The Brazilian economic crisis
Despite having adhered to an economic strategy which entailed an overvalued currency, high interest rates, huge capital inflows and liberalization, Brazil has plunged into crisis. Contending that orthodox remedies of fiscal and monetary austerity will only deepen the economic contraction, this paper by Oxfam (Great Britain) calls for an emphasis on human development considerations, especially the oft-neglected question of equity, in national and international responses to the crisis.
There are many people watching Brazil's unfolding economic crisis - Washington politicians, Argentine ranchers, City of London bankers, IMF economists and Sao Paulo industrialists. The most affected parties, largely invisible in the drama, are the ordinary Brazilians who work in factories and shops, on farms and street corners, whose life chances are being determined by the global economic system and its putative managers. Those most vitally affected are the 60 million Brazilians already in poverty. Regrettably, for a desperately poor farmer in the Northeast, whose conditions are as harsh as anywhere in the world, or for a child in a favela spending his days on the streets, the economic policies prescribed by the government and endorsed by the IMF and US authorities are having disastrous consequences. The issue of where the burden of economic adjustment falls is particularly relevant in Brazil, a country where the poorest 40% of the population share an 8% slice of the national income cake and the wealthy 10% consume 48%. After a short introduction, Part 2 of this paper analyzes government economic policies, what went wrong, and the likely consequences. Part 3 looks at national policies that could help protect those in poverty, and Part 4 makes recommendations on the role of the international community in relation to both the crisis in Brazil and global financial management.
Hot money seeks cooler climes
Brazil, as the ninth largest economy in the world, is regularly mentioned in the world's financial press, but since capital started pouring out of the country in August 1998, hardly a day passes without articles referring to its crisis and the international repercussions. What was seen as a promising emerging market, in the hands of a safe economic team, has become one more global problem. The summer drain on reserves, in which $30 billion winged their way out of the country, was followed by an autumn international support operation led by the IMF. Careful timing helped avoid impediments to President Cardoso's electoral victory in October over Lula, his left-wing challenger. Three weeks later, the government announced a $22.5 billion package of spending cuts and tax hikes.1 The New Year came, and "the markets" looked anxiously at the slow progress in shrinking the public sector deficit. The IMF's $41.6 billion cushion seemed threadbare, capital took flight once more and the currency crisis exploded. The government attempted a controlled devaluation on 13 January and threw in the towel two days later. By the end of the month, the real, hero of the victory over hyper-inflation in 1994, had fallen from 1.21 per US dollar to 2.05. Forecasters revised their guesses about the depth of the 1999 recession down to 5-6% negative growth - and the IMF negotiators flew back to Brasilia to redo their sums. The new economic package to be announced on 8 March after three weeks' negotiation will be a lot tougher than its predecessor.
Another IMF rescue bites the dust
The Brazilian approach to stabilization, backed by the international financial institutions, has failed. As attempted elsewhere in the 1990s, the strategy was to anchor the local currency to the dollar. This reduced import prices and put market pressures on domestic producers to keep prices down. Crucially, it also reassured economic actors and broke the cycle of self-fulfilling inflationary expectations. The model required substantial inflows of foreign capital in order to have the reserves to defend the exchange rate. This in turn required 20-30% real interest rates. It was not only a rather rigid model, it also effectively "externalized" economic policy at a time when world markets were awash with capital. "Investor confidence" mattered more than the realities of the domestic economy and when it evaporated, the house came tumbling down, taking Brazil deep into recession. Now, the majority of the Brazilian public no longer trust government economic management.
2. What went wrong?
To make sense of today's malaise, we have to look back to the 1980s, when Brazil and other Latin American countries faced stagnation, high inflation, weak currencies and debt crises. The import - substitution growth strategy had reached its last gasp, since no government had been prepared to expand its domestic market through redistributive measures, and sheltered, uncompetitive industries could not hold their own abroad. Early IMF stabilization programmes, which were designed from an orthodox monetarist standpoint and prioritized debt solvency through fiscal austerity, signally failed to stop inflation or generate growth - indeed, they created hardship for many in the region. Later prescriptions, which evolved into the "Washington consensus" on how to run an economy, combined more sophisticated anti-inflation policies with a growth strategy based on market liberalization, that is, privatization, trade liberalization, opening up to foreign capital and the euphemistically dubbed "flexibilization of labour".
