What’s Ailing the Brazilian Economy?

Capital Finance International, Autumn 2016

Brazil’s GDP is poised to decline by close to 7% in 2015-2016. Per capita GDP in 2016 is likely to shrink by more than 10% as compared to three years ago. We argue here that a double malaise has been ailing the Brazilian economy: given an anaemia of productivity increases, an appetite for public spending without prioritisation has led to a condition of fiscal obesity. We further approach why market reactions to the Brazilian government’s proposal of crisis response have been positive.

Brazil has been suffering from anaemic productivity growth. This is a major challenge because in the long run, sustained productivity increases are necessary to underpin inclusive economic growth. Without these, increases in real labour earnings tend to conflict with global competitiveness; collecting taxes in order to fund government expenditure on infrastructure and social policies becomes a heavy burden; returns to private investment becomes harder to achieve; and ultimately citizens will have less access to high quality goods and services at affordable prices. The focus on urgent fiscal reforms adopted by the new government – public spending cap, social security reform, etc. – must be accompanied by action on the productivity front.

“It is now widely accepted that a systematic increase in Brazil’s labour productivity and TFP will be needed if the growth-with-social-inclusion that prevailed in the 2000s is to return.”

Brazil’s recent social and economic progress was achieved without major productivity growth. Both minimum and average wages rose a lot faster than labour productivity, and employment moved toward sectors with few opportunities for productivity growth (see chart 1).

According to estimates reported by the World Bank, Brazil’s total factor productivity (TFP) increased at an annual rate of 0.3% from 2002 to 2014 – and only 0.4% p.a. during the roaring years from 2002 to 2010. Two-thirds of Brazil’s GDP increase can be accounted for by higher quantity and quality of labour being incorporated in the economy. Only 10% can be attributed to TFP gains.

Demographic trends – a growing working-age population – leading to labour force growth were responsible for 1.1 percentage points of annual GDP growth in 2002-2010, while increases in labour force participation, especially among women contributed about 0.6 percentage points. Better access to education accounted for about 0.7 percentage points of average growth in the same period.

Since the investment-to-GDP ratio remained at or below 20%, it is not surprising that growth in the capital stock contributed only about 0.9 percentage points to growth on average. In labour productivity, Brazil lagged behind most of its peers over the period.

It is now widely accepted that a systematic increase in Brazil’s labour 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. In addition to being a source of gross fixed capital formation, sustainable investments in infrastructure would alleviate bottlenecks that became increasingly tight as the economy expanded: “For at least the past two decades, investment in infrastructure in Brazil has been below the rate of natural depreciation. The rate of infrastructure investment needed simply to offset depreciation has been estimated to be of the order of 3 percent of GDP. In Brazil, total investment in infrastructure has been less than 2.5 percent of GDP annually at least since 2000.”

As illustrated in the World Bank report, substantial negative effects in terms of wasted resources – labour time, misallocation of resources, product loss etc. – are derived from the insufficient investment in infrastructure and the bad state of energy supply and connectivity such as transport, logistics, and ICT (see chart 2). Reducing the waste of resources through more and better investments in those areas would result not only in direct productivity gains, but would also induce private investment in other sectors.

Additionally, horizontal productivity gains could be achieved in the private sector by improving Brazil’s business environment. The Doing Business Report, prepared annually by the World Bank for 189 countries, has indicated year after year how a typical Brazilian company is obliged to spend human and material resources on activities that do not generate value because of the difficulties and costs associated with starting a business, registering a property, getting credit, paying taxes, and enforcing contracts. The negative consequences for productivity are three-fold: it subtracts productivity at both enterprise and macroeconomic levels; it stifles competition as it raises barriers to entry and to the contestability of markets, especially for smaller firms that are unable to dilute the costs of doing business through scales; and it stimulates informality.

The Brazilian business environment is especially unfriendly to investments and technological learning obtained through foreign trade (see chart 3 on the right). Transaction costs and difficulties to access technologies, equipment, and supplies from abroad limit innovation, productivity increases, and competitiveness. Investments in logistics infrastructure would help, but an evaluation of the costs of the complex structure of tariff and non-tariff barriers – like local-content requirements – embedded in trade protectionism is also needed. Brazil has become an unusually closed economy as measured by trade penetration and the opportunity cost of failing to open its economy has risen dramatically in the recent past. Not by chance, foreign direct investment is mostly aimed at accessing Brazil’s large domestic market, rather than seeking efficiency in production.

