Economic Survey of Brazil 2005: Macroeconomic policies: paving the way for sustained growth

 

The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Brazil 2005.

The Brazilian economy is bouncing back

 Brazil’s growth performance has been erratic in recent years but the foundations for a sustained recovery appear to be broadly in place. The measures implemented by the new administration, which took office in January 2003, have contributed to gradually restoring confidence, which had faltered during and in the aftermath of the presidential election in 2002. These measures have succeeded in stabilizing foreign exchange markets, reducing sovereign credit risk, and taming inflation. At the same time, the remarkable external adjustment since the floating of the real in 1999, with continued strong export performance and the ensuing turnaround in the external current account, is making the economy less dependent on foreign financing and, consequently, more resilient to changes in market sentiment. But more is needed, particularly in keeping the momentum of the reform process, to ensure that this positive outlook ushers in a virtuous circle of improved confidence and resilient, equitable growth.

Having posted anaemic growth in 2001-02 and then stagnated in 2003, following the faltering of confidence in 2002, the economy grew briskly in the first half of 2004, well above market expectations. GDP growth is expected to be about 4½ per cent in 2004, facilitated by the monetary easing that took place from the second half of 2003 to mid-2004, and the restoration of confidence. Domestic demand is strengthening, taking over from a period of strong increase in net exports. Private consumption is recovering, pushed by the expansion of credit and improvements in the labour market. Formal unemployment remains high in the major cities but is trending down and real wages are on the rise, having stagnated or fallen in recent years. An improving climate for business is providing further impetus for private investment, which is showing signs of recovery. Net exports will continue to contribute positively to growth, in addition to keeping the external current account in surplus. This is important for sustained recovery as the external sector has been Brazil’s Achilles heel for many years, constraining growth. The gradual reduction in trade restrictions throughout the 1990s has made foreign trade more responsive to external price signals and changes in relative prices. Continued effort to further remove trade restrictions is therefore welcome. It is also important to note that export growth remains constrained in key markets by tariff and non-tariff barriers, particularly in agriculture.

The improvement in the economic outlook owes much to the strengthening of institutions. The maintenance of macroeconomic discipline and the prompt policy response to adverse shocks would probably not have been possible without the reforms in this area. This perception seems to be entrenched in Brazilian society, making the strengthening of institutions an on-going process. Of particular importance in the macro area are the inflation targeting framework for monetary policymaking and the Fiscal Responsibility legislation. These have become the main institutional pillars for macroeconomic management and consolidation. These institutions have been put to the test but have withstood the succession of negative shocks the economy has faced in the past few years. The 2001 OECD Survey of Brazil had been particularly sceptical about the resilience of Fiscal Responsibility legislation. The authorities should be praised for their continued resolve in defending and strengthening these institutions, even in adverse conditions.

The consolidation of macroeconomic stabilisation should continue 

The consolidation of macroeconomic stabilisation, which will require vigilance on the part of the authorities, is of paramount importance in the years to come, anchored by a prudent monetary-fiscal policy mix in pursuit of continued disinflation and a steady reduction in public indebtedness.

  • On the fiscal side, high public indebtedness remains an important source of vulnerability. In the years to come, a consolidated primary surplus of at least 4¼ per cent of GDP will need to be maintained to ensure a steady decline in the debt-to-GDP ratio, reinforcing the recent trend with an estimated reduction of almost five percentage points in the debt ratio in 2004 relative to 2003. An increase in the primary surplus target — not only in 2004 as recently announced in the wake of higher-than-expected GDP growth, but over the medium term — would be welcome to allow for a faster reduction in the public debt ratio. This is desirable because high indebtedness introduces a pro-cyclical bias in the fiscal stance, making corrective tightening in “bad” times and loosening in “good” times difficult to avoid. Against this backdrop, a reasonable medium-term objective would be to bring the public sector borrowing requirement into balance over the business cycle, underpinned by robust primary surpluses and resulting in a sustainable decline in real interest rates. This would create room for manoeuvre as economic conditions change, allowing the fiscal policy to be more counter-cyclical while ensuring a steady reduction in indebtedness.

