The Legacy of the Real Plan and an Alternative Agenda for the Brazilian Economy*

The legacy of the Real Plan and an alternative Agenda for the Brazilian economy*

Fernando Ferrari-Filho** Luiz-Fernando de Paula***

The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes John Maynard Keynes

Abstract The Real Plan is considered the most successful plan of economic stabilization that the Brazilian economy has experienced recently in relation to the prime objective of reducing and controlling the country’s inflation rate. Although price stabilization represents the incontestable success of the Real Plan, it fails when we look at the poor performance of Brazilian economic activity throughout the period of real. This paper has two objectives. First, it aims at analyzing the reasons of successful – that is to say, the reduction and control of the inflation rate – and unsuccessful – low economic growth, high unemployment and macroeconomic instability (fiscal budget and balance of payments deficits) – of the Real Plan. In this context, the paper shows that the Brazilian stabilization policy, during the period of real, resulted in increasing the fiscal imbalances and balance of payments deficits. These disequilibria, as a consequence, impose some constraints concerning the recovery of Brazilian economic growth in the medium and long runs. Second, it presents an Economic Agenda able to control inflation and promote economic growth in Brazil in a sustainable path.

Key words: Real Plan, Brazilian economy, stabilization plan.

JEL Classification: E12, E63, E64.

* This paper was presented at the Jornada da Sociedade de Economia Política, December 11-12, 2002, ANPEC Annual Meeting, Nova Friburgo, Brazil. The paper was written originally in May 2002. We are very grateful to Philip Arestis and two anonymous referees for many helpful comments on an early version of the paper. All remaining erros are, of course, our responsibility. ** Full Professor of Economics at the Federal University of Rio Grande do Sul and Research Fellow in Economics at CNPq, Brazil. E-mail: [email protected] *** Associate Professor of Economics at the University of the State of Rio de Janeiro and Research Fellow in Economics at CNPq, Brazil. E-mail: [email protected] 1 Introduction

After many frustrated attempts at stabilization policies in Brazil during the 1980s and 1990s1, the Real Plan is considered the most successful plan of economic stabilization that the Brazilian economy has experienced recently in relation to the prime objective of reducing and controlling the country’s inflation rate. The inflation figures witness the success of the Real Plan: in June 1994, one month before the introduction of real as the legal tender, the annual inflation rate was around 5,150.00%, while in December 2001 the annual inflation rate was, approximately, 10.0%. Although price stabilization represents the incontestable success of the Real Plan, it fails when we look at the performance of Brazilian economic activity throughout the period of real: from 1994 to 2001, the average growth rate of GDP was only 2.8% per year, very similar to the average growth rate of GDP of the Brazilian economy in the 1980s – by the way, this period was considered as a ‘decade lost’ by Brazilian economists; the growth rate then was 2.9% per year2. This paper has two objectives. First, it aims at analyzing the legacy of the Real Plan: on the one hand, the inflation in Brazil was eliminated; on the other hand, the Brazilian economy became highly vulnerable due to its dependence upon foreign finance and the financial fragility of the domestic debt. In this context, the paper shows that the Brazilian stabilization policy, during the period of real, resulted in increasing the fiscal imbalances and balance of payments deficits. These disequilibria, as a consequence, impose some constraints concerning the recovery of Brazilian economic growth in the medium and long runs. Second, it presents, in the light of the Post Keynesian theory, an Economic Agenda, able to control inflation and promote economic growth in Brazil in a sustainable path. Going in this direction, besides this introduction, the paper contains four sections. It begins in section 2 by bringing back the logic and theoretical framework of the Real Plan. Section 3 shows the management, by monetary authorities, of economic policy during the period of real and its impact on real variables, before and after the Brazilian currency crisis, in January 1999. Further, it presents an interpretation of 1997-1999 Brazilian currency crises. Section 4 analyses if there are important changes in the macroeconomic constraints of the

1 Cruzado Plan in 1986, Bresser Plan in 1987, Verão Plan in 1989, and Collor Plan in 1990 are some examples of these frustrations. 2 These average growth rates of GDP were calculated according to Table 1.

2 Brazilian economy after the exchange rate devaluation in January 1999. The last section presents some policy recommendations able to restore the macroeconomic balances, indispensable to maintain the inflation under control and, at the same, achieve economic growth and social development in Brazil permanently.

2. The logic and theoretical framework of the Real Plan

2.1 Stabilization plan with exchange rate anchor and liberalization of the trade and capital accounts of the balance of payments: some stylized facts3

Experience with stabilization programs based on some kind of exchange anchor and the liberalization of the trade and capital accounts of the balance of payments shows that, generally speaking, such plans at first generate an abrupt drop in the rate of inflation, accompanied by marked appreciation in the exchange rate4. The local currency appreciates as a result of differential evolution by domestic and foreign prices in a context where the nominal rate of exchange remains stable, causing the balance of payments current account to contract substantially, due principally to the increase in the value of imports. Normally, the resulting deficit is accompanied by a large capital account surplus, thus not only enabling the former to be financed, but allowing the volume of the country’s international reserves to grow. The latter increase occurs as a result of the surge of foreign capital entering the country drawn by the stabilization plan’s initial success, combined generally with liberal structural reforms. Higher domestic interest rates, an added attraction to external financing, are normally used to reinforce these factors still further. Indeed, the defense of the exchange rate requires that monetary policy be devoted mainly to maintaining the exchange rate. The introduction of tight monetary policies and greater freedom for foreign investors create an interest rate differential sufficiently large to attract arbitrage capital inflows. The increasing influx of foreign capital, however, can lead to a still greater real appreciation of the exchange rate, leading to a further increase in imports and also a downturn in exports. On

3 This Section is partly based on Paula and Alves, Jr (2000, Section 1). 4 Dependence on foreign capital flows causes, among other problems, the real exchange rate to appreciate, non-tradables to expand at the cost of tradables, and trade deficits to increase, which can leave the country’s economy increasingly vulnerable to external factors. In this connection, see Gavin et al (1995) and Corbo and Hernandez (1996).

