Chanting and drumming as they marched, thousands of Brazilians took to the streets of Brasilia and Rio in October to protest against President Michel Temer’s economic austerity plan, PEC 241, which imposes 20-year caps on government spending in areas like public health and education. Some protesters accused Temer of “imposing his fascist and cruel capitalism” after coming to power last May, in what has been described as a parliamentary coup. Temer rose to prominence after elected president Dilma Rousseff was removed from office following an impeachment trial in the Senate.
Why does Temer’s team, which replaced the left-leaning administration of Rousseff, argue that Brazil needs to rein in its public sector deficit? What are the odds that the government’s new spending caps will actually revive foreign confidence in the Brazilian economy, which has continued to contract in 2016? What other reform measures will Brazil need to enact in order to revive the country’s growth and economic attractiveness?
As recently as 2010, Brazil’s GDP was humming along at an annual rate of 7.5%, not far below the growth rates of China and India. Last year, according to the Brazilian Institute of Geography and Statistics, Brazil’s GDP shrank by 3.8%, thanks to collapsing levels of investment, lower commodity prices and constrained government spending. For 2016, the IMF expects the economy to contract by about 3.5%. Moreover, according to its Central Bank, in 2015 Brazil’s primary budget deficit (before interest payments) – was roughly $27.29 billion, equivalent to 1.88% of its GDP. Including interest payments, it was $150.36 billion, equivalent to 10.34% of its GDP. Temer has warned that the pension system’s deficit will hit 100 billion reais ($31 billion) this year and could reach 150 billion by the end of 2017.
Felipe Monteiro, senior fellow at Wharton’s Mack Institute for Innovation Management, argues that while spending caps are painful, they are necessary for reviving Brazil’s economic health. “It is always healthy if you go to the gym [when you are not sick], rather than having to undergo drastic measures like surgery [after you are sick]. Are the drastic measures that Brazil is taking [now] the ideal solution? I don’t think so. But in the current situation, I am not sure you can avoid something as drastic as [these spending caps]. If Brazil had done its homework early on, they could probably have avoided a measure in which they would have to place a big freeze on everything. But, for many reasons, they did not do their homework. So we are at the point where, if we don’t do this, the consequences will be even worse.”
Monteiro adds that it is fair to question whether the Temer team’s austerity measures will be for “for real,” or only “for show.” During the early nineteenth century, Great Britain pressured Brazil to impose a ban on the slave trade, but Brazil continued to import slaves even though that ban was officially the law there. In Brazil, that sort of ban – nominal but not seriously intended — is still said to be the sort of measure that is “para inglês ver” – only “for the English to see.” The expression applies to any measure merely intended to create the convenient illusion that real progress is taking place. Despite the deep roots of suspicion that are commonplace in Brazilian history, Monteiro is optimistic that the austerity plan will indeed be “for real.”
However, Monteiro voices concern about the fact that “Brazil is a country of exceptions,” in which there are numerous legal exceptions to each rule. Thus, it might be said that “this provision is the law, but in the case of X situation, this provision is not applicable. And as for conditions Y and Z, this provision does not apply at all.” He explains further: “And so, something that is supposed to be straight-forward is no longer straight-forward. The entire tax system is like this.” Monteiro recalls one Brazilian executive who said there were so many exceptions to the tax regulations, he wound up employing more people in his accounting department, sorting out the complexities of the Brazilian tax code, than he hired as employees in his marketing department — despite the fact he operated in a sector that typically required a large marketing staff.
“We are at the point where, if we don’t do this, the consequences will be even worse.” –Felipe Monteiro
What does that imply for the Brazilian economy? While the new austerity measures will likely not be simply “for show,” there may remain major risks in a measure of this sort. For example: Will this measure really be applied to everyone? Or will there be so many exceptions written into this spending freeze that it becomes completely ineffective – and does little to boost confidence in the economy? It’s too early to answer such questions.
On the positive side, notes Monteiro, “Temer is a very experienced politician; he has been in the Congress forever. And his team is doing “a much better job than Dilma” Rousseff did, in terms of knowing how to negotiate and win approval for the expenditure cap. “He is much more experienced and has much better channels with the Congress than his predecessor.”
Monteiro is also optimistic about the credentials of Temer’s economic team. “The problem is not easy but at least you have credible people in those positions – well-trained and experienced. So on that front, things have a positive look.”
The Consequences of No Action
According to Monteiro, the worst-case scenario for Brazil is that the spending freeze won’t be approved — an outcome he believes is unlikely. Second-worst: It is approved but it never really takes off. “If this [freeze] doesn’t happen for real, there is a risk of a time bomb, because you just have an immense fiscal deficit that is not bearable anymore.”
Monteiro stresses the psychological importance of the budget freeze when it comes to jump-starting the revival of Brazilian growth. “There are a lot of things in Brazil that depend on what people believe — how confident people are in terms of the economy moving forward. If the level of confidence returns, it means getting foreign investors returning and investing in the infrastructure. I think economic growth will come back, but it really depends on the confidence people have about whether the government will be able to implement tough measures.”
As for the leftist opposition, Monteiro says that in recent municipal elections, the labor party “was the big loser all over the country. Today, those supporters are really a minority. Obviously there is a concern that Temer needs to have an open channel with other parties; he cannot rule with just one or two. There are so many other political parties in Brazil. Whatever he is doing in terms of austerity measures will not mean that all of the social programs that Brazil did in the past are to be discontinued [under Temer].” Temer’s leftist opponents circulated “big propaganda” to the effect that Temer would revoke all the socialist programs currently undertaken by the government, but “I don’t think that’s what he wants to do. Yet it is important that he provides those reassurances” about his intentions when he communicates to other political parties and to the public, Monteiro notes.
