Promoting a sustainable recovery in Brazil

Economic Policy
Macroeconomics - Economic growth - Monetary Policy

Brazil’s hopes for economic growth rates on a par with those of the most dynamic emerging markets in Asia have been sadly disappointed lately, as output growth slowed from an unprecedented 7.5% in 2010 to just 2.7 % in 2011, and has nearly stagnated in the first half of 2012. At the same time, inflation has remained well above the mid-point of the central bank’s (BCB) target range, and the current account deficit has not improved, despite further gains in the terms of trade.

The government’s response to the deteriorating economic performance --a rapid reduction in policy interest rates; a reversal of earlier measures to moderate credit growth; and the announcement of selective excise tax cuts and acceleration of public investments-- suggests that they attributed the slowdown primarily to demand factors. At the same time, they tried to offset the increasingly evident loss of competitiveness through controls on capital inflows, and increases in tariff and non-tariff protection.

In the more recent months, however, while maintaining a stimulative stance of macro-economic policies, the government has announced a range of additional measures aimed at addressing some of the long-standing structural obstacles to sustained growth. The measures include the launching of major programs of investment in infrastructure, involving the private sector through public-private partnerships (concessions); changes in some key regulatory frameworks, in particular for the energy sector; and selective cuts in social security contributions.

1. Why was the strong growth of 2010 not sustained?

In a historical perspective, the economy’s performance in 2010 was a clear outlier, with GDP growth far in excess of the already relatively high 4.8 % average of 2004-08, a period in which fruits were reaped from the adjustment efforts of 1999-2003 and the international economic environment was very favorable to Brazil. Moreover, the strong 2010 growth reflected a rebound from the downturn caused by the global financial crisis of 2008, and was fueled by a moderate easing of monetary and credit policies, and by a clearly expansionary fiscal stance.1 

But, the rapid closing of the output gap soon exposed significant supply constraints, as evidenced by a tightening of labor market conditions, particularly in the construction sector, the acceleration of consumer price inflation, escalating real estate prices in large metropolitan areas, and a surge in imports. Despite the increasingly clear signs of overheating, a tightening of fiscal and monetary policies was delayed until the first half of 2011, and was relatively modest and short-lived. By September, the BCB had embarked on a new easing phase, driving the SELIC down in steps to a historically low 7.25% by October 2012, and the government had taken the fiscal stimulus measures mentioned above. 

Against this background, it would be difficult to argue that restrictive demand-management policies bear significant responsibility for the lackluster economic performance of the last two years.2 Instead, it has become increasingly clear that the main factors behind the downturn (in addition to the slowdown in foreign demand) were dwindling profitability in the tradable goods sector, as a result of both a sustained growth of labor costs well in excess of productivity and the appreciation of the exchange rate; growing shortages of skilled labor in various sectors; tightening infrastructure bottlenecks; and a rapidly increasing debt burden for lower income households, reflected in rising non performing bank loans. 

2. Will the measures announced so far succeed in securing sustained higher growth?

The substantial reduction in interest rates is likely to boost domestic demand, both by alleviating the debt burden on households and credit-dependent enterprises, and by reducing the attractiveness of financial savings instruments. Demand will also be supported by the operation of the automatic fiscal stabilizers and by the selective tax and social contributions cuts. Indeed, there are signs of a recovery in output in the more recent months. Moreover, the business climate has been clearly boosted by the announcement of the concessions program. Although many investments under that program are unlikely to begin before 2014, it is seen as a signal of a more pragmatic and welcoming attitude of the government towards involvement of the private sector in a key sector hitherto largely reserved for the public sector.

What are then the risks for a sustained economic recovery? Unfortunately, they are several and significant:

  • First, those associated with the external environment, such as an exacerbation of the crisis in Europe, or of geopolitical tensions in the Middle East; a failure to avoid the “fiscal cliff” in the US; and a protracted slowdown in China.