3 the other hand, the need to maintain high interest rates in order to attract foreign capital, and efforts to sterilize the inflow of foreign capital (also requiring high interest rates) lead to increasing public internal debt and also a deteriorating fiscal balance. In fact, sterilization of inflows is a potentially expensive strategy for the government due to the fact that the interest rate of the domestic bonds that the central bank sells is higher than the interest rate of the foreign bonds that the central bank buys. So, sterilization can create significant fiscal costs in financing high levels of reserve holdings depending on the scale of the operation and the size of the interest differential vis-à-vis external rates in reserve centers. (Cardoso and Goldfajn, 1998:165) In this context, a larger and growing current account deficit will only be sustainable if equivalent levels of long-term external funding are available, associated with productive investment capable of generating a future flow of exchange revenues sufficient to pay off outstanding debt. The precise nature of capital inflow is fundamentally very important, since one of the great perils of stabilization plans with exchange rate anchors is that a reversal in the flow of foreign capital can lead to a balance of payments disequilibrium of such a magnitude that it becomes unfeasible for the government to maintain the existing exchange rate5. Expectations for exchange rate devaluation are generated among international investors, leading in turn to further shrinkage in inflows of foreign capital and, consequently, a fall in levels of reserves, leaving the government no option but a substantial devaluation in the nominal exchange rate. This in turn may have a prejudicial effect on domestic prices and on the behavior of non-resident investors, thus jeopardizing partly the stabilization effort. Therefore, balance of payments disequilibrium results from the fact that, in a world of globally mobile financial and productive capital investments, domestic stabilization policies can be inherently destabilizing. This is because, under these conditions, the initially successful application of an internal stabilization policy may generate an endogenous process of deteriorating economic conditions (a growing public deficit, a growing deficit in its balance of payments current account and dependence on foreign capital, among others),

5 If expectations for exchange rate devaluation are generated among international investors, leading in turn to further shrinkage in inflows of foreign capital and, consequently, a fall in levels of reserves – that is to say, when speculative attack arises – the government strategy is just a substantial devaluation in the nominal exchange rate.

4 which may leave a country vulnerable to speculative attacks on its currency and thus subject to currency crises (Kregel, 1999).

2.2. The Real Plan: conception and phases

The Real Plan, developed by a group of academics from Pontifical Catholic University of Rio de Janeiro (PUC), such as André Lara Rezende, Francisco Lopes and Pérsio Arida, that designed the heterodox shocks in the 1980s6 and implemented by the former Minister of Finance of the Itamar Franco government and later President of Brazil, Fernando Henrique Cardoso, diagnosed that the Brazilian inflation rate was related to the public deficit and the general indexation of the nominal contracts of the economy. Considering this diagnosis, the Real Plan aimed to create a new framework for economic management to change (i) the contents of fiscal policy and (ii) the monetary regime. Thus, economic stabilization was developed in three steps: first, the Government adjusted the short-term fiscal deficit; secondly, the monetary authorities introduced a price index to stabilize the relative prices of the economy; and finally, the monetary reform was implemented – real as the legal tender. The disequilibria of fiscal budget was a consequence – according to the formulators of the Real Plan – of what was named reverse Olivera-Tanzi effect (Bacha, 1994)7. The basic argument is that there was a ‘hidden’ public deficit in Brazil as the taxes were protected against the inflation since they were indexed while the government expenditures were established in nominal terms. As a result, inflation caused a reduction in the government expenditures in real terms. Therefore, the ‘hidden’ public deficit would appear as soon as the inflation fell. For this reason, it was necessary to do an ex ante fiscal adjustment in order to control the inflation rate.

6 According to this group, the Brazilian inflation rate was, basically, related to the to the general indexation of nominal contracts of the economy. This idea, known as inertial inflation, argued that if there is not a price shock in the economy – such as, demand push or supply cost – the current inflation is determined only by past inflation. In this context, the strategy to eliminate the inflation rate involved freezing of prices and wages, the de-indexation of the economy and/or the monetary reform. It was in fact consistent with the Plano Cruzado, Plano Bresser, and latter the Real Plan. See, in this connection, among others, Resende (1985) and Lopes (1985). 7 This effect was called latter as Bacha effect.

5 On the other hand, monetary reform would avoid some eroded solutions against high inflation, such as price freezing or confiscation of financial assets. In this connection, the main features of the monetary reform introduced by the Real Plan were “a stabilization plan announced in advance, without price freezing and no confiscation of financial assets, or recession, and followed by a flexible exchange rate and monetary policy” (Bacha, 1997: 11). The short-term fiscal adjustment, created, at the end of 1993, by federal government, and later approved by the National Congress, was called Fundo Social de Emergência. This Fund imposed fiscal measures to reduce public expenditures of all levels of government and, at the same time, created a tax over financial transactions to increase the fiscal revenue. Moreover, it allowed that federal government could use freely 20.0% of the predetermined items of the fiscal budget during the fiscal years of 1994 and 1995. As a result, in June 1994, one month before the monetary reform, the primary fiscal surplus was equivalent to 2.6% of GDP, as well as the nominal public deficit – the overall result of operational and primary fiscal of Union, States and Municipalities and the public enterprises’ surplus – was reduced to 1.0% of GDP. The second step of the Real Plan was characterized by the introduction, in March 1994, of Unidade Real de Valor (URV) as standard of monetary value, while the cruzeiro real continued to be used as a legal tender. The URV, an average index of some representative inflation indexes of Brazil – IPC/FIPE, IPCA/IBGE and IGP-M/FGV – that was considered a unit of account linked to the U.S. dollar, aimed to push the economic system to find a sustainable price set and to recuperate the notion of a stable unit of account in the economy, essential to remove the indexation process of all nominal contracts of the economy. The idea was to introduce a diary index linked to the U. S. dollar, so that it could be simulated more or less the same conditions of dollarization in the Brazilian economy, such as in hyperinflation context, although the Brazilian economy was not dollarized in fact. Under this transitory monetary system, wages, residential rents, school fees and public fees were converted compulsorily to URV, while other prices would freely be converted to URV. It is important to emphasize that the success of this step of the Real Plan occurred because, contrary to other Brazilian plans of economic stabilization, the URV was introduced in a context in which the market mechanisms were totally respected. However,

6 the success of this phase was only partial, as URV did not play its role properly, as most of the prices of goods among different sectors were unbalanced when the new legal tender was introduced, that is in beginning of July 19948. On the other hand, as wages were converted by their average value and after that they were indexed to URV, the workers claims for income losses that followed others stabilization programs in Brazil were successfully neutralized (Sicsú, 1996). The last step of the Real Plan made, in July 1994, the URV as the legal tender. In other words, a monetary reform was introduced: the real replaced the cruzeiro real as the medium of exchange, unit of account, standard of deferred payment and store of value. The new legal tender was thus created in July 1st, 1994 and its initial value was equivalent to the last value of the URV (CZR$ 2,750.00). Moreover, the Government established two nominal anchors: monetary and exchange rate. Focusing on the monetary anchor, the monetary authorities established some targets to expand the money supply, more specifically to control the high-powered money. The exchange rate anchor was characterized by the following scheme: the Central Bank of Brazil would control the maximum price of the exchange rate – one real could not be superior to one U.S. dollar – while the exchange rate market would establish the buying price of the exchange rate9. Therefore, the exchange rate anchor would be used to reduce and control the inflation rate, while the strategy of monetary anchor would be used to reduce the ‘impetus’ of the aggregate demand. To sum up, the Real Plan was conceived on the same basis as stabilization programs with a nominal anchor that have been applied in Latin America since the late 1980s, using a fixed or semi-fixed exchange rate in combination with more open trade policy as a price anchor. It is important to say that many of the criticisms leveled at the stabilization program implemented in Brazil in 1994 related to the consequences of the pattern of financing for current account deficits and financial commitments assumed in the recent past. In particular, the argument goes, holding interest rates at high levels since the Real Plan came

8 For this reason, the success of the second step of the Real Plan – that has been considered the main reason of the success of the plan – tends to be overestimated by the analysts, according to our view. 9 According to Bacha (1997:181), in the terms of the “asymmetrical exchange band”, the Central Bank undertook to intervene in the exchange rate to avoid the devaluation of the real against the dollar beyond its 1:1 parity, but would leave the market free to appreciate the real against the dollar.

