Negotiating the Hurdles

If expectations alone determined the health of a country’s economy, Brazil would be bounding along at double-digit growth rates. Mauro Molchansky, executive director at Globopar, the financial arm of Brazil’s Globo media group, declares, “I am very optimistic that Brazil will do well this year and that in the next two to three years [growth in] Brazil will explode. There will be tremendous growth. There are risks, such as Argentina, but nothing fundamental.”

Confidence among business leaders in Brazil is so widespread and so firm that government officials are warning against complacency. Although corporate Brazil is looking forward to a bumper year for sales and profits (see “Confidence Trick,” page 3), there is still a lot wrong with the economy. Brazil still has a heavy burden of government debt, imposes too many of the wrong kind of taxes, suffers from cripplingly high interest rates and must import prodigious amounts of capital from the world’s financial markets. As a result, Brazil’s feeble-looking external accounts make it vulnerable to unpredictable shifts in the global economy and investor sentiment.

Pedro Malan, the long-serving finance minister, is aware of these vulnerabilities and, with the backing of President Fernando Henrique Cardoso, has run an aggressive fiscal policy. Since 1999, the government has run a primary fiscal surplus equivalent to over 3% of GDP, but interest payments eat up all these gains and last year left an overall deficit equal to 7.4% of GDP. The problem is that the government spends too much money and in spite of aggressive tax collection, keeps running big budget deficits.

José Augusto Arantes Savasini, an economist at the University of São Paulo, warns that unless policies change, the debt could become unmanageable. Between 1995-2001, the country’s debt grew by 12.3% a year on average, about six times faster than average GDP growth, in spite of multibillion-dollar privatization programs. It is true that a large portion of this debt was simply a bookkeeping effect as the government owned up to undocumented debts.

There are few such “skeletons” left for the government to recognize. Yet the result is the same: the public sector must continue to borrow heavily, creating a crowding-out effect that has pushed interest rates to unsustainable levels for private-sector borrowers. “A scenario in which interest rates of 50% to 70% plus taxes cannot last or risk restricting economic growth to 1% to 2%,” warns Savasini. Without overcoming this, and Brazil’s heavy dependence on international capital markets, “Brazil is condemned to growing unemployment and social problems until it collapses just like Argentina.”

Brazil’s economy is unlikely to grow by more than 1.5% to 2% this year, about the same as in 2001. This would be yet another poor year for Brazil as it continues to trail behind expansion of the world economy. The economy is struggling to recover from the effects of electricity rationing, the US recession, falling commodity prices and the crisis in Argentina. Although unemployment fell to 6.4% at the end of 2001, job creation is still weak. Furthermore, the participation rate – the number of people in the labor market – has fallen to 56%, its lowest level since 1983. Women are staying at home, giving up looking for work and others are drifting into the informal economy.

Economists at Credit Suisse First Boston calculate that despite the increase in public debt to an expected 56% of GDP in 2002, the government can stabilize or even cut this burden. However, doing so will be tough. Were future governments to continue the present policy of running a primary surplus equivalent to 3.5% of GDP, the debt ratio would only fall to 47% by the end of the decade. Meeting this heroic challenge would require Brazil’s economy to grow by 3% a year, hold annual nominal interest rates at 11% and allow inflation to rise by no more than 3% annually. Furthermore, the real needs to depreciate by no more than half a percent each year. If the primary surplus were to fall to an average 2.5% of GDP from 2004-2010, then the debt would merely stabilize close to its present levels. If the primary surplus falls to 2% of GDP, then the debt would continue growing steadily to nearly 60% of GDP by 2010.

It seems as if there really is no way to substantially cut the debt. This disheartening prospect is mitigated only by the poor record of economists in long-range forecasting. Brazil may yet surprise the world by returning to the double-digit growth rates it posted in the 1960s and 1970s. Equally, it could go on disappointing by limping along at well below its potential and be confronted with a debt crisis in a few years’ time.

