Bringing Brazil’s States Back to Financial Health

(Runners participate in a race on the Avenida Paulista in Sao Paulo, Brazil (photo: IltonRogerio/iStock by Getty Images)

By Paulo Medas

(Spanish, Português)

Many Brazilian states are facing a fiscal crisis. With high debt levels, liquidity pressures, and accumulation of large payment arrears, several states have been unable to pay wages, such as for teachers and police officers.

These payment delays have also spilled over into critical areas such as public investment and environmental protection—hurting economic growth prospects, especially for small businesses. There are growing calls for the federal government to bail out states by providing additional debt relief or financial support.

For instance, Rio de Janeiro has already negotiated a fiscal recovery program with the federal government, but progress has been limited and core public services (public safety, education) have been severely affected.

As the federal government is already undergoing a difficult fiscal adjustment--restricting growth of expenditures to contain the high and rising public debt--there is very little room to provide additional support.

So, what can be done? Our latest research from an IMF staff study finds that reforms that promote greater fiscal discipline and enhance transparency and accountability can help to put Brazil’s states’ finances on the right track.

Subnational overborrowing

This is not a new story. After the crises of the 1980s-90s, and several expensive bailouts by the federal government, a new framework was established to impose stronger controls on the subnational finances and prevent future crises. Reforms, including the fiscal responsibility law helped initially to improve states’ financial health of states. However, the economic crisis—especially the deep recession in 2014-2016—highlighted the institutional weaknesses in the framework.

States were not well prepared to manage the economic turbulence in part because of lack of fiscal discipline during the economic boom. The fiscal rules and administrative controls, over time, were not followed and therefore failed to prevent large spending increases and overborrowing by large states.

The enforcement of fiscal rules has been undermined by several factors, including weaknesses in reporting of the states’ finances due to the lack of standardized reporting and creative accounting. The lack of dependable data on public wages is a key example. The application of sanctions by the fiscal responsibility law has also been weakened by judicial decisions, where courts have prevented suspension of transfers as envisaged in the law.

The design of the fiscal rules also contributed to procyclical policies, where governments overspend during economic booms and have to tighten during bad times. The limits on debt and personnel expenditure are expressed as a ratio to revenue. Thus, even temporary revenue increases allow states to boost expenditure. This partly explains the rising trend in public wages in subnational governments, which then is difficult to reverse.

One emblematic example is Rio de Janeiro, where generous wage increases provided during a period of high oil revenues, 2009-2014, became unaffordable after oil prices collapsed.

Financial bailouts

To avoid market discipline, subnational governments tend to borrow mainly with federal guarantees or from public banks with limited consideration of the risks. As the chart shows, states with worse credit ratings have been able to borrow more with federal guarantees at effectively lower costs.

This is because these states were able to receive regular debt relief or avoid repaying their debts with the federal government with the help of the courts. As such, states have an incentive to take risks and borrow too much with the expectation that they will ultimately be bailed out.

The institutional safeguards also failed as the many roles of the federal government created conflict of interests and negatively impacted the credibility of the system. The federal government is the main lender and is also supposed to enforce the fiscal rules and limits to borrowing. At times, it has undermined the rules by granting exemptions and loans beyond limits.

As a consequence, the federal government is seen too closely associated with states’ fiscal decisions—creating the expectation of financial bailouts. This was confirmed starting in 2014 with a large debt relief granted to all states and judicial decisions in favor of the subnational governments.

Healthy public finances

More support from the federal government is expected over the next few years (e.g. through more credit guarantees and future oil receipts). However, while it provides some temporary relief, it will not address the core problem. Our latest report proposes a significant change in the institutional framework to promote greater fiscal discipline and sustainable policies.

The new approach would demand greater transparency and accountability by states and municipalities. The main changes are:

Significantly reform the subnational borrowing framework. This includes:

  • Restrict the use of federal guarantees and limit lending by public banks, while allowing more flexibility to access private capital markets for those that abide by the rules. This would bring more transparent, efficient borrowing and some market discipline.
  • Improve the Fiscal Recovery Regime to be more effective to bring the debt down to prudential levels conditional on performance under the adjustment plan. The regime could include a fund for state debt that would promote risk sharing across states and more credible fiscal adjustment programs.

    Strengthen the fiscal responsibility framework. This encompasses improvements in the subnational fiscal rules and enhancing transparency, such as:

  • creating an independent fiscal council to monitor fiscal performance and compliance with fiscal rules by subnational governments;
  • strengthening fiscal rules to better contain and stabilize public expenditure growth and tighten the debt limits to more prudent levels; and
  • adopting common accounting and auditing standards across all levels of governments.

Further, the institutional changes in the fiscal framework will also need to be accompanied by progress in addressing fiscal pressures from rising budget rigidities, including pensions, and excessive tax incentives.