Public Debt and Growth in Brazil

The economic situation in Brazil remains dire and the measures taken by the Luiz Inacio Lula da Silva administration will prove fundamental for assuaging fears of a meltdown and preparing the country for future growth. In July 2002, pessimism concerning Brazil’s economic prospects gripped the financial markets. The likely election of Luis Inacio Lula da Silva triggered an investor panic that tumbled the Bovespa, raised the “Brazil risk” (yield spread of Brazilian debt over US Treasury securities) above 2,000 points, and caused the Real to lose 36% of its value. However, Lula’s likely victory was not the primary reason for investor risk aversion. Even with the IMF package on August 7, 2002, financial markets showed great concern that Brazil might be forced to default on its public debt, regardless of which candidate won the elections. This paper will begin by examining the problems in the rise of public debt issuance after the Real Plan. Two related problems that will be addressed are the dynamics of the public debt and their implications for the Lula government. Some of the inherent aspects of the debt and the policy direction needed to control its growth may prove difficult for the administration. Three factors described in the paper are reduced public spending and fiscal tightening, the growth of inflation-linked bonds, and high interest rates. Lastly, the paper will address the issue of growth in Brazil, examining problems and evaluating prescriptions to reduce volatility, promote productivity gains, revise the inefficient tax structure, make use of rising trade surplus, and improve poverty fighting efficiency.

Since 1995, the net public debt of the public sector in Brazil increased from 28.5 percent to nearly 60 percent of GDP, at one time passing the 64 percent mark. The policy implications of the Real Plan (1994) were similar to the reforms introduced by the military government in the second half of the 1960’s: the use of marketable public securities to finance fiscal deficits. The development strategy of the 1970’s was based on the ability to fund public projects through the issuance of debt and later to borrowing from international commercial lenders.[1] By the early 1980’s it became clear that this method of growth was faulty. High inflation led to considerable increases in the volatility of expected returns of public debt and investment dwindled. Cuts in commercial bank credits and increasing interest payments on the debt around this time spurred the adoption of emergency adjustment programs that led to declines in real income, unemployment, and escalating inflation. Stabilization would come with the advent of the Real Plan in 1994. The program lowered the inflation rate with remarkable speed: it fell from four digits in 1994 to 2 percent in 1998. However, the Real Plan was based in policies that raised the country’s indebtedness.

The economic boom that began in 1994 originated with an increase in real wages and not a decline in real interest rates. The consequent gains in income fueled a consumption and import boom. Between 1995 and 1998, passive real interest rates averaged 22 percent a year.[2] The Real Plan was also based on fiscal adjustment but that initiative was short-lived. The primary surplus declined in 1995 and turned into a deficit in 1996. Among the factors contributing to the deficit was a 43 percent increase in pensions and other political expenditures as the 1998 elections approached. Another important dynamic of Brazil’s debt development is the real exchange rate appreciation during this time. In fact, Brazils’ success in bringing down inflation was associated with the appreciation of the real. Additionally, the large current account deficits that were bound to prevail at the going exchange rate were inconsistent with long-term growth. Another implication of overvaluation discussed below is that it encourages a decline in private savings as residents substitute present for future consumption. By undermining savings, overvaluation hinders economic activity because high interest rates are needed to maintain the capital inflows to support the exchange rate. In effect, high interest rates reflect the inability of establishing credibility in a country that has been historically plagued by macroeconomic imbalances. The result: a sharp increase in the public debt. Lack of confidence in the government’s ability to maintain the anchor and meet its obligations resulted in increasing use of dollar denominated and floating rate debt. The eventual currency collapse exacerbated the price of the debt.

Some of the inherent aspects of the debt and the policy direction needed to control its growth may prove difficult for the incoming government. Three factors described below are reduced public spending and fiscal tightening, the growth of inflation-linked bonds, and high interest rates.