Prices down, votes up
Brazil signed up to the "consensus" later than most, though there was a botched attempt in 1990 by President Collor to halt inflation by freezing bank accounts. Collor, who was later forced out of office on corruption charges, also scaled down the tariffs surrounding the economy and attempted to cut public spending. In 1994, Fernando Henrique Cardoso, the Brazilian Social Democratic Party (PSDB) economy minister in the next administration, introduced the Plano Real, with full backing from the international financial world. It stopped hyper-inflation by anchoring the currency to the dollar and by keeping interest rates high and the exchange rate overvalued. The "inflation tax" was lifted from the shoulders of lower-income families, generating a one-off but significant increase in living standards and a consumer boom. This success ensured Cardoso's election to the Presidency in October 1994, in alliance with the conservative Liberal Front Party (PFL).
Trade troubles...but the dollars roll in
The high interest rate and overvalued real, needed initially to squeeze out inflation, were sustained too long and had critical consequences for trade. With the revaluation in 1994, export competitiveness deteriorated dramatically and imports flooded in. The tariff liberalization in the 1990s and declining commodity prices contributed to the growing current account deficit, which reached 4.5% of GDP in 1998. This deficit could only be sustained by an influx of foreign capital, which indeed poured into Brazil in the 1990s, taking reserves to a peak of $73 billion. Part of the flow was foreign direct investment, some of it stimulated by the huge privatization programme. The greater part of the flow was more volatile portfolio investment - a mixture of equity and bond purchases, along with bank deposits - and commercial loans. The latter, much of it short-term, inflated Brazil's total external debt to $230 billion by end-1998. The government believed that the only way to attract and retain foreign capital on the scale required was to keep interest rates amongst the highest in the world, and keep investor confidence in exchange rate stability.
Double your money
High interest rates kept a lid on growth, though less so than might be expected. Larger companies self-financed their investment or borrowed abroad, and consumers were prepared to run up big personal debts in the first years of the Plano. The far greater problem was the effect of interest rates on the public domestic debt, which by 1998 had ballooned to $265 billion. Throughout the 1990s, state spending on goods and services substantially exceeded tax revenue. The shortfall was covered by privatization receipts ($80 billion to date) and borrowing. One reason for issuing bonds, it should be noted, was the need to neutralize the inflationary effect of the huge capital inflows. By 1996, expenditure on servicing the public debt had overtaken the combined health and education budgets, and in 1998 was heading for $60 billion - over 7% of GDP. By this time, every 1% hike in interest rates that the IMF recommended was costing the government a further $2.5 billion. This was seventh heaven for foreign investors and wealthy Brazilians, who could leave their money in the bank and watch it double every few years. The fact that spiralling public debt has been a mechanism for the transfer of fabulous sums of public monies to the better-off is glossed over by the government and the international financial community.
The Sheriff of Nottingham would be proud
If reducing the public sector borrowing requirement was central to successful stabilization, why did it never happen? The primary explanation is that, quite apart from the transfers through debt service described above, national elites have always been important beneficiaries of state spending in Brazil and have steadfastly resisted surrendering their privileges - a phenomenon which has led many Brazilians to call for the "desprivatizaçao do público" (de-privatization of the public sector).
- Much of the state's expenditure has traditionally been overt and covert subsidies to the private sector, such as cheap loans, often not repaid, or prodigious construction contracts. The Cardoso government's $24 billion bailout of badly-run state and private banks amounted to more than annual spending on health and education; this subsidy was effectively another cost of the economic strategy, as securing investor confidence was an overriding concern.
- According to World Bank calculations, even social spending favours the wealthy. 24% is allocated to the richest fifth of the population while 13% reaches the poorest fifth. The principal explanation for this regressive pattern is the pensions system, which particularly benefits the upper layers of public administration.
- Populism and clientilism are deeply embedded in the political culture and depend on state resources. The key reward for loyalty to a politician is a public sector job, be it as a primary school teacher or the head of a federal agency. The political elites at all levels, therefore, have a vested interest in the status quo.
