For more information, see Brazil and the IMF

The following item is a Memorandum of Economic Policies of the government of Brazil, which describes the policies that Brazil intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Brazil, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Brazil Memorandum of Economic Policies
March 8, 1999

I. Background
  1. The economic developments leading to the formulation of the Brazilian government program, supported by the IMF, the World Bank, the IDB, the BIS, and most industrial countries, were outlined in the memorandum of economic policies attached to the letter of November 13, 1998 requesting a Stand-By Arrangement from the Fund. The Brazilian government reaffirms its commitment to those policies, modified as indicated below to adapt them to the new exchange rate regime.

  2. The government was initially successful in implementing the elements of the fiscal package that were the core of its program. Prior to the approval of the stand-by arrangement by the IMF Executive Board on December 2, 1998 it had enacted, or successfully guided through congress, the constitutional amendment on the social security reform and an increase in the COFINS--an earmarked contribution based on enterprise turnover. However, the proposed measure to increase the social security contribution on active civil servants, and extend it to retired ones, was not approved by the House in early December, and the government's efforts to pass the financial transactions tax (CPMF) ran into delays. During the month of December the central bank progressively reduced the overnight interest rates (which stood at over 40 percent in mid-November 1998) to 29 percent by year-end.

  3. Notwithstanding the prompt announcement that the government would continue its efforts to have the CPMF approved as soon as possible, and that it would resubmit the rejected fiscal measures in the near term, and the presentation in December of a package of additional compensating fiscal measures, market confidence continued to weaken in January 1999, also reflecting concerns over the commitment of some important states to adjusting their finances. Following strong pressures on foreign exchange reserves, on January 13, 1999, the central bank widened the exchange rate fluctuation band, and stepped up interventions in the spot and future markets. Pressures, however, did not abate, and, on January 15, the real was allowed to float. The exchange rate averaged R$1.52/US$ in January and R$1.91/US$ in February compared with R$1.21/US$ prior to the change in regime.

  4. These setbacks did not prevent progress with the passage of the fiscal program in January. In particular, the measures on the pension contributions for active and retired civil servants were presented again and approved quickly by congress, as were the increases in the social contribution on profits (CSLL) and in the IOF, that the government had proposed to compensate for the delay in the approval of the CPMF increase. The latter passed the required two votes in the Senate and was sent to the House, where it is expected to pass its second vote by end-March. Finally, the 1999 budget was approved on January, 25 1999.

II. Economic Prospects for 1999
  1. Economic activity in 1999 is now expected to be weaker than projected a few months ago, with GDP declining by 3.5 percent to 4 percent on average for the year. This reflects a more pronounced than initially projected downturn of activity in the second half of 1998, and a likely further decline in domestic demand in the first half of 1999, that will be only partly offset by a recovery of net exports. The economic downturn is expected to bottom out around mid-year, with a gradual recovery beginning during the second half of 1999 and gathering momentum in 2000, as confidence recovers, external financing constraints are eased, and real interest rates decline.

  2. The new floating exchange rate will require a new nominal anchor for economic policy. Monetary policy, along with strengthened fiscal adjustment and a firm wage policy in the public sector, will be instrumental in preventing the recurrence of an inflationary spiral and ensuring a rapid deceleration of the rate of inflation, following the initial impact of the depreciation of the real on the prices of tradeable goods. The consumer price index may rise by over 10 percent in the first half of 1999, but its rate of increase should then taper off, reflecting the firm stance of monetary policy and the absence of domestic demand pressures. By the end of the year, the monthly rate of inflation is projected to be in the range of 0.5-0.7 percent.

  3. The depreciation of the real has provided a major boost to Brazil's competitiveness. As a result, and also because of greater cyclical differential between Brazil and its trading partners, the trade balance is now expected to show a more pronounced improvement, from a deficit of US$6.4 billion in 1998 to a surplus of nearly US$11 billion in 1999. The current account deficit is also likely to decline significantly, from 4.5 percent of GDP to around 3 percent of GDP, roughly equivalent to the expected inflow of foreign direct investment. Despite the improvement in the current account, the overall balance of payments is expected to continue to show deficits in the next few months, reflecting heavy amortizations and the fact that capital inflows can be expected to recover only gradually. A pickup in those inflows, as confidence strengthens, should help move the overall external balance into surplus during the second half of the year.

