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Brazil's Real Plan celebrated its second birthday in July, but still without the constitutional fiscal reform needed to achieve sustained strong economic growth in a low inflationary environment. Is it time to panic?
The answer is no at least not for some time. Although the 1995 fiscal balance was a shocker there was a deficit of 5% of GDP, compared with 1994's 1.3% operational surplus president Fernando Henrique Cardoso's economic team began preparing years ago for a long battle with congress.
The team say the government's top priority is a reduction in the fiscal deficit, now that it has successfully reduced monthly inflation to below 1.5% and is on target for annual inflation this year of between 13% and 14%. This is Brazil's lowest in 39 years it was 23.2% in 1995 and 941.3% in 1994.
Reducing the fiscal deficit is possible, the team argues, even without constitutional reform. They claim to have a list of more than 30 measures that do not involve constitutional change that can be taken to reduce wage and social security costs. These, in combination with a visibly accelerated privatization programme and a new series of IMF-style contracts with state governments, should reduce the public sector borrowing requirement (PSBR) operational deficit to around 3% of GDP this year, compared with 3.5% in the first half of 1996, and continue reducing it thereafter. The forecast for this year's nominal GDP is around R740 billion ($748 billion).
But so far this year Cardoso has failed to get any significant constitutional reforms through, and there's precious little he can do in the next few months, given municipal elections in October and November. The social security reform has advanced the furthest through congress this year, but it has been watered down to the point of irrelevance in the lower house. It is being debated in the senate again, but it is expected that senators will try to amend changes made in the chamber of deputies and return it to the lower house for another round of votes. Presidential elections in 1998 mean Cardoso only has 1997 in which to count on the full attention of congress. But it will probably take years of incremental moves towards constitutional reform before he will be able to cross the bulk of items off his wish list. That's understandable, given how big the task is.
"There are many things that could be done at the federal, state and municipal levels without constitutional reform," says Gustavo Franco, director of international affairs at the central bank of Brazil and one of the principal architects of the Real Plan.
Many of the measures are hardly worth mentioning, say economists, because of the barely perceptible dent they would make in Brazil's projected R250 billion net public sector stock of debt this year. But although their efforts are not likely to grab headlines, they could have an impact on market sentiment. A crucial objective is to show markets that every effort is being made to rectify the imbalance. "The passing of a constitutional amendment, or even an ordinary law, issues a political blueprint for everyone doing things that have a political cost, but also a good alibi. Constitutional reform works much more as political agenda setting," says Franco.
Now the onus is on the economic team to come up with the goods, but they must face the fact that not all of their measures will see the light of day. Nevertheless, they argue that even with a modicum of success they will be able to keep the fiscal deficit under control and so buy themselves more time to implement constitutional change.
"I am confident that even without constitutional reform we will have fiscal accounts under control and on a downward trend," says Murilo Portugal, treasury secretary. "It's just that if we have constitutional reform we can have a much more effective fiscal policy. Then you will see a much higher rate of growth in Brazil like 6% a year. Without reform we cannot achieve this." The economic members' expectations are that, in the medium term, Brazil can grow in the 3% to 4% range without reform.
A return to 50% a month inflation and widespread indexation is not in the picture, says Jose Roberto Mendonca de Barros, the government's highly respected secretary of national economic policy. "I am not a public servant. I used to be a consultant of the financial sector and I came to the government because I believe this plan has every chance of stabilizing the country," he says. "Quite frankly, I am much more confident now than in the beginning; I am absolutely sure, even from a political point of view, that we are past the point of no return. Every economic agent in this country is past the point of no return. Even if their particular interest groups are suffering from the adjustment process they know that we have to go forward; we cannot go back."
Independent surveys indicate that the vast majority of Brazilian businesses support the Plan and are highly critical of congressmen who obstruct constitutional reform. The most recent state elections showed that the most successful governors at the polls were those who supported the Real Plan or austere fiscal and monetary measures. However, there's clearly a long way to go before such political rhetoric turns into more congressional votes for president Cardoso's proposals.
