states are now in hock to federal banks to the tune of $35b.

Brazil Needs to Prevent Rising Fiscal Debacle

Brazil Needs to Prevent Rising Fiscal Debacle

Brazil’s stand-in president Michel Temer hasn’t had it easy. In the six months he’s been in office—following the suspension and then impeachment of his predecessor Dilma Rousseff for budget crimes—Temer has lost his sixth minister to scandal, stood by while key allies led a shameless assault on Brazil’s anti-corruption efforts, and see a wan economic recovery turn into a near-rout. So when the Brazilian Senate approved a key piece of the government’s austerity plan this week, the relief in Brasilia was almost palpable.
As revolutionary as the Temer government’s proposed public spending cap could be, it’s far from the only measure Brazil needs to prevent a fiscal debacle. Among the many dysfunctions dogging Latin America’s biggest democracy—prolonged recession, a loss-making pension system, systemic corruption—one of the most insidious has gotten scant attention to now: explosive state and local debt, Bloomberg reported.
Consider Rio de Janeiro, which in June declared a state of financial calamity, the political equivalent to bankruptcy. The crisis, announced just as the state capital was readying to host the Summer Olympics, forced Temer’s hand, bagging Rio an $850 million emergency loan—but to little avail. State employees are clamoring for back pay, pensions and study stipends are overdue, and public hospitals are short of supplies and physicians. 
A celebrated public safety chief recently stepped down amid serious budget constraints and spiking crime. Even as angry police and firefighters stormed the state legislature last month, Governor Luis Fernando Pezao warned that depleted state coffers can only cover just seven months of next year’s payroll. The state has announced plans to spend some 85% of its expected 2016 oil royalties to pay off debts.

 State Governments in Trouble
Rio is not alone in penury; most of Brazil’s state governments are in trouble, with some of the largest running debts of over twice annual revenues. That’s a violation of Brazil’s fiscal responsibility law, the same offense that led to the impeachment of Rousseff on Aug. 31. What’s more worrisome, local governments cannot declare bankruptcy, which means that failing states are ultimately the federal treasury’s headache. 
Last month, under intense pressure from the hinterlands, Finance Minister Henrique Meirelles offered bereft states a share of the $26 billion the federal government expects to collect from wealthy Brazilians in a one-off foreign asset tax amnesty. Meirelles conditioned the bailout on belt tightening, including deep salary cuts. The deal lasted all of a week, as several governors advised they had no intentions to slash budgets.
How much the federal fix will help is another question. The roots of the financial collapse owe to a years-long festival of overspending, lavish lending, and generous tax breaks that began in Brazil’s boom years but carried on long after the economy started to tank in 2014. From 2010 to 2014, spending by state and local governments outpaced revenues by around 50% a year. The recession spoiled the party in 2015, but even then public revenues fell three times faster than spending. States are now in hock to federal banks to the tune of $35 billion.
What’s harder to fathom is how the country’s nominally robust institutional firewalls failed to prevent the disaster. Monica de Bolle of the Peterson Institute for International Economics traces the problem to a combination of magical economic thinking and willful politics that reached its peak as Rousseff stumped for reelection. “We don’t need to reinvent the wheel here. Brazil actually has safeguards against fiscal irresponsibility,” de Bolle told me. “But they fell down on the job. I think it came to a point where everyone ramped up spending and shut their eyes.”

 Financial Crunch in LatAm Countries
This is not just Brazil’s worry. True, most of the bigger Latin American economies have less debt and a better handle on their state finances than Brazil, according to Humberto Panti of Fitch Ratings. Last year, Mexico passed a fiscal reform which tightened federal oversight of sub-national debt. In Argentina, provincial governments may not raise debt abroad without the imprimatur of the federal treasury. But the safeguards are only as good as the gatekeepers.
In June, Moody’s Investors Service warned that Mexico’s local governments were quietly bingeing on debt, now riding a 20-year high at $28 billion. Moody’s downgraded all but one of the country’s 31 states in April.
Argentina, too, has been in a borrowing frenzy since market-friendly Mauricio Macri took office in December and settled the country’s quarrel with foreign creditors. While most of the new debt is federal, provincial governments following Macri’s lead are piling up dollar-denominated bonds, a potentially troubling sign in a land where overextended local governments have often triggered national crisis.
“A lot of Latin America’s spending takes place through sub-national budgets,” Goldman Sachs’s Ramos said. “With slow growth, spending at the sub-national levels makes the fiscal burden higher, which can add to national debt burden. It’s a significant threat.”
With the region’s economy sluggish and uncertainty growing over the policies of the coming US administration, Latin America’s financial crunch is about to get worse. “Emerging market bonds have been the asset to dump,” Bloomberg’s Christopher Langner recently reported.
Brazilians, understandably, are outraged over their political elite’s displays of callous behavior even as the economy stagnates. Many cheered and danced in the streets when former Rio governor Sergio Cabral was arrested on Nov. 17 for allegedly spending taxpayers’ money on personal luxuries, including extravagant soirees in Paris and Monaco. Who will pay for the next carnival is an open question.

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