Could Brazil become a model for poorly managed Latin American economies? (2009)

Brazil’s transformation from economic problem child to poster child is remarkable. The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed.

Brazil’s transformation from economic problem child to poster child is remarkable. After averaging a mere 2.5% in the decade before 2003, annual real GDP growth picked up to 4.7% during 2003-08. Given global headwinds, it is doubtful that Brazil will continue to grow at this pace, but growth of around 4% over the next decade is achievable. After experiencing repeated crises throughout the 1980s and 1990s and as recently as 2002, Brazil’s economic and financial resilience is today almost second-to-none. Following Fitch and S&P, Moody’s is about to award Brazil an investment grade rating. True, the economy is forecast to contract slightly this year. But not only do the fundamentals remain strong, the economic contraction is also much less pronounced than in many other emerging and developed(!) economies and a return to sustained growth is just around the corner.

Brazil has come a very long way. In a previous comment, we attributed Brazil’s resilience and quick rebound to the reduction in foreign-currency mismatches, increased FX reserves and a disciplined fiscal policy. We perhaps should have added to the list the resilience of the banking system, the de facto independence of the central bank and a strong and credible commitment to economic stability. However, it is also a well-known fact that economic policies in the run-up to the crisis were far from optimal. It would undoubtedly have been preferable to contain the increase in current government spending, fuelled by buoyant tax revenues. This would have supported a more rapid decline in government debt and interest rates, thus allowing for a greater increase in private sector investment and faster economic growth. This might have helped to contain (if not avoid) the overheating pressures that emerged in 2004 and 2007 (and the subsequent monetary tightening in 2005 and 2008). Such a policy would also have given the authorities greater scope to pursue counter-cyclical fiscal policies today.

It is no secret either that the Lula I/ II administrations have been far less successful on the structural reform front. A limited public sector pension reform at the very beginning of Lula I has been the most eye-catching reform thus far, although several smaller reforms have been passed. The list of desirable structural reforms remains very long, including further pension reform, labour reform, central bank autonomy, tax reform, education etc. With the president’s second mandate drawing to a close, it is very unlikely that anything major will be achieved before the next president takes office in 2011.

Source: IMF

Why did macroeconomic reform take place, while microeconomic reform did not (or barely)? The answer to this question is multifaceted. First, the government has much more control over fiscal and monetary policy than over structural reform. Structural reform requires support from a great number of political “veto players”, including, most crucially in Brazil, a fragmented and difficult-to-control congress. Second, the political cost-benefit analysis made macroeconomic discipline much more enticing and rewarding than microeconomic reform. Tight macroeconomic policies cause short-term costs (economic growth) but also generate both short-term and medium-term benefits (increasing real incomes, especially among the poor, and greater economic stability). By contrast, microeconomic reforms cause a fair amount of short-term political costs and consume political capital (antagonizing well-organised, entrenched interests, typically forcing the government to compensate these groups in other ways), while the economic and political dividends are generally only reaped several years down the line (higher medium-term growth). From an electoral point of view, this is not particularly attractive. Finally, the political capital a government has to spend to adjust macroeconomic policy is far less than what it needs to spend to get structural reforms approved by congress due to its greater degree of control over macroeconomic policy instruments.

Critics will argue that the Lula administration simply got lucky, benefitting from a very favourable global backdrop. But this is a little ungenerous. Lula I/ II did raise and maintain large primary surpluses even at a time (after 2004-05) when lower surpluses would not have undermined debt sustainability. The administration also upheld the de facto autonomy of the central bank against at times harsh criticism of its tight monetary policy. The political calculus underpinning these decisions was straightforward and did pay off, leading Lula to be re-elected in 2006. The president’s approval ratings have surged since the onset of the crisis and were the president allowed to run for a third term, he would probably win hands-down.

The Lula administration’s key strategic insight was that lowering inflation and increasing economic stability, albeit at the expense of lower short-term economic growth, can be politically and electorally rewarding, as it raises the real incomes of the poor and satisfies the demands of the urban middle class for an end to near-permanent economic instability. What in 2003 may have looked like an emergency response to contain the financial crisis and avert a sovereign default has not only transmuted into a long-term policy; it has actually become the cornerstone of Brazilian economic policy and the main reason why Brazil is weathering the global crisis relatively unscathed. Is there any reason why this formula could not become a winning formula for political leaders in the currently poorly managed Latin American countries?

Responding to the crisis: Did Brazil and China miss an opportunity? (2009)

The major emerging markets have made use of their increased policy autonomy and implemented expansionary macroeconomic policies. Not only have they been able to support economic growth by letting automatic stabilizers absorb part of the growth shock. They have also managed to stimulate domestic demand through a mix of expansionary monetary, credit and fiscal measures. In fact, the IMF estimates that measured as a share of GDP the emerging G-20 countries introduced a larger discretionary fiscal stimulus than the advanced G-20 members.