Brazil’s public sector debt has increased rapidly in recent years and the markets have justifiable concerns when worrying about the sustainability of Brazil’s public finances. High interest rates during the Real Plan, a need to finance a fiscal imbalance through the inflow of foreign capital, and a strong devaluation of the real in 1999 led to an explosion of the public debt. If analyzed with the concept that the official counting of the debt is too low due to the doubtful liquidity of claims netted out by the Brazilian government or the presence of skeletons-the debt/GDP ratio may currently range from 60%-70%. This in turn, calls for higher primary surplus targets to convince the market of the government’s determination to stabilize the public debt and avoid a default. Raising it to 5% or even 6% of GDP may be the only way to inspire confidence. The fiscal surplus requirement accorded with the IMF was 3.75% but the Banco Central has raised it to 4.25%. This has been done in light of escalating inflation forecasts. The methods the PT will likely adopt are to cut public expenditures, although it may opt to raise taxes. A resort to inflationary financing would be a contradictory and desperate signal. However, contractionary measures may prove politically unfeasible for Lula, a candidate elected on a platform to fight poverty. Some promises made during his campaign, such as a rise in the minimum wage and in public servants’ pay, will probably not materialize. The administration is even facing resistance against their signature social program, the Fome Zero (Zero Hunger) initiative. Additionally, an austerity induced recession may impress investors by cutting government spending, but it may provoke an economic slowdown, lower tax revenues, increase borrowing needs and make it harder for Brazil to pay its debts.[3]

The Brazilian public debt is also not homogenous. Some of it is external debt and some of it internal. In July 2002, the net external debt amounted to $56 billion, since then becoming more expensive due to a depreciating real. The domestic debt in July 2002 was R$ 677 billion. Nearly 42 percent of the debt (all the external debt and a significant part of the domestic debt) is dollar linked. A second component of the domestic debt has an interest rate that is linked to the overnight interest rate set by the Banco Central do Brasil, known as the Selic rate. Another part of the debt is held in inflation-linked bonds and now receives an average real interest rate of about 10 percent per year. In fact, the government is stepping up its sales of bonds tied to consumer prices, gambling that inflation will slow.[4] Brazil more than doubled its sales of inflation-linked notes in November. The problem is that every percentage point increase in the inflation rate will cost the government R$ 400 million a year in interest. The Banco Central do Brasil forecasts the annual inflation rate to fall to 6 percent next year and the target is held at 6.5%. However, some economists are predicting more than double that. In fact, the inflation rate in Brazil has been above 2 percent each month since November and the forecast for 2003 is an annual inflation rate above 14%. Additionally, will the government refrain from financing its large deficit through money creation? If inflation ends up being worse than the government expected, and now it looks like it will be, they will have dug themselves another hole.

Although the average maturity of the total debt has increased, it remains low by world standards. During the Real Plan, the Central Bank did not want to issue long maturity debt since interest rates were very high and the debt would be unsupportable in the long run. The advent of the Asian and Russian crises forced the Banco Central to issue even shorter bonds. The problem with this action is that when debt maturity decreases, the debt must be rolled over more often. To increase maturity and relieve some rollover risk, the fiscal budget would suffer losses when interest rates had to be lifted in the future. The treasury has recently announced an attempt to increase the maturity of its securities to an average 38 months from 33 months at the end of 2002.

The devaluation of the real in 1999 only made the increase in the debt more expressive. Today, Brazil has one of the largest real interest rates in the world and many economists see its reduction as fundamental for Brazilian growth. Moreover, many economists see the growth of the internal public debt as a direct consequence of an economic policy decision to maintain extremely high domestic interest rates. The justifications for this policy choice is that it attracts foreign investment and keeps the nominal exchange rate relatively stable. Additionally, it should prevent cost inflation, obtain real exchange rate revaluation, provide a shock of foreign competition to formerly protected Brazilian industries, and contract credit and consumption- thus reducing the current account deficit. However, years of high interest rates have discouraged investment in export sectors that could not pass their higher costs to prices at the international market. Moreover, lower interest rates would exacerbate productive forces and reduce the cost of the public debt. Conversely, the interest rates are tied to the “risk Brazil”, and its reduction is imperative for a reduction in real interest rates.

The near future will be decisive for Brazil’s debt reducing strategy. The government announced a plan to sell $4 billion of international bonds in 2003, returning to the foreign markets for the first time since early 2002. The hope is to raise money in international markets to help finance about 55 percent of the $7.3 billion in foreign bonds and loans coming due this year. The plan also includes financing the rest through domestic debt sales or government cash reserves.[5] This is in line with Lula’s pledge to reduce Brazil’s reliance on foreign financing. The international bond sale might be soured by reduced investor desire for emerging market debt should the U.S. lead an attack against Iraq or belief among investors that the Lula administration is not serious about reform. For this reason, the initial months are crucial for Lula and his team.