  • Public debt management needs to remain prudent. Much progress has been made to strengthen the institutional framework for public debt management, including measures to increase liquidity in secondary markets and to clarify the roles of the Central Bank and the Treasury in issuing public debt securities in domestic and foreign markets. But the relatively high, although falling, share in public debt of instruments paying floating interest rates and securities indexed to the exchange rate makes the debt dynamics overly sensitive to financial volatility. Public debt management should therefore continue to focus on mitigating rollover risks in “bad” times and reducing exposure to foreign exchange and interest rate volatility in “good” times. In doing so, the debt dynamics would become less vulnerable to changes in market sentiment, allaying concern over the sustainability of Brazil’s public debt dynamics and, thereby, contributing to further reducing risk premia. At the same time, pressure for renegotiating the debt restructuring arrangements between the Treasury and the regional governments (states and municipalities) should also continue to be firmly resisted, which will continue to require strong political resolve.

  • Monetary policy will need to carry on responding swiftly to inflationary pressures. The Brazilian authorities should be praised for setting up a fully-fledged institutional framework for inflation targeting following the floating of the real in 1999. The policy regime is working well —although targets have been missed a number of times, due essentially to adverse supply shocks — and has been instrumental in anchoring medium-term inflation expectations, particularly in situations of financial stress. In a volatile macroeconomic environment, the monetary authorities have been successful in communicating to markets their policy response to adverse shocks, consisting of accommodating the first-round effects of these shocks, while acting to mitigate their secondary effects on prices and economic activity. In 2004, market expectations have consistently been that inflation would remain within the bands set by the government, despite movements in commodity prices. There also seems to be broad agreement that the ultimate goal of inflation targeting is to deliver low, stable inflation over the longer term to reduce risk premia and to encourage longer-term investment by the private sector. Improvements are welcome, possibly including a strong commitment to the second-year target, without losing sight of the importance of delivery the easier-to-verify first-year target. But drastic institutional changes should be avoided in the course of disinflation. At the same time, while the Central Bank is broadly perceived as being de facto independent, granting it de jure operational autonomy would contribute further to enhancing credibility in macroeconomic institutions.

Inflation targets and outturn, 1999-2006
In per cent

What are Brazil’s main challenges?

Notwithstanding several accomplishments, there are three main challenges identified in the Survey which need to be addressed. These are:

  • Improving the quality of fiscal consolidation,
  • Enhancing the investment climate, and
  • Improving the cost effectiveness of social programmes.

These challenges are interrelated. They also require a comprehensive set of measures in order to consolidate recent achievements, boosting the economy’s resilience to shocks and paving the way for sustainable, more resilient growth and for a faster catch-up in relative living standards.

On the fiscal side, the government’s record in meeting the annual budget targets is commendable, even in adverse conditions, making the fiscal effort all the more impressive. But fiscal adjustment has been contemporaneous with the increase in primary expenditure, thus being achieved in recent years primarily by hiking revenue and compressing public investment. Non-mandatory spending commitments have at times been curbed through the ad hoc sequestration of funds during the fiscal year, making budget execution more difficult, in part to accommodate higher-than-expected increases in entitlements. This is because the retrenchment of current spending has become increasingly difficult owing predominantly to downward rigidities in the budget. Revenue earmarking is widespread and minimum expenditure levels have been introduced over the years, often through constitutional provisions, severely curtailing budget flexibility. Also, until 2003, reform of the social security regime for civil servants had lagged behind that of the private-sector regime, placing a heavy burden on the budget. The authorities should be praised for avoiding increases in the minimum wage above inflation, which would have had a detrimental impact on the budget, underscoring their commitment to fiscal rectitude. In spite of recent progress, more emphasis should be put on rationalizing the largest items of current spending to improve the quality of on-going fiscal consolidation.

