It is in the nature of Brazil’s political cycle that governments, whether new or re-elected, implement most of their unpopular measures in their first year. It is not news, therefore, that 2015, the year after next year’s presidential election, will be a year of economic adjustment. But this time will be different. The adjustment will have to go beyond the usual restraint in spending by which governments purge the excesses of the previous election year.

Radical change will be required in 2015 to replace the policy model in place since 2005, which has become increasingly dysfunctional. Also important will be the need to correct policy mistakes, from price controls to the use of accounting tricks to formally meet fiscal targets. While the need for change is clear, the question, however, is whether the government of President Dilma Rousseff will be able to postpone it until after the October 2014 election. This will depend in part on how much Chinese economic growth decelerates and how fast monetary stimuli are reduced in the United States. Popular discontent with the Rousseff government, and the dynamics of recent street protests in many cities, will increase the temptation to try to “buy” back popular support.

The Current Economic Model

Let me start from the beginning. A series of macroeconomic reforms in the 1990s had made the Brazilian economy more efficient. Contrary to expectations – and to Luiz Inacio “Lula” da Silva’s policy positions while an opposition candidate – most of those reforms were kept in place after Lula became president in 2003. This greatly reduced policy risk. Growth accelerated between 2004 and 2010, thanks, to a large extent, to the rise in China’s demand for commodities. These developments facilitated the repossession of loan collateral and helped generate a major credit boom.

The increase in loans boosted retail sales and construction. Because unemployment was initially high and the currency was steadily appreciating, the ensuing pressure on prices was moderate. In particular, currency appreciation caused imports to boom, helping to supply consumers with the goods that they demanded, while keeping domestic prices in check.

In the past, a similar rapid rise in imports would have led to a large external deficit and, eventually, to a foreign-exchange crisis. But the external accounts remained relatively solid. One reason was because Brazil had a current account surplus in 2005, when the boom in credit and consumption took off. Another more important reason was that export prices rose substantially from 2004 to 2011 as a consequence of the surge in China’s demand for commodities.

This was a period of euphoria in Brazil. Employment and real earnings went up, while inflation and interest rates came down. Household consumption and company and bank profits boomed, attracting more investment. Economic expansion led to an increase in government revenues, thus enabling more spending on politicians’ pet projects. There was something good for everyone.

The inherent dynamics of this model were, however, unsustainable. Continued currency appreciation and rising real earnings compromised manufacturing competitiveness. Debts increased faster than incomes and would have to be paid back some day. Export prices could not rise forever, nor could the current-account balance decline indefinitely without generating an external financing crisis. And without sufficient investment and productivity growth, output expansion would have to decelerate once Brazil ran out of unemployed workers, especially skilled ones.

The first signs that this model had become dysfunctional emerged in 2010. The new government that took office in January 2011, led by President Rousseff, seemed to understand the new situation and tightened monetary and fiscal policies to rein in inflation. By the second half of 2011, however, policy makers went back to stimulating domestic consumption. It was then that they adopted President Rousseff’s "new economic matrix".[1]

The “new economic matrix” was predicated on expansionary monetary and fiscal policies, a weak currency and large volumes of subsidized credit to finance consumption and national champions – large firms hand-picked by the government to become Brazilian multinationals.[2] Thus, in due course, the Central Bank brought the policy interest rate (Selic) down, while the National Treasury abandoned the primary-surplus target (just meeting it, pro forma, via accounting tricks). Several controls were also put on capital inflows.

The result was the opposite of what the government had expected. The potential for GDP growth collapsed, due to persistent high inflation despite low output growth. Faced with these dismal results, the government decided to redouble the stimulus to consumption rather than change course. Meanwhile, it intervened more in the economy through price controls and selective tax exemptions in order to keep inflation from increasing too much.

