BRAZIL: Rates of change
Lower interest rates are seen as key to luring much-needed private investment to Brazil’s notoriously decrepit infrastructure. But inflation could yet derail Brasilia’s ambitious plans
It was supposed to be a nice break on the beach. São Paulo workers like Diego Martins were looking forward to September 7, Independence Day, time to enjoy a rare three-day weekend by the sea.
But the 23km traffic jam Martins endured to go to a resort just 70km away, the power blackout he experienced when he left a fancy restaurant in a theft-prone neighbourhood, and the six hours spent returning to São Paulo are good examples of Brazils legendary infrastructure bottlenecks.
Those same bottlenecks are also holding the Brazilian economy back.
The consumer boom of recent years has benefitted millions of Brazilians following decades of pent-up demand. But most of the countrys infrastructure, which has long been inadequate, is now stretched to the limit.
Car sales, for instance, have soared in recent years thanks to an increase in real income, low unemployment and abundant credit, not to mention a recent series of tax breaks that have extended the duration of the automotive boom.
Brazil has become the worlds fourth-largest car market. But there are not enough roads and when there are, many believe they are just not good enough. Insufficient capacity results in chronic congestion and waste. In other words, gigantic Brazil is becoming too small for its aspirations to become an economic superpower.
Every government over the past 20 years has launched its own plan to reduce what is commonly known as the Custo Brasil the additional cost one has to bear to operate in Brazil. The latest initiative, unveiled this August, is to promote a transport revolution, says president Dilma Rousseff, thanks to a new concession programme in infrastructure.
The ambitious plans include $65 billion in financing to modernize roads and railways over 25 years, including a big push to invest some $40 billion within five years. The first contracts to build or upgrade 7,500km of roads and public-private partnerships to set up 10,000km of railway lines are due to be signed next year.
The private sector will later be called to the rescue to invest in ports and airports three airports were privatized earlier this year, including the countrys main international airport in São Paulo.
Yet the thinking behind these plans isnt new. Brazilians have already heard similar grand schemes in the past (from Brasil em Ação in the 1990s to the Programa de Aceleração do Crescimento, or PAC, just five years ago). Rousseff herself was dubbed the PACs mother by the former president Luiz Inácio Lula da Silva, as she was in charge of coordinating his infrastructure programme.
In both schemes, progress was limited, partly due to the lack of public investment, and each failed to redress old woes. The investment rate has remained desperately low (17.9% of GDP at the end of June 2012 a 3.7% decline compared to the second quarter of 2011). The savings rate was even lower (16.9% of GDP in June 2012 a 2.1% decline, year-on-year, since the second quarter of 2012.)
But this time, it will be different, say many private investors as well as Brazilian officials. Indeed, Rousseff has extended a friendly hand to the private sector, which, in turn, benefits from a better investment climate.
She wants the best of both worlds: Our purpose, she has said, is to get the best of what the private initiative can offer in terms of efficiency, and the best that the state can and must offer in terms of planning and management of public resources.
The goals are ambitious. The Brazilian economy has now reached a different stage, says Nelson Siffert, director of infrastructure at the state-owned social development bank (BNDES) in Rio de Janeiro. We are not only talking about the new middle class 40 million Brazilians have moved to the middle class in recent years which has boosted consumption, because [the increase in] consumption will not be sustainable if we do not have investment in infrastructure and if we are not able to attract private capital.
BNDES is expected to finance between 65% and 80% of the $65 billion package on favourable terms (at below market rates: up to 1.5% per year plus the banks long-term interest rate, known as TJLP, currently at 5.5%, over 20 years and with a three-year grace period as far as roads are concerned; and up to 1% plus TJLP over 25 years with a five-year grace period for railways).
It will take some time to address these bottlenecks, says Siffert. Demand will tend to increase in the coming years in line with the growing consumption of the middle class. Our aim is to manage to reach a European standard of quality in 10 to 15 years.
The central banks loose monetary policy which has been in place since August 2011 is also pushing investors in the right direction.
Real interest rates fell to a historical low of around 2% (when compared to the benchmark Selic rate). This also acts as an incentive to invest. The attraction becomes even greater. Several institutional investors and other fixed-income investors may now migrate towards other assets and invest in equities. Right now we have pension funds getting involved directly in [infrastructure] projects, says Siffert.