Much has been written about the policy prescriptions of the “Washington Consensus” and how it focused mainly on efficiency enhancing mechanisms-fiscal discipline, liberalization of trade and investment, deregulation of domestic markets and the privatization of public enterprises. In 1990 (when John Williamson wrote about the consensus regarding the ten policy instruments) the region’s main priorities revolved around achieving macroeconomic stability and the need to deviate from a development model founded on protectionism. Accordingly, the region has grown. The “first-generation” reforms have raised economic growth rates and set the foundation for continued development throughout Latin America. The Brazilian case offers interesting insights. First, it is a clear example of a country where Washington Consensus policies led to growth but not reduced poverty or inequality. Second, with the election of Lula, it seems prime to dabble into areas concerned with “second-generation” reforms and those that alleviate poverty and ameliorate the high-income inequality persistent throughout the country.

The following is set of observations and recommendations for the new government. It takes into account the previous discussion on the rise of the public debt and works around the difficulties of assuaging fears of a default. The recommendations will be an eclectic mix of macro and microeconomic prescriptions and political economy considerations. In some regards it is a wish list of policies that are extremely difficult to implement given historic and structural rigidities in Brazilian society and polity. But they do reflect a need for change in fundamental areas of Brazil’s development direction and methodology.

The Lula government should evoke the maintenance of stability with prospect for growth. It is important to calm the markets but also show the country that the economy has potential for growth so that credit markets start lending at more favorable rates. First, the government should stabilize the debt and prevent it from growing. It should then proceed to establish a reduction goal of 50%-55% of GDP. Monetary and fiscal policy should be reigned in for the immediate future- thus regaining credibility from the international market structure. This step invariably involves difficult measures, and the Lula government should make use of its huge initial political legitimacy to enact policies that would otherwise be arduous.[6]

A reduction in the burden of the domestic debt is important for Brazil’s future growth potential. Instead of arbitrary upsetting debtor/creditor relationships that would occur under any debt reduction exercise, the government should reduce the level of domestic interest rates. The projected burden of the Selic-linked debt will be enormous in the long term unless something changes.[7] If Brazil emerges from the current situation without a debt restructuring, interest rates in Brazil could drop to its lowest levels in many years- especially if a Lula government laid to rest any fears of a default. With chances of a default undermined, investors could see low prices of Brazilian assets as offering an opportunity to buy at bargain prices (Brady Bonds selling for under 60 cents on the dollar- there is possibility for price appreciation of over 50 percent).

Once the fear of a default is assuaged, the government should implement its growth strategy. It should focus on the reduction of volatility and stimulation of domestic private investment and productivity gains. One way to absorb new technologies and reducing the volatility of the economy in relation to external shocks is maintaining a consistent and diversified trade policy. Brazil should make good use of its rising balance of trade surplus. There are forecasts for a surplus of more than $12 billion this year. The government should use this to reduce its dependence on foreign financing and the surplus is expected to enable the country to more than halve the deficit in its current account. It should encourage private exporters to develop relationships with foreign buyers and expand the demand for Brazilian goods. The benefits of deepened trade liberalization and possible hemispheric integration are various: increased investment, technology transfers, learning effects, positive externalities on the levels of democracy, reduced uncertainty about market access. The Lula government should pursue a multi-targeted approach to deal with the approaching deadline for FTAA adoption. It should complete and deepen its market reforms so as to be prepared for the inevitability of a hemispheric trade regime and negotiate for the lifting of special restrictions on some of its exports and the importance of fair sequencing of tariff elimination. There is a realization in Brazil and other Latin American countries that access to rich country markets is central for job and economic growth. The benefits include creation of jobs in sectors such as agriculture, shoes, and textiles, and would increase the demand for less-skilled labor and allow for the “officialization” of displaced workers from the informal sector. Brazil cannot rely on a new market as its sole driver of growth. It should also prepare for adjustments at the firm level, sectoral level, and social level. In the end the prospect for freer trade should be welcomed as a tool to signal to the markets Brazil’s reduced macroeconomic volatility and as a new paradigm in the policy dialogue between business and government- hopefully leading to a decrease in rent-seeking behavior.[8]