In normal times, investors would have reacted badly. But times were not normal. After the 2008 crisis, Brazil’s terms of trade improved significantly, with export prices increasing 48% between 2009 and 2011. This allowed for the continued rise in imports without pressuring the external accounts too much. In addition, the central banks in developed economies greatly increased international liquidity. With more money floating around, interest in Brazilian assets exploded, enabling a drop in interest rates on government and corporate bonds. The government, in particular, was able to finance itself at a declining cost and for longer periods of time, despite all the complaints about the quality and transparency of fiscal policy.

Just when everything was pointing toward the survival of President Rousseff’s “new economic matrix,” at least until the 2014 elections, two new factors intervened. One was a change for the worse in the external environment. The other was the street demonstrations that attracted hundreds of thousands to protest against the government.

A Less Favorable External Environment

Emerging Asia had reacted to the collapse of Lehman Brothers and the ensuing 2008 crisis by strongly boosting domestic demand. This gave a new impetus to Latin America’s export boom. However, this picture began to change in 2012, when the region expanded a mere 6.6%, a fifth less than the 2008-2011 average. This affected Brazil’s export prices. After peaking in the third quarter of 2011, they have declined almost steadily. The trade balance also fell, despite low GDP growth, and the current account deficit reached 3.2% of GDP in the 12 months ending in June 2013, one percentage point more than a year before.

Brazil’s external accounts will deteriorate further in 2014, when the current account deficit will probably approach 4% of GDP. A 4% deficit is at the threshold that led to the currency-devaluation crisis of early 1999. In principle, this time the consequences will not be as dire as in 1999 or 2002, given Brazil’s large international reserves. Moreover, the recent devaluation and low GDP and investment growth will act as automatic stabilizers, limiting the expansion in imports. Still, the external accounts will become an increasing source of concern.

Notwithstanding the high level of Brazil’s international reserves, I expect the fatal blow to the current economic model to come from a shortage of external funds to meet the country’s external financing needs. The only foreseeable alternative is the election of a new government with different views on the economy.

As Warren Buffet once said, "only when the tide goes out do you discover who’s been swimming naked." Monetary normalization in the United States, albeit still in its early stages, has already lowered the “tide” of international liquidity. Given the recent behavior of Brazilian asset prices, from stocks to the currency and bonds, investors seem suspicious about the “clothes” with which Brazil has been surfing the international scene.

It is likely that as yields in the United States continue to rise, so will interest rates in Brazil. Brazilian companies already are finding it more difficult to secure financing in local and international capital markets. It is probable that, as time goes by, less liquid markets such as the property market will also feel the squeeze. Both corporate and household investment should be negatively affected.

The Protests

In June 2013, more than one million Brazilians (0.5 percent of the population) took part in street protests in tens of cities. The protests in Brazil were influenced by similar demonstrations in Southern Europe, the Arab countries and Turkey. They were also sparked by young adults with a college or at least a secondary education who formed the majority of those at the protests. Also similar were the use of social networks and mobile communication to organize the protests, as well as the lack of political-party affiliation among the protesters.

However, somewhat counter-intuitively, Brazilian young adults had never had it so good in economic terms. For those aged 18 to 35 with college or secondary education, the unemployment rate had declined from 13.5% in 2007 to 7.8% in May 2013, while real earnings had risen at an annual average rate of 3.1%, accelerating even more over the last three years. The labor market had improved even more for less-educated young people.[3]

Thus, although high inflation and the increase in bus fares contributed to bringing protesters into the streets, the demonstrations that erupted in June were not about the economy, or at least not about macroeconomic policy. Protesters complained mainly about widespread corruption and the government’s spending priorities, specifically that so much money had been spent on soccer stadiums when health, education and public transportation services remained so poor.

Looking Ahead

The protests of mid-2013 completely changed Brazil’s political scene. President Rousseff’s approval rating fell 27 percentage points, turning the 2014 presidential election into an open contest, rather than a sure re-election. The government’s reaction further complicated things. On the one hand, the relationship between President Rousseff and Congress became more tense, limiting the scope for new policy initiatives. On the other hand, the quality of economic policy continued to deteriorate. Fiscal policy became even more expansionary, with the president promising more spending on public transportation and more money to city mayors. The increase in bus fares was reversed, straining municipal finances. A hike in road tolls was also aborted and concessionaires were released from making necessary investments in Brazil’s highways.

