Under President Fernando Henrique Cardoso, Brazil has tried hard to reform its economy, but it has not tried hard enough. Its persistent budget and current account deficits have led to the rapid accumulation of a very heavy debt burden. Any mood shift in the financial markets is enough to bring the country to the brink of disaster. The government owes $287 billion, double the level in 1995. The real, which was worth more than a dollar when it first appeared in 1994, is worth less than 30 cents these days. Interest rates have been close to 20% for years. As a result, the economy has sputtered along without quite breaking down but without taking off either. For a country as poor as Brazil, failure to grow is enough to cast its entire experiment with free market economics into doubt. The economy, measured in dollars, is smaller today than it was five years ago, even though the population is growing by 1.6% a year.
Cardoso’s achievements in his eight years in government – killing hyperinflation, partially reforming the machinery of state, liberalizing trade – are impressive given the tremendous inertia in the Brazilian economy and the power of special interests. The government, particularly Central Bank President Armínio Fraga, deserves praise for keeping inflation down despite the real’s severe depreciation. And there is a national consensus in favor of rational economic policies, particularly in support of price stability. Nobody wants a return to the 1980s, a period of heavy inflation and economic stagnation. Ominously, the real’s steady devaluation is pressuring prices, and the central bank has consistently missed its inflation targets.
Voters will expect whoever wins the elections to return the country to growth quickly, yet the obstacles the new government must overcome first are formidable. Cardoso leaves the country as vulnerable to the whims of financial markets as ever. This is in spite of close monitoring by the International Monetary Fund, which has had lending programs in place with Brazil since September 1998. Until recently Brazil could get by on gargantuan inflows of foreign direct investment. In 2001, $22.6 billion-worth of FDI entered the country, just about enough to cover the current account deficit. But inflows have slackened to $17 billion in 2002, $3 billion less than the current account deficit.
Fraga, one of his generation’s most gifted central bankers (and LatinFinance’s Man of the Year in 2002), says Brazil can become financially independent by setting itself a few simple, but ambitious goals for the years ahead. To start with, the next government should aim for an investment grade debt rating. Brazil has always had a junk bond rating. “I believe it’s possible in the next 30 months, despite the current situation, to pull the country out of this high-risk category. It’s a perfectly feasible project,” Fraga told an audience of incredulous business leaders. “A lot of the basics already exist. With a bit of perseverance, we can get there. It’s not possible for a big and sophisticated country like Brazil to develop without getting out of this high-risk category. We’ve made a lot of progress, but we’re still not perceived as a country that has conquered its historical demons.”
The IMF will retain a central role in exorcizing those demons. The terms of its $30 billion rescue package in August require the next government to deliver a hefty primary budget surplus (before interest payments) of 3.75% of GDP, compared with 3.5% before. The Fund will monitor compliance on a quarterly basis. But the greatest obstacle to exorcizing Brazil’s fiscal demons lies in the capital Brasília. The net public sector debt has climbed to almost 60% of GDP from 34% of GDP in 1997. The debt burden keeps interest rates high, maturities short and crowds private sector firms out of the financial markets. This prevents companies from investing more, creating jobs and stoking economic growth.
Rodrigo Azevedo, chief economist at Credit Suisse First Boston in São Paulo, says, “The government spends a lot and it spends the money badly. It raises a lot of taxes of the wrong sort.” The next government’s priority must be to reform public finances, making them more transparent, financed by a less iniquitous tax system and to eliminate public sector waste and corruption. Cardoso struggled throughout his second four-year term to deliver a primary budget surplus of 3.5% of GDP and did so with a salad of “temporary” taxes on financial transactions and company turnover and by raising personal and corporate income tax rates. Ricardo Amorim, head of Latin American research at the consultancy IDEAglobal, says, “The adjustment was always done by raising taxes and not cutting spending, so therefore it is the private sector that winds up paying.” The government has cut spending in response to this year’s emergency, but without much consideration to where the cuts fall.
Not all the money is wasted. Brazil under Cardoso has drastically improved the quality of the public education system. The public health system has also improved. Brazil leads the way in providing free drugs to AIDS patients. The Fiscal Responsibility Law, passed during Cardoso’s second term, is intended to prevent a return of the great tradition of Brazilian politics – stuffing the public sector payroll with allies, friends and family. However, public spending still leaves a great deal to be desired even in prestige showcase projects. For instance, the São Paulo State Symphony Orchestra performs in a lavishly restored railroad station in a run down neighborhood of the city. The house is often full because the government subsidizes tickets for its middle class patrons, while the homeless huddle in the streets outside. Reducing the orchestra’s subsidy might improve the public finances somewhat, but spending, particularly at federal level, looks remarkably rigid. Amorim says, “There is an absurd inflexibility in public spending. Ninety percent of resources are fixed and only 10% are discretional.” Interest payments alone gobble up money equivalent to 9% of GDP every year. CSFB’s Azevedo calculates that the incoming government must maintain a primary budget surplus of 3.5% of GDP simply to keep the debt-to-GDP ratio stable. Were this effort to slip, the debt burden would keep rising. It is easy to see why investors are so scared of a government led by Luis Inácio Lula da Silva of the Workers Party. Assuming that Brazil manages to avoid defaulting on its debts for now, it will still be hard for the new government to explain to voters why it should keep transferring such huge resources to the financial markets.
