The Reform Process in Brazil. Examining the Roots of the economic stability and performance of Latin America’s largest country

Seminar Paper, 2009

55 Pages, Grade: 1,3


Table of Content

List of figures and tables

List of abbreviations

1. Introduction

2. The Real Plan - The origin of macroeconomic stability
2.1. Introduction of the Real Plan and its consequences
2.2. Brazil under Lula and the financial crisis

3. Drivers of the economic growth: In-depth analysis of the economic sectors
3.1. The agricultural sector
3.2. The industrial sector
3.3. The service sector
3.4. Trade and domestic demand

4. Implications for Brazil’s economic future - Analysis of necessary conditions for growth

5. Conclusion



List of figures and tables

Figure 1: Current account of Brazil

Figure 2: US$ to R$ exchange rates

Figure 3: Public debt (country comparison)

Figure 4: Brazilian federal tax revenues

Figure 5: Brazil’s GINI-coefficient of inequality

Figure 6: BOVESPA index

Figure 7: Prime interest rate

Figure 8: Bank-capital adequacy: Brazil’s performance compared to the Basel Index .

Figure 9: Industrial capacity utilization

Figure 10: Composition of Brazil’s GDP

Figure 11: Composition of Brazil’s total labor force

Figure 12: Brazilian service sector’s share of the GDP

Figure 13: HNWI population growth in 2007 (country comparison)

Figure 14: Composition of China’s GDP and total labor force

Figure 15: Import, export and trade surplus

Figure 16: Support of Lula and his policies

Table 1: Automotive sales (country comparison)

Table 2: Brazil’s PISA results

List of abbrevations

illustration not visible in this excerpt

1. Introduction

In 2003 Jim O’Neill, the head of global economic research at Goldman Sachs, coined the term BRICs to refer to four countries whose economies will be larger than the G6 in US Dollar terms by 2050 (Goldman Sachs 2003). The “B” in BRIC stands for Brazil. Brazil is today’s fifth largest country in the world with an abundance of natural resources that is unique on the planet. Its role in a future globalized world is predetermined; Brazil is going to be the number one supplier of “hard” and also “soft” commodities for the rest of the world. However, since O’Neill referred to Brazil as one of the most promising economies of the future, Brazil has not been able to live up to the expectations. In terms of GDP growth Brazil has lagged behind the other three promising countries - Russia, India and China - but now after all Brazil “is beginning to deliver” (Prideaux 2009). In the light of the world’s worst recession since the Great Depression, Brazil has shown that its economic policy in the past with the object to ensure macroeconomic stability, but at the cost of mediocre or rather low economic growth, was right and will permit Brazil to reap the rewards for the hard work in the past.

This paper analyzes the path that Brazil’s economy has taken to reach today’s status; the status of a stable economy that shows high potential to meet the challenging expectations that economists set on it. The idea is to source the roots of the economic stability and performance of Latin America’s largest country and to highlight the implications it will have in the near and remote future.

Chapter 2 focuses on the Real Plan launched in 1994. A set of reforms which transformed Brazil’s economy from a protected economy facing four-digit inflation rates into a stable economy capable of competing with developed economies. It discusses the implementation of the Real Plan, its measures and its positive and negative consequences for the Brazilian economy.

Furthermore we are going to deal with the recent past of Brazil’s economy since the presidential elections in 2002, when the leader of the workers’ party Lula da Silva was elected. We focus on the economic policy of the president and its government, whose election has almost led to the default of the Brazilian state because financial markets were afraid that the socialist candidate would pursue a 180 degree turn compared to the neoliberal economic policy of his predecessor. We analyze why Joao Miguel Rodrigues, Christian Sprinkmeyer Brazil was one of the last countries being affected by the financial crisis and why it was one of the first to leave it behind.