7 into operation attracted short-term foreign capital in volumes many times greater than the needs indicated by the balance of payments, thus raising the level of reserves and fostering real appreciation of the exchange rate, which has had two effects. Firstly, as trade arrangements were being liberalized, the exchange appreciation resulted in significant balance of trade deficits, a consequence of increasing imports. Secondly, this capital inflow entails foreign exchange commitments concentrated largely in the short term, which was alleged to spark off an incessant pursuit of funds to refinance them. The effects of this liberal economic policy arrangement were claimed to have aggravated Brazil’s external financial fragility, due to its increasing dependence on obtaining foreign financing to sustain current account deficits10.

3 The announcement of a devaluation process?

3.1 The evolution of the Real Plan: some macroeconomic imbalances

As is well-known, the Real Plan was successful in bringing quickly inflation down due to the combination of desindexation, exchange rate appreciation, and a huge reduction in the imports taxes11. As a result, in the short run demand was expanded12. Table 1 shows the performance of the inflation rate and GDP growth rates ex ant and ex post the Real Plan. On the one hand, from July 1994 to December 2001 the inflation rate was 175.34%; it represents an average inflation rate, during this period, of 1.13% per month. Six months before the Real Plan, the average inflation rate was 43.2% per month. On the other hand, in the beginning of the Real Plan, more specifically in 1994 and 1995, the average growth rate of GDP was roughly 5.0% per year, while, between 1990 and 1993, the average growth rate of GDP was only 1.3% per year.

10 See more, in this connection, in the next Section. 11 In August 1994, Brazilian government reduced tariffs on imports to a maximum of 20.0% to more than 4,000 products. 12 The demand was expanded for three reasons: first, in a context of a rapid decline in inflation, money supply increased sharply; second, the decline in inflation reduces abruptly the nominal interest rate; third, low- income wages had an immediate real increase as inflationary tax was reduced a great deal after the introduction of the new legal tender, the real.

8 TABLE 1 Some Macroeconomic Indicators Period IGP- GDP Growth Exports (X) Imports (M) X – M DI/FGV1 Rate 1990 1,476.7 (4.3) 31.4 20.7 10.7 1991 480.2 1.0 31.6 21.0 10.6 1992 1,157.8 (0.5) 35.8 20.5 15.3 1993 2,708.2 4.9 38.6 25.2 13.4 1994 1,093.92 5.8 43.5 33.1 10.43 1995 14.8 4.2 46.5 49,8 (3.3) 1996 9.3 2.7 47.7 53.3 (5.6) 1997 7.5 3.6 53.0 59.8 (6.8) 1998 1.7 (0.1) 51.1 57.7 (6.6) 1999 19.9 0.8 48.0 49.2 (1.2) 2000 9.8 4.2 55.1 55.8 (0.7) 2001 10.4 1.54 58.2 55.6 2.6 Source: Fundação Getúlio Vargas (IGP-DI) and Central Bank of Brazil. Note: (1) Inflation rate; (2) From January to June 1994, the inflation rate was 763.2%, while in the second half of 1994 the inflation rate was 38.1%; (3) Between January and June 1994, the surplus was, approximately, US$ 6.9 billion, while in the second half of 1994 the trade balance surplus was US$ 3.5 billion; and (4) Preliminary estimate.

The combination of bringing inflation down and provoking demand expansion, at least in the short run, forced the Government to slow down the economy, by controlling domestic credit and increasing the real interest rate. It is important to say that the Brazilian government was afraid that a ‘consumer bubble’, that had happened in the former stabilization plan – the Cruzado Plan, could happen again. The consequence of the high real interest rate and capital account liberalization was short-term capital inflows. Thus, the exchange rate became quickly overvalued. Figure 1 shows the evolution of real exchange rate during the period of real.

9 FIGURE 1 Real Exchange Rate, Post Real (1994-T2 =100.0)

140

120 Index 100

1 3 1 1 3 3 1 1 3 T T3 T T1 T T3 T T T3 T 4 4 5 6 7 7 8 0 0 1 9 9 9 9 9 9 9 0 0 0 9 9 9 9 9 9 9 0 0 0 1 1 1995 T11 1 1996 T31 1 1998 T 1 1999 T11999 T 2 2 2001 T 2

Source: NAPE/CPGE/UFRGS. Note: T2 means second quarter.

The expansion of demand and the overvalued exchange rate brought, immediately, some difficulties to the Brazilian external sector: the trade balance declined and the current account deficit of the balance of payments increased in nominal terms13. The figures of the trade balance show that, between January and June 1994, the surplus was, approximately, US$ 6.9 billion, while in the second half of 1994 the trade balance surplus declined to US$ 3.5 billion – a drop of almost 51.0%. Table 1 also presents the evolution of the trade balance, before and after the period of real. According to this Table, the trade balance deterioration, during the period post real, is incontestable: between 1990 and 1994 the trade balance accumulated a surplus around US$ 64.0 billion, while during the period 1995-2001 there was a deficit in the trade balance around US$ 21.6 billion. Despite the fact that the trade balance was drastically reversed, the monetary authorities were optimistic on the sustainability of the Brazilian balance of payments14. Indeed, before the 1998-1999 currency crisis, the Brazilian government took the view that the growth in imports that could be observed was a consequence of the restructuring of industrial production activities that had been ongoing in Brazil in recent years – as a result

13 It is important to emphasize that the critical situation of the current account deficit was during the Russian crisis, in 1998: at that time, it was almost 4.5% of GDP. 14 In the view of the Government, the imbalance of the balance of payments would be problematic only if the relation between current account and GDP was above 3.0% (Franco, 1998).

