Brazil faces the risk of triggering a vicious cycle of devaluation, inflation and weaker growth momentum if the country fails to rein in its record-high fiscal deficit in 2021, with international investors growing wary of the country's rising debt-to-GDP ratio, analysts told S&P Global Market Intelligence.

In a bid to prop up economic activity during the coronavirus pandemic, the Latin American powerhouse will have spent 615 billion reais, or 8.6% of GDP, on stimulus measures by the end of 2020, more than the averages of 7.1% and 4.3% projected for developed and developing countries, respectively, according to recent estimates provided by Brazil's economy ministry.

While such spending has effectively lessened Brazil's economic decline relative to its regional counterparts, it will also raise the country's fiscal deficit to a record 16.8% of GDP by the end of this year, considerably higher than the averages of 11.1% of GDP among regional peers and 10.7% of GDP in emerging markets, as per the International Monetary Fund's latest Fiscal Monitor Report.

The IMF's forecast falls in line with estimates provided to S&P Global Market Intelligence by Oxford Economics, Capital Economics and the Getulio Vargas Foundation, which placed Brazil's 2020 fiscal deficit between 15% and 18%, and the primary deficit — which does not include debt servicing — between 12.5% and 15%.

What's more, the government's higher expenses will take Brazil's public debt to a record high of 96% of GDP, with the Economy Ministry expecting an increase up to 100.8% of GDP by 2026.

"The deficit is unsustainable, and the forecast will depend on signals from the treasury and the government regarding commitment to a sound and credible fiscal adjustment, but I am a pessimist about this," Fernando Ribeiro Leite, an economist with business school Insper, said, expressing concern that authorities were taking too many steps down the "path of populism."

This year, the government distributed between 300 reais and 600 reais per month to more than 60 million people directly through the main emergency aid program, by waiving a fiscal cap that prohibited spending increases in real terms. "This program ... is behind the gigantic deficit, [which is] the biggest in emerging markets," Felipe Camargo, a Latin America economist at Oxford Economics, told S&P Global Market Intelligence.

Although Economy Minister Paulo Guedes has vouched for a return to a path of fiscal consolidation next year, such restraint would be difficult to pull off faced with a potential second-wave scenario. Brazil currently has the sixth-highest level of coronavirus-related deaths per million inhabitants in the world, as well as the third-largest total case count, although daily deaths and active case numbers have both declined steadily since August.

It remains to be seen whether the government led by Jair Bolsonaro will reinstate the public spending cap in 2021, just a year ahead of a presidential election.

"The government’s current plan is to turn to austerity next year to try to stabilize debt, but there are question marks about whether this is politically palatable, particularly with a general election in 2022," William Jackson, chief emerging markets economist at Capital Economics, told S&P Global Market Intelligence. Brazil's "starting point coming into the crisis was worse than most other countries, with a budget deficit of about 6%," he added.

For Marcelo Kfoury Mouinhos, an economics professor at the Getulio Vargas Foundation, or FGV, and former chief economist at Citi Brasil, the main risk of seeing a higher-than-expected deficit in 2021 would be "a second wave of COVID-19 that brings another lockdown and additional monthly stipends for vulnerable people."

Short and medium-term risks

The Brazilian economy faces several risks in the short- and medium-term due to higher public spending this year.

"Brazil is actually experiencing one of the short-term risks as we speak, and it's that it has the worst-performing [exchange] rate this year," Oxford Economics' Camargo said, pointing to "the bad domestic market sentiment this rise in debt has caused" as the main explanation.

Regarding the medium-term risk, the economist highlighted a debt hangover that will prolong the need for fiscal adjustment and hold back private investment, an exchange rate-induced acceleration in inflation, and weaker growth momentum once the fiscal stimulus is over in 2021.

"Under our current baseline, it should take Brazil over about 20 years just to repay 2020’s debt increase as a percentage of GDP," he noted.

For FGV's Kfoury Mouinhos, "anything over a 3% of GDP primary deficit next year will spook investors."

In the meantime, Brazil has not been honoring its 2020 commitments to most international organizations, with the economy ministry recently telling Valor that it has only paid 15.5 million reais out of a total of 4.2 billion reais owed to the World Health Organization and the United Nations, among other agencies.

"So far the risk of a default is low, but the slope of the yield curve is a measure of risk, and the 10-year bond pays a 7% interest rate, much higher than the [benchmark] Selic rate that is at 2%," he added. In fact, recognizing the risk of seeing higher inflation, the central bank's monetary policy committee said Nov. 3 that it would reevaluate its pledge not to raise the rate if the fiscal situation were to deteriorate further.

According to Capital Economics' Jackson, "the large scale of the deficits is a worry for investors, as it’s causing the debt ratio to rise sharply, and there’s a risk of a vicious cycle of concerns about the debt trajectory, which leads to higher interest rates and an even higher path for public debt."

"This is about fiscal control," Insper's Ribeiro Leite said, emphasizing that "fiscal debt and fiscal deficits restrict the efficiency of monetary policy."

As of Nov. 4, US$1 was equivalent to 5.67 Brazilian reais.