President Lula’s government has confounded critics with its fiscal restraint, yet the economy is still slow. Will Brazilians have the patience to see if this cautious approach pays off? Jonathan Wheatley reports.
All hopes for Brazil’s economy in 2003 are pinned on the fourth quarter. In the first half of the year the country went into recession and third-quarter figures are expected to be flat. For the year as a whole, most economists expect a sluggish performance of (at best) 1% expansion of gross domestic product. It could even be worse.
“The second half will be better, but 2003 as a whole still won’t make it into the black,” says Marcelo Carvalho, chief economist at Itaú Corretora, a Săo Paulo brokerage owned by Brazil’s second biggest private-sector bank.
Back from the brink
It is a gloomy outlook for a government that has done an impressive job of bringing the country back from the brink of disaster. For much of 2002, foreign investors were leaving Brazil in droves, pulling out about $30bn during the year. Stocks, bonds and the currency all went into freefall before and after last October’s presidential elections. What spooked investors was the fear that Luiz Inácio Lula da Silva of the leftwing Workers’ Party (PT – Partido dos Trabalhadores), who led polls throughout the year and won a resounding victory, would overspend the country into turmoil and debt default.
But the PT government, which took office on January 1, has turned out to be a model of fiscal austerity. It has retained the previous administration’s monetary policies, setting inflation targets and using high interest rates to achieve them. Despite railing while in opposition at the damage that high interest rates caused to output and employment, the PT raised the Central Bank’s base rate from 20% a year to 26.5% during its first two months in government. And it stood firm against noisy demands from business and labour groups to cut rates quickly once inflation began to fall.
Inflation down
Consumer price inflation over the previous 12 months fell to 15% in August from 17.2% in May. More importantly, market expectations of inflation for the following 12 months had fallen to 6%, down from 43% in January. By mid-September the overnight rate had returned to 20% and was on a steady downward path.
It is the same story with fiscal policy. In opposition, the PT ridiculed the government for being in thrall to fiscal targets agreed with the IMF. In government, it has met them scrupulously in every quarter (though a dip in tax revenues in the third quarter has rattled a few nerves) and is on target to achieve the 4.25% primary budget surplus (ie before interest payments) set for 2003.
Investor confidence has been restored. Country risk – as measured by the premium demanded by investors to buy Brazilian bonds instead of US Treasury bills of similar maturity – has fallen from a peak of 2400 basis points to about 750bp. Access to export finance from foreign banks, which shrank to zero during the crisis, has been fully restored.
Yet despite all the good news, the economy refuses to take off.
“Growth this year will be slow,” finance minister Antônio Palocci concedes in an interview with The Banker (page 118). “Because of the crisis last year, the fact is that growth has been compromised. But what’s important is that the macroeconomic adjustments should allow growth to begin now and be sustained into the future.”
Mr Palocci hopes that Brazil is entering a virtuous circle. Under this scenario, inflation will continue to fall, allowing interest rates to fall further. This will boost earnings and growth, making investors and consumers feel more confident, which will allow interest rates to fall further, producing more growth. This in turn will produce higher tax revenues, allowing the government to increase spending on health, education, security and other social programmes – it already plans to raise spending on poverty relief from R$4.3bn ($1.5bn) to R$5.3bn next year. It would also allow the government to boost growth further by reducing the tax burden which, at 41.7% of salaries, is one of the heaviest in the world.
Income eroded
Things are unlikely to be that straightforward, however. Dany Rappaport, an economist and partner at Tática Asset Management in Săo Paulo, points out that Brazilian consumers had an enormous one-off boost to their spending power when the previous government launched its inflation-busting stabilisation plan in 1994. Since then, their income has been eroded; according to government figures, in the year to July alone, the earnings of those in work fell by 16.4%.
“This is very positive from the historical point of view because it means the government can cut interest rates without having to worry about inflation or the trade balance,” Mr Rappaport says. “But the negative side is that, even with lower interest rates and other fiscal stimuli, we’re not going to see growth.”