The government should not overlook its own need to devise a viable investment strategy, especially in basic infrastructure, health, and especially education. Brazil has poor quality and unequal distribution of education. A substantial share of the total population receives extremely low levels of schooling. Families who can afford to send their children to private schools do. Even middle-class families opt to send their children to private schools, often at burdensome costs for a level of education similar to public schools.[9] This poor distribution of education reduces average income growth, especially in light of a rising wage gap between the skilled and unskilled. Brazil has among the lowest primary school completion rates in Latin America and should pursue policies to improve the quality of education and incentives for the educated among the most poor. Special consideration should be given to early education since the benefits from this schooling far outweigh the costs from a lack of it. Programs already in place such as Bolsa Escola in Brasilia and the attempts in Minas Gerias to decentralize and strive for greater parent and community control of schools should be emulated. Benefits of early schooling include attention to nutritional health, sociability skills, reading and writing, and general preparation for continued primary schooling. Additionally, since many households have all the caregivers working at a time, early schooling prevents children from the dangers of street life. Educational attention should also be given to vocational training. This initiative should be controlled by small-medium enterprises through a state-funded voucher like system. They have a better perspective as to the changing demands of private industry and benefit the earliest form a trained and skilled worker.

One should note the difficulties of a development approach based on investment in human capital. It is very vulnerable politically since social programs have to compete fiercely for public resources and they are long-term investments with uncertain returns. As the global market and internal conditions warrants tighter and more austere measures, these programs are the first to die.[10] Therefore, it is important to have, as Nancy Birdsall calls it, “brilliant fiscal policy”. According to Birdsall, Latin America is faced with two problems: more shallow domestic financial markets that are less resilient to downturns and bad history. Recent volatility in Brazil’s capital markets are a testament to this. Shallow financial markets make it more difficult for governments to manage instability. And bad history leaves creditors skeptical of the political ability of governments to manage their budgets without resorting to printing money or excessive and costly borrowing.[11]

Another related factor imperative for growth is the development of increased savings and subsequent accumulation of capital. Historically, Latin America has had a low rate of domestic savings and ineffective allocation of productive investment. Sustained growth will require significant increases in both the volume and quality of investment. Higher domestic savings will contribute to growth and help attain sustainable current account balances. The effects of high interest rates on savings rates are inconclusive. On the one hand there is a substitution away from current consumption, which tends to increase savings. On the other hand, higher interest rates generate a negative wealth effect- it lowers the amount required to attain the flow desired.[12] Brazil has a low volume of credit as a fraction of national income when comparing it with countries of similar GNP/capita. It also has high interest rates and bank spreads. High spreads appear to be related to difficulties in executing contracts, fiscal burden or levels of structural inadequacies.[13] The recommendations below are particular to Brazil’s banking and regulatory sector’s deficiencies in providing a framework for credit provision and supervision. These steps are linked to an improvement in domestic savings levels. Among the recommended steps are: 1) Improve the credit rating and credit information centers- such that private debtors are evaluated for credit risk; 2) Improve the process of firm valuation, including the collection of tax rebates and incentives; 3) Improve the bankruptcy process so that firms are not subject to predatory actions and creditors are involved in process; 4) Improve transparency structure of lending decisions and facilitate competition while regulating for high risk-behavior.

Additionally, Brazil has a one of the largest tributary loads among countries with similar GDP/capita. However, its tax structure is inefficient and gives rise to large informal sectors that erode productivity. One often mentioned proposal to combat fiscal inefficiency is the progressive adoption of an aggregate value tax instead of indirect taxes. Arminio Fraga, president of the Banco Central under the Cardoso administration, recently declared that reforms in the Social Security and tax systems were ready, merely awaiting approval. The most urgent reforms should aim to formalize low wage labor, create a system of credit accumulation by fiscal contribution, and reduce the costs and facilitate the process of opening ad regulating firms.[14] Persistent high real interest rates also undermine fiscal efforts. But it was numerous spending loopholes embedded in the 1988 Constitution, the allowance excessive pension payments, and the increased expenditures during the elections of 1998 and 2002 that put the fiscal situation in precarious conditions.[15] The following are the main characteristics of Brazil’s social security system, an important contributor of Brazil’s persistent fiscal deficit: 1) The average Brazilian retires at forty-nine; 2) Many Brazilians have longer retirements than careers; 3) Two-thirds of retirees of the public sector in 1998 were under forty-five; 4) Seventy-five percent of 1999 budget deficit came from benefits to just over ten percent of Brazils’ retirees- government bureaucrats; 5) In 1999, benefits paid to retirees was equivalent to 5 percent of economic output and twice the spending on healthcare.[16] This problem is, more than anything, a political economy problem. Efforts to curb the drain of retirement benefits have been met with opposition.