Putting a positive spin on things is obviously in the economic team's interest, but it seems bankers and corporate investors are also confident that if the team members keep the fiscal deficit, inflation and the trade balance under control over the next few years the markets will be willing to finance shortfalls until more sweeping constitutional fiscal change is enforced.
Cautiously bullish
The feeling is that Brazil is gaining the confidence of the world's leading corporates, and this is supported by a record R4.96 billion of direct foreign investment inflows in the first half of 1996 51% up on a year ago and up from all of 1995's R2.97 billion. Expectations are that direct foreign investment will hit R8 billion by the year-end.
"Although we believe fiscal concerns are well taken ... we assess these risks to be much smaller than what some think," says Dan Dorrow, manager of Latin American economics at Merrill Lynch in New York. "Our view is that the hurdle to fiscal stability is much lower than is commonly believed and that Brazil is moving towards rather than away from a stable debt-to-GDP ratio."
No-one expects Brazil to hurtle towards a Mexico-style currency crisis. Although the real is overvalued, overvaluation is probably of the order of 15% not the 40% that has been suggested by some economists. Brazil also has a 3% current account deficit, compared with Mexico's 8%, and at $58 billion its international reserves are more than three times its monetary base.
"We know there will be some bumps along the road ahead," says Jack Purnell, chairman and chief executive officer of Anheuser-Busch International, which this year established a joint venture with Antarctica, Brazil's leading beverage producer. "However, the beer and soft-drink industries have shown reasonable historical stability in their profits, and our partner's profits should grow as we exchange best practices with Antarctica." Like others, Anheuser-Busch is betting that the huge returns possible in Brazil can exceed the effects of even worst-case exchange rate and inflation scenarios. With vibrant sectors like telecoms where demand for product is so huge that phone lines sell for R2000 each on the black market fears of a Mexico-style collapse have been pummelled in the rush.
"We think they will get further constitutional reforms through over the next few years and keep things on track in the meantime," says William Romary, Latin American economist at UBS Securities in New York. "We believe that constitutional reforms are key to realigning their fiscal imbalance. Brazil's policy mix is ill-conceived, but the adverse consequences of that mix are more likely to be felt over the medium or long term, rather than in the near term. We're not ready to throw in the towel yet."
As a result, investors have this year changed their own deadline for Brazil's success. At the beginning of 1995, when Cardoso began his term, the general expectation was that he would push through at least some significant constitutional reform in his first year in office. If he did not, it was felt, surely things would quickly unravel. But 18 months later there have been no major constitutional changes, apart from a sudden rush of amendments last year that opened up sectors such as waterways, telecommunications, ports and petroleum to private competition.
Indeed, some observers harbour vague feelings that Brazil's stabilization plan could jump off track within, say, two years if sufficient fiscal reform cannot be accomplished. Although the debt to GDP ratio at 33% is low compared with OECD standards, Brazil's short history of economic stability makes markets more unforgiving of even the slightest signs of deterioration.
Without fiscal reform the Real Plan is only half complete as the economic team have been at pains to stress all along. "We don't need any foreign professor telling us the importance of fiscal balance," snaps Gustavo Franco, referring to MIT's professor Rudiger Dornbusch, who believes the real is overvalued by as much as 40% and predicts a Mexico-style crisis. "It's something we emphasized even before we started with the Real Plan."
One of the essential economic problems is that the current combination of tight monetary policy and loose fiscal policy is ultimately unsustainable. The economic team have kept the mix thus far only because they have had no choice. Real interest rates have dropped from a 1995 annual 30% to around 15%. And, judging from futures prices, the rate is expected to fall to between 12% and 14% by the end of 1996. Even so, rates are still cripplingly high. Apart from the effects on the private sector and GDP growth, high interest rates mean servicing public-sector debt is more expensive which is all the more dangerous in the absence of fiscal restraint. "If you do nothing to reduce the fiscal deficit and it continues to increase, then interest rates will increase further; you could fall into a debt trap where the debt and the interest rates feed on one another," says Marcelo Carvalho, an economist at JP Morgan in Sao Paulo. "To avoid this is one of the challenges right now in Brazil."
