By PAULO NOGUEIRA BATISTA JR.*
Would loans from China ease Brazil’s fiscal constraints?
The Brazilian government, at the end of its second year, experienced strong financial and exchange rate instability, largely due to its dependence on domestic and foreign private creditors, who offer credit under onerous interest and maturity conditions. These private financial flows also exhibit strong volatility, confirmed once again at the end of 2024. The markets calmed down in January, but the vulnerability of the Brazilian state remains.
What could be done to protect the public sector? One possible alternative would be to find new, more attractive sources of financing abroad, for example in China and, to a lesser extent, in oil-exporting countries in the Middle East. These are countries with surplus official reserves, well above their precautionary needs. The contribution of these sources of external credit could, in theory, constitute a more favorable source of financing for the Brazilian State, freeing it in part from the extortionate conditions of credit from expensive, short-term and unstable domestic sources. If the volume of new external funding is significant, with longer terms and lower interest rates, there would be an immediate impact on the macroeconomic framework, with exchange rate revaluation, lower inflationary pressure and a fall in domestic interest rates.
Are these positive expectations well-founded? Intuitively, the answer is yes. It is more correct to say that they will be well-founded only if certain financial and macroeconomic preconditions are met. This point is not always understood, and even economists do not take it into account.
This article begins by discussing the preconditions for the eventual entry of external loans from these new sources to be truly beneficial to the Brazilian State. It then discusses a negative side of this financing alternative which, depending on the size of the pre-existing net external debt, can lead to excessive exposure to exchange rate risk. It concludes that borrowing abroad, even from more attractive sources, can lead to a new form of financial dependence. Even so, it is argued that taking out official external loans, subject to certain preconditions, can indeed change the short-term macroeconomic framework for the better, especially if it is used to replace domestic debt with foreign debt.
Replacement of internal debt with external debt
What are these preconditions? I will try to explain them briefly, without resorting to equations. To simplify, I will only address the immediate impact on public finances, the balance of payments and national accounts, without considering second-order effects. To understand this first impact, it is necessary to consider the budgetary constraints of the public sector, the national accounts, the government's net external debt, as well as the stability of domestic financing and its terms and interest rates compared to those of new loans that China or other countries would offer to Brazil.
Let us assume, to begin with, that there is indeed, on the supply side, a source of large-scale financing, with attractive cost and term conditions. These could be Chinese public banks, for example, with deep pockets. It is also assumed that this financing comes freely, not tied to imports. Without these initial preconditions, the macroeconomic impact would be small.
What compensation could Brazil offer to its foreign creditors? In the case of China, it could be a commitment to formally join the New Silk Road, China's major and priority international initiative since 2013. The Lula government did well not to join immediately, making entry into the New Road conditional on compensation.
Brazil could also commit to increasing the share of the Chinese currency, currently only 5%, in Brazil's international reserves. The yuan is eligible for this purpose, since it has been part of the short list of internationally liquid currencies that make up the IMF's Special Drawing Rights basket since 2014. Given the size of our international reserves, Brazil's decision would make a significant contribution to China's goal of gradually internationalizing its currency.
Realistically, however, it is reasonable to assume that these new loans would be denominated in foreign currency, since foreign creditors would hardly be interested in acquiring exchange rate risk in reais on a large scale, granting significant loans to a country that, as is well known, carries significant risk premiums in the domestic and international markets. These countries or foreign institutions will only accept exposure to Brazilian risk if there is no additional exposure to exchange rate risk. Incidentally, these problems are also recognized by Chinese credit rating agencies, although they are more flexible than traditional agencies (Moody's, S&P and Fitch).
What are the consequences of these loans from abroad? First: other things being equal (all else being equal), the gross and net external debt of the public sector increases in proportion to the borrowing. “All else being equal” means, among other things, that the inflow of these external resources does not translate into a corresponding increase in the country’s international reserves, which are an external asset of the public sector. If reserves increase in proportion to the increase in the gross debt of the public sector, the net public debt remains constant and there is no additional fiscal space to increase the government deficit or reduce the domestic debt. In other words, external borrowing only increases fiscal space if international reserves do not increase. for so much.
