Revenue Windfall Will Be Lower This Year

Brazilian states' revenue collection is very sensitive to nominal economic growth. This mainly stems from consumption taxes on merchandise and services (ICMS), which make up 50% of states' aggregate operating revenues, and central government transfers (22%), which are mainly composed by nationally collected taxes redistributed to states. Last year's surging inflation, especially the abrupt increase in energy prices (fuels and electricity), swelled states' coffers, with ICMS growing 24% in 2021 and government transfers 0.5% (net of the countervailing effect of the withdrawal of the support package--see: "Credit FAQ: To What Degree Will Fiscal Package Help Brazilian Local And Regional Governments?," published June 9, 2020). However, because inflation has remained stubbornly high, social pressure forced changes in taxation. These changes aim to limit pass-through effects from high international energy prices, including changes to the prices and formulas used to calculate taxes on gasoline sales, which have somewhat disconnected these taxes from price movements.

While these changes won't result in a nominal fall in tax collection growth, they limit the growth potential in 2022. Moreover, as inflation continues to hit Brazilians' purchasing power, other initiatives to change taxation could gain traction. The most recent example is a presidential decree that temporarily reduces the tax on industrial products, which will hamper states' budgets through the federal transfers mechanism. These fiscal measures come on top of an expected economic slowdown to 0.4% in 2022 from 4.6% in 2021, which will slow Brazilian states' baseline revenue growth.

Mounting Expenditure Pressures Will Test Liquidity Resiliency

On top of slower revenue growth, pressure is rising to increase payroll and infrastructure spending following the pandemic-related shock. In 2022, the government lifted the freeze on personnel salaries after almost two years of real losses in the salaries of states' public servants. We expect payroll spending to increase 18% in 2022 versus 2021, and increase 27% compared to 2019 (the last year before the salary freeze). Moreover, slowing but still relatively high inflation in 2023 will continue to put upward pressure on salaries following the national election: we expect payroll spending to rise 6% in 2023.

Adding to social and salary pressures, Brazilian state governments only have discretion on a small share of their budgets (less than 10%) because legislation set at the national level has significant effect on local and regional government (LRG) finances. Recently, Brazil's congress increased the minimum salary for education workers by 33%. This decision has significantly affected state budgets, because the increase established is well above the real loss of the last two years, and its implications cascade to active education workers as well as retired workers via pension benefits paid by the states. We estimate that education payroll represents 15% of local operating budgets. Some states with better financial positions have already increased education salaries in the last year, moderating the impact of the measure, but that isn't the case for most states.

On the other hand, states do have autonomy to decide on the adjustments to other categories of their payroll spending. However, the decision to raise education salaries sets expectations for other public servants, especially since the strains from the pandemic haven't dissipated, and employees working in health and security sectors have recently had extremely challenging years. There have been strikes demanding higher pay, and some states have already granted double-digit salary increases.

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Spending pressures go beyond payroll. Since Brazil's 2015 economic crisis, infrastructure execution has been delayed, which has resulted into a notable deterioration of public services. Additional revenues bolstered public works in 2021, and we expect states to use part of their accumulated cash to continue expanding spending on public works this year, mostly reflecting high infrastructure needs. Electoral dynamics amid the upcoming election will likely reinforce the accelerating trend in public works, at least in the first half of 2022, because of limits on public work inaugurations before elections.

Restrictions On Borrowing Have Lowered States' Debt

The central government requires states to meet strict spending rules. States are mandated to spend at least 37% of their annual revenue on education and health. Because revenue has become structurally higher in the aftermath of the pandemic, it automatically implies higher spending. In that sense, the extraordinary spending on health during the pandemic won't recede, but states will reallocate it. Additional rigidities include indexation rules in many other sectors of government spending.

Strategic liquidity planning is becoming more relevant amid limited access to borrowing sources. The federal government has begun to limit access more stringently to new loans as highly indebted states declared fiscal calamity status during 2016-2018, and in 2020. Since 2016, states missing payments on guaranteed loans or loans held by the central government have led to the government paying R$44 billion in guarantees. Even before the pandemic, the federal government had become more wary of lending or granting guarantees to states, and as a result, state borrowings were only R$10.5 billion in 2019 from R$21 billion in 2015.

This limited access to lending is despite recent improvement of states' financial indicators. The federal government is discussing stricter rules for borrowings, which could further narrow borrowing options of Brazilian states, because these changes are part of the central government's plan to promote LRGs' fiscal sustainability. As of the end of 2021, state borrowings were R$10 billion and we expect this level to remain stable for the next two years.

On the other hand, restrictions on borrowings and spending containment have been lowering states' debt levels. We expect the debt as share of operating revenues to continue falling in 2022 and 2023 because we anticipate available cash to mainly cover the increase in capital expenditures.

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More Structural Fiscal Space Would Improve The Creditworthiness Of Brazilian States

We view the recent improvement in states' fiscal performance and the shift in expenditure composition as positive developments in terms of their creditworthiness. However, we still see high uncertainty about how this trend will play out in the next few years, and especially how states will manage spending pressures in the context of weak real growth and high inflation. If slow growth and accelerating inflation squeeze state budgets and access to debt remains limited, liquidity buffers could rapidly erode.

We expect Brazil's GDP growth to decelerate to 0.4% this year and to average less than 2.0% in the next few years. Monetary tightening, a more difficult fiscal scenario, supply chain disruptions in manufacturing, and the uncertainty around the outcome of the general elections will weigh on growth this year. (See: "Economic Outlook Latin America Q2 2022: Conflict Abroad Amplifies Domestic Risks," March 28, 2022).

In our view, states' commitment to fiscal sustainability will be key to turning a temporary cash windfall into a structural fiscal improvement that allows states to face future shocks from a more comfortable position and depend less on sovereign support. Although the fiscal support that the central government provided amid the pandemic was more than adequate to compensate for the shock, and was among the most generous in the world (see: "Non-U.S. Local Governments: To What Extent Did Sovereign Support Offset The Pandemic Downdraft?," July 19, 2021), there is no established framework for future support to LRGs and sovereign fiscal space has narrowed after the pandemic-induced crisis.