10 of the interaction of the processes of globalization, stabilization and privatization (Barros and Goldenstein, 1997) – and that the resulting productivity gains would contribute to generating trade surpluses sufficient, in due course, to restore stability to the balance of payments. In addition, it was argued that short-term debt was being supplanted by long- term debt and foreign direct investment, basically, because the privatization program was attracting substantial inflows of capital, bringing the restructuring strategy into line with financial timeframes. Besides, the high level of foreign reserves was considered a ‘shelter’ that the government could use to defend the domestic currency against any speculative attack. At that time, some critics of the exchange rate regime, such as the former Minister of Finance, Antonio Delfim Netto, the former President of the Central Bank of Brazil, Affonso Celso Pastore, and the leftist economist, former Federal Deputy, Maria da Conceição Tavares15, among others, used to argue that the appreciation of the exchange rate would create an unsolved problem to the Real Plan, because the current account deficits would not be sustainable in the medium and long runs. However, the Brazilian monetary authorities used to reply to their critics arguing that the appreciation of the exchange rate was the ‘natural’ outcome of low inflation and of financial liberalization. In addition, they supported the idea that the current account deficits could be financed by ‘foreign saving’, with increasing predominance of foreign investments16. In Table 2, the figures of the current account, during the period of real, show that the critics of the exchange rate regime seemed to be right concerning this debate. According to this Table, from 1994 to 1995 the current account deficit increased 958.8%. Moreover, this Table shows that the current account deficit continued to increase until 1998. The unsustainable trend in its foreign accounts placed Brazil at risk of a currency crisis, because of the high degree of external financial fragility of the Brazilian economy, which left it susceptible to short-term changes in the international situation17.

15 See, for instance, Delfim Netto (1999), Pastore and Pinotti (1999), and Tavares (1997). 16 In the beginning of the Real Plan the current account deficit was financed by ‘foreign saving’. However, the same did not occur in the years 1997 and 1998: according to Table 2, during these years, the overall current account deficit was around US$ 64.5 billion, while the capital inflows, for the same period, was around US$ 46.6 billion; that is to say, the capital inflows financed only 72.2% of the current account deficit during 1997 and 1998. 17 See more, in this connection, in Section 3.2.

TABLE 2 Balance of Payments (BP), 1994-2001, US$ Billion Period Trade Balance Current Capital Net Overall Account Inflows Investment BP 1994 10.4 (1.7) 14.3 7.3 12.9 1995 (3.3) (18.0) 29.3 4.7 13.5 1996 (5.6) (23.1) 33.9 15.5 9.0 1997 (6.8) (30.9) 25.9 20.7 (7.8) 1998 (6.6) (33.6) 16.3 20.5 (17.3) 1999 (1.2) (24.4) 13.5 30.1 (10.7) 2000 (0.7) (24.7) 22.3 29.6 (2.6) 2001 2.6 (23.1) 26.8 22.6 3.3 Source: Central Bank of Brazil.

The Mexican crisis, 1994-1995, indicated that the consequence of the appreciation of the exchange rate would provoke, sooner or later, a currency crisis in Brazil. Due to the ‘Tequila’ effect, foreign investment declined and, as a result, foreign reserves dropped. At that time, the critics of the Real Plan claimed that the devaluation of the exchange rate was the solution to restore equilibrium in the balance of payments. However, the monetary authorities, worried that the devaluation of the exchange rate could cause an inflationary shock and, as a consequence, bring back the indexation process, did not devalue the exchange rate. But, they decided to introduce a crawling peg system to operate the exchange rate flexibly18 and raise interest rate to nearly 65.0%. Moreover, they moved tariffs upwards for some specific sectors19 and increased the nominal interest rate in an attempt to bring back international capital, especially portfolio capital. Figure 2 shows the evolution of nominal interest rate post real.

18 This system was abandoned in January 1999, when was adopted a flexible exchange rate regime, that was followed by the adoption of an inflation targeting regime. 19 As is well-known, in the beginning of the Real Plan tariffs reductions were used as a weapon against domestic price-makers.

12 FIGURE 2 Annual Nominal Interest Rate*, 1994-2001

75 60 45 % 30 15 0

5 5 6 7 8 8 9 0 1 1 9 9 9 9 9 994 99 99 00 00 00 1 1 1 2 2 2 r r 19 r 19 r r 19 r e e h e h h rch 19b rch 19 rch 1999 rc m arch 1996 mbe mbe Ma te M Marc Ma te Ma Marc Ma te p ptemb p ptemb p eptembe e e eptember 1997e e e S S S S S S September 2000S

Source: NAPE/CPGE/UFRGS. * (1) From July 1994 to September 1996 and from June 1999 to December 1999 the nominal interest rate was Over/Selic, while from December 1996 to March 1999 the nominal interest rate was TBAN.

The result of an orthodox monetary policy was the recovery of foreign reserves in the end of 1995, as Figure 3 shows: in December 1995 the foreign reserves were around US$ 50.0 billion, while in June 1995 they were around US$ 31.0 billion – an increase of 61.2%. FIGURE 3 Net Foreign Reserves*, US$ Billion

80,0

60,0

40,0

US$ Billion 20,0

0,0

4 6 7 99 01 996 998 001 199 1 1 19 20 2 199 r 2000 er er b rch m a Marche 1994March 1995March 199 Marchemb 1997March March 1999Marchtembe 2000M pt pt e eptember 1995 e eptember 1998 ep S S September S S September S September

. Source: Central Bank of Brazil. * Operational concept, including disposable assets.

13 These measures were sufficient to avoid a speculative attack on real and, as a consequence, the Brazilian currency crisis did not occur. However, the consequence was the slow down of the growth rate: the average growth rate of GDP in the years 1995 and 1996 dropped to 3.4%, according to the figures in Table 1. Moreover, on the one hand, the increase in the nominal interest rate produced a strong fiscal imbalance and the growth of net public debt. Figure 4, for instance, shows the relation between net public debt and GDP. According to this Figure, the relation between net public debt and GDP increased 85.9%, during the period 1994-2001. On the other hand, the policy of high nominal interest rate brought some difficulties to firms in terms of financial fragilities and, as a result, the financial system presented a serious crisis, due to the rapid increase of bad loans. At that time, to avoid the crisis of the financial system, characterized by its fragility, monetary authorities decided to help this sector by launching the PROER20.

FIGURE 4 Net Public Debt/GDP

55 50 45

% 40 35 30 25 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: Central Bank of Brazil.

Up to the end of 1996, the two basic pillars of the Real Plan, overvalued exchange rate and high interest rates, were aggravating macroeconomic instability – the trade balance and the current account deficits became worse, the public debt increased and the economic

20PROER aimed at stimulating and restructuring the National Financial System. It was launched to avoid the contagious crisis caused by the microeconomic vulnerability of three important private domestic banks: Bamerindus, Econômico and Nacional.

