Wednesday, April 20, 2011


Brazil’s policymakers are struggling to put the economy on a more sustainable, balanced growth path as domestic demand growth continues to outstrip supply, inflation pressures are rising and abundant global liquidity poses dilemmas for currency management. Recent actions to respond to these challenges have created new uncertainty regarding the direction of policy.

The previous policy framework that served Brazil well for most of the past decade–based on sizeable primary fiscal surpluses, inflation-targeting and a floating exchange rate–was well understood by investors, but these three pillars are now being undermined. Inflation has continued to accelerate: annual mid-month inflation in April (IPCA-15 index) quickened to 6.44%, up from 6.13% in mid-March, the fastest pace since November 2008. Inflationary expectations have come further adrift of the 4.5% central target for 2011 and 2012. (Inflation ended 2010 at 5.91%.)

A new macroeconomic policy framework is emerging, characterised by a more heavily managed exchange-rate policy to try to curb currency appreciation and the heavy deployment of so-called macro-prudential measures to try to control credit growth and bolster the financial system, as well as to take the burden off with the standard policy tool, the Selic overnight intervention rate, in the fight against inflation. Even so, the Central Bank’s monetary policy committee is likely to increase the Selic by 50 basis points, for the third straight time, at its April 20th meeting. The Selic currently stands at a steep 11.75%.

Effectiveness unclear

The effectiveness of the macro-prudential measures that have been implemented in recent months is still not clear, but the Central Bank (BCB) has begun to communicate the strategy in more detail in the quarterly inflation report published on March 30th. However, the report did not quantify the impact of the new measures in terms of how they are equivalent to Selic policy rate rises; this would have helped investors understand the new strategy more clearly.

Moreover, the quarterly inflation report was dovish in that it recognised that the 4.5% central inflation target would not be achieved this year. The BCB envisages annual consumer price inflation of 5.6% in December 2011. It stated that it would accommodate the recent rises in international commodity prices, which it quantified as adding 2.2 percentage points to inflation, and seek to control the second-round effects on wage demands. It said that to achieve the central target it would need to take measures to bring about a faster deceleration in the economy than it was prepared to accept, giving the impression that it has dual GDP growth and inflation mandates.

Expectations adrift

With the annual rate of inflation expected to remain close to the ceiling of the 6.5% inflation range until August or September, after which it should begin to ease, there is a risk that inflationary expectations will rise further if domestic demand growth does not decelerate as envisaged and/or new supply shocks emerge. Should inflation overshoot the 6.5% ceiling, policymakers will struggle to bring it down to the central target of 4.5% in 2012, because of a high degree of indexation in Brazil’s economy.

That said, and despite uncertainty regarding the new policy framework, sentiment towards Brazil is still being buoyed by its still-firm growth prospects and considerable market opportunities in a context of elevated global risk appetite. But a failure to bolster macroeconomic stability would increase the economy’s exposure to an unexpected abrupt stop in capital flows (which we see as unlikely in the short to medium term) or sharp deterioration in the terms of trade, for instance, in the event of a sudden slowdown in China.

How much more?

There is also uncertainty over how extensive the macro-prudential measures will be. More can be expected as policymakers strive to reduce credit growth to the private sector (particularly that of consumer credit) from 21% in February in nominal terms (year on year) to 10-15% by year end, a level that appears to be an intermediate policy target of the BCB. This is also designed to ease demand-side inflationary pressures.

The initial measures introduced last December included raising bank reserve requirements–shrinking liquidity by R61bn (US$35.9bn)–and increasing capital requirements for long-maturity loans (over 24 months). However, despite moderation in January, in February credit grew by 1.3% month on month, taking the stock to R1.74trn (46.5% of GDP). Policymakers have signalled that the full effects will be seen only later in the year.

Policymakers have deployed other macro-prudential measures for multiple purposes, including easing pressure on the Real, raising tax revenue and reducing risks to the health of the financial system. On March 28th the authorities increased the Imposto sobre Operações Financeiras (IOF, the financial transactions tax) on credit card purchases abroad from 2.38% to 6.38%–in the context of a strong Real, Brazilians spent US$10.1bn abroad using credit cards in 2010, up from US$6.5bn annually in 2008 and in 2009. This measure was part of a tax-raising package to offset the impact of a 4.5% rise in the personal income tax threshold (taxes on beverages were also increased). The government stated that this was designed to reduce the risk of consumer indebtedness.

The next day the authorities raised the IOF tax on corporations and banks borrowing abroad to 6% for up to 360 days, but kept the rate at zero for longer-term borrowing. Previously, the IOF tax was levied at 5.38% on loans up to 90 days and a zero rate was applied beyond that. But overseas short-term borrowing by companies and banks has surged, with banks borrowing US$25.5bn and companies US$13bn in the year to March 28th, given the much lower international rates available. This has mostly explained net foreign exchange inflows of US$33.5bn in the year to March 25th, compared with US$24bn in 2010 as a whole.

Despite the flurry of measures and the purchase of nearly US$19bn in the foreign exchange market year to date, the Real has strengthened below the R1.65:US$1 level that the BCB appeared to be defending, raising the possibility that the BCB may well soon defend a level of R1.60:US$1. Because of Brazil’s high local interest rates, the quasi-fiscal costs of sterilised intervention are very heavy, at an estimated US$30bn in 2010 and rising.

Eyes still on fiscal policy

That fiscal policy is not being sufficiently utilised to dampen demand growth is adding to uncertainty over the policy framework. Despite R50bn in envisaged “cuts” in the 2011 budget, fiscal policy remains expansionary. Federal spending is set to expand by 4% in real terms this year, and this does not include off-budget transfers of R55bn from the Treasury to Banco Nacional de Desenvolvimento Econômico e Social (BNDES, the state development bank) to enable it to lend R145bn this year at heavily subsidised rates (of only 6%). Although this year’s transfers to BNDES are lower than in 2009 (R100bn), when policymakers provided a countercyclical boost, and 2010 (R80bn), when they continued to boost lending, the transfers will nonetheless add to aggregate demand.

The government has set a 2.9% of GDP primary fiscal surplus target for the consolidated public sector in 2011, and central government fiscal results so far have been in line with the central government’s target (of 2.1% of GDP). Yet the authorities may still use contingency measures (such as not counting some investment spending and using “savings” from last year) to achieve its target, undermining efforts to rebuild confidence in fiscal discipline.

A service of YellowBrix, Inc.

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