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Brazil President Dilma Rousseff in New York last week. (Photo: Roberto Stuckert Filho/PR)
Wednesday, July 22, 2015

Brazil: A Failed Adjustment?

The seeds for Brazil’s crisis are home-made, driven by growing state interference in the economy.


For Brazil, 2015 will be a bad year. Will it be a wasted year as well? After the vortex of the Lula presidential administrations (2003-2010), the mismanagement of President Dilma Rousseff’s first administration (2011-2014) and the ruinous consequences of her reelection victory—now questioned in colossal popular protests and seen in the abysmal drop of her approval ratings—the answer goes beyond the short-run macro adjustment, although that in itself is a major challenge. There are two other dimensions, governance and longer-term growth.

The problem of governance is most palpable in the succession of scandals— most notably at Petrobrás—the nerve center of the government's investment program. Its rapid decline is therefore a threat to overall investment, which in 2014 dropped 4.3 percent yoy (year on year) and will drop further in 2015, possibly by as much as 7-8 percent yoy. Corruption, however, is only a manifestation of deeper problems of political governance. Brazil lives with an unwieldy and dysfunctional political system, with the challenge of taming populism in a mass democracy, and with the legacy of its military regime (1964-1984)and the creation of the 1988 Constitution created in its aftermath.

Brazil today has institutions that are incompatible with the government's capacity to fund itself. The government taxes close to 40 percent of GDP; spends directly 46 percent of GDP and indirectly, an additional 12-15 percent of GDP, mainly through directed credits. Yet, to keep its model of political clientilism operational, the government cannot cut back. On the contrary, to be successful it always needs to spend more.

Its institutions are also incompatible with the demands of "the new middle class," which justifiably wants to hold on to its recent gains but likely will be the first to lose them as other, more entrenched political players, the myriad of corporate groups including worker and employers unions, the civil service bureaucracy, and the existing beneficiaries of the social security legislation, and the like, are better able to protect their share of the shrinking pie.

The other dimension of adjustment, the third together with short-run macro and political governance, concerns the longer-run economic prospect. Brazil's prosperity from 2004 to 2010 was a mirage. It was the product of a large transfer of external resources through favorable terms of trade linked to China's takeoff into rapid growth—"the commodity cycle"—and, in 2009, after the "Lehman Moment" at the onset of the global financial crisis, of China's unprecedented fiscal and credit stimulus. Brazil’s growth in 2004-2010 was also propelled by corporate external borrowing to take advantage of low global interest rates. Throughout this period, and especially after 2008, Brazil’s economy was increasingly guided by state interventions and public spending. The public debt increased from 56 percent of GDP in August 2008 to 66 percent in December 2014, and corporate external debt increased even faster during the period by $105.8 billion. And yet, in Dilma's first term, GDP growth averaged 2.2 percent per annum (pa) and, even worse, productivity in industry averaged a paltry 1.9 percent pa. The model of state-led growth was spent.


What will 2015 look like? Most likely GDP will contract between 1-2 percent yoy, inflation will shoot up to 8-10 percent yoy, the external current account balance will remain heavily in deficit to the tune of $70-75 billion (about 4 percent of GDP), the fiscal accounts will show a deficit of 5- 6 percent of GDP (in part because the government interest bill will exceed 7 percent of GDP) and the public debt will increase to about 70 percent GDP. In short, it will be a disaster.

Will 2016 be better? Yes, but likely not by much; most probably growth will be null to still negative, inflation will continue to exceed the midpoint of the target (4.5 percent) and the public debt will continue to grow on the back of another deficit of 4-5 percent GDP.

The reality is that the adjustment will take time. What was built in terms of misguided tax concessions, reckless and useless expansion of social services, irresponsible price controls on electricity suppliers, political manipulation of regulatory agencies and other policies will all have to be dismantled, which will take time.