This interaction between street protests and the quality of economic policy will become an increasing source of economic and political instability. Brazil now faces a less-benign external environment, with a decrease in demand for its goods and assets. This will eventually result in a decline in real incomes, reversing part of the gains obtained during Lula’s government. This decline will occur either through a further slowdown in growth to limit the secondary effects of the exchange-rate devaluation, or through an acceleration in inflation.

Recently, the labor market weakened and real earnings declined a bit. I expect that labor-market conditions will worsen further. This will affect the banks through higher delinquency rates. Government banks seem especially exposed. New protests against the government may erupt, this time more focused on the economy. The president’s approval rates will suffer additional declines, which may lead to more fiscal stimulus and a premature end to the tightening cycle recently initiated by the Central Bank.

Thus, whoever wins the 2014 elections will have to manage a transition to a new policy framework that restores macroeconomic stability and confidence in policy makers. This will entail a further cooling of the economy and a processing of the decline in real incomes if the country is to adapt to the new external environment. It will take a very talented political leader to guide the country through this transition, which will certainly be unpopular. There is a non-trivial risk that the government might abandon this course midway or might even not start it. Obviously, these risks are higher in the case of re-election than if a new government is elected.

The good news is that this transition, if and when it is completed, will lead to a more sustainable growth model. In particular, the decline in unit labor costs will restore manufacturing competitiveness and lead to more balanced growth. Moreover, the necessary changes can be carried out without Congressional approval; they mainly involve restoring the three policy pillars in place during most of the administrations of President Fernando Henrique Cardoso (1995-2002) and President Lula (2003-2010). First, the Central Bank will have to focus once again on meeting the inflation target. Second, the National Treasury will have to focus on meeting the primary surplus target, without resorting to the “smoke and mirrors” tricks of the last three years. Third, the government will have to intervene less in the foreign exchange market, giving more flexibility for the exchange rate to float. It will also be important to restore the autonomy of regulatory agencies by appointing more qualified and less politically-involved board members.

Historically, pragmatism, rather than the more ideological stance of recent years, has been the hallmark of Brazil’s economic policy making. I am therefore confident that Brazil will manage to carry out this necessary policy transition. However, one should expect a lot of turbulence in the next year and a half, so fasten your seat belts.

[1] “O primeiro ano da nova matriz econômica,” Guido Mantega, Valor Econômico, December 19, 2012.

[2] Eike Batista’s “X” group is perhaps the best known of these hand-picked would-be national champions.

[3] These statistics are from Naercio Menezes Filho, “As manifestações e o trabalho,” Valor Econômico, July 19, 2013, p. A13.

Originally published in August 2013, as an opinion piece, by the Center for Hemispheric Policy, University of Miami

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“It’s the economy, stupid.” James Carville made his reputation with this clear message to Bill Clinton in 1992. Clinton took it to heart and trounced George Bush, Sr., to win the presidency. Were Carville an economist looking at Brazil, he would probably send an equally direct message to the authorities regarding their adamant insistence on an economic model that has clearly failed to attract private investment and generate growth. Whether they would heed his counsel is, of course, another matter.

In this article I show why correcting economic policy is currently Brazil’s main economic challenge. The argument is presented in three stages. First, I review how the economy moved from a stellar performance in 2010, when, under President Luiz Inacio “Lula” da Silva, GDP expanded 7.5%, to a dismal expansion of just 0.9% in 2012, in the second year of Dilma Rousseff’s administration. Next, I describe the main pillars of Rousseff’s economic “model” and analyze why they account for the lackluster performance of 2011-12. I then present my economic outlook for 2013, arguing that economic performance may again frustrate more hopeful expectations.

