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1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. A Decade of Reforms: The 90’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Trade Liberalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Privatization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102.3 Deregulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3. The Real Plan and Macroeconomic Imbalances: 1995/1998 . . . . . . . . . . 14 4. Three Policy Changes in 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 5. Shocks in 2001: Short-Term Turbulence or the Sunset of a Would-Be5. Model? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 6. The Challenges Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 7. Final Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Appendix. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Abstract
This paper looks at the transformations that Brazil’s econ- omy went through in the 1990s, which involved the adoption ofa new macroeconomic policy framework and market-friendlyreforms. It argues that, despite a series of policy missteps andsevere external shocks, this new policy regime have laid thefoundations for the resumption of sustained growth-cum-pricestability. It also argues, though, that this outcome hinges criti-cally on the country’s ability to consolidate and deepen its com-mitment to free trade and a macroeconomic regime which restson three pillars: fiscal austerity, low inflation and flexible ex-change rates.
Texto para Discussão nº 91 Texto para Discussão nº 91 1. Introduction
The poor performance of the Brazilian economy in 1980- 2000 is sharply at odds with the country’s growth record in therest of the twentieth century. Indeed, for several decades Brazilwas one of the fastest growing economies in the world [Maddison(1995)]. In 1950-80, annual growth fell below the 4% mark in justfour occasions, and in this 30-year period there was no absolutedecline in GDP. In contrast, during the 1980s per capita incomefell by an average 0.5% per year, growing a mere 1.1% during the1990s, netting just 0.3% per year over these two decades.1 Despite the similar performance in terms of GDP growth, the 1980s (known as the “lost decade”) and the 1990s differ in atleast three important regards. First, while the 1980s were a periodof rising inflation and chaotic macroeconomic policies, thenineties were marked by the successful stabilization program,which brought annual inflation down to one-digit levels. Second,whereas the 1980s saw high and often rising levels of stateintervention, the 1990s can be characterized as the “decade ofmarket-oriented reforms”. Third, and largely as a consequence ofthe first two, while the 1980s ended with a feeling of hopelessness,without a clear consensual diagnosis of the crisis and with thecountry close to hyperinflation, at the end of the 1990s there weresigns of a return to a trajectory of sustained growth, this time ina context of price stability.2 Despite the importance of these changes, the challenges that Brazil still must meet for this scenario to materialize are notsmall. Stabilization still depends on the continuity of large pri-mary fiscal surpluses to bring the debt/GDP ratio to more man-ageable levels and on a sizable expansion of exports to reduceBrazil’s vulnerability to external shocks. Structural reformsundertaken in the 1990s need to be consolidated and extendedto areas such as the judiciary and capital and labor markets, tocreate an institutional environment more conducive to invest-ment and productivity growth.
This paper seeks to look into these changes and challenges that, since the early 1990s, have been part of country’s agendato resume sustainable growth. It examines the contribution of themarket-friendly reforms of 1990s, discuss the current challengesfaced by Brazil and analyze whether, after two decades of nearstagnation in per capita income, growth is likely to accelerate,making 2001-2010 a decade of prosperity, the first since the“golden seventies”. The degree to which the transformations that Had Brazil continued to grow in 1980-2000 as in 1950-80 (7.4% p.a.), rather than at the actual annualrate of 2.1%, per capita income in 2000 would have been US$ 9663, or 2.8 times the actual figureof US$ 3512.
For a less favorable view on Brazil’s accomplishments in the 1990s, see Amann and Baer (2000).
Texto para Discussão nº 91 occurred have been consolidated, and whether or not they willensure high rates of growth in the future are questions that arediscussed in the text.
The paper continues with six additional sections. Follow- ing this brief introduction, we look at the structural reforms ofthe 1990s. The third section analyzes the gains produced by theReal Plan (1994) and the macroeconomic imbalances unveiled bythe end of high inflation. Section 4 highlights the changes in thepolicy regime that occurred in 1999, with the currency devaluationand the adoption of inflation targets and rigid fiscal discipline.
Section 5 discusses the recent shocks that hit Brazil’s economy andargues that, given the characteristics of the new policy regime, theyshould not threaten the country’s medium and long-term growthprospects. Section 6 takes on the country’s most importantchallenges which still lay ahead in the road to sustainable growthand a final section draws the relevant conclusions.
2. A Decade of Reforms: The 90’s3
The Real Plan and the ensuing reduction in inflation rates were undoubtedly the most noteworthy events in the Brazilianeconomy in the 1990s. Yet, a full assessment of the transforma-tions that characterized Brazil in that decade, and indeed a properunderstanding of why the Real Plan has succeeded where previousstabilization attempts failed so badly, have to account for thesupply-side reforms carried out in that period. These compriseda number of initiatives aimed at raising productivity throughreduced regulatory intervention and increased competition in theeconomy. Foremost among these initiatives were trade liberaliza-tion, privatization and deregulation.
2.1. Trade Liberalization
To properly gauge the importance of trade liberalization in the 1990s, one has to take into account that over the previoustwo decades Brazil had become one of the most closed economiesin the world. The strategy of import substitution was taken toextremes, with the imports’ share of domestic consumption ofmanufactured goods reaching Soviet levels (4.8% in 1989) [More-ira and Correia (1998)]. These policies were clearly unsustainableand as the foreign exchange constraint lessened in the lateeighties, Brazil gradually moved towards a more open and neutraltrade policy.
See Souza (1999) and Giambiagi and Moreira (1999).
Texto para Discussão nº 91 In 1988-93 protection to domestic producers was greatly reduced. Two reforms, in 1988 and 1989, brought the averagetariff on imports down from 51 to 35 percent. Most non-tariffbarriers were eliminated in 1990, with the ban on imports ofcomputer products ending in October 1992. In addition, a pre-announced schedule of tariff reductions gradually brought theaverage nominal import tariff down from 32.2% (with a 19.6%dispersion) in 1990 to 14.9% (with an 8.2% dispersion) in thesecond semester of 1993 (Table 1). Trade liberalization wasparticularly significant for consumer goods: tariffs for durableconsumer goods came down by 66 percentage points, whileelimination of the negative import list gave domestic consumerslegal access to foreign goods that had in practice been banned fordecades.
