A general view of the skyline of Sao Paulo April 2, 2015. REUTERS/Paulo Whitaker/Files

Brazil's fiscal fragility stokes funding fears, despite record low interest rates

Like other countries, Brazil needs to borrow so heavily because of the economic crisis triggered by COVID-19

Brazil’s official interest rates and the average cost of servicing its public debt have never been lower, but investors are becoming worried that the government could face a funding crisis next year.

The premium that investors demand to lend longer-term to Brazil has risen amid record borrowing and government debt, along with concern that the far-right administration of President Jair Bolsonaro will relax a key fiscal discipline rule to combat the COVID-19 crisis.

That is forcing the Treasury to borrow for much shorter durations, such as six months, reducing the average maturity of Brazil’s debt profile and increasing the need to refinance on a more regular basis.

As long as the benchmark Selic interest rate stays low and lenders are willing to accept these historically low returns, the debt situation will be manageable.

But with the fiscal outlook deteriorating and almost 1 trillion reais ($180 bln) of public debt maturing next year, nerves are fraying. This prompted official approval last week for the central bank to transfer 325 billion reais to the Treasury to help ease the strain.

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“When you shorten the debt profile, you raise the risk of refinancing in the future. You force yourself to issue bigger volumes, and risk being forced to issue at any price,” said Sergio Goldenstein, former head of open market operations at the central bank. “This is a really risky debt management approach.”

Maturities shortenings

Brazil’s Treasury on Friday raised its 2020 ceiling for the federal public debt to 4.9 trillion reais and revised the profile of its debt stock to reflect the economic crisis and market volatility this year.

The share of short-term debt maturing in the next year will be increased to as much as 28% of the total, and the average maturity of the overall debt stock will be as low as 3.5 years.

As the Treasury chart below shows, the average maturity of the domestic debt stock ticked up slightly in July but was still a historically low 3.75 years, while the average maturity of new debt issued in July was barely 3 years.

Source: Reuters

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Jose Franco, sub-secretary for public debt at the Treasury, said that short-term financing risk was the main reason behind the central bank-Treasury transfer. He also pointed to widening spreads between the benchmark Selic and longer-term yields.

Like other countries, Brazil needs to borrow so heavily because of the economic crisis triggered by COVID-19. The government’s budget deficit is on course to reach 11% of gross domestic product, swelling overall debt to around 95% of GDP.

These are developed economy levels of indebtedness. The Latin American & Caribbean median this year, according to Fitch Ratings, will be 4.3% and 58.8% of GDP, respectively.

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Tony Volpon, chief Brazil economist at UBS and former central bank director, said the central bank-Treasury transfer was likely fully priced in by financial markets and may not fully allay market fears over the financing cliff ahead.

Is there a liquidity crunch? Like most things, that is not black or white. It is in the eye of the beholder.

Tony Volpon, chief Brazil economist at UBS

“But the Treasury’s financing need is so large, there is a limit on how much floating rate notes can be issued,” Volpon added.

While the central bank has made clear it does not intend to raise rates for some time, that could change if the government fails to get public finances back on a more sustainable path.

Game over

So far, at least, the mostly domestic investors who buy the debt seem willing to lend on these terms. On August 13 the Treasury sold 30 billion reais of six-month fixed rate bills at an average rate of 2.08%. It was by far the biggest-ever sale of six-month debt since comparable records began over 20 years ago.

More than 20% of Brazil’s entire public debt is due to be refinanced next year.

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The Treasury’s Franco would not be drawn on exact figures, but said the central bank transfer means the liquidity cushion covers more than three months’ funding needs. He also said the extra cash does not mean less issuance in the future.

But Drausio Giacomelli, head of emerging market strategy at Deutsche Bank in New York, noted that the Treasury has reduced year-to-date net issuance by around 8% because market conditions have deteriorated, and it does not want to risk a failed debt auction which would push yields sharply higher.

He argues the only way to allay these concerns is for the government to stick to its rule limiting increases in public spending to the rate of inflation, and show a credible long-term commitment to bringing down the public debt.

“Will people want to fund the government if the spending cap is broken and spending is not brought under control?” he asked. “If you don’t have primary surplus, lenders may say we are not funding you any more. Then the game is over.”