Lula's problem is that the economic machinery for controlling inflation was one-dimensional and primitive: interest rates. These were jacked up to 26.5% (16% in real terms) to squash inflation. Now interest rates are falling, the economy should revive. At least that is the assumption.
What is strategically important is that Lula and his government are extending the economic machinery needed to control inflation. The key bits of new kit are the tax and pension reforms, which, ironically, Lula and Co had blocked when they were not in power. These reforms, both of which are about half way through congress, will put government finances on a firmer footing. This, in turn, should make the economy less vulnerable to outbreaks of inflation. The president's economic strategists never fail to stress the importance of reducing the public sector debt, which is currently about 54% of GDP.
All this economic spade-work is essential. The government reckons that the reforms are all but through congress, though the senate still has to deliver its verdict on them. Luckily for the government, there was no serious questioning of what it was doing in the lower chamber. Nor was there much doubting of the correctness of the government's economic priorities: get the hard work of reforms over, even if it costs a year's stagnation, and then rev up the economy.
Gamble
The issue is whether the gamble of sacrificing one year of growth for faster growth next year and beyond will pay off. The central bank gave the government a nasty shock when the minutes of its most recent monetary policy committee (Copom) was published. The committee agreed that the pace of cuts in interest rates, which have taken rates down from 26.5% in May to 20% at the end of September, may be slower from now on. This news did not please the stockmarket: economists had been pencilling in cuts of at least three percentage points in the final quarter of the year.
These cuts may still happen. The Copom said that it wanted to see how the economy was performing before it cut again. What is clear is that the economy is failing to spark, let alone fizz. The Brazilian press is full of gloomy stories about the state of the economy.
The most obvious sign of the weakness of the economy is the jump in unemployment. Unemployment set a new record in São Paulo, and went back up to hit 13% nationally. What worries people is that the August rate was higher than the July rate.
The government argues that the unemployment rate is not as bad as the statistics make it appear. Officials pointed out that the number of people in work in the metropolitan region of São Paulo was actually 3.9% higher this August than in August 2002. In per skull terms, this means that there are actually 600,000 more people in work than a year ago.
Labour economists argue that the number of people who define themselves as unemployed (ie, without work and looking for it) tends to rise when the economic news becomes more optimistic, as it did in July and August when interest rates began to be cut. This is because people who have withdrawn from the labour market reckon that they now have a better chance of finding a job so say they are looking, when before they may have defined themselves as students, pensioners or housewives. The official statistical agency, Ibge, reckons that there are around 3m such people who float in and out of the labour market according to economic conditions.
Bald figures
The bald percentages for unemployment are not encouraging. In São Paulo, the unemployment rate hit a new record of 14.9% in August. This was up on the July rate (14.5%) and the rate last August (13.1%). São Paulo accounts for 40% of the national index, which is composed of six regions. Of the 339,000 people rendered unemployed nationally between August 2002 and August 2003, 226,000 of them live in São Paulo.
Another, less encouraging sign for the government is the poor quality of the jobs being created. Ibge noted a rise in the number of people employed in the informal sector: the number of people employed in the formal sector fell by 1.6%, while the number employed in the informal sector rose by 9.5% over the year to August.
What is worrying about the national figure is that unemployment has reversed its July fall. Then it came down to 12.8%, from 13%. Disappointingly, the rate has now gone back over 13%. What policymakers had hoped is that companies would start to take on people once interest rates started to fall.
Business and the government are still confident that the economy will pick up in the final quarter of the year and do well (3.5% plus growth) in 2004. Indeed, there are even some faint signs of a firming-up of the labour market. Average real pay was R$848 in August (US$292 a month), up 1.5% on July, though 14% down on August last year. Economists say that the main reason for the increase in real pay is the ebbing of inflation.
Retailing businesses and industry say that they have yet to see this rise in living standards lead to a boost in demand. The Brazilian supermarkets' association reports that customers were still economising. The supermarkets said that sales in 17 of 25 categories fell in the first half of the year, compared with the same period of 2002. The big drops in sales (all of 4.9% or more) were of soya oil, cheese, sugar, vinegar, and tomato paste. Overall, the supermarkets said that like for like sales were down by 1.5% in the first seven months of the year, compared with the same period of 2002.
Equally worrying is the eighth consecutive monthly fall in retail sales. These were down by 4.4% in July, year-on-year. The only optimistic gloss the official statistics agency could put on the figures was to point out that the rate of decline was slower than the 6.3% registered in May and the 5.6% of June.
Real interest rates
At current levels, the real interest rate is still well above the 9% that the president of the central bank, Henrique Meirelles, reckons is the equilibrium level for real interest rates. He defines equilibrium as a level which causes neither inflation nor deflation. By international standards, even Meirelles's equilibrium rate is extravagantly high: real rates in the US are 2.75%. Even in Taiwan they are 4.5%, while in Japan the real interest rate is virtually zero.
Geraldo Langoni, one of the most influential ex-central bank presidents and now at the most important economic think-tank in Brazil, the Fundação Getúlio Vargas, reckons that the economy will start to fire up once real interest rates are down to about 10%. He expects that to happen when nominal rates get down to between 16% and 17% in the first quarter of 2004. In 2000, when real interest rates were between 9% and 11%, the economy grew by 4.5% and inflation came in at 8.9%.