Brazil and China make for an interesting comparison n in this respect. The authorities in both countries eased monetary policy and pushed bank lending to the private sector. But while both countries introduced expansionary fiscal measures, the nature of these measures differs sharply. The Chinese measures focus on raising public investment in infrastructure, while the Brazilian measures are more heavily focused on encouraging consumption. The Chinese measures tend to be temporary in nature, while some of the Brazilian measures may turn out to be more permanent. From a short-term crisis-management point of view, the measures seem to be working in terms of buffering the downturn and contributing to a speedy economic recovery. However, from a medium-term economic perspective, Brazil should have adopted the measures China has adopted – and vice versa. Brazil should have increased public investment, while China should have boosted domestic consumption.

China “suffers” from an excess savings ratio amounting to more than 50% of GDP. With investment running at more than 40% of GDP, this resulted in mind-boggling current account surpluses of 10-11% of GDP in 2007-08. Such large external surpluses are unprecedented for a country of China’s size. They are politically unsustainable and, from a welfare point of view, they are not in the interest of a relatively poor country like China. Why forego domestic consumption and finance consumption in wealthier countries in return for financial assets of potentially uncertain future value? As far as fiscal policy is concerned, China has two options to address this issue: it can raise domestic investment or it can reduce savings (raise consumption).

While some would argue that raising public investment further will lead to an inefficient allocation of capital, overcapacity and maybe even an investment bust, others would point out that, although Chinese investment is already massive, there still exist sufficiently profitable investment opportunities (esp. infrastructure in the less developed interior). However, the drawback of increased public investment spending is that it will absorb “excess” savings only temporarily. Furthermore, raising public investment by several percentage of GDP may be fraught with risks (e.g. quality of investment). A permanent increase in public or private consumption, on the other hand, would appear desirable in terms of rebalancing the economy from a potentially wasteful investment-intensive growth pattern to a more stable consumption-led pattern.

Low public debt, a modest fiscal deficit, large public savings and strong medium-term growth provide the Chinese authorities with considerable scope to finance measures aimed at raising domestic consumption. This is much less the case for Brazil, where a more onerous debt burden, substantial long-term expenditure commitments and a much lower growth rate limit the scope for permanent consumption-increasing fiscal measures. This difference also explains why China’s discretionary measures will amount to a massive 5.8% of GDP versus a mere 1.2% of GDP in Brazil during 2009-10, according to the IMF. The Chinese government can afford to boost consumption by permanently expanding, for example, health, pension and education outlays. This would help reduce public-sector savings and it might help reduce precautionary household savings, raising both private and public consumption.

The government can also address the “excess” savings of the corporate sector by taxing it more heavily. This would both reduce savings in the corporate sector and allow the government to finance further consumption measures. China thus missed an opportunity to shift towards a more balanced growth mix. That being said, if one believes that China’s capital stock remains relatively small, that there exists a sufficient number of profitable investment opportunities and that the government is competent enough to identify and implement these projects, an increase in infrastructure investment does not look like such a bad idea. Nonetheless, the fact remains that over the longer run the present investment-led growth pattern is unsustainable, economically and politically. While China may save too much, Brazil saves too little. China may or may not invest too much, but Brazil certainly invests too little. Over the past decade and a half, Brazilian domestic investment averaged a mere 17.5% of GDP, compared with China’s 40%. Savings were even lower, averaging less than 16% of GDP, compared with China’s 44%.

This largely explains why China grew at an average rate of 10% per year, while Brazil grew at a mere 3.3%. Brazil’s fiscal stimulus should therefore have focused on raising investment, not consumption. The level of (government) consumption is already high and is one of the main causes of high interest rates and low domestic investment. Brazil’s public debt position is also much less sound than China’s, making (temporary) investment measures preferable to potentially more permanent consumption measures. To be sure, not all the fiscal stimulus consists of consumption-based measures, let alone permanent ones. However, further consumption-supporting measures, including minimum wage adjustments, will be introduced later this year, and let’s not forget that 2010 is an election year! Over the longer term, Brazil will have to raise its savings and investment ratios if growth is to meet the government’s informal growth target of 5%.

So why did Brazil and China do the opposite of what would have been preferable from a medium-term perspective? Here are some hypotheses. Brazil faces greater bureaucratic obstacles to boosting public investment, so boosting consumption is a more effective way to support domestic demand in the short term. By contrast, China faces much fewer bureaucratic obstacles and has greater experience with public investment projects, so increasing public investment (by mainly front-loading or bringing forward projects already in the pipeline) seems a more optimal policy choice. Brazilian households also have a greater propensity to consume than Chinese households, so revenue measures targeting private consumption are likely to be more effective in Brazil than in China. But be that as it may ….. from a longer-term perspective both Brazil and China missed an opportunity to shift towards a more sustainable and more balanced growth mix, consisting of greater investment in Brazil and greater consumption in China.