- The wealthy have also resisted pay- ing taxes. Revenue is derived largely from indirect taxation, which hits rich and poor alike. Even basic foods are taxed. Personal taxation is low and widely evaded, as is company tax. Employers have social security arrears of $33 billion, which dwarfs budgets for core social services.
Since international creditors are forcing closure of the fiscal gap, a key equity issue - to which the IMF and international financial establishment pay insufficient attention - is who is paying the extra taxes and where are the expenditure cuts falling. Unfortunately, elite interests are prevailing, not least because the governing coalition includes the main conservative party. At the same time, there is extensive middle-class opposition to public sector reform for fear of job losses.
The house of cards
By 1997, the government, with advice and approval from the multilateral financial institutions and G7 governments, had constructed an effective anti-inflation policy, was privatizing services, industry and mining, and was steadily liberalizing trade and the capital account. High interest rates, overvalued currency and huge capital inflows were integral parts of the strategy, but arguably there was space in 1996 and 1997 to speed up the rate of devaluation and bring interest rates down - steps which might have precipitated a currency crisis, but on a lesser scale than the present one. The ripples from the 1997 Asian crisis, however, prompted the government to re-commit itself to "more of the same", even though this would slow the economy to a standstill by mid-1998. Amongst the victims of spending cuts after the Asia crisis were communities displaced by the World Bank-funded Itaparica dam, who have been supported by Oxfam since the 1980s. $60 million, or more than 40%, was cut from the resettlement budget.
The real jolt came with the Russian crisis in August 1998. This time, as some of the "fundamentals" looked wrong, potential investors and lenders stayed away, and the herd began to move. Reserves fell by $30 billion in the next two months as the government struggled to shore up the real and loans were paid off. Inside boardrooms, fears of loan default were discreetly voiced. The IMF moved quickly and by October had set up a $41.6 billion loan package. The breakdown by donor was: IMF $18.1bn, World Bank $4.5bn, Inter-American Development Bank (IDB) $4.5bn and bilateral assistance $14.5bn. The UK contribution was $1.2bn. Although the G7 and IMF argue for private sector participation in crisis assistance, there was none forthcoming for Brazil, raising criticisms that investors are again getting a free ride.
Brazil's November Letter of Intent committed it to a range of targets, including reduction of the fiscal deficit from 8% of GDP to 4.7%. This was to be achieved on the revenue side by upping the tax on financial transactions, raising pension contributions from public sector employees, and increasing the employers' social security contribution. On the expenditure side, the target was a reduction of a little over $7 billion. Priority social programmes including those to combat child labour and assist the disabled suffered cuts of nearly $750 million. Part of the deal was to keep monetary policy tight even though the economy was now in recession and despite the cost to the public purse. By now, even the World Bank was voicing its disquiet with the strategy. According to some observers, IMF action and policy guidance, especially on the exchange rate, ensured that a massive repayment of capital owed to developed country banks and investors could occur without losses to the investors. The economy, meanwhile, slid further into recession.
Faced with reserves at half their previous level and the enlarged current account deficit, the government opted for 8% devaluation in January. The relieved Sao Paulo stock market immediately rose 34%, but markets abroad went down, revealing the different perceptions of what was good for business. The government, reportedly under heavy pressure from the IMF, put interest rates even further up but this did nothing to reassure the international investors, who decided the real was heading downhill. Indeed, the interest hike may have persuaded many that default and deeper recession were on the way, so it was time to go. The government decided it would be throwing good money after bad to support the exchange rate, so down it plunged.
The impact of the currency crisis on the real economy is hard to predict - one factor, of course, is the policy choices being made now, especially on interest rates and public spending - but there is no doubt a major recession is on its way:
- Sky-high interest rates will restrain domestic investment, particularly by smaller enterprises. Companies will struggle to pay their dollar-denominated debts and, as in Indonesia, will find overseas credit sources have dried up. Foreign and national investment will also be deterred by poor growth prospects and the uncertain economic and political climate, reinforcing the recessionary cycle.
- Reduction of the public sector deficit will mean lower demand, output and jobs. Given the rocketing costs of servicing the public external debt of $80 billion and the $50 billion of internal debt indexed to the dollar, the pressure for substantial cuts will be even greater than before.
- Lack of demand and liquidity will make most companies scale back production, or in some cases become insolvent, with repercussions on the banking sector.