Interest rates have to stay high in Brazil because together with a strong real they are the main anchors of inflation, but this also means a high GDP growth rate cannot be achieved without bumping into inflationary concerns and worsening trade deficits. If the government could get through constitutional reform in particular administrative reform so it can cut its wage bill, retrench public workers and overhaul its public-sector social security system it would be able to purge Brazil of inflationary expectations and make room for lower interest rates.
The market consensus for Brazil's GDP growth rate this year is between 2.75% and 2.8%. Unemployment, although officially at 5.9% and expected to remain stable for the rest of the year, cannot be eased further because of stifled economic growth. Union estimates, which include the informal economy, indicate that unemployment in the city of Sao Paulo is closer to 16%.
Ways to trim the deficit
With fiscal restrictions imposed by the constitution, the markets have been at a loss to know what the government can do to improve the so-called primary balance, which collates all (PSBR) expenditures, not including real interest payments on debt.
The net public-sector stock of debt in Brazil was R207 billion in 1995 and is forecast to be at least R250 billion in 1996; it will increase so long as the flow of debt continues. Although the government recognizes that it cannot wipe out fiscal deficit without constitutional reform, it claims that it can slow the deficit's growth rate, keeping it within the European average of 4% to 5% nominal deficit. Brazil's public-sector nominal deficit was a little over 7% in 1995 and is expected to be between 5% and 5.7% in 1996.
Owing to its long history of high inflation, Brazil always refers to its deficit in operational terms. The PSBR operational fiscal deficit includes all of the costs of the states and municipalities, the federal government (including the treasury, central bank and the general social security system), the state and federally owned enterprises and real interest payments on debt. Take off the real interest payments and you have the so-called primary balance.
The government is working in three areas that do not involve constitutional change to reduce the fiscal deficit: raising revenues and cutting expenditures to cut its own central government costs; speeding up privatization of state and federally owned enterprises; and encouraging privatization at the state and municipal government level and gaining at least some control over fiscal behaviour at these levels by getting the states to sign separate IMF-style contracts. Treasury secretary Portugal has concentrated for the last few years on trying to bring Brazil's 26 state governments into such contracts with the federal government. So far about 19 have committed themselves, says Portugal.
The PSBR operational fiscal deficit blew out in fiscal year 1995 because of a jump in payrolls and pension costs, mainly at central government level. These were caused by increases in the minimum monthly wage from R70 to R100; this in turn increased the general population's social security benefits, which are tied to the minimum wage. There were also increases in public servants' wages, and the number of people in the federal public service applying for retirement soared in 1995 in expectation of reforms: applications to retire from the federal public service increased from 21,765 in 1994 to 36,918 in 1995.
The reason for this jump, therefore, was a spending spree rather than a revenue shortfall. Real interest payments accounted for about a quarter of the fiscal deterioration in 1995.
For the federal government, primary-balance deterioration was about double the increase in real interest payments, whereas for the state and local governments these two elements contributed about equally. Although the federal government was the largest source of 1995's fiscal deterioration, state and local governments were by far the greatest contributors to the overall operational deficit in 1995: they accounted for about 56% as against 27% from the federal government and 17% from state companies.
This year the federal government is estimating a substantially improved PSBR deficit of around 3% of GDP. Market estimates are for a 3.6% deficit for 1996, decreasing to around 3% by the end of 1997.
The reason for this year's significant improvement is almost entirely the halving of real interest rates in 1996 over 1995. Although the drop is welcome, the heat is now on for the economic team to find ways of cutting huge chunks of cost out of the total public sector's primary balance. JPM's Carvalho explains: "We saw real interest rates drop from 30% to 15% this year. You obviously cannot further reduce interest rates by another 15% in real terms going into 1997, so further improvements in the fiscal deficit must come from a reduction in the so-called primary balance."
