The Achilles’ Heel of the Brazilian Economy

The Achilles’ Heel of the Brazilian Economy: High Interest Rates in Brazil and the Need for Central Bank Reform Could Dampen President Lula’s Reputation

by COHA Research Associate Felix Blossier

With a massive labor force and abundant natural resources, Brazil normally has offered a promising environment for foreign investment. But all too often these expectations have proved hollow. Despite its numerous advantages, Brazil has suffered from chronically poor law enforcement, weak corporate governance and extremely high and unpredictable levels of inflation mainly caused by the legacy of an inefficient and corruption-prone government. The case of Henry Ford provides some insight. In the 1920s, Ford established an industrial town in the Amazon –Fordlândia– to cultivate rubber plants for the production of tires. Today, the town is abandoned; the project abjectly failed and ended up as a complete business disaster. This was mainly due to inappropriate management and the lack of support from a government that was wary of foreign investments. As The Economist notes, even the dubious wizardry of Goldman Sachs, the inventor of the expression “BRIC” (acronym for Brazil, Russia, India, China referring to developing countries with fast-growing economies and investment opportunities), faced real difficulties establishing a stable presence in the country. It was not until the economic reforms undertaken by the then Minister of Finance Fernando Enrique Cardoso in 1994 that Brazil was partially cured from the plagues assaulting its economy. Since then, Brazil has often been praised as a model of successful financial development, which is reflected by the high position it holds in the rankings published by the World Economic Forum (a nonprofit organization that surveys business environments throughout the world).

Yet at the same time, the Brazilian financial system is at a tipping point. From the Great Depression to the 1994 Mexican devaluation or even the 1998 Russian crisis, Brazil has often been more sensitive to financial crunches than other countries. But after two quarters of negative growth in 2009, Brazil has recovered remarkably well from the 2007-2010 global economic and financial crisis. While Brazil is now close to proving that it can compete with India and China as a model of a large and successful financial development, its growth is still significantly slowed down by its high interest rates. Here we will be examining the origins and the consequences of such high rates in order to see what policy recommendations might emerge for Brasilia to encourage further financial success for its economy.

The negative and selective effects of high interest rates

The Real plan, launched in 1994, consisted of the introduction of a new currency (the Real), an indexation of prices and wages and the legal control over the governmental budget by the Brazilian Congress. It was logically finished off by an extremely high SELIC (Sistema Especial de Liquidação e Custodia) rate, the Central Bank’s overnight lending rate (the one used by the Bank to influence monetary policy). Indeed, higher interest rates make it more expensive for people to borrow money, therefore, domestic demand decreases and the increase in prices slows. Overall, the plan was successful in targeting inflation, even though the fiscal reform was not as efficacious as expected and despite the fact that Brazil was still facing an uncomfortable debt. The price of this success was the prevailing high SELIC rate (currently at 8.75%, an all time low) that discouraged borrowing. Such a high overnight lending rate continues to be at the root of countless constraints and sizeable additional costs for individuals and firms, especially those seeking to finance long-term projects.

Not only do those high rates have terrible consequences for the Brazilian economy, but they also discriminate against the poorest economic agents while the largest Brazilian firms seem to be spared this credit constraint. They have access to foreign financing, like the 33 firms that are currently cross-listed at the New York Stock Exchange. They also benefit from below market interest rates from international lending institutions, such as the World Bank’s International Finance Corporation (IFC), while also having the opportunity to diversify their debt structure across various lenders, mechanisms and currency denominations.

Conversely, at the bottom of the economic ladder, small and medium enterprises cannot evade this scarcity of capital, and typically have nowhere else to turn for loans. According to the World Bank’s World Business Survey, 90% of Brazilian small firms named high interest rates as one of their major problems. In addition to restricting the development of the smallest firms in Brazil, such high interest rates also deter them from becoming formal. Indeed, the only motivation for firms to “go formal”, i.e. to pay important taxes and to go through an encumbering red-tape, is to be able to borrow money from banks. But since such loans at predictably high rates of interest are rarely affordable, small entrepreneurs choose to stay informal and prefer to borrow money from acquaintances and family members.

