Without curbing the relentless expansion of public spending, it is futile to intervene in currency markets.
With the recent improvement in the central government’s fiscal performance (almost half of the fiscal target for 2011 had already been attained in April), a growing number of people, both in and outside the government, have been suggesting that the moment has come to prioritize other themes of the economic policy agenda, as if the Brazilian economy’s fiscal problem had already been resolved. Nothing could be further from the truth.
As specialists in the matter have been alerting, the improvement recorded during the first four months of the year was largely based on an increase in revenues. Curbs on spending concentrated mainly on public investments. Given the agenda of future commitments—the PAC (the government’s Growth Acceleration Program), social expenditures, World Cup, Olympic Games, the exploration of the sub-salt layer oil fields—, as well as next year’s municipal elections, this fiscal improvement is highly unlikely to be long-lasting.
The increase in the primary surplus is undoubtedly good news but is far from heralding a comfortable fiscal situation during the next few years. Our medium and long-term fiscal problems are well-known. They demand structural changes, especially in the case of social security. Opening these cans of worms is indispensable for long-term fiscal equilibrium but is extremely unpopular. Even a simple measure like curbing the real growth of federal public employee expenditures is stalled in Congress due to the government’s lack of effort. Generally speaking, the government’s silence regarding long-since mapped reform proposals is positively deafening. The most likely outcome is that the fiscal problems inherited by the president will be bequeathed to her successor, in 2015, in a considerably aggravated state.
For many years, public spending has been expanding at much faster rates than GDP, thus requiring a growing tax burden that has caused increasing distortions and hampered productive investment and job generation. We need a cyclically adjusted fiscal policy in which the primary surplus increases during years of expansion and declines during years of recession, as occurs in various countries. Chile has been adopting a fiscal rule of this kind – the structural surplus – with enormous success. In the past, when it was a question of reducing the surplus, finance minister Guido Mantega declared that it would be appropriate to adopt a cyclically adjusted budget. Unfortunately, he has never broached this subject again.
The final result is that public saving has been negative for decades, which, together with the low rate of private savings, has resulted in an insufficient level of domestic savings that puts a severe limit on the investments that are essential for achieving sustained growth rates of around 5% a year.
To grow 5% a year in a sustainable fashion, it is estimated that it would be necessary to invest at least 23% of GDP. As domestic savings are well below this (less than 16% of GDP during the first quarter of 2011), it will be necessary to resort to high levels of external savings (current account deficits), unless one believes in the illusion, unfortunately very widespread in Brazil, that “investment creates its own savings”.
In other words, in order to attain the objective of 5% sustained growth, it will be necessary, in the years ahead, to live with large capital inflows to finance investment. Fortunately, the Brazilian economy is nowadays seen as a safe haven for foreign investments, and these capital flows are coming to finance the investments we need. Unfortunately, however, the entry of capital appreciates the exchange rate, making our products – especially industrial ones – expensive.
What should the government do? The answer is clear, based both in terms of economic theory and the experience of other countries: deepen the fiscal consolidation process by reducing public spending’s rate of expansion. Not only would this directly devalue the real exchange rate, but it would also allow the Central Bank to reduce the high rate of interest, thus discouraging part of the speculative capital flows that take advantage of high interest rates (the carry trade). This would be the first order of business in order to depreciate the real exchange rate.
However, very little has been done and even less will probably be done in the future in terms of a real fiscal consolidation process. The government has so far implemented merely stop-gap measures such as foreign exchange interventions and capital controls, and we can probably expect more of the same. As well as being onerous, they are an inefficient way of mitigating currency appreciation, as I have argued in previous articles.
The Chilean example is quite clear on this point. In 1997, Chile controlled the exchange rate and imposed capital controls. Nowadays, the country has a floating exchange rate, no capital controls, a much higher copper price, and the country is considerably wealthier with a substantially positive net international investment position (NIIP). Such conditions should currently lead to a more appreciated exchange rate. However, the opposite is true. Due to an excellent fiscal situation that makes it possible to have very low interest rates, the real exchange rate, which is what matters for local production’s competitiveness, is currently more depreciated than in 1997.
In order to guarantee sustained growth, it would be a good idea for the president’s new chief of staff to adapt Bill Clinton’s victorious 1992 campaign strategist, James Carville’s, successful initiative and place signboards in front of all Brasilia’s ministries, as well as Congress, saying: “It’s the fiscal, stupid!”.