The target for inflation next year is 5.5% and the consensus amongst independent economists is that the government has a good chance of hitting that figure. Most of these independent economists seem to be central bank alumni and had been reckoning on Copom cutting rates by one percentage point in each of the next three months. The prospect of lower rates is already pushing money out of the economy. In the first 10 days of September the country saw a net outflow of almost US$1.6bn. This money could have been profit taking: the Brazilian stockmarket has risen by 57% in dollar terms so far this year.
The paradox
The paradox about the Brazilian economy is that although the financial markets were celebrating, there was not much to cheer about in the real economy. The economy would have contracted by 5.3% if the effect of exports were to be stripped out. This is the finding of a study by Rosenborg & Asociados. The official contraction in the second quarter was 1.6%, according to the statistics agency Ibge.
The Rosenborg figure assumed that the trade surplus was unchanged from the second quarter of last year (when it was just US$1.6bn). In fact, it quadrupled in the second quarter of this year, to US$6.6bn. The latest forecasts from independent economists, complied by the Banco Central, found an increase in the estimate for the trade surplus this year, from US$18.5bn for the year to US$19bn. Next year, the surplus is expected to fall as the economy imports more and triples its growth rate to around 3.1%. The consensus forecast for export growth next year is 3.5%. Imports, however, will surge by 12.5%.
The financial markets are quite happy with the government's economic policy. The country's risk premium fell to around 650 basis points over US Treasuries. This was low enough for the government to tap the markets again for US$1.25bn (CK).
Shaking
The government's line that everything was starting to come right in the economy, now that interest rates are falling, has taken several knocks. The most dramatic was administered by the Instituto de Pesquisas Econômicas Aplicadas (Ipea), which is linked to the government's planning ministry. It slashed its growth forecast for this year from 1.6% to 0.5%. This drew a furious response from Guido Mantega, the planning minister, who said that Ipea's methodology was flawed. He claimed that the Ipea implied that the economy was still contracting when in fact the contraction was over.
The government assumed, in the draft budget for 2004, that the economy will grow by 1.8% this year. It has since admitted that growth will actually be half this rate. It is forecasting growth of 3.5% for next year. Mantega said that growth over the next 12 months would be between 2% and 3%.
Ipea is much gloomier than it was in June about domestic consumption. It is now forecasting that domestic consumption will decline by 1.5% this year: in June it reckoned on a 0.2% decline. On the other hand, Ipea is more optimistic about industry: it expects a decline of 1% rather than the 1.8% decline it forecast in June. For next year the Ipea is forecasting a jump of 4.4% in industrial output. It is also forecasting a 3.5% surge in domestic consumption.
Ipea's bucket of cold water was followed by bleak news from the car industry. Despite more incentives to boost sales (notably a cut of 3% in taxes on new cars, which came into effect at the beginning of August), sales fell by 11.3% in August compared with July. What is worrying is that the year-on-year comparison showed production down by 6 %, but domestic sales down by 20%. This undermines the government's argument that all the demand side of the economy has been waiting for is lower interests: once rates fall (and base rates have fallen from 26.5% in May to 22% now), domestic demand will pick up and the economy will start firing on more cylinders.
Ipea itself pointed out that the high interest rate policy is a blunt instrument. It only works when interest rates are jacked up to extravagant levels. This is because domestic credit is equivalent to only 25% of GDP: When interest rates do start to have an effect, the consequences for consumption are dramatic: in the first half of this year domestic consumption in Brazil fell by 4.7%. Ipea pointed out that the high interest rate policy had been effective in bringing inflation to heel: inflation forecasts, which stood at 12% for the next 12 months in January 2003, are now down to half that.
In practice
What bothers economists is that the August car figures were much worse than those for the year as a whole. Over the first eight months of the year, production fell by 1.5%, while sales were down by 10%. Carmakers, on the other hand, are pretty confident that things will start to pick up in September. They may be talking their book as the industry has 147,000 unsold new cars stuck in showrooms and on factory forecourts. The industry association, Anfavea, points out that vehicle exports in August were the best since May 1998 and were worth US$520m. Vehicle exports so far this year have brought in US$3.32bn.
The Brazilian car industry is fretting about the challenge from Argentina. This is despite the fact that in August Argentina produced just over 15,300 vehicles while Brazil produced over 132,800. The Brazilians are complaining about the new incentives the Argentine government is offering: the main one is allowing Argentines to use bonds to pay for new Argentine-built cars. Brazilian carmakers say that as Argentina has been buying 13% of Brazil's vehicle exports, the incentive discriminates against them and is unacceptable and probably illegal under Mercosul rules.
Fiscal reform
Overall, the Brazilian government's line is that next year will be much better: the world economy is reviving; domestic interest rates are falling and the government will have done the heavy economic lifting needed to sort out the country's perennial pension and fiscal problems. The pension reform is now before the senate while the tax reform, which simplifies the tax system, has started on its progress through congress.
The tax reform looks likely to face some heavy amendments: both business and some of the state governors are unhappy with the detail. Business claims that the changes will increase the tax burden and boost the informal economy. Businesses are suggesting, for example, that the financial transactions tax on them should be half the rate levied on individuals. The tax reform is scheduled to emerge, finally, from the senate on 11 November. The pension reform should be through before then.
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