Tequila or Tortilla

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Tequila or Tortilla

Tequila or Tortilla?

    * Notes on the Brazilian Economy in the Nineties

    **Franklin Serrano

    January 1998

    “It is a great pleasure to meet again the President of Mexico”

    [Jacques Chirac, President of France, greeting

    President Cardoso, of Brazil, 1997]

1. International Capital Flows and Macroeconomic Instability

    Like most other Latin American countries, the Brazilian economy was very much affected by what were perhaps the two most important changes in the external conditions affecting the continent since 1980, namely, the interruption (and even reversal) of international capital flows to the region after the 1982 Mexican default and the sudden resumption of these flows

    1in the early 1990‟s. The first of these shocks combined with world recession, a

    deterioration in the terms of trade for commodities and the unprecedented increase in international interest rates that happened in the early eighties plunged Brazil into a decade

    2of stagnation and persistent and extremely high rates of inflation which led also to the progressive dismantling of a successful regime of state-led industrialization. The sudden resumption of capital flows towards Latin America in the early nineties was decisive for economic recovery and the dramatic reduction and successful stabilization of the rate of inflation, the latter obtained in Brazil with the 1994 Real plan, which was based on deindexing the economy and (more crucially) strict control of the nominal exchange rate.

2.Indexation and Inflation

    The external debt crisis and the interruption in capital flows was common to most Latin American countries but its particular effects on the Brazilian economy were, of course, very

     *Financial support from CNPq/Brazil is gratefully acknowledged. ** IE/Universidade Federal do Rio de Janeiro, Brazil. 1 On this surge see Ffrench-Davis,Titelman & Uthoff (1994) 2 On these four shocks and their impact on Latin America see Singh (1994).


    much influenced by some distinctive features of the Brazilian economy and its development strategy.

    One of these peculiar Brazilian features was the high degree of price indexation of the economy. In fact, widespread indexation in Brazil can be traced back to the mid-sixties. The military government of the time decided to follow a development strategy in which the local currency should not become persistently overvalued relative to the U.S. dollar. That led to a crawling-peg exchange-rate regime with frequent mini-devaluations. This continuous nominal devaluation of the currency in turn led to the need, in order to prevent capital flight, of formally indexing interest rates on government bonds (the so-called “monetary correction”

    mechanism). Indexation then spread to all financial contracts and introduced an element of inertia in inflation which at the same time made necessary or perhaps inevitable (even in a repressive regime) a partial but growing indexation of wages. The latter by its turn reinforced

    3 the inertia in inflation rates giving further stimulus to widespread indexation of all contracts.Therefore, when the external shocks due to the debt crisis hit Brazil the economy already had a very high degree of indexation and a relatively high and persistent rate of inflation. That explains why inflation accelerated so much and reached such high and persistent levels in Brazil during the eighties. The debt crisis led to the so-called “maxi-devaluations” on top of

    the crawling peg as a means of altering the real exchange rate, promoting exports and making imports more costly in order to obtain a trade surplus to service the debt and make up for capital flight. Those maxi-devaluations accelerated inflation and led to further increases in interest rates and then of wages. On the other hand the complex system of indexed contracts allowed the economy to operate normally even with record-high rates of inflation. Thus, indexation at the same time made inflation rates much higher and persistent than in other countries but on the other hand prevented the disorganization of the economy that happens

    4under open uncontrolled hiperinflation.

    In the period 1980-94 Brazil attempted many different types of stabilization plans. But, regardless of such efforts, until the 1994 “Plano Real” the Brazilian economy lived with a

    permanent inflationary process with strong trends towards hyperinflation, briefly contained

     3 On the early Brazilian debate about indexation and inertia see Serrano (1986) 4 On the Brazilian “indexed-money”regime see Mendonça de Barros (1993).


    by these increasingly ineffective stabilization attempts. Inflation rates measured by different price indexes presented very abrupt oscillations and, from 1988 onwards, four digit figures were quite common

    nd National Development Plan and the Export Drive 3. The 2

    Another feature of the Brazilian development strategy that was crucial to explain the peculiar performance of the economy in the eighties was that, in marked contrast to most other Latin American countries (where the external debt financed capital flight) a good part of the

    ndBrazilian external debt was used to finance the 2 National Development Plan which

    invested heavily in the capital goods sector and infrastructure. Those investments were instrumental in reducing the dependency of the economy on some imports (such as oil, for instance) and, more importantly, served to complete the local industrial base (including some indigenous capacity to generate technology) and provide the cost externalities (in transportation, energy and basic inputs) that allowed the country in a short period of time to become a major exporter of industrial commodities. This successful export performance coupled with the stagnation of the economy and other measures to ration imports allowed the

    5country to produce large trade surpluses after 1983 for ten years

4. External Debt, Inflation and the Crisis of the Public Sector

    The vicious circle of exchange-rate shocks and inflation acceleration had destructive effects upon public finance. The management of the country‟s foreign debt – virtually nationalized in

    the beginning of the 1980s as part of the policies to face the problems of the balance of payments led to a chronic disequilibrium in public finances, while the acceleration of inflation led to a collapse in the demand for the local currency, continuously devaluated, and

    6decreased the ability of the public sector to borrow long.

