Brazilian economic growth has been disappointing of late. At the end of Lula II, the seven-year real GDP growth had crept up to 4%. By 2015, seven-year growth will have declined to its multi-decade average of 2.6%. Put differently, under Lula I and II (2003-10), real GDP growth averaged 4%, significantly higher than the 2.3% registered under Cardoso I and II (1995-2002). (This does not mean that the Lula governments can take all the credit. After all, it was the Cardoso reforms that laid the foundation for subsequent accelerated economic growth, helped by rising commodity prices and moderate-to-low global interest rates.)
If current forecasts are correct, economic growth will average around 2% under Dilma I (2011-14). Admittedly, Brazil is not the only EM to experience a broader decline in trend growth. India, Russia, Turkey, even China, have seen lower growth in recent years, compared to the 2003-10 period. Nonetheless, real GDP growth of 2% is very low even by EM standards. This raises the question why the government has not taken more aggressive measures to lift economic growth.
The government did, of course, react to slowing growth. However, the Dilma government has focused more on demand than supply side measures. This has proven to be a mistake, for it resulted in higher inflation and larger (quasi) fiscal deficits, while it failed to prevent a decline in the economic growth rate. It is tempting to argue that, absent these measures, economic growth would have been even weaker still. However, higher inflation points to supply side constraints rather than a lack of demand. Under Dilma I, inflation has been 120bps higher (6% vs 4.8%) and real GDP growth has been 250bps (2.1% vs 4.6%) lower than under Lula II.
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| Source: IMF |
The government did, of course, react to slowing growth. However, the Dilma government has focused more on demand than supply side measures. This has proven to be a mistake, for it resulted in higher inflation and larger (quasi) fiscal deficits, while it failed to prevent a decline in the economic growth rate. It is tempting to argue that, absent these measures, economic growth would have been even weaker still. However, higher inflation points to supply side constraints rather than a lack of demand. Under Dilma I, inflation has been 120bps higher (6% vs 4.8%) and real GDP growth has been 250bps (2.1% vs 4.6%) lower than under Lula II.
While the demand-side-oriented policy response to the global financial crisis in 2008-09 was completely appropriate, the continuation of relatively loose monetary and fiscal policies, including quasi-fiscal expansion through public-sector bank lending, failed to address the real problem: growing supply-side constraints. Basically, Brazil’s output gap closed quickly post-crisis due to a tight labour market and insufficient investment. If anything, the gradual erosion of the macroeconomic policy regime (higher inflation, larger fiscal deficits) may have helped undermine policy credibility in the eyes of the (real economy) private sector. While tax cuts and energy price reductions, for instance, were meant to make the economy more competitive, they were largely interpreted as lacking credibility and as unsustainable over the medium term given their fiscal costs. In this context, the government investment programme (PAC-2) and concession sales, which have been slow to take off mainly due to squabbles over rates of return, has thus far proven too little too late.
So what are the chances that Brazil will see a policy shift over the next year? In the past, severe financial crises spurred reform efforts. Hyper-inflation led to plano real under then FM Cardoso, admittedly after repeated failures to defeat inflation over the previous decade. The banking crisis in the mid-nineties led to large-scale bank restructuring and regulatory reform. The financial crisis of 1998-99 led to the adoption of the Fiscal Responsibility Law. Last but not least, the balance-of-payments crisis of 2002 led the Lula government to convert to fiscal discipline and an orthodox monetary policy.
Today Brazil is not at risk of an imminent crisis. In the worst-case scenario, it will be stuck with a 2.5% growth rate. Unfortunately, low economic growth appears to be a politically stable equilibrium in the short-term. Unemployment is at record-lows, real incomes continue to rise and a large number of people continue to move into an expanding middle class. This has allowed the president to maintain a dominant lead in the polls and this makes a meaningful shift in policy before the October elections extremely unlikely.
The relevant question to ask is how sustainable this equilibrium is over the medium term. If real GDP growth continues to trend lower, an uptick in unemployment looks quite possible given continued labour force growth. A sustained slowdown in income growth might also affect government popularity. Equally important, dissatisfaction with public services and an inadequate infrastructure is on the rise. Dilma’s approval ratings hit all-time lows during last year’s protests. This might give the next government sufficient political incentives to more aggressively focus on supply-side-oriented reforms and infrastructure investment (including concessions).
In short- to medium-term, a variety of supply side reforms (e.g. labour market, minimum wage, foreign trade) and an acceleration of public investment and concessions sales would help raise the growth potential and might also help address public discontent. Sooner rather than later, however, the government will have to slow down the growth of current expenditure (mainly transfers) to below the rate of GDP growth in order to increase domestic savings and the economy’s capacity to finance higher domestic investment. Politically, this appears unpalatable, not least becase inter-temporal trade-offs are typically solved in favour of limiting near-term political costs rather than long-term economic benefits. In Brazil, as in most democracies with competitive elections, short-term political expediency tends to outweigh longer-term economic rationality.
A more orthodox policy might go some way in restoring confidence. (Presidential candidate Eduardo Campos has talked about the need for a more orthodox monetary and fiscal policy.) Broader structural reforms aimed at raising total factor productivity are also highly desirable. But unless the adjustment takes place in the context of slowing down the growth of current expenditure, it is likely to negatively impact public investment. This makes the government understandably reluctant to do what is necessary to live up to its recently re-affirmed commitment to fiscal discipline. Sooner or later, the government will have to accept that it needs to slow down the growth of current expenditure if domestic savings and investment are to rise sustainably.
One might think that such a policy shift may become less costly in political terms once income growth slows, unemployment rises and public dissatisfaction with a poor infrastructure increases. Unfortunately, the government will likely seek avoid such an adjustment and the concomitant political costs by allowing the fiscal deficit to widen. In other words, there is for now a way for the government to have its cake and eat it. In terms of fostering higher long-term growth, this is a sub-optimal policy and it will likely be insufficient to lift real GDP growth above 3%. A credible, longer-term fiscal adjustment aimed at raising government savings (aka limiting the growth of current expenditure) and flanked by accompanying supply side reforms is necessary to raise domestic investment, increase productivity and lift the growth potential back to where it was during Lula I and II.