When Dilma Rousseff became the first woman to sit behind the Brazilian presidential desk on January 1, she was grateful for the record job creation and social mobility achieved under the eight-year rule of her predecessor and mentor Luiz Inácio Lula da Silva.
But there was little time for celebration: Brazil’s economy – long the toast of international investment – had already begun to show distinct signs of overheating. Growth clocked in at 7.5% for 2010, following a contraction of 0.6% of GDP in 2009. It was the best performance in nearly a quarter of a century.
At the same time, annual inflation was already running at 6%. It is set to increase at least until mid-year, while the official inflation target stands at 4.5% (with a tolerance margin of up to 6.5%). Monetary policy has been tightened again, but this is attracting the kind of capital flows that appreciate the currency yet further.
Government officials say the only way to break this vicious cycle is to implement the sort of fiscal adjustment that Rousseff previously rejected before and after her election last October. “This is the bill from overheating, which was especially reflected in the labour market and very high wage inflation,” says André Loes, chief economist at HSBC in Brazil. This, together with abundant credit facilities, has fuelled price rises.
TOO FAST
Officially, the government remains bullish about growth prospects and has played down overheating concerns. “The growth of the Brazilian economy in 2010 was quality growth,” says finance minister Guido Mantega. “Investments grew approximately three times GDP and also three times the consumption of families... the Brazilian economy is not very heated and will start the year in 2011 with an average growth rate of around 4.5% to 5%. We are heading towards moderate growth.”
Yet IMF managing director Dominique Strauss-Kahn – speaking the same day as Mantega talked about quality growth – said: “7.5% growth, the best in 25 years, it is fantastic. But sometimes you may run too fast. That is exactly the situation here. If you go too fast, there is a risk that you will just hit the wall. It is time to decelerate.”
APPLYING THE BRAKES
There are signs that policymakers have already begun to apply the brakes. On the monetary front, the government has adopted a mix of interest rate hikes and quantitative (so-called macro-prudential) measures of monetary control to avoid a credit bubble and to rein in inflation. While the benchmark Selic rate has edged up by 100bp to 11.75% since the beginning of the year, the central bank has also raised banks’ compulsory reserve requirements and capital equity ratios in an effort to cool down credit activity.
This tightening cycle is expected to be extended for another few months. But Loes says the central bank will be reluctant to hike rates too much further, so as to prevent exchange rate appreciation. “Apparently, there is a strong signal from the government, possibly the president herself, in this direction,” he says.
Guillermo Mondino, chief Latin American economist at Barclays Capital, believes that this reluctance to raise rates due to concerns about capital inflows and currency appreciation could risk Brazil falling behind the curve in its inflation-fighting efforts, and could risk excessive tightening further down the line.
“Brazil’s central bank has been on the conservative side in hiking rates, and there’s a risk of falling behind the curve compared to where Latin American central banks would historically have been at this juncture,” he says. “They’ve been on the dovish side of things, and this has had an impact on expectations.”
WHITHER PRUDENCE?
But progress on fiscal consolidation is more relevant to Brazil’s long-term economic sustainability than the short-term monetary policy outlook, Mondino notes.
Officially, at least, the new administration has shown signs of addressing such concerns. President Dilma announced a fiscal consolidation programme in February aimed at delivering R50 billion ($30 billion) in cuts. This headline figure is in line with market expectations of what is needed to restore fiscal discipline after the accelerated public spending during the global financial crisis and in the run-up to elections in 2010, and it includes some real cuts (such as in the defence ministry and in the social housing programme, Minha Casa, Minha Vida).
Fred Jasperson, director of the Latin America department at the Institute of International Finance (IIF), believes that the fiscal consolidation marks “a genuine departure” from the old administration by the new president. “The new administration would like to take any political heat early on, and position itself well for having a good long run in power,” he says.
John Welch, emerging market strategist with Macquarie Capital in New York, says that while the programme is well-intentioned, it may not be enough. “It is a real cut. Some of it is fudged, but some of it is real. It may not be quite enough, but it is better than what I had feared. It is less expansionary and it looks more credible.”