Brazilian Import Tariffs: 1990-95 (in %)
Source: Own calculation based on Receita Federal data. On the export side, trade policy has also become more neutral since the mid-1980s and especially after 1990. Severalsubsidies were discontinued in 1983-85. As the Collor govern-ment took office, in March 1990, export subsidies were eliminatedand incentives reduced. As a consequence, incentives fell from anaverage of 3.1% of GDP in 1981-84 to 1.3% in 1990-91. In the1990s, the government continued to seek a complete tax exemp-tion of exports, including some levied at the state level, and movedto strengthen export financing schemes [Sucupira and Moreira(2001)].
Another remarkable development in Brazil’s trade policy was the establishment of Mercosur in 1991, a regional tradeagreement comprising Argentina, Brazil, Paraguay and Uruguay.
Mercosur has been key in attracting FDI into Brazil, which helpedto make the country a regional export base for many multinationalcorporations [Pinheiro and Moreira (2000)]. Overall, Brazilianexports to its Mercosur partners increased 235% from 1991 to2000, while imports from them went up 244%.
The impact of trade liberalization has been dramatic re- garding both the degree of trade and investment integration intothe world economy, and the extent to which it has contributed toencourage technological modernization and rises in productivity Texto para Discussão nº 91 [Moreira and Correia (1998) and McKinsey (1998)]. Non-oil im-ports jumped from US$ 11.0 billion in 1987 to US$ 44.3 billionin 1995, and reached US$ 49.4 billion in 2000. Imports ofconsumer and capital goods, in particular, expanded substan-tially in the nineties. Stiffer competition and easier access toforeign intermediate and capital inputs have stimulated domesticproducers to improve their competitiveness [Muendler (2001)].
Export performance, though, somewhat tarnished what would otherwise be a remarkable response to trade liberalization.
Exports were slow to respond. After signs of a strong recovery in1992-94, export growth moved into a downward trend, reversedfor only a brief period in 1997. More to the point, despite thereduction in trade bias, a substantial trade-off between internaland external markets prevailed during the period, with firmsswitching to domestic sales whenever local demand picked up.4 The appreciation of the exchange rate seems to have played a large role in this slow response. Contrary to the advice of mostannalists (see, e.g. Papageorgiu, Michaely and Choski, 1991),trade liberalization in Brazil’s was not followed by a real exchangerate devaluation. Quite the contrary. By December 1998, the localcurrency had appreciated 18% against the dollar (see Graph 1).
This trend was only broken in January 1999, when the deterior-ation of the international markets, disrupted by the Russiandefault, forced the government to float the exchange rate, adecision which produced a major devaluation (see Section 3). Thischange in relative prices did not take long to show its relevance.
In the last quarter of 1999, exports grew by 11.3% (yoy) and in2000, export growth accelerated to 14.7%, led by manufacturingexports (20.6 %).
Apart from an exchange rate appreciation, exports also suffered from the lack of investment in infrastructure – a conse-quence of the public finance crises of the 1980s – and from aninefficient tax system which penalized producers with cumulativetaxes. In the case of the former, considerable progress was madein the second half of the nineties through privatization of the stateenterprises (see next section). The tax system, though, has yet tobe reformed.
2.2. Privatization
Although Brazilian privatization dates back to eighties, it was in the following decade that it gained prominence, becominga centerpiece of economic policy.5 In March 1990, President Collorlaunched the National Privatization Program (PND), expanding Brazilian privatization during the Collor administration is discussed, respectively, in Pinheiro andGiambiagi (1994). For a Latin-American perspective, see also Baer (1994).
Texto para Discussão nº 91 the divestiture program to include large and traditional state enter-prises. In September 1992, President Collor was impeached andreplaced by Vice-President Itamar Franco, who, despite earliermisgivings, continued the privatization process at its previous pace.
Together, the two administrations sold 33 state-owned enterprises(SOEs), with results amounting to US$ 11.9 billion, including bothproceeds and debt transfers (Table 2). Particularly important in thatperiod was the divestiture of the steel sector, which had beendeveloped after World War II under public guidance and that untilthe eighties was thought to be critical for national security.
Brazilian privatization reached its peak during President Cardoso’s first term (1995-98), when 80 companies were sold,generating US$ 73.3 billion in total results (Table 2). Two relateddevelopments allowed such substantial expansion in the size andscope of privatization. One was the engagement of state govern-ments in the privatization effort, leading to the sale of severalelectricity distribution companies. Another was the decision toamend the constitution to discontinue public monopolies and enddiscrimination against subsidiaries of foreign companies. Thisopened the opportunity to extend privatization to telecommuni-cations, electricity and mining, in which were Brazilian largestSOEs. During this period, other sectors controlled by the state fordecades, such as the railways and ports, were also partly or totallytransferred to the private sector.6 The enlargement of privatization allowed it to play an important role in sustaining the Real Plan, especially in Cardoso’sfirst term [Pinheiro and Giambiagi (2000)]. In particular, with thelarge sales of 1997-98 Brazil attracted sizable volumes of foreigndirect investment, which helped to finance the country’s highcurrent account deficit – in 1997-2000, the ratio between FDIinflows associated with privatization and the current accountdeficit averaged almost 25%. Privatization was also instrumentalin averting an explosion in public debt, in spite of the growingfiscal deficit posted since 1995. Carvalho (2001) shows thatthanks to the predominant use of privatization proceeds to abatethe public debt, in December 1999 this was 8.4% of GDP lowerthan what it would have been in the absence of privatization.