14 activity slowed down. Thus, the uncertainty about the future of the Real Plan became part of the economic agents’ expectations. However, the elasticity of foreign reserves assured the monetary authorities, especially Gustavo Franco (1998), director of Foreign Affairs and later President of the Central Bank of Brazil, to argue that the world was in a bad situation, but the Brazilian economy was in a good shape. The East Asian crisis, in the second half of 1997, nevertheless, did not avoid a speculative attack on real, showing, at that time, the external vulnerability of the Brazilian economy. As a consequence of the speculative attack, the capital inflows moved way out and the foreign reserves dropped. According to Figure 3, the foreign reserves between June and December of 1997 declined by almost 10.0%. The reaction of the Government was rapid and, once again, conservative: the nominal interest rate went up – as shown in Figure 2, TBAN, the basic interest rate of the economy, increased from 24.5% per year in October 1997, to 46.5% per year in November of the same year; and the current expenditures of the Government were cut. These orthodox measures to avoid the Brazilian currency crisis21, brought about some ‘confidence’ to economic agents. After its successful defense of the real, the Brazilian government partially restored foreign investors’ confidence, since capital outflows were stanched during the first semester of 1998. The Brazilian economy regained a sort of ‘appearance of normality’, as was evidenced by the fact that foreign reserves reached the level of US$ 70.0 billion at the end of July 1998 (compared with US$ 40.0 billion at the beginning of the Real Plan in July 1994). In the third quarter of 1998, however, the speculative attack on the real, a mix of a contagious crisis arising from the Russian crisis and the perception by market operators that Brazil had serious macroeconomic imbalances, would show that foreign reserve was not considered a shelter against any attempted speculative attack on the Brazilian currency. Given that 1998 was politically important to the Government, due to the presidential election, the monetary authorities, despite the pressures to devalue the real, insisted in

21 A currency crisis was prevented only by swift action from the Government, which sold off part of its voluminous international reserves (that fell from US$ 61.2 billion in September 1997 to US$ 51.4 billion in December 1997), raised annual interest rates sky-high (from 21.0% to 44.0%) and increased the supply of hedge financing by selling exchange-adjusted government securities, so as to revert the speculative process under way at the time. In addition, the Brazilian government announced a strong fiscal policy package and measures to attract capital inflows.

15 adopting another short-term orthodox economic policy: once again, public expenditures were cut, taxes increased and the Central Bank of Brazil pushed the nominal interest rate to the sky22. At that time, however, different from what had happened after the Mexican crisis and the East Asian crisis, the orthodox policy did not inspire confidence in the Real Plan. Indeed, disappointment with slippage in fiscal adjustment in 1998 and the continuous growth of the public debt contributed to the sentiment that Brazil remained vulnerable. This sentiment was due to the loss of government capacity to improve the economic fundamentals, in particular the public sector deficit: the Brazilian government had promised a strong fiscal adjustment, but did not fulfill its promise. After the devaluation in mid- August 1998, the crisis in Russia led quickly to pressures on emerging markets and affected particularly Brazil’s external capital account. Then, with macroeconomic imbalances and uncertainties about the future of the Real Plan, capital outflows emerged and foreign reserves quickly dropped: between September and December 1998, foreign reserves declined by 38.0% as shown in Figure 3. The solution found at that time was an agreement with the International Monetary Fund (IMF) in which the Brazilian economy would receive financial support from the IMF of around US$ 40.0 billion. Brazil, however, had to compromise in terms of (i) adopting fiscal and monetary austerity policies and (ii) accepting the financial and trade liberalizations. Despite the IMF financial assistance package, the financial markets did not restore their confidence on the Real Plan and, as a result, Brazil was not able to defend its currency. Repeated financial crises – Asian and Russian – in a very short period of time and the international recession of 1997-1998 also contributed to deteriorating the Brazilian economy. Thus, in January 1999, the Fernando Henrique Cardoso government admitted that the real was overvalued and, finally, changed the exchange rate regime, due to the continuous losses of foreign reserves: the ‘fix’ exchange rate regime, main pillar of the Real Plan, became floating. The change of the exchange rate regime brought some additional difficulties to the Brazilian economy. First, as usually occurs after fixing a nominal price during a long period, the devaluation of the exchange rate created an overshooting process: at the

22 According to Figure 2, the annual nominal interest rate increased from 29.7%, in June 1998, to 42.2%, in December 1998.

16 beginning of January the exchange rate was around R$ 1.2 per dollar, and in March the exchange rate jumped to R$ 2.1. The consequence of the exchange rate shock was the increase of inflation in 1999, which jumped from 1.7% in 1998 to 19.9% in 1999, as shown in Table 1. Secondly, the devaluation of the exchange rate forced the Government to abandon the agreement with the IMF23. Given that short-term scenario, skepticism became part of the expectations on the Brazilian economy in the beginning of 1999. Economists, entrepreneurs and politicians expected (i) an explosive inflation, with the possibility to reach the inflation rates of before the Real Plan, and (ii) a dramatic recession and, as a result, increasing unemployment rates. In other words, the scenario imposed a rupture of economic agents’ expectations showing that the state of confidence on economic stabilization would be abandoned. However, some months after the economic turbulence caused by the devaluation of the exchange rate, the Brazilian economy, surprisingly, would show signals of stabilization and recovery. In the second half of 1999 and during the year of 2000, the figures improved impressively: in 1999 and 2000 the GDP increased 0.8% and 4.2%, respectively – specifically in 2000, there was a positive growth in all components of demand; the inflation rate in 2000 rose only by a cumulative 6.0 %, probably due to the high degree of desindexation of the Brazilian economy that time; the trade balance and the current account deficits declined; and the medium and long-term inflows of portfolio capital and, basically, international direct investments rose. As a consequence of the Brazilian economy’s performance in 1999 and, especially, in 2000, President Cardoso called their critics as ‘neo- bobos’ (new fools). Thus, the monetary authorities argued that the Brazilian economy, due to its macroeconomic fundamentals and insertion into international financial and productive circuits, was entering a new prosperity cycle characterized by low inflation and average growth rate of GDP around 5.0% per year.

23 Of course, months later the agreement with the IMF would be renegotiated on different terms.

17 FIGURE 5 Current Account/GDP

0 1996 1997 1998 1999 2000 2001 -1

-2

% -3 -3,03 -4 -3,77 -4,24 -4,08 -5 -4,77 -4,61 -6

Source: Monthly Bulletin of Central Bank of Brazil.

However, in 2001, due to a number of international shocks, such as the slowdown and recession in the U.S. economy – particularly after the terrorism attack in New York, on September 11 – the stagnation of Japanese economy and the Turkish and Argentine crises, the Brazilian economy deteriorated again: the economic growth was 1.5%24, down from 4.2% in 2000, and the inflation rate was 10.4%. On the other hand, although current account’s balance of payments has reduced from US$ 33.6 billion in 1998 to US$ 23.1 billion in 2001 (Table 2), the ratio current account’s balance of payments to GDP remained over to 4.0% (Figure 5). The behavior of this ratio is partly explained by the fact that GDP in dollar shrank after 1999 due to the devaluation of the real. Anyway, Brazil still remained vulnerable to the mood of international financial markets due to the necessity to finance its current account deficit with external capital. Furthermore, the high level of external debt – that jumped from 20.8% in 1997 to 37.7% in 2001 (Figure 6) – introduced a huge constraint to macroeconomic policy in Brazil as the floating exchange regime under this condition is not able to eliminate the exchange rate risk. Besides, this is a further reason that explains Brazilian external vulnerability.