    The real value of tax revenues tended to fall given the well-known lags between nominal incidence and actual payment (the „Tanzi‟ effect). However with a series of fiscal reforms the

     5nd On the 2 National Development Plan see Cano(1993).

    6 On the link between the foreign-debt crisis and crisis of the public sector see Cruz (1994,1995). On the “lost decade” see also Cardoso de Mello (1992).


    government did manage to index most tax revenues and created a large number of new taxes (including one on financial transactions) that, in spite of the growing trend of tax evasion, prevented a complete fiscal collapse.

    Progressively the only means of financing a deficit still available was the emission of fully-indexed public bonds with very short maturity and guaranteed (and full) liquidity. In practice such bonds became the country‟s indexed currency. Capital flight, and the

    consequent open hyperinflationary explosion, was avoided but at a very high cost for the public sector not only in financial terms, but also in terms of the government‟s ability to implement and control macroeconomic policy.

    The need to guarantee liquidity for government bonds in practice implied a passive and virtually uncontrolled monetary supply. The only tool still available for avoiding open hyperinflation was the management of internal nominal interest rates. However, the exclusive reliance on increasing interest rates for the macroeconomic management of the economy had two consequences. First, it reinforced the financial component of the public deficit. Second, it also led to the acceleration of inflation as, in such context of a drastic shrinking of the maturity of all contracts, the increase in very short-term interest rates on government bonds also increased the minimum opportunity cost also for productive capital and led to an increase in mark-ups and hence on the supply prices for all sectors of the Brazilian economy. Note that short-term interest rates became a factor in accelerating inflation for two reasons. First, because the shortening of the maturity of all contracts made the distinction between short and long rates practically disappear. Short-term rates (rather than the inexistent long rate) thus became the “cost of capital” both in the sense of representing its financial cost and,

    7. more importantly, as its opportunity cost

    The second reason is that, given the fact that the country had been cut out of the international financial markets since 82, increases in the domestic interest rate did not have, in that period, the antiinflationary effect of attracting capital inflows and slowing down exchange-rate devaluations.

     7 On the long rate of interest as the determinant of the “cost of capital” and markups see Pivetti (1991) and Serrano (1993). On the short rate affecting the markups in the Brazilian context of high inflation see Serrano (1994).


    Therefore, under those conditions an explosive exchange-rate, interest-rate, prices, wages, exchange-rate spiral was continuously reproduced as nominal interest-rate increases to avoid hyperinflation at a given point in time led to a worsening of the inflation process in subsequent periods. This spiral was temporarily interrupted by stabilization plans that tried to rein in nominal exchange-rates, wages and sometimes included price controls. The most spectacular of these plans were the Cruzado plan of 1986 and the Collor plan of 1990. The 1986 Cruzado plan, implemented by the first civilian government after the military withdrew, included a comprehensive price freeze and a number of deindexing measures. A faster-than-expected recovery of the activity levels (mainly due to a credit boom) together with the over-extension of the price freeze for electioneering reasons led to growing inflationary speculation, particularly (though not exclusively) in regard to the frozen nominal

    8 In a context of great fragility in the country‟s balance of payments (the exchange-rate.

    planned external debt renegotiation had not achieved the desired results), speculative attempts such as these were bound to be successful, and inflation and indexation quickly returned to

    9their accelerating spiral as soon as price controls were lifted.

    In the 1990 Collor plan there was a rather drastic but very short-lived attempt to control and dismantle the indexed-money mechanism, which included the government seizing a large part of the public‟s liquid assets and transforming them compulsorily into a 18-month loan to the

    Tresury. That led to a large (but temporary) increase in the demand for the local currency that temporarily stopped the nominal exchange rate devaluations.

    However the government did not manage to change the rules concerning the liquidity of new issues of public bonds and the informal indexation of short-term interest rates. The government quickly (in less than one month) allowed, through a number of formal and informal channels, the restoration of the liquidity of the private sector, undoing thereby the increase in the demand for the local currency. Given that failure, and the fact that the external debt situation was still unresolved, soon the pressure to devalue the currency to service the external debt and to increase interest rates to avoid capital flight proved irresistible, leading to

     8 Because of formal capital-account controls this was done mainly by postponement and anticipation and under- and over- invoicing of exports and imports, respectively. 9 See Tavares (1989).


    the gradual reindexation of the economy and with it to the quick return of high and

    10 accelerating inflation.