It is impossible to attempt to confront Brazil’s problems without confronting poverty. The unequal distribution of income in Brazil has been unfathomable for the past thirty years: the top ten percent of the population contributing to fifty percent of the national product and the bottom fifty percent contributing to ten percent. More than forty percent of the disparity is related to a disparity in the individual’s level of schooling.[17] It is not a matter of volume of money directed at the problem – Brazil spends R$ 150 billion a year on it- it is the efficiency of its use. Most of the resources do not benefit the poorest and there is no national system of checking and evaluating the effectiveness of these programs. Elected on a poverty-reducing platform, Lula will find the economic constraints limiting his options difficult to maneuver. As stated above, Brazilian social policy should invest and prioritize in the general schooling of the population and improving the qualification of employees, including adult education. This goes in line with an emphasis with combating poverty from a structural viewpoint in contrast to compensatory measures. The government should strive to facilitate a market for credit and improve conditions for commercialization of products. These programs should be unified under a social budget and regulated by an efficient results-driven evaluating mechanism.

The early measures adopted by the Lula administration will be fundamental for Brazil’s future growth potential. Specifically, the way in which the administration handles the precipitous rise in the public debt during the Real Plan will both be constrained by its inherent factors and dictate the levels of social programs undertaken by the government. To calm fears of a default, the government must convince the markets of its resolution to stabilize the public debt by raising the primary surplus target. The government must also rein in public expenditure in the near future and raise taxes. It is also important to note the components of the debt. Nearly 42 percent of the debt (all the external debt and a significant part of the domestic debt) is dollar linked. A second component of the domestic debt has an interest rate that is linked to the overnight interest rate set by the Banco Central do Brasil, known as the Selic rate. Another part of the debt is held in inflation-linked bonds and now receives an average real interest rate of about 10 percent per year. It is important for the government to set a balance between interest rate and inflation reduction based on the debt obligations. This austerity driven policy is in line with Brazil’s plan of selling $4 billion of international bonds in 2003, returning to the foreign markets for the first time since early 2002. The hope is to raise money in international markets to help finance about 55 percent of the $7.3 billion in foreign bonds and loans coming due this year.

In regards to development policies and growth in the past decade, the Brazilian case offers interesting insights. First, it is a clear example of a country where Washington Consensus policies led to growth but not reduced poverty or inequality. Second, with the election of Lula, it seems prime to dabble into areas concerned with “second-generation” reforms and those that alleviate poverty and ameliorate the high-income inequality persistent throughout the country. The paper presented a “wish-list” set of policies aimed at preparing the country for equitable growth and development. It first stressed the need to reduce the debt burden. The growth strategy mentioned involves focusing on the reduction of volatility and stimulation of domestic private investment and productivity gains through trade. The Lula government should pursue a multi-targeted approach to deal with the approaching deadline for FTAA adoption. It should complete and deepen its market reforms so as to be prepared for the inevitability of a hemispheric trade regime and negotiate for the lifting of special restrictions on some of its exports and the importance of fair sequencing of tariff elimination. The government also should not overlook its own need to devise a viable investment strategy, especially in basic infrastructure, health, and especially education. The paper also mentioned the need to devise a structured and regulated domestic mechanism for savings, investment, and capital accumulation. Among the areas highlighted were the banking sector’s deficiencies in providing credit provision and supervision. The paper also stressed the need to reform Brazil’s tax system and social security structure. The anecdotal evidence provided stresses the importance of this reform. Lastly, it is impossible to attempt to confront Brazil’s problems without confronting poverty. Elected on a poverty-reducing platform, Lula will find the economic constraints limiting his options difficult to maneuver. However, the administration should use its early political capital to instill the need to fight poverty on structural rather than compensatory grounds.