III. Fiscal Policy
  1. The depreciation of the real, through its impact on, in particular, the external and foreign-exchange indexed public debt, has boosted the value of the debt by the equivalent of about 11 percentage points of GDP, to over 53 percent of GDP. The government intends to reduce steadily the ratio of the public debt to GDP to around 50 percent by end-1999, and to below the value initially projected in the November 1998 program for the end of 2001 (46.5 percent), through higher than originally targeted primary surpluses of the consolidated public sector in the next three years. The pursuit of this objective should also be helped by the decline of real interest rates expected to result from the strengthened fiscal adjustment and move to the floating exchange rate regime. Projections of the path of the debt to GDP ratio under plausible assumptions about GDP growth, real interest rates and the real exchange rate suggest that primary surpluses of 3 percent a year during the period 1999-2001 would be sufficient for this purpose. Nevertheless, to build a safety margin in the event of a less favorable than projected environment, the government intends to increase the targeted primary surplus to at least 3.1 percent of GDP in 1999, 3.25 percent of GDP in 2000, and 3.35 percent of GDP in 2001. These targets will be revised upwards (by the equivalent of up to 0.15 percent a year) to reflect the additional revenue (net of constitutional transfers) that would be obtained by the federal government in the event of favorable decisions by the Supreme Court on pending cases to remove certain exemptions from the income tax on capital gains and from the COFINS.

  2. The federal government will need to make a major contribution to the targeted fiscal adjustment. Accordingly, its primary surplus is expected to increase from 0.6 percent of GDP in 1998 to at least 2.3 percent of GDP in 1999 (compared with the original program of 1.8 percent of GDP). To achieve this objective, the government will keep nominal expenditures on goods and services below the 1998 outcome. In setting budgetary priorities , the government intends to safeguard to the maximum extent possible programs targeted to the poor, and has sought financial support from the World Bank and the IDB related to selected social safety net programs.

  3. To improve the primary balance, the following other measures, additional to those already enacted or announced in late 1998, have been announced or will be announced: (i) increases in domestic energy prices and other public tariffs sufficient to ensure the pass through to final users of the cost of imported inputs; (ii) the suspension until the end of the year of the rebate to exporters of the earmarked levies on turnover (PIS and COFINS); (iii) an increase in the rate of the IOF on consumer loans; (iv) submission to congress of legislation increasing the social security contributions for military personnel; and (v) a reduction (equivalent to 0.15 percent of GDP) in budgeted federal expenditures on wages and salaries, to be achieved by, inter alia, reducing new hires, postponing certain career stream adjustments, and deferring promotions. Of the new measures, only the increase in military pension contributions requires a new law from the outset to be implemented. The others can either be implemented by decree, or by a provisional measure, which requires subsequent ratification by congress.

  4. A surplus of 0.6 percent of GDP is targeted for the federal enterprises in 1999, partly offset by a small consolidated deficit of the state and municipal enterprises (around 0.2 percent of GDP). To help achieve this objective, the investment programs of the federal enterprises have been cut by the equivalent of about 0.9 percent of GDP. The primary surplus of the federal enterprises can be expected to decline over time, reflecting the privatization of some of the more profitable companies.

  5. A number of state governments (including some of the larger ones) remain in need of additional fiscal adjustment. As explained in the previous memorandum of economic policies, the debt restructuring agreements between the federal government and the states require the latter to generate primary surpluses to service the restructured debt. The government is committed to continuing to enforce these agreements at the original terms, using the means provided to it by the agreements, as it has already done on a number of occasions so far. The recently enacted administrative and social security reforms provide the necessary legal framework for the states to begin steadily reducing their payroll spending, an indispensable condition for the generation of primary surpluses by many of the states. In this connection, the government is discussing with the World Bank a structural adjustment loan to finance the once-over costs associated with the retrenchment of state employees, to facilitate the compliance by states with the requirement of the administrative reform. Our projections suggest that the target in the stand-by program of 0.4 percent of GDP for the consolidated primary surplus of the states and municipalities in 1999 remains feasible.

  6. While many of Brazil's municipalities enjoy sound financial positions (as evidenced by the fact that the consolidated primary balance of municipal governments has shown small surpluses in recent years), some large municipalities have accumulated substantial securitized and contractual debts, especially with the domestic banking system, which they have not been effectively servicing for several years (with the unpaid accrued interest being capitalized). The total municipal debt at end-1998 is estimated at around R$24 billion (around 2.5 percent of GDP), already included in the public debt. With a provisional measure issued on February 26, 1999, the federal government proposed to refinance the securitized and contractual bank debt of the municipalities over a 30-year period, at an interest rate equivalent to 9 percent plus inflation. These debt-restructuring agreements will be modeled on those already signed with the states, and will carry the same types of guarantees of service of the restructured debt, and interest penalties for noncompliance with the requirements of the Camata Law on limits to payroll expenditures. Access by municipalities to new financing will continue to be severely limited. The debt restructuring agreements are estimated to have a favorable impact on the consolidated primary balance of the public sector equivalent to about 0.1 percent of GDP in 1999, since they will require the affected municipalities to begin generating primary surpluses to service the restructured debt.

