2017 GROWTH STRATEGY Brazil July 2017 BRAZIL´S ADJUSTED GROWTH STRATEGIES FOR 2017 Table of Contents A. Economic Objective and Context .......................................................................... 2 B. Implementation of Past Growth Strategies .......................................................... 3 C. Major New Policy Actions Supporting Growth – Hamburg Summit .................... 3 C1. Macroeconomic Policies and Infrastructure Investment ................................. 5 C2. Structural Reform and Other Actions to Foster Strong, Sustainable Balanced and Inclusive Growth ............................................................................................. 6 Annexes ...................................................................................................................... 8 Annex 2. Implementation of Past Growth Strategies – Hangzhou, Antalya and Brisbane commitments .............................................................................................. 9 Annex 3. Major New Policy Actions Supporting Growth – Hamburg Summit ....... 27 A. Economic Objective and Context Economic Scenario: After two years of negative GDP, growth signs began to accumulate and the economic activity is starting to recover, indicating the end of the recession. GDP is expected to speed up in the second semester of 2017. According to the Brazilian Ministry of Finance, the projections for the Brazilian GDP growth are 0.5% in 2017, 2.5% in 2018 and 2019, and 2.6% in 2020 (see Annex 1). Some increase of investment should start to appear as the year progresses, stimulated by the lower interest rates and better confidence of business executives, and especially because of the reforms under way in different areas. Consumption is still slippery since households are indebted and the job market is fragile, but there are signs of consolidation in the credit market. The current momentum of the global economy, supported in particular by expansion of advanced countries, is positive to the Brazilian growth. The slightly more robust international growth makes the climate favorable to Brazilian exports, even with the relatively strong exchange rate. This was already observed in the beginning of the year, markedly iron ore, soybeans and petroleum. Monetary Policy: One of the most positive developments regarding the economy is the substantial and generalized decline in inflation. After reaching 10.67% in 2015, the inflation rate decreased sharply to 6.29% in 2016, falling within the tolerance band. The disinflation process persists in 2017 and estimates indicate that the consumer price index (IPCA) will close below the target (4.5%) this year. With well anchored inflation expectations, the Central Bank is expected to extend its easing cycle, which saw the policy interest rate (Selic) fall 400 bps, from 14.25% to 10.25%, since the beginning of the cycle in August 2016. Continued monetary easing will be a key contribution to the recovery of the Brazilian economy in the short-run. Fiscal Policy: Because of the unfavorable public debt dynamics (76.6% in 2017- 2018, 78.1% in 2018-2019), Brazil is adjusting its fiscal position and improving the quality of its expenditures. The very first step was the freezing of spending in real terms (for 20 years). Additionally, a deep reform of the Social Security and Pension system is about to be approved by the Congress, so that the country will be in better situation to face the country demographic shock. Labor Market: One of the challenges faced by government is to translate the economic recovery into job openings. According to the Brazilian Ministry of Finance, the unemployment rate is now projected to reach 12.4% in 2017-2018, following two years of severe drops in GDP. However, data from informal jobs and labor income indicate a slightly less worrying evolution, signaling that the deterioration of these indicators are losing momentum. Hence, as the economic environment recovers and the ongoing labor reform lowers labor costs for businesses, we see risks that the labor market will overperform our own forecasts. Political Scenario: The political scenario presents risks to the reforms agenda. The main risks is the uncertain speed of approval of the reforms, in particular the Social Security and Pension reform. Nevertheless, executive authorities continue to push for the approval of the reforms proposed and expect that this agenda continues to move forward in the next few months. 