This is a homemade crisis. Its seeds were planted in Lula's second term, when, after the “Mensalão” scandal in 2005, he re-aligned his government with the union leadership and the pro-statist factions within the Partido dos Trabalhadores (PT), after Finance Minister Antonio Palocci resigned and was replaced by Guido Mantega. The structure of heavy-handed interventionism took off in 2009-10, in theory as an "anti-cyclical" response to the global crisis, but in practice, as part of the political campaign to elect Dilma. It consolidated in Dilma's first administration and took particular shape with the introduction of the "New Economic Matrix" toward the end of 2011. The matrix involved a closing down of the economy to foreign competition through the enactment of "national content" rules, the systematic deployment of public banks for policy objectives, subsidies to targeted industries and the selection of "national champions" at the firm level to receive special dispensations and tailor-made fiscal aid, and a megalomaniacal public investment program to be implemented by state enterprises and financed by the private sector without an overall economic logic or rationale and, in many cases, without a clear social purpose and lacking any measure of benefits and costs.

The administration gave up on fiscal discipline and on the inflation target. The outcome was uncertainty, loss of confidence, a precipitous drop in investment and a loss of savings without gains in productivity. Except for a rapid growth in subsidized public programs (the legacy of which will show in future quasi-fiscal costs) the investment program never took off. The commodity boom was wasted on consumption, not investment. When the boom was gone, consumption continued, financed by borrowing abroad.

In contrast to what happened in the United States, where consumer imports forced producers out of business, in Brazil the producers themselves organized to retain market share by importing intermediate and finished goods, not risking new ventures at home but maintaining distribution chains and oligopolistic footholds over protected markets. Consumption and government spending sustained employment, also already unbalanced social security system). In short, this was a calamity that got worse in 2014. The fiscal deficit increased to 6.7 percent of GDP, with the emergence of a primary deficit for the first time since 1997. The current account deficit ballooned to 7.1 percent of GDP, with financing concentrated on short-run portfolio flows. Inflation shot up to 6.4 percent despite price controls that, among other things, destroyed Petrobrás' profitability and led to the crisis in the electricity sector.


What to do? After some hesitation, the reelected Dilma opted for the inevitable: an orthodox fiscal consolidation. The hallmark of this unexpected U-turn was the appointment of Joaquim Levy as finance minister. Levy came with irreproachable credentials: a PhD from the University of Chicago, early work at the International Monetary Fund and increasingly visible and successful performances in the civil service as the chief economist at the Ministry of Planning and Budget, secretary of the treasury and secretary of finance of the State of Rio de Janeiro—each stint under a different administration from a different political party. However, Minister Levy’s goal of producing the target of 1.2 percent of GDP in the primary (non-interest) surplus for 2015, a 2 percentage-point turnaround from the primary deficit in 2014, will demand much more than the political system will tolerate. Because the recession will push down real revenue, the government will deliver less and the task for 2016 will be even larger. Most likely, the primary surplus this year will be 0.7-0.8 percent GDP—and GDP will plummet. In the new GDP methodology, growth was slightly positive in 2014. Even so, there were negative growth rates in the last three quarters of the year, which technically is a recession. The outlook is for at least another three quarters in recession. If there is a turnaround it will come only in the fourth quarter of 2015, with a slow recovery in 2016. In this scenario, the adjustment cannot be restricted to eliminating tax concessions and increasing taxes. It must include cuts in expenditure beyond what would be needed to counteract additional spending on the automatic stabilizers (e.g., increased outlays for unemployment insurance, expenditure on the safety net and social security). For this, congressional support will be critical.

Minister Levy's first six months in office have been impressive. He has shown rare skill in crossing the landmines created by the unusual political landscape: A debilitated, distant president seeking distance from her party; a resurgent yet always unruly congress reluctantly yielding the limelight to the heads of the lower and upper Houses; the three poles intermediated by the unlikely vice president, who shares the party affiliation of the heads of congress (PMDB), but not their sympathies; the three men engulfed by the reigning political scandal seeking the demise of the PT, and the leadership of the now-dominant political center, the PMDB. In the midst of opposition from the PT and silence from the president, Levy pushed through the fiscal adjustment. His proposals have been diluted, but on his credentials and promises rest the hesitancy of the downgrade from the rating agencies. He will not deliver the full-fiscal adjustment, but, perhaps more importantly, he may deliver the turnaround in economic policy. This, together with Petrobrás' capacity to limp along and seek support from the Chinese (who else?), increased foreign confidence enough to attract portfolio flows and keep the balance of payments funded. Critically, Levy is buying time for Brazil; the crisis is avoided on a vote of confidence. The question remains, however, of whether the political will can endure through at least 2016 to deliver the requisite adjustment, not only the promise of one.


