President Luiz Inacio Lula da Silva recently announced his long-awaited package of measures aimed at boosting Brazil´s sluggish growth rate to 5% a year. The Growth Acceleration Program (known locally as the PAC) consists of a variety of measures including higher government spending, fiscal incentives and greater availability of credit to specific sectors. The package was greeted with little enthusiasm by the market which feels that unless it is accompanied by moves to curb government spending and implement reforms to the tax system and labor laws it will not bring long-term sustainable growth. One person who was not impressed was Alexandre Schwartsman, a former international director of the Brazilian Central Bank, who is now chief economist for Latin America of Dutch bank ABN AMRO. In this interview he gives a detailed reaction to the PAC and also discusses his projections for 2007, the possibility of Brazil achieving investment grade and his time at the Central Bank.

Alexandre Schwartsman: I would sum it up as “much ado about (almost) nothing”. I don't believe  it will have a significant impact on long-term growth. By putting the government at center stage,  the program overlooks  alternatives that could deliver more efficient results and  does not  sufficiently address  the  issue  of  high government spending and taxation, which, I believe, is at the core of poor growth performance. It starts from the  assumption that the public sector should be at the core of the growth process and I do not believe this should be the case.

Schwartsman: In Brazil the government has never left the stage, even during period in which we were supposed to be under a “liberal” administration, but this time it seems there is a belief that being on stage is not enough. According to the program directives the government must take center stage and the public sector should be both an actor and a catalyst of the growth process. The government is scheduled to play the main role as an actor because the pillars of the program are the infrastructure projects to be executed by the government through its various entities, from logistics to energy. There are some 50 of these – talk about micro-management! - under the control of chief of staff, Dilma Roussef, who is increasingly taking the reins as the government manager. The essential assumption behind this strategy seems to be that the government has some advantage vis-à-vis the private sector when it comes to these projects. Presumably this is because the government is not constrained by private yield considerations and can incorporate into the returns of the project aspects that are not captured by any private entrepreneur – such as “externalties”.

Schwartsman: These can include public investment in infrastructure which can increase the returns of private investments, such as a road where previously there was none which allows the expansion of, say, soybean production. Therefore, private investment would presumably follow public investment. It is worth noting that there is nothing terribly unorthodox about these beliefs. The literature on public finances has dealt with the externality issue over the last 50 years. That said, the best response to these issues need not require government intervention through the lines that apparently rule the PAC. If there are returns to an investment in addition to those captured by the private entrepreneur, the appropriate choice of subsidies can solve the problem without the government actually getting into the investment business itself.

Schwartsman:  Congress spent a good couple of years putting together the Public Private Partnership (PPP) framework to deal precisely with this sort of problem. The consensus is that the project finally approved does offer the required guarantees for both public and private sectors, which reduces the need for direct government intervention. Moreover, when it comes to infrastructure investment, there are also considerations about regulatory uncertainty that, if addressed, could raise the perceived return for these investments without any need for direct intervention.
That is, there are strong reasons to believe that direct intervention, even in cases where one can forcefully argue about externalities (a case, incidentally, that has yet to be proven about the projects in PAC), need not be the best strategy to deal with the issue. True, it may be more difficult to get the incentives for the private sector right than simply having the government do the job. At the same time, however, this is not the first (nor the second) time that the public sector in Brazil has opted for a hands-on approach and, frankly, on average results have not been that great.