5. Economic Stagnation and the end of State-Led Development

    Due to the shrinking of the maturity of all financial contracts (in Brazil over that period contracts with a maturity of more than one month were usually classified as long-term contracts) and the virtual inexistence of feasible interest rates which could compensate the risks of either borrowers or lenders over a longer time-span, along the eighties the Brazilian economy gradually drifted to a state of financial regression. The credit system collapsed and there was a drastic and permanent fall in both the demand and the supply for credit (both for consumers and firms). The state became the only big borrower and the financial system organized almost exclusively around the intermediation of indexed government bonds. The scarceness of credit, together with the effects of inflation on wage-earners‟ incomes led

    to a relative stagnation of consumption expenditure and housing investments. Government expenditure particularly on investment slowed down due to the financial crisis of both the

    Treasury and the state-owned firms. In that macroeconomic context the only dynamic component of final demand was exports and therefore the incentives for the private sector to invest for the domestic market were rather limited. However, given the other negative trends in aggregate demand, the export drive by itself did not (and in a large economy such as Brazil‟s could not) manage to sustain growth in private investment. Thus, firms invested as

    little as possible in increasing their productive capacity, slowing down equipment renovation which, together with the costly and difficult access to imported capital goods, implied growing industrial obsolescence.

    The macroeconomic instability and the high inflation rates, together with the adjustment costs of the external debt resulted not only in a deep crisis of the public sector but, more importantly, led to a profound institutional crisis of the State (aggravated by a long and slow transition from military to civilian rule), marked by an increasing disarticulation and loss of

     10 On the Collor Plan see Teixeira (1994) and Tavares (1993).


    planning and operational capacity by most agencies and policies related to industrial promotion, such as taxation, international trade, science and technology. Progressively the State allowed its capabilities to promote industrial development both in

    terms of incentives and regulation to weaken. At the same time, increasing constraints on

    public finances reduced to minimum levels all maintenance and expansion investments in infrastructure services such as energy, transports and telecoms.

    Gradually the regime of incentives for nationalization and regulation against imports (the latter had been strengthened because of the debt crisis) was dismantled. Under pressure from the World Bank, restrictions on imports were lifted, initially at a slower pace, but later accelerated by reforms implemented by the neoliberal Collor administration in 1990. Thus, persistent macroeconomic instability (deep-seated recession and very high inflation) together with increasing trade liberalization became the context within which the Brazilian economy had to operate in the beginning of the 90‟s.

6.The Resumption of Capital Flows and the New Exchange Rate Regime

    The situation of Brazil and of all other Latin American economies was bound to change drastically when in the beginning of the nineties, capital suddenly started flowing again towards the continent. These new flows were of a markedly different nature from that of the seventies. Instead of bank loans they consisted mostly of short-term speculative flows and securities often coming from pension funds and other institutional investors trying to diversify their portfolios and escape from the relatively low interest rates prevailing in international markets.

    Provided that local nominal interest rates (corrected by expected exchange-rate devaluation) were reasonably attractive and that local regulations were such that capital was free to move in and out at very short notice, there was suddenly, after so many years of severe credit rationing to Latin America, no difficulty in attracting what from a local point of view were large amounts of capital.

    Indeed, the Brazilian case clearly shows the exogenous nature of the surge. Official international reserves more than doubled between 1991 and 1992, in spite of triple-digit


    domestic inflation, long-standing recession and an increasingly disorganized public sector. The capital flows were of such magnitude that in spite of the subsequent import boom reserves were to increase more than sixfold from 91 to 95.

    For a number of reasons mostly related to the domestic political situation and the election calendar only in 1994 the government was able to take full advantage of this new external situation in order to launch a new (and this time successful), radical stabilization attempt, the Real Plan.

    That plan, like the 1986 Cruzado was also based on stabilizing the nominal exchange rate and on synchronizing and deindexing wages, prices and financial contracts. The main differences were a certain lack of concern for possible real-wage losses during the preparatory phase of

    11 and the maintenance of very high interest rates to ensure the continuation synchronization

    of foreign-capital flows. The interest rate was set so high when monetary reform was introduced that it quickly led to a nominal appreciation of the new currency, which was initially supposed to be pegged on a one-to-one basis to the U.S. dollar and eventually went as high as 85 cents of Real to the dollar, for a short while. The Brazilian Central Bank since then has followed a policy of slowly and gradually making small devaluations. But the large current-account deficits since then showed that those exchange-rate “corrections” have not

    managed to prevent even an increasing currency overvaluation, let alone making up for the initial real appreciation.

