Macro-economic Study Brazil

Analyzed by: Group 1 Alekhya Chakrabarty 08FT-002 Ankit Goel 08FT-006 P Randheer 08FT-026 Raviraj Kurdekar 08FT036 Rohit Kumar 08FT-038 Vikas Gupta 08FT-059

Brazil - Statistics GDP: US$ 1.994 trillion (2008*) Currency: Brazilian Real GDP Per Capita: US$ 10.551 (2008) Inflation (CPI): 4.46% (2007) Population below poverty line: 14% (2008) Labour force: 101.77 million (2008) Unemployment: 7.6% (2008) Exchange Rate: 2.50 per $ Exports: US$ 218.6 billions (2008) Imports: US$ 145.7 billion (2008) Public finances: Public debt US$ 103.2 billion; 6.4% of GDP (2008)  Credit rating: BBB Reserves: US$ 219,4 billion (2008)           

Brazilian Economy  Largest economy in Latin America  Tenth in world at market exchange rates  Ninth largest in terms of PPP  Regarded as one of the group of four

emerging economies called BRIC  Booming exports

Objective of the Study To understand the macroeconomic policies and study their implication on the Brazilian economy in light of the various internal as well external crises that were faced by the country in the post war period

Post-war Period, 1945-64  Favourable condition post World War II  Exports increased sharply, though constraints on

imports  Allied victory discredited fascism and encouraged constitutional system  Half billion dollars in reserves, constraint on import capacity eliminated  Fixed nominal exchange rate resulted in overvaluation and worsened trade balance

Post-war Period, 1945-64  Overvaluation and increased imports worsened

current accounts  Reinstituted exchange controls rather than confronting the overvaluation directly.  Development programs financed through extending monetary base  The trade balance and the balance of payments worsened, first inflationary surge

Post-war Period, 194564

Post-war Period, 1945-64  Accelerating inflation  Slowdown in GDP growth  Severe foreign exchange shortage  Affected production especially in

industrial sectors

Stabilization and Reform, 1964-67

 On March 31, 1964, military coup occurred and

Army Marshal Humberto Castelo Branco became the first President of the Military regime  Economist Roberto Campos was appointed planning minister.  Immediate economic concerns:  Rising inflation  Worsening external payments position  Stabilization program included,  Strict control of public debt  Restrictions on credit and wages

Stabilization and Reform, 1964-67  Fiscal strategy consisted of:

 increase in direct and indirect taxes  Reduction of subsidies through realistic pricing of

public utility services  Increased tax revenues through the indexing of tax rates  Financing of government debt through the sale of bonds.  The authorities established monetary growth rates of 70 percent for 1964. 30 for 1965, and 15 for 1966.

Stabilization and Reform, 1964-67  Credit expansion during the 1964-66 period was 18.5

percent below the mean for the 1960-62 period.  But an increase in net foreign borrowing and foreign direct investment, and the fixed nominal exchange rate resulted in an unintended monetary expansion.  Under a law passed in 1965, nominal wage adjustments could only be made at twelve-month intervals and had to take into account the official inflation forecast, the average real wage of the preceding twenty-four months, and an officially mandated "productivity gain.“

Stabilization and Reform, 1964-67 Short Term Effects  Inflation fell from an annual rate of 90 percent in 1964 to    

about 25 percent in 1967. The federal deficit fell from 4.2 percent of GDP in 1963 to 1.1 percent of GDP in 1966 Monetary financing of the deficit fell from about 85 percent in 1963 to about 13 percent in 1966 Foreign payments arrears of $300 million in 1963 were replaced by reserves of about $400 million by 1966. The real GDP growth rate increased from 1.6 percent in 1963 to 5.1 percent in 1966 and 4.8 percent in 1967.

Stabilization and Reform, 1964-67 Long Term Effects  The economy's allocation mechanisms were

deeply compromised  In principle, the government's strategy was an economic democratization carried out under government supervision.  The government would use its policy instruments to allocate resources according to its own predetermined objectives and the demands of those interest groups that were still allowed a voice by the government.  In reality, government supervision did not end. Instead, it multiplied.

Stabilization and Reform, 1964-67 Long Term Effects  The government increasingly disregarded

price mechanisms to allocate resources.  The efficacy of price mechanisms was further compromised by Indexation.  Indexation sped the transmission of shocks to other sectors of the economy and increased the variance of the rate of inflation.

Brazil: 1964 -1967  The post-1964 regime has often been characterized as one in

which the private sector was given much freer rein than it had previously enjoyed.

 Foreign trade remained subject to a variety of administrative

controls, and commercial policy was relatively protectionist .

 The prices of numerous goods and services were subject to

government control throughout the period, and foreign exchange controls remained in effect.

