Seeking growth without inflation

Brazil looks set to meet fiscal targets agreed with the IMF and also seems to have inflation under control. But fiscal discipline has rested on increasing revenues rather than cutting expenditure, a course that will eventually restrain rather than promote growth. Reform of the tax and welfare system has barely been tackled and doubts persist about whether the government has enough political clout to see it through. A key gain is that the real economy is moving out of stagnation and into growth. Jonathan Wheatley reports

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If Brazil's economics team felt they deserved a pat on the back for the job they've done over the past 18 months, they got one on August 10. That was the day Brazil launched the biggest-ever bond swap by an emerging-market country and the country's longest-ever maturing bond, placing $5.2 billion in 40-year global bonds in exchange for existing Brady bonds. It was also the day it completed the sale of a 28% stake in Petrobrás, the state-controlled oil group, for $4.1 billion.
The success of both operations took markets by surprise and exceeded even the government's expectations. "The only way to see it is as a tremendous vote of confidence, and they've been due one for some time," says Andre Loes, chief economist at Banco Santander in São Paulo. "Carrying out the fiscal adjustment they've achieved in the middle of a recession was a very difficult job. It took enormous political commitment."
Few would contest that. There is now no doubt that the government will meet the fiscal targets agreed with the IMF following the devaluation of the real in January 1999. It seems comfortably on course, too, to meet its inflation targets, of 6% this year and 4% in 2001, which have been adopted as the new "anchor" for its floating-rate monetary policy.
But it is not all plain sailing. The fiscal adjustments have been made by raising revenues, not by cutting spending, and have relied on measures that, in the medium to long-term, will restrain rather than promote growth. Almost six years after president Fernando Henrique Cardoso came to power, little progress has been made on crucial reforms such as tax and welfare. That means much-needed investment in Brazil's future, on faster economic growth, on healthcare and education, falls far short of need. The question now is whether the government has the political clout to see these reforms through.

But first the good news. After an inevitably sluggish year in 1999 following the devaluation (though not as sluggish as was thought - recent figures show GDP growth was rather more than 1%, not slightly less as previous figures showed) the economy is set to grow by as much as 4% this year. The budget deficit, though still high at about 4.2% of GDP, is less than half what it was a year ago; this year, the government is likely to achieve a primary budget surplus (not counting interest payments) of about 3.5% of GDP.
Debt, too, seems to be under control. The total debt burden rose to more than half GDP last year. It is now about 47% (of which about a fifth is external and the remainder domestic), and the government has recently succeeded in improving its profile, achieving longer maturities and placing fixed-rate rather than floating-rate paper on the domestic market.
Better still, there are signs that the real economy is moving out of stagnation and into growth. Aggregate salaries, eroded throughout last year, have started to grow. Industrial production has recovered to levels last seen during the 1997 boom. Employment, too, is rising. The number of people in work rose by 4% during the first half of this year compared with the first half of 1999. The number of people seeking work rose by the same amount, so the unemployment rate remains stable, and high, at about 8%, but the trend is positive.
Best of all, for a country previously hooked on inflation, growth is apparently being achieved without inflationary pressures. Prices rose sharply during July because of seasonal factors and increases in government-controlled fuel prices and utility charges, but monthly inflation is expected to return to about 0.5% for the rest of the year. The government is so confident of meeting its 6% target that it cut the central bank's basic interest rate by two percentage points during June and July, to 16.5% a year. Many analysts expect the nominal rate to fall to about 15% by the year-end, meaning real interest rates, after inflation, will be close to single figures.

Most economists agree there is no risk of a return to high inflation and that the government can continue to relax interest rates into next year. Some go further, saying the government has broken with the IMF-led Washington consensus that growth is bad for Latin American countries because it stokes inflation. Writing recently in the Wall Street Journal, David Malpass, chief international economist at Bear Stearns, argued: "By aggressively cutting rates while growth is accelerating, Brazil appears to have recognized that faster growth is not inflationary if achieved in an environment of currency stability and rising productivity. This is a departure from anti-growth economic models, and is a policy breakthrough that could well mark a milestone for the Brazilian economy."
Others remain cautious. Mauro Schneider, chief economist at ING Barings in São Paulo, says the relationship between interest rates and inflation in Brazil "is an experimental science. The government is calculating how much it can cut interest rates, how much prices will rise, and how much the economy will grow. At 4% economic growth, its current policy is probably sustainable. If the rate of growth increases beyond that, inflation will be a risk again."
The extent of that risk will become clearer over the next year. So far, economic growth has taken place without much input from consumers. The increase in industrial activity this year is largely due to intermediate sectors, such as paper and pulp, steel, and those supplying equipment to sectors catching up with repressed demand such as telecoms and electricity. The retail sector has been slow to follow. Where consumer sales have picked up is in areas sensitive to credit: motor vehicles and other durable goods. Soon, though, the gradual recovery in aggregate salaries should feed through and give a boost to sales of semi-durable and then non-durable goods.
Even if consumption does pick up quickly, though, the level of capacity use among manufacturing industry is low enough to keep inflation at bay. Indeed growth so far is being led by the supply side, raising the prospect of a virtuous circle, as Malpass argues, in which falling interest rates and price stability encourage an inflow of foreign direct investment, leading to "a stronger currency and an increase in international reserves, inviting further interest rate cuts". In these circumstances, Malpass reckons, growth of as much as 6% a year is possible without stoking inflation.
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