That means raising revenues and cutting expenditures at state and federal levels.
Brazil's total tax take is historically very strong, at around 30% of GDP in 1995. Federal revenues rose about 10% in 1995, but expenditures at this level increased faster, at 17%. The federal government's payroll surged 16% in 1995 in real terms over a year ago: at about R3 billion monthly on an accrual basis, the payroll last year ran at about 45% of revenue. For some state and local governments, this ratio was as high as 80%.
Revenue-raising is limited, given that the tax take in Brazil is already quite high. However, Portugal says there are measures already approved that will have a fiscal impact, albeit small.
In December, congress approved a change in corporate income tax. The full gain is estimated at R5.4 billion: the government will get about R2.4 billion in 1996 and R3 billion in 1997. Secondly, through a provisional measure it has established a 12% social tax on the pensions of retired federal civil servants: this will show in the fiscal accounts in September and will ultimately contribute an annual R1.8 billion. Congress has also unified the tax rate between self-employed workers and other workers; now the self-employed contribute 20% rather than 10% of their monthly pay as social security payments. This will raise about R1.2 billion a year. Finally, congress has approved a financial levy called the CPMF tax, which will raise $4.8 billion a year.
In other revenue measures, state-owned enterprises have increased some public tariffs such as petrol, gas, electricity and telecommunications, which are effective immediately.
Further measures are planned. The government hopes to rule that tariffs should be indexed to future, rather than past inflation, so that tariffs will rise in real terms.
Crackdown on slow payers
The government will also try to limit the legal right to delay tax payments, which is a very popular strategy during periods of high inflation. By achieving this it hopes to recover unpaid taxes amounting to about R8 billion. "Even if we can recoup a small part of this it will be a good result," says Mendonca de Barros. He adds that attempts will be made to do away with similar payment-delaying tactics in the social security system. "The legal structure is pretty much the same," he explains. "There are a series of procedures which in practice can enable an enterprise to delay its contribution to the social security system for his employees by more than five or six years."
The impact of these revenue measures, however, is tiny compared with expenditure. And many of the revenues will be subject to transfer to the states. Portugal says the impact will be around a 1% real rate of revenue growth in 1996 compared with 1995, rising to about 6% in 1997.
The economic team's challenge is more to downsize the public sector, which will improve the fiscal figures at the state level. "That's why privatization is so important," says Mendonca de Barros. "We can significantly reduce the size of the public sector [in the absence of constitutional reform] only through privatization, and that's why we are pushing very strongly in that direction."
Privatization can have enormous benefits in reducing the wage bill. Take, for example, the federal railway privatization currently under way. The government has already leased two federal railway network concessions and will have leased all five by March 1997, by which time it will have reduced the railway public servant workforce to just 400 from 45,000. "We also expect that the real cost of transportation will be reduced, and that is extremely important in improving the efficiency of our export industries, especially agriculture and mining," says Mendonca de Barros.
Apart from privatization, the economic team has defined 30 measures that can reduce the wage bill without constitutional reform. The team would not divulge the contents unsurprisingly given the imminence of the municipal elections. However, it's believed they are generally aimed at encouraging voluntary retirements, reducing the hours worked per day, and reducing the so-called vegetative growth of the wage bill caused by such factors as automatic promotion through the ranks.
Cutting down on non-lifers
Not all public servants, for instance, fall under the 1988 constitutional stipulation that public employees get lifetime job guarantees. That applies only to those who had been in a government job for at least five years before the constitution's enactment.
It is estimated that about 55,000 of the central government's 600,000 employees are not covered by this guarantee. If the government were to begin voluntary retirement programmes for these employees it could cut its wage bill by 5%. That might not sound much, but its effect is considerable, because the federal government's wage bill is about half its total expenditure. A far greater number of these "non-lifers" are employed by the states, and the government is providing certain states with funds to pay for voluntary retirement programmes.