24 Preliminary estimate.

18 FIGURE 6 External Debt/GDP

45 40,85 40 37,76 35,77 35

30 27,97

25 20,77 % 20 17,48 18,58

0 1995 1996 1997 1998 1999 2000 2001

Source: Central Bank of Brazil.

3.2 The 1997-1999 Brazilian currency crises: an interpretation25

The speculative attacks on the real that occurred in October 1997 and during the second semester of 1998 seem to have stemmed from a mix of a ‘contagion crisis’ arising from the effects of the East Asian and Russian crises on Brazil and an outbreak of speculative activity triggered by market operators who perceived clear macroeconomic imbalances in Brazil. The contagion effect became evident in the fall in the price of bonds issued by Brazil (and all emerging countries) and traded on international financial markets and also in the losses taken by global players in their applications on East Asian and Russian stock markets, both contributing to investors on the Brazilian market selling their positions in reals to cover their losses on other markets. In fact, the Russian moratorium not only produced large losses for major Western financial institutions, but also led them to sell assets in emerging markets to raise funds to cover theirs losses, thus creating an outflow of capital from those markets. This affected Brazil in particular because the markets for Brazilian equities and Brady bonds are among the largest and most liquid of emerging markets, and play important roles in global

25 This Section is partially based in Alves, Jr et alli (2001).

19 arbitrage strategies. On the other hand, the perception on the international financial market was that the Brazilian economy had features in some way similar to that of Russia: a large and growing public sector deficit, an exchange-based stabilization policy, real appreciation and rising foreign deficits sustained by large short-term capital inflows based on interest rate differentials, and vulnerability to commodity price declines. In terms of doubtful economic fundamentals, the unsustainable trend in its foreign accounts placed Brazil at risk of a currency crisis, because of the high degree of external financial fragility of the Brazilian economy, which left it susceptible to short-term changes in the international situation. As Paula and Alves, Jr (2000) stressed, there is clear evidence that the degree of Brazil’s external financial fragility increased during the Real Plan, principally in 1996 and 1997, basically because exchange liabilities – actual and potential – were not covered by current revenues and sources of longer-term financing, which has left Brazil systematically dependent on external refinancing. The economic authorities seemed to neglect the effects of a possible change in the international situation, while putting across the idea that the real was a bulwark. The central idea was that the large trade deficits that could be observed were the result of the process of restructuring industrial production in Brazil, which promised productivity gains sufficient, in the medium-term, to offset exchange appreciation. The exchange risks of this strategy would be minimized by the fact that the deficit was claimed to be soundly financed, with growing participation by long-term foreign capital. In addition, the high level of foreign reserves was considered a ‘shelter’ against any attempted speculative attack again the Brazilian currency, the real. Nonetheless, events in Brazil demonstrated that, in view of the increasing current account deficits, long-term financing for these deficits was insufficient to preclude external vulnerability. Brazil was thus obliged to resort to external refinancing, which contributed to increasing the already voluminous stocks of bonds and credits with short maturities, leaving the Brazilian economy more and more vulnerable to shifts in the short-term expectations formulated by foreign investors. The Brazilian currency crisis was directly associated with the dissolution of the context of normality that had prevailed since the beginning of the Real Plan and agents' deteriorating expectations in relation to this context, as a result of a loss of confidence in the Government's ability to maintain this regime and in the

20 sustainability of the balance of payments26. The IMF-led financial assistance package, shaped to be a program of a ‘preventive nature’, was not able to restore confidence on the financial markets that Brazil was able to defend its currency, given that not only the IMF conditions were onerous and complex, but also that the IMF's image had deteriorated since the failure of its intervention in East Asia. Repeated financial crises – East Asian and Russian – in a very short period of time and the international recession of 1997-1998 also contributed to deteriorating the Brazilian economy.

4 Is there any change in macroeconomic unbalances after the devaluation of real? The Brazilian economy in 1999-2001

As we have already mentioned, the period after the implementation of the Real Plan was marked by a remarkable reduction of inflation, even after the major devaluation of January 1999. However, the evolution of GDP, after two years of economic growth (1994- 1995), as a result of the initial effects of the stabilization plan based on an exchange rate anchor, disappointed previous expectations of sustainable economic growth after price stabilization. Furthermore, its movement has followed a ‘stop-go’ pattern (Table 1). Indeed, the Brazilian economy has suffered the impact of the succession of crises – Mexico in 1995, Asian countries in 1997, Russia in 1998, its own crisis in late 1998 and first days of 1999, and, more recently, Argentina’s ones since end-2001 – because the perception of high external vulnerability, as a result of the necessity to finance high balance of payments’ current account deficits, the semi-stagnation of the economy, the adoption by central bank of very high short-term interest rates and the consequent increase of public debt. All these factors have contributed to define a very unstable macroeconomic context. Macroeconomic constraints in Brazil are mainly related to the heritage of the period of adoption of an exchange rate anchor in a context of trade and current account

26 In the case of Brazil, the normality as regards the external context during the Real Plan was closed associated with the strong belief among resident and non-resident agents in the stability and maintenance of the exchange rate regime (the “crawling exchange rate band”), including the Government's ability to maintain this regime, and also in the sustainability of the balance of payments. This belief created a macroeconomic context in which a sort of “convention of stability” prevailed, so that economic agents believed in the macroeconomic sustainability of the price stabilization policies. On the other hand, the currency crisis was associated with the dissolution of the context of normality and deteriorating expectations among agents as regards this context, as they lost confidence in the Government's ability to maintain this regime and to sustain the balance of payments.

21 liberalizations that generated a high external fragility of the economy and consequently some serious macroeconomic unbalances (for instance, the high foreign debt, the fast growth of internal public debt, and so on). The state of expectations of the private sector has deteriorated due to the impacts of various external shocks, the weak performance of the Brazilian economy, and the very high rates of interest. Despite the change from an exchange anchor to a floating exchange rate regime plus an inflation targeting regime in June 1999, there is no significant improvement in the macroeconomic variables of the economy. One could expect that the adoption of a floating exchange regime would make it possible to reduce more quickly the rate of interest in Brazil. Although, after the sharp increase of overnight rate at sky-high levels (reaching more than 40.0% per year), since the effects of Asian crisis until the devaluation of the real in January 1999, the rate of interest declined, it increased again during 2001 (Figure 2), in view of the turbulence in international markets (effects of 11 September 2001, Argentina’s crisis, and so on). Very high rates of interest are the result of high country-risk (due to high external vulnerability and the risk of fiscal insolvency), the adoption of inflation targeting27 in a context of various macroeconomic constraints, and the high level of internal debt with low average maturity. However, the management of monetary policy has been very conservative in Brazil in the recent years, that is any signal of macroeconomic instability is faced with a rise in the rate of interest by Brazilian Central Bank. For this reason, rate of interest tends to absorb all the macroeconomic imbalances. Bresser-Pereira and Nakano (2002) suggest that the causality between interest rate and country-risk can be inverse: since short-term rate of interest has been in a very high level, foreign creditors believe that country-risk is high. According to these authors, the rate of interest is high in Brazil because there are multiple functions for it: to hit the inflation targeting, to limit the devaluation of exchange rate, to attract foreign capitals, to rollover public debt, and to reduce trade deficit through the control of internal demand28. High interest rates have had two effects: (i) it constraints economic growth, through the price of the credit (loan rates), as well as negatively through entrepreneurs’

27 Under the inflation targeting regime, the Central Bank of Brazil operates the monetary policy only to keep inflation low and under control, while the levels of output and unemployment are determined on the supply- side of the economy. In other words, the inflation targeting regime supposes that there is a separation between the real side and the monetary side of the economy, the well-known ‘classical dichotomy’. 28 See, also, in this connection, Toledo (2002) and Oreiro (2002).

