Significance

Brazil has decided not to renew its standby agreement with the IMF, which expires later this week, and will instead go it alone.

Implications

The fact that Brazil is not entering into a new programme indicates the extent to which the Lula administration has transformed investors' expectations and does not preclude further IMF intervention in the event of a future crisis.

Outlook

Tight fiscal and monetary policies have been key to the government's success in boosting market confidence, with the decision not to renew the deal set to play well with the electorate. Nevertheless, the inefficiencies of public-sector activity and structural weaknesses must still be tackled if the country's economic prospects are to improve into the long term - regardless of whether or not the country is under IMF tutelage.

Lula Government Transforms Market Expectations

What a difference two years or so make. In the run-up to the presidential elections of October 2002, investors took fright at the prospect of a left-of-centre politician - namely, Luiz Inácio Lula da Silva - winning office and, upon assuming the top job, breaking with the orthodox economic policies pursued by his predecessor Fernando Henrique Cardoso. They thus voted with their feet, considerably increasing the chances of an involuntary default as a result, as the authorities struggled to roll over existing debt and keep the public finances on an even keel. Country risk - the spread between Brazilian sovereign debt and comparable US Treasuries - soared to 2,500 basis points at one point, with the real weakening to 4:US$1 and stocks slumping as confidence crashed.

Yesterday's statement by Finance Minister Antonio Palocci demonstrates how far Brazil has come since then. There was no need for the country's US$42-billion programme, which expires later this week, to be renewed, he said: 'We understood that the IMF accords have as their purpose the relief of trade and current-account crises. Therefore, there is no need for such an accord for Brazil'. A glimpse at Brazil's key fiscal, macro-economic and market indicators appears to bear out the government's decision:

The closely tracked ratio of public debt-to-GDP closed last year at 51.8% of GDP, down from 57.2% a year earlier. The improvement reflects the primary fiscal surplus of 4.61% of GDP clocked up in 2004, as well as economic growth of 5.2%, the strongest recorded for a decade.

Crucially, the current account - so often the Achilles' heel of the Brazilian economy in the past - has undergone a spectacular transformation. It notched up a surplus of 1.94% of GDP in 2004, compared with a deficit of 4.55% as recently as 2001. The turnaround stems from the bumper trade surplus: this hit a record US$33.74 billion last year as exports surged, and is set to remain heavily in the black this year, generating continued positive balances on the current account as a result. Trade Minister Fernando Furlan this week revised up his forecast for total exports this year to US$112 billion. 

While falling back in line with their counterparts across the region and beyond, the Bovespa stock index remains close to its all-time highs while the real has clung on to the lion's share of its recent gains - despite the authorities' efforts to push it down. Similarly, bond prices are off their recent highs but country risk remains more than 20 percentage points below its 2002 peak.

Foreign reserves have risen sharply in recent months, standing at US$59.017 billion (including loans from the IMF) and US$31.426 billion (excluding IMF loans) in February. 

Inflation, while proving rather sticky, closed below the official target ceiling of 8% in December.

Brazil has indeed benefited from a wonderfully benign global environment, in which demand for higher-risk assets and exports have soared. However, the Lula administration's success in turning around market expectations must not be underestimated. By pursuing a tight fiscal policy - indeed, going beyond what was agreed with the IMF in this area - the government has calmed the nerves of those expecting it to veer off into free-spending, debt-increasing territory. From the financial markets' perspective, the Lula administration's decision not to prioritise legislation to grant the central bank autonomy has underwhelmed. All the same, the monetary authorities have proved remarkably tenacious in their efforts to push inflation and inflation expectations down into line with their targets - in the face of fierce opposition from politicians of all political hues, trade unions and industry leaders alike.

Whither IMF-Brazil Relations?

Given that their formal ties have now been loosened, where do relations between the IMF and Brazilian authorities go from here? Two factors stand out in this respect:

Brazil still owes the Fund some US$23.2 billion, according to the Brazilian government, with the total due to be paid off in full by 2007. As matters stand, there is little reason to expect the country to attempt to reschedule its obligations or fail to make good on them. 

Bilateral relations are extremely strong, with the Lula administration having hit, or even exceeded, the targets agreed with the Fund and the institution lavishing praise on it as a result .

This second point is crucial. There was speculation on many parts - ourselves included - that Brazil might strike a skeleton deal with the Fund. This would not have involved the rigorous quarterly reviews and targets of a fully fledged standby agreement but would have given Brazil access to substantial IMF funds in the event of a crisis. The fact that an off-the-peg agreement of this sort was not available, given the demise of the short-lived Contingent Credit Line Facility, as well as the fact that Brazil decided so late in the day, was probably the nail in the coffin of such an arrangement.

Outlook and Implications

Despite the absence of a formal agreement, it is highly probable that the IMF will be prepared to intervene in the event of an emergency - a likelihood that will not have passed markets by. As such, the decision to go it alone may prove to be a bold and successful one for the Lula government. Not only will it yield the political dividends of cutting free from the IMF, whose actions and influence are often perceived as detrimental to national sovereignty and social conditions, but there is almost a tacit guarantee that the Fund will once again step in should its financial firepower be demanded. In addition to the political benefits, the Lula administration's decision not to renew its deal may have been fomented by its apparent failure to persuade the IMF to adjust the way in which it calculates Brazil's primary fiscal surplus to free up additional resources for infrastructure spending.

The absence of a new deal has only limited implications in terms of economic policy. There has been vocal criticism from some quarters that monetary policy has had to be tightened in an exaggerated fashion owing to the authorities' failure to adopt a more austere fiscal stance. However, what some see as the imbalance between fiscal and monetary policy has occurred within the confines of an IMF deal and the lack of such an arrangement will change little. While the authorities will probably stick to a primary fiscal surplus target of 4.25% of GDP this year and next, this will still allow some scope for increases in public spending. These are being demanded by members of the government and voters alike as the countdown to the October 2006 presidential elections begins. As for the reform agenda that a new standby arrangement presumably would have framed, few observers doubt that many areas - including the labour code, taxation and social security system - remain overdue for an overhaul. However, the electoral timetable and Lula's heterogeneous coalition in Congress would have made significant advances on these fronts unlikely in any case.

Brazil has proved itself willing and more than able to abide by the terms of its standby agreement. The Lula administration has invested a huge amount of political capital in turning around investors' expectations and will not therefore veer off the policy rails without the IMF watching over its every move. However, the inefficiencies and corruption that characterise so much of public-sector activity and the structural weaknesses that continue to constrain Brazil's competitiveness must still be tackled if the country's prospects are to improve into the long term - regardless of whether or not the country is under IMF tutelage.