 Despite the development of financial markets after 1964,

government intervention in these markets resulted in wide variations in interest rates

Positives and Negatives Positive side: Intervention in key industrial sectors produced a more diversified industrial base than might otherwise have developed. Negative side:  The government’s lack of concern about allocative efficiency suggests that intervention exacted a high price in welfare terms.  No institutional checks and balances  Increased degree of uncertainty surrounding economic decisions.

Inflation and Indexation The root of Brazilian inflation : Monetization of part of the government's deficit. Inflation took its first substantial leap in the period after World War 11. Reaction to Inflation:  Tightened fiscal policy, increased prices for public services to levels that would cover costs, and reduced the growth of government services. in order to reduce the deficit that underlay money supply increases Extensive system of indexation, or "monetary correction." Brazilian inflation was both a cause and an effect of the extensive indexation that developed after 1964. In October 1989 price inflation was running at

Inflation and Indexation 

Cornerstone of this policy was Law 4357, which legalized the revision of nominal financial values to reflect inflation, in effect permitting financial contracts to be made in real terms

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Government sold indexed government obligations to the public. Private sector absorption of the debt, which had been negligible before 1964, was large enough by the late 1960s

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The shift from monetization to public debt financing in the decade after 1964 was one of the reasons for the drop in inflation rates between 1964 and 1974.

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But the arbitrary nature of Government decisions about the price indices that underlay the indexation system increased the uncertainty caused by inflation

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Monetary correction in the external sector also lagged behind financial market indexation.

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Brazil adhered to a fixed nominal exchange rate policy until 1968

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Wage readjustment was less frequent and less automatic than was monetary correction. Only in 1979, for example, was the adjustment in the minimum salary (saldrio mininio) changed from an annual to a semiannual increase.

Then, in August 1968, Brazil adopted a crawling peg or "minidevaluations“ (minidesvalorizaq6es). which in effect indexed the exchange rate.

ECONOMIC GROWTH IN THE MILAGRE YEARS(1968-1973)  Restraints of the 1964 stabilization program

began to weaken in 1967  Centre of power in economic policy making

shifted to the Finance ministry headed by Antonio Delfim

DELFIM’S ECONOMIC POLICY SHIFT  Less orthodox & restrictive than Campos mainly due

to substantial decline in inflation rates produced by the earlier regime  Move to expansionary policy also facilitated by considerable excess capacity in the economy mainly in the industrial sector & by improvement in balance of payments  Main policy difference –diagnosis of inflation – demand side to supply side  Tolerate gradual slowing of inflation in exchange for higher growth rate of real O/P & employment

DELFIM’S ECONOMIC POLICY SHIFT

 Most important strategy was monetary

policy  Believed inflation in part due to high interest rates by producers, hence expanded the money supply rate greater than the income based monitory growth rate  Maximize short run growth rate preventing liquidity constraints in private sector  To implementcreated credit through open market operations along with govt control of interest rates

PRICE,WAGE & SECTORAL POLICIES UNDER DELFIM

 Created a price control agency  Actual value of nominal wages in the

previous 12 month period was replaced by a value that would have occurred if the inflation rate was predicted correctly

 Crawling peg exchange rate policy  Sought to improve agricultural productivity

through subsidies,greater mechanisation,fertilizers but had limited effect

MACROECONOMIC PERFORMANCE DURING THE MILAGRE

 Performed brilliantly between 1968-1973  Real O/P grew at an avg 10.8% a year,per capita

GDP grew to average 7.9%

 Annual inflation was held at avg of 20%,public

deficit fell from 1.2% of GDP in 1968 to 0.2% of GDP in 1972

 Ratio between Net External debt & exports fell from

1.9 % in 1968 to 1.5 in 1972,situation under control

 High real income growth rate permitted the

increase in real money supply at an annual average rate of 14% without corresponding increase in inflation.

MACROECONOMIC PERFORMANCE DURING THE MILAGRE

 Capacity utilization in manufacturing rose

to 90.5 %

 Industrial employment rose at slightly

less than 9% during 1968-1974

 Industrial output expanded at an annual

average rate of more than 11%

 Tightness of labor markets in the early

1970s was reflected by substantial gains in real wages in industry & agriculture

The First Oil Shock, 1973  Policy making from 1973-82 attempted to

prolong the boom of preceding years  Steep rise in oil prices rose the import bill from $6.2billion to $12.2 billion  Only half of the increased prices were shifted to consumers, rest absorbed by subsidies  The growth rate slowed down in 1974-75, but still high by world or Latin American standards

The First Oil Shock, 1973  Aggregate demand remained

unbalanced  External borrowing increased and reserves decreased.  Burden of external shocks heavier than they had been dealt with promptly

The First Oil Shock, 1973  Aggregate demand remained

unbalanced  External borrowing increased and reserves decreased.  Burden of external shocks heavier than they had been dealt with promptly

