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special issue: federations and the economic crisis
Brazil responds rapidly to global crisis
REUTERS/Joe Chan
Brazil’s President Lula da Silva and Chief of Staff Dilma Rousseff talk during a ceremony celebrating International Womens’ Day in Brasilia.
By bernardo kucinski
Brazil reacted quickly to the economic crisis. In a series of swift moves, the federal government provided liquidity to financial markets and stimulated domestic demand to compensate for a sudden drop in exports.
Prolonged recession seems to have been avoided and an unemployment increase was contained. But the blow was a very heavy one and economic activity did not immediately return to the pre-crisis level.
The initial effect on the Brazilian economy of the collapse of banks in the United States and Western Europe was a sudden and total shutdown of credit, despite the country’s strong financial system and healthy economy.
But only a few very small banks felt the global liquidity squeeze and there were no fatalities within the banking system. The vulnerability was elsewhere, in the vast quantity of hot money - speculative investment funds that entered Brazil’s financial system in recent years to take advantage of the country’s extraordinary interest rates, which range from 12 to 19 per cent.
In a panic, foreign investors rushed to repatriate their money, either to seek refuge in U.S. Treasury bills or to cover their losses on Wall Street. Moreover, subsidiaries of multinationals increased the proportion of profits they sent home to help bolster their parent companies’ bottom lines.
Within weeks, the exchange rate of Brazilian reals to U.S. dollars rose more than 40 per cent. This was disastrous for many large Brazilian exporters that had loans tied to an exponential cost clause if the exchange rate rose higher than a pre-determined threshold. That threshold was surpassed in the early days of the crisis, causing many companies to report massive losses in the range of billions of reals. Suspecting that this disaster had also spread to many other companies, most banks stopped lending completely, severely hurting exports and capital investment financing.
REUTERS/Paulo Whitaker
A Brazilian labourer works on the construction site of the Octavio Frias de Oliveira Bridge in Sao Paulo.
At that point, gross domestic product was growing at an annual rate of 6.8 per cent, inflation was at its lowest level in years, about 4.5 per cent per year, and industries were expanding productive capacity after three years of sustained growth.
President Lula da Silva – enjoying unprecedented popularity after including an estimated 13 million poor in the market economy and creating nearly 14 million jobs – was preparing for the victory of his intended successor, Dilma Roussef, his chief of staff and former energy minister, in the 2010 presidential elections. To boost her candidacy, she was given responsibility for a program aimed at accelerating investment in infrastructure projects throughout the country.
Response swift but cautious
The government’s response to the dramatic changes in economic expectations was swift but cautions. First, it drew from its plentiful foreign reserves to meet the strong demand for dollars, stopping the exchange rate from rising. Then, to prevent a run on small banks, the central bank increased the guarantee on investments by individuals and companies in small banks facing difficulties.
To add liquidity, state banks were directed to expand lending aggressively, the percentage of deposits that smaller banks had to place at the central bank was reduced and a planned increase in similar compulsory deposits on leasing contracts was cancelled. A special credit line was also created to help small banks in difficulty.
To tackle the export market’s sudden paralysis, the government instructed the two federal state banks and the National Development Bank to offer exporters a special credit facility and relaxed rules for its main export incentive program to include more products and companies.
But the severe damage was already done. By October, export cancellations had hit the car industry hard, as well as meat and iron ore exporters and the aircraft maker Embraer. Corporate capital investment was also cut, helping contribute to a 3.6 per cent decline in gross domestic product in the last quarter of 2008 from the previous quarter, with manufacturing output tumbling 25 per cent.
This came as a shock to Lula’s entourage, while the opposition saw an unexpected opportunity to defeat his candidate in 2010. The conservative media could not hide their satisfaction with this complete economic reversal and the prospect of Lula being defeated by a recession.
Lula then issued an ultimatum to central bank chairman Enrique Meirelles to cut the prime rate, at the time the world’s highest – 13.75 per cent. In an unfortunate move, the central bank had actually increased the rate by 0.75 percentage points last September when most central banks were cutting rates. Brazil’s abnormally high rate was maintained through the first three months of the crisis, to the astonishment of economists. Ultimately, pressure from Lula and industry leaders sparked major cuts in the prime rate in January and April, bringing it to 10.25 per cent, still one of the world’s highest.
Little added to liquidity
These cuts added little liquidity and lending remained highly selective. But each percentage point decline in the prime rate means 10 billion reals less in the public debt’s service cost. This saving allowed the government to implement substantial tax cuts elsewhere, to stimulate domestic demand without adding to the federal deficit. Lula, who was particularly alarmed about job losses in the auto industry, issued a decree in January to reduce the Industrial Products Tax (IPI) on most cars and to eliminate it for small cars.
