When Expectations Disappoint

The next president of Brazil will have many things to thank his predecessor Fernando Henrique Cardoso for, but he will probably have many more reasons to curse him. Cardoso is handing over his country in much the same way he began his second mandate in January 1999, with the currency crashing, the country struggling to pay its debts and the economy sinking into recession.

Yet Cardoso has achieved a lot since he first won election in 1994. He has modernized the country’s institutions, introducing a degree of transparency and honesty into public affairs that few other Latin American countries can match. He has pressed ahead with reform whenever he was able, never easy given that he lacked a solid majority in Congress. On his watch, Brazil stopped hyperinflation, bringing a semblance of order to the public finances, privatized companies by the dozen, restructured state governments’ finances and put a lid on future overspending. Cardoso even made headway in reforming the social security system. He has complied with an International Monetary Fund program in place since September 1998.

Unfortunately, Cardoso’s achievements were not sufficient to prevent Brazil from being drawn into a severe financial crisis, although they did qualify Brazil for a $30 billion IMF rescue package in August, put together in exchange for stiffer performance criteria in the years ahead. Cardoso’s greatest failure – an inability to radically reorganize the country’s public finances – made the present financial predicament inevitable. When he took office in 1994, the public sector’s net debt was equivalent to 21% of GDP, according to the IMF. Now it is nearly 60% of GDP. Cardoso joins a long and inglorious line of profligate Latin American leaders who have stuck their countries with debts so large as to be almost unpayable.

Extreme risk aversion triggered by last year’s terrorist attacks, Argentina’s collapse last December and America’s crooked corporations have coincided with political uncertainty to stampede the markets. However, fear over the growing popularity of Luis Inácio Lula da Silva of the Workers Party would not have pushed Brazil over the edge were it not for the country’s vast debts. Risk-averse markets are no longer willing to finance a country with a capital structure as ramshackle as Brazil’s with its stock of short-term, index-linked domestic bonds that makes up 80% of the total debt. The result is a massive credit crunch and deepening recession.

Bolívar Lamounier, a leading political analyst, says, “Eight years ago there was tremendous optimism and belief that for the first time in many years we were adopting some strategic measures that [would bring growth].” There was a widespread belief that merely halting inflation, which Cardoso achieved in 1994 with his Real Plan that created the new currency, would create the necessary and sufficient conditions for a return to steady growth. However, as Lamounier points out, “These reforms have not yielded the fruits that were expected. They have not led to the paradise that people wanted. Now, people want change, something different.” Luis Nassif, one of Brazil’s leading financial journalists, comments that, “Cardoso was very reactive. The government used international liquidity to delay difficult reforms by accepting huge capital inflows to keep the economy in growth.” Walter Appel, partner in São Paulo’s Banco Fator, says that the stability the real brought was merely “a big lie.”

High Costs
Yet there is always plenty of reason for hope in Brazil. Visitors to São Paulo, the business capital, are always struck by the city’s pounding energy. Its business community is inventive, highly skilled and sophisticated. The country has astounding natural and human resources, a highly diversified industrial base and a complex financial system. The business community has learned to be infinitely adaptable, able to work under conditions unimaginable for most American or European executives. What would you do for example, when the currency collapses, credit is no longer available at any price and your best clients can no longer pay for your products, just as the government has altered an important regulation or raised taxes? Brazilian businesses have weathered similar storms in the recent past. Most successful companies are liquid, operate with high margins and whenever possible are increasing exports. According to the Inter-American Development Bank, productivity has risen an average 5.2% between 1996-1999. Median operating margins for listed companies are a healthy 24%, according to an analysis by Economática, a Brazilian consultancy. Yet few can generate profits large enough to both honor their existing debt and invest in new ventures essential to their growth. A debilitated private sector cannot create jobs and pay wages for a population desperate for work.

Roger Wright, managing partner with Bassini, Playfair&Wright, a São Paulo consultancy, says, “There is a six- month window of opportunity for the next president and he needs to know what he is doing and act quickly. Brazil advanced a lot in the last eight years but not enough to consolidate the reforms. The president needs in the next four years to continue with what has been done.” There is broad agreement on the urgent structural reforms that the incoming government must carry out – once it has dealt with the country’s immediate financial crisis. These start with a tax reform to straighten out the hodge-podge of taxes on sales, revenues, incomes, bank and capital market transactions. In their place would come a few simple, easy to collect taxes accompanied by an implacable attack on evasion. A lighter tax burden for all would encourage growth. After that comes the final stage in the reconstruction of the state social system. Transferring from the state-sponsored, pay-as-you-go scheme to a private system is too expensive to contemplate now, but the next government must end the present arrangement in which public employees are entitled to budget-busting pensions. The government also needs to place greater emphasis on the quality of public spending. Federal, state and municipal governments have been inefficient, wasteful and corrupt. Yet states and cities scattered throughout Brazil have cut spending by 25% or more by adopting simple management tools such as setting performance targets for staff.