Improving the Profile
If there is little the government can do to tackle the debt mountain, there is a lot it can do to improve its profile. The Treasury and Central Bank have worked hard to increase the maturity of the government’s debt as well as improve whenever possible the type of debt the government issues. They have made considerable progress, which has reduced volatility in the markets and eased the Treasury’s exposure to refinancing risk. In May 1999, two-thirds of domestic debt matured in 12 months or less, with an average duration of six months. Now, little more than a quarter of the debt matures in 12 months and the average maturity has risen to nearly three years.

Even so, the Treasury still needs to refinance about a quarter of its R$624 ($270 billion) local currency debt this year and around 80% percent of that total matures before July. The government issued much of this debt as dollar-linked securities following the September 11 terrorist attacks in the US to enable private-sector borrowers to hedge against volatility. Refinancing this debt at better rates should not be a problem now that the local and international financial markets have settled down. In January, the government refinanced R$1.4 billion in maturing dollar-linked debt it had issued post-September 11 with paper maturing in up to six-years. Dollar-linked debt is still 31% of total federal debt, against 22% in December 2000.

Going Long
The next challenge for the authorities is to convince investors to buy more longer-dated paper at fixed interest rates. This is a delicate task and the Treasury can only get away with selling fixed rate bonds when the market is convinced that the real is strengthening and that real interest rates are heading down. In December, less than 8% of the government’s real debt was at fixed rates, half what it was a year earlier. Investors demand floating-rate bonds linked either to the exchange rate or the Central Bank’s short-term Selic interest rate. This exposes the government to terrifying risks, such as last year, when the real plunged by about a third against the dollar by September before rallying, and the Central Bank yanked the Selic rate up to 19% a year from 15% a year in the first quarter. Critics say the government should issue more inflation-linked debt rather than tying it to the Selic. Inflation last year rose only 7.4% so the savings would be considerable. But Central Bank officials say they are anxious to avoid re-indexation. Although it is eight years since the government unwound the country’s intricate and self-reinforcing indexation system, reintroducing this mechanism could make it very hard to continue cutting inflation.

The government is seeking to finance itself mainly in reais, rather than taking on more dollar debt, even though this would be cheaper. The Selic rate is more than twice the spread on Brazil’s international bonds, which trade at around 830 basis points over US Treasurys. The point is that the government has a decisive advantage in the local market as it is both the largest borrower and can change the rules of the game when necessary. It has no such advantages in the international markets. Furthermore, maturities on foreign bonds are longer than those in the local market so the government runs the risk of locking in high interest rates for years to come.

Armínio Fraga, the Central Bank president, has said Brazil intends to issue no more than $5 billion this year in foreign debt, which is only slightly more than the $3.6 billion in repayments due this year. The Central Bank, which manages the government’s foreign debt, placed $1.25 billion in 10-year bonds in January, in an audacious operation staged on the first Monday after Argentina abolished its currency board and devalued the peso by 29%. Luiz Chrysostomo, managing director at JP Morgan’s Rio de Janeiro office, says “We still built a $2 billion book in four hours in the middle of a crisis.” This was in spite of a similar bond from Mexico, an investment-grade country, coming to market on the same day. The Central Bank plans further issues in all three major international currencies this year as well as more debt exchanges to further improve the quality and profile of Brazil’s yield curve.

Refinancing Risk
If the country’s debt burden seems scary, there is some consolation. To start with, the main risk – for the time being – is not one of default but of the terms the government and private-sector borrowers will have to pay to refinance maturing debt. Furthermore, the international environment is improving so Brazil can expect to export more and attract more foreign direct investment than was forecast last year. Even so, Brazil needs to raise around $55 billion to finance its current and capital account this year.

Foreign direct investment of at least $16 billion, and possibly more, plus a small trade surplus of around $4 billion, will go part of the way to financing the external accounts. Although Brazil can no longer safely rely on foreign investment to cover its expected current account deficit of $21.5 billion, it has started to generate a trade surplus for the first time in years. Although comparatively small, this is an important advance for a country that trades little with the outside world. The remainder of Brazil’s financing needs must come from international organizations like the World Bank and Inter-American Development Bank and from the markets. Private-sector borrowers have to repay about $26 billion in debts this year. Bankers do not foresee problems for Brazil’s companies and banks to refinance or simply pay down maturing debt since they are generally liquid and well-capitalized.