More important in the long run, however, is the significant change that privatization brought to the way former SOEs aremanaged. In private hands, those companies became more cus-tomer oriented, technologically updated, and equipped with bet-ter information systems and human resource management, withfewer but in general more motivated employees. The impact ofthese changes and of a greater access to capital on output,productivity and investment has been quite positive.7 Becoming See the papers in Pinheiro and Fukasaku (2000) for further discussion on privatization duringPresident Cardoso’s first administration.
For analyses of the impact of privatization on SOE performance, see Pinheiro (1996).
Texto para Discussão nº 91 more efficient and adopting better commercial practices they wereable to greatly increase their profitability, raising their creditworthi-ness, and in turn facilitating the finance of new investment. Theresults have been noteworthy in both industry and infrastructure, inwhich all sectors registered the rehabilitation of physical networksand increases in productivity, even if these gains have been morespectacular in some sectors than in others. In telecommunications,in particular, the density of fixed lines more than doubled afterprivatization, reaching 20.2 fixed lines (against 9.6 in 1996) and 15.0cellular phones per 100 inhabitants (against 1.6 in 1996) in 2001.
In the industrial sector privatization has been not only a remarkable success – witness the gains in output and competi-tiveness of previously almost bankrupt companies such as steel-maker CSN and airplane manufacturer Embraer – but also a doneprocess once ownership changed hands. In infrastructure, how-ever, privatization is just a step in the regulatory reform process,which will not be complete until sound regulation is put in placeand well-functioning regulatory agencies are fully operational. Inthis sense, in infrastructure it is necessary to go beyond reduc-tions in technical losses, better management, and rehabilitationof existing facilities, and be able to foster a large expansion inoutput capacity and to translate productivity gains into lowerprices to consumers. And in these areas the degree of success ofthe new regulatory framework is relatively heterogeneous acrosssectors, reflecting the varying quality of sector regulation.
Privatization Results: Proceeds and Debt Transferred: 1991-2000
(US$ Million)
Texto para Discussão nº 91 For various reasons, the privatization process decelerated to almost a complete stop in President Cardoso’s second term.
Foremost among those reasons was the decline in popular sup-port for privatization. But also relevant were the reduced press-ures stemming from the needs of macroeconomic policy – as a resultof changes in the fiscal regime and a large inflow of non-privatizationrelated FDI – and the rising technical and political complexity ofprivatizing the remaining SOEs. As a result, the state remains theowner of sizable assets in sectors such as electricity, water andsanitation sectors, many of which would likely generate highersocial benefits in the hands of the private sector.
2.3. Deregulation
Brazil also adopted a number of initiatives to increase competition in domestic markets, by freeing firms and marketsfrom a host of administrative controls introduced over the importsubstitution period or before. A first set of measures were im-plemented by the Federal Deregulation Program (PFD)8 under theaegis of which 113,752 presidential decrees were revoked, from atotal of 123,370 decrees issued in the previous hundred years.
Other initiatives involved, inter alia, foreign trade (e.g., the end ofpublic monopolies in exporting coffee and sugar and in importingwheat and the elimination of import and export licenses) andforeign investment (elimination of most restrictions).
A second set of measures aimed at strengthening anti-trust and consumer protection policies. In 1991 the anti-trust lawenacted in 1962 was reinforced by new and more stringentlegislation, and in 1994, a new anti-trust law was passed, con-solidating the legislation on competition, while establishing har-sher penalties and more expeditious enforcement. Since March1991, a Consumer Protection Law, approved in September 1990,has made firms liable for the quality of their products and thetruthfulness of their advertising.
A third group of measures comprised the elimination of a host of legal restrictions limiting entry into a number of non-trad-able sectors. Foremost among these were the constitutionalamendments that discontinued public monopolies in infrastruc-ture and the differential treatment afforded to national andforeign companies. Other infraconstitutional distinctions, suchas the restrictions imposed by Law 4,131 on the access of foreignfirms to public credit, were also discontinued.
The end of legal restrictions limiting entry and establishing price controls in a number of sectors, such as civil air transport,ports, interstate and international road transportation, the dis-tribution of fuels and the distribution and transportation of steel This program, established in March 1990, was quite active until Collor’s impeachment in late 1992.
Texto para Discussão nº 91 also encouraged competition. Nationwide price equalization wasdiscontinued for fuel and other prices and services. Infrastructureregulatory reform also fostered competition through the settingup of a non-monopolistic industrial structure, with several SOEsbeing separated horizontally and vertically before privatization.
Examples of horizontal separation include the railroad, elec-tricity and telecom sectors, while vertical breakups occurred intelecommunications and electricity. Limits were imposed on theparticipation of individual investors in different markets, re-gional and national, and even on the ownership structure ofsome companies (such as the mining giant CVRD and therailroads). Furthermore, restrictions to entry of new playerswere kept to a minimum and in some cases, such as telecom-munications, were only temporary.
3. The Real Plan and Macroeconomic Imbalances:
3. 1995/1998

Unveiled in 1994, the Real Plan can be seen as the logical macroeconomic counterpart to the market-oriented reforms car-ried out in the 1990s, both in the sense of magnifying their impacton growth and of generating the political conditions to pursuethem.9 The Plan led to a remarkable fall in inflation, which, asexpected, boosted efficiency, encouraged competition and at-tracted foreign investment. The fly in the ointment, though, wasa clear worsening of the fiscal and current account deficits.
The Plan was an ingenious, alternative approach to the problem of high inflation. It is worth noting that in 1986-91 therewere no less than five stabilization plans, based on price freezesor variants, all of which failed.10 What made the difference in thecase of the Real Plan was a virtual currency, known as the RealUnit of Value (URV), pegged to the dollar. The government set aperiod of four months for economic agents to adapt to this newunit. During this period, not only the exchange rate, but also somebasic prices such as public-sector salaries, pensions, the mini-mum wage and tariffs charged by public utilities were compul-sorily converted into URVs, with the private sector doing the samevoluntarily for most other prices. Through this scheme, thegovernment adopted the logic of the dollarization, without ac-tually doing it or resorting to a currency board.
