Global Insight Perspective

Significance

Despite an increase in macro-economic and financial stability since the 2002 election, faster growth that could contribute to a significant reduction in poverty remains elusive, with Brazil still locked into its portrayal of itself as “the country of the future”.

Implications

The leading presidential candidates President Luiz Inácio Lula da Silva and Geraldo Alckmin of the Brazilian Social Democratic Party (PSDB) have both pledged to continue policies aimed at maintaining stability as well as promoting growth with social inclusion, but the election build-up has seen little debate regarding specific proposals that would tackle some of the issues that remain a barrier to greater investment and sustained growth.

Outlook

The improved performance of the economy over the past four years is one of the reasons why Lula looks likely to win re-election, even though much remains to be done if Brazil is to meet its full growth potential.

Elections See Little Debate on Economic Issues

Both the National Confederation of Industry (CNI) and the United Kingdom's Financial Times have lamented the fact that this year's elections have not seen more of a debate on economic issues. Some of the Brazilian press have gone further and accused President Luiz Inácio Lula da Silva of shying away from any debate at all by not attending TV discussions or giving many in-depth newspaper interviews. That the economy has not featured more prominently in the electoral campaign is in large part a testament to the increased economic stability achieved under the Worker’s Party (PT) administration and the perception that macro-economic policy would differ little, irrespective of whether President Lula or his main rival the former governor of São Paulo Geraldo Alckmin were to be elected. There is another possible explanation for the lack of specific legislative-reform proposals in Lula's programme: the implicit assumption that building a consensus in Brazil's Congress for controversial reforms will be even more difficult in a second term. Although Lula remains popular, the PT is expected to be punished for its involvement in the corruption scandals that have dominated Brazilian politics for over a year, which means that if Lula is re-elected he will be even more reliant on allied parties to form a governing coalition with a working majority .

Increased Macro-Economic Stability Under PT Rule

The economy is certainly looking far healthier than when President Lula took office in January 2003. The imminent sovereign debt default that had been feared by some investors in mid-2002 if Brazil's first left-wing president was elected was averted. Instead, investor confidence has risen to such an extent that Lula was able to announce last year that the government had decided not to renew Brazil's standby arrangement with the IMF, without triggering a backlash from investors. In addition, several rating upgrades from the main international credit rating agencies, to reflect an improvement in Brazil's debt profile and satisfaction with the macro-economic policies pursued by the government, mean that the goal of attaining investment grade status in the coming years no longer seems such a distant dream.

Brazil's key economic indicators also show a marked improvement, the major achievement of Lula's administration is relative price stability: since the end of 2002, when inflation was above 12%, the rate of growth of the consumer price index has decreased by 2 percentage points each year. Inflation is estimated at 4% for December 2006. The commitment of the central bank to lower inflation has led to lower inflationary expectations, which, in turn, has allowed the bank to reduce interest rates. Lower interest rates are expected to encourage consumption and investment that should lead to acceleration in the economic growth rate. In addition, lower rates will also help public finances as an important fraction of the public debt is subject to floating rates, particularly the targeted SELIC rate. Two-thirds of the fiscal budget is allocated to debt service (interest plus principal payments), while only one-third goes to non-interest current expenses and public investment.

Although, in the last five years, economic growth has been disappointing, the prospect for future expansion is good in the context of lower inflation and lower interest rates. Another important achievement of Lula's economic policy—and this will be key for his re-election—is poverty reduction, which, coupled with improvements in income distribution, has alleviated the critical situation of the poor in Brazil. This is the reason why, despite relatively low GDP growth rates, the majority of the electorate approve of his administration and economic policy.

Increased economic stability has been achieved largely thanks to the maintenance of the three keystones of Lula's predecessor Fernando Henrique Cardoso's macro-economic policy: the floating exchange rate, established after the 1999 devaluation crisis; inflation-targeting; and a tight fiscal policy. The tax and social-security reforms approved at the end of 2003 also represented a continuation of Cardoso's reform agenda. Indeed, the main difference between the two in terms of economic policy appears to have been that the PT administration has abandoned Cardoso's ambitious privatisation programme and that there has been an increase in state interference in some of the regulated industries. It is this policy continuity that has led to the perception that there is little to differentiate Lula and Alckmin on the economy. In general terms, this is indeed the case, but there are still some differences between them (see Table 1). The lack of debate on economic policy in this year's election obscures these differences. It has also meant that there has not been an in-depth discussion about the issues that need to be tackled if Brazil is ever to reach the full potential offered by its size.

Table 1: Main Differences Between Lula and Alckmin

National Development Strategy

Both candidates want faster growth with social inclusion and a greater focus on education.

Fiscal Policy

In his programme for government, Lula defended government spending on social projects and pledged to authorise further increases of the minimum wage above the rate of inflation. He also promised to raise investment to over 25%. However, a pledge to follow responsible fiscal policies indicates that if re-elected Lula may increase public spending, but would not go so far as to sacrifice all the progress on fiscal stability achieved during his first administration.
In contrast, Alckmin has said that he would continue the social policies of the current government and promote public and private investment, but has called for reduced public spending and promised a “management shock”, including a reduction in the number of ministries. Alckmin has also said in interviews that a government headed by him would aim toclose the nominal deficit.