IV. Monetary and Financial Policies
  1. The overriding objective of monetary policy is securing low inflation. The central bank intends to put in place as rapidly as feasible a formal inflation targeting framework. As a first step in this direction, the government will revise as appropriate the draft legislation on the central bank and other financial institutions, which is currently pending before congress, with a view to strengthening the operational independence of the central bank in pursuing its anti-inflation mandate. The revised proposal will include: procedures for establishing an annual inflation target, and for reporting to congress on the pursuit of this target; fixed terms of office for the president and the directors of the central bank; and appropriate limitations on the types of subsequent employment for departing Board members of the bank . Also, the central bank intends to seek the benefit of relevant foreign experiences in setting up the technical infrastructure for inflation targeting, and for this purpose has asked the assistance of the Monetary and Exchange Affairs Department of the Fund in organizing (in cooperation with the central banks of countries which utilize an inflation targeting framework) a workshop in Brasilia in April to discuss the main issues in this area.

  2. Since the move to formal inflation targeting will take some time, the central bank will rely, in the meantime, on a quantity based framework under which it will target its net domestic assets. The proposed path of NDA, set out in the attached technical memorandum of understanding, is predicated on the projected paths of inflation, real GDP and net international reserves referred to in paragraphs 6 and 8 above, assuming a likely initial increase in velocity of money, as prices increase in the wake of the exchange rate slide, followed by a gradual decline as inflationary expectations recede in the course of the year. Considerable uncertainty inevitably besets the projections of money demand in the current environment of unsettled expectations. These uncertainties are compounded by the difficulty of quantifying the prospective impact of changes in the IOF and CPMF taxes on the composition of households' and enterprises' financial portfolios. It will be necessary, therefore, to keep the development of the monetary aggregates under close review, and be prepared to modify the program targets if the exchange rate (as a leading indicator of inflationary pressures) or rate of inflation were to deviate significantly, and on a sustained basis, from their assumed paths, since such developments could signal that the demand for money had been either overestimated or underestimated.

  3. An increased focus by the central bank on inflation and the monetary aggregates will require appropriate flexibility in the management of interest rates. As a step in this direction the central bank on March 4 eliminated the existing band for rediscount rates (TBC and TBAN), linking the latter to the overnight market rate. It also raised the reference rate for the overnight interbank market by 6 percentage points, to 45 percent. Also, with a view to reducing bank liquidity, the central bank had already increased on March 3, 1999 from 20 percent to 30 percent the remunerated reserve requirements on time deposits. It will also endeavor to reduce its stock of overnight repos with banks, lengthen their maturity, and begin offering to the market fixed rate securities with short maturities. The central bank intends to reduce over time the stock of its own securities in the market, utilizing treasury paper for its operations in the interbank market. For this purpose, the treasury will increase gradually its net issues of securities in the months ahead, with a view to partially replacing maturing central bank paper.

  4. The financial system has been weathering relatively well the impact of the economic downturn and the high interest rates. Although the share of nonperforming loans in the banks' portfolio has risen from 6 percent in June 1997 to 9.2 percent in November 1998 (from 3 percent to 5 percent for private banks), partly reflecting more stringent classification standards, provisions remained above 120 percent of nonperforming loans through November 1998, and preliminary information indicates that bank profitability continued to rise significantly in 1998. Stress tests suggest that the main private banks would continue to exceed required capital adequacy ratios, even if the ratio of their nonperforming loans would more than double. The central bank will monitor closely developments in the portfolios of private and public banks in the months ahead, and ensure that capital adequacy requirements are strictly observed. The central bank will also strengthen its supervision of currency exposures in the banking system, by issuing in the near term improved regulations, in line with Basle standards to limit such exposures. The central bank will also issue by the end of 1999 regulations on market risks of banks, based on Basle standards, and implement a forward-looking loan classification scheme, with technical assistance from the World Bank.

  5. The government will pursue with determination its ongoing policy of streamlining and reducing over time the role of public banks in the economy. It has already privatized in 1998 the federal Banco Meridional, and will privatize the sixth largest Brazilian bank (BANESPA), which is under federal administration, in the course of 1999. It has also requested the high-level committee overseeing the remaining federal banks (Banco do Brasil, Caixa Economica, BNDES, BASA, and BNB) to present by end-October 1999 recommendations on the future role of these institutions including possible divestitures, mergers, sales of strategic equity stakes, or transformation into development agencies or second-tier banks. These recommendations will be analyzed and decided upon by the government before the end of the year, and the decisions will be implemented in the course of 2000. The government has already decided on the privatization of the asset management affiliate of the Banco do Brasil (BB/DTVM) and of the federal reinsurance company (IRB Brasil-RE). At the same time, the ongoing process of privatization, closure or transformation into development agencies of remaining state banks will continue. The privatization of the banks of, in particular, the large states of Bahia, and Paraná, is expected in 1999, following the successful privatization of the state banks of Rio de Janeiro, Minas Gerais, and Pernambuco, among others, in the last two years.