22 expectations; (ii) it increases public debt, once this is mainly formed by indexed bonds or short-term pre-fixed bonds. Indeed, the strong demand for hedge against exchange devaluation and interest rate changes, in turbulent periods, has influenced the Brazilian internal public debt. Brazilian government has been constrained to offer exchange rate and interest rate hedge to the security buyers that charge a high premium risk to rollover public debt. As a result, since the end of 1998 more than 50.0% of federal domestic securities has been indexed to overnight rate, while more than 20.0% has been indexed to foreign exchange, as Table 3 shows. Besides, the ratio of net public debt to GDP rose from 34.5% in December 1997 to 53.3% in December 2001 (Figure 4)29.

TABLE 3 Federal Domestic Securities, Percentage Share of Index Numbers End-of- Foreign Reference Overnight Long-term Inflation Preset Other Total period exchange rate* rate interest rate Dec 1996 9,4 7,9 1,8 18,6 61,0 1,4 - 100,0 Dec 1997 15,4 8,0 0,3 34,8 40,9 0,6 - 100,0 Dec 1998 21,0 5,4 0,4 69,1 3,5 0,2 0,5 100,0 Dec 1999 24,2 3,0 2,4 61,1 9,2 0,1 - 100,0 Dec 2000 22,3 4,7 5,9 52,2 14,8 0,0 0,0 100,0 June 2001 26,8 5,0 7,1 50,2 10,8 0,0 0,0 100,0 Dec 2001 28,6 3,8 7,0 52,8 7,8 0,0 0,0 100,0 Source: Monthly Bulletin of Central Bank of Brazil. (*) Average rate of time deposits.

Therefore, the behavior of domestic public debt in Brazil has been very vulnerable to the changes in the rate of interest or exchange rate. The decline in the public debt depends on the reduction in its financial burden, through a fall in the interest rate or the appreciation of exchange rate, and/or the increase in the primary fiscal surplus. Thus, the Brazilian government has been forced to generate high primary fiscal surplus (around 3.5% of GDP), which impedes the use of any anti-cyclical fiscal policy. This fiscal effort, however, is partly neutralized by increases in the rate of interest or in the exchange rate. Here there is a sort of dilemma: due to the structure of the public debt, a fall in the rate of interest at the same time that reduces the financial cost of the part of debt tied to overnight

29 For a comprehensive analysis on the recent behavior of public debt in Brazil, see Sobreira (2002).

23 rate, it can have a negative impact on the part of debt tied to the dollar as a result of an exchange rate depreciation. Taking into consideration this evidence, a question arises: Does the Brazilian economy have consistent macroeconomic fundamentals, as the monetary authorities have argued, to assure inflation under control and promote at the same time economic growth and social development in the medium and long runs?

5. How to expand effective demand in conditions of macroeconomic inconsistency?

It was shown previously that Brazil, like other Latin American countries, has implemented, during 1994-1999, a stabilization policy based on trade and capital account liberalization, currency overvaluation and high domestic interest rates. This policy became the Brazilian economy highly vulnerable due to its dependence upon foreign finance and the financial fragility of the domestic debt and, as a consequence, the Government faced some difficulties, such as speculative attacks and currency instabilities. Moreover, from 1994 to 2001, the average growth rate of GDP was very low and unemployment increased rapidly. Furthermore, as we have already stressed, there was no significant improvement in the macroeconomic variables of the Brazilian economy in 1999-2001, that is after the adoption of a floating exchange regime plus an inflation targeting regime. Indeed, the nominal anchor of the domestic prices changed from a fixed exchange rate to an inflation targeting regime. Brazilian recent experience shows that in countries with a high level of external debt the excessive dependence on external finance can cause periods of intense exchange rate instability, that can jeopardize the execution of the announced inflation target. Besides, it can also cause a low economic growth, as monetary authorities tend to increase rate of interest in periods of financial instability. We turn to the question formulated in the last paragraph of the previous section, namely is the Brazilian economy entering a new prosperity cycle and the current macroeconomic inconsistency does not matter? If not, how could Brazil enters in a self- sustainable economic growth path that could be compatible with equilibrium in the balance of payments and low inflation?

24 Focusing on the external imbalance, despite the fact that, in the last two years, the balance of payments has improved, the Brazilian economy still has external vulnerability for the following reasons: (i) considering that in the last years of the 1990s the current account deficit plus amortizations represented around US$ 50.0 billion per year, as well as assuming that the past is a guide for the future, the Brazilian economy needs, in the next few years, a substantial volume of ‘foreign saving’ to equilibrate the balance of payments30; (ii) the mega trade surplus expected by the economic authorities after the devaluation of the exchange rate perhaps can not be reached in the long run, due to the high income-elasticity of imports in Brazil, that means that in periods of economic growth mega trade surplus can be reached31; (iii) the degree of trade openness, in the 1990s, made the Brazilian economy very dependent on import inputs and, as a consequence, any expansion of industrial production push imports to go up; (iv) the international investment has entered in Brazil during the last years is basically related to non-tradable goods32; thus, in the future, the deficit service balance will increase due to the outflows of royalties, profits and dividends, among others; and (v) the consequences of the U.S. recession, the fragility of the euro, the deflation and recession in Japan and, recently, the devaluation of Argentine peso will bring additional difficulties to Brazilian exports. Looking at the imbalance of the fiscal sector, even the Government decides to implement another short-term fiscal policy – such as to squeeze current expenditures and increase taxes – the current real interest rate compromises the equilibrium of public sector due to the fact that, as is well-known, the main cause of the fiscal deficit is the financial component due the increasing costs to rollover the public debt. Considering this context, balance of payments deficit and fiscal imbalance, there are strong restrictions to recover the growth rate path of the Brazilian economy. At this point, knowing that the complexity of the Brazilian economy restricts the possibility of operating short-term economic policy, we believe that the adoption of an Economic Agenda, what we have called as Post Keynesian economic growth targeting,

30 At this point, it is difficult to expect that, in a world of slowing growth rates, due to economic problems in Japan, the U.S. economy and Argentina, capital inflows, both of risk and portfolio, will maintain its past trend. 31 In 2002, trade surplus was reached due to the mix of excessive exchange rate devaluation with low GDP growth. 32 See, in this connection, Laplane et alli (2000).

