Analyzed by: Group 1Alekhya Chakrabarty 08FT-002 Ankit Goel 08FT-006P Randheer 08FT-026 Raviraj Kurdekar 08FT-036Rohit Kumar 08FT-038 Vikas Gupta 08FT-059

Brazil - Statistics GDP: US$ 1.994 trillion (2008*) Currency: Brazilian Real GDP Per Capita: US$ 10.551 (2008) Inflation (CPI): 4.46% (2007) Population below poverty line: 14% (2008) Labour force: 101.77 million (2008) Unemployment: 7.6% (2008) Exchange Rate: 2.50 per $ Exports: US$ 218.6 billions (2008) Imports: US$ 145.7 billion (2008) Public finances: Public debt US$ 103.2 billion; 6.4% of

GDP (2008) Credit rating: BBB- Reserves: US$ 219,4 billion (2008)

Brazilian Economy

Largest economy in Latin America Tenth in world at market exchange

rates Ninth largest in terms of PPP Regarded as one of the group of four

emerging economies called BRIC Booming exports

Objective of the Study

To understand the macroeconomic policies and study their implication on the Brazilian economy in light of the various internal as well external crises that were faced by the country in the post war period

Post-war Period, 1945-64

Favourable condition post World War II Exports increased sharply, though

constraints on imports Allied victory discredited fascism and

encouraged constitutional system Half billion dollars in reserves, constraint

on import capacity eliminated Fixed nominal exchange rate resulted in

overvaluation and worsened trade balance

Post-war Period, 1945-64

Overvaluation and increased imports worsened current accounts

Reinstituted exchange controls rather than confronting the overvaluation directly.

Development programs financed through extending monetary base

The trade balance and the balance of payments worsened, first inflationary surge

Post-war Period, 1945-64

Post-war Period, 1945-64

Accelerating inflation Slowdown in GDP growth Severe foreign exchange shortage Affected production especially in

industrial sectors

Stabilization and Reform, 1964-67 On March 31, 1964, military coup occurred

and Army Marshal Humberto Castelo Branco became the first President of the Military regime

Economist Roberto Campos was appointed planning minister.

Immediate economic concerns: Rising inflation Worsening external payments position

Stabilization program included, Strict control of public debt Restrictions on credit and wages

Stabilization and Reform, 1964-67 Fiscal strategy consisted of:

increase in direct and indirect taxesReduction of subsidies through realistic pricing of

public utility services Increased tax revenues through the indexing of tax

ratesFinancing of government debt through the sale of

bonds. The authorities established monetary growth rates of

70 percent for 1964. 30 for 1965, and 15 for 1966.

Stabilization and Reform, 1964-67 Credit expansion during the 1964-66 period was 18.5 percent

below the mean for the 1960-62 period. But an increase in net foreign borrowing and foreign direct

investment, and the fixed nominal exchange rate resulted in an unintended monetary expansion.

Under a law passed in 1965, nominal wage adjustments could only be made at twelve-month intervals and had to take into account the official inflation forecast, the average real wage of the preceding twenty-four months, and an officially mandated "productivity gain.“

Stabilization and Reform, 1964-67Short Term Effects

Inflation fell from an annual rate of 90 percent in 1964 to about 25 percent in 1967.

The federal deficit fell from 4.2 percent of GDP in 1963 to 1.1 percent of GDP in 1966

Monetary financing of the deficit fell from about 85 percent in 1963 to about 13 percent in 1966

Foreign payments arrears of $300 million in 1963 were replaced by reserves of about $400 million by 1966.

The real GDP growth rate increased from 1.6 percent in 1963 to 5.1 percent in 1966 and 4.8 percent in 1967.

Stabilization and Reform, 1964-67Long Term Effects The economy's allocation mechanisms were deeply

compromised In principle, the government's strategy was an economic

democratization carried out under government supervision. The government would use its policy instruments to allocate

resources according to its own predetermined objectives and the demands of those interest groups that were still allowed a voice by the government.

In reality, government supervision did not end. Instead, it multiplied.

Stabilization and Reform, 1964-67Long Term Effects

The government increasingly disregarded price mechanisms to allocate resources.

The efficacy of price mechanisms was further compromised by Indexation.

Indexation sped the transmission of shocks to other sectors of the economy and increased the variance of the rate of inflation.

Brazil: 1964 -1967

The post-1964 regime has often been characterized as one in which the private sector was given much freer rein than it had previously enjoyed.

Foreign trade remained subject to a variety of administrative controls, and commercial policy was relatively protectionist .

The prices of numerous goods and services were subject to government control throughout the period, and foreign exchange controls remained in effect.

Despite the development of financial markets after 1964, government intervention in these markets resulted in wide variations in interest rates

Positives and NegativesPositive side:

Intervention in key industrial sectors produced a more diversified industrial base than might otherwise have developed.