Growth After the Shock, 1974-79  Long term investments in import

substitution and capital goods encouraged  Exports had grown rapidly during Milagre period  Reserves had grown from $650 million to $6 billion  Financing the current account deficit through additional external borrowing

Growth After the Shock, 1974-79  Inflation rate soared as monetary policy    

became accommodative Stagnation in world economy slowed exports growth Increase in domestic interest rates to slow growth Output growth rate fell, internal supply shock, 1978 Increased imports and further inflation

After the Shock, 1974-79

External Shocks & Response, 1979-82  Foreign interest rates increased sharply  Second oil price shock  Trade deteriorated  Delfim’s policies  Maintain high rate of growth  Deal with high interest and inflation rates  Agriculture and energy sectors encouraged  Strict control to reduce nominal interest rate  New wage policy to improve income distribution

External Shocks & Response, 1979-82  Delfim’s policies  Correct external imbalances  30% devaluation of domestic currency  New subsidies for exports, compulsory deposits on

imports, incentives to borrow abroad

 GDP increase of more than 7% in 1980  Negative trends in all other measures  Monetary authorities switched to targetting

money supply

External Shocks & Response, 1979-82  Financing debt through sale of exchange

rate indexed-treasury bonds  Ready market as real depreciation was increasingly likely  Real liquidity fell and domestic real interest rates increased  1981, GDP growth rate was negative for the first time, output dropped by 10%

External Shocks & Response, 1979-82  Inflation continued to be high  Trade balance became positive due

to cuts in imports rather than exports growth  Net interest payments accounted for 70% of current account deficit  Increase in domestic interest rates encouraged foreign borrowing  External debt increased

Collapse of Foreign Lending, 1982-85  Central bank reserves had fallen

sharply  Brazil viewed as riskier borrower following the collapse of Mexico  Principal commercial lenders suspended new and rollover of expiring credits  Brazil resisted turning to the IMF

Collapse of Foreign Lending, 1982-85  Central bank reserves had fallen

sharply  Brazil viewed as riskier borrower following the collapse of Mexico  Principal commercial lenders suspended new and rollover of expiring credits  Brazil resisted turning to the IMF

Milagre

Oil Shocks

Lending Collapse

Heterodox Economic Shocks The efforts to stabilize the economy saw three shocks:  The Cruzado Plan (1985)  The Bresser Plan (1987)  The Summer Plan (1989)

The Cruzado Plan  Price was freezed  Wage readjustments and freeze  Readjustment and freeze of rents

and mortgage  Ban on indexation Immediate results were spectacular, inflation fell close to zero, economic growth up surged, foreign accounts were

The Cruzado Plan: In Trouble  With fixed price and growing

economy, real income increased  Price fix was maintained for too long  Demand increased

•Excess demand created inflationary pressure •Indexation was back to control inflation

The Bresser Plan and Summer Plan  Both plan were introduced in 1987 and

1989 respectively  Attempt to control inflation  Introduced price freeze and banned indexation  Not able to address the public-sector disequilibrium •1980 ended with high and accelerating inflation and a stagnant economy •Public debt was enormous •Govt. had to pay very high interest rate to ensure public spending in govt. debt instruments

REAL PLAN •In 1994 by Fernando Cardoso •Introduction of a new currency (The Real) •Deindexation of the economy •Initial freeze of public sector prices •Tightening of monetary policy

REAL PLAN  Reduced tariffs(of 51 percent in 1988 to an    

average of 14 percent in 1994) Liberalize foreign investment On the expenditure reduction in the funds the states and municipalities. On the revenue side, federal income tax rates were increased. Monetary policy was restrained gradually.

REAL PLAN  Effects:        

Brought inflation down to under 2% per month food consumption rose 30%, purchase of consumer goods increased imports increased, the economy grew 4-5% every year since 1993 unemployment dropped to its lowest level and real wages grew from 5% in 1994 to 13% in 1995 between 1994 and 1995 the income of the lowest 50% of the workers grew by around 30% whereas the income from the top group grew only 10%

 Economic crisis in Asia and Russia affected the

Brazilian recovery

1999 Crisis : Fiscal Deficit Persistent accumulation of these deficits by a country that has a history of debt defaults or moratoriums clearly discomfited investors. Financial crises in Asia and subsequently in Russia. Brazil responded to these crises by raising interest rates in hopes of maintaining its exchange rate and holding foreign capital in the country Led to drop in Brazil’s industrial production index in second half of 1998 Forced up nominal fiscal deficits, aggravating existing concerns over sovereign default

1999 Crisis : Real Devaluation As problems became more acute in 1998 fiscal deficit a big issue , call for a Brazilian devaluation New budget plan intended to save $23 billion and $41.5 billion International Monetary Fund Devaluation postponed December 1998, a deficit reduction bill was voted down Minas Gerais Governor Itamar Franco’s announcement refused debt payment six other governors followed suite Capital outflow :$1 billion per day, 9 percent Devaluation in Dec 1998 Brazil declared floating exchange rate at the end of Dec 1998 January 1999, when the exchange rate