- Exports could be a silver lining but certainly not the country's salvation, since primary product prices are low, as is demand from Latin American neighbours. Exporters may fail to exploit new opportunities because of the credit squeeze.
Overall, the economy could contract by 5% or more - nobody knows. This means plummeting living standards for poor people. One crucial variable is inflation. Imported inflation is not a big problem since imports are only 8% of GDP, but it will trigger pre-emptive price hikes by economic actors. The upward spiral could reach 20% or more, eating away incomes, especially for the more vulnerable groups. The employment effect cannot be predicted but it will be very severe, and it will come after successive years of rising unemployment due to labour shake-outs - in Greater Sao Paulo, the industrial heart of the country, open unemployment had already reached 18% last year. The burden of recession may engender greater social violence and political instability, leading to further deterioration in the quality of life.
So what next?
Even before the East Asia crisis, the Brazilian economy was failing to deliver the goods to the majority of the population, and the social panorama was bleak. Though presiding over moderate expansion of GDP in the 1990s, successive governments did not institute the pro-poor growth policies, redistributive measures and social policies that could have brought lasting gains for the disadvantaged. The PSDB under Fernando Henrique Cardoso, having opted for a political alliance with the right wing, based its anti-poverty strategy on price stabilization and "trickle down". Banishing inflation in 1994 did bring very real benefits, but they were shortlived. A growth policy based more on expansion of internal demand through redistribution and an active industrial policy, including a big investment in education, would arguably have been less vulnerable to the external shocks to which the "Washington consensus" condemned Brazil and other developing countries. But the damage is done, the question is - what now?
3. What is to be done?
The general principles that should guide policy are:
- Human development and poverty reduction objectives must be integrated into the design of macro-economic reforms and short-term stabilization policies. Inequalities need to be reduced by targeted growth, but income redistribution through market-based mechanisms and the mediation of the state is also essential.
- People living in poverty should not be made to suffer as a result of under-regulated international market forces, and the costs of crisis should be shared by the owners of capital, not merely passed on to the poorer sectors of society. The international community should take urgent steps to combat global financial instability and stimulate growth in Brazil and other Latin American countries in recession.
- There needs to be wider consultation about policies with civil society, especially groups that represent or work with the poor and vulnerable. The government and the institutions of the international financial system could behave in a more transparent and accountable way.
Within this framework, key national policies that would assist the poor include:
Lower interest rates could make a substantial difference to the depth of the recession and the size of the public sector deficit. The government's economic policy depended on a continuous stream of capital from abroad, which in turn required the lure of high interest rates, a strong currency and lack of regulation. This strategy failed to deliver stable growth. As the World Bank has observed, high interest rates and fiscal austerity aggravated the Asian crisis, yet the IMF, supported by the US Treasury, persists in calling for these policies as part of developing countries' crisis management. It is true devaluation-induced inflation has to be nipped in the bud, and monetary discipline plays a part, but low inflation should not be the only policy aim.
If the balance of payments does not improve, the government may need to apply temporary capital/foreign exchange controls, or taxation on exiting capital. As in Malaysia, this could have a negative impact on investment inflows but may be the lesser evil until the economy stabilizes. In the medium term, regulation of inflows may be a more desirable mechanism for capital account stabilization.
In Brazil, perhaps more than anywhere in the world, there is scope for reduction in the fiscal deficit by socially progressive taxation. The wealthy 10% enjoy half the national income, and pay very little tax. Improved enforcement plus higher taxes on earned and unearned income, on property and inherited wealth, could bring in substantial sums. As noted earlier, investors in the financial markets are currently enjoying higher windfalls than ever by lending to government and some of these profits could be clawed back. Unfortunately, with the exception of the financial transaction tax, which spares the 60% of Brazilians without a bank account, the government is doing none of this. On the contrary, it is planning to extend flat-rate indirect taxes. Another policy option is to pursue companies for the $33 billion they owe the exchequer in overdue social security payments, and call in unpaid loans made by public banks. These funds could be used to extend credit to small and medium enterprises that have not been abusing the system.