Negative side: The government’s lack of concern about

allocative efficiency suggests that intervention exacted a high price in welfare terms.

No institutional checks and balances Increased degree of uncertainty surrounding

economic decisions.

Inflation and IndexationThe root of Brazilian inflation : Monetization of part of the government's deficit.Inflation took its first substantial leap in the period after World War 11.Reaction to Inflation:

Tightened fiscal policy, increased prices forpublic services to levels that would cover costs, and reduced the growth of government services. in order to reduce the deficit that underlay money supply increasesExtensive system of indexation, or "monetary correction."

Brazilian inflation was both a cause and an effect of the extensive indexation that developed after 1964. In October 1989 price inflation was running at approximately 40 percent a month, or well over 1,200 percent a year: Hyper Inflation

Inflation and Indexation Cornerstone of this policy was Law 4357, which legalized the revision of

nominal financial values to reflect inflation, in effect permitting financial contracts to be made in real terms

Government sold indexed government obligations to the public. Private sector absorption of the debt, which had been negligible before 1964, was large enough by the late 1960s

The shift from monetization to public debt financing in the decade after 1964 was one of the reasons for the drop in inflation rates between 1964 and 1974.

But the arbitrary nature of Government decisions about the price indices that underlay the indexation system increased the uncertainty caused by inflation

Monetary correction in the external sector also lagged behind financial market indexation. Brazil adhered to a fixed nominal exchange rate policy until 1968 Wage readjustment was less frequent and less automatic than was monetary

correction. Only in 1979, for example, was the adjustment in the minimum salary (saldrio mininio) changed from an annual to a semiannual increase.

Then, in August 1968, Brazil adopted a crawling peg or "minidevaluations“ (minidesvalorizaq6es). which in effect indexed the exchange rate.

ECONOMIC GROWTH IN THE MILAGRE YEARS(1968-1973)

Restraints of the 1964 stabilization program began to weaken in 1967

Centre of power in economic policy making shifted to the Finance ministry headed by Antonio Delfim

DELFIM’S ECONOMIC POLICY SHIFT

Less orthodox & restrictive than Campos mainly due to substantial decline in inflation rates produced by the earlier regime

Move to expansionary policy also facilitated by considerable excess capacity in the economy mainly in the industrial sector & by improvement in balance of payments

Main policy difference –diagnosis of inflation –demand side to supply side

Tolerate gradual slowing of inflation in exchange for higher growth rate of real O/P & employment

DELFIM’S ECONOMIC POLICY SHIFT

Most important strategy was monetary policy

Believed inflation in part due to high interest rates by producers, hence expanded the money supply rate greater than the income based monitory growth rate

Maximize short run growth rate preventing liquidity constraints in private sector

To implementcreated credit through open market operations along with govt control of interest rates

PRICE,WAGE & SECTORAL POLICIES UNDER DELFIM

Created a price control agency

Actual value of nominal wages in the previous 12 month period was replaced by a value that would have occurred if the inflation rate was predicted correctly

Crawling peg exchange rate policy

Sought to improve agricultural productivity through subsidies,greater mechanisation,fertilizers but had limited effect

MACROECONOMIC PERFORMANCE DURING THE MILAGRE

Performed brilliantly between 1968-1973 Real O/P grew at an avg 10.8% a year,per

capita GDP grew to average 7.9%

Annual inflation was held at avg of 20%,public deficit fell from 1.2% of GDP in 1968 to 0.2% of GDP in 1972

Ratio between Net External debt & exports fell from 1.9 % in 1968 to 1.5 in 1972,situation under control

High real income growth rate permitted the increase in real money supply at an annual average rate of 14% without corresponding increase in inflation.

MACROECONOMIC PERFORMANCE DURING THE MILAGRE Capacity utilization in manufacturing

rose to 90.5 %

Industrial employment rose at slightly less than 9% during 1968-1974

Industrial output expanded at an annual average rate of more than 11%

Tightness of labor markets in the early 1970s was reflected by substantial gains in real wages in industry & agriculture

The First Oil Shock, 1973 Policy making from 1973-82 attempted

to prolong the boom of preceding years Steep rise in oil prices rose the import

bill from $6.2billion to $12.2 billion Only half of the increased prices were

shifted to consumers, rest absorbed by subsidies

The growth rate slowed down in 1974-75, but still high by world or Latin American standards

