Brazil is approaching a remarkable set of milestones that somehow receive surprisingly little attention It will simultaneously have: 1. One of the largest budget deficits among major economies: the overall government deficit is currently running close to 10% of GDP, having been above 8% on average for the last 13 years now 2. One of the highest VAT rates in the world, with the new Brazilian consumption-tax system requiring a reference rate of 28% (!!) 3. One of the most complex and burdensome tax systems anywhere, despite a tax reform ostensibly being designed to simplify it (the OECD itself describes the existing fragmented system as a major distortion and cost to doing business) Add to that extreme income inequality, a rapidly deteriorating public-debt trajectory and public services whose quality is difficult to reconcile with the amount the state collects and spends To sum up, Brazil is increasingly a macro basket case And yet the BRL trades at an extremely rich valuation regardless, supported to a remarkable extent a carry that will either come to an abrupt end or finally bankrupt the country A real time bomb, so to speak... $BRL $USDBRL $IBOV $EWZ

Brazil is approaching a remarkable set of milestones that somehow receive surprisingly little attention It will simultaneously have: 1. One of the largest budget deficits among major economies: the overall government deficit is currently running close to 10% of GDP, having been above 8% on average for the last 13 years now 2. One of the highest VAT rates in the world, with the new Brazilian consumption-tax system requiring a reference rate of 28% (!!) 3. One of the most complex and burdensome tax systems anywhere, despite a tax reform ostensibly being designed to simplify it (the OECD itself describes the existing fragmented system as a major distortion and cost to doing business) Add to that extreme income inequality, a rapidly deteriorating public-debt trajectory and public services whose quality is difficult to reconcile with the amount the state collects and spends To sum up, Brazil is increasingly a macro basket case And yet the BRL trades at an extremely rich valuation regardless, supported to a remarkable extent a carry that will either come to an abrupt end or finally bankrupt the country A real time bomb, so to speak... $BRL $USDBRL $IBOV $EWZ

Fun fact: local inflation linkers in Brazil (the equivalent of TIPS in the US) now pay a whopping real interest rate of around 8.5% at the long end You read that right: 8.5% real rates. Not nominal We are probably watching the early stages of a serious macro reckoning in Brazil... Nearly 30% of Brazil’s local public debt is made up of NTN-Bs, the local inflation-linked bonds, and that share has been growing over time. Households and a large share of local savings vehicles both have meaningful exposure to them. The “inflation protection” feature is extremely popular in a country with a long institutional memory of hyperinflation, and the average duration is long enough to allow for people to dream about retirement with nearly double digits "risk-free" real returns locked in For a naive investor, that might sound like a no-brainer. Upon closer inspection though, a few things become obvious: 1- Crowding out 101 If a local investor can lock in 8.5% real rates with government bonds for a 7y+ horizon, equity investments become almost impossible to justify. As a matter of fact, this investment vehicle ends up sucking in a large share of available domestic liquidity, while the private sector has to survive under severe credit scarcity The most successful bankers in Brazil are often those working in credit structuring (it's fun talking to these folks...they are quite creative). That is not a coincidence 2- Unsustainability In a healthy economy, real rates should bear some relationship to potential growth. The fiscal math works when total debt is roughly the size of GDP because the government pays interest on one side (the stock of debt) while collecting taxes on the other side, with both sides growing at broadly similar nominal and real rates (which follow nominal and real economic growth) One small detail: Brazil’s potential growth is probably below 2.5%, with a downward bias. Now redo the math... 3- Credit rating agencies in denial Even for people completely unaware of the dire state of Brazil’s fiscal accounts, a quick look at the real rates the government is paying to finance local debt should raise deafening alarm bells An 8.5% real yield for 7y+ local inflation-linked debt does not sit comfortably with ratings of Ba1 from Moody’s, BB from S&P, and BB from Fitch The rating agencies are once again badly behind the curve. You do not help a drug addict by telling him everything is fine and that he can keep taking drugs @Moodys, @SPGlobalRatings and @FitchRatings: shame on you 4- Tough choices ahead If the Brazilian government were a private company, creditors would have been called to the table a long time ago For a sovereign, though, two choices remain if we rule out an outright Russian-style default on local debt: Option A: as orderly as possible Brazil could come up with a “Plano Real 2”: a detailed, credible and constitutionally protected roadmap to balance the fiscal accounts A primary surplus of 3–4% of GDP, with no exceptions, would likely be needed for the next 5–10 years. That would require a series of reforms that would also help improve productivity dramatically. In order of importance: political reform, administrative reform and social-security reform A credible plan would allow local interest rates to fall dramatically. That, in turn, would allow the FX rate to re-rate to a more realistic level as hot money leaves the country. A 10.00 USDBRL would be painful in the short term, but it would be a welcome boost for the exporting sector and would help rebalance the economy With a credible plan in place - ideally enshrined in the Constitution - a debt swap could become more palatable for local debt holders and provide essential relief to the fiscal accounts Option B: disorderly adjustment Brazil has been through this before, more times than anyone would like Willingly or not, inflation will do the job. There is absolutely nothing the Brazilian Central Bank can do about that if fiscal dominance takes over. In fact, the central bank is now cutting rates while inflation and inflation expectations drift further away from target...probably a late recognition of this basic constraint But it gets worse... Nearly one-third of the local debt is linked to inflation indexes, mainly the IPCA, which is also the official MonPol target. We have also seen this movie before: over time, the index may start reflecting less and less of the true price dynamics of the economy, and the government may have increasing difficulty issuing new NTN-Bs That would call for new solutions to finance the local debt, including a possible renaissance of local USD-linked instruments or even a return to external debt issuance And, of course, if the country is struggling to attract external savings to finance the debt, it cannot afford to lose the paltry internal savings it still has. Yes, the return of capital controls become a natural consequence...need Dollars? Go ask your dealer...Ptax rate also becomes insignificant, except for the $100bn+ in USD Swaps the market in long against the BCB (but let's not get started on that) You choose the disorderly option, you get chaos...hardly unfair. The truth is that too many people benefited from the imbalances that brought Brazil here. Whichever adjustment path is chosen, they will be asked to help pay for the solution. Also hardly unfair... @macrokurd @AlfredoMenezes6 @RaoulGMI @TopadoDuran

A triste realidade