EXECUTION CONCERNS
But Welch’s words belie widespread concerns about execution risks shared by many experts, with analysts warning that the actual cuts may amount to just R13 billion (less than a quarter of the headline figure).
“The fiscal package in Brazil looks encouraging on paper. The problem is implementation,” says Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets. “We don’t know if it is going to have the desired impact.”
The result has been mixed market reaction. “Credibility is currently low... Markets have initially reacted with disbelief,” says Roberto Padovani, market strategist at WestLB in São Paulo. “There is no confidence in the market, but I think adjustments will be made.” He believes that government popularity will suffer if it fails to control inflation and that it will shy away from orthodox policies.
Others are more sceptical. “The spending cuts only reduce the real growth rate of spending from 2010 to 2011, but real spending growth will continue to be positive. As such, there is no fiscal retrenchment on the cards, just slower expenditure growth,” says Douglas Smith, Latin America head of research at Standard Chartered.
TOUGH TALK
Some fiscal hawks even consider the government’s latest move as a mere smokescreen.
“This whole talk of promoting an adjustment without cutting investment and social spending does not exist,” says Sergio Vale, chief economist at MB Associados, a São Paulo consultancy. “The announcement of the cuts looks like a mere letter of intent, such as the ones we used to write to the IMF in the 1980s time and time again – those that were never fulfilled.”
Vale says the most disturbing aspect of the current policy is that it is merely a short-term fix, and that new taxes are looming to finance a further spending spree. “The government does not see the adjustment as something permanent, but as a short-term necessity, and also rather as a nuisance. This is not a real change,” he says.
MIXING IT
Mondino also doubts the government’s commitment to large-scale fiscal readjustments, and believes that it is indicative of a “sub-optimal” policy mix.
“Policymakers should be doing a lot more on the fiscal front at this juncture,” he says. “Fiscal policy remains lax and should be tightened a lot more to absorb the impact of commodity inflation, fighting appreciation and helping monetary policy so that interest rates don’t have to rise that much. The cyclical nature of fiscal policy is putting an excess burden on monetary policy.”
Others are more hoping that, with a new president at the helm, and with the appointment of a new Brazilian central bank governor, Alexandre Tombini, who succeeded the long-serving Henrique Meirelles at the beginning of the year, a more sustainable monetary and fiscal balance can be found.
“The overall quality of economic policy will improve. Under Lula’s second term, you had an expansionist fiscal policy, and the monetary policy had to be more restrictive. There is an understanding today that both should go hand in hand,” says WestLB’s Padovani, who points to better governance thanks to an improvement in policy coordination under Rousseff. “There is a better understanding now from the presidency that this needs to be done.
The new administration has also improved team coordination. There is a better orchestration, which stems from the fact that there is a better understanding of how economic policy should be managed. Under Lula, the policy mix was very confusing,” says Padovani.
Tombini’s international reputation as an economist has helped boost the credibility of the central bank. “This is a different style from previous central bank presidents. He is a little bit more of a dove than Arminio Fraga or Henrique Meirelles. He is less vocal,” says Welch. “He just gets the job done. He is technically great. He listens very, very well. And when it comes time to tighten, he is tightening. He will do what he has to do to keep inflation in shape.”
Yet there is a definite air of scepticism over the fiscal intentions of Rousseff’s team. “The government kept on substantially increasing public spending last year. This team is the same. Now, public spending will increase less than GDP growth, but it does not mean actual budget cuts,” says Padovani.
All of which casts doubt on finance minister Mantega’s confidence that fiscal measures will be effective and that base rates may fall as early as the second half of 2011. “Now the central bank is raising interest rates,” he says. “But when inflation declines thanks to spending cuts and the economic growth slowdown, there will be a possibility for the central bank to stop hiking or even start cutting rates along the year.”
And either way, monetary tightening and slower growth are likely to be politically problematic for Dilma.
“Now they have to move more slowly, but people expect a much higher rate of growth,” says Eduardo Levy-Yeyati, professor of economics at the Universidad Torcuato Di Tella, Buenos Aires. “The politicians now have to communicate this to their voters – and that’s very difficult.”