The First Oil Shock, 1973 Aggregate demand remained

unbalanced External borrowing increased and

reserves decreased. Burden of external shocks heavier

than they had been dealt with promptly

The First Oil Shock, 1973 Aggregate demand remained

unbalanced External borrowing increased and

reserves decreased. Burden of external shocks heavier

than they had been dealt with promptly

Growth After the Shock, 1974-79 Long term investments in import

substitution and capital goods encouraged

Exports had grown rapidly during Milagre period

Reserves had grown from $650 million to $6 billion

Financing the current account deficit through additional external borrowing

Growth After the Shock, 1974-79 Inflation rate soared as monetary

policy became accommodative Stagnation in world economy slowed

exports growth Increase in domestic interest rates to

slow growth Output growth rate fell, internal

supply shock, 1978 Increased imports and further inflation

After the Shock, 1974-79

External Shocks & Response, 1979-82 Foreign interest rates increased sharply Second oil price shock Trade deteriorated Delfim’s policies

Maintain high rate of growth Deal with high interest and inflation rates Agriculture and energy sectors encouraged Strict control to reduce nominal interest rate New wage policy to improve income

distribution

External Shocks & Response, 1979-82 Delfim’s policies

Correct external imbalances 30% devaluation of domestic currency New subsidies for exports, compulsory

deposits on imports, incentives to borrow abroad

GDP increase of more than 7% in 1980 Negative trends in all other measures Monetary authorities switched to

targetting money supply

External Shocks & Response, 1979-82 Financing debt through sale of

exchange rate indexed-treasury bonds

Ready market as real depreciation was increasingly likely

Real liquidity fell and domestic real interest rates increased

1981, GDP growth rate was negative for the first time, output dropped by 10%

External Shocks & Response, 1979-82 Inflation continued to be high Trade balance became positive due

to cuts in imports rather than exports growth

Net interest payments accounted for 70% of current account deficit

Increase in domestic interest rates encouraged foreign borrowing

External debt increased

Collapse of Foreign Lending, 1982-85 Central bank reserves had fallen

sharply Brazil viewed as riskier borrower

following the collapse of Mexico Principal commercial lenders

suspended new and rollover of expiring credits

Brazil resisted turning to the IMF

Collapse of Foreign Lending, 1982-85 Central bank reserves had fallen

sharply Brazil viewed as riskier borrower

following the collapse of Mexico Principal commercial lenders

suspended new and rollover of expiring credits

Brazil resisted turning to the IMF

Oil ShocksMilagre Lending Collapse

Heterodox Economic ShocksThe efforts to stabilize the economy

saw three shocks: The Cruzado Plan (1985) The Bresser Plan (1987) The Summer Plan (1989)

The Cruzado Plan

Price was freezed Wage readjustments and freeze Readjustment and freeze of rents

and mortgage Ban on indexation

Immediate results were spectacular, inflation fell close to zero, economic growth up surged, foreign accounts were under control

The Cruzado Plan: In Trouble With fixed price and growing

economy, real income increased Price fix was maintained for too long Demand increased

•Excess demand created inflationary pressure•Indexation was back to control inflation

The Bresser Plan and Summer Plan Both plan were introduced in 1987 and

1989 respectively Attempt to control inflation Introduced price freeze and banned

indexation Not able to address the public-sector

disequilibrium•1980 ended with high and accelerating inflation and

a stagnant economy

•Public debt was enormous

•Govt. had to pay very high interest rate to ensure

public spending in govt. debt instruments

REAL PLAN

•In 1994 by Fernando Cardoso•Introduction of a new currency (The Real)•Deindexation of the economy•Initial freeze of public sector prices•Tightening of monetary policy

REAL PLAN

Reduced tariffs(of 51 percent in 1988 to an average of 14 percent in 1994)

Liberalize foreign investment On the expenditure reduction in the

funds the states and municipalities. On the revenue side, federal income tax

rates were increased. Monetary policy was restrained

gradually.

REAL PLAN

Effects: Brought inflation down to under 2% per month food consumption rose 30%, purchase of consumer goods increased imports increased, the economy grew 4-5% every year since 1993 unemployment dropped to its lowest level and real wages grew from 5% in 1994 to 13% in 1995 between 1994 and 1995 the income of the lowest

50% of the workers grew by around 30% whereas the income from the top group grew only 10%

Economic crisis in Asia and Russia affected the Brazilian recovery

1999 Crisis : Fiscal DeficitPersistent accumulation of these

deficits by a country that has a history of debt defaults or moratoriums clearly discomfited investors.Financial crises in Asia and subsequently in Russia.Brazil responded to these crises by raising interest rates in hopes of maintaining its exchange rate and holding foreign capital in the countryLed to drop in Brazil’s industrial production index in second half of 1998Forced up nominal fiscal deficits, aggravating existing concerns over sovereign default

1999 Crisis : Real Devaluation

As problems became more acute in 1998 fiscal deficit a big issue , call for a Brazilian devaluationNew budget plan intended to save $23 billion and $41.5 billion International Monetary FundDevaluation postponedDecember 1998, a deficit reduction bill was voted downMinas Gerais Governor Itamar Franco’s announcement refused debt paymentsix other governors followed suiteCapital outflow :$1 billion per day,9 percent Devaluation in Dec 1998Brazil declared floating exchange rate at the end of Dec 1998 January 1999, when the exchange rate system broke down

Summary of the post 1994 Period

Strategy for Economic Growth : Brazil

Analysis of the PastAnd

Recommendations for Future

Macroeconomic framework of countries with high external indebtedness

Revisiting the Past

Revisiting the Past• The 1999 switch from an exchange anchor to a floating

exchange rate regime plus an inflation target regime brought no significant improvement in the macroeconomic variables.