Access to finance is another aspect of the Brazilian business environment limiting productivity growth. Finance for long-term projects and for small- and-medium enterprises (SMEs) is limited – except for a small group of preferred enterprises with access to government subsidised credit.

In most of its dimensions, Brazil’s business environment not only takes a toll in terms of waste in the use of resources, but also fails not create incentives towards innovative, technology-adaptive, productivity-enhancing corporate behaviour. Lack of competition is part of the problem:

“Compared to other emerging markets, Brazil has a wider dispersion of productivity levels across firms and a larger number of low-productivity firms. Large gains could be made in aggregate TFP if physical and human capital were reallocated in a way that allowed more-productive firms to grow and the least-productive ones to shrink or exit. High firm dispersion in Brazil suggests market and policy failures that create an uneven playing field for firms, negatively affecting the entry and expansion of more-efficient firms and the exit of less-efficient ones.”

The window of opportunity opened by the on-going corruption scandals will be used to upgrade governance in the interface between public and private sectors, with many gains such as: improved rule of law and corporate governance, resulting in lower risk perceptions; improved competition and market discipline in key sectors, particularly those bidding for public projects; and cutting out wide-spread kickbacks that will reduce both public overspending and the notorious Brazil Cost (Custo Brasil) born by the private sector.

Besides infrastructure investments and addressing the business environment, a third obvious source of systematic productivity gains would come from better and more accessible continuing education and skill acquisition by workers. Despite improvements in quantity and quality of education over the last decade, there remains the legacy of a long history of educational neglect with respect to large swaths of the population that accompanied the non-inclusive nature of Brazil’s economic progress over the previous century.

Even as Brazil achieved upper middle income status and captured higher positions on some global value chains – such as technology-intensive agriculture, sophisticated deep-sea oil drilling, and the aircraft industry – a substantial share of the population remained mired in poverty. With inadequate education, poor health conditions, and a lack of on-the-job training preventing many workers from increasing their productivity, Brazil’s potential economic growth has been compromised. Provided that the country manages to return to a comprehensive poverty reduction path which includes improved access to healthcare, financial services, and education Brazil’s overall productivity could improve in the coming years.

Lack of Priorities in Public Spending

The anaemic productivity increases in the last decades have taken place while a political desire to finally come to terms with the poverty and inequality has also been exercised. Such a political desire, after the return to democracy, translated into a large role for the public sector, along which primary government expenditures as a proportion of GDP rose from 22% in 1991 to 36% in 2014.

The uptick of public spending took place with increased earmarking of tax revenues and the ability of interest groups to maintain existing privileges. It was matched by a rising tax burden based on levies on consumption and also dependent on rising levels of formalisation in the labour market. When the conditions that allowed for the growth-cum-poverty-reduction experience of 2003-2010 exhausted, the aftereffects of the fiscal pro-activeness on the economy became hard to trim.

Had productivity risen more than it did, the demand on government services in absolute terms would have meant less of a share of GDP and of a tax burden on the private sector. On the other hand, the run-up to a fiscal overweight condition was pushed forward and postponed as the boom of the new millennium unfolded.

Indeed, even without substantial productivity gains, the Brazilian economy went through a period of macroeconomic stability and economic growth-cum-poverty-reduction in the first decade of new millennium. The preservation of the economic policy tripod – inflation targeting, floating exchange rates, and significant government primary surpluses – along the transition from President Fernando Henrique Cardoso to President Luiz Inácio Lula da Silva led to substantial stabilisation gains as gauged by rising business confidence and decreasing risk premiums, which culminated with the upgrade of public debt to an investment grade status by the three major international rating agencies.

Such stabilisation gains in a context of very favourable external conditions – the upward phase of the super-cycle of commodities and the abundance of global liquidity – paved the way for a prolonged boom. The creation of formal jobs proceeded at a fast pace, with rising rates of formalisation in the labour market and unemployment rates falling from 11% in the beginning of the decade to 5% in 2010. The differential income growth at the bottom of the social pyramid was particularly remarkable, with a correspondingly impressive emergence of a new middle class. While GDP grew at an average rate of 4.5% per year, income of the bottom 20% rose at rates above 7% p.a.

The favourable external scenario supported growth in several ways. Rising commodity prices provided a fiscal windfall, used to boost social objectives while leaving existing privileges untouched. Improved terms of trade translated into increasing domestic purchasing power of goods and services, besides positive wealth effects for natural-resource owners. Foreign currency indebtedness of the private sector was facilitated. Official external reserves skyrocketed.