But Brazil’s tax system remains a mess. The government relies on too many taxes that muddle market signals and hurt companies and consumers. These taxes are generally levied on financial transactions, which distorts market signals, rather than the more neutral taxes on income and sales. To make matters worse, Brazil has a tradition of charging taxes on taxes – a method known as “cascading taxes.” This means that a small tax charged at the beginning of the production process grows as more taxes are piled on as it wends its away along the distribution chain. Says Winston Fritsch, president of Dresdner Bank in Brazil, “The tax system is very distorted and there is no focus on its microeconomic effects.”

As the government’s hunger for revenue has grown, it has imposed more distortive taxes because they are quick and easy to collect. This has driven companies into the informal sector while increasing the burden on larger companies that are too big to go underground. Brazilians pay about 33% of GDP in taxes, a significant amount for a developing country. Last year, Everardo Maciel, the loathed head of the federal tax department, collected R$196.76 billion in taxes, 11% more than in 2000. Direct taxes, such as income tax, were only a third of the total.

Political Problems
The government is wary of straightening out this mess because it fears that doing so would require too many political compromises in Congress and threaten its revenues. However, Fritsch says the government “could carry out a tax reform without affecting revenues by making taxes more simplified and production-friendly.” This would make the system more equitable and transparent and could ensure the support of the powerful business lobby in Congress.

Instead, José Paulo Kupfer, a columnist in the business newspaper Gazeta Mercantil, notes that the government is actually increasing its use of distortive taxes like the CLLS tax on financial transactions. The tax falls on 32% of a company’s annual sales at a rate of 9%, which the government has now increased by a third to 12%. A decade ago, these cumulative taxes were equivalent to less than 6% of total tax revenues. Since then, they have risen six-fold. It is hard to see a government pushing tax reforms through Congress on the eve of a presidential election, especially one that would make many of these and other unseen taxes all too visible. Powerful state governors dislike the federal government’s demand that Brazil adopt a single uniform sales tax, now collected by the states, which can vary rates as they like.

Better than improving taxes would be to cut government spending, or at least freeze it at its present levels. Like many governments, Brazil wastes money through incompetence, mismanagement, overstaffing and corruption. Although the Cardoso government has improved the transparency of public spending, especially in health and education, unknown billions are still wasted in bureaucracy or lost in corruption.

Civil Generosity
Almost as egregious is the money lavished on retired civil servants. They receive generous allowances even though they have not contributed enough to pay for their pensions. The government partially reformed the public pension system in 1999 by putting contributions from private-sector workers on a sounder actuarial basis and virtually eliminating the deficit on these pensions. But Cardoso lacked the nerve to impose a similar rule on federal employees because that would cut payments. As a result, the benefits paid to former state employees have become one of the largest chunks of the government’s budget deficit and it is growing larger every year. In 2001, social security revenues rose 12% to R$63.4 billion as wages and employment both increased. But benefit payments rose by 15%, leading to a deficit of R$12.8 billion. In 2000, the deficit was R$10.1 billion.

Since the chances of the government pushing through a tax reform or cutting spending are slim, Brazil must rely on the semi-independent Central Bank to continue managing monetary policy as skillfully as it has over the last three years since Fraga’s team took over. He adopted an inflation-targeting policy a few months after the real collapsed in January 1999, threatening the viability of the government’s commitment to low inflation. The Central Bank has set targets to steadily lower inflation and succeeded in meeting them in 1999 and 2000. But last year, inflation rose by 7.4%, a lot more than the 4% target. Fraga says that this was because the Central Bank wanted to avoid a sudden economic slowdown by raising interest rates to keep inflation on track. A depreciating real in 2001 raised the IPCA price index by 2.9 percentage points, according to the Central Bank. Regulated prices for electricity, gas and telephone charges rose another 1.7 percentage points. Were it not for these impacts, the IPCA would have risen only 4.3%. Fraga says that his careful approach enabled him to reverse negative expectations in the markets and toward the end of the year, “allowed an appreciation of the currency, reduction in risk premiums and improving perspectives for the Brazilian economy.”