EVENTS

Date:	Thursday, January 22, 2004
Time:	9:00 AM -- 12:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

January 2004
Brazil: One Year after Lula

On January 1, 2003, Luis Inácio "Lula" da Silva of Brazil's Workers Party assumed the presidency. Contrary to widespread expectations, President Lula has not gone down the populist path as financial experts had feared prior to his election. Instead, he has embarked on economic policies supported by the IMF and has launched an important agenda of structural reform. Experts convened at AEI on January 22nd to take stock of Lula's political and economic achievements in his first year in office and to examine Brazil's prospects in the year ahead. 

Panel 1: The New Brazilian Political Landscape

Mark Falcoff
AEI

I would like to offer three observations regarding the Lula government in Brazil.  First, the Partido de Trabalhadores (Workers Party or PT) has had experience governing at a variety of levels in Brazil.  They have already faced the problems of budgetary constraints and social expectations.  From this experience in government, the party has become less revolutionary and more pragmatic.  Second, Lula has been willing to draw on the country's reserve of intellectual talent, and at the same time he is willing to spend political capital when he needs to, in this way-and only this way-he resembles President George W. Bush.  Third, it is obvious that Lula is going to engage in serious coalition building across party lines, partly because this is a necessity as parties are weak in Brazil.

Brazil and the United States are rivals for hemispheric leadership, and they have entirely different visions for the future of the region.  I always accept as a given that U.S.-Brazil relations will be conflictive and problematic on a wide range of subjects, not just Latin America.  Brazil sees itself as a counterweight to the United States in the region and in the world.  

Albert Fishlow
Columbia University

Brazil is by no means orthodox.  Moreover, it would be a mistake to presume that Brazil is orthodox simply because it instituted economic policies that have resulted in an interest rate decline from 25 percent when the new government took office to 16.5 percent yesterday.  The focus on reducing interest rates is universal-it is not merely a policy followed by conservatives.  I think that the major point that needs to be emphasized with regard to Brazil is that Antonio Palocci, like all ministers of finance, sees policy from a more conservative standpoint.  This has been the case in Brazil since time immemorial.  In 2004 there will be a test that will determine whether the conservative policies will continue or whether one will see more efforts at industrial policy and the use of the Brazilian Development Bank funds, the largest source of finance in the country.  All of this, however, is still unknown. There continue to be large divisions within Brazil.  Brazil has the highest levels of income inequality in the world.  Trying to deal with social problems in a coherent manner is something that Fernando Henrique Cardozo failed to do during eight years-this will be the real test for Lula: will he be able to address social problems while leaving in place the private incentive structures that encourage private investment and consequently more growth in Brazil.

The key thing that has not happened in Brazil is an increase in the domestic rate of savings.  The domestic rate of savings runs somewhere around 18 percent-this is too low to provide the rate of growth the government has promised.  It is only with a reduction in interest rates that Brazil's long-term debt position is viable.  Furthermore, a reduction in interest rates means that the government surplus can be used for savings and thus transformed into investment.  This is what Brazil desperately needs.  Brazil is going to have to deal with the major inequalities that exist within its society if it is going to have any hope of achieving its goals for the future.

Riordan Roett
Johns Hopkins SAIS

There are a number of very interesting contrasts in this administration, starting with former guerillas who are now becoming orthodox managers of policy.  Moreover, compared to previous administrations, this one has been far more successful in taking ninety deputies and the Workers Party and building around it a relatively coherent working majority in the congress.   By pulling the large but ideologically abandoned Partido do Movimento Democrático Brasileiro (Party of the Brazilian Democratic Movement) into the fold of the PT party, Lula has masterfully constructed an alliance.  Moreover, Lula understands the Brazil is a federal system-governors are important-and this has helped him to build widespread national support for the PT party.  This is the first president in decades that has an agenda and is able to build the political support required.  Brazil needs to focus on adding value to exports in a more selective manner than it currently does, and it needs to place more attention on improving the educational system and fostering entrepreneurship.  I think the Lula administration has shown the flexibility of the Brazilian political system-while ideology is present, this is not an ideologically driven administration. 

Vincent Truglia
Moody's Rating Agency

The reason we had a B2 rating of Brazil while it looked like the country was about to default on its debt was because the PT government did not frighten us, as they had been reasonably good administrators.  When we look at politics we do not really care who runs things; instead, we care about the forces at work-the fundamental things driving political parties.  In Brazil, we believe that federal politicians do not intend to be federal politicians for life.  Rather, they aspire to run state and local governments, as that is where the jobs are located and where they can hire their friends and family.

Our rating is still quite low because Brazil remains confidence-sensitive; its debt dynamics can become unstable as soon as there is any confidence shock regardless of whether it is internal or external.  Brazil's investment levels are far too low and amount to less than 16 percent of GDP, similar to aging industrial nations-not developing nations.  Brazil cannot grow at under 16 percent investment.  Moreover, there is a balance of payments constraint-as investment rises the current account will return to deficit.  In summary we have confidence-sensitive public sector debt, and confidence-sensitive balance of payments, thus growth means that a balance-of-payments constraint will emerge immediately and could cause concern about the exchange rate. 

Panel 2: Remaining Economic Challenges

John Williamson
Institute for International Economics

To discuss the fundamentals of the economic situation in Brazil we must start in the summer of 2002.  During that summer, the real went through a depreciation, which gave a kick to the inflation rate; and as the Brazilian central bank is committed to inflation targeting, it was thus obliged to raise interest rates.  That had two standard effects: the first was to create a recession that happened in the middle of last year; the second was to bring down the rate of inflation to something in the single-digits.

