High Interest Rates and Financial Fragility in Brazil
José Luis Oreiro
Associate Professor, Department of Economics, University of Brasília (Brazil)
“Brazilian inflation had the same nature of inflation in European countries and the United States: it is the result of supply shocks originated from the effects of COVID-19 pandemic over global supply chains and the huge increase in food and energy prices due to the war in Ukraine.”
In an article published in the Brazilian financial newspaper, Valor Econômico, on February 27 (see at: Mais empresas têm geração de caixa insuficiente para cobrir despesa financeira | Finanças | Valor Econômico (globo.com)), it was written that approximately 15% of all Brazilian publicly-traded companies had an EBITDA (Earnings Before Interest Services, Taxes, Depreciation of capital and Amortization of debt) that was insufficient, even for the payment of interest services that these companies owe on their debts.
These companies had what Hyman Minsky, an American post-Keynesian economist, called the Ponzi financial posture, which is when a company’s cash flow is not sufficient to even pay interest services of their outstanding debt. In other words, companies that have this kind of financial position are increasing their indebtedness, not by increasing investment, but to simply pay the interest on the debt that they already have.
Figure 1 above also shows that 73.6 % of publicly-traded companies had a leverage ratio equal or higher than 3 in the third quarter of 2022, making then highly fragile to changes in financial conditions in debt markets and in earnings from their operations.
In such a situation of private sector financial fragility, the bankruptcy of a single large non-financial firm can trigger a confidence crisis over the entire non-financial sector, forcing banks to increase rates of interest on loans, and having capital markets demanding high liquidity and risk premium for private bonds. An event closer to this one occurred in January 11 when one of the largest retail trade firms of Brazil, Lojas Americanas, announced an initial accounting inconsistency of 20 billion Reais (more or less 4 billion US dollars) on its balance sheet, that was increased to 40 billion Reais (more or less 8 billion US dollars) in the subsequent weeks. So far, the investigation carried out seems to conclude that the “accounting inconsistency” is probably the result of fraud that was actually committed to cover up the financial fragility of Lojas Americanas. In other words, what happened, from the data that has been presented so far, is that Lojas Americanas has been shortening the maturity of their liabilities and found a creative way of manipulating its accounts to hide it.
This may be a sign of worse things to come: a symptom that something similar is happening to companies in the retail sector, which are companies that rely heavily on working capital. As a result of increases in the rate of interest, the cost of working capital gets very high for these companies and then they end up doing some kind of creative accounting or creative financing to survive.
The Brazilian Central Bank had a clear mandate to guarantee the stability of the financial sector, but not the stability of the non-financial sector. The balance sheet of Brazilian commercial banks is, up to now, in very good shape with a low leverage ratio, high liquidity ratio, and capital requirements much higher than the level required by Brazilian Central Bank, which is also higher than the normal standards in developed countries. The Brazilian Central Bank would argue that since the stability of the financial sector in not an issue, then it should only care about inflation, which is higher than the current target. In this situation, monetary policy should continue in its contractionary stance.
If Brazilian inflation was a problem caused by an overheated economy, then a contractionary monetary policy may be the correct policy to adopt considering the low level of centralization and coordination of wage bargaining in Brazil that makes it almost impossible to deal with inflation with an incomes policy. But this is not the case. Brazilian inflation had the same nature of inflation in European countries and the United States: it is the result of supply shocks originated from the effects of COVID-19 pandemic over global supply chains and the huge increase in food and energy prices due to the war in Ukraine.
The target for the base rate of interest in the first quarter of 2023 is 13,75% p.y. for an inflation accumulated in last 12 months of only 5.63% (measured by IPCA-15), which means a real base rate of 7.68% p.y. probably the highest real rate in the entire world. If we consider the average rate of inflation and real interest rate for the entire period of inflation targeting in Brazil (1999–2022), we get an average inflation of 6.43% and an average real base rate of 5.91%. Compared to the historical record of inflation targeting in Brazil, inflation does not seem to be too high, but the real rate is clearly higher than the long-term average. What explains this puzzle?
One of the possible explanations is the insistence of the National Monetary Council to keep the inflation target unchanged for 2023, at a level of 3.25% with a band of (+/-) 1.5 %.[1] This means that the maximum inflation that the Central Bank can accept for 2023 would be 4.75%. The problem is that in the last two years, the Brazilian Central Bank were not only incapable to reach the ceiling of the band, but target inflation is lower than the previous year. This reduces the space the Central Bank has to loosen monetary policy. Since the inflation target for 2022 was not reached, and target inflation for 2023 is lower than target inflation for 2022, then the Central Bank sees no way to lower the interest rate. Moreover, inflation expectations are around 5.8% for 2023, much higher than the ceiling of the band for target inflation. So, due to the insistence on maintaining an unrealistic inflation target, the Central Bank, fulfilling its mandate, will have to keep the interest rate unchanged for as long as it takes until inflation converges to a level that is within the band of target inflation.
The solution to this problem is a little more realism from the National Monetary Council. A target rate of 3.25% for 2023 is simply a “bridge too far”.
FOOTNOTES:
[1] In Brazil the National Monetary Council — composed by the Minister of Finance, Minister of Planning and the President of Brazilian Central Bank — is the institution that defines the targets of monetary policy, mainly the annual target for inflation.
