Underpinned by a strong political consensus, the main thrust of economic policy will remain unchanged under the new president. A modest and hence manageable erosion of the macroeconomic policy framework, which started under Lula II, looks set to continue. Thanks to much improved fundamentals and the availability of greater “macroeconomic” space, this won’t jeopardise financial stability or undermine economic growth during the next four years. It will however limit Brazil’s upside growth potential and complicate economic policy management in the context of continued strong capital inflows.
The Dilma government will, by and large, bring policy continuity. The incoming government has little incentive to change the basic direction of economic policy. The political consensus in favour of economic stability, especially low inflation (benefitting the poorer social groups) and fair, if not stellar, economic growth (benefitting everybody, including the government, which has more money to spend) is strong. While this will prevent the government from pushing up economic growth at the expense of higher inflation, it will also limit the government’s appetite for big-ticket, growth-enhancing structural reform – especially given the trade-off between the short-term political costs of reform and their medium-term economic benefits.
The new government will not make fundamental changes to the basic economic policy framework that has served Brazil well over the past eight years. However, it will likely take a less purist approach to adhering to the framework, including quantitative targets. First, the government will remain committed to a sufficiently large (recently revised) primary surplus target of 3.1% of GDP. However, repeated accounting changes have reduced fiscal transparency and opened the government to criticism that it seeks to obfuscate the underlying deterioration in fiscal performance.
Quasi-fiscal spending in the guise of lending by public sector banks and investment by state-owned companies will also continue, albeit at a lesser pace. To be fair, the government remains committed to reducing net public debt to 30% of GDP by 2014 from just over 40% at present and it has re-affirmed the need to restrain expenditure. (It would be desirable to reduce gross debt equally aggressively.) However, no specific proposals have been put forward so far in terms of reining in current expenditure and the significant amounts of investment required in the run-up to the 2014 World Cup and the 2016 Olympics will make it difficult to reduce investment expenditure.
Second, in terms of monetary policy, the authorities seem to have adopted a less hawkish stance. Market expectations are currently for an inflation rate of 5.2% in 2010 and 5.7% in 2011, way above the 4.5% mid-point of the 2.5-6.5% target range. A medium-term inflation rate of, for example, 5.0-5.5% rather than 4.5% would not destroy the central bank’s hard-won credibility but it does carry the risk of undermining it somewhat. While reaffirming the central bank’s independence, the government announced its desire to overhaul the IPCA inflation index. Rightly or wrongly, this has left the market with the impression that the government may be trying to influence monetary policy through the backdoor. Similar to fiscal policy, an erosion of the monetary policy regime at the margin might prevent a faster decline of real interest rates via a reduction of inflation volatility and an anchoring of inflation expectations.
Third, the government continues to adhere to a “dirty float”. But this float has recently become “dirtier”. The central bank’s intervention policy is quite asymmetric: it intervenes when the currency is under appreciation pressure, but it acts much less forcefully when the currency is under depreciation pressure. This is not necessarily unreasonable but does suggest that the authorities seek to limit currency appreciation or, to put it more politely, prevent “excess volatility” and overshooting, especially since the level of precautionary FX reserves is above levels generally considered safe.
Recent changes providing the Treasury with greater flexibility to purchase foreign currency and aiming to make the sovereign wealth fund fully operational in terms of FX intervention point in the same direction. Combined with the re-introduction and subsequent incremental tightening of capital controls, Brazil is moving towards a more controlled and less freely floating exchange rate regime. One may legitimately disagree about the desirability of these moves. The fact remains that the policy regime is being modified, or eroded, if one happen to be critical of these changes.
Taking advantage of a greater monetary and fiscal space, the Dilma government is likely to adhere less strictly to the “letter” or, at least, the “spirit” of the monetary and fiscal targets and take a more “controlling” approach to exchange rate policy. In this sense, the Dilma government represents the continuation of the Lula II government, as opposed to the much more “orthodox” Lula I government. None of this will prevent economic growth from averaging 4-5% over the next few years. However, the more “flexible” fiscal stance and, specifically, the continued expansion in current spending, will be contributing to a sub-optimal policy mix by keeping interest rates at elevated levels. This policy is not only preventing a (faster) rise in domestic savings, investment and growth. By preventing interest rates from declining, it is also decidedly unhelpful in dealing with ample global liquidity, rapidly rising capital inflows and the – from the government’s point of view – economically “nefarious” consequences of currency appreciation.
Concerns about a marginal erosion of the policy regime notwithstanding, Brazil does carry an investment grade rating, enjoys solid external fundamentals and significantly greater room for manouevre (or slippage, if you happen to a critic) than in the past. Greater discipline and a stricter interpretation of economic policy targets would nonetheless help to address rising concerns about a potential drift in Brazilian economic policy.