This throws the government back on the problems that have dogged Brazil for years. It must reduce spending on expensive areas such as social security and pensions, simplify the tax system, reduce the tax burden and reduce the ratio of public debt to GDP. With these obstacles behind them, Brazilians and their government will be able to dedicate less of their income to taxes and debt, and more to savings and investment. Brazil would be less dependent on foreign capital and less vulnerable to external shocks, laying the ground for sustainable growth.
Remarkable progress
Brazil has already made remarkable progress on these fronts. During its first eight months in office, the PT government won congressional support for pensions and tax reforms that the previous administration failed to secure in eight years. While reforms approved by September in the Chamber still had to go to the Senate and, if modified, return to the Chamber, the speed of the government’s initial victory and its evident skill at political negotiation came as encouraging news.
The problem will be to keep up the momentum. “Just to achieve more of the same [next year] will require a major effort,” says Mr Carvalho at Itaú Corretora. He points out that growth in net trade, which will produce GDP growth of about 1.5% in 2003, cannot be counted on for 2004. “Keeping up the budget surplus, given the demands for social spending, will be a key challenge,” he says. “The question is whether Brazilians will be patient enough.”
Support remains high
Support for the president remains extraordinarily high and is virtually unchanged since the beginning of his government. Of more concern for the future are poll findings that many voters are unhappy with the level of economic growth but they do not – so far – blame the PT because they see this as a legacy of the previous administration.
Vladimir Caramaschi, an economist at Fator Doria Atherino brokerage in Săo Paulo, says that while the short-term outlook is good, the longer-term picture is less encouraging. “There is a lot of pressure for a change of direction,” he says, “from business leaders and unions wanting more interventionist policies, to leftwing pressures for more income distribution, to others wanting less orthodox economic policies.”
Structural change
He warns that fending off such pressures will be a big enough job by itself, but that the government should also be pressing ahead for further structural change. The pension reforms now in Congress, for example, deal with the short-term problem of overspending on pensions for public-sector workers, but largely ignore the longer-term problem of a growing deficit in the system that pays state pensions to private-sector workers.
The tax reform, too, falls short of the ideal. While it will make important advances by removing taxes on exports and simplifying the state-level value added tax, it fails to reduce the bewildering number of taxes in the economy or to reduce the total burden.
That is not to mention the need for changes to Brazil’s restrictive labour laws, or for political reform, or for an overhaul of the police and the judiciary. In the early days of the Lula government, there was talk of making the Central Bank independent and the first steps were taken. For now, this idea seems to have been dropped.
With little room left in the congressional diary this year, any progress on these issues would, in any event, have to wait until 2004. But 2004 is another election year, when Brazilians will elect more than 5500 mayors. As the municipalities are important in supporting and implementing federal polices, and the biggest cities have enormous political power, the government will not wish to undermine support for its candidates.
Eye on public debt
While it works out how to tackle all these issues, the government must keep one eye on the persistently high level of public debt as a percentage of GDP. This rose from 32.3% to 56.4% during the previous government’s eight years in power, and was a major contribution to last year’s investor anxiety. Although the profile of the debt has improved significantly this year, with longer maturities and less debt linked to the dollar, the ratio of debt to GDP has increased slightly to 57% at the end of July. To reduce the level of debt, and therefore to be able to make significant cuts in real interest rates, the government must continue to produce substantial primary budget surpluses.
This will not be easy while the economy refuses to spark into life. Several indicators give cause for concern: industrial production was down by 2.7% in July from a year earlier and unemployment was a near-record 12.8%. There must be some doubt about the government’s target of achieving GDP growth of between 3% and 4% next year, as a prelude to faster growth thereafter.
Nevertheless, this government has so far earned the benefit of the doubt. When Lula and the PT won the elections a year ago, few observers imagined his government would be able to produce either the boost to confidence or the progress on its reform programme that it has already achieved. If growth does finally emerge in the fourth quarter, it could secure the government the support it needs to keep up with the good work.