Summary of the post 1994 Period

Strategy for Economic Growth : Brazil Analysis of the Past And Recommendations for Future

Macroeconomic framework of countries with high external indebtedness

Revisiting the Past

Revisiting the Past The 1999 switch from an exchange anchor to a floating exchange rate regime plus an inflation target regime brought no significant improvement in the macroeconomic variables. • Balance of payments have improved their accounts in 2003-04 due mainly to the increase in the trade balance surplus.  Average investment rate in the last fifteen years was insufficient to generate a robust growth for the Brazilian economy.  This behaviour of investment rate was mainly due to the “economic policy model” adopted by Brazilian policy makers since the beginning of 1990´s. •

(i) high nominal and real interest rates in order to achieve price stability; (ii) growing liberalization of the capital account in order to integrate Brazil to international capital markets; (iii) overvaluation of domestic currency. (iv) since 1999 an increasing primary fiscal surplus – generated mainly by the reduction of public investment – in order to stabilize public debt/GDP ratio.

Alternative economic policy model Adoption of a crawling-peg exchange rate regime in which devaluation rate of domestic currency was set by the Central Bank at a rate equal to the difference between a target inflation rate and average inflation rate of Brazil’s most important trade partners  Adoption of market-based capital controls in order to increase the autonomy of the Central Bank to set nominal interest rates according to domestic objectives (mainly to promote a robust growth)  Reduction of nominal interest rate to a level compatible with real interest rate  Reduction of primary surplus from current 4.5% of GDP to 3.0% of GDP. These elements are fundamental for the required increase in the investment rate of Brazilian economy from current 20% of GDP to 27% of GDP needed for a sustained growth of 5% per year. 

1)The first principle of the “alternative economic policy model” entails the abandonment of the current Inflation Targeting Regime (hereafter ITR). .... For the workings of this system, however, there must be a floating exchange rate regime. ……Adoption of a crawling-peg exchange rate regime will reduce the exchange rate risk. •crawling-peg exchange rate regime is that it will serve as nominal anchor for the Brazilian economy, substituting ITR as a device for inflation control. 2). The adoption of capital controls. These controls are necessary for two basic reasons. a) Increase private investment b) Control over nominal exchange rate. • To reduce capital inflows, it is necessary the introduction of reserve requirements over all capital inflows, except foreign direct investment

Current challenges  Brazil remains far from the full employment :8.2 percent  Controlling inflation:6.4%(Present)-4.5 %(Target)-Food Prices  Agricultural prices have risen substantially in the last few

months, a trend that may begin to be seen in other sectors, given the huge increase in internal demand  lack of technically qualified people to attend to certain sectors  Insufficient electricity generation to support a lengthy period of economic growth.  The large trade surplus from agricultural and mineral commodities, and the influx of speculative capital stimulated by high interest rates, without neutralizing measures, causes overvaluation of the real, which in turn undermines the competitiveness of national industry, resulting in lower exports and an invasion of cheaper imported goods.

Lesson’s from Brazil  Monetary growth is an endogenous

process, driven by the need to finance fiscal deficits  Can be faced immediately, postponed. But in the long run it cannot be avoided  Consequence of populist attempts to ignore the fiscal disequilibrium : Economic turmoil

Lesson’s from Brazil, Contd.  Large economies can also be vulnerable to

external shocks  The large capital inflows of the 1970s ; a mixed blessing, when real interest rates rose in world markets, Brazil's terms of trade worsened, and lenders declined to roll over maturing loans  Despite its success in weathering the external payments crisis, failure to increase domestic savings imposed a high internal cost as investment declined

Lesson’s from Brazil, Contd.  Long import substitution made the economy

more vulnerable to external shocks than more open policies would have  Trade restrictions permitted the delay of real exchange rate adjustment which would have reduced the effects of the oil shocks  In the long run it encouraged rent-seeking and undermined the competitiveness of a number of sectors

Lesson’s from Brazil, Contd.  The greatest learning experience has been

with stabilization plans  Price freezes without fiscal adjustment waste valuable time and undermine government credibility when they eventually fail  Markets respond more favorably to sustained and consistent policies than to quick fixes  Extending price controls to trade (ie, by fixing the nominal exchange rate) may aggravate the situation further.

References  Donald V. Coes (1995), “Macroeconomic

Crisis, Policies and Growth in Brazil, 1964-90”, World Bank ‘Comparative Macroeconomic Studies’  José Luís Oreiro and Luiz Fernando de Paula(2005), “Strategy for Economic Growth in Brazil”  www.economist.com  www.worldbank.com