Up to this point Lula's constituency has not been relieved by the economic policies of the government.  Lula's constituency is not comprised of foreign investors who are relieved to get their money back.  If Lula is to be reelected in 2006, he must deliver to his constituency.  His constituency is looking for two things: a step-up in the quality of social programs and higher economic growth to generate more jobs.

I think there are several reasons to believe the market would allow interest rates to be brought lower.  First, the government has no desire to preserve a strong real in the exchange markets.  Second, one always has a high real interest rate as one emerges from a long period of inflation.  Prior to 1994, Brazil had the longest period of really high inflation of any country in history.  Third, there has been a demonstration that by not defaulting Brazil has broken with that tradition.  Finally, throughout the 1980s and 1990s there was a fear that if Lula took office he might expropriate the wealthy.  Now that Lula has indeed taken office we see that our fears were unjust. 

David De Rosa
De Rosa Associates

I am going to give you a different approach to the situation in Brazil.  I keep wondering if the guy who appears to be Lula is not a clone-while the real Lula is in a safehouse somewhere in the Amazonian jungle struggling to get out.  Then again maybe Lula pulled the old Clinton trick of running on the left and becoming centrist once in office.  If that is the case, Lula outdid any American politician in that regard.

When I look at the macroeconomic figures we all have, I see that consumer prices have begun to slow and that is why the interest rate has continued to decline.  Employment has not really budged and no significant growth has taken place.  We have tight fiscal policy with decreases in the sustained growth of the money supply-in my opinion you can kiss that growth goodbye.  One theory is that Lula is the ultimate Clinton, but I see more similarities between Lula and the Count of Monte Cristo-maybe the guy in the iron mask escaped and is going to return.  I do not believe Lula when he says that Brazil will eliminate hunger and establish a nationwide power grid.  If anything happens to the minister of finance, the curtain may come down.  That is my speech on subverting the dominant paradigm.

Phil Gerson
International Monetary Fund

In the past year the Lula administration has taken several steps with regard to economic policies.  It has shown its commitment to debt sustainability by raising the primary surplus target for 2003 to 4.25 percent and by committing to maintain that surplus over the medium term.  In addition, the central bank acted decisively in raising interest rates to control the inflationary impulse as the economy was emerging from the currency depreciation of 2002. Congress made substantial progress passing pension reform measures, which demonstrated Lula's ability to make progress on his agenda even though his party did not have a majority in the Congress.  Moreover, there was significant progress in tax and bankruptcy reform.  Lastly, the government was successful in improving the efficiency of social programs.

While it is clear a lot has been achieved in Brazil, I believe that there are three areas with remaining challenges.  The first is in crisis-proofing the Brazilian economy.  While the economy of Brazil has come back and then some from the market crisis of 2002, some of the underlying factors that made Brazil susceptible to such a crisis remain.  Second, Brazil's growth performance has been disappointing over the last several years.  Third, Brazil still suffers from extraordinary levels of poverty and income inequality, which has a tremendous social cost. 

In conclusion, it is clear that the progress last year was remarkable.  Fiscal and monetary policies remain disciplined, there was important progress on the structural reform agenda, and markets have really embraced Brazil.  Brazil's institutions were put to the test last year and by and large proved their worth.  Bearing in mind the need to remain skeptical, I think we have good reason to remain cautiously optimistic about developments in 2004 and in the medium term.

Lisa Schineller
Standard and Poors

We see a combination of cyclical and structural factors in place that should support growth moving forward:  the consolidation and reinforcement of macro-fiscal inflation-targeting policies, the movement on the reforms, and the constitutional amendments.  The creation of a coalition to pass these constitutional amendments is no easy feat.

The combination of these factors leads us to believe that we are at the point where growth could indeed be sustained, but we need more than a cyclical uptick to ensure that that happens.  There remain questions about energy sector reform, regulatory agencies, telecommunications, water, electricity, and transportation, which are important from the investor climate perspective, especially abroad.  The independence of regulatory agencies and their ability to monitor certain types of activities is crucial.  In conclusion, Brazil's tax and transfer system is not progressive-one could resolve some of the income inequality problems by revamping the tax-and-transfer system. 

Otaviano Canuto
World Bank

The sound policy choices made last year were not made by chance or as a response to the crisis.  The letter to the Brazilian people issued by President Lula expresses a vision that is coherent with the policy choices made thereafter.  The party realized that if it were to have a future it would need a policy that worked with the markets.

With regard to the debt dynamics one may bet that with the maintenance of primary surplus at the level the Brazilian government has maintained, coupled with real basic interest rates in the 8 percent to 9 percent range and growth rate in excess of 3 percent, naturally the public debt to GDP ratio will decrease in the following years.  It will necessarily become easier to keep the primary surplus with less pressure and less sacrifice than was necessary last year. 

Has Brazil come back to where it was before the last crisis?  I think not.  In 2000 the real interest rate reached a valley of 10 percent in real terms, inflation was close to the target, and the economy grew at 4 percent.  Now, we have a higher primary surplus; the public debt to GDP ratio started to climb and inflation is close to it target.  Moreover, the trade surplus and balance of payments situation is now better than it was in 2000.  The structural change has manifested itself in the improvement of the trade surplus.  Markets are pricing these factors into account, so we are not back to where we were before the crisis.

The government has promised to couple macroeconomic responsibility with social responsibility.  There are many challenges to be faced: the fiscal sustainability will not be solved by panaceas.  There are many reasons to believe that growth will be easier in the next year, and that will reinforce the willingness of the government to go ahead with further structural reforms.

AEI Intern Jason Fill prepared this summary.