The government cannot cut wages, but it can erode them by not awarding new wage increases. "We did not give any pay rises in January this year. If you take inflation from January to June at 21% and factors such as the vegetative growth in the wage bill, you will see that it will cost us 17% less in wages in January 1996 compared with January 1995. Over a year the gains equate to about 9.7%, taking into account an estimated inflation rate of 13% by the end of this year."
In terms of current expenditures those costs associated with the day-to-day running of federal government the team claims it can find ways to ensure that ministries spend R10 billion less than the R26 billion congress approved in the 1996 fiscal year. And by cutting down primary expenditures the public sector will also reduce its interest charges.
Portugal adds that the effects of fiscal policy take longer to show even than monetary policy, often running years into the future. This also means that further interest rate reductions this year will still have some effects in 1997.
There are reasons to believe that other elements that caused a blowout in the wage bill will not persist. The number of public servants applying for retirement should decrease to normal levels and there will not be such large payout adjustments to account for inflation. Another way to cut the wage bill is to reduce the bonuses civil servants are awarded when they retire, which can be as high as 20% of their salary.
The government is also drafting a bill which includes measures it can implement to cut the general social security bill without constitutional reform.
Brazil's governments are constitutionally prohibited from sacking public servants except in extremis, cutting nominal wages, cutting social security payouts, changing the retirement age or reducing the level of revenue transfers to the states.
As a result it has public servants with lifetime job security and public-sector retirees receiving their full salaries on retirement. In the general social security system, where the employer pays a certain percentage to the government and then the state provides retirement funds, certain retirees can pass on their pensions which can be the same as their final salaries to their spouses if they die; and if the spouse dies the children then receive the pension until they reach the age of 20.
The retirement laws are so generous that after 30 years of service for males and 25 years for females, private-sector workers can opt for early retirement with pensions of 70% of the average of their last 36 monthly salaries, plus 6% extra for every year they have worked beyond that before they hit the normal 35 years, and 30 years of service to be eligible for 100% of the average.
That means that someone who started working at 14 can retire at 39 (females) and 44 (males) on 70% of a full salary or at 44 and 49 years for females and males respectively on 100% of full salary. Teachers and professors can always retire after 30 years (male) and 25 years (female) and get pensions equal to 100% of their salaries. Those working in stipulated harsh jobs, such as coal-mining, can retire at full salary after 15 years' service. Although the law should cover only those who do hard labour, office-bound engineers are also retiring early, claiming they are working in a harsh sector.
Brazilians can also retire at 65 (males) and 60 (females) in urban areas and 60 and 55 in rural regions on the same average of their last 36 monthly salaries if they have been employed for the last seven years. In other words, they can get their full wage as a pension even if they have only contributed to the social security system for the previous seven years.
Cultivating the system
These rules include everyone, regardless of whether they make R1000 or R10,000 a month. Anyone who has at any time lived in a rural area can add those years on as years of service even though they didn't contribute to the social security system at the time because they were sons and daughters of farmers doing the usual family household chores. Around 70% of Brazil's population has lived in a rural area at some point and the government has found 300,000 pensioners who have spuriously counted their early days on the family farm as years of service, even though they are doctors, politicians, lawyers and other professionals with no connection to rural work.
Although there's little the government can do, there are some ways of reducing the anomalies. For instance, although it cannot change the age of retirement or the length of service required for retirement without changing the constitution, it can propose legislation reducing the 70% of full salary early retirees receive as pensions. Although the effect would be small about R300 million to R600 million a year it would reduce the incentive for early retirement. There are also moves to set up a team of 300 specially trained doctors to audit claims of permanent incapacitation: more than R6 billion a year goes on social security benefits to people claiming they are unable to work for the rest of their lives, and preliminary audits have suggested that about 20% of these are spurious claims.
The social security ministry is also moving to crack down on evasions of social security contributions by Brazil's top corporates, which preliminary audits suggest could be as high as 25% per year among about 1.5 million companies.