By tackling these problems, the need for fiscal consolidation can be reconciled with that of alleviating Brazil’s already high tax burden in the years to come, better channelling budgetary resources to meet society’s economic and social priorities. Brazil’s revenue ratio, at close to 35 per cent of GDP, is already high by international comparison and close to the OECD average. It is detrimental not only to growth but also to the labour market, encouraging informality. This is confirmed by international comparison, based on the OECD methodology for assessing the rigidity of employment protection legislation, which suggests that informality in Brazil appears to be more of a fiscal, rather than legal, problem. Alleviating the tax burden on labour would make social security more affordable to lower-productivity workers in the informal sector, while making it more attractive for employers to hire them with a formal contract. Nevertheless, there appears to be limited agreement on how this can be achieved, underscoring the need for a comprehensive labour reform. Options for making social insurance affordable to those with low incomes include, for example, variable contribution rates, either by making them progressive or by allowing individuals to choose between alternative levels of protection. By the same token, discussion on the gradual replacement of at least part of employers’ social security contributions by levies on value added could be encouraged. Brazil’s indirect tax system has become more efficient in recent years through the conversion of federal levies on enterprise turnover (starting with PIS/Pasep in 2002 and COFINS in 2003) into value added-type taxes. Against this background, policy effort is needed to reduce the tax burden over time, once public finances have strengthened, and to gradually increase reliance on direct, rather than indirect, taxes, reviewing the role inter alia of corporate income taxes, including CSLL.

There appears to be widespread recognition that rigidities in the budget adversely affect the quality of fiscal adjustment. Of particular importance is the on-going policy debate about the constitutional provision linking adjustments in the minimum pension to those in the minimum wage. The option of severing this link while preserving the purchasing power of pensions should therefore be considered. In health care, a constitutional amendment enacted in 2000 sets a floor for aggregate federal spending, while the earmarking of federal transfers also increases sub-national spending, placing Brazil among the countries with high levels of public expenditure on health care in relation to GDP. In education, minimum spending levels per student enrolled in primary and lower-secondary education (1st to 8th grades) have been established, requiring the federal government to top up outlays in the states that cannot afford the national spending floor. In this context, a comprehensive assessment of existing revenue earmarking and mandated spending requirements against the achievement of their intended policy objectives could pave the way for more cost-effective spending.

Further social security reform will be needed to ensure that the social security system is financially sustainable over time. This is a pre-requisite for making room in the budget for higher spending on more cost-effective programmes, and for increasing Brazil’s preparedness to cope in the years to come with the spending pressures associated with a fairly rapidly ageing population. The share of population aged 65 and over is projected to nearly double to about 9 per cent by 2020, a rapid pace of demographic change in comparison with OECD countries. An important problem in this area is that the social security regime for civil servants acts as a drain on the budget, accounting for two-thirds of the overall social security deficit. And civil servants continue to benefit from more advantageous pension entitlements than their counterparts in the private sector. These distortions underscore the need for reform, which is under way. The main pending issues in this regard are twofold: i) to create defined-contribution complementary pension funds for civil servants subject to the same prudential regulations and operational rules as those for private-sector workers; and ii) at a later stage, to aim at unifying the pension regimes for federal, state, and municipal civil servants, and standardizing entitlements between the regimes for private- and public-sector workers. Further reform in the social security regime for private-sector workers is also needed and could focus on the introduction of a minimum retirement age, further elimination of exemptions and increasing the contribution period.

The rationalization of current public expenditure would free budgetary resources which could be channelled to finance higher, externality-rich public investment. At the same time, the reduction in indebtedness, as discussed above, should help reduce the crowding out of private investment. New legislation on public-private partnerships (PPPs), which have hitherto been confined predominantly to leasing operations and concessions, will complement the current legal framework for public procurement, thereby militating to encourage private investment, particularly in infrastructure. Public-private partnerships will need to be encouraged in a fiscally-sound manner, adequately balancing risks between the government and its private-sector partners. There appears to be widespread recognition that fiscal consolidation should not be undermined and that the federal government should set standards for the states and municipalities in this area. An important policy objective is therefore to standardize requirements for the accounting and reporting of PPP operations, as well as the dissemination of information to markets and society at large, together with the risk assessment of individual projects. Draft legislation envisages a leading role for the Treasury in this area. In this regard, the Fiscal Targets Annex of the Budget Guidelines Law (LDO), which each level of government is required to submit to their legislatures, could be the main vehicle for the dissemination of information on PPPs in budget documentation.

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