Monetary Policy

Both Lula and Alckmin have expressed support for lower rates and inflation control. However, Alckmin has expressed support for granting the Central Bank formal autonomy, while Lula has not.

Tax Reform

Alckmin has said that he wants to reduce taxes, but has not given a specific target. In his speech at the PSDB national convention, Alckmin also pledged, if elected, to send a reform to simplify the tax model to Congress in the first week of government, including the unification of the ICMS state tax (i.e., the second phase of the tax reform approved at end-2003 that stalled because of difficulties in forming a political consensus between all levels of government). In his programme, Lula pledged to continue with discretionary tax-break programmes aimed at boosting production, but appears to have shied away from making a specific commitment to a complete overhaul of the tax system. Nevertheless, in speeches he has expressed a desire to work in the future towards the approval of a reform that creates a single unified value-added tax (VAT).

Social Security Reform

Lula's programme does not advocate any further pension reform that would help to reduce the social security deficit, currently a significant element of public spending. Both Lula and Alckmin want to secure the approval of bills already in Congress to regulate the social-security reform approved in 2003.

Employment

Both candidates have said that they want to stimulate employment and reduce the informal sector, although, unlike his 2002 campaign, this time Lula has refrained from setting a specific target for job creation.

Despite the achievements of the Lula administration on the economic front, the rate of GDP growth in Brazil over the past five years has been disappointing compared with the other BRIC economies—Brazil, Russia, India, and China (see Table 2).

The reasons why Brazil's economy is not expanding as rapidly as China’s or India's are complex and include factors such as Brazil's relatively high debt-to-GDP ratio and the fact that the country underwent an earlier period of industrial expansion. None the less, Brazil could be growing at a faster rate and needs to if it is to make further progress in terms of poverty alleviation and debt reduction. Brazil's ability to attract greater investment in infrastructure has also been disappointing.

High Taxes and Bureaucracy Continue to Hold Back Brazil

Two recent surveys have highlighted some of the operational issues that need to be tackled to improve productivity and attract greater investment. The annual Doing Business survey by the World Bank's finance arm the International Finance Corp. (IFC), published in early September, saw little improvement in terms of business regulation in Brazil, with the country only rising one place, to 121st, in the ranking of 175 countries . The survey highlighted the costs of excessive bureaucracy to Brazilian business, revealing that it takes an average of 152 days to register a new business in Brazil, compared with 32 days in neighbouring Argentina, 18 days in the United Kingdom, and just 5 days in the United States; and that dealing with licences for ongoing operations can take 460 days. The survey also pointed to the rigidity of labour laws in Brazil and the high corporate tax burden, which it said can absorb up to 71.7% of gross profits, as costs to doing business in Brazil both for foreign companies and for small- and medium-sized local businesses that want to enter the formal sector.

A separate study on global competitiveness published on 4 September by the São Paulo Federation of Industry (Fiesp) placed Brazil 28th out of 43 countries that together account for 95% of global GDP. Brazil's relatively low ranking was attributed to the appreciation of the currency, the high tax burden (equivalent to 39% of GDP in 2005), and relative high real interest rates. The better known annual Global Competitiveness Index prepared by the World Economic Forum (WEF), a Swiss-based non-profit foundation, ranked Brazil 57th out of a total of 117 countries in its 2005 index, behind three other countries in the region—Chile, Argentina, and Costa Rica. The most problematic factors for doing business identified by respondents were: the tax system; government bureaucracy; access to financing; restrictive labour regulations; inadequate infrastructure; and only then corruption. The WEF's next survey is due to be released by end-September.

However, it is not just the operational environment for foreign and domestic investors that could be improved; structural reforms are also needed to remove constraints to sustained growth, in particular further pension and tax reforms.

Outlook and Implications

The economy eclipsed almost all other concerns in the 2002 electoral campaign. In contrast, the “risks” that financial investors attach to the 2006 election are far lower than in 2002 poll, with the prospect of a possible victory for Lula in the first round no longer seen as a reason for undue concern. Left-wing candidates like Heloísa Helena or former education minister Senator Cristovam Buarque, who would be more likely to advocate a more interventionist approach to the economy, are too far behind in the polls to be considered serious threats and there is expected to be policy continuity in the economic sphere irrespective of whether Lula or Alckmin are elected. Even so, investors would no doubt prefer a victory for Alckmin as he is regarded as the candidate most likely to advocate tighter public spending and to attempt more far-reaching reforms, such as granting the Central Bank independence and deeper tax reform.

Despite this year's election having seen a greater focus on corruption than on the economy, Brazil's sluggish growth and the business sector's preoccupation with issues such as the country's heavy tax burden, the high level of interest rates, and the crisis in the farming sector, are reminders that the economic policies adopted by whoever wins the elections do matter.

Contact: Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9411
raul.dary@globalinsight.com

www.globalinsight.com