Chapter 3 analyzes on the one hand the agricultural, the industrial and the service sector and on the other hand the trade and the domestic demand in Brazil. First of all we will clearly show the development of the three economic sectors until today and point out their influences on each other. In this context we will search for reasons for the strongly growing service sector and for the decreasing economic relevance of the agricultural and the industrial service sector. But of course we cannot neglect those two sectors in the Brazilian economy. Thus, we will clearly point out why the agriculture and the industry are indispensable for Brazil’s economy, although their share of the GDP has extremely lost ground against the one of the service sector over the last years. After this we will discuss the development of Brazil’s trade and domestic demand until today. Again the agriculture will play an important role due to the fact that Brazil’s commodities are extremely demanded abroad. But this increased demand is not only a benefit; it also bears several dangers, which we will have a closer look on, too.

The fourth chapter of this paper evaluates the future potential of Brazil. The basis for this section is an analysis of the four conditions for growth mentioned by Goldman Sachs (2003). Will Brazil be able to meet Goldman Sachs’ expectations? What are strengths and weaknesses of the economy and which opportunities and threats await Brazil on its path to 2050 (Goldman Sachs 2003)? Does Brazil possess the necessary macroeconomic stability necessary to support high level GDP growth rates? Will Brazil finally open itself for more trade and profit from its abundance of natural resources? What about the efficiency and stability of political institutions? How is the current level of education, which is extremely important regarding labour productivity? Answers to these questions and consequently a general outlook into Brazil’s future will be provided in this part of our paper.

After our analysis we are going to state our opinion about whether we have to be prepared for a new superpower called Brazil. What will be Brazil’s role in a globalized world and how did it develop? And finally, does Brazil deserve to be the “B” in the BRICs or was it to hasty of Goldman Sachs to add Brazil to the group of countries whose economies will together be larger than the G6 by 2050?

2. The Real Plan - The origin of macroeconomic stability

2.1. Implementation of the Real Plan - Analysis of measures and consequences

Since the 1950’s the Brazilian economy was mainly characterized by high inflation rates. These gradually increased to reach the value of 2477% yearly inflation in 1993 (Werneck 2008). Since the end of military dictatorship 1985, the main goal of Brazilian economic policy was to fight inflation. New currencies were introduced in 1984, 1989, 1990 and 1993, several action plans were executed, but until 1994 all measures to accomplish the aim of lowering inflation were effectless (Abreu 2004). When minister of foreign affairs Fernando Henrique Cardoso was appointed finance minister by President Itamar Franco in May 1993, nobody really thought that the 4th finance minister within 8 months would be able to successfully control the inflation (Werneck 2008). Today there is no doubt that Cardoso did not only manage to lower inflation to a historical low level, but he also paved the way for the economic success of the world’s 5th largest country in the first decade of the 21st century by making the Brazilian economy able to compete on world market and stabilizing it. With the help of a group of economists from the PUC-Rio he developed the Real Plan which aimed to solve the three most severe problems of the Brazilian economy: These were “inflation, inflation and inflation”. (Werneck 2008) Cardoso and his panel of experts identified two chief causes for the extreme high inflation in Brazil. On the one hand the high budget deficit of the Brazilian state and on the other hand the indexation of all monetary values to the inflation.

The Brazilian state was highly indebted. 1984 public debt was 50% of GDP mainly because of a growth program started in 1970 and the both oil crises in the beginning and end of the 1970’s. In 1964 the military dictatorship had already decided to peg debt and wages to inflation, as it had become difficult to attract creditors given high inflation rates. Henceforward all wages and prices were indexed to the inflation and led to a wage and price spiral and to inertial inflation as prices and wages depended heavily on the expected inflation. Indexation seemed inevitable, but even worsened the problem of inflation (Goldfajn 1998).

The Real Plan was organized in three stages (Abreu 2004). The first stage started in the end of 1993 and aimed to solve the budget deficit of the Brazilian state. The following measures were taken in order to reach a budget equilibrium: All federal taxes were increased 5 percentage points, extensive savings amounting to $ 7bn were determined and the „Fundo Social de Emergencia“ was founded into which 15% of all tax earnings were paid to compensate future budget deficits. Furthermore, Cardoso wanted to privatize state-owned companies, but this proved to be harder than expected, as this plan had to be accepted by the Brazilian parliament. This is why Cardoso first started to abolish monopolies of state-owned companies and resumed the privatization of state-owned companies in a later stage.