If Brazil's problem today is economic, the obstacles are mainly political. Since the election, Dilma has seen her support wane in the polls and in the streets. She also has lost her support in congress. Dilma was elected with an impressive congressional majority, the product of a coalition far stronger in terms of numbers than her margin in

the presidential election. The PMDB, Brazil's major party and part of her coalition, continued to hold the largest plurality in both houses. Threatened by its dominance following the elections and even before launching her new fiscal program, the president attempted to usurp the PMDB’s leadership by forging new congressional alliances. The attempt failed. As a result, Dilma lost, and has not regained, control over the political agenda in congress. An emboldened PMDB proceeded to elect leaders in each house who, while ostensibly not in the opposition, are clearly at a standoff with the president.

As a result, congress has handed Dilma humiliating defeats, including in legislation required for the fiscal adjustment.

Something will have to give. The power game, however, is made more complicated by:

· The repercussions of the Petrobrás scandal, involving several members of congress, including the two new leaders, under investigation.

· Discussions about a political reform bill that has languished in congressional commissions for the past 12 years and has now been made urgent by the scandals.

· At the root of the scandals are the ways of financing political campaigns. The parties themselves have practically no autonomous sources of funding, except for the paltry sums provided by public funding. They must obtain private money to finance expensive "American-style" campaigns from a private sector that is unwilling to finance them unless otherwise "compensated."

· Dissent within the PT, the president's own party: The president and her chief-of- staff, a potential candidate in the 2018 presidential race, are not part of the majority group led by Lula, who is also potentially a pre-candidate for the 2018 election.

· The political ambitions of the new leader of the Chamber of Deputies, Eduardo Cunha. Since 1985, the PMDB has been the indispensable ally for a succession of Brazilian presidents, gaining ministerial appointments and dominant influence in exchange for accepting a secondary role, at most the position of vice president. The new leader, however, is angling for the presidency in 2018. His aim is to change the party's role from that of a "party of the government" to a party that supports the administration on occasional, programmatic issues. This may include the fiscal adjustment, which the party supports, but only if the political onus of the adjustment falls squarely on the president and her party (the PT) as the "party of the government."

At present, congress holds more power than it has had at any point since the impeachment of President Collor de Mello in 1992, shortly after the return of democratic rule. This is an unusual situation for a political system that is based on a strong presidency with enormous power over the disposition of public money. How congress will use this power is uncertain. It will not derail the fiscal adjustment, but it will not make it easier.

Moreover, beyond today's political urgencies are unresolved issues of political representation. How can the system and its governance change to make both compatible with a well-functioning private economy that supports, and is regulated by, the public sector, but is not ruled by it. Key political institutions are outdated. Consider the structure of labor laws imported from Fascist Italy in the 1930s and enacted into law in 1943. At the time, these laws served the role of regimenting/co-opting a nascent urban industrial working class, a minority group gaining limited political access in an oligarchic society dominated by rural elites. What the state then granted in the form of support was a pittance. The size and influence of the targeted population was small, if not miniscule. Fast-forward 70 years and the kinds of rights and benefits of that minority make little sense in a predominantly urban, educated labor market of nearly 40 million workers. Nevertheless, the law has not changed. The separate, duplicate, legal systems for labor and civil laws prevail. What is worse, the political system has been incapable of organizing a constructive debate on how to change the situation. The few changes that were accomplished (for example, limiting some of the excesses of the social security legislation) were the product of crises and disruptions. The Constitution of 1988, while advancing greatly in matters related to democratic representation, failed to constrict the role and scope of the government. On the contrary, it created new constitutional rights that, while desirable as objectives, show little regard as to how they might be obtained, thereby creating a situation rife for political rent-seeking, clientilism and populism.

Of course, this problem is not uniquely Brazilian. A more dramatic example may be what is happening in Greece today as it struggles to make its institutions operable in the context of the euro zone. However, the example of Greece is also a warning: not all societies evolve into growing, competitive and innovative economies. Brazil may be one of them if it does not change.


