“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