WASHINGTON, Oct. 2 (UPI) -- With four days until Brazil's Presidential election Oct. 6, domestic and foreign holders of $280 billion (gross, $240 billion net) in Brazil's debt are biting their fingernails. If, as currently expected, Workers' Party leader Luiz Inacio Lula da Silva (known universally as Lula) wins, will he stick to his recent promises of honoring outstanding contacts, or will he default on Brazil's debt?
Wednesday, Mark Weisbrot, of the Center for Economic and Policy Research and John Williamson, of the Institute for International Economics, debated the question. Weisbrot is well known for questioning the "Washington Consensus" approach to development finance, whereas Williamson is a supporter -- indeed, he invented the term -- so disagreement was to be expected. Also as expected, I disagreed with both of them!
In Weisbrot's view, default is inevitable, and should be undertaken by Lula as soon as possible, because delaying default simply increases Brazil's liabilities. Brazil's debt to gross domestic product ratio, even after more than $100 billion of privatization proceeds, has doubled since Fernando Henrique Cardoso became president in 1994, from about 30 percent to 58 percent today -- a figure which is climbing as the Brazilian real declines. Of this debt, approximately 20 percent is international (after the country's foreign exchange reserves have been netted out), of which half is owed to the international financial institutions.
In addition, a very large portion of Brazil's debt is greatly increased in cost by economic turmoil. Forty-percent of total debt is denominated in dollars, so increases as a percentage of GDP when the Brazilian real drops in value against the dollar. Another 37 percent of debt is linked to the "Selic" overnight money market rate, so becomes very expensive when, as for most of the last 8 years, uncertainty raises domestic interest rates. A further 8 percent of Brazil's total debt is inflation-linked, so has been a "good deal" for the country in the last 8 years but could become very expensive if the country returns to hyperinflation.
Weisbrot pointed out that the average real (inflation-adjusted) interest rate on Brazil's public debt over the 1994-2001 period was 16.1 percent per annum, and the projected real interest rate on Brazil's public debt for 2002 is 21.0 percent. If interest rates remain at these levels, the debt will become unmanageable, rising above 100 percent of GDP in 2006-2009, and spiraling thereafter, if policy remains as at present. Brazil's balance of payments would also be a problem, since public debt is currently 4 times the level of the country's export earnings.
The government's economic policy in 1994-2002 has followed IMF recommendations closely, and been fairly restrictive, with the "primary" budget surplus (before interest payments) currently in the range of 3 percent to 4 percent of GDP, although in Cardoso's first term, 1994-98, budgetary policy was less tight, with only a small primary surplus.
Weisbrot thus believes that default could only be avoided if the Central Bank followed a policy of much lower interest rates. Such a policy, possible only with stringent capital controls, would directly contravene the wishes of the IMF, which conditioned most of its recent $30 billion bailout loan package on Brazil continuing to stick to the current policy mix.
In Weisbrot's view, it is time for Brazil to consider a partial default on international debt, followed by a return to the more autarkic economic policy approach of the 1960s and 1970s, when economic growth was far higher than since 1980. Growth of just over 1 percent per annum in GDP per capita, at the cost of spiraling foreign debt, as has been achieved under Cardoso, cannot be regarded as a success.
Williamson, on the other hand, believes that with IMF funding available, default is not inevitable. In his view, if Brazil's market borrowing costs were reasonable, below 10 percent per annum in real terms, Lula would not default on or restructure Brazil's debt. Even though Brazil's real borrowing costs are currently above 20 percent per annum, this is a temporary premium from the uncertainty surrounding the election, and should drop fairly rapidly, though not immediately, after the election. At a value of Rs. 3.86=$1, the Brazilian Real is substantially undervalued; Williamson believes that the true equilibrium value is no lower than Rs. 2.50=$1. Hence Brazil's balance of payments has substantially improved in 2002, with imports depressed by Brazil's recession and exports increased -- up 27 percent year on year in September -- by the favorable exchange rate. September's trade surplus was $2.7 billion, ample to service international debt.
Williamson also questioned how much Brazil could expect to achieve by default. If it defaulted on international debt only, maintaining payments on debt to international institutions (as it would have to in order to keep credit lines open) while restructuring other debt to reduce its net present value by 50 percent, the financial benefit would be only 5 percent of Brazil's international debt, or less than 3 percent of GDP.