Increasing fiscal space means, in this context, opening up two non-mutually exclusive options: (i) the possibility of recording a higher nominal or total deficit, increasing public investment in infrastructure (or other priority expenditures); and (ii) the possibility of replacing domestic debt with foreign debt, increasing the State's bargaining power vis-à-vis current portfolio investors, whether domestic or foreign. This second option seems to be the most relevant in the current Brazilian circumstances.
Another precondition is that the remaining public sector external debt should not be reduced. If this were to occur by the same amount, the public sector's gross external debt would remain constant, changing only its composition. The increase in credit to the federal government would only reduce the rest of the public sector's access to international credit, without any other effects on public finances and the economy.
An additional precondition, this one less intuitive, relates to the country's balance of payments. The inflow of external resources implies, other things being equal, an increase in the surplus in the capital account and in the overall balance of payments. Let us assume, for the sake of simplicity and to make the argument more concise, that neither reserves nor external credit for the rest of the public sector will change.
Well, not everything else can remain constant. Either the current account deficit increases or there is a greater net outflow of capital from the private sector. In the first hypothesis, the inflow of external credit is offset by an increase in external savings, without any change in internal savings. In the second hypothesis, the public sector reduces the private sector's space in terms of access to external credit; internal and external savings remain constant, as does aggregate investment, which, in an open economy, corresponds by definition to the sum of the two.
One of the two hypotheses (or a combination of them) would be necessary to take advantage of the planned access to new official external loans. This is because only then would the overall balance of payments and reserves not change. And only then would the entry of external credit to the federal government make it possible to increase the overall public deficit or reduce the internal debt, contributing to increasing the State's room for maneuver.
If the increase in external debt translates into a decrease in internal debt, as one might expect, this improves the composition of the total public debt in terms of interest rates and maturity. Given the volatility of internal financing, it also increases the overall stability of public sector financing, since private sources of internal credit (internal and external investors who buy and sell bonds in reais) are highly volatile and therefore unreliable. The government would then become more independent of local and Western capital markets, without having to make an additional effort to adjust its accounts.
It should be noted, by the way, that a central aspect of the vulnerability of the Brazilian state is the result of the premature liberalization of capital inflows and outflows, something that dates back to the governments of Fernando Collor and FHC in the 1990s. At that time, it was decided to remove exchange controls, granting capital holders great freedom to enter and leave the Brazilian economy whenever they wished. The money laundering crowd, by the way, was grateful and rewarded the economists responsible for this decision with generous jobs or consulting contracts later. It would be interesting, for example, to draw up a chart of the careers of the economists of the Plano Real in the financial market, after their time in the federal government.
This liberality, however, brought with it problematic effects that persist to this day. Given the significant stock of volatile or short-term external liabilities, every Brazilian government has been living, since the 1990s, under the permanent threat of the impacts of an outflow of such capital, in certain periods, or of an excessive inflow of portfolio capital, in others. An abrupt and large-scale outflow could destabilize the economy as a whole, as happened in December 2024. An excessive inflow, in turn, makes internal monetary control difficult and creates the risk of bubbles in local financial markets.
Cambial risk
But I will leave that aside and return to the issue of new loans from official sources. In principle, we could celebrate this possibility. But not without reservations, since this maneuver would also increase the State's exposure to exchange rate variations. It is only worth following this path if the pre-existing external debt is small.
In the current Brazilian case, the gross external debt is in fact small, lower than the country's international reserves. In other words, the Brazilian State is a creditor against the rest of the world. Through this channel, it therefore profits from the exchange rate depreciation, a fact that is rarely discussed. This conclusion holds true even if we take into account the internal public debt indexed to the exchange rate and the Central Bank's currency swaps.
One possible criterion for determining the maximum volume of new external loans that the State could absorb without exposing itself to exchange rate risk would be to limit this volume to the difference between reserves and the pre-existing public sector gross external debt, plus the domestic public debt indexed to the exchange rate and the Central Bank's currency swaps. Within this limit, the net exposure to exchange rate risk would be zero or negative. If the borrowing is below this limit, the depreciation of the real would continue to contribute, in this way, to a reduction in public debt as a percentage of GDP.