The second stage of the Real Plan started on March 1st, 1994 by the introduction of the Unidade Real de Valor (URV). This unit was pegged 1:1 to the US Dollar. All prices started to be declared in the official currency “Cruzeiro Real” and in the new URV. Money of payment was still the Cruzeiro Real and prices declared in Cruzeiro Real continued to change daily according to inflation. However, the URV did not change as it was indexed to the US Dollar. This had a psychological effect on the consumers and the problem of inertial inflation was addressed; in various action plans in the past, governments had tried to address this problem through wage and price stops without success. (Abreu 2004) The third and last stage of the Real Plan was the currency reform on July 1st, 1994. The Real was introduced as the new money of payment. It was pegged 1:1 to the URV and thus pegged 1:1 to the US Dollar. If the Real lost value with respect to the US Dollar, the Brazilian central bank would intervene in favour of the Real. If the Real gained value against the US Dollar, the Brazilian central bank did not act, but let market forces work. The management of the money supply was regulated by law.

The required reserve ratio for banks was raised and consequently led to an increase of the real interest rate. This had already been very high compared to other countries so that the Real gained 15% value in the first months after the currency reform because of the increased volume of capital imports. The overvalued Real had outrageous effects on the trade balance and the high real interest rate had a tremendous effect on investments inside Brazil which we will discuss later on.

Now we want to focus on the Real Plan’s consequences on the inflation rate. It was able to reduce the inflation rate significantly compared to the past months, years and decades. Unfortunately compared to other developed countries, it still was relatively high, leading to a further appreciation of the Real. Cardoso won the presidential elections in October 1994 against today’s President Lula. Cardoso’s victory was mainly due to the mobilization of the lower class, who originally wanted to vote for the socialist candidate Lula. He managed to gain their votes by decreasing inflation, which affected especially the lower class. (Busch 2009b) A large part of the lower class did not have a bank account and was therefore fully exposed to the depreciation of their money. By reducing inflation Cardoso basically increased the real income of these people who thanked him by voting him. From one day to another the domestic market had millions of new customers who earlier were excluded because of inflation. Payment by instalments was made possible through the reduction of inflation and caused a demand boom on the domestic market. In view of this demand boom, there was the substantially danger to lose the just gained price stability as the Brazilian industry was not prepared for this high demand and hence supply was not sufficient to meet it. Given this potential danger the Brazilian government decided to implement following two measures to face them. On the one hand it increased the reserve requirement ratio to reduce liquidity in the market and hence reduce demand. On the other hand the government abolished the protectionism of the Brazilian economy which prevailed since the 1950’s to fight the potential lack of supply through imports. Until 1994 the Brazilian economy had been one of the most closed economies on earth. Brazil had followed an economic policy known as import substitution industrialization1 since the Great Depression. This economic policy requested the protection of the own industries from imports from other countries. The Brazilian government protected their industries by introducing high import tariffs and even prohibitions of many imports. (Abreu 2000) This policy of protection was maintained until the introduction of the Real Plan in 1994. The average import tariff dropped from 32.2% of the import’s value in 1990 to 12.5% in September of 1994 (Abreu 2004). This opening of the Brazilian domestic market in combination with an overvalued Real has already led to a current account deficit in 1994. (See appendix: Figure 1) Cardoso successfully fought the inflation, but he clearly failed in consolidating the public budget. On the contrary, the budget deficit even increased. The reason for the increase of the deficit was the rise of the real interest rate since the implementation of the Real Plan. Higher real interest rate made credits dearer for the state and consequently public indebtedness increased after the Real Plan. The package of measures introduced to lower the budget deficit in the end of 1993 showed no effect resulting in the implementation of new measures in 1996. These included further increase of tax rates until 1999, a special tax on financial transactions and lower transfers to the states. Furthermore, privatizations of state-owned companies gained more importance. The earnings of these privatizations were used to rebuy government bonds and as the state-owned companies were preferably sold to foreign investors, the government was also able to get the necessary currency reserves to stabilize the Real. (Abreu/Werneck 2005)