However, the upswing phase from 2004 onwards of the commodity super-cycle brought double-edge effects, while reinforcing the consumption-led, labour income-led underlying growth model. Combined with exchange rate appreciation and rising minimum wage floors – as well as public-sector disbursements indexed to the latter – the commodity boom allowed a virtuous domestic cycle featuring positive feedback loops between consumption – especially services – and formal employment.

On the other hand, profitability levels in the manufacturing industry were crushed and levels of production practically stagnated after 2008 before ultimately declining in 2014. The Brazilian economy ran toward a competitiveness cliff. With the fall of global prices of metals since 2012, followed by food prices in 2014, the cycle began to unfold in the opposite direction.

It is in that context that the government attempted to find a shortcut to a new, investment-led growth cycle in 2012-2014. In response to the global financial shocks in 2008-2009, the Brazilian government had employed counter-cyclical fiscal and monetary policies that helped lift GDP by more than 7% in 2010. As growth returned to lower levels afterwards, the government implemented a second round of stimulus policies, including a sizable package of tax exemptions, local-content policies, credit expansion via transfers of proceeds of public-debt issuance to public-sector banks and, in a failed attempt to slow down inflation without hiking interest rates, curbs on regulated prices. It is worth noticing that the expansion of public spending accelerated after 2008 and tax revenues have collapsed since the beginning of the economic downturn in mid-2014. Given the structural reasons for the private investment retrenchment, the main legacy of what we have called a failed effort to chase animal spirits was mainly fiscal deterioration (as depicted in chart 4).

In fact, macroeconomic policies implemented in 2015 may be primarily seen as the unwinding of that attempted shortcut. The upward realignment of regulated prices, together with the realignment of foreign versus domestic prices (exchange rate depreciation), both led to an expected inflation shock. The Central Bank then used interest rate hikes to contain expectations of future inflation and avoid the diffusion of the corrective inflation shock. Furthermore, ambitious targets of fiscal adjustments were announced at the beginning of the year, although the barriers to reach such targets – rigid, legally-mandated public expenditure rises with pensions and others – came to be recognised with successive announcements of unwinding of fiscal targets.

Another factor behind the current bust has been the collapse of private investment following the previously mentioned investigations of market rigging and corruption initially associated with Petrobras, the state-controlled oil company, which subsequently spread to much of private-public sector. Large and GDP-relevant domestic private groups involved in those scandals have faced direct impacts – financial drought, operational disarray, and a sudden halt of demand. Furthermore, deteriorating confidence has spread throughout, accompanied by a wait-and-see attitude pervasive with outsiders. The ensuing political crisis not only reinforced the investment paralysis, but also hindered the congressional approval of fiscal adjustment measures.

As remarked, the medium-term silver lining of the investigations is an improved perception of rule-of-law by investors, besides a fiercer private sector competition and lessened cost-effectiveness of public spending in those activities where there is an interface between public and private sectors. However, in the short term, these non-economic factors have been partly responsible for the GDP decline. Furthermore, as tax revenues fell at an even faster rate than GDP, the fiscal adjustment effort has been thwarted and an open fiscal crisis came to the fore.

To summarise, the combination of anaemic productivity increases and a substantial growth in public expenditures oriented towards government transfers (pensions, social programmes) – and real wages rising faster than productivity – during the growth-cum-poverty-reduction cycle was sustainable only while external conditions were highly favourable. 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.

A Straitjacket on Public Spending

Reversing the explosive fiscal trajectory of the last few years has become widely accepted as a government policy top priority. The Brazilian government has proposed to congress a constitutional amendment forbidding central government expenditures for up to twenty years to increase annually in nominal terms by more than the inflation rate of the previous year. Provided that the inflation stabilises at some level, such a cap will eventually mean a decrease of public expenditures as a ratio of GDP as soon as the latter exhibits positive figures – even if public spending keeps rising in real terms in the immediate future ahead while inflation remains on a descending path.

If tax revenues accompany GDP, the fiscal rule will automatically lead to reversal of negative primary balances and of the current rising trend of fiscal imbalance and public debt. The rule may be understood as a trade-off of medium-term enhancement of the fiscal landscape in exchange for some flexibility in the short term, given the prevailing budget hard rigidities (see current simulations from the ministry of Finance in chart 5 and those from JPMorgan in chart 6).

