beyondbrics

By Márcio Garcia of PUC university, Rio de Janeiro

A decade ago, when Jim O’Neill coined the Bric acronym, he was harshly criticized for including Brazil. 2001 had been a bad year for the economy, with contagion from the Argentine crisis, our own energy crisis and political disarray in the governing coalition. When the central bank governor wrote to the finance minister to explain the breach of the upper limit of the inflation target band, he said inflation should trend down as shocks of the kind that hit Brazil that year were not to be expected in the future. Little did we know what was coming.

In 2002, Brazil suffered a significant sudden stop, as investors, domestic and foreign, fled the country in fear of Lula, the leftwing presidential candidate, then perceived as market-unfriendly. The Brazilian real lost half of its value against the dollar (see chart 1) and inflation rose from 7.7 per cent in 2001 to 12.5 per cent in 2002 as the economy stalled (see chart 2).

Chart 1

Chart 2

But from 2003, O’Neill’s choice of Brazil would be vindicated. Lula trashed his party’s economic programme and kept the sound macroeconomic framework inherited from the Cardoso administration, based on the tripod of primary budget surpluses, inflation targeting and a floating exchange rate. China helped. Brazil rode the commodities wave, supplying farm produce and iron ore. Chart 1 shows the narrow correlation between commodity prices, as measured by the CRB index, and the nominal exchange rate: as commodities prices rose, the value of the BRL increased. This combination also helped to control inflation, as higher commodity prices in USD were mitigated by the appreciation of the BRL. From 2003 until the 2008 international crisis, the government undertook major reform of the public sector balance sheet, doing away with many of the exchange rate mismatches that had haunted Brazil for decades. Domestic debt indexed to foreign currencies was eliminated, foreign debt was reduced and foreign exchange reserves accumulated (see chart 3).

Chart 3

Although Brazil suffered in the 2008 crisis, it was able to quickly resume growth. Policy reactions included moderate monetary easing and abundant fiscal and parafiscal expansion through an expansion of credit from government-owned banks. As a result, the reduction in interest rates had to be interrupted when the Selic policy rate was still quite high, at 8.75 per cent. Expansion of public debt and public spending, which had much more to do with electoral considerations than fighting the recession, contributed significantly to higher inflation, which is still with us today, as shown in chart 4.

Chart 4

The policy reaction to the current stage of the international crisis is supposed to rely more on monetary easing. The Selic rate has fallen from 12.5 per cent to 11 per cent. In spite of its still very high level, most forecasts do not assume that this time – barring strongly deflationary cataclysmic events emanating from Europe – monetary easing can proceed further than it did before without compromising the fight against inflation.

The need for very high real interest rates to keep inflation at bay remains a major obstacle to achieving the goal of long-term sustained growth at 5 per cent a year. There is much debate over why Brazil needs such high rates but there is a consensus that our low saving rates, specially the negative savings of the public sector, are a big part of the answer.

Indeed, long-term fiscal adjustment is the main macroeconomic challenge for Brazil over the next 10 years, despite our very good position relative to other countries. Brazil has maintained a solid primary surplus for many years – notwithstanding sizeable doses of creative accounting in recent years – and net debt has been falling steadily. Nevertheless, the fiscal accounts will tend to deteriorate in the long run. The steep rise of the fiscal burden, which increased from 25 per cent of GDP in 1994 to 35 per cent in 2010, will slow. But government outlays will keep rising due to the severe rigidity of public spending – worsened by the reaction to the 2008 crisis – and to the inevitable burden that demographics will place on a very generous social security system. As the current situation in many Europeans countries shows, countries tend to wait until crisis is upon them before taking actions known to be inevitable well in advance. Brazil, unfortunately, is not an exception.

As long as China keeps growing, Brazil will benefit, mainly by exporting commodities. Brazil’s discovery of very large offshore oil reserves will help further – presenting great technological challenges which, when conquered, will usher Brazil into OPEC. But under this optimistic scenario the currency will remain overvalued and Brazilian manufacturing will keep suffering.

To boost productivity, many reforms must be undertaken. Taxation is very heavy and distortionary, promoting informality. Labour laws are outdated and harm job creation. Justice is extremely slow and property laws are poorly enforced. Competition is weak in many areas and protectionism is always a threat. Above all, education is still found wanting. Although universal coverage has been achieved at the fundamental level, Brazilian children learn very little, as evidenced by the standardized international tests results. Its poorly educated labour force is Brazil’s Achiles heel. This is changing all too slowly, despite social policies that have reduced income inequality.

Jim O’Neill got his call potentially right. Brazil has great potential – not to grow at Chinese or even Indian rates, but to grow at a robust 5 per cent a year over the next decade. To achieve this goal, governments must act now for the future, not commemorate past success.

Márcio Garcia is associate professor in economics at the Pontifical Catholic University (PUC) in Rio de Janeiro

Related reading:
Brics at 10 file, beyondbrics