At the end of this 4-month period (on June 30, 1994), during which inflation in the old currency reached almost 50% a month, the See Pinheiro and Giambiagi (2000) for an analysis of this bidirectional relationship in the case ofprivatization.
10 For an overview of the history of Brazilian inflation, see Tullio and Ronci (1996).
Texto para Discussão nº 91 URV was converted into the new currency, hardly by coincidence,called the ‘real’, to give the idea that its purchasing power wasconstant. The entire monetary base in the old currency was thenphysically replaced in just a few days. The parallel with the classiccase of the end of the German hyperinflation, in the 1920s, andthe role played at the time by the new German currency is evident.
In the years following the Real Plan, the economy’s perfor- mance was mixed. The Plan was very successful in reducinginflation: in the 12 months preceding the Plan, inflation had accu-mulated an impressive 5,154%, as measured by the general priceindex (IGP). After the launching of the Plan, 12-month cumulativeinflation fell almost continuously for 41⁄2 years, ending 1998 at only1.7%. In other words, in 1998 Brazil had the same inflation rate fora year that it had had in a single day prior to the Real Plan.11 On the minus side, however, Brazil has had since 1995 a substantially larger fiscal and current account deficits, which overtime led to mounting public and external liabilities, compoundingthe original disequilibria. In the case of the fiscal accounts, theprimary consolidated result for the public sector, which excludesinterest payments, fell from an average surplus of 2.9% of GDP in1991-94, to an average deficit of 0.2% of GDP in 1995-98. Thisdeterioration was due, on the one hand, to the unveiling of previousdisequilibria, “solved” until then through rising inflation rates, and,on the other hand, by a poor management of fiscal instruments.
Until 1994, it was relatively “easy” to control real public sector expenditures with the ‘aid’ of price increases, by delaying the momentof actual spending. Inflation facilitated management of intragovern-ment political disputes for resources.12 With the fall in inflation, the“political price of saying No” became explicit and, in practice, the greaterdifficulty of opposing external and internal demands for funds alsohelped to boost the real level of public expenditure. In addition to thefall in inflation, the deterioration in the fiscal accounts was alsoassociated to a more expansionist fiscal policy and to structural flawsin the public sector finances:13 • the significant rise in real discretionary spending of the • the 43% nominal increase in the minimum wage in 1995, when inflation was just 15%, with direct impact on all pensionbenefits, contributing to the deterioration in the pensiondeficit, for both private and public sector employees; and 11 Inflation of 1.7% per working day corresponds to a monthly inflation of 45%, similar to the inflation of June 1994, when the Real Plan was launched.
12 See Cardoso (1998) and Bacha (1994).
13 For a discussion of the Brazilian fiscal crisis of the latter half of the 1990s, see Giambiagi and Além Texto para Discussão nº 91 • the situation of state governments, whose revenues were drained by payroll increases observed in 1994-95, withreal and lasting effects since then.
The rise in the current account deficit, in turn, was the result of demand enhancing and demand switching effects of theReal Plan. Aggregate demand went up as a result of higher realpublic spending and booms in private investment and consump-tion. On top of that, the rise in creditworthiness achieved withprice stabilization and the tight monetary policy (i.e. high interestrates) increased the demand for reais, substantially appreciatingthe exchange rate, which had already been strengthening since1992. Between June 1994 and February 1995, the real exchangerate appreciated by 30% (Graph 1).14 The government would soon abandon the free floating of the exchange rate, adopting in exchange a band system thatallowed for the gradual nominal depreciation of the real. Theundesirable side effect of this policy was the establishment of arelatively high floor for nominal interest rates. A large, unan-nounced devaluation was feared both for its inflationary impactand for the risk of severely compromising government credibility.
To a certain extent, these imbalances reflected the well- known dilemmas faced by policymakers when trying to pursuean agenda of market-oriented reforms, which includes both sta-bilization and trade liberalization. As Londero (1997 p. 273) putit, “while stabilization will normally result in an overvaluation ofthe domestic currency. for the more protected economy, tradeliberalization requires a real depreciation…” Real Exchange Rate*
Source: BACEN*Based on Brazil’s IPCA and US CPI. An increase means a devaluation. 14 The figure presents the real R$/US$ exchange rate, with CPI representing the US consumer price index, and IPCA, the Brazilian consumer price index. The appreciation of the R$ – which was initiallyset equal to US$ 1 – was more than 15% in the first months of the Real Plan. To this must be addeda not insignificant residual inflation.
Texto para Discussão nº 91 The appreciation of the real, combined with a jump in aggregate demand, caused a dramatic inversion in the tradebalance, which shifted from an US$ 11 billion surplus in 1994 toa US$ 3 billion deficit in 1995. The deterioration of the tradebalance was compounded by an increase in interest and dividendpayments (that more than doubled from 1994 to 1998), leadingto uncomfortably high current account deficits (4% of GDP in1997) and to a drastic worsening of traditional solvency indicators– the debt-service-to-exports ratio, for instance, jumped from38.9% in 1994 to 122.7% in 1998. The risks of these mountingimbalances did not go unnoticed to policymakers, the market oracademia.15 Yet the government believed that the prevailing situ-ation in international capital markets – marked by high liquidityand wide access to capital by emerging economies – made possiblea strategy of gradual adjustment.
The worsening of the current account and the fact that a large part of its deficit was financed by short-term capital flowsmade Brazil more dependent on external financing and, accord-ingly, more vulnerable to external shocks. This rise in externalvulnerability was suggested initially by the Mexican crisis inMarch 1995, reaffirmed by the Asian crisis in October 1997 andmade unbearable by the Russian default in 1998. Yet, Brazil’stribulations in late 1998 and early 1999 resulted not only fromstructural imbalances – the traditional Latin-American fiscal andexternal predicaments – but also from the policy regime’s lack ofcredibility.