As noted before the current account was in deficit after the implementation of the Real Plan as a result of the increased value of imports. The Brazilian government answered this problem by attracting more foreign investors. The strategy was to balance the current account deficit with capital imports. A risky strategy, because every upcoming doubt about the stability of the Brazilian economy led to capital flight and consequently Brazil was extremely vulnerable with regard to external shocks. The first time Brazil’s economy was a victim of such an external shock was in 1995. The Mexican crisis had as a consequence that foreign investors withdraw capital from Brazil. The measures taken by the government during this first crisis became more or less typical for all future crises affecting Brazil and leading to capital flight. The central bank used its currency reserves to intervene in favour of the Real and to maintain the pegging of the Real to the US Dollar. Because this measure did not prove to have the desired effect, the government determined a package of measures to on the one hand reduce the current account deficit and on the other hand attract capital inflows. The real interest rates were raised to attract foreign investors as well as to reduce the domestic demand. Moreover the opening of the Brazilian economy that had taken place only a year ago was a bit reversed by increasing the import tariffs and by introducing import quota for the by then most demanded import goods - cars and white goods.2 The Real devalued 5.7% and a band width within which the Real was able to float freely was introduced.

The most effective measure was the restrictive monetary policy. The current account deficit decreased and the capital imports increased and even exceeded the current account deficit. In fact the GDP growth was abruptly reduced, but Cardoso always pointed out that he could rather live with low GDP growth than with an increase of inflation. (Werneck 2008)

High real interest rates which ought to increase capital imports, at the same time affected Brazilian companies heavily. Domestic demand was decreased. In other words higher interest rates decreased revenues and increased interest expenses for Brazilian companies. Additionally the opening of the Brazilian economy for imports in combination with an overvalued Real affected the Brazilian companies negatively. The pressure of competition was aggravated. The imported products were cheaper than the Brazilian products, because foreign companies produced with higher productivity. Until the opening of the economy Brazilian companies did not strive for productivity improvements due to the protectionism supported by the government. The Brazilian corporates had backlog regarding productivity. (Busch 2009b) Because of the high real interest rates increasing the productivity by investing in more modern technologies was only an option for few Brazilian companies. A clear trend was observable that companies borrowed increasingly money abroad. This put pressure on the government to not let the Real devaluate. But all in all, the main measure to improve productivity was the suspension of staff, which resulted in a higher unemployment rate. Many companies had to file for insolvency due to these tremendous changed circumstances.

In spite of the overvalued Real, exports increased after the introduction of the Real Plan. Not only agricultural goods but also cars were exported especially to other Latin American countries. Compared to the growth of imports the export’s growth was relatively low, resulting in the fact that the current account deficit prevailed throughout the 90’s.

However, a big deficit of the economy was its external vulnerability. Every time the financial markets started to doubt the stability of Brazil’s economy, capital flight was the consequence. But capital inflows were necessary to fight the current account deficit and consequently to support the indexed Real. So to attract foreign investors the central bank increased the interest rates during critical situations. They did so during the Mexican crisis, the Asia crisis and the Russia crisis more or less successfully, but in January 1999 when the Brazilian state Minas Gerais declared that it would not be able to service its debt for the next three months, the capital flight was so intense that the government had to undo the indexation of the Real to the US Dollar. In 1999 the Real depreciated extremely resulting in an even higher foreign indebtedness of the state. Given this Cardoso had no excuses anymore. He had to manage the enormous budget deficit and the public indebtedness. A new stabilization plan was enforced that aimed to re-establish fiscal sustainability, to assure that the external accounts could cope with the new situation of a free floating Real and to keep inflation under control given the high depreciation of the Real. Surprisingly, the inflation rate did not increase as expected and in addition doubts about the challenging plan to fight the budget deficit were reduced. Optimism led to an appreciation of the Real and rising foreign capital inflows. This in turn gave the central bank the opportunity to reduce interest rates and the fears that GDP would fall 4 percent in 1999 vanished. The GDP even grew 0.8% in 1999 and the expectation that public debt would increase as a consequence of the depreciated Real did not come true.