Bevilaqua Alfonso S., and Marcio G. P. Garcia. Debt Management in Brazil: Evaluation of the Real Plan and Challenges Ahead. PUC- Rio de Janeiro, November 1999.

Birdsall, Nancy. “From Social Policy to Open-Economy Social Contract in Latin America.” Prepared for the 50th Anniversary conference of the BNDS. 9/11/2002.

Birdsall, Nancy and Augusto de la Torre. “Washington Contentious: Economic Policies for Social Equity in Latin America”, (Carnegie Endowment for International Peace and the InterAmerican Dialogue, 2001)

“Brazil Boosts Inflation-Linked Note Sales on Demand,” in Bloomberg Latin America, November 04, 2002

Cardoso, Eliana. “Brazil’s Currency Crisis: The Shift From an Exchange Rate Anchor to a Flexible Regime”, in Wise and Roett, eds. Exchange Rate Politics in Latin America (Brookings Institution Press, 2000).

Cardoso, Eliana. “Virtual Deficits and the Patinkin Effect”, IMF Staff Papers, vol. 45 (December 1998).

Edwards, Sebastian. Crisis and Reform in Latin America: From Despair to Hope (Oxford University Press, 1995)

Salazar-Xirinachs, Jose M. “The FTAA Process: From Miami 1994 to Quebec 2001”, in Salazar-Xirinachs and Robert, Toward Free Trade in the Americas (Brookings Institution Press, 2001).

Scheinkman, Jose. “A Agenda Perdida: Diagnósticos e Propostas para a Retomada do Crescimento com Maior Justiça Social”, (www.ifb.com.br).

Williamson, John. “Is Brazil Next?” in International Economic Policy Briefs, August 2002, number PB 02-7.

[1] Bevilaqua, Alfonso S. and Marcio G. P. Garcia, “Debt Management in Brazil: Evaluation of the Real Plan and Challenges Ahead”. PUC- Rio de Janeiro, November 1999, p. 3-7.

[2] Cardoso, Eliana. “Brazil’s Currency Crisis: The Shift From an Exchange Rate Anchor to a Flexible Regime”, in Wise and Roett, eds. Exchange Rate Politics in Latin America (Brookings Institution Press, 2000), pp. 75.

[3] Williamson, John. “Is Brazil Next?” in International Economic Policy Briefs, August 2002, number PB 02-7, pp. 4-8.

[4] “Brazil Boosts Inflation-Linked Note Sales on Demand,” in Bloomberg Latin America, November 04, 2002.

[5] Ibid.

[6] “De novo na mira dos especuladores,” in Veja, October 23, 2002.

[7] Williamson, John. Is Brazil Next? International Economic Briefs, pp. 15.

[8] Salazar-Xirinachs, Jose M. “The FTAA Process: From Miami 1994 to Quebec 2001”, in Salazar-Xirinachs and Robert, Toward Free Trade in the Americas (Brookings Institution Press, 2001).

[9] Birdsall, Nancy and Augusto de la Torre. Washington Contentious: Economic Policies for Social Equity in Latin America (Carnegie Endowment for International Peace and the InterAmerican Dialogue, 2001)

[10] Birdsall, Nancy. From Social Policy to Open-Economy Social Contract in Latin America. Prepared for the 50th Anniversary conference of the BNDS. 9/11/2002.

[11] Birdsall, Nancy. From Social Policy to Open-Economy Social Contract in Latin America.

[12] Edwards, Sebastian. Crisis and Reform in Latin America: From Despair to Hope (Oxford University Press, 1995) pp. 227.

[13] Scheinkman, Jose. A Agenda Perdida: Diagnósticos e Propostas para a Retomada do Crescimento com Maior Justiça Social (www.ifb.com.br)

[14] Ibid.

[15] Cardoso, Eliana. “Virtual Deficits and the Patinkin Effect, “IMF Staff Papers, vol. 45 (December 1998) pp. 619-46.

[16] Wall Street Journal, September 9, 1999, p. A1.

[17] Scheinkman, Jose.