Domestically, one-third of Brazil's public debt is held by the banking system, which would have to be protected against the default if the government did not want to run into a huge illiquidity problem as in Argentina. Hence a restructuring involving a write off of 50 percent of NPV on that portion of the international and domestic debt on which default was practicable would provide a benefit of only 16 percent of GDP. Against that, even a partial default on domestic debt would involve a huge social problem (since the social security system is largely invested in such debt) and would be heavily deflationary, since holders of defaulted debt would doubtless reduce their spending.
From the above analysis, Williamson concluded that economically, Lula would be well advised to continue working with the IMF, and not default or restructure debt. However, he admitted that politically, this may be difficult for him. For example, if he gives way to what are probably his own instincts, and those of the left of his party, and institutes a substantial increase in the minimum wage, this will have a huge effect on public spending, absent major legal changes, since most social transfers and pensions are linked to the minimum wage, as are many wage contracts in both the public and private sectors.
Following Weisbrot's recommended policy, and dropping interest rates, particularly if it was accompanied by a burst of social spending, would probably result in a return to hyperinflation. This would not severely affect the public sector workers and blue collar workers who form Lula's main base of support. The principal sufferers would be the truly poor, in the favelas, who typically operate on a cash basis and hold relatively substantial cash balances for several weeks at a time. Thus the deflationary "real" plan of 1994, which conquered hyperinflation, caused an improvement of two full points in Brazil's excessively high GINI (inequality) coefficient as the cash balances of the poor came to maintain their value.
In my view, "neo-liberalism" has not failed in Brazil because it has not recently been tried. The high growth rates of 1960-80 were the result of primarily free market economic policies pursued by finance ministers Robert Campos (1964-67), Delfim Neto (1967-73) and Mario Henrique Simonsen (1973-78) under a military dictatorship that suppressed the politically powerful trades unions and public sector workers. These policies produced growth; also, far from worsening economic inequality, they improved it somewhat, because the suppressed unionized labor and public sector workers are generally well above average in the Brazilian income distribution.
Once democracy was restored, partially in 1979 and fully in 1984, the politically powerful once more exerted a baneful influence on the system. The constitution of 1988 made it impossible to fire public sector workers, and prevented Cardoso from restructuring the public sector properly, even had he wanted to. The problem was worsened by the blocking of all financial assets in 1990, and by a period of negative real interest rates and very high inflation that was highly destructive to the savings of the middle classes, and hence to small business formation.
Brazil's public debt has been high throughout the period, declining somewhat only when hyperinflation allowed the government to reap rewards at the expense of middle class savers and the poor. Resources have always been primarily directed through the government, which runs a public sector deficit as large as it thinks it can get away with, thus raising interest rates -- a "primary surplus" of 3 percent to 4 percent of GDP is nowhere near enough for stability if it translates to a true public sector deficit of 4 percent to 5 percent of GDP after debt service has been accounted for.
Brazil's problems will be solved when a government runs a true budget surplus, meaning initially a "primary surplus" of 8 percent to 10 percent of GDP, and does this not by raising taxes, but by slashing the size of the public sector, and scaling back drastically on those transfer payments that primarily benefit the non-poor. Running a tight fiscal policy, the government will soon be able to move to a relatively loose monetary policy, which will quickly bring down real interest rates while stabilizing the currency. The debt burden will then begin to diminish, so that the government can embark on a program of tax cutting, providing the social services, particularly education and health, that are truly necessary, encouraging private saving and promoting economic growth that will finally bring the favela-dwellers fully into the economy.
Given his base of support and his declared policies, Lula is vanishingly unlikely to provide that type of government, as is the current administration's candidate Jose Serra (Roseana Sarney, who might have done so, was forced out at an early stage by the government's political fixers.) Lula thus has a choice, between four years of IMF-decreed austerity, following policies that disappoint all the people who elected him, or default (probably total rather than partial) followed by a new start, with the international world hostile but Brazil, because of its size, well able to pursue an autarkic path with the freedom to make the policy choices his supporters demand. In the long run, such a policy will impoverish the country further, and increase the misery of the favela-dwellers. In the short run, it will appeal to Lula's base in unionized labor and the public sector.
Expect a default fairly soon after Lula is elected.
