Many in and outside of Brazil have questioned the customary inclusion of Brazil among the more dynamic emerging markets commonly referred to as BRICs. After all, the economy’s overall growth performance for decades has paled in comparison to its more glamorous counterpart nations. Signs are emerging, however, that Brazil could over the next few years remove doubts about its eligibility for full and unquestioned membership in this exclusive club of fast growers.
Yesterday’s sovereign upgrade for Brazil (by S&P’s to BB+ from BB with a “positive outlook) gives us more reason to reflect upon the pros and cons of the tide of capital pouring into Brazil and the currency appreciation it has brought. When reserves increase as rapidly as they have in Brazil (up $40 billion in 2007 alone), it is a sure sign that past patterns are changing quickly.
The potential problem is that the currency appreciation (which owes much to the China-fueled boom in commodity prices) raises “Dutch disease” concerns for Brazil. Granted, the data so far on non-primary exports and industrial performance do not support the fear, widely expressed in Brazil, that the economy is “de-industrializing”. It is quite the contrary, in fact. However, it would be foolish to dismiss out of hand the possibility that unchecked currency appreciation could undermine future manufacturing export performance. It is a risk worth monitoring in the future.
In the meantime, the government can do relatively little to halt the currency’s appreciation trend. The Central Bank’s spot market interventions are ultimately counterproductive as a tool to prevent currency appreciation. The level of the EMBI-Brazil is affected by the amount of reserves on hand in the Central Bank. As the EMBI falls (it is now near an all-time low), the cost of external capital declines for Brazil bringing more dollar inflows from foreign investors and encouraging more Brazilian firms to borrow abroad and to issue equity at home.
While risks are present, I would emphasis that these times present Brazil with a spectacular opportunity to mend critical fault lines in economic policies and to prepare solid ground for much higher rates of growth of potential GDP growth in the future.
Clearly, the first opportunity is with respect to monetary policy, more specifically to move rapidly toward interest rate convergence. Inflation expectations have been tracking steadily lower in Brazil for many months; they are, in fact, well below the mid-point of the Central Bank’s target inflation rate. Recent research by noted economist Affonso Celso Pastore of LatinSource suggests that the major factor explaining the fall in inflation expectations has been the appreciation of the currency. As the pass-through effects from currency strength to inflation expectations operate with a lag, it is likely that inflation expectations in Brazil are likely to continue declining in the months ahead.
Brazil’s double-digit nominal interest rates (the overnight rate is now 12.5%) are an anachronism in an economy growing only modestly and with well behaved inflation expectations. A more aggressive easing posture by the Central Bank is in order, starting with the June 5-6 COPOM meeting and continuing throughout 2007. The really good news in this is that Brazil’s nominal and real interests are headed down and credit availability is bound to improve for this most credit-starved of all the BRICs.
The second huge opportunity for Brazil is to address the real economic Achilles Heel – the always worrisome public sector accounts. Despite experiencing rising revenues for years, and despite Lula’s (bold, I would say) commitment to primary fiscal surpluses, aggregate public sector accounts are still in deficit (about 3% of GDP) and the public sector debt to GDP ratio is still high at 43%.
More than these aggregate numbers suggest, the problem in Brazil is that the structure of the public sector budget is awful: skyrocketing growth in numerous entitlement payments and other current spending, inefficient use of earmarked revenues, paltry public sector infrastructure spending, and a monstrous tax burden. Given this weak fiscal backdrop, it is not surprising that the IMD in Switzerland in its recent World Competitiveness Yearbook ranked Brazil in sub-BRIC territory: 49th place out of 55 countries surveyed as a good place to do business.
Brazil should be in a position, much as Chile is today, to be generating fiscal surpluses in rising revenue times such as these. In the case of Chile, the fiscal surplus is 7% of GDP and the Chilean social investment fund which gathers this surplus is stored abroad in the form of a rainy day fund and a fund to cover future government needs, including infrastructure investments.
None of this sort of counter-cyclical fiscal policy is remotely possible in Brazil today, in part because of the scale of inherited problems and in part because the fiscal reform zeal that characterized Lula’s first two years in office withered and died through the course of recent political scandals and re-election campaigns.
The good news on fiscal reform is that the government seems once again emboldened to act. It has dusted off plans to reform the inefficient tax system and to take another bite out of the social security reform agenda, among other important fiscal measures. The initiative could not come at a better time, in the midst of an external boom and in a non-election year. The Lula government has talked reform before without delivering, so these initiatives may come to naught, but at least they are back on the agenda. Moreover, the political environment is right; with aggregate demand and employment both rising, Brazil can afford to address fiscal reform.
The third major opportunity for Brazil is with respect to international trade and, more generally, industrial policy. While overall levels of industrial protection are lower in Brazil today than they used to be, tariff protection levels for many industrial sectors are still relatively high. If Brazil had pursued serious trade liberalization in the past, the steady appreciation of the currency could have been attenuated earlier by a rise in productivity-enhancing imports, including much needed imports of new technology. Instead, the tariff barriers, and onerous taxation of exporters, has walled the economy off to a large extent from global trade. (Openness is still less than 30% of GDP, well below levels of the other BRICs.)
These imports are now occurring, but only after a considerable lag and still in the context of overly protected manufacturing and service sectors in Brazil. Brazil has a golden opportunity right now in the context of the Doha Round (where it exercises strong leadership in the G-20) to forge a much more attractive bargain for what it wants in global trade talks (liberalization in agriculture) in exchange for what the rest of the world wants: a softening in Brazil’s defensive posture in manufacturing and services.
These times of strong dollar flows, a huge trade surplus, and a lower cost of external capital present Brazil with its best chance in generations to lower interest rates, modernize the public sector accounts, and open the economy to free trade. This is the path to faster potential GDP growth in the future and membership in the BRIC club with no need for asterisks!