If these initiatives are planned and executed properly, they can make a profound dent on the public sector deficit. Attacking waste and corruption in government could easily save up to a quarter of discretional spending, if not more. A tighter grip on spending would allow the next government to implement an effective package of housing, education and welfare policies to overcome the country’s vast social problems. And a convincing attack on the sources of overspending, rather than simply raising taxes to pay for these excesses would convince markets that Brazil’s public sector is on the mend. A declining deficit would allow interest rates to fall, further accelerating the decline in the debt. Companies would be able to raise financing at reasonable costs for longer periods.

Pipe Dream
This may sound like a pipe dream but these initiatives are easily within reach of an incoming administration willing to act decisively within weeks, if not days of taking office. Brazil is a democracy with a Congress jealous of its privileges, and any ambitious reform program will affect many special interests. The power of small, vocal minorities is likely to remain as strong as ever since the next government is unlikely to have a majority in the Chamber of Deputies, the lower house, or the Senate. Civil servants and public sector unions will lobby aggressively against any assault on their privileges as they have in the past. The chances are that the next government will be a left or center-left administration, so their views are bound to carry considerable weight.

Whoever wins the October elections must form a coalition government, just as Cardoso had to. The president has hinted that the PSDB, his social democratic party, will support Lula, the four-time candidate of the Workers Party (PT), in the second round of voting if José Serra, the government candidate, fails to make it to the run-off. This assumes party members do not defect to Ciro Gomes, the upstart candidate who has made Serra’s life hell. The PSDB will likely have a say in framing government policy, whoever wins, and will probably take a few key posts too, perhaps even the finance ministry or presidency of the nominally independent central bank. Members of the amorphous PMDB and the conservative PFL party are also supporting Gomes, a former state governor who served briefly as finance minister.

The constraints on power – from the legislature, party politics and the independent judiciary – seem too great to allow an excessive degree of experimentation or adventurousness in policymaking. Indeed, Cardoso’s cornerstone legislation – the Fiscal Responsbility Law – imposes strict limits on spending in the years ahead and it will not be easy to override these restrictions.

Future Perils
There are two great risks that lie ahead for Brazil and its international creditors. The first would be an uncontrolled collapse in the financial system, brought on by a debt crisis. Brazil’s banks are heavily exposed to the government with about 35% of their $414 billion assets invested in government bonds. Erivelto Rodrigues, a São Paulo banking consultant, says a default “would trigger a systemic crisis in the banking system” similar to that which has befallen Argentina. “The debt needs to be honored and if they do [restructure] it will be very complicated. There will be a chain reaction [of defaults] across the economy.” Cleaning up the mess would take a long time and be hugely expensive. Above all, it would make any pretensions to achieving an investment grade rating in the years ahead – as Armínio Fraga, the outgoing central bank president has said may still be possible – a laughable proposition. A major debt crisis could cut both Brazil and the rest of the region off from the world capital markets, throttling growth for years.

The next pitfall, inexperience, is inevitable with an incoming administration. Yet Brazil can scarcely afford to wait as the next president and his team learn the ropes. This danger is particularly acute for Lula and the PT. Lula has never held executive office since quitting the São Paulo metal workers union 20 years ago to enter politics. He served briefly as a member of the Chamber of Deputies. The party runs several important cities (São Paulo) and states (Rio Grande do Sul) although it is notable more for the honesty of its members than great administrative ability. Furthermore, the party’s conversion to middle-of-the-road politics is recent and is resented by the rank-and-file who could demand a return to more militant policies or at least take a hard line in debt negotiations.

Gomes is also likely to face a steep learning curve. He has not spelled out what his government really stands for and has assembled a broad but weak base of support. Indeed, Lamounier comments that Gomes needs to “show the maximum amount of ambiguity to get elected.” The oligarchs of the backward northeast have few interests in common with politicians from the more developed south. It is not hard to see his government becoming bogged down by infighting between rival groups of “allies.” The PMDB in particular has no clear ideology beyond advancing the goals of its factions and a handful of powerful members.

Serra, with his impressive record in academe, Congress and more recently, as health minister, is the best-qualified candidate to lead Brazil out of its mess. He may be fiercely intelligent but he projects dullness and continuity when voters want an exciting new leader promising change and prosperity. Serra may seem boring, but he is quick-tempered, arrogant and known to harbor a grudge. He has made some powerful enemies across the political spectrum who have gleefully plotted his downfall. Serra may make it to the second round, but would probably lose to Lula.

Future Paths
There is a real risk that Brazil will be dragged into a prolonged period of confusion and stagnation. That would make it even more difficult for countries elsewhere in the region to shake off their economic problems. Worse still, a profound economic upheaval in Brazil could unleash a full-blown systemic crisis devastating emerging markets, condemning Latin America to yet another “lost decade.” The consequences would be drastic, possibly on an Argentine scale, where economic collapse has led to political unrest.

But Brazil could get lucky, and quickly surmount its immediate financial problems. If Brazil gets doubly lucky, the next president will immediately embark on an energetic package of structural reforms leading to a period of sustained growth. However, the incoming government’s policy responses will only partially determine which outcome will come to pass. The reaction of the financial markets, the US government and the Washington institutions – the International Monetary Fund, the World Bank and the Inter-American Development Bank – will be crucial. It is a long shot, but Latin America, led by Brazil, could still come marching out of its morass sooner than many expect. n