25 stands a very good chance of stimulating the economic growth of GDP and the social development without compromising the monetary stabilization33. As is well-known, the essential element in the Post Keynesian policy is the government intervention to remove constraints on full employment and to reduce the inequality of wealth and income distribution, as Keynes remarked, long time ago. To address this objective, the government has to operate fiscal policy to expand effective demand, to manage monetary policy to have a significant impact on the level of economic activity, to co-ordinate the financial markets, to develop an industrial policy, and so on34. Such policies can promote a stable environment for the private sector to encourage it to reduce speculation and liquidity preference and, as a result, invest. Taking into consideration this idea, the focus on Brazilian economic policy must be concentrated in reversing the short-term macroeconomic constraints, fiscal and external. Thus, the point is how could monetary authorities reduce short-term interest rates, as it is one of the crucial condition to start an economic recovery, and at the same time to reach a balance of payments’ equilibrium? The external balance in order to decrease the dependence on foreign capitals should be the priority of the economic policy. For us, it can be reversed by adopting the following points:

 The Central Bank of Brazil has to manage the exchange rate every time speculators want to manipulate the market – in other words, the exchange rate regime must be similar to a dirty floating system. However, this mechanism is limited, as countries with high external debt tend to have very often unstable exchange rate market. For this reason, monetary authority has to be able to provide an anti-speculative mechanism to regulate movements of capital.

 The government has to implement fiscal and financial policies to stimulate exports – for example, the BNDES has to increase its role in financing exports – and also decrease the domestic taxes that take place on exports, in order to become them more competitive.

33 Ferrari-Filho (1999), among others, explores this point. 34 For a post Keynesian theoretical approach of what could be an Economic Agenda, see Arestis and Sawyer (1998), Cardim de Cravalho (1992: Chapter 12) and Davidson and Davidson (1996).

26  The government and the private sector have to operate an industrial policy to aim at (a) inserting the Brazilian economy in the international scenario in a context in which it can incorporate the technological and structural revolutions that are occurring in the world and (b) bringing the international investments that can add aggregate value to export – that is to say, international investments that produce tradable goods35. Industrial policy has to be used to both increase and change the composition of the exports in Brazil, in order to include other products with high level of aggregate value.

 Considering that the current World Trade Organization agreements prescribe special treatment for developing countries36, the government has to revise the trade policy, in the sense of reducing the tariffs related to import of capital goods and increasing the tariffs associated to import of durable goods.

In other words, as the exchange rate devaluation would face issues concerning inflation pressures, the increase in the trade balance surplus in order to reduce the necessity of foreign capitals, understood as a necessary condition to overcome Brazil’s external vulnerability, would require a more active trade policy and a policy of industrial restructuring in order to promote exports of goods and a process import substitution that could reduce the aggregate value of imports. For this purpose, Brazilian government should use, in a selective way, tariffs on imports and non-tariff mechanisms, such as subsided credit, that could stimulate the import substitution by domestic production in some sectors. Indeed, the production of trade balance surplus in the balance of payments is essential to decrease the external vulnerability of the Brazilian economy, and as a result to decrease rate of interest so that it could be compatible with a greater level of economic growth. Besides, it should be necessary to implement some kind of capital controls, in a preventive way, on capital account of the balance of payments, using a modern and efficient system of regulation of inflow and outflow of capitals in Brazil37. Capital controls

35 Concerning industrial policy, it would be important to create some mechanisms to legalize, through fiscal incentives to micro, small and medium enterprises, the informal sector. Thus, it could also be related to international trade. 36 See www.wto.org. 37 See, in this connection, Batista, Jr (2002).

27 should be used to allow the adoption of more autonomous monetary policy, as they can be a useful mechanism to break the arbitrage between the prices of assets (including rate of exchange) that become rate of interest exogenous. They can also reduce the instability of exchange rate through the selection of the capital flows that the country wants to absorb, using mainly market-based controls, such as unremunerated reserve requirement38. Aiming at the equilibrium of the public sector is of paramount importance. Going in this direction, to have fiscal austerity of Union, States and Municipalities, to fight the fiscal evasion, to operate a tax reform39, to implement the Social Security reform and to operate a privatization program40 are relevant but they are not enough. To create conditions to reduce interest rates is also essential to reach a fiscal balance, as part of the public debt is indexed to overnight rate, as we have already seen. Furthermore, if we want to balance the public sector, it is necessary to extend the maturity of the public debt. We think that current taxes over financial transactions could be a strong weapon to extend the maturity of the public debt. Thus, the taxes for short-term financial applications could increase, while the taxes for long-term financial applications could decrease. The result of this tax policy over capital gains plus a restatement of the agents’ confidence in the economy would be the reduction of the interest rate, basically due to changes in the liquidity preference of the economic agents. Two points are very important to achieve wealth and income redistribution. On the one hand, it is necessary to keep inflation under control. Income policies are essential to regulate wages and prices in order to reduce and maintain low inflation. Furthermore, as inflation in Brazil has been essentially in the supply side (costs inflation) since Brazilian economy has been stagnated in the recent years, it is essential to manage permanently the sources of the rise of the prices. For this purpose, the use of regulation stock of some products and the revision of some contracts and practices in terms of some sectors that have

38 For a comprehensive analysis on capital controls, see Neely (1999). 39 The project of tax reform that is in National Congress could be an interesting proposal of tax reform. 40 It is necessary to emphasize that the privatisation program is an efficient mechanism to eliminate the economic and social idiosyncracies of the State. However, to reduce the stock of public debt by using the revenue of privatisation program does not solve the public deficit, basically because the annual revenues of privatisation is less than the nominal interest rate that the Government has to pay for postponing its debt. Besides, the Brazilian experience showed that the privatisation is so peculiar: first, the state monopoly is becoming, after privatisation, private monopoly; secondly, BNDES is financing the privatisation process. For us, privatisation is not an ideological issue; but, it is necessary to define what to privatise, how to privatise and what to do with the revenues of the privatisation.

28 their prices linked directly to exchange rate (petrol) and inflation rate (utilities in general) can be an important tool to face inflation. These policies could avoid often use of the rate of interest to face any inflation pressure whatever could be its cause. On the other hand, fiscal policies, such as progressive income taxes and capital levies, guaranteed minimum income41 and social expenditures to improve the standard of living of poorer people are required to promote personal income redistribution. In sum, government intervention is necessary to achieve income redistribution. These are, according to us, the policy economic recommendations that could be part of an Economic Agenda to Brazil. To sum up, an economic stabilization cannot neglect fiscal, monetary, exchange rate and trade policies as instruments of stabilizing prices and expanding effective demand. To finalize, instead of having an inflation targeting regime, Brazil needs a economic growth targeting!

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