2 B. Implementation of Past Growth Strategies Brazil has made significant progress in the implementation of the commitments contracted in the past Growth Strategies. The initiatives that were thought to enhance foreign trade and improve several aspect of SMEs’ environment (e.g., red tape issues, youth employment, access to foreign markets, increase productivity) are now maturing and have started to deliver important results in 2017. While some key (and non-key) commitments are ongoing projects, another important share is fully implemented and is expected to have either permanent or long lasting effects on the economic growth. Regarding the past key commitment “Fiscal Consolidation Program and the Review of Fiscal Rules in order to restore Macroeconomic Stability (2015-2017)”, due to its importance the Brazilian new government has decided to transform it into a larger scope commitment dealing with the Brazilian public finances. This new commitment, which also incorporates elements of the previous commitments that are already ongoing, is now called “Implementation of Fiscal Consolidation Program (2015-2018)”. One important example is the creation of the Infrastructure Working Group to identify market failures in infrastructure financing and propose solutions through regulatory reform. This work resulted in a new program promoting the consolidation of ongoing infrastructure projects and improving governance with the creation of the Investment Partnership Program (PPI) in 2016 - listed as a new key commitment. Another important commitment that has been dramatically deepened is the fiscal consolidation. Brazil is responding to the recent crisis by taking on many steps towards cutting and perfecting government spending, yet preserving policies that engender the creation of jobs and induce productivity gains in the Brazilian economy. Many of these reforms—also listed as new key commitments—affect the structure of markets, align incentives and reduce frictions, resulting in larger medium-and-long-term growth. The implementation status of the past key commitments is listed in Annex 2. Nevertheless, measures that characterize a major realignment of some of the past commitments are listed in Annex 3 as new key commitments. C. Major New Policy Actions Supporting Growth – Hamburg Summit Notwithstanding some past commitments being enhanced, either by accentuating or realigning the initiatives, the current administration is committed to promoting major reforms in the Brazilian economy in order to resume economic growth. Among them we highlight the Social Security and Pension Reform in Brazil that together with the new fiscal regime will make room for a profound change in government spending, allowing for the implementations of pro-inclusive growth policies. Additionally, other important reforms are aimed at increasing the productivity and the competitiveness of the Brazilian economy. They align the functioning of some domestic markets with the best practices adopted by advanced economies—ranging 3 from labor market flexibility (that also accounts for new immigrants rules), to improving credit market conditions for both creditors and debtors, to leaning on acts governing new and ongoing investment projects. Microeconomic reforms. There is a national awareness that reforms need to be made to sustain economic growth in progress. Among the microeconomic reforms to improve the country's productivity and reduce bureaucracy, we can mention measures to reduce the time of opening of companies, simplification of the payment of taxes and greater facilitation for the import and reduction procedures. Structural reforms. Main structural reforms announced at the end of the last year are positive factors to encourage foreign investors towards Brazil. One important aspect affecting openness that was recently addressed is the local content policy. A more flexible New Local Content Policy was implemented for the upcoming oil and gas auctions in Brazil—reducing the local content requirements. This policy review seeks to reduce the burden over investment projects, increase the processes transparency and attract foreign competition for the next auctions bids. Since these sectors are responsible for large shares of the gross fixed capital and technology induction, resuming investments should contribute to improve both productivity and growth. Besides trade and investment opening measures, Brazil is advancing important reforms that should help raise productivity and free up resources for investments, while improving the social cohesion. First of all, the flagship of these reforms is the Social Security and Pension System in Brazil. It aims at strengthening the sustainability of the social security system, which is one of the pillars for the protection of low-income households. The measures are aligned with international best practices and assess the minimum retirement age, the adjustment of welfare benefits, and the convergence of the rules of the private and public systems. Although the effects of the proposed Social Security and Pension System reform are expected to have full direct effects only in the long run, the improvement in the economic scenario, resulting from its approval, will have impacts in the short term, with a positive effect on fiscal policy, making it possible to further lower real interest rates