The infrastructure programme is part of a wider agenda to slash business costs. Part of it has been controversial. On the eve of Independence Day, when drivers were stuck in congested motorways, Rousseff announced sweeping cuts in electricity rates, especially for industry and corporate users (up to 28% from next year) as part of her effort to cut costs. However, it later emerged that electricity companies will have to assume most of the cost if they want the government to extend their concessions beyond 2015.
But the most ambitious programme that has been launched by the Rousseff government is directed towards labour costs, with an effort to substitute a heavy tax on companies payrolls by a smaller levy on their gross revenues 40 sectors already benefit from the change, including a quarter of industrial sectors.
Finance minister Guido Mantega says the measure, which intends to support employment, amounts to a 60% cut in labour cost. This is a fairly good [tax] relief; it reduces the cost of human labour for these companies and makes them more competitive in this moment of crisis, he said recently.
Government officials also expect a positive impact of such measures on inflation. Supply-side policies that have been announced tend to contribute to reduce production costs, and as such contain pressures on prices in the medium term, said Alexandre Tombini, president of the central bank during a Senate hearing.
Economic activity, which remained sluggish during the first half of the year, is now showing signs of recovery after policymakers have embarked on an all-out strategy to boost growth, says the Institute of International Finance.
Officials have used a mix of loose monetary policy there may be another round of cuts in interest rates on October 10, even though the central bank has slashed its base rate by 500bp since August 2011 as well as various incentives to buy anything from cars and refrigerators to furniture. BNDES-sponsored loans also offer credit to buy trucks and machinery at negative real interest rates.
The outcome, according to some detractors, may well be inflation indeed, the government dangerously flirted with the top range of the 6.5% inflation target last year.
Alexandre Schwartsman, a former central bank director, is one of these critics. He argues that the central bank has all but abandoned the inflation targeting regime that was introduced in Brazil in 1999 when the real was floated.
Luiz Inácio Lula da Silva, who succeeded Fernando Henrique Cardoso as head of state in 2003 amid severe inflationary pressures, appointed Henrique Meirelles, a market orthodox figure, as governor of the central bank, who continued a strict inflation targeting regime.
Now it seems that Alexandre Tombini, who was appointed by Dilma Rousseff, is taking liberties with inflation targeting. The return path to the inflation target was interrupted, says Schwartsman, who served under Meirelles. The central bank has been forecasting that inflation will remain above [the core] target until 2014. Yet it continues to cut interest rates. So it becomes completely impossible to hit the target.
The current inflation target is 4.5%, with a tolerance margin of two percentage points. It seems to me that the central bank nowadays has a target in terms of exchange rate and growth rather than inflation. Just take a look at the central bank minutes it does not include the word inflation. That says a lot, Schwartsman says.
The finance ministry and the central bank are working hand in hand to support government strategy another big change from the Meirelles years.
Repeated interventions in the foreign exchange markets and capital controls have also put in question the governments commitment to the free-floating exchange regime. Schwartsman considers this is a policy mistake.
The current exchange rate policy does not allow for cushioning the impact of any hike in basic products. In the past normally, the real was appreciating when there was an increase in commodity prices. This was softening part of the blow domestically, he says. But not anymore, it seems, with the dollar still hovering around 2 reals in mid-September because of the central banks soft monetary stance.
This has led to some hawkish forecasts. In Brazil, the dragon will arrive a year later [compared to the Chinese horoscope], as 2013 will bring the year of the inflation dragon, says Marcelo Carvalho, chief economist at BNP Paribas, who forecasts an above target inflation rate of 6.7% next year. Inflation will prove to be a much worse headache than anticipated.
Even though the planned cut in electricity rates may shave half a percentage point off the benchmark IPCA inflation rate next year, there are increasing signs that the government will have to increase fuel prices (although Mantega denies this).
Carvalho estimates that a 20% hike in petrol prices would add a full percentage point to headline inflation. Sooner or later, the authorities will need to start tightening policies again next year, if they care about inflation, Carvalho says.