The new Brazilian administration faces a daunting challenge. Interim president Michel Temer has assumed power with conditional support in Congress and little popular support. His term is uncertain, as the senate may exonerate Dilma Rousseff and reinstate her as president. Rather than the proverbial first 100 days, this may be all the time the Temer administration will have.
One would think under such conditions an ambitious economic reform programme would be out of the question. But the opposite is true. Only by following a vigorous reform initiative can the government afford to be less tight in its short-term macroeconomic stance and still generate positive economic expectations and stabilise the economy.
Brazil is experiencing the worst recession in its modern history – a nearly 10% cumulative fall in GDP has surpassed even the downturn of the early 1980s, when the international debt crisis inaugurated Latin America’s ‘lost decade’. At the same time, macroeconomic imbalances have widened, threatening an even worse crisis. There is no ‘fiscal space’.
Public debt has climbed to around 70% of GDP and Brazil’s sovereign credit rating continues to be downgraded. The government mostly borrows domestically and in local currency securities, but persistent inflation means real interest rates at home will remain high. In 2015, the cost of debt service surpassed 8% of GDP. There is also little space for expansionary monetary policy.
As the central bank’s credibility has eroded, inflation expectations have become more entrenched. This means monetary expansion would produce price increases rather than stimulating growth.
Brazil faces a dilemma. A macroeconomic adjustment is necessary. But with double digit unemployment and increasing credit delinquency, it cannot risk exacerbating the recession.
Brazil should lay the basis for improved macroeconomic sustainability by applying measures that do not tighten aggregate demand in the short term. Fiscally, reform of the pension system should be prioritised. This would have a small short-term impact but help achieve sounder public finances. Cutting waste is less costly than cutting services.
Regarding inflation, regaining credibility is key and will require a more independent central bank. It is also time to start laying the groundwork for reform of credit policies, particularly the highly subsidised credit to ‘national champions’. The central bank has the data and technical expertise to assess this issue and formulate a strategy. With these initiatives, it may be possible to cut short-term interest rates to reduce inflation.
Policies should focus on deeper reforms that ensure long-term fiscal sustainability and central bank credibility. If there is tangible progress, there will be less need to achieve a high primary surplus in the short term or tighten monetary policy.
For stabilisation to succeed however, growth needs to be revived on a sustainable basis. This requires a recovery in investment and productivity growth. According to the International Monetary Fund, Brazil’s fixed capital accumulation will decline by 20% over the next three years. Productivity growth has contributed just 0.5% to GDP growth over the past decade.
Productivity stagnation is likely to relate to two areas – Brazil’s protectionism, and the country’s negative business climate. Excessive protectionism has isolated Brazil from world trade, and trade is even lethargic within the Mercosur regional trading bloc. Brazil’s industrial business association has started to push for greater openness, as isolation from global production chains restrict opportunities for the industrial sector.
Brazil is also infamous for its lowly ranking on the World Bank’s annual ‘Doing Business’ survey. According to the 2016 survey, which gave Brazil an overall ranking of 116 out of 189 economies, Brazilian businesses require 2,600 hours per year to comply with tax forms, compared with the Latin American average of 361 hours.
These are formidable challenges. But there is hope that a viable economic policy can be implemented, even if the fluid political situation produces more unexpected change. The Brazilian model of the 2000s can no longer work, not after the perfect storm of declining export prices, weaker capital inflows, the Petrobras scandal, a deep political crisis, and the exhaustion of credit-driven expansion.
The Brazilian economy will re-emerge only under a new model and new management, with substantive reforms to strengthen macroeconomic policy-making and enhance productivity.