Lower Interest Rates Won’t Be Enough for Brazil. But It’s a Start.

The Brazilian president needs to improve the current economic policy.  The people deserve a robust economy that diminishes unemployment while controlling inflation.  It is undeniable, however, that the economy improved in 2004. 

Economic growth was above 5 percent, pushing down the unemployment rate in late 2004, to below 11 percent.  In 2004, bankruptcies fell 22.5 percent and inflation fell to 7.6 percent within the 2.5 percent spread of the targeted inflation rate set at 5.5 percent. 

Also, the trade balance registered a record US$ 33 billion surplus with exports earning over US$ 94 billion, stimulated mostly by a devalued real.  On the fiscal side, the government budget deficit fell to 2.5 percent of the GDP, from nearly 4.5 percent in 2003. 

In 2004, federal revenue grew 10.6 percent compared to 2003, coming in at a record 333 billion reais (US$ 123 billion) after adjusting for inflation.  Even while considering these economic improvements in 2004 many expect a weaker economy in 2005. 

The failure to adjust the current interest rate policy is inhibiting further economic improvements.  Interest rates fell throughout most of 2004, but they are still amongst the highest in the world. 

Today, real interest rates, which discounts for inflation, stands at 11.77 percent.  The effect of this policy has worsened Brazil’s long-term economic outlook. 

The exuberant levels of interest rates have forced the government deeper into debt while reducing spending in an already depleted budget in order to find the funds to maintain the interest payments. 

In 2004, the government paid 120 billion reais (US$ 44 billion).  This is in light of a record primary surplus of 4.25 percent of the GDP that excludes interest payments. 

In fact, after a small bout of economic turbulence in 2004, the government quickly adjusted the primary surplus to a record 4.50 percent of the GDP, hoping that such a move would quell inflation and not force up interest rates. 

This policy failed.  Interest rates have gone up since October.  Throughout 2004, the federal internal debt increased by 80 billion reais (US$ 29 billion), an 11 percent increase over 2003. 

Today, this federal debt stands at more than 834 billion reais (US$ 308 billion).  This calculation of debt does not include the high levels of external debt or the debt owed by states or municipalities. 

Over 50 percent of the current federal debt is directly correlated to domestic interest rates.  The fiscal condition of the government continues to worsen even in contrast to record levels of revenue obtained by the government.

The government should still maintain a primary surplus but at a lower level, around 3 percent of the GDP.  The current hike in interest rates will dampen economic growth in early 2005. 

Lula has realized that if the economy weakens too much this year, and does not grow vigorously in 2005, it will undermine his strong re-election bid in 2006.    

But most people in Brazil support changes to the current interest rate policy to strength the long-term economic outlook of the economy.     

Both, Gustavo Loyola, the ex-president of the central bank during the Cardoso administration and Luiz Carlos Mendonça de Barros, former Communication Minister under president Cardoso, support changes to current interest rate policy. 

Both men propose extending the current available 12 month time period that the central bank has to meet the targeted inflation rate.  Mr. Loyola believes the central bank should be given 18 months to meet its inflation target while Mr. Barros supports a 24-month timetable. 

Either plan would be a considerable improvement from the current policy that increases interest rates due to cyclical government controlled prices. 

The Central Bank committee (Copom), which decides interest rates, could meet every two months instead of meeting every month as it does now.  This would give it more time to assess the trajectory of inflation.

The President could restructure the composition of the central bank directors who make up the Copom committee.  The central bank, the finance and planning ministry could also set less ambitious inflation targets.  Brasí­lia should debate the success of trying to bring inflation below 5 or 4 percent. 

In Rudi Dornbush’s, Keys to Prosperity, the author cites Chile’s economic progress as a roadmap for developing nations.  Over the past ten years, Chile’s average inflation rate was 17 percent. 

In the early 1990s, yearly inflation was 30 percent.  Recently, the government’s slow but steady work on reducing inflation has brought yearly inflation to less than 7 percent. 

Mr. Dornbush lauded the Chilean policy that refuses to set inflation rates below 2 percent, commonly done in developed countries, while pursuing low interest rate that induces economic growth (53). 

Dornbush refers to how the Mexican economy before the 1994 crisis attempted to push inflation below 2 percent.  The effect of this policy was a massive appreciation of its currency that eventually led to the “Tequila Crisis” in 1994. 

In late 2004, the government moved towards adjusting its inflation rate slightly.  Many expected that the inflation target for 2005 would be set at 4.5 percent.  In late September 2004, the targeted inflation rate moved to 5.1 percent. 

It might also be prudent if the central bank paid a little more attention to the core inflation figures instead of the more volatile inflation data mostly due to government adjusted prices.  Many in Brazil are scared that changing the inflation system will cause unforeseen economic instability.   

The market does not fear a more flexible inflation targeting system.  The market panics when there is uncertainty.  Also, high economic growth makes a country a more attractive place to invest. 

But if the market decides to pull capital out of Brazil, in a pursuit of more profits under fictitious fears, the government must study the idea of temporary capital controls. 

Chile, for example, required that foreign investment deposit 20 percent of their investment in an account for one year without interest.  In fact both Chile and Singapore used capital controls before they signed a free trade agreement with the United States. 

China, India and Malaysia, have all used some form of capital control to maintain economic stability.  But the use of capital controls must be accompanied by other economic measures such as a fixed currency, set at possibly 3.5 reais per dollar, and the regulation of its currency market away from foreign speculators. 

If done correctly, interest rates could fall without causing a devaluation of the currency, avoiding any inflationary effects to the economy.  Also, a fixed currency regime attracts more long-term investment by guaranteeing investors the value of the currency, helping them better judge how much money is needed to make a return on investment. 

Capital controls could be messy in Brazil but the need to protect the economy from exuberant capital flight that forces the interest rates and inflation higher, killing any chance of sustained economic growth must end. 

For now, investors are not leaving Brazil because of the attraction to very high domestic interest rates, but how will the market react when the debt/GDP ratio worsens if the economy slows? 

Will it demand a larger primary surplus than the targeted 4.25 percent of the GDP?  Can Lula ask his allies in Congress to reduce spending to pay more on Brazil’s interest payments near a presidential election?                       

Clearly, lower interest rates alone will not save the Brazilian economy.  Reforming the regressive tax system is quintessential and the need to reduce the powerful bureaucracy seems to be a future government priority. 

Lula still needs to take charge in changing the current interest rate policy.  There is evidence that lower interest rate increases economic growth, but even if it did not, the large fiscal benefits to federal government make it almost a necessity. 

Brazil’s once rapidly growing economy cannot sustain unjust interest rates that this month moved back up to 18.25 percent. 

It is interesting to note that the currency has rapidly appreciated without a slow down in inflation.  There is also fear among some in the Lula administration that any adjustments to the inflation targeting system could cause the return of hyperinflation. 

Let us not forget that similar fears were invoked by the previous administration when there were widespread calls to devaluate the pegged currency in 1997 and 1998. 

Even, former President Cardoso accepts that he waited too long to devalue the pegged currency.  The economic policies that direct the Brazilian economy cannot be based on fear but on hope that all can benefit from economic growth generated by low interest rates.

Daniel Torres is a political science and economic major at the University of Massachusetts.  He can be contacted by email at dftorres@gmail.com.


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