In this way, the development of Brazil from the ground up and the reduction of inequalities are hindered by the backbreaking interest rates and interest spreads (the difference between the borrowing and the lending rate) that prevent the poorest Brazilians from borrowing money. Moreover, this tendency is furthered by the country’s semi-autarky and its inward-oriented economy that restricts access to offshore financing.

“A long history of misbehavior?”

The traditional explanation for high interest rates in Brazil is the country’s history of hyperinflation (the cumulated inflation rate for the 1964-1994 period is calculated at 1,000,000,000,000,000%). The elevated SELIC rate appears as “the consequence of a long history of misbehavior,” as former governor of the Brazilian Central Bank (BCB) Arminio Fraga portrayed it. Thus, the high level of the interest rate perhaps is a necessary evil, and the only way to forestall the return of an uncontrollable inflation. As former chairman of the Federal Reserve Alan Greenspan has noted; “Implicit in any monetary policy action or inaction is an expectation of how the future will unfold, that is, a forecast.” In other words, high interest rates are only chosen as a way to offset Brazilians’ expectations of high inflation.

As the writings of William Phillips and the corrections ventilated by Milton Friedman suggest, in the short term, every government faces a tradeoff between combating inflation and unemployment. For example, the Brazilian military dictatorship opted for a proemployment policy by raising inflation in the 1970s and the 1980s. Moreover, the fiscal burden at the time resulted in an increase of the country’s account deficit (from US$1.7 billion in 1970 to US$12.8 billion ten years later), a deficit that was financed by a huge foreign debt (reaching US$54 billion in 1980). The current government is still dealing with the effects of these past policy decisions, battling the expectations for high inflation among its citizens. The fear of hyperinflation is still present: the forecasts remain high, and an elevated interest rate therefore appears to be the sole way to secure low inflation.

This explanation is fundamental and necessary but not sufficient. In his paper called “Brazil’s Elevated Interest Rates: a Case of Irrational Pessimism or Guarded Optimism?” Ed Johnson compares Brazil’s interest rates with other countries’ that suffered from hyperinflation in their contemporary history. The results of this comparative study are edifying; the SELIC rate is higher than the overnight lending interest rates in Chile, Israel and Argentina, while those countries that recently recovered from hyperinflation have a similar, if not higher, debt. Among the numerous countries that have suffered from hyperinflation, Brazil is one of the few still holding one of the highest real interest rates in the world. But, such high rates cannot only be explained by Brazil’s economic history and one needs to survey its public debt and its institutions to adequately understand their causes.

The public debt issue and jurisdictional uncertainty

One complementary explanation for the high level of interest rates is the fact that fiscal adjustments have not yet been completed in Brazil. Governmental debt is high and the public sector requires important funding. Therefore, the latter must compete with domestic firms for access to the available savings. Meanwhile, the demand for capital at favorable interest rates increases. Since the government debt is less risky than any other, it takes the savings out of the system and the credit constraint for firms is advanced. Moreover, the Brazilian debt is mainly denominated in U.S. dollars, an “original sin,” according to economists. Indeed, a debt constituted in dollars is likely to trigger aversion from the local currency and a corresponding drop in the liquidity of the existing debt. Therefore, the Central Bank has to launch an even more orthodox policy to offset its small leverage (since the domestic currency is challenged by the dollar).

The Brazilian economy is also considered to be at a “bad equilibrium.” There is a negative correlation between interest rates in a country and the risk premium asked by creditors; the higher interest rates are, the lower the risk premium will be since high interest rates reduce the risk of inflation. But over a certain point, the correlation reverses. When interest rates become too high, lenders will fear a default from its borrowers and therefore ask for higher premiums. This is one of the explanations for current credit constraints in Brazil.

Finally, Brazil also suffers from a history of poor enforcement of credit contracts. As the political scientists Lamounier and Souza (2002) noted, there are no longterm financial savings available under Brazilian jurisdiction because of the difficulty for creditors to repossess their collateral in case of a default. This is not only due to the poor enforcement capacities of the Brazilian legal system, but to what Lamounier and Souza call the “anti creditor bias” among the Brazilian judges and legislation.