In 2000 the US Dollar/Real exchange rate was 30 percent below its nominal level before the devaluation. (See appendix: Figure 2) However, the effect on exports was not as positive as expected. Increasing taxes led to a primary surplus of 3.3% of GDP in 2000 and not only this was a success of the macroeconomic policy, but also the GDP growth rate reached 4.4% in 2000. Despite the turbulences after January 1999, one can definitely say that the new stabilization plan, especially the law that a primary surplus has to be achieved by every Brazilian state and the government itself, had a very positive effect on the Brazilian economy. Despite the negative effects for the economic growth, we think the Real Plan set up the foundation for Brazil macroeconomic stability which is - as we will point out in the second part of this chapter- an important aspect why Brazil has not suffered from the ongoing recession. Pegging the local currency to the US Dollar and high real interest rates have overcome the problem of inflation. The opening of the economy has made Brazil more interesting for foreign investors and at the same time forced the local economy to productivity improvements resulting in the fact that today Brazilian companies are capable of competing with foreign competitors. (Busch 2009b) After 1999 the foreign public debt -the reason for Brazil external vulnerability- was able to be reduced significantly. This in turn reduced the country’s external vulnerability.

2.2. Brazil under Lula and Brazil’s performance within the financial crisis

In this chapter we want to deal with the economic policy under the Lula administration. 2002 Luiz Inácio Lula da Silva was elected and succeeded Cardoso as president. Previous to his election Brazil’s economy again was hit hard by fears about its stability. There were in particular three reason for the crisis in 2002 during which the Real depreciated significantly and the exchange rate to the US Dollar was 3.53. (Fritz 2003) First of all Brazil was not untroubled by the general doubts about the world economy after the happenings of 9/11. Secondly, the fear about Argentina’s default contributed to a lack of trust in the Brazilian economy. But the factor that contributed most to the crisis in 2002 was the fear of a possible victory of the socialist candidate Lula in the presidential elections. During the spring of 2002 it became more and more obvious that Lula would win the elections in October 2002. Until then many people still thought that one of the government-supported candidates would be able to beat Lula in the finishing campaign. These hopes vanished after one of the candidates was involved in a corruption scandal and the other just did not manage to get enough support from the Brazilian population. (Abreu/Werneck 2005) So as Lula’s victory was becoming increasingly obvious, the financial markets were confronted with speculations about a turnaround of the Brazilian economic policy. The fear was that Lula as a president would adopt a completely different economic policy than Cardoso did before. The fear of a possible default on foreign debt was tremendously and led to an extreme capital flight. The exchange rate which was at R$2.4/US$ in early March reached the 3.4 mark in the end of July, after the currency had lost 30% of its value. All attempts to calm down speculations were in vain. Lula himself even tried to calm down the financial turmoil by statements clearly indicating that he would not change the current economic policy under Cardoso. But financial markets were still unconvinced. (Abreu/Werneck 2005) The misgivings the workers’ party (PT) candidate Lula would not be capable of managing Brazil’s economy, because of his lack of experience and his bondage to populist policymaking did not decrease until the Election Day. (Fritz 2003)

Contrary to all the fears, Lula maintained the economic policies introduced by Cardoso. Lula continued with the austerity introduced in 1999 under Cardoso and even managed to increase the primary surplus of the state. (Fritz 2003) A high inflation rate threatening the economy due to the enormous depreciation of the real was successfully avoided by the central bank raising the key interest rate. These measures successfully led to the fact that financial markets did not distrust Lula anymore. The Real appreciated rapidly after Lula took office in January 2003.

Until today Lula has not changed his economic policy and is reaping the fruits of the past by doing nothing else than maintaining Cardoso’s economic policy. Due to a difficult economic environment and many economic crises affecting Brazil’s economy, it was difficult for the country’s economy under the Cardoso administration to grow substantially and meeting its expectations. Increasing commodity prices, easier access to credit for private households and a sound economic environment since Lula’s election in 2002 have contributed to higher GDP growth rates, compared to the time after the implementation of the Real Plan and during Cardoso’s second term. However, the growth rates during the first term of the Lula administration were not as analysts had expected (Goldman Sachs 2003). All in all we must say that the measures taken since 1994 aimed at achieving macroeconomic stability rather than economic growth. From 1994 to 1999 an overvalued Real and high real interest rates were used to control inflation - as already mentioned - with negative effects on the internal demand, but positive effects on the foreign capital inflows. The opening of the economy led to losses by the domestic industry. The effects on the current account and public budget were terrible. From 1999 on the new stabilization program aimed at limiting the debt and keeping inflation at low levels. The achieved primary surpluses were used by the government to pay off debt leading to the fact that Brazil was able to reduce its ratio of debt to GDP to 36.9%. (See appendix: Figure 3) Of course, this economic policy did not promote growth at all. The economic growth of the country remained very low respectively moderate. (de Oliveira et al. 2007)