In fact, it became clear with the Asian crisis that adjust- ments were needed, forcing the government to gradually changecourse in two main ways: first, through the continued nominaldevaluation of the real (around 8% per year), in an environmentin which domestic inflation was very close to international levels,leading to an annual real devaluation of approximately 6% in1998; and second, by improving the primary result of the consoli-dated public sector by 1% of GDP relative to 1997. Too little, toolate, for despite the significance of these measures, they wereinsufficient to substantially reduce the magnitude of the macro-economic imbalances.
In this environment, the burden of monetary policy in sustaining exchange rate stability increased enormously, withannualized interest rates rising above 40% in October 1998 (withvery low inflation, it should be remembered), negatively affectingoutput levels and the public accounts. Sustaining this policy overthe medium term would require a level of primary surplus tosupport the burden of interest payments that would be politicallyand socially unattainable. On the external side, there was, there- 15 See, inter alia, Goldfajn and Valdés (1996) and Cardoso and Goldfajn (1997). For a defense of the exchange rate policy of that time, see Franco (1999).
Texto para Discussão nº 91 fore, a growing perception that this policy framework wasunsustainable.16 Over 50 days, between the first days of August and the end of September 1998, Brazil lost US$ 30 billion in internationalreserves. The announcement in October that an agreement withthe International Monetary Fund (IMF) was under considerationbrought some respite. Brazil nevertheless found itself in a situ-ation in which it could not afford the luxury of a mistake. Therejection by Congress of an important fiscal adjustment measureand the announcement of a moratorium on federal debt by theState Government of Minas Gerais precipitated events. Betweenthe end of December 1998 and the first days of 1999 Brazil lostbetween US$ 500 million and US$ 1 billion a day in reserves. OnJanuary 15, after rejecting suggestions of “Malaysian-style” capi-tal controls, the authorities did the only thing remaining in theirpower to prevent the quick evaporation of reserves: let the ex-change rate float.
Despite happening already in the first month of his second term (1999/2002), the currency crisis can be seen as the final actof Cardoso’s first administration (1995-98). For all its problems,this administration was particularly instrumental in deepeningand consolidating the market-oriented reforms initiated in theearly 1990s. The privatization of public utilities, increases inproductivity, the strengthening of the financial system and, aboveall, the control of a runaway inflation are gains whose importancecan hardly be overestimated. Yet, the failure to move quicklyenough in solving the country’s main macroeconomic imbalancesleft major obstacles in the road to recovery. The fiscal reforms oflate 1998 and early 1999 and the January 1999 devaluation werethe first steps towards overcoming these hurdles.
4. Three Policy Changes in 1999
The early developments of the currency crisis in Brazil followed along the paths of Mexico in 1995 and South Korea in1997 – a substantial overshooting in the devaluation in the firstmonths of the crisis, which did not last more than a year. Yet,while in Mexico the overshooting was eliminated via inflation,which rose to over 50% (IPC) in 1995, in the case of South Korea,the adjustment occurred mainly through a nominal appreciation,with a very limited role for inflation. In the case of Brazil, therewere fears that the appreciation of the real would follow Mexico’sfootsteps, given the country’s dismal inflationary record, fears 16 Therefore, they combined elements of the two types of currency crises described by Krugman (1998), associated with the so-called models of first and second generation. As argued by Drazen and Masson(1994), there comes a time when commitment to “even more austere” policies becomes ineffective.
Texto para Discussão nº 91 that also explain why the authorities had been reluctant tovoluntarily allow the exchange rate to float in the first place. Inpractice, however, the process was similar to that of South Korea.
The R$/US$ exchange rate that stood at R$ 1.21 before thedevaluation, peaked at R$ 2.16 at the height of the crisis, beforeending 1999 at R$ 1.79. At this point, the nominal devaluationamounted to 48%, against a consumer inflation of 9%, i.e. apassthrough of less than 20%.
The fact that the devaluation coincided with slow growth explains partly why inflation did not explode, as feared by thegovernment.17 There were also other important ingredients suchas: • the quality management of monetary policy, with an accurate and timely “fine tuning” of interest rates; • the renegotiation of the IMF agreement, which signaled to a credible fiscal adjustment and provided room for theCentral Bank to intervene in the currency market; • the announcement of moderate increases in the mini- • the decision to adopt an inflation target regime.
The limited impact on inflation, which averted a dramatic fall in real wages, and the sound balance sheets of financialinstitutions, which mostly benefited from the devaluation, helpto explain why devaluation did not lead to a drastic recession asin Mexico and South Korea.18 With a close to 50% nominaldevaluation, a 10% consumer inflation and a modest expansionin GDP, driven by an improvement in the trade balance and agood agricultural year, Brazil carried out a relatively successfultransition in exchange rate regimes.19 Underlying this processwere important changes in the economic policy regime, which, byeffectively dealing with the macroeconomic imbalances inheritedfrom Cardoso’s first term, paved the way for a new cycle ofsustainable growth. Three of them stand out: 17 In December 1998, seasonally adjusted monthly industrial production was 10% below its historic peak reached at the end of 1994, and 7% below the near-term maximum of mid-1998.
18 On the relatively sound situation of Brazil’s financial sector, see Standard & Poors – S&P (1999).
The external crisis of 1999 found the Brazilian financial system relatively well adjusted to theparameters established by the Basle Accord. Moreover, Banks were well prepared for the prospectof devaluation, especially after the Asian crisis of 1997. To a certain extent, Brazil benefited fromthe fact that the Mexican and Asian crises had already happened, since this gave the banksconsiderable time to prepare for a possible crisis.
19 The change in the trade balance was much less impressive than in the case of Mexico and Korea, in the absence of a large contraction in GDP, as in Mexico and Korea. Moreover, Brazil experienced asharp deterioration in its terms of trade in 1999, with a 13% fall in the average price of exports.
Despite this, in volume terms, exports of goods grew by 8%, while imports fell by 15%, compensatingthe moderate falls in investment, public-sector spending and consumption, and causing GDP togrow 0.5%.
Texto para Discussão nº 91 • the adoption of a floating exchange rate regime, replac- ing the quasi-fixed regime in place until 1998; • the implementation of fiscal targets; and • the implementation of inflation targets.
