OREANDA-NEWS. Early signals by Brazil's interim government to tackle spending increases and the social security deficit show a renewed focus on fiscal consolidation, Fitch Ratings says. However, political uncertainty remains high enough to affect the content, scope and pace of fiscal reforms. This uncertainty is one factor reflected in the Negative Outlook on Brazil's sovereign rating, which Fitch maintained when we downgraded Brazil to 'BB' in May 2016.

Michel Temer's interim administration took office after the vote to impeach Dilma Rousseff triggered her six-month suspension. Since then, new Finance Minister Henrique Meirelles has announced plans for a constitutional amendment to control spending growth. The government is also planning pension reform, although the exact details and the related savings are uncertain. It has begun to rein in quasi-fiscal stimulus by having Banco Nacional de Desenvolvimento Economico e Social (BNDES) repay to the Treasury BRL100bn over a three-year period, in sharp contrast to the loans extended by the Treasury to support BNDES lending in recent years.

These initiatives suggest a cohesive attempt at controlling spending, although they may not be sufficient to achieve rapid fiscal consolidation that would stabilize the growing government debt burden. Moreover, fiscal policy is still subject to political risk as the stability and durability of the interim government coalition, and its ability to implement economic reforms, is not guaranteed. The popularity of the Temer administration remains relatively low and the Lava Jato investigations are a continuing source of political disruption. Public tolerance of deep fiscal austerity may be constrained by the sharp and prolonged economic contraction and rising unemployment.

The interim administration has obtained approval for a new budget target for 2016, which envisages a federal government primary fiscal deficit of about 2.8% of GDP. The higher target reflects the challenges a weak economy presents to government revenues, and excludes revenues from asset sales, reflecting difficult market conditions. It also includes the cost of the moratorium on debt repayments that the federal government granted to state governments for the remainder of 2016.

The higher primary deficit target for 2016 means a weaker starting point for fiscal consolidation. Currently, Fitch projects that general government debt burden will climb to nearly 80% of GDP by 2017, assuming no costs to the sovereign from supporting banks or corporates. The 2017 primary deficit target is expected to be announced soon, which will provide a signal on the pace of consolidation that can be expected in the near term.

Government debt dynamics will not stabilise without primary surpluses and faster economic growth. Fitch currently projects subdued growth of 0.5% on an annual basis in 2017. Recent increases in business and consumer confidence and a reopening of domestic and international capital markets to some Brazilian corporates are positive signs. But a sustained rise in confidence and the pace of the recovery will be influenced by political developments and the credibility of fiscal adjustment.

Political stabilisation that translates into effective policy implementation and reduces macroeconomic imbalances, including creating greater confidence around public debt stabilisation, could stabilise the sovereign rating Outlook, as Fitch noted in our rating sensitivities when Brazil was downgraded in May. We think it will take time for the interim government's policy settings to become entrenched and for evidence of their effectiveness to emerge. Policy drift and an inability to implement measures that improve the outlook for public finances, government debt trajectory and growth would be credit negative.

Fitch discussed our outlooks for the Brazilian sovereign and Brazilian corporates and banks at our "Fitch on Brazil" investor events in Frankfurt and London last week.