Since 1999 the primary surpluses had been achieved by two measures. On the one hand by raising taxes and on the other hand by cutting public expenditures. High taxes led to unfavourable conditions for investors and it decreased demand by reducing the disposable income of the population. Between 1998 and 2006 the tax burden rose from 29.7% to 38% of the GDP. Cuts in public expenditures did not favour growth either. Especially the necessary investments in infrastructure, social security, health and education were neglected in order to meet the state’s financial obligations since 1994. From 2002 to 2006 the ratio of public investments to GDP decreased from 1% to 0.5% (Goldman Sachs 2006). Higher growth rates are not able to be achieved by such a policy of low investments. However, Cardoso and Lula always pointed out that economic stability is the number one priority and that economic growth will follow. During the first term of the Lula administration the Brazilian economy has grown at 2.7% on average (Goldman Sachs 2006). During the campaign for the presidential elections in 2006, Lula had already promised his population to start implementing economic policies that would boost demand during his second term as president (Goldman Sachs 2006). Consequently in the end of January 2007, the Lula administration announced the start of the PAC. This set of measures aimed at accelerating the economic growth during the second term of Lula’s administration and more concrete to achieve a growth of at least 5% from 2008 on. Until 2010 R$500bn had to be invested in infrastructure projects. There were doubts whether the government would realize this ambitious program and until the last quarter of 2007 these doubts remained, but beginning in the end of 2007 Brazil started to look like a giant construction site. The reason why the effect of the PAC was not immediately perceived was that it was more difficult than expected to design and implement projects and that especially the intended tax reduction required parliament’s approval. (Hofmeister 2008) PAC, again increasing commodity prices and an increasing middle class that had easy access to consumer debt led to a GDP growth of 5.4% in 2007. This economic growth was also perceived by the population (GDP per capita growth of 4% in 2007) resulting in a high satisfaction with Lula among the population. Household consumption grew at 6.5%, foreign debt and unemployment were significantly decreased. Finally the process to stabilize the economy started to pay off in 2007. Given this very good state of the economy, the government’s tax revenues increased 20% in 2007 compared to the year before. (Hofmeister 2008) (See appendix: Figure 4)

Since Lula took office in 2003 he was also able to reduce the inequality in terms of allocation of wealth in the country. The GINI index was able to be reduced significantly. (See appendix: Figure 5) The most famous program to improve the standard of living of the large amount of poor Brazilians was “Bolsa Familia”. This program successfully improved the financial situations of 11.5 million families. Steadily increasing the minimum wage also had a tremendous effect on the income situation of many Brazilians. All these positive effects were good signs for foreign investor resulting in a steady appreciation of the Real since Lula took office in 2003. The current accounts have always been positive since 2003 (See appendix: Figure 1) also supporting the appreciation of the Brazilian currency. (See appendix: Figure 2)


1 For detailed information see Abreu (2000) and Beck (1999)

2 These measures to “close“ the Brazilian economy were undone again shortly after their introduction, because the WTO put pressure on the government.

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The Reform Process in Brazil. Examining the Roots of the economic stability and performance of Latin America’s largest country
Otto Beisheim School of Management Vallendar
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Lula, Cardoso, Brazil, Brasilien, Reform process, BRIC, sector analysis, financial crisis, developing country, Emerging markets, Economic challenges
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Christian Sprinkmeyer (Author)Joao Miguel Rodrigues (Author), 2009, The Reform Process in Brazil. Examining the Roots of the economic stability and performance of Latin America’s largest country, Munich, GRIN Verlag,


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