    The plan was very successful in bringing inflation down. The stabilization as in other similar programs had a marked expansionary effect in the short run, mainly due to the sudden recovery of consumer credit. In consequence, the economy started growing faster. That was not to last very long since the upsurge in the demand for imports forced the government to slow down the economy (through credit controls and record-high real interest rates) and growth slowed down again from mid-95, to a figure averaging around 2-3 % since then. The combination of a very appreciated currency in a new environment of liberalized imports (which were further liberalized in the first months after the monetary reform), on one hand,

     11 Synchronization was achieved through a special indexed transitory unit of account, the URV- Unit of Real Value by which wages were compulsorily converted at their average real value over a period, while other prices were freely and voluntarily converted at any desired rate.


    with burgeoning credit, on the other, naturally led to an explosion of imports. Very quickly monthly figures for imports more than doubled. As exports did not and could not follow suit, Brazil ran a deficit in 1995, after more than a decade of trade surpluses. In fear of a Mexico-style balance-of-payments crisis, the authorities decided to put the brakes on the economy, basically through monetary policy.

    That consisted mainly of very tight credit controls and record-high real interest rates. High nominal interest rates with a relatively stable exchange rate attracted a massive inflow of foreign hot money, that much more than compensated for the growing trade deficit. That large inflow of foreign capital and the ensuing accumulation of reserves put great pressure on public finances (internal debt) as the government, in order to keep the high interest-rate differential, was forced to sterilize the liquidity generated by the balance-of-payments surplus by issuing public bonds. Sterilization operations together with the high domestic interest rate has led to an explosion of internal public debt and interest payments. This, together with stop-and-go growth performance, which prevents tax revenues from growing sufficiently, resulted in large government deficits and an increasing pressure for the government to cut or at least prevent the growth of public expenditures. The Real Plan represents a complete break with macroeconomic regime of relative real exchange-rate stability that was consistently kept since the early sixties to avoid compromising the export performance of the economy. Now the government‟s policy goal is

    to achieve the greatest possible stability of the nominal exchange rate in order to control inflation and prevent the return of indexation. More important, perhaps, is the fact that such relative nominal stability seems to be also strictly necessary for the strategy of financing growing trade and current-account deficits through short-term capital inflows. Thus, the situation faced by firms in the Brazilian industry in the mid-90‟s is one in which

    competition from imports is very intense (given liberalization plus overvaluation). Moreover, aggregate demand grows relatively slowly, mainly due to the fact that the marginal propensity to import seems to have increased substantially and the explosion of imports following any upturn in economic activity leads the central bank to slow down the economy to prevent trade deficits from growing too fast. Additionally, exports have been growing


    slowly, having lost a number of incentives as Brazil joined and followed the WTO and Mercosur rules, while export profitability was reduced by real exchange-rate appreciation. The continuing fiscal difficulties together with the neoliberal ideological stance of the present administration mean that the government has neither the will nor the means to give incentives

    12 Thus, while the and generate externalities that could improve systemic competitiveness.

    state-led pattern of development was abandoned in the eighties, no alternative industrial development strategy has been devised to replace it, there being no signs that any such comprehensive strategy will emerge in the near future.

    7. On Bananas and Alligators

    There has been a lot of discussion about whether and to what extent the Real is overvalued, with government officials going as far as saying that the real exchange has found a new more appreciated market-equilibrium level, determined , “just like the price of bananas”, by supply and demand. Even without touching the quantitative part of this heated debate there are of

    13course a good number of reasons to believe that the real is indeed overvalued.

    The more obvious, and seldom discussed, reason is that local interest rates have been systematically higher than the external interest rate paid on Brazil‟s dollar-denominated debt

    (equal to international interest rate plus sovereign-country risk spread). This is, of course, the reason for the large growth in internal debt described above, which comes from sterilization operations designed to keep the interest-rate differential sufficiently positive in order to support the governments‟ target exchange rate. If market-equilibrium exchange rates had

    prevailed, domestic rates would be equal to the above-mentioned foreign rate since then, by definition, expected devaluation and exchange-risk premiums would be zero. Another frequent argument is that, if measured in terms of the wholesale-price index, the overvaluation is not getting worse since at least some of those prices have lately (after a couple of years) began converging to international levels. That convergence of course is not to be observed in the cost-of-living index, which contains a large proportion of services,

     12 Note that the sectors that were still considered to be internationally competitive in the early nineties in a comprehensive study of Brazilian industry were precisely those that were targeted either directly or indirectly nd(via infrastructure externalities) in the 2 National Development Plan of 1974. See Coutinho & Ferraz (1994). 13 For the curious idea of the exchange rate being at its free market equilibrium determined by supply and demand “just like the price of bananas”(sic) see Franco(1995).


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