The lack of institutional credibility

Thanks to the efforts of the Brazilian Central Bank, which has successfully limited inflation for more than 15 years, the SELIC rate reached an all time low despite the aforementioned elements pushing for higher rates. However, the Central Bank still lacks institutional credibility since it is closely related to the government.

The BCB, was created during the presidency of military leader Humberto de Alencar Castelo Branco in December 1964, to replace the SUMOC (Superintendência da Moeda e do Crédito). Although it is technically an autonomous federal institution, it is far from being independent. It works in common with the Ministry of Finance (Ministério da Fazenda) and the President of the Republic appoints its governor (under the condition of the Senate’s approval). Several controversies have taken place as a result of the relationship between the government and the BCB and the personal acquaintances among the President and the governor of the Central Bank. For instance, in 2004, the Brazilian Senate approved a measure backed by President Lula that afforded the governor immunity after the publication of reports alleging Henrique Meirelles, the governor of the bank failed to declare income earned overseas to the Brazilian tax authorities. The possibility that Meirelles may run for the 2010 general elections also demonstrates the inbreeding between the Central Bank and politics.

To sum up this situation, one could quote Ed Johnson who persuasively argues that the Brazilian economic history left “a permanent scar on economic agents’ ability to foresee the future.” This scar is not likely to disappear with the current lack of independence on the part of the Central Bank. Brazilians will keep on anticipating high levels of inflation as long as the government maintains control of the Central Bank and its monetary policy.

Perspectives for change and policy recommendations

Institutional reform is far from being an easily achievable solution. It will be a long process that requires good communication from the government and is bound to raise the levels of dissatisfaction of those benefiting from the current (though unfair or inefficient) situation. However, the excessively high interest rates in Brazil need to be addressed; due to the BCB’s lack of institutional credibility, reforming the Central Bank appears to be the only solution as of now. The aim of such a reform should be to give complete autonomy to the Central Bank. As Princeton University scholar Alan Blinder notes:

“Monetary policy requires long time horizons because the lags through which interest rate exchanges affect output and inflation are typically long. If monetary policy decisions were left to politicians, on a day-by-day basis, the temptations to reach for short-term gains at the expense of the future (that is, to inflate too much) would be hard to resist, especially in the run-up to an election. Knowing this, many governments wisely try to depoliticize monetary policy by, e.g. putting in the hands of unelected technocrats with long terms of office and insulation from the hurly-hurly of politics.”

Brazil has taken a significant step in that direction with the creation of the Central Bank Monetary Policy Committee (COPOM). Established in 1996, this committee is aimed at facilitating the bank’s communication with the public. Since June 1999, the BCB has adopted an inflation target and has taken full responsibility to achieve it. After the success of several Central Bank reforms in different parts of the world (The European Central Bank, Bank of England etc.), it seems logical and necessary for Brazil to continue in this direction. The timorous attempts to tackle hyperinflation in Brazil in the late 80s all thunderously failed, as will modest reforms aimed at tackling interest rates in Brazil – hence the need for a major reform.

Harvard professor Kenneth Rogoff once ironically said, “perhaps Latin America would have done better in terms of economic stability, had the printing press never crossed the Atlantic.” It is true that hyperinflation has been a major problem in most Latin American countries and Brazil is no exception with its past of hyperinflation and other factors calling for high interest rates (even if they have considerably decreased over the past decade).

If Brazil wants to seriously address this issue, it needs to undertake a reform that will guarantee the independence of the Central Bank. In other words, it must bind itself in the present to avoid possible failures in the future, as Odysseus did when he tied himself to the mast of his vessel in order not to be later tempted by the chants of the sirens. With higher than usual inflation expected for 2011, and a SELIC rate that is about to rise for the first time in years after the next BCB meeting on April 28th along with the upcoming general elections scheduled for October 3rd, the situation is likely to change for the better before the end of the year, with one expressing enthusiasm for these potential changes.

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This analysis was prepared by COHA Research Associate Felix Blossier
Posted 21 Apr 2010
Word Count: 2400

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