The new exchange rate regime gives monetary policy greater room for maneuver, freeing the government from the needto defend a certain level of exchange rate. It also enhances theflexibility of the price mechanism to adjust to the structuralchanges that Brazil’s has been going through since the beginningof the nineties. The minus side is the risk of increasing exchangerate volatility, which can be detrimental to price stability, invest-ment and trade.
The adoption of fiscal targets under the “umbrella” of the IMF agreemen.20 led Brazil to join an emergent worldwide trendtowards adopting fiscal rules. As Bayoumi and Eichengreen(1995, p. 32) had already stated in 1995, “restraints on the fiscalfreedom of budgetary authorities are increasingly in the news”.
This trend has intensified over the last few years fuelled byfactors such as the European Union member countries’ effortto meet the Maastricht criteria and the implementation of“IMF-style” programs by several developing countries. Brazilhas moved, then, from a situation in which the fiscal deficit wasthe variable which would equate the chronic mismatch betweenthe society’s demands for public goods and its willingness toaccept the corresponding taxation, to a scenario where a rigidfiscal target is established and the adjustment falls on revenuesor expenditures.
A host of extraordinary measures, such as temporary taxes or proceeds from the sale of state-owned enterprises, allowedrevenues to rise as a percentage of GDP, despite the low growthand high unemployment (Table 3). All of this led to a consolidatedprimary surplus for the public sector of over 3% of GDP, in sharpcontrast to the situation in previous years.21 The adjustment also benefited from a series of fiscal re- • the establishment of certain restrictions on retirement in the public sector and the approval of a constitutionalamendment turning the computation of pension benefits 20 For a defense of the logic of IMF programs, see Mussa and Savastano (1999).
21 When the December 1998 agreement with the IMF was renegotiated after the devaluation, the level of future inflation and the consequent level of interest rates and the nominal deficit for 1999 werestill highly uncertain. As a consequence, the agreement was signed taking the performance criterionas the floor value for the primary deficit, instead as the ceiling for the nominal deficit, as usual inIMF programs.
Texto para Discussão nº 91 Public Sector Borrowing Requirements – PSBR (% GDP)
(-) Transfers (states and municipalities) bIncludes primary deficit of Central Bank. cDifference between the results “above” and “under the line”. A positive value means increase of PSBR. d(-) = Surplus.
Source: National Treasury Secretary (STN) and Central Bank. For 2001, authors’ forecast, based on the results of halfof the year. a non-constitutional matter (i.e. a matter for ordinarylegislation); • the approval of a new formula for calculating pension benefits, reducing the pensions of new retirees who leaveservice while still very young, or with only a few years ofwork; • the renegotiation of state debts against collateral asso- ciated with federal government transfers to states, pro-viding the former with the legal instruments to enforcethe negotiated terms. This implied, by definition, a needfor all levels of government to make their own adjust-ments, since they will no longer be able to count ontreasury bailouts; • the approval of the Fiscal Responsibility Law, inspired by similar legislation in New Zealand, which establishesparameters of behavior for the various levels of govern-ment, and defines ceilings for spending on payrolls forthe various parts of the public sector; Texto para Discussão nº 91 • the privatization of several local state banks used in the past as alternative sources of funding for the localtreasuries; • the privatization of the majority of companies owned by state governments that have traditionally been loss-makers.
Finally, the adoption of inflation targeting meant a fun- damental change in policymaking in Brazil.22 The commitment tostability can no longer be understood as a rhetorical figure in theofficial discourse, since the message to economic agents hasbecome extremely clear: the government will do everything in itspower to meet inflation targets. In addition, the targets set wereparticularly strict, since they were fixed more than two years inadvance, with no room for mid-term adjustments. The targets setfor 1999-2001, using the IPC as a benchmark, were, respectively8%, 6% and 4%, with a 2-percentage points margin of error oneither side in all cases.
Greater confidence in the new regime will also depend on the progress made in the external adjustment. A significant stepwas already taken in this direction: the current account deficitdropped from US$ 34 billion in 1998 to an average US$ 25 billionin 1999-2001 (Table 4). External vulnerability will depend on thepermanence of large inflows of foreign direct investment (FDI),which after averaging a mere US$ 1 billion per year in 1980-94,rose steadily to an yearly average of US$ 13 billion in 1995-98and double that amount in 1999-2001.
Current Account Deficit (US$ Million)
aExcluding portfolio.
Source: Central Bank. For 2001, authors’ forecast, based on the results of half of the year. 22 For a defense of the adoption of “inflation targets,” see Mishkin (1999).
Texto para Discussão nº 91 5. Shocks in 2001: Short-Term Turbulence or the
5. Sunset of a Would-Be Model?

Brazil’s economy finished 2000 in great style. The inflation target was met, GDP growth hit 4.4%, manufacturing outputjumped by more than 7% in the last quarter, real interest ratesfell for the second year in a row and investment gave strong signsof recovery. Buoyed by this performance, the government arguedthat the reforms have finally paid-off and that Brazil was on thethresholds of a period of sustained growth, with rates rangingfrom 4.5 to 5.0%. This good economic performance also gave aboost to the president’s popularity, increasing the government’schances in the 2002 presidential elections.
These favorable conditions, though, did not last long. After a promising first quarter, the economy began to face majordifficulties both domestically and abroad. First came the deepen-ing of Argentina’s recession and the sharp downturn of the USeconomy, which reduced capital flows to Latin America andcurtailed the market for Brazil’s exports. Second came the energycrisis, which struck in the second quarter of 2001. The worstdraught in the last seventy years (hydroelectricity accounts inaverage for 90% of Brazil’s power supply), coupled by regulatoryshortcomings and low investment, forced the government toration electricity to avert energy blackouts. Last, in third quarter,came the terrorist attacks in the United States, which thrown theworld economy, and particularly the emerging market, in disar-ray, delivering yet another blow to the already bleak prospects ofcapital flows to and exports from developing countries.