The international crisis hit Brazil both through the trade and the financial channels. As world trade collapsed, contracting 10% in 2009, compared to an average annual expansion of 8% in 2005-07, so did Brazilian exports. On top of this, there was a decline in trade and corporate finance that exacerbated the problem: external credit contracted across the board, threatening a liquidity crisis among medium banks and corporations. Investment and industrial output dropped steeply in late 2008 and early 2009.

The Lula administration reacted with a large array of policy responses, using international reserves to secure trade finance lines, reducing reserve requirements on bank deposits, expanding credit by state banks and pursuing expansionary fiscal and monetary policies. This combination of good policy responses and a quick turnaround of China, which by then had become Brazil’s main trade partner, allowed the country to weather the crisis relatively unscathed, being among the first to recover. In the second half of 2009, GDP expanded at an annualized rate of 10%.

Even as the economy recovered, however, policy was kept in high gear ahead of the October 2010 elections. When measured in the third quarter of 2010, the economy had grown 7.6% in 12 months. With domestic demand expanding a full 9.1% in this period, led by a surge in investment (21.2%), inflation also went up. With election success in hand, policy was again tightened.

In the first months of Rousseff’s administration, everything indicated that the government’s more interventionist stance would be limited to microeconomic matters, with fiscal and monetary policies being spared as they had been under Lula. Indeed, Lula had basically maintained the macroeconomic policy model adopted by President Fernando Henrique Cardoso after the devaluation of January 1999 and the subsequent adoption of the inflation-targeting regime. Together with fiscal targets and a floating exchange rate, this had become known as the policy tripod.

That perception started to change, however, in the monetary-policy meeting of August 31, 2011, when the policy interest rate (Selic) was reduced, despite inflation being well above the 4.5% target: 7.2% in the 12 months up to August, making it 2.7 percentage points above target. Inflation expectations were also above target: 5.4% for the following 12 months. The Central Bank justified its surprising decision as a preemptive move to counteract the deflationary pressures stemming from the deepening European crisis. In subsequent meetings the Monetary Policy Committee further cut the Selic, until it was brought down to 7.25% in the October 2012 meeting, from 12.50% in August 2011.

It is remarkable that interest rates continued to be cut, despite the fact that inflation, the external deflationary effect notwithstanding, was running well above the target. Consumer prices went up 6.5% in 2011. Inflation dropped to 5.8% in 2012, but this apparent decline resulted from a change in the weights used to calculate the consumer price index, and was thus illusory. Correcting for this, inflation was the same in both years. Fiscal policy also became increasingly expansionary.

The higher tolerance for inflation was seen at the time as reflecting a rebalancing of priorities, with monetary policy more focused on growth, which was decelerating sharply. In this regard, Brazil was not alone in the global scene, as other countries have adopted a similar stance since the crisis began. Its underlying situation was, however, different. In the Brazilian case, the new policy stance backfired, with the rise in uncertainty resulting from the abandonment of the policy tripod more than compensating for the gains from increased stimulus.

Two factors explain this outcome. First, despite the slowdown in output growth, labor markets continued to tighten. Together with generous increases in the minimum wage, this caused real earnings to rise substantially, bringing inflation in the non-tradable sector to the 8%-9% range. Second, fearing that inflation would rise above the ceiling of the inflation target band (6.5%), the government began to directly manage some key prices in the economy, from freezing gasoline prices to asking mayors and governors to postpone raising public transportation fares.

At least in the case of gasoline prices, this policy had negative consequences. The profits of Brazil’s main oil company, Petrobras, fell sharply, reducing its investment capacity. The ethanol sector was also negatively affected, for it found itself unable to compete with the low gasoline prices offered by Petrobras. Moreover, the concern with rising inflation may have influenced the government’s urgency to force a decline in electricity prices, which will shave half a percentage point from 2013’s inflation. By hastily renewing power concessions on terms many concessionaires found unreasonable, and about which they had to decide rapidly and without sufficient regulatory certainty, the government further compromised the investment climate.