Cuts in public spending should be targeted at the subsidies to the private sector and the privileges of the civil service elite. Costs can also be reduced through efficiency gains. Although the primary balance of public sector spending is in surplus (that is, before calculating debt service), it remains essential to reducing spending. Economies can be made in the subsidies given in a variety of forms to private enterprise, usually larger concerns. There is some scope for lessening the public sector wage bill by reducing overstaffing, provided there is a corresponding investment in improved management and a consultative and transparent process. This will initially be more feasible at the federal level than at municipal and state level, where clientilism and cronyism are more prevalent. Salaries and perks for higher-paid civil servants at all levels of government could certainly be slimmed down. Some resources, however, need to be reallocated to low-paid public sector employees, such as teachers and nurses.
Reductions in social spending should be targeted exclusively at the benefits reaching the better-off. The 1999 federal budget contains cuts in health, education, sanitation and water supply, which should be restored. There is also a reduction of $4 billion in the allocations to state and municipal government; concern has been expressed that this will prejudice the poorer regions, such as the Northeast, which are more dependent on these transfers. The pensions system for public employees, which ran a $20 billion deficit last year, should be a target for reform, though the state system for private sector employees also needs overhauling, since both involve huge transfers to the better-off. The reform measures now going through Congress help reduce the privileges, but some remain. The ceiling on civil service pensions should be lower, and the many highly paid professionals that have already retired in their forties and fifties, on full pay, should have their benefits scaled down. The armed forces should also lose their special pension rights. World Bank funding for pensions reform, a component in the November package, should be clearly directed to equity objectives.
The government should make specific commitments to protecting all social expenditure that benefits the poorer sections of the community, especially women and children. This includes basic education, vocational training, public health services, investments in water and sanitation, welfare programmes in drought-affected areas, care of the elderly, social provision for children at risk, and so on. Other areas of spending important for people in poverty include reform of the appalling prison system and the judiciary, which does little to protect their rights at work or in the community. We agree with the government and World Bank view that the amounts spent on social services are not matched by results on the ground and there is a need to improve the design and management of delivery systems and the degree of accountability to the community. The improvement in public and child health in the Northeastern state of Ceará shows what can be done though better management and targeting.
Proactive measures are needed to generate employment. Apart from facilitating measures such as education and training, unemployment needs to be reduced with the introduction of targeted, labour-intensive public works programmes. There is an enormous need for social and economic infrastructure - such investments not only create jobs directly and through backward linkages, they also provide poor people, especially women, with economic assets for survival in the informal or semi-formal sector: a house with electricity, water and solid walls becomes a hairdresser's, a store or a workshop. The government's promise to invest in the construction of 250,000 houses, if it survives the current round of cuts, is a step in the right direction. As with all such schemes, civil society participation in implementation is essential in order to reduce favouritism and waste. ]
Integrated support can be given to small and medium enterprises including access to credit, technical assistance and training. In the rural areas, family farmers can be helped in the same way, as well as having enhanced access to land and, in the case of the dry Northeast, to water resources. Redistribution requires political will as much as money, since there is much land in public ownership or which has been illegally taken over by large farmers and ranchers which could be available. The land market can also be modified by taxing unused land. In January, however, the government reduced the 1999 Land Reform budget by 43% in relation to the 1998 budget, suggesting there will be no proactive measures for the landless.
Environmental protection and improvement must not be further weakened by government cuts. Existing programmes, whether in the relatively high-profile rainforest areas or the semi-arid Northeast, or in the swampy favelas of Recife and factory belt of Sao Paulo, are underfunded already. Some economies have already been made in 1999 budgets, including resources for the National Environment Programme, which levers much larger funding from international donors. The cuts would have been worse had it not been for pressure from environmentalists at home and abroad and the intervention of the German government.
Transparency and civic participation are necessary to ensure government credibility and effective decision-making which takes full account of social reality and social needs. There is concern amongst Brazilians that the government conducts its economic policy and, above all, its crisis management, behind closed doors, talking only to foreign bankers and World Bank officials but not to its people, especially those representing poorer sectors of the community. In the negotiations over the IMF package, the government has also marginalized Congress, including the Senate, which is constitutionally charged with approving foreign loans. The attitude of the government tends to be "there is no choice, so there is nothing to debate", when in fact there are many policy choices and there are differences of opinion, even within the inner circles. This conduct contrasts sharply with Brazil's pioneering experiences of civic participation in budget planning at state and municipal level - the southern city of Porto Alegre being an outstanding example. In the longer term, it is important that civic organizations are able to participate in monitoring the social situation and government policies, and can contribute to a national debate around poverty reduction.
role of the international community
Oxfam believes G7 and European Union governments and the international financial institutions, principally the IMF, should assist recovery-orientated responses to the crisis, paying full attention to human development considerations.