About a dozen other tax reductions or deferments in tax payments were introduced from January to May 2009, covering domestic appliances, building materials and motorcycles. By the end of the first quarter, industry was recovering, but extremely slowly. First-quarter industrial output was still 7.9 per cent below that of the previous quarter and 14.7 per cent below what it was a year earlier. At the same time, the GDP slipped an estimated 1.2 per cent.
In desperation, the federal government announced a new ambitious program in April to build one million heavily subsidized houses for the poorest people in partnership with local and provincial authorities. States and municipalities must offer land for the houses to be built on and people have to apply for the program at municipal offices.
By mid May, 11 states, nearly 300 municipalities and 11 metropolitan areas had joined. But in many municipalities, people found that their mayors knew nothing about the program due to federal government planning failure and a degree of mistrust.
Lula is using the crisis to accelerate Latin American integration, his major priority in foreign policy. One move in this direction was a change to what Brazilians call “reciprocal payments” – a mechanism by which only the balance of trade between two countries is periodically settled in hard currency. Lula ordered an increase in the limit for reciprocal payments with Argentina.
In addition to this, a US$300 million credit line was offered to Argentine companies, Brazil’s main trading partners, and a credit swap line was created for Latin American countries through which importers of Brazilian goods can pay back with their own currencies loans taken out in Brazilian reals.
Sub-national options limited
Brazil’s state governments can help to counter a recession by cutting their main state tax, the value added tax known as ICMS, on certain key products to stimulate demand. But state governors traditionally use ICMS reductions only to wage trade wars among themselves, not to fight recession, which they consider an exclusive responsibility of the federal government.
However, the political logic of state governors works in the opposite direction: they seek to maximize state revenue to build as many roads, bridges and other major public works as possible. Roads are mainly a state responsibility, and building them draws votes in a large country lacking a complete road network. Also, governors use contracts to reciprocate for political campaign donations from road-building companies. Building roads, bridges and tunnels adds little to demand because such work does not require a large workforce. But they do add a lot to political campaign financing as contractors are by far the largest political donors in Brazil.
Only the state of Paraná has substantially reduced the ICMS to counter recession. Some states, such as São Paulo, are actually reducing their social security net to cut spending. São Paulo – Brazil’s richest state with 35 per cent of industrial output – was hit hard by rising unemployment. But instead of cutting taxes, its governor, also a potential candidate for the 2010 presidential election, is privatizing a large number of state roads as a means to raise funds to build even more roads and bridges. Municipalities are more sensitive to local effects of the crisis, particularly towns with only two or three large factories where a large number of workers were suddenly laid off.
The tax cuts introduced by the federal government to deal with the crisis, plus the overall decline in economic activity, led to an 11.2 per cent decline in federal funds received by states and municipalities in the first quarter of 2009 compared to a year earlier.
The constitution specifies that 21.5 per cent of the two main federal taxes, income tax and the IPI – the federal excise tax on manufactured goods – is transferred to the states and 23 per cent to municipalities, in proportion to their populations. An additional 10 per cent of the IPI is transferred to the states according to their level of exports. Also, 29 per cent of a federal tax on fuels is transferred to states in proportion to the extent of their road networks. In turn, each state has to transfer one-fourth of this fuel tax rebate to its municipalities.
After an outcry from governors and mayors, the federal government made several refinancing facilities available to states and municipalities. Municipalities were granted compensation for loss of their share of industrial products taxes and were given 20 years to repay their debts to the social security fund. To state governments, the federal government offered up to 4 billion reals in term credit, with eight years to repay and a one-year grace period.
By early May 2009, banks resumed lending at a slightly lower rate of interest, although they were still highly selective with their lending. China resumed imports at a high pace, presumably to replenish its stocks of raw materials. But the prognosis is not encouraging. The recovery will be a slow one, most specialized analysts say. The year might close with marginal GDP growth, in the range of one to two per cent. At this pace, unemployment will increase because Brazil needs annual GDP growth of at least five per cent just to accommodate new arrivals into the workforce. Furthermore, at the very first signs of recovery, hot money began to flow back to Brazil on a large scale. This means that vulnerability has now returned to the Brazilian economy. 
REUTERS/Sergio Moraes
A view of a wall being built by Rio de Janeiro to limit the expansion of a slum from encroaching on the forest in Rio de Janeiro. Under Brazil’s infrastructure program, federal authorities plan to build some 3,616 homes in four different Rio slums.
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