Of course, the main requisite for success will be a review of public spending rigidities and legally-mandated increases. Not by chance, the government has declared that it will also send to congress a proposal of pension reform, a key ingredient of the recent fiscal obesity, as a way to make space for other essential public expenditures not to be dramatically curbed.

Government forecasts point to a deficit of the social security system around 2.7% of GDP next year, larger than the overall government deficit. Although currently still a moderate deficit, pension expenditures are poised to accelerate given demographic trends and prevailing rules. Brazil’s ministry of Finance forecasts social security spending to reach almost 10% of GDP in ten years under existing conditions even with GDP growing by 2.5% p.a. from 2018 onward. Brazil, for instance, is one of the very few countries without a minimum retirement age.

Chart 7 – extracted from a study by Fernandez, Moreira, and Souza, contained in JP Morgan’s Global Data Watch of August 9, 2016 – illustrates how relatively generous Brazil’s social security system is compared to most other countries:

“Brazil paid 6.4% of GDP in pensions in 2011, even though only 7% of the population was above 64 years of age (orange dot marked 2011 in chart 4). By 2016, total expenditure rose to 8.4% of GDP while the proportion of the population over 64 grew to 8.2% (dot marked 2016 in chart 4). Spending is far above the OECD trend, which suggests that Brazil spends as much as countries with higher proportions of people over 64, of about 13% in 2011 and 16% in 2016 (dots around the centre of chart 4). Pensions in Chile, a Latin American peer, amounted to 3.2% of GDP in 2011, with 9.9% of the population older than 64.”

The two previous fiscal adjustments in the last twenty years – at the end of the 1990s and after President Lula’s first election – relied mainly on a combination of tax hikes, discretionary spending cuts, and growth in following years. This time the tax burden is already relatively high, recovery of growth will be gradual, and the share of discretionary spending is only about 25% of the total. Reform of mandatory expenditures as imposed by the straitjacket will have to happen.

More generally, a review of public spending should help abiding to the new constitutional rule. To the extent that one may locate benefits and public subsidies that do not find justification in terms of poverty reduction or needs of the productive system, their elimination would make room for redirection of the corresponding resources.

A review of public spending may also bring a great potential contribution to TFP and economic growth, with effects spanning across two factors behind the productivity anaemia – infrastructure and business environment – as we saw. For an economy with a high tax burden and proportion of public spending in GDP such as Brazil, improvements in the quality of the latter have significant direct and indirect impacts.

More generally, international experience has shown how transparency, evaluation of results, accountability, and competition in public procurement reduce corruption and improve the quality of public spending. There is also evidence that the quality of public services responds positively to the presence of incentives that reward good performance. Improvements in the quality of public spending would provide gains not only as a significant part of GDP, but also as part of the production inputs used by the private sector.

In addition to the fiscal regime change, the government has also obtained – or is seeking – congress’ approval for other reforms with potential positive effects on investments and productivity. As of the moment this text is written: Petrobras has been freed from the obligation to invest in all pre-salt fields; a reform of the regulatory agencies law has improved their governance and budget independence; prevalence of negotiation over labour legislation; and simplification of two taxes with heavy impact on Brazil’s cost of doing business. The government has also launched a first package of new 34 infrastructure concessions.

The economic agenda proposed by the government and the track record already established with respect to its congress approval have been among the factors explaining the favourable recent evolution of long-term interest rates and risk premiums levels (chart 8). Confidence levels and other early signals point to a private investment-led recovery starting last quarter of this year.

Bottom Line

Brazil’s remarkable achievements in terms of growth-with-poverty-reduction of the last decade can be repeated. As long as due attention is given to the double malaise – productivity anaemia and consequent fiscal obesity – that has been ailing its economy. Although fiscal adjustment comes to the fore as a most immediate focus of measures, success will ultimately depend on how well the productivity anaemia is dealt with, since only with productivity increase the poverty reduction-motivated demand for government services will be exercised without conflicting with fiscal soundness.

About the Author

Otaviano Canuto is the executive director at the board of the World Bank for Brazil, Colombia, Dominican Republic, Ecuador, Haiti, Panama, Philippines, Suriname, and Trinidad & Tobago.

The views expressed here are his own and do not necessarily reflect those of his employer or any of the governments he represents.

Follow Mr Canuto on Twitter: @ocanuto