- Economic policy prescriptions and conditions attached to rescue packages and official debt renegotiation should not include maintenance of excessive interest rates, or prohibit measures to control the capital account. These are not areas of policy- making where the "correct choices" are at all obvious, and the prescriptions of the financial establishment have not proved benign to date. The November 1998 fiscal targets negotiated with the IMF should be revised to take into account the sharper revenue decline now expected.
- IMF assistance should be provided within the framework of agreed social development objectives as well as macro-economic goals. The release of loan instalments should be linked to achievement of "social benchmarks" with the same status as the present "structural benchmarks". Reductions in the public sector borrowing requirement should be designed on the principle of raising revenue from those most able to pay and reducing the benefits of those who least need them.
- Loans provided by other multilateral and bilateral sources should be allocated for social sector spending and reform that benefit poorer sectors of the community and for economic recovery programmes prioritizing small and medium enterprises. There should be a commitment by government not to transfer its own resources out of these areas. The poverty focus of the World Bank and IDB's $9 billion assistance is to be welcomed; close monitoring with civic participation will help ensure funds are applied effectively.
- The terms and scheduling of existing official debt should be renegotiated. If the situation deteriorates further, a temporary suspension of payments should be considered. Freed-up national resources should be added to existing state funding for poverty reduction.
- The multilateral banks and G7/EU governments should more actively seek to bring international private lenders into the rescue effort, ensuring they also renegotiate debts, especially the short-term lending to Brazilian banks and companies.
- Private and untied official trade credits should be extended to Brazilian importers to finance inputs. The EU, which enjoys a trade surplus with Brazil, should review tariff preferences for Brazil, scheduled to end in mid-1999, and ensure non-tariff barriers and anti-dumping measures are not used with protectionist intent.
- Bearing in mind the general economic downturn and growing balance of payments problems throughout the region, and the repercussions of the Brazil crisis, the G7/EU should consider renegotiation of official and commercial debt in other Latin American countries and co-ordination of currency interventions.
in global arrangements:
An internationally co-ordinated reduction in volatile, short-term capital movement. The administrative and market-based mechanisms could include:
Host countries should not be pressured to open up their economies indiscriminately or prematurely to foreign capital or free currency movement; proposals to include capital account liberalization in the Articles of the IMF should be abandoned.
More effective international financial institutions: The recent experience of Brazil confirms once again that governments need to review the strengths and weaknesses of IMF interventions to identify appropriate institutional and policy reforms. The review should look particularly at the growth and distributional effects of different types of stabilization and adjustment programmes, with a special focus on the impact of high interest rates, pegged/overvalued exchange rates and capital account liberalization. The IMF's future role should be more accountable and transparent, and should be integrated within what James Wolfensohn calls a "holistic development framework" in which "basic structural, social and human prerequisites should balance macro-economic considerations".2 Nevertheless, a reformed IMF with increased resources may not be enough to cope with future crises and a fresh look at the functions and institutions of global financial management is required, with stability, sustainability and, crucially, equity considerations to the fore. (Third World Economics No.205, 16-31 March 1999)
1. Sums in reais have been converted at US$1=R$1.21, the rate prior to the January 1999 devaluation.
2. A Proposal for a Comprehensive Development Framework, internal World Bank discussion draft by James Wolfensohn, January 1999.
This paper is reproduced with the permission of Oxfam GB from whom a 2-page summary is also available.
Oxfam (Great Britain), a member of Oxfam International, has been funding relief and development projects in the Northeast and Amazon regions of Brazil since 1968. The programme focuses on family agriculture and urban services, with particular stress on public policy work. This paper was written by Michael Bailey and Heinz Stecher. For further information, contact Michael Bailey in the central Policy Department (+44 1865 312494 or firstname.lastname@example.org ) or Jessica Pelham in the Recife office (+ 55 81 231 5449 or email@example.com ).