Brazil’s sharp economic slowdown last year came as little surprise amid higher borrowing costs, a surging currency and an increasingly fragile global environment.
But its extent – growth slumped to 2.7% of GDP in 2011 from 7.5% the year before – has meant that Latin America’s largest nation substantially underperformed its emerging market peers, including China and India, thereby dealing a blow to a government that has pledged the fruits of high growth to an increasingly expectant population.
This has raised huge questions for economic policy in Brazil, not least at the central bank, which many believe has shifted away from its traditional inflation-targeting mandate towards a focus on growth.
Yet despite the slowdown, Alexandre Tombini – who took over the job of central bank president in January last year – believes things are looking up. In an interview with Emerging Markets, Tombini says a rebound is gathering speed, and he expects growth this year to outpace 2011, accelerating in the second half of the year.
In the meanwhile, he says monetary policy will continue to support the recovery.
Under Tombini, the central bank first wrong-footed the market when it abruptly loosened its monetary stance last August against a background of falling inflation. “From September to January consumer prices have come down by over 130 basis points – and this trend will continue in the future,” says Tombini.
The central banker says that what’s needed is not just lower interest rates but a different paradigm for lower rates, and that more aggressive rate cutting need not create an equally aggressive rise in inflation.
The central bank surprised the market this month by slashing the benchmark Selic rate by 75 basis points to 9.75%, when many observers had expected a fifth consecutive reduction of just half a point. The move has raised expectations the bank will cut rates by as much again next month.
Official central bank documents, such as the minutes of the monetary policy
committee in February, had already pledged further easing. And in international forums the message has been the same. Following a G20 meeting in Mexico last month, Tombini noted that “there is a high probability that we’ll have a single digit interest rate in the future.” He added: “The process of interest rate cutting has not come to an end in Brazil.”
A SINGLE DIGIT
Talk of a single digit base rate has a revolutionary feel to it in Brazil. The benchmark Selic rate has historically remained high in order to dampen inflationary pressures. (The only exception was in 2009 when it touched a low of 8.75% before climbing up again due to overheating pressures.)
But Tombini’s approach so far has been different. Even though inflation has remained relatively high, he has favoured pursuing lower interest rates, as he anticipates that the worsening global environment will ease price pressures.
“Part of the story we’ve seen since late August has been the slowdown in the global economy,” Tombini says, “and the many revisions that we have had since then in terms of expectations of global growth – in Europe and even Asia and the US. So the slowdown, and the many transmission channels to emerging markets, have no doubt reduced the inflationary pressures that we had in early 2011.”
Experts are divided on the wisdom of this approach. And some suspect the central bank is slowly abandoning its inflation-targeting regime. Tombini flatly denies this.
“Our regime of monetary policy is based on inflation targets in a multi-year framework. Of course a slow economy opens up space for adjusting policies as was the case in Brazil in the second half of last year. But, the global environment should be mostly characterized by slow growth in the years to come and very high levels of liquidity.”
His stance is beginning to gain acceptance. “It’s still too early to say, but Tombini has probably been correct in his approach,” says Ricardo Amorim, head of the Ricam consultancy in São Paulo. Amorim, a former West LB emerging market strategist in New York, now sees the chance of interest rates dropping below their 2009 level.
Through his actions, Tombini has furthered a debate among economists about what would constitute a “neutral” interest rate in Brazil.
Although the debate remains controversial, market estimates show that his moves are going down well domestically. The exercise has also squared nicely with the goal of president Dilma Rousseff – now entering her second year in office – of lowering interest rates and reducing their differentials with the rest of the world.
Rousseff earlier this month said that rate cuts are necessary to avert a “tsunami” of foreign speculative capital. She also lambasted “the fiercest protectionism” inherent in western monetary policy, vowing to do “whatever is possible” to defend Brazilian competitiveness.