In large numbers, the net foreign exchange position (defined as international reserves plus the Central Bank's stock of line operations minus the institution's position in foreign exchange swaps) was US$230 billion at the end of 2024. After deducting the domestic debt indexed to the exchange rate, equivalent to around US$50 billion, the government's external creditor position reached something like US$180 billion at the end of last year. Therefore, Chinese and other country loans could not exceed US$180 billion if the objective is to eliminate or maintain negative net exposure to foreign exchange risk, protecting the government from foreign exchange risk.
How would this external debt work in macroeconomic terms? From the perspective of the balance of payments, as we have seen, it would increase the current account deficit or change the composition of the capital account. An increase in the current external deficit or the net outflow of private capital would result in the conversion of reais into foreign currency, with an equivalent contraction of the monetary base. This contraction would be neutralized, however, by the foreign exchange revenue provided by the equivalent amount of foreign credit entering the government.
External funding would be converted from foreign currency into reais and used to redeem domestic debt in the same amount, with no effect on the monetary base and the liquidity of the economy. There is therefore no net issuance of currency and no need for open market operations to “sterilize” the impact of exchange rate operations.
In short, the increase in the public sector's net external debt opens the way for an increase in the nominal deficit (via investment in infrastructure, for example) or a decrease in the domestic debt by an amount corresponding to the increase in international credit for the federal government. If the nominal deficit remains constant, the need to resort to investors in domestic debt, whether resident or not, decreases.
This second result would reduce the government's dependence on expensive, short-term and volatile credit obtained from domestic sources and foreign portfolio investors.
If new external credits are granted, as intended, under more favorable interest and term conditions than the average conditions of the existing external debt stock, the debt structure will improve, becoming cheaper and longer-lasting, with a favorable impact on the balance of payments. At the same time – and more importantly – assuming that the government does not use (or does not use all of) the external credit contribution to increase its deficit, the change in the composition of the public debt, with the replacement of internal debt by external debt, would bring three advantages: (a) it would reduce the average cost of the debt (assuming, of course, that the new debt with China or other countries would have a lower cost than the internal debt); (b) there would be an extension of the debt (if external loans are longer than the average term of the internal debt); and (c) it would increase the stability of financing to the public sector (reducing dependence on resident and non-resident investors who, taking advantage of the open capital account and the liquidity of Brazilian bonds, enter and leave the country easily and quickly).
It can be assumed that borrowing from China or other countries would indeed have the potential to bring these three advantages. Replacing domestic debt with foreign debt would, however, imply an increase in the dollarization of the public debt stock, which is currently limited.
Immediately, the entry of loans from new official sources and the replacement of internal debt with external debt would cause exchange rate appreciation, less pressure on inflation, a reduction in long-term interest rates and room for the Central Bank to reduce the base rate, reducing the cost of government debt.
A new form of dependence
It should be noted that, in order to produce these immediate effects, the Brazilian government would be, in a sense, trading one thing for another, that is, dependence on Faria Lima and Wall Street for dependence on China or other countries. This new dependence would be smaller and less costly, but it would still appear and could not be ignored.
Recourse to external financing, even under attractive terms and conditions, is more complicated than it may seem at first glance. As a general rule, one should not rely too heavily on foreign sources. Countries do not have friends, but interests, warned Charles De Gaulle. It is better for the financing of public accounts and productive investment to be done primarily with national capital and savings. Capital is made at home, as Barbosa Lima Sobrinho recommended.
It remains to be seen, however, whether there is indeed a willingness to lend large sums to the Brazilian government. As mentioned above, Brazil's risk premium in international markets is relatively high, since the country is without investment grade for many years. The loans eventually granted could not, evidently, be computed as reserves of the creditor countries, since they would be long-term and would not have the liquidity or security required for these financial assets to be launched as international reserves.
It is most likely that China and other potential creditors will only be willing to offer new loans in dribs and drabs, testing the waters and asking for compensation. This would continue to be of interest to Brazil, in principle, but it would perhaps not bring about the macroeconomic turnaround that could theoretically be contemplated.
Even so, if the initial loans can be presented as part of a broader program of replacing domestic debt with foreign debt, agreed with China and other countries, there would be an immediate and probably significant impact on market expectations.
*Paulo Nogueira Batista Jr. is an economist. He was vice-president of the New Development Bank, established by the BRICS. Author of, among other books, Estilhaços (Contracorrente) [https://amzn.to/3ZulvOz]
Extended version of article published in the journal Capital letter, on February 07, 2025.
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