  • Second, the fact that inflationary expectations remain above the target, despite the slow growth of demand, and may well increase as the latter firms, given the already tight conditions in the labor market. Should inflation accelerate again in the coming months, the BCB, to safeguard its credibility, would need to begin a new tightening cycle sooner rather than later in 2013. 

  • Third, the outlook for the public finances, that are adversely affected by a number of factors: the cyclical slowdown in revenues; the significant fiscal cost of the tax and social security contributions cuts; the cost of the indexation of a large share of pensions to the minimum wage, which was increased by 14% at the beginning of 2012; the initial cost of the reform of civil servants’ pensions that will become effective in 2013; and the acceleration in the pace of execution of the pipeline of public investment projects. These factors are likely to make the achievement of the 3 percent of GDP primary surplus target very difficult, if not impossible --barring one-off operations-- in both 2012 and 2013.3  Although Brazil has gained fiscal space through the decline of its public debt to GDP ratio over the last decade, a substantial budget overrun would weaken market confidence and boost inflationary expectations, hastening a renewed tightening of monetary policy; and 

  • Finally, the foreseeable difficulties and delays in implementation of the ambitious infrastructure and energy programs, reflecting long-standing weaknesses in the area: a scarcity of bankable projects; the short duration of private credit facilities for investment; lack of adequate insurance mechanisms; lingering regulatory uncertainties; inadequate coordination among responsible federal government agencies; and limited project design and supervision capacity in the majority of state and local governments involved in project execution.

3. What more could be done to improve the chances for sustainable higher growth?

In a longer-term prospective, Brazil’s chances for ratcheting up its growth rate on a lasting basis depend of course on the factors affecting its potential output, namely human and physical capital and total factor productivity. On all these fronts, Brazil needs a substantial and sustained structural reform effort to, in particular: 

  • Improve the quality and coverage of secondary and tertiary education

  • Increase flexibility in the formal labor market 

  • Address vigorously the above-mentioned hindrances to investment in infrastructure

  • Improve business climate by reducing bureaucratic red-tape and the very high tax compliance costs 

  • Increase competition in relatively sheltered sectors, including the financial one

  • Reduce segmentation in credit markets, facilitating access to financing for SMEs; and

  • Strengthen the effectiveness of public support to research and innovation.4

Some of these reforms would entail budgetary costs, and creating the necessary fiscal space would require a more aggressive and successful government effort to increase flexibility and effectiveness in current spending at all levels of government through, among others, further pension reforms, civil service reform, and reductions of the pervasive expenditure earmarking provisions. Also crucial would be tax reforms aimed at leveling the playing field in enterprise taxation; and reducing the well-known distortions of federal and sub-national indirect taxes. The recent reduction in employers’ contributions is a step in the right direction, but it is limited to selected sectors, and is partly offset by an increase in the (still relatively distorting) contribution based on turnover (COFINS). It is to be hoped that the government will use the political “window of opportunity” of absence of elections in 2013 to make meaningful progress in such long-overdue fiscal reforms.

Unfortunately, it must be recognized that some of other structural reforms mentioned above (in particular as regards domestic and external competition, the role of the state in the financial system, and the labor legislation) do not accord with the ideological platform of the ruling coalition, and therefore may not materialize, especially if, as it is likely, demand and output will be boosted in the next couple of years by expansionary macro-economic policies. Time will tell how soon such a demand-driven expansion will hit renewed supply constraints. My guess is sooner rather than later.

1In 2010, the structural primary balance deteriorated by 1% of GDP; primary expenditures rose by 1.6% of GDP; and the fiscal stimulus was compounded by significant quasi- fiscal operations, especially through the public banks.
2In fact, it can be argued that a less pro-cyclical fiscal stance in 2010 would have helped to avoid the emergence of supply constraints and, probably, to moderate the real exchange rate appreciation.
3Moreover, although not included in the calculation of the primary balance and the net public debt, the substantial (estimated at over 0.6% of GDP this year) below-the-line support to public banks will add to the gross public debt.
4For more details, see T. Ter-Minassian: “Structural Reforms in Brazil: Progress and Unfinished Agenda”, IDB Policy Brief no. 158, May 2012

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