Brazil's economy: Showing strength

The Brazilian economy is bouncing back, but is the recovery here to stay?

Brazil's economic recovery is now well under way. Following a few years of unimpressive growth, the economy has bounced back more strongly than anticipated, with GDP growth of more than 5% in 2004, the fastest expansion in 10 years. Since taking office in January 2003, the new administration has done a good job in restoring confidence, which had faltered in the run-up to the presidential election. Domestic demand has since picked up, consumers and businesses are more upbeat, and private investment is recovering. But is the recovery here to stay, or could more be done to make it sustainable?

To be sure, the economy appears to have become more resilient to external shocks. Until now, a reliance on foreign financing has tended to make Brazil vulnerable to changes in global market sentiment. But record trade and current account surpluses emerged in 2004 on the back of robust export growth rather than a fall in imports. Importantly, the maintenance of a freely floating exchange rate has been essential in making the economy more responsive to external price signals.

Another fillip has come from the gradual reduction in trade barriers. The usual indicators of vulnerability, such as the ratio of external indebtedness to exports, have improved a great deal. This is encouraging for growth, as it shows the recovery is not merely linked to the upswing in the current economic cycle. It also means the country is better equipped to withstand sudden reversals in international financial conditions, should these occur.

Institutional improvements have also played a role, with several noteworthy reforms over the years helping to strengthen the policymakmg framework. The Fiscal Responsibility legislation, which has instilled greater financial discipline at all levels of government, is a case in point. Not surprisingly, given this strong institutional set-up, Brazil's track record in meeting annual budget targets has improved, even under difficult economic conditions.

And on the monetary front, the central bank is committed to targeting as a way of bringing about low and stable inflation in the long run. This should lead over time to lower interest rates-which in Brazil are high at over 10% in real terms-and stronger private investment. A further boost to confidence in the institutional set-up would come if legal operational autonomy were granted to the central bank, whose independence is not yet ensured by law.

So far, so good, though clearly there are challenges. Consider public debt first of all. Cautious fiscal management has helped to reduce public indebtedness to around 52% of GDP in 2004, down from over 58% a year earlier. Though commendable, this is but a first step. The trouble is that fiscal adjustment has been achieved over several years predominantly by hiking taxes and cutting back public investment. As a result, Brazil's tax ratio has risen by nearly 7 percentage points since 1995 to about 35% of GDP in 2004, which is much higher than average for emerging markets.

Yet, OECD experience shows that fiscal consolidation is more likely to be successful over time when based on tighter current spending rather than investment cuts and revenue hikes. Shifting the emphasis of fiscal consolidation from further increasing the lax take to reducing spending would mean that consolidation can be achieved while channelling resources to meet society's economic and social priorities.

A second challenge is to improve the investment climate to boost investment in support of long-term growth. Changing this is easier said than done. A new bankruptcy law is an important step forward to encourage the creation of credit to the private sector and to reduce interest rate spreads. Effort has been made to address regulatory uncertainty in network industries, such as oil, gas and electricity, which also weighs on investment. These regulatory reforms are well thought out. But implementation will be their ultimate test.

In the case of electricity, for example, a new regulatory framework is now in place, but, as the government has increased its role in long-term planning, the risk of failure should not be underestimated. Water and sanitation is another area where private investment continues to be constrained by a lack of clarity over the assignment of regulatory powers across different levels of government. For instance, it is not clear if the provision of water and sanitation services comes under the purview of the states or the municipalities. Public-private partnerships should help to boost investment in infrastructure, if carried out in a fiscally responsible manner.

Yet Brazil's experience with regulatory reform in the telecom sector shows what a well designed and executed regulatory framework can do: privatisation has fostered competition, so reducing charges and facilitating access to improved services. New legislation on public-private partnerships should follow this lead and open up opportunities for private investment in a host of infrastructure sectors.

A third challenge is to strengthen policies in pursuit of the government's social agenda. Brazil has come a long way in this area, such as in raising the level of school enrolment. But the government already spends a high proportion of GDP, almost one-quarter, on social programmes, and not always on the ones that are most cost-effective. In fact, public spending on pensions accounts for over 10% of GDP, a higher share than in the average OECD country, despite Brazil's younger population. In contrast, more effective means-tested programmes, such as on subsidies for childcare or care of the elderly and disabled persons, take up a relatively small share of public social spending. Policymakers know that such approaches may be costly to start up and demand administration, but their effects are positive over time in terms of reaching the poor and getting value for money.

All in all, 2004 was a positive year for Brazil. The economic outlook is promising, with the conditions for sustainable growth by and large in place. Budget consolidation has been difficult, but is paying off. The government's reform agenda is vast. It is important not to lose momentum and to make the most of these good times to address those policy areas that have so far proved difficult to reform.

Reference

* OECD (2005), Economic Survey of Brazil.

Luiz de Mello, OECD Economics Department

Copyright Organisation for Economic Cooperation and Development Mar 2005
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