and stimulate investment and job creation. Recent estimates suggest that, in terms of government spending, the proposal allows for savings of 1.1 p.p. of GDP by aligning the rules for accessing social security benefits with Brazil’s current fiscal and demographic reality. On the other hand, revenues could go up by 0.3 p.p. of GDP, mainly because people will remain in the labor force longer, contributing to the sustainability of the pension system. The approval of the Social Security and Pension Reform bill, together with the approved constitutional amendment imposing strict rules limiting increases in public expenses (for 20 years), would be a key step toward the stabilization of public debt in the medium term, the further reduction in interest rates and the resumption of steady economic growth. Another important step is the modernization of the Brazilian labor legislation that is under way. This refinement to the labor legislation aims at making the job market more flexible. One of the main principles of the labor reform is to give legal legitimacy to contracts signed through collective bargaining. The negotiations between employers and employees will prevail over the Labor Laws (CLT), 4 limiting the power of courts in interpreting the law, and ending the compulsory contribution to labor unions. In addition, the labor market reform will generate more formal jobs in Brazil. As a result, more workers will be contributing to the social security and pension system, which contributes to improve the result of the social security and pension accounts. The labor market reform complements the macroeconomic measures that make the business environment in Brazil more dynamic, efficient and competitive. And there is more to come: new financing instruments for deepening the market for real estate, new market-oriented interest rate for the BNDES loans, refined regulatory framework for micro-and-individual entrepreneurship, updated Bankruptcy Law, etc. The implementation status of key commitments listed below is in Annex 3. C1. Macroeconomic Policies and Infrastructure Investment Macro policies Fiscal consolidation program: The central government has taken actions to limit and, at the same time, to revise the priorities for government spending, seeking higher quality in expenditures. Moreover, studies are under way to modify segments of the tax system. These steps concur for increasing the predictability of macroeconomic policies, restraining the real growth of public expenditure, and assuring the sustainability of the public debt. The main steps already in place are limiting federal government spending and consolidating debts of subnational entities. Others, like rationalizing social programs, federal support (to BNDES, for example) and tax rules are under study and should be out for approval later this year. Infrastructure Investment Investment Partnership Program (PPI): The central government decided to improve the governance of its interaction with the private sector through partnership contracts for the execution of infrastructure projects. The guidelines include greater maturity in the projects to be tendered (including in the issue of environmental licenses), incentive to international competition and medium players, greater rationality in the required investments (with the use of demand triggers), and greater transparency both in service level indicators to be provided and in the risk matrix. Also under discussion is the Renewal of PPI Contracts. It seeks to extend the partnerships in order to enable new investments not initially predicted in the original contracts, with the inclusion of new performance rules and goals. On another venue, a more flexible New Local Content Policy was implemented for the upcoming oil and gas auctions in Brazil, aimed at bringing back investments in the oil and gas sectors. The new policy intends to reduce the number and complexity of the rules, consequently, the burden over investment projects, and to increase the process transparency and attract foreign competition for the next auctions bids. 5 C2. Structural Reform and Other Actions to Foster Strong, Sustainable Balanced and Inclusive Growth Social Security and Pension Reform An extremely important measure forwarded to the National Congress is the proposal for a Constitutional Amendment that reforms the Social Security and Pension System in Brazil. It aims at strengthening the sustainability of the social security system, which is one of the pillars for the protection of low-income households. The measures are aligned with international best practices and assess the minimum retirement age, the adjustment of welfare benefits, the convergence of the rules of the private and public systems. Although the effects of the proposed reform are expected to have full direct effects only in the long term, the improvement in the economic scenario, resulting from its approval, will