After an initial burst of significant microeconomic reforms during Lula's first term in government, the last two PT administrations, misdiagnosing the external commodity boom for a new source of home-grown growth, attempted to create a peculiar and distorted "virtuous circle": a high-wage and high-employment economy with little competition from abroad (or even domestically), focused on the production of so-called "wage goods" and correlated domestic-made capital goods, mainly in the energy subsector. The goal was to create a form of state capitalism operating through the private sector and with a bias towards "the new middle class."

What was created in reality was an economy with an ever-expanding state engaged in multiple transfer programs, with pervasive state interference in investment decisions and in price-setting mechanisms, without actively redistributing income except through minimum wage and other labor-related legislation, and without structural changes in taxation, government programs or interference with property rights.

The model ultimately failed. It could not be sustained without the massive international transfer of resources associated with the commodity boom. Instead of creating a "new platform with local content industries," it induced a boom of imported consumer goods complemented by inefficient producers of capital goods. Luckily, the backbone of efficient and competitive agribusiness exporters survived and prospered.

Policies to induce higher wages without corresponding gains in productivity, and to subsidize lending for capital investment through the state banks, led to capital deepening in the more competitive sectors (mainly, agribusiness) and to shrinking profit margins—hence, investment—elsewhere. Potential GDP decreased, to the point that it is now below 2 percent pa or less.

Low potential GDP, coupled with below-potential outcomes, are huge hurdles for the just-launched program of macroeconomic (mainly fiscal) adjustment.  Without growth, job losses during the adjustment are larger. Indeed, everything is more difficult. Presently, to get growth back, macro adjustment is not enough—though it is, as always, indispensable. The year 2015 is not 2003. Then, absent the external constraints and mistrust of the new administration, ample excess capacity, a return of confidence and a buildup in latent domestic demand sufficed to trigger a robust supply response, soon turned exuberant thanks to the added external impulse.

Of essence today is confidence with a correlating reduction in political and economic uncertainty. The surest way to achieve this is through the agenda of structural change. Because Brazil is not a leader in technology, it is unrealistic to think that an endogenous burst in innovation will open the road to new investments as occurred with the IT revolution in the United States in the mid-1990s. In Brazil, the private sector alone cannot do it. There is a critical role for public policy that galvanizes public-private partnerships and draws in new, more productive, private investment. Many things could be done: certainly changes in the structure of taxation, in the above-mentioned labor regime and, generally, in reducing the so-called "Brazil cost." Yet perhaps, in such a complex polity, the feasible way would be to set the course around a central theme. If there is one such central theme today, it surely would be openness (much as, at the start of Lula's first administration, it was the need to eradicate poverty). What is needed is openness to foreign and domestic competition; a gradual breakdown of the many barriers and associated privileges granted by the state that thousands of groups have cultivated from oligopolistic producers and distributors hiding behind national-content rules and barriers to domestic trade; to students with access to free public universities (regardless of family income) and half-fares in public transit; to retirees with their half-price tickets to movie houses.

The future lies in finding ways to increase efficiency, and the woefully low productivity of labor. Overall investment is low, but its efficiency is even lower, mainly because of the "way things are combined and put together" and "the environment supporting investment and output" are not right. In other words, total factor productivity is low. Recent studies have shown that the productivity of a Brazilian worker is 20 percent that of a U.S. worker, and 50-70 percent of that difference is explained by lower total factor productivity, not the lower level of capital per output.  This must and can change, but only if the necessary macro adjustment is complemented by deep microeconomic reforms.

Paulo Vieira da Cunha is partner and head of research at ICE Canyon LLC in New York City, where he specializes in macroeconomic analysis of emerging markets. He is currently a director of the Brazilian-American Chamber of Commerce. Previously, Vieira da Cunha was a partner at Tandem Global Partners and deputy governor of the Central Bank of Brazil. For nearly a decade he managed and produced research for the global securities industry, first at Lehman Brothers and later at HSBC Securities.

This column is an excerpt from the Perspectives on the Americas series from the University of Miami’s Center for Hemispheric Policy. Republished with permission.: Perspectives

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