Following Through
Yet there are at least two ways in which a new government could deal decisively with its finances. First, the next president could finish Cardoso’s half-baked reform of the public social security system, which he began in 1999 but failed to complete. Second, he could root out waste and corruption in the public sector. In 1999, Cardoso only managed to convince a majority in Congress to reform the deficit-ridden social security system because the economy was balancing on a knife-edge following the real’s devaluation. However, Congress only accepted cutting benefits to private sector contributors. This was an improvement, certainly, but left a separate scheme for state employees untouched. This is a very expensive exemption since it consumes about 4% of GDP every year for the benefit of about three million retirees, a relatively small contingent of people. The social security system’s expenditures have risen 85% in five years, while revenues grew 60%. This year’s deficit is likely to hit $6 billion, double the gap in 1997. Cardoso failed to staunch the red ink because public employees won court rulings defending their “acquired rights,” a sacred constitutional privilege. Current and former state workers are unionized and politically active. This makes it hard to believe that a left- wing government with its roots in the public sector and ties to powerful labor unions would take away their privileges, particularly because most government employees earn little during their working lives but can look forward to a decent pension. Nevertheless, stranger things have happened and reform may yet come about. Although the immediate impact of a reform might be limited, since the government would probably recognize existing pensions, a decision to change the system would still send an unmistakable message to the markets.
Luis Nassif, head of a financial news agency and tireless campaigner for clean government, says equally large savings could be wrung out of the government easily. He says programs designed by private groups, together with local government and federal departments, can deliver savings of 20%-50% by introducing basic management techniques. For instance, the state of São Paulo, the wealthiest in Brazil, eliminated its budget deficit by cutting waste and corruption, not by raising local taxes. It set performance targets for government departments. It standardized state contracts and held reverse auctions to fill procurement contracts. The federal finance ministry’s office in the northeastern state of Ceará achieved savings of 50% with a similar approach. Savings on this scale throughout the federal government would bring immediate gains, improving the economy’s efficiency and reducing the pubic sector borrowing requirement.
“The next president has to be a good manager, not a thinker. This is a question of good management,” says Nassif. It is also a question of political will. Politicians infest the bureaucracy, using it as a source of patronage to finance their campaigns and line their pockets. A serious crackdown on waste and corruption would be like playing with dynamite. To his credit, Cardoso has tidied up the public sector a lot by privatizing state companies, tightening up on budget management at federal level and by breaking with allied political bosses accused of corruption or malpractice.
The tax system also needs close attention. Although the government has increased taxation steeply – taxes now account for 34% of GDP – it has done so with an ad hoc series of inefficient taxes. All the main presidential candidates vow to carry out a tax reform without specifying too precisely what they propose. Most economists hope they intend to snuff out Cardoso’s economically inefficient “distortive” taxes without increasing the budget deficit.
Dismantling Barriers
Economists also would like the next government to lift taxes on exports in the hope that this would boost foreign sales. The real has lost over 40% of its value since 1999, but exports have risen sluggishly. Part of this is due to low prices for Brazil’s exports, which are mainly agricultural and industrial commodities, plus protectionism in the country’s main export markets in the European Union and the United States. This has not prevented Brazil from lowering its once formidable trade barriers, which has produced considerable productivity gains (see Business, Sticking to Theri Guns). However, the fight for free trade has not been easy. Brasília had to confront powerful business lobbies, spearheaded by Fiesp, the federation of São Paulo industries. The business community will probably mount a spirited campaign against plans to join a Free Trade Area of the Americas. Horácio Lafer Piva, president of Fiesp, says, “For some sectors that are not ready, FTAA will be absolutely fatal. There is an absolute necessity to resolve the asymmetries in infrastructure and taxation between Brazil and developed countries. Without doing that you can’t even start playing the game.”
Fiesp should be able to count on a sympathetic hearing by the next government, since all three leading candidates are suspicious of free trade. Bolívar Lamounier, one of Brazil’s most respected political analysts, says, “There is a strong consensus in the country that a very aggressive, accelerated opening would weaken everyone. People always say that the examples of successful liberalization in Chile, South Korea or Mexico don’t apply here.”
Trade liberalization, fiscal austerity and tax reform are important in their own right but it is unlikely that these policies alone can deliver sustained growth rates. Only an unrelenting effort to stabilize the public finances is likely to make that possible. A debt default or restructuring could have disastrous consequences. Politicians rail against the central bank for its tight money policies and stiflingly high interest rates, and accuse Cardoso of running up massive debts. Yet they are unwilling to support a more responsible fiscal policy that would cut debt and allow interest rates to decline naturally without allowing a burst in inflation.
The next government would do well do heed the advice of the current central bank president, Armínio Fraga. He believes that if only Brazil could make the transition to a new government without a serious mishap, a “substantial drop in country risk will become possible with benefits for the nation that would begin to be felt immediately. We need to reinforce even more the commitment to preservation of fundamental [policies] like monetary and fiscal responsibility. These concepts are not ideological or party-based, but form the necessary basis to carry out a development project for the country.” He is right, but that does not make continued reform any easier or less controversial.