Tombini agrees that lower interest rates are needed to avert massive capital inflows – a scourge over the past 18 months across many fast-growing emerging markets. “If you combine a high level of liquidity with low risk aversion, then emerging market countries will have to face more intense capital inflows,” says Tombini, who points to the central bank’s experience in dealing with this problem.
“For many years, Brazil has continued to accumulate international reserves to sterilize interventions in the foreign exchange market,” he says. “We have to be mindful because, if you combine this very high level of liquidity, which is there due to improved risk appetite, we could have a situation like that at the beginning of 2011. We need to be careful how we deal with these capital flows.”
In reaction to hot money inflows, in early March, Brazil also extended a 6% tax on financial investment with a maturity of less than three years.
“The predominant market expectation is that during the next two years there will be additional cuts to the neutral interest rate,” Tombini said in February.
The large interest rate differential between the Brazilian Selic and the rest of the world is partly responsible for substantial capital inflows to Brazil that have also piled upward pressure on its currency, the real.
The currency hit a 12-year high in 2011, and maintaining export competitiveness is a key challenge. This has led many to conclude that, in a break with tradition, there will be increased coordination between monetary policy and foreign exchange policy in Brazil.
Government officials – including finance minister Guido Mantega – have come out with strong statements in recent weeks on the possibility of intervention in the market to force a depreciation of the currency.
Prospects for lower interest rates are also helping ease pressure on the currency. Official February data showed Brazil’s 12-month inflation rate declining to 5.84% from 6.22%.
“There’s space for a looser monetary policy in Brazil, with a high probability of interest rates moving towards single digits, without hurting our objective of bringing inflation down to 4.5% in 2012,” says Luiz Awazu Pereira, a central bank director.
Analysts are warning, however, that inflationary pressures could be set for a comeback, not least given a volatile oil price and the prospect of military action against Iran. But Tombini insists that the central bank is keeping a watchful eye on oil and its impact on inflation (Petrobras, the oil company, has put pressure on the government to be able to raise fuel prices).
“The outlook for soft commodities is neutral,” he says. “But over energy there is a question mark.”
Last year, the consumer price index peaked at 7.3% and then declined to 6.5% at the end of the year, which coincides with the top range of the tolerance margin. The central bank is committed to bringing the benchmark inflation rate back to the centre of its target band – 4.5% – this year, but many believe it will take longer to achieve this goal.
COMPLEMENTARY FISCAL POLICIES
A looser monetary policy was also assisted last year by a tighter fiscal policy in Brazil, which allowed the government to reach a
primary budget surplus of 3.1% of GDP in line with its fiscal target. Finance minister Mantega had pledged to reach its target by 2014.
Earlier this year, the government announced budget cuts of 55 billion reais ($32 billion), following similar cuts last year. “They can probably repeat the same positive fiscal performance that they achieved last year. They can take advantage of a window of opportunity and continue to cut rates,” says André Loes, chief economist at HSBC in São Paulo.
But others reckon more fiscal consolidation would also help ease inflation, thereby supporting the central bank’s goal of lowering interest rates. Says Columbia University economist Guillermo Calvo: “A tighter fiscal policy in Brazil would give the central bank more breathing room and reduce pro-cyclical risks.”
Talk of single digit interest rates is not universally celebrated, however. “This is a concern to us,” Loes says. “The central bank has never acted like this since the introduction of inflation targeting. This can be a long-term objective, but it shouldn’t be a short-term goal.”
Loes reckons that the central bank’s stance on price rises will mean it will have to reverse policy and raise rates later this year to keep inflation in check.
Brazilian officials are also satisfied that the package of macro prudential measures introduced over the past 18 months have proved more efficient than expected. “We can always decide at any point to use a mix of micro and macro prudential measures because we know of their efficiency and of their complementarity together with adjustment of monetary conditions, to reach our objectives of macroeconomic and financial stability,” says Luiz Awazu Pereira.
Macro prudential measures, which include higher capital requirements, have proved useful to slow down credit activity, according to the central bank, and they can be used again.