The Brazilian economy grew by 4.2 percent annually from 2004-2010, more than double its annual growth from 1999-2003 or indeed its growth rate over the prior quarter century. This growth was accompanied by a significant reduction in poverty and extreme poverty, especially after 2005, as well as reduced inequality. This paper looks at the combination of external changes and changes in macroeconomic policy that contributed to these results.
The overall policy framework since 1999 has consisted of a “tripod” of explicit inflation targets, a (very “dirty”) floating exchange rate regime, and specific (and quite large) targets for the primary budget surplus. The Brazilian inflation-targeting system requires that the monetary authority pursue a single objective, the control of inflation, which must remain inside a pre-defined range within a calendar year. Although the inflation target was not achieved in the years 2001 to 2003, since 2004 the government was successful in keeping inflation within the target range every single year, even in the turbulent year of 2008.
This paper shows that the Central Bank was able to meet its inflation target after 2004 through a continual appreciation of the exchange rate. It is argued by the Brazilian monetary authorities, and commonly believed in media and policy circles, that inflation is driven by changes in aggregate demand. The commonly accepted story is that when the Central Bank raises policy interest rates, it causes a reduction in aggregate demand and therefore lowers inflation. However, as the authors demonstrate, inflation in Brazil is driven by cost-push pressures and not by changes in aggregate demand; and so it is the reduction in import and export prices, due to appreciation of the Brazilian Real, that has allowed Brazil to maintain its inflation target during these years. When the Central Bank raises policy rates, this attracts capital inflows, thus appreciating the currency and reducing inflation by reducing import and export prices. Therefore, the Brazilian inflation-targeting system, in which the interest rate is used to control inflation, actually works directly through the exchange-rate cost channel.
There was more policy space for Brazil after 2003 because of more favorable external conditions. The improved current account, and the resumption of large capital inflows allowed the government to quickly repay in full – and get rid of – IMF loans and conditionalities in late 2005, reduce the overall external debt, and accumulate a massive amount of reserves. The ratio of short-term external debt to foreign exchange reserves, which had reached more than 90% on the eve of the 1999 exchange-rate crisis, fell to about 20% by 2008.
Brazil’s expansion was initially led by a boom in exports and GDP growth was not very fast; but from 2006 on, export growth lost steam and the internal market began to grow faster, thanks to a more expansionary macroeconomic policy. This was especially important when the economy was hit by the world crisis in late 2008; it had three quarters of negative growth but recovered quickly in late 2009 so that annual GDP fell only 0.65 percent in 2009.
The lower interest rates in the high-income countries, and reduced interest-rate spread between “emerging market” and high-income countries also had the favorable effect of allowing the Brazilian central bank to achieve its inflation target with lower real interest rates than previously. There was also an increase in public investment since 2006, from very low levels.
Inequality has dropped continuously over the decade, but prior to 2004 this was accompanied by an actual decline in share of wages in income. It appears that up to 2004 the reduction of inequality was coming at least as much from a fall in higher-wage incomes as from an increase in the wages of poorer workers. Average household incomes started to grow after 2005, not only because of faster growth of the economy and of formal employment, but also because by then the real minimum wage grew even faster and the wage share started to grow also. So, although the Gini index continued to fall after 2005, it is perhaps not surprising that poverty reduction also seemed to occur faster in this period.
The official poverty rate fell from 35.8 percent in 2003 to 21.4 percent in 2009, and extreme poverty fell from 15.2 percent to 7.3 percent during the same period. The appreciation of the real exchange rate during these years also contribute to poverty reduction, by increasing real wages.
One important harmful effect of the large real (inflation-adjusted) exchange rate appreciation over the past seven years was its effect on industrial and manufacturing competitiveness, especially in higher-technology industries. Another harmful effect has been the rapid deterioration of the current account balance. Some analysts discount the risks posed by ever-rising current account deficits because of the massive amount of foreign exchange reserves; and the widespread hope that Brazil in a few years could become a major exporter of oil (exploiting the recently found, deep sea “pre-salt” oil reserve). But the fact is that since late 2009 inward foreign direct investment has not been enough to offset the current account deficit, and the continuing accumulation of reserves has depended on short-term external capital inflows.
Some economists argue that the Brazilian authorities should cut public expenditures, thus reducing aggregate demand and “allowing” the central bank to lower policy rates, and thereby stem the appreciation of the currency, or even depreciate it. The authors argue against this contractionary policy on the grounds that it would reduce growth and shrink real wages, without any direct and systematic impact on inflation, since inflation is driven by “cost-push” pressures. This paper also warns that a large real exchange rate depreciation, however it is accomplished, would have negative effects on real wages and income distribution.
The authors put forth a number of possible policy changes that would allow for continued growth and progress in poverty reduction and income inequality, while keeping inflation under control. In order to avoid reliance on exchange rate appreciation to fight inflation, it would make sense to reduce the degree of indexation and/or excessive profit margins of privatized public utilities and to make more use of fiscal instruments to fight external commodity cost-push inflation. The latter can be done by temporarily lowering taxes or tariffs on imports of basic goods whose prices are very volatile and are visibly rising too much, as Brazil has done quite successfully with diesel and gasoline and with wheat prices in 2008. At the same time the exports of some basic goods could also be taxed more when their dollar prices increase too much in a short period in order to prevent these increases to be passed onto domestic prices of these products.
If a relatively large nominal depreciation of the real is deemed necessary to restore external competitiveness, the selective lowering of taxes on imports and increased taxes on exports would have to be larger. This would also have the positive effect of mitigating the negative impact of the currency depreciation on real wages. Ideally it should happen together with a reduction of mark-ups and lower indexation of monitored prices, so that even if real wages in the end decline a bit in terms of tradable goods, this can be compensated by increases in terms of non-tradable services.
High export taxes for some commodities would also prevent the devaluation from increasing even more the relative profitability of the commodities export sector. This would help change the structure of exports away from excessive reliance on commodities.
A real exchange-rate depreciation, however useful, is certainly not enough to restore industrial competitiveness. Brazil needs to have more public investment in infrastructure to improve the logistics and reduce the costs of exports, and to practice a more substantial industrial policy of technological upgrading in some sectors, ideally using government purchasing policy (procurement) to guarantee results. Brazilian industry is badly in need of promoting some import substitution in the more advanced technological sectors, in order to reduce the trend of increasing import penetration coefficients. These policies appear to have more positive externalities in terms of improving the overall competitiveness and productivity of the economy than mere tax incentives and/or tax burden reduction to firms that are favored by those who propose large fiscal cuts.
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