Cutting with kindness
The government is also pushing public enterprises to embark on their own downsizing. Petrobras for instance, has cut its workforce by almost 10,000, from 58,000 to 49,000, in the past two years. However, because of their very nature, actions that downsize the government and cut general and public service pensions will not be something the team will be anxious to publicize, in deference to the unions.
The most complicated effort involves introducing fiscal austerity measures at the state and local government level. Treasury secretary Portugal and the economic team have been trying to strike agreements with the states ever since they came to Brasilia. They strengthened the process last January by introducing lines of credit agreements similar to the IMF's own country agreements, whereby the government offers states three different lines of credit in return for their meeting certain fiscal targets.
The first line of credit gives the states funds with which they can pay arrears in their wages bills; the second provides them with funds for retrenchment programmes of public servants not covered under the lifetime employment guarantee; and the third provides them with medium-term funding enabling them to pay off extraordinarily high short-term loans they receive from their state banks in lieu of future revenues.
The process is a formal one and the federal government sends what is called a treasury mission to the state that wants to join the programme. The team is led by treasury and administrative representatives who determine how the state can cut its wage bill. Representatives from national development bank Banco Nacional de Desenvolvimento Economico e Social (BNDES) also join the mission to determine what can be privatized and how. After 10 days in the state, the mission prepares a report recommending measures that could be taken to improve the fiscal situation.
"The aim is to have, in a three-year period, the state generating a primary surplus, which in turn helps it achieve an operational balance," says Portugal. "So far we have signed agreements with 19 of the 26 states. We have given them R2.2 billion. Of course, like all human action, it will not have a 100% success rate, but I don't think it will have a zero success rate, either: some states are doing very well, such as Rio Grande do Sul. We gave them finance to begin voluntary retrenchments. They had already laid off 15,000 employees by last May, which is 6% of their total public workforce. Four other states have also begun similar programmes and are receiving lines of credit under their agreement [with the federal government] to pay for the severance cost."
The federal government is enticing the states to take up many other measures. Sometimes these have small fiscal effects, but they are important because they sow the seed of fiscal reform at the state level. Another example is CESP, the Sao Paulo electricity utility, which earlier this year made its debut in the Deutschmark Eurobond market after receiving a guarantee on that issue from the Republic of Brazil. The aim of the issue was to improve the company's debt profile ahead of privatization by using 100% of the proceeds of the issue to pay off debt it owed the federal government.
Ultimately, the bet investors have to take with Brazil is whether Cardoso will be able to push through constitutional reform. Some commentators argue he's not screaming loud enough: "It's all too much a process of trying to accommodate different interests, which is the typical way of Brazil," says Francisco Gros, chairman of Morgan Stanley Brazil and the former Brazilian central bank president during president Fernando Collor de Mello's administration. "The states are not being given any really hard choices. It's all just carrots and no sticks."
Gros was referring in particular to the federal government's recently announced rescue plan for ailing state-owned banks. This will provide 100% of the financing needed to restructure debt of banks being privatized, liquidated or turned into development banks. It also offers to refinance up to half the debt held by state banks whose governments decide to keep control of their banks.
Although Gros and many others have criticized the plan for sending an all-too lenient message to the states, the deal is realistic and goes some way to breaking the stand-off between the states and the government over the future of their state banks. Sao Paulo's state bank Banespa, for instance, is owed R20 billion by its state owner, but in spite of its collapse it has still not been privatized or taken out of the state's hands.
After the announcement of the new measures, the state of Minas Gerais reached an agreement with the federal government to receive nearly R700 million in loans needed for the privatization of its state bank, Credireal. The Rio de Janeiro state government is also going to participate in the plan for privatization of state bank Banerj. Taking the state banks out of the hands of the state governments will take away one of the biggest sources of fiscal corruption in Brazil.
The plan may not have a 100% success rate, but these days in Brazil, you grab what you can get.
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