• Balance of payments have improved their accounts in 2003-04 due mainly to the increase in the trade balance surplus.

Average investment rate in the last fifteen years was insufficient to generate a robust growth for the Brazilian economy.

This behaviour of investment rate was mainly due to the “economic policy model” adopted by Brazilian policy makers since the beginning of 1990´s.

(i) high nominal and real interest rates in order to achieve price stability; (ii) growing liberalization of the capital account in order to integrate Brazil to international capital markets; (iii) overvaluation of domestic currency. (iv) since 1999 an increasing primary fiscal surplus – generated mainly by the reduction of public investment – in order to stabilize public

debt/GDP ratio.

Alternative economic policy model

Adoption of a crawling-peg exchange rate regime in which devaluation rate of domestic currency was set by the Central Bank at a rate equal to the difference between a target inflation rate and average inflation rate of Brazil’s most important trade partners

Adoption of market-based capital controls in order to increase the autonomy of the Central Bank to set nominal interest rates according to domestic objectives (mainly to promote a robust growth)

Reduction of nominal interest rate to a level compatible with real interest rate

Reduction of primary surplus from current 4.5% of GDP to 3.0% of GDP. These elements are fundamental for the required increase in the investment rate of Brazilian economy from current 20% of GDP to 27% of GDP needed for a sustained growth of 5% per year.

1)The first principle of the “alternative economic policy model” entails the abandonment of the current Inflation Targeting Regime (hereafter ITR). .... For the workings of this system, however, there must be a floating exchange rate regime. ……Adoption of a crawling-peg exchange rate regime will reduce the exchange rate risk.•crawling-peg exchange rate regime is that it will serve as nominal anchor for the Brazilian economy, substituting ITR as a device for inflation control.

2). The adoption of capital controls. These controls are necessary for two basic reasons. a) Increase private investment b) Control over nominal exchange rate.• To reduce capital inflows, it is necessary the introduction of reserve requirements over all capital inflows, except foreign direct investment

Current challenges

Brazil remains far from the full employment :8.2 percent Controlling inflation:6.4%(Present)-4.5 %(Target)-Food

Prices Agricultural prices have risen substantially in the last few

months, a trend that may begin to be seen in other sectors, given the huge increase in internal demand

lack of technically qualified people to attend to certain sectors

Insufficient electricity generation to support a lengthy period of economic growth.

The large trade surplus from agricultural and mineral commodities, and the influx of speculative capital stimulated by high interest rates, without neutralizing measures, causes overvaluation of the real, which in turn undermines the competitiveness of national industry, resulting in lower exports and an invasion of cheaper imported goods.

Lesson’s from Brazil

Monetary growth is an endogenous process, driven by the need to finance fiscal deficits

Can be faced immediately, postponed. But in the long run it cannot be avoided

Consequence of populist attempts to ignore the fiscal disequilibrium : Economic turmoil

Lesson’s from Brazil, Contd. Large economies can also be vulnerable to

external shocks The large capital inflows of the 1970s ; a

mixed blessing, when real interest rates rose in world markets, Brazil's terms of trade worsened, and lenders declined to roll over maturing loans

Despite its success in weathering the external payments crisis, failure to increase domestic savings imposed a high internal cost as investment declined

Lesson’s from Brazil, Contd. Long import substitution made the

economy more vulnerable to external shocks than more open policies would have

Trade restrictions permitted the delay of real exchange rate adjustment which would have reduced the effects of the oil shocks

In the long run it encouraged rent-seeking and undermined the competitiveness of a number of sectors

Lesson’s from Brazil, Contd. The greatest learning experience has

been with stabilization plans Price freezes without fiscal adjustment

waste valuable time and undermine government credibility when they eventually fail

Markets respond more favorably to sustained and consistent policies than to quick fixes

Extending price controls to trade (ie, by fixing the nominal exchange rate) may aggravate the situation further.

References

Donald V. Coes (1995), “Macroeconomic Crisis, Policies and Growth in Brazil, 1964-90”, World Bank ‘Comparative Macroeconomic Studies’

José Luís Oreiro and Luiz Fernando de Paula(2005), “Strategy for Economic Growth in Brazil”

www.economist.com www.worldbank.com