It did not take long for this combination of events to have a dramatic effect in the exchange rate. The prospects of a drop incapital flows and sluggish exports, in a country with relativelyhigh external obligations, led expectations to change rapidly andthe exchange rate to suffer a second maxidevaluation. Nominaldevaluation between December 2000 and November 2001 was30%, inflicting at least three serious ‘collateral damages’. First,given that the public sector had, by the end of 2000, a dollardenominated debt (external debt plus dollar-indexed domesticbonds), which amounted to 20% of GDP, the public-debt-to-GDPratio soared despite the stringent fiscal adjustment carried outby the government. Second, inflation rebounded, moving the12-month index beyond the Central Bank’ s target, and third, andas a result of the latter, the Central Bank was forced to raiseinterest rates, reversing a hard-won downward trend, initiated in1999. This deterioration of the ‘fundamentals’ brought the econ-omy to a halt. GDP growth fell from 4.5% (yoy) in the first quarterto 1.8% in the second quarter.
Texto para Discussão nº 91 Against this backdrop, the opposition wasted no time in mentioning indisputable facts such as the sluggish growth, en-ergy bottlenecks, rising inflation and interest rates, an increas-ingly weak currency, a current account deficit close to 5% of theGDP, and, despite the costly fiscal adjustment, a 5% of the GDPincrease in the public debt. Exposed to this type of criticism, thePresident’s popularity fell again, strengthening the lead of theopposition candidates in the opinion polls for the 2002 presiden-tial election.
If one looks, though, beyond the immediate consequences of the second maxidevaluation, there is no reason for pessimism.
As the experience of the 1999 devaluation has already indicated,Brazil’s new policy regime has enough flexibility to withstandexternal shocks, without inflicting too much damage on theeconomy’s long-term prospects. In this regard, one can easilythink of a reasonable and likely scenario for the next two years,in which the economy gradually overcomes the current difficul-ties. It would be based on the following reasonable premises: • the energy crisis dies down during 2002 as a result of a combination of factors such as the end of a very unusualdraught, the ongoing increase in the government’s en-ergy-related investments, a revamped regulatory frame-work and growing private investments in thermal plants; • the exchange rate will level off or even appreciate once Argentina reschedule (voluntarily or involuntarily) itsdebt, investors overcome the panic that usually followsdramatic events such as the terrorist attacks in the U.S.
and the ongoing adjustment in Brazil’s current accountgains full strength; • the stabilization of the exchange rate combined with primary budget surpluses at the current level of close to3% of the GDP will bring the dynamics of the public debtback to a sustainable trend; and • as in 1999, inflation will respond to the current tighte- ning of the monetary policy and, in the next years, willstay within the target set by government.
In this context, a premature, Wagnerian finale for the new policy regime would be far from a foregone conclusion, as sug-gested by its critics. In fact, our view is that the current difficultiesreflect a drastic and, to a great extent, unexpected deteriorationof the external environment, against which the new regime is fullyequipped to fight. More to the point, judging by gravity of therecent situation and by what happened during the early 1980sand late 1990s shocks, the damage to the economy’s growthprospects has been so far relatively small. If the next governmentreaffirms its commitment to the present regime (i.e. fiscal aus- Texto para Discussão nº 91 terity, inflation targets and floating exchange rate) and continueto pursue an important agenda of microeconomic and institu-tional reforms (see next section), the economy, once the externalenvironment improves, has all the conditions to get back on asustainable growth path of 4.5 to 5.0% a year. In this scenario,inflation would gradually fall to international levels, vulnerabilityto external shocks will be reduced by devaluation-related im-provements in the trade balance and interest rates and the publicdebt-GDP would resume a downward trend.
6. The Challenges Ahead
Even though the country seems to be a good position to weather the current difficulties, it would be wrong to say that thenineties have exhausted Brazil’s growth agenda. At least two bigchallenges remain ahead. First, there is the need to consolidatethe new macroeconomic policy regime. One can mention, forinstance, the need to take the fiscal adjustment beyond temporarysources of revenue, such ad hoc taxes and the lack of an inde-pendent central bank, with a clear mandate to support thecurrency and fight inflation.
Second, there are important microeconomic and institu- tional reforms, related to investment, productivity and exports,which are essential to any sustainable growth scenario. There hasalready been progress in some of these areas: the investment rate,which in the first half of the nineties remained below 15% (1980prices), rose to 19% in 2000; total factor productivity, which haddeclined an average 2.4% per year in 1980-91, showed an annualincrease of 1.7% in 1991-2000 [Bacha and Bonelli (2001)]; andexports, as mentioned in Section 2, after a lackluster performancethroughout the decade, showed signs of recovery after the 1999devaluation. Yet, the likelihood of consolidating or even buildingon these gains will be greatly enhanced if the structural andinstitutional reforms are deepened or extended towards areassuch as the labor markets and the tax and judicial systems – anagenda of challenges that has become known as the secondgeneration of reforms.
On the issue of investment, there is little doubt that the country has still a long way to go. According to some estimates,investment would have to rise to 23.4% of GDP for the economyto return to annual growth rates around 5%. Given the balanceof payment constraints, any surge in investment will have to befunded by higher domestic savings, based not only on a solid fiscalstance (already in place), but also on higher private savings. Thelatter can only be boosted by further reforms in the social securitysystem and by the strengthening and deepening of the financialmarket. Decades of high inflation, coupled with a flawed legal Texto para Discussão nº 91 system that does not properly enforce investor rights, have “re-pressed” the financial sector’s role in mobilizing and allocatingresources [Pinheiro and Cabral (1998)]. There is clear evidencethat firms in Brazil are financially constrained, undermining theircapacity to invest and grow [Thomas (2000)].
