Brazil’s Economic Policies Under President Rouseff

I would be the first to admit that I am not very good at reading the political tea leaves in Brazil.  I once anticipated that Jose Serra would win the presidency – in 2002!  I even thought this pragmatic centrist had a good chance to win in 2010.  Of course, I never envisioned the emergence of Dilma Rouseff.  Wrong again!   It now looks like Dilma in an absolute landslide and in the first round, no less.

All of this should disqualify me from speculating about the economic policies to be adopted by President-to-be Rouseff when she assumes office in January 2011.  But I am going to hazard some guesses anyway on the (dubious) theory that if you cannot forecast well, forecast often. 

I will start with a fairly safe call.  The new administration will go to some lengths to convey continuity with Lula in terms of policies and players.  After all, why rock the boat when the foreign investors are so happily on board?    

Ex-Finance Minister Antonio Palocci has been rehabilitated and asked to reprise his 2003 role as the market-friendly face of the new administration.  Talented and experienced technicians from the Lula era will be recycled, including such individuals as Luciano Coutinho of the BNDES, Secretary of Economic Policy Nelson Barbosa, and Planning Minister Paulo Bernardo.

Staying on message, Dilma is professing devotion to the holy trinity of Brazilian economic policy – a floating exchange rate, inflation targeting, primary fiscal surplus.   Look for the new team to throw in a surprise or two, such as a small reduction in the annual inflation target and a small increase in the primary fiscal surplus, to burnish their market credentials by addressing broad concerns that fiscal spending is out of control and inflation re-emerging.

While all this seems unremarkable, I think that the powers and capability of the Brazilian state to intervene in the economy to propel economic growth will change in a big way under Dilma.  This more “developmentalist” role for the state and state enterprises will be a big move away from the thinking in the 1990s and early 2000s that brought, among other landmarks, unilateral trade liberalization and the Brazilian program of privatization, arguably the largest and (I would argue) the most successful program of its type in the world.   

President Dilma’s diagnosis will be that Brazil’s principal problem is that it lacks dynamic firms in sufficient numbers to compete in the global markets and generate lots of jobs at home.  Why is this the case?  Because private sector investment plans in Brazil are frustrated by the lack of access to long-term investment financing and the poor state of  economic infrastructure ranging from energy to transportation.  Hence, a rationale will be created for the state to take on a much bigger role through aggressive use of its many banks and state-owned companies and through its ability to influence private investment decisions.  Simply put, because the private sector is seen as weak, the Brazilian state must be strong, and there is no time to waste.

The most obvious example of what to expect would be a continued expansion of the role of the BNDES.  Originally conceived of as stimulus spending, the amount of credit extended to the private sector by the Bank has been enormous.  The credit portfolio of public banks in Brazil, principally the BNDES, but others as well, has expanded from about 0.5% of GDP in 2008 to close to 7% of GDP.  The credit gusher is likely to continue flowing.  (In a parallel fashion, pension funds in Brazil under the control of state-owned enterprises have become major investors in favored infrastructure projects.)

This new role of the BNDES raises issues, not least concerning credit quality (how could so much credit be extended so quickly without leading to credit losses down the road?) and the fact that the resources it is spending come from issuance of public sector debt.    Government economists have estimated that the subsidy to private sector firms implicit in BNDES lending operations is nearly equal in magnitude to spending under the government’s signature social program, Bolsa Familia.  Furthermore, this reverse transfer of income via the BNDES from taxpayers to a relatively few favored firms (the largest of which are considered “national champions”) has occurred rather quickly without much public debate about what the BNDES is or ought to be doing. 

The new model of state capitalism emerging in Brazil will be on display in the push to create infrastructure in Brazil.  This is emerging as the cornerstone of Dilma’s economic program. 

Take the case of Petrobras, and the development of the pre-salt petroleum reserves.  Brazil’s new model of petroleum exploration gives the company the dominant role in the development of these deep-water reserves.   Even for a company of Petrobras’ solid reputation, this is a daunting geological and financial challenge, all the more so in the aftermath of the Deepwater Horizon disaster.  Does Petrobras really have the technology to drill safely in such deep waters?  (Does any oil company?)  Can the enormous amounts of financing needed be safely absorbed on the company’s balance sheet? 

In addition, Petrobras is being pressured to expand refining operations in Brazil to generate employment and to use its procurement policies to stimulate the growth of a local oil supply industry in Brazil, even if the costs of sourcing locally wind up being higher than similar imported equipment.  Moreover, a new state-entity, called Petrosal, is to be created to manage the production sharing contracts and it could have a major influence on how the reserves are developed. 

The particular brand of state capitalism practiced in Brazil is evolving in other directions as well.  For example, a new company (actually an old one that is being brought back) is being created in telecommunications to create and run a national fiber optic network.  The new firm, known as Telebras, is also intended to stimulate greater competition in broadband, a segment of the industry the government sees as oligopolistic.  The possibility that the state-owned firm will compete with the private sector in the provision of broadband services cannot be discounted although that presently is not on the table.President Rouseff will also be pushing for faster progress in energy, particularly hydroelectricity, an area in which subsidiaries of the state-owned Eletrobras still provide almost 60% of Brazil’s generating capacity.  Energy shortages, which occurred in 2002, are likely to reoccur unless huge amounts of new investments take place.  Some of these new state investments, such as the planned hydroelectric facility of Belo Monte in the Amazon, are quite controversial, but likely to move ahead.

Other examples of a more active state role in infrastructure are evident as well, including the proposed bullet train between Rio and Sao Paulo and, of course, the infrastructure that will be needed as Brazil prepares to host the 2014 World Cup and the 2016 Olympic Games in Rio.   

President Dilma will have earned the right at the ballot box to impose a new direction on economic policy in Brazil.  The question is whether all of this expansion in the economic role of the state will be good or bad for Brazil’s growth in the medium-term.   The answer depends on whether or not the government can free up the budget resources needed to finance the investment push without creating debt and inflation problems and pressures on the balance of payments.   The recent data suggest that some of these problems may already be emerging, although still at an early stage.   

On the possibility of creating flexibility in the fiscal budget by cutting non-investment spending, cause for concern exists.  As everyone knows by now, federal and state expenditures in Brazil have been expanding for years both in absolute terms and as a percentage of GDP, driven by the growth of social programs and by increases in the minimum wage which drives federal spending on social security, a big-ticket item.  It is doubtful that President Dilma will have sufficient political support to cut back on these types of government programs which are very popular and, arguably, very much needed in Brazil.  The investment push that is coming, in other words, will come on top of already large government expenditures leading to the risk the government will become overextended, especially in the event of slow global growth which diminishes demand for Brazil’s exports.

So I think that the new government will be facing some very tough choices and very soon after it takes office.   It can choose to dial back on the expansion of the state’s role in the economy and focus instead on creating incentives for greater private sector involvement and the strengthening of market institutions, such as the capital markets.  Or it can take advantage of its broad electoral mandate to push the state and state-owned banks and companies ever more to the forefront in the economy in order to accelerate capital accumulation.  I would favor the former, but believe the latter to be more likely.