This heightened interventionism was not, though, solely the result of random attempts to control inflation. On the contrary, it was part of a different economic “model”, put in place by President Rousseff, the main pillars of which are tighter state guidance, lower rates of return for financial and physical capital, and greater protection for industry, ranging from higher import tariffs to larger credit subsidies.

Thus, the electricity sector was not alone in undergoing major regulation changes over the last two years. Railways, ports and airports were also subject to dramatic changes that included reducing the rate of return that private investors could obtain from exploring these infrastructures. Similarly, in 2012 the government initiated a campaign to bring down interest spreads on bank loans, which, in addition to having public banks price their loans more aggressively, included bashing private bankers.

These various initiatives in macroeconomic and sectoral policies are interconnected and reflect a view, in a sense expressed by President Rousseff early in her administration, that interest rates and the return on capital were too high in Brazil. Thus, more than a response to a deflationary pressure from tradable prices, or an attempt to foster growth, the cuts in the Selic resulted from the perception that, with monetary policy at record expansionary levels worldwide, it was time to bring down interest rates in Brazil, even at the cost of increasing inflation.

That rates of return and interest rates in Brazil were too high for international standards is a fact. But, then, so are the risks involved, which are also greater in Brazil than in most developed economies. Lowering rates in an ad hoc fashion, without accompanying reforms, is unlikely to make this decline sustainable. Rather, by lowering those rates by administrative fiat, the government raised uncertainty and caused a contraction in supply. Investment, in particular, contracted sharply, falling for four consecutive quarters, beginning in the last quarter of 2011 -- ironically, right after the Central Bank started to cut the Selic. This, of course, was not what policy makers had expected; they expected investment to surge as a reaction to lower interest rates.

Policy makers realize that something has gone awry, but their interpretation seems to differ from the one exposed here. In their view, it is not the model that is wrong, but the market that has failed to understand the benefits of the new model. Give it time and this understanding will come.

My view is that this will not happen in 2013. Despite the lax monetary policy, a new round of fiscal stimulus and the significant rise in credit by public banks (21% in 2012, in real terms), the economy is likely to accelerate only modestly in 2013. The market foresees GDP growth of 3.0% this year. At the Instituto Brasileiro de Economia of Fundação Getúlio Vargas (IBRE/FGV) we are slightly more bearish, predicting a 2.8% expansion. And the risks are mostly on the downside.

Despite three consecutive years of low growth (2011-13), inflation is projected to remain around 5.7%. Risks, in this case, are tilted to the upside. If growth in fact rises to around 3%, inflation may again approach the ceiling of the inflation target band. One should therefore not be surprised if gasoline prices remain frozen, after the modest rise in January, and new tax exemptions are adopted for some critical products, as was recently the case with foodstuffs.

The main uncertainty currently centers on the direction of monetary policy. Traders are betting that the Central Bank will raise the Selic still in the first semester, to avoid entering the critical election year of 2014 with inflation on the rise. Most economists, on the other hand, seem to believe the authorities’ message that inflation will decline without any tightening in the second semester, although some have converted to a more pessimistic view in recent weeks.

My view is that the government has a greater chance of encouraging the private sector to invest by focusing on reducing inflation and offering realistic rates of return in concessions, as well as meddling less in how banks price their loans, rather than by pursuing current policies. I am skeptical, though, that this will happen. It could change, however, if there is a turn for the worse in the labor market, or if the fear of losing the 2014 elections leads to a shift in course.

The bottom line is that economic policy has changed much more dramatically than is generally perceived. The changes are mostly well intentioned, but lack the substantive fundamentals to be market consistent. The resulting inconsistencies will take time to harm the economy to an extent that a reversal becomes necessary. This flexibility stems in part from the fiscal space created by the lowering of interest rates and the decline in the net public debt to GDP ratio, which together caused interest payments to fall, as well as from the large pool of liquidity that exists in the global economy. Give it time, though, and the government’s policy will have to change again.

Originally published in March 2013, as an opinion piece, by the Center for Hemispheric Policy, University of Miami

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