Still, there are two reasons why the government’s austerity initiatives could potentially represent a setback to efforts to alleviate the plight of Brazil’s poorest communities, argues Monteiro. First, if Temer makes cuts in social programs, but there are exceptions for the wealthiest segment of the population – such as Congressmen – “then you are going to have an increase in income inequality. That’s why when the government says that its austerity efforts involve everyone, it has to be for everyone,” so that the spending caps don’t wind up increasing social inequality.
“Brazil approved these Draconian measures at a time when the rest of the world is being extremely flexible.” –Lourdes Casanova
Second, adds Monteiro, it is important for the government to enact financially sound measures that reduce inequality in a sustainable way, over time. “It’s one thing right to do what the previous government did — there were a number of good programs.” But if you do more than you can really afford over the long term, those programs will create expectations that are inevitably thwarted, despite your best intentions. “You need to take measures that don’t just work on a temporary basis,” but are affordable and effective over the long haul, he points out.
Lourdes Casanova, academic director of the Emerging Markets Institute at Cornell University’s Johnson School of Business, takes a somewhat different approach to the challenges of the Temer government’s austerity plan. “We are in a world that is a bit strange. Nowadays, we have the U.S. and Europe with interest rates that are close to zero and unusual measures like central banks that are printing money.… And in this context, we have a country like Brazil with the highest interest rates in the world after Venezuela, with a lot of difficulty finding financing for its local economy – with corruption and scandals that have left the private sector completely depleted. And a new government that is trying, among other things, to bring back [economic] orthodoxy in a world where orthodoxy does not exist any more because all those countries that were imposing orthodoxy measures [in the mold of] the Washington Consensus are not doing it themselves [now].” (The Washington Consensus was a set of economic policy prescriptions considered to constitute the standard reform package promoted for crisis-ridden developing countries by Washington, D.C.–based institutions such as the International Monetary Fund, World Bank, and the U.S. Treasury Department.)
Casanova adds, “I am a little bit skeptical of these austerity measures. I think we are in a moment in which all countries are looking for flexibility…. Brazil approved these Draconian measures at a time when the rest of the world is being extremely flexible. How can you apply these twenty-year measures in an emerging country where we know that volatility is the name of the game, and governments have to go through very volatile times and adjust [to changing conditions]? I think it is going to be too strict a [strait] jacket for [the next] 20 years, when you don’t know what the needs of the country will be for next year — let alone, for five, ten or fifteen years down the road.”
Brazil is a welfare state in an emerging market, Casanova points out. “When it comes to reform measures, one of the low hanging fruits everybody mentions is the [system of] pensions; of course, a country like Brazil cannot afford to have government officials retiring very early. There is a consensus in the population that these measures need to implemented, but what was approved [the freeze in mid-October] was a little bit too far-fetched.”
Casanova notes that following the country’s lengthy recession and period of political disarray, many “Brazilians are sick and tired; people cannot react any more.” Many Brazilians have a hard time making ends meet. “So in this situation, there is some fatigue. These measures have been too strict. Governments have a role to play; let’s not forget about that. They have to be flexible; have to help the private sector find solutions for the country. The prices of commodities are cyclical; a new cycle will arrive, but we don’t know when. So if the country is going well, why freeze investments that are key for the prosperity of the country for the long run?”
A ‘Double Malaise’
Otaviano Canuto, executive director at the board of the World Bank for Brazil, Colombia, Dominican Republic, Ecuador, Haiti, Panama, Philippines, Suriname and Trinidad & Tobago, believes that “a double malaise” has been ailing the Brazilian economy.
“A medium-term fiscal adjustment — to be supported by measures to raise the pace of productivity increases — is essential to return to inclusive growth.” –Otavio Canuto
Moving beyond measures to address the country’s burgeoning fiscal deficit, Canuto says that Brazil has been suffering from anemic productivity growth. “This is a major challenge because in the long run, sustained productivity increases are necessary to underpin inclusive economic growth. Without them, increases in real labor earnings tend to conflict with global competitiveness; collecting taxes … becomes a heavy burden; returns to private investment become harder to achieve; and ultimately, citizens will have less access to high-quality goods and services at affordable prices.”
Canuto maintains that the focus on urgent fiscal reform adopted by the Temer government “must be accompanied by action on the productivity front.” Unfortunately, “Brazil’s recent social and economic progress was achieved without major productivity growth. Both minimum and average wages rose a lot faster than labor productivity, and employment moved toward sectors with few opportunities for productivity growth.”
According to the World Bank, Brazil’s Total Factor Productivity (TFP) increased at an annual rate of 0.3% from 2002 to 2014 but by only 0.4% per year during the boom years from 2002 to 2010. Thus, “two-thirds of Brazil’s GDP increase can be accounted for by higher quantity and quality of labor being incorporated in the economy. Only 10% can be attributed to TFP gains,” Canuto notes. “It is now widely accepted that a systematic increase in Brazil’s labor productivity and TFP will be needed if the growth-with-social-inclusion that prevailed in the 2000s is to return.”
But how can Brazil come up with these productivity improvements? One obvious source of productivity gains is infrastructure. According to the World Bank, the rate of infrastructure investment that is simply needed to offset depreciation has been estimated to be in the order of 3% of GDP, but total investment in Brazil’s infrastructure has been lower than 2.5% of its annual GDP since at least 2000.
“The combination of anemic productivity increases and a substantial growth in public expenditures oriented toward government transfers (pensions, social programs) — and real wages rising faster than productivity during the growth-cum-poverty-reduction cycle — was sustainable only while external conditions were highly favorable,” Canuto says. “Now, a medium-term fiscal adjustment — to be supported by measures to raise the pace of productivity increases — has become essential to return to inclusive growth.”