If there’s one accusation you can’t levy at Brazil’s central bank, it’s that it’s behind the curve. The bank’s late August move to slash its benchmark interest rate was an almost unprecedented policy U-turn – the first this year for any emerging market central bank – following six months of tightening, which had taken rates to a 30-month high of 12.5%.
The shock half a percentage point rate cut was triggered by a gloomy reading of a deteriorating global economy. But it might also lead to a much-needed rebalancing in Brazil’s economic policy mix.
The alarming speed with which global recession fears surfaced this summer has forced a dramatic policy shift away from measures to temper what had until recently been seen as an overheating domestic economy. The tide, it seems, has finally turned.
Unlike the 2008/09 crisis, where the economic response was led mainly by fiscal policy – through a pro-cyclical stimulus via the BNDES, Brazil’s state-owned development bank, and government spending – the government has publicly urged the central bank to use monetary policy to keep the economy on track.
As a result, the surprise rate cut has also raised questions about the bank’s independence – partly because some politicians such as Fernando Pimentel, a government minister, had earlier predicted, against market expectations, that “interest rates will fall in the very near future”.
But finance minister Guido Mantega dismisses suggestions of political meddling in the central bank’s decision. The rate cut, he says, “is the central bank reacting to the international situation. They presume that the deterioration of the international economy will affect the Brazilian one.
“So, taking into consideration our economic deceleration and the recent strengthening of fiscal policy, I don’t see why we should imagine that there is any political pressure being put on it.”
ALL CHANGE
Mantega believes that all parties now see that the mix between fiscal and monetary policy has to change. “We want more monetary policy and less fiscal policy,” he says. “If there were a further worsening of the economic crisis, the central bank will implement more expansionist monetary policies.”
His moves to encourage the central bank to deal with the international slowdown through monetary interventions echo similar thoughts from the central bank. Its president, Alexandre Tombini, even before the rate cut had hinted that its policies would be supportive for longer than many had expected.
Tombini has also been urging a more cautious fiscal stance from the government and talks about re-establishing investor confidence.
Public spending cuts have been something of a taboo since Luiz Inácio Lula da Silva came to power in 2003. Calls from his successor, President Dilma Rousseff – who took office this January – for $30 billion budget cuts earlier this year have been partially implemented.
Mantega, who assumed office five years ago with a reputation for being a big spender, is nowadays busy spreading a newgospel of restraint – and one that will also tackle rising prices. “Cuts in public spending lower aggregate demand,” he says, “and contribute in the fight against inflation,” he told Emerging Markets shortly before announcing a R10 billion ($6.25 billion) increase in August of the official target for this year’s primary budget surplus, now set at R128 billion.
“This extra R10 billion adjustment is intended to prevent an increase in public spending. When you lower or fail to increase public spending, you leave room for a cut in interest rates, and the central bank understands this is possible.”
During the first half of the year, Brazil had already achieved a primary fiscal surplus of R78 billion. “I can assure you that we won’t use increases in tax collection to boost spending,” says Mantega. “We won’t allow new spending. We’ll save it and use it for tax relief.”
Paulo Nogueira Batista Jr, who represents Brazil (as well as Colombia, Ecuador, Guyana, Haiti, Panama, Dominican Republic, Surinam, and Trinidad and Tobago) on the IMF’s executive board, praises the rate cut. He says the IMF believes that the international situation is one of “extreme concern” for the region.
Speaking as an academic – he is also a professor at the Getúlio Vargas Foundation in São Paulo – he recommends an “ultra disciplined fiscal policy” to achieve a combination of low interest rates and a weaker exchange rate.
BATTLE LINES DRAWN
The novelty here is that the finance ministry and the central bank, which were so often at loggerheads during the previous government, now seem to be dancing to the same tune in favour of such a new policy mix. Tombini, for example, is keen to praise the new fiscal rigour which, he believes, differentiates Brazil from other emerging countries.
Specifically, Tombini says there is common cause between Brazil’s top officials on the issue. “The president, the minister of finance, and myself are in complete agreement that it’s important to maintain our solid fiscal stance,” he says.
Part of the credit for this can be attributed to the new government of President Rousseff, which has made a strong start since taking office. Aside from sacking four ministers – three of them are facing corruption allegations – in barely nine months, she has also managed to bring her finance minister and central bank president closer together.
But with headline inflation running at 7% a year (including 9% for services), against a central inflation target of 4.5%, Tombini knows the central bank has a challenge ahead.
Nevertheless, he foresees a substantial drop – of around two percentage points – in the consumer price index between September and next April, courtesy of the monetary tightening implemented since January (175bp between January and August 2011), and the impact of the global economic environment, which will dampen economic activity in Brazil.
“Some global headwinds may be seen as helpful, as long as they remain moderate,” says Marcelo Carvalho, chief economist at BNP Paribas in São Paulo. Indeed, Brazil may benefit from some unexpected gains from the crisis: the global slowdown has helped cool credit growth, which had previously allowed the credit to GDP ratio to double in five years, especially among private-sector banks.
However, a deterioration in the domestic job market may lead to a further increase in payment arrears, following a long boom.
The state-owned BNDES also cut its lending to R56 billion during the first half of the year, compared to R110 billion during the previous half. “That’s quite a substantial moderation,” says Tombini. “Almost 50%.”
Brazil’s financial lines of defence have also been strengthened. The country sits on a healthy $350 billion of international reserves – $150 billion more than before the 2008 financial crisis – and has substantial reserve requirements to guarantee the liquidity of the financial system (R420 billion in compulsory requirements from banks are deposited at the central bank).
Carvalho sees a less pronounced credit crunch than the one that followed the fall of Lehman Brothers in 2008. “We do not seem to now have the kind of corporate sector exposure which was a key transmission channel for the crisis back then,” he says. “There will be some impact, but it will not be as severe as in 2008.”
The main transmission channels, meanwhile, remain commodity prices, which could take a severe hit if the US falls into recession and China’s economy slows sharply; a pronounced slowdown in the world’s second-largest economy could have a substantial knock-on effect on Brazil.
“If China experiences a bigger downturn, and if commodity prices take a hit, then Brazil will suffer – a lot depends on China and export commodities in the end,” says Carvalho. For now, he sees China as an “alleviating factor” that “seems to be doing fairly well. If you see abundant global liquidity continue to provide support for commodity prices, then Brazil won’t suffer as much,” he says.
But genuine doubts remain over the government’s fiscal policy. Additional cuts are expected by the end of the year, which could bring some relief in terms of pressures on the real to appreciate (Brazilian officials have launched a series of interventions within the past two years to stem the potentially destabilizing capital inflows into the country).
But the real question is whether fiscal restraint will continue beyond the short term. “The risk of a global recession is setting the backdrop for looser monetary policy, and if combined with a tighter fiscal stance, this is clearly good news,” says Marcelo Salomon, a Barclays Capital economist in New York. “But if this tighter fiscal stance is only based on short-run adjustments without a longer-term commitment to lower spending, the period of lower interest rates could be short-lived.”
Brazilian officials have signalled that the primary fiscal surplus of around 3.3% of GDP will be met next year, but investors are wary about a series of public spending increases, such as the 14% increase in the minimum wage from next January, and the fiscal cost of Brazil’s industrial policy.
Official forecasts point to a 5% GDP growth rate next year, but an economic slowdown would mean lower tax revenues next year. “The risks are that by not pre-committing to a longer-term path of fiscal restraint, which would boost total government savings and allow higher private investments, what we could see is more rate volatility, with inflation resiliently close to the upper band of the target [6.5%],” says Salomon.