On productivity, whereas there is still a considerable agenda to push through in terms of trade liberalization, privatiz-ation and deregulation, it seems unlikely that these factors alonewill be enough to keep productivity growing at the rates seen inthe 1990s. The major source of future gains seems to be onderegulating the labor market and on upgrading the skills of thelabor force, an area where Brazil lags behind even by LatinAmerican standards [Ranis and Stewart (2001)]. The benefits ofhigher and more efficient investment in training and educationare likely to be threefold: • it might speed up the catching-up process; • it would lay down the groundwork for a move towards more productive, technology-intensive sectors, withpositive externalities for the whole economy; and • it would reduce inequality, historically the black spot of On export performance, the sustainability of the momen- tum gained after the 1999 devaluation will depend heavily on thegovernment’s ability to promote investments in infrastructure, tocarry out a tax reform, to deepen the capital markets and toprovide a better institutional support and improved market ac-cess for exporters. In the case of infrastructure, as mentionedearlier, considerable progress was made in the second half of thenineties through privatization of state enterprises. Yet, there isstill a lot to be done, particularly in areas such as energy (asshown by the severity of the recent crisis) and transport. Taxreform is an imperative given the characteristics of the presentsystem, which penalizes producers with cumulative taxes. Fin-ancial deepening is a key precondition to bring small and mediumfirms into exporting and to allow firms to survive in sectors suchas high-unit-value capital goods, where competitors count notonly on more advanced capital markets, but also on state-spon-sored export credit agencies.23 On the institutional side, in a highly informational-intens- ive activity, especially in terms of business opportunities, govern-ment support to disseminate information can be a powerful toolto promote exports. There are already initiatives in this direction— the export promotion agency (APEX), recently established, is acase in point — yet, compared to what has been done in East Asia, 23 For a discussion of Export Finance in Brazil, see Sucupira and Moreira (2001).
Texto para Discussão nº 91 there is still a long road ahead. Finally, there is the issue of marketaccess, where this and the next government face crucial negotia-tions, particularly in agriculture and antidumping, involvingMercosur, the FTAA (Free Trade Area of the Americas), theEuropean Union and the WTO.
7. Final Remarks
In the last two decades, Brazil’s economic performance fell well short of its potential and tradition. GDP growth averaged1.5% a year between 1981 and 1990 and 2.7% in the followingten years, a far cry from the more than 7% a year achieved in theprevious 30 years. In the early 1990s, though, Brazil began topursue a far-reaching agenda of market-friendly reforms, in aneffort to regain the economy’s lost dynamism. The history of thesereforms can be divided into three periods. In the first (1991-94),Brazil dropped its traditional import substitution regime, openingup its economy and privatizing industrial firms. The economyresponded positively, but high inflation hold back efficiency gainsand growth. In 1995-98, the first Cardoso government tookstructural change one step further by taking privatization toinfrastructure and by bringing inflation down from 5,000% a yearto close 2% in 1998. Yet, delays in floating the exchange rate andlack of fiscal discipline led to mounting fiscal and current accountdeficits, compromising growth.
In the third and final period, 1999 onwards, a new macro- economic policy framework was implemented based on fiscalrestraint, inflation targets and a floating exchange rate. For thefirst time since the beginning of the reforms, Brazil had managedto combine in depth structural reforms with a proper macroecon-omic policy. This long overdue combination raised hopes that theelusive goal of sustainable growth was finally within grasp. Theseexpectations were initially confirmed by a more than 4% GDPgrowth in 2000, yet, after a series of external and internal shocks,recovery was aborted and some began to question the ability ofthe new regime to deliver its promises of growth.
The shocks – the energy shortage, Argentina’s crisis and the worst world recession since the 1970s – were a powerful blowto economy’s fundamentals, particularly when one looks at indi-cators such as public-debt-to-GDP ratio and the current accountdeficit. Yet, as shown by the 1999 currency crises, the new policyregime is fully equipped to deal with short term disturbances,particularly those caused by external shocks. Moreover, one hasto look well beyond shocks to assess the implications of extensivereforms such as those carried out during the nineties. One could,for instance, draw a parallel between these reforms and thoseimplemented in the mid-1960s, under the “Government Econ- Texto para Discussão nº 91 omic Action Plan” (Plano de Ação Econômica do Governo). In bothcases, there were long overdue policy and institutional changesthat needed to be implemented. The 1960s reforms ended uppaving the way for the so-called “Miracle” (1968/1973), a periodof unparalleled rapid growth. Likewise, by dealing with bottle-necks inherited from decades of antitrade bias and macroecon-omic mismanagement, the 1990s reforms might become knownfor paving the way for a new cycle of rapid growth.
This outcome, though, will fundamentally hinge on the ability and political will of the next government (2003/2006) toreaffirm the country’s commitment to free trade and the newmacroeconomic regime. This would involve not only keeping thestatus quo, but would also require, first, a move to reinforce theinstitutional side of the new regime and second, an effort topursue the so-called second generation of reforms, which areessential to boost investment, productivity and exports, three keyingredients of a sustainable growth path.
All in all, one can argue that Brazil is at the crossroads of growth and stagnation. On the one hand, the country has gonethrough major market-friendly reforms, which paved the way fora sustainable recovery. Yet, on the other, given a number of policymissteps, particularly at the fiscal and exchange rate manage-ment, and a series of external shocks, results were slow to come,notably in terms of growth. This delay has produced a “reformfatigue” that undermined political support for the new regimeand, more importantly, for a second generation of reforms, whichare key to complete and consolidate the achievements of the1990s. If, despite the fatigue, a pro-reform approach prevails in2003, the 1990s might pass into history as laying the foundationsof a long spell of prosperity. Yet, if the critics have their way, thenit might be view as yet another lost decade.
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Texto para Discussão nº 91 Appendix
Brazil: Economic Indicators
1993 1994 1995 1996 1997 1998 1999 2000 2001 National accounts (% GDP, current prices) aGDP divided by the average exchange rate (R$/US$). bGross rate (SELIC). Deflator: “Centered IGP”. Since 1995, CPI.
Sources: IBGE, IPEA and FGV. For 2001, authors’ forecast, based on the results of half of the year.
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