have impacts in the short term, with a positive effect on fiscal policy, making it possible to lower real interest rates and stimulate investment and job creation. Labor Market (and inclusive growth) Major microeconomic reforms are being implemented and are also expected to impact the productivity of the Brazilian economy. For instance, some of the labor market rules prevent firms from hiring employees in a more flexible way. Hence, proposals are being made to grant greater legal weight to collective contracts— limiting the judiciary power in interpreting the legislation—, which would result in both more stable rules and more prominent roles for workers when negotiating their rights. Another measure that will impact the labor market in Brazil is the modernization of the Immigrants Law. Recently approved, the Law guarantees equal rights to foreign residents—as those of native-born—in Brazil, including the access to public health and education services. Credit Markets The government has announced that in 2018 the interest rate BNDES’ loans (TJLP) will be replaced by a new rate, the TLP. This measure will move the rates charged on BNDES’ loans closer to the ones applied by the market. In order to further develop and improve credit conditions for the Brazilian real estate sector, the central bank just ended the public audience period for the terms of a new funding instrument, the Secured Real Estate Bills. Once issued, it will increase the sources for real estate financing as well as reduce the risk for investments in the sector. Also in line with the improvement of credit conditions, the Brazilian Bankruptcy Law is under revision. In spite of the improvement of the creditors’ rights achieved by the legislation put forth in 2005, the increase of the amount of credit taken and the reduction of the costs, Brazil is drafting a new streamlined law to improve the efficiency of the bankruptcy practice in the country. 6 One additional initiative aims at providing access to credit to individual microentrepreneurs and microenterprises through government owned banks by means of intense digitalization of both the eligibility analysis and the risk- assessment of the targeted public. Business Environment It is being implemented an initiative to refine the Regulatory Framework of Microentrepreneurship and Individual Microentrepreneurs. It aims at designing and implementing adequate, simplified and specific regulatory framework to microentrepreneurships and individual microentrepreneurs. The measure should reduce the incidence of informal jobs and businessmen in the country. Although some of the measures catalogued above will improve the business environment, the Brazilian National Congress is also preparing a specific bill to strengthen the autonomy of the regulatory agencies in order to increase infrastructure investments. 7 Annexes Annex 1. Key Economic Indicators Maccoeconomic Indicators 2016 2017 2018 2019 2020 2021 Real GDP (% yoy)(1) -3.6 0.5 2.5 2.5 2.6 na Nominal GDP (% yoy) (1) 4.4 7.0 8.0 7.9 8.0 na Output Gap (% of GDP) (1)(2) -3.1 -2.4 -0.8 0.0 0.4 na Inflation (%,yoy) (1) 8.7 4.2 4.5 4.25 4.0 4.0 Fiscal Balance (% of GDP) -2.5 -2.1 -0.9 -0.2 na na Unemployment (%)(1) 11.5 12.4 12.4 12.3 12.0 na Savings (% of GDP)(1) 13.9 17.7 na na na na Investment (% of GDP) (1) 16.4 16.3 16.8 17.4 18.0 na Public Fixed Capital Investment (% of GDP) na na na na na na Private Fixed Capital Investment (% GDP) na na na na na na Total Fixed Capital Investment (% GDP)(1) 15.4 17.7 16.8 17.4 18.0 na Current Account Balance (% of GDP)(3) -1.31 1.45 na na na na Source: Ministry of Finance. “na” means “not available”. Notes: (1) Ministry of Finance/Secretary for Economic Policy (2) A positive (negative) gap indicates an economy above (below) its potential (3) The Central Bank of Brazil 8 Annex 2. Implementation of Past Growth Strategies – Hangzhou, Antalya and Brisbane commitments Infrastructure Identifying market failures in infrastructure financing and Working proposing solutions through regulatory reform Group Inclusion of the commitment in Brisbane Growth Strategy. growth strategies Interim Steps for Implementation Status The group was launched on May 7, 2014, with a term of one year to present final recommendations. The conclusions of this working group were analysed by each regulatory agency in their respective field of responsibility and by other government institutions (Ministry of Detailed Finance and the National implementation Development Bank-BNDES) in path and status order to prepare specific measures Completed to tackle the problems identified and the implementation of its proposals. The conclusion of this working group resulted in the creation of Investment Partnership Program (PPI), which aim at regulating the interaction between the Brazilian federal government and the private sector through partnership contracts for the execution of infrastructure projects. 9