Schwartsman: The program has fiscal costs but these should not be enough to derail the consistent decline of the debt-to-GDP ratio. Indeed, according to the Finance Ministry simulations, a reduction of the primary surplus by 0.5%2 (the size of the PPI) would still push the debt-to-GDP ratio to 39.7% in 2010 from the current 50%, assuming market consensus forecasts for interest rates and inflation, and GDP growth reach 4.5% this year and accelerate to 5% thereafter.
If, however, we use market consensus growth rates for the 2007-10 period, the debt-to-GDP ratio would drop to 42.2%, some 2.4 percentage points higher than the official forecast. Furthermore, if someone has deep reasons to believe the program will have no effects whatsoever on growth, the maintenance of the primary surplus at 4.25% of GDP (rather than the 3.75% implied by the use of 0.5% PPI) would bring the debt-to-GDP ratio to 40.1% at the end of 2010.
In other words, if the program does not accelerate the economy as much as forecast (a sizable risk if our past history is invoked), the decline in the debt-to-GDP ratio would be only 7.8% of GDP, rather than the official 10% figure, if the PPI is used. If, however, the PPI is not used and the primary surplus is maintained at 4.25%, the debt-to-GDP ratio would drop by nearly 10% of GDP.
This gives us a measure of the risks involved in the program. If the program were to fail completely to accelerate growth, the debt-to-GDP ratio would drop 2.4 percentage points less than it would in the absence of the program.

Schwartsman: This takes us back to one of my favorite issues, which is now quickly turning into a full-fledged obsession, i.e. that long-term GDP growth in Brazil has been limited by fiscal constraints. The high and increasing level of government spending limits resources available for the private sector to invest. At the same time, the increase in tax distortions to match expenditures has had negative effects on private sector expected returns, with dire consequence for private investment as well.

Schwartsman: Not as far as I am concerned. For a start, we are talking about a reduction of the primary surplus by means of additional spending rather than a meaningful reduction in taxes that would benefit the private sector as a whole. Moreover, current spending is also increasing this year, a fact acknowledged by the Finance Ministry itself, which should not contribute to foster growth if our views about the fiscal origins of low GDP growth in Brazil are correct. Against this backdrop, the chances of tax reform that eases the pressure on the private sector seem slim at best.
Higher current spending and, at the very least, maintenance of the tax burden at the current level do not spell good news for a fast resumption of investment. To be sure, the program promises to put the reins on current spending from 2008 onward, but this belongs in the realm of things that have a certain probability to materialize. As for the “here” and “now”, the program has only delivered more of the factors that contributed to the poor performance of the past.

Schwartsman: In all, I do not expect much from the program. I sincerely hope I am wrong about that but I fear not.

Schwartsman: We expect GDP to rise by closer to 4% than the market average of 3.5%, based on the lagged effect of the monetary policy. It takes about two quarters for interest rate cuts to start affecting growth, and the peak of these effects takes place some good six quarters after the change in monetary policy. Based on that, we expect the rate of growth to pick up by the end of this year, led by private sector demand, which could rise by 5.5% to 6%. On the other hand, we are more conservative in terms of interest rates and think they will end the year at 12% whereas the market consensus is 11.75%. We expect inflation to come to around 4%.

Schwartsman: I think this could happen in late 2007 or early 2008. Given what´s going on with the fiscal policy, this might seem optimistic. However, if the GDP/debt ratio were to keep falling, interest rates remained well behaved, the debt profile continued to improve and foreign reserves continued rising, the agencies would take these factors into consideration and review the rating.

Schwartsman: This possibility has already been partly priced in by the market so maybe the main difference would be psychological. Having said that, investment grade would be a great achievement and governments would be careful about taking measures which could endanger it.

Schwartsman: I love what I do but the truth is that I enjoyed my time at the Central Bank even more. Any macroeconomist would love to have the opportunity to take part in decision-making at national level. I loved the Copom meetings which set monetary policy and still miss them. In addition to being a voting member of the Copom, I was also responsible for sovereign external debt management until the end of 2004, foreign exchange and international capital transaction regulations and was the Brazilian representative at international level at organizations such as the World Bank, IMF and G-20. I am particularly pleased about my role in helping reform the normative framework under which Brazilians conducted FX and capital transactions. For instance, I am proud of the changes that made it easier for Brazilian companies to increase their investments abroad above the previously set limit of US$5 million. How could CVRD have been flexible enough to have made its recent US$ 18 billion takeover bid for the Canadian company Imco if this rule was still in force? When I see transactions like that I think that some consequences of the changes we made are improving the conditions for doing business in Brazil.

© John Fitzpatrick 2007