V. External Policies
  1. Under the new floating exchange rate regime, central bank sales of foreign exchange in the market will be conducted regularly to meet the projected overall balance of payments financing needs. A limited amount of unsterilized intervention may be undertaken occasionally to counter disorderly market conditions. The central bank will refrain as from the beginning of March 1999 from intervening in the foreign exchange futures market. The adoption of a floating exchange rate regime has facilitated the elimination as of February 1, 1999 of the dual exchange markets (the commercial and the floating rate). This paves the way for early acceptance by Brazil of the obligations under Article VIII, Sect. 2, 3, and 4 of the IMF's Articles of Agreement. Assistance has been requested from the Fund's Legal and Monetary and Exchange Affairs Departments to ascertain which, if any, obstacles remain to such a move.

  2. The government intends to seek the voluntary commitment of foreign banks to maintain, and over time gradually increase, their exposure to Brazil. Brazilian corporate borrowers have continued to access foreign capital markets in recent months with small issues of notes and commercial paper, and we expect this trend to accelerate in the months ahead, as confidence rebuilds. We are also planning one or more sovereign bond issues later in the year, as market conditions improve. It is, however, the government's intention to limit the public and publicly guaranteed external debt within the ceilings specified in the technical memorandum of understanding, and also to limit the share of the short-term debt in the public external debt.

  3. The government remains committed to the policy of trade liberalization adopted in the first mandate of President Cardoso (summarized in the Memorandum of Economic Policy of November 1998). In order to level the playing field for Brazilian exporters, the government carries out a program of limited export financing and equalization of interest rates similar to those provided by OECD members, in line with the Berne Union consensus and in conformity with WTO regulations. The 1999 budgetary appropriation for interest rates equalization is equivalent to less than 0.1 percent of GDP, and most of this is already committed. Given the improvement in competitiveness, and in view of the very high level of domestic interest rates, and tight credit, the government intends to limit the scope of the interest equalization program to exports of goods with a long production cycle, such as capital goods. As indicated in paragraph 10 above, it has also suspended the rebate of the PIS and COFINS to exporters.

VI. Structural Policies
  1. The previous memorandum on economic policies provided a comprehensive overview of the government structural reform agenda in the short to medium term. This memorandum outlines the progress made in the last three months in the pursuit of that agenda, as well as some planned modifications to it.

  2. An important landmark was the final approval by congress in November 1998 of the constitutional amendment on the reform of the social security. This reform sets out general principles--applying to the public pension systems for both private and public employees--regarding actuarial balance of the systems, minimum number of participants and individual notional contribution accounts. It also caps for public pension systems the ratio of employer to employee contributions at 2:1; and requires an increase in employee contributions whenever pension expenditures (net of contributions) at any level of government exceed 12 percent of the net revenue of that government. Congress also approved on January 28, 1999 laws raising the contribution rate for civil servants from 11 percent to 20-25 percent, depending on the salary level, and introduced a graduated contribution on retired civil servants whose pensions exceed R$600 per month. The government will present to Congress during the next few months more detailed legislation to implement the principles set out in the constitutional reform of the social security for private and public sector workers, as well as new legislation to regulate private pension funds.

  3. The enabling legislation for the Administrative Reform Law (a constitutional amendment approved in 1998) is progressing through congress. A bill establishing the modalities to apply the Camata Law--which sets limits on government payroll spending as percent of net revenues--was approved by the House in January, and is now under consideration in the Senate. So are rules governing the dismissal of civil servants in case of overstaffing. A law regulating dismissals for substandard performance and another providing increased flexibility in the recruitment of civil servants have been sent to Congress.

  4. A tax reform proposal to revamp the present complex and inefficient system of indirect taxation was presented by the government in December 1998. The proposal includes: (i) the replacement of most existing indirect taxes (including the VAT-like federal and state taxes (IPI and ICMS) and some of the earmarked social contributions levied on turnover (PIS and COFINS) or on profits (CSLL)) with a new national VAT, with a federally determined level and base, but administered by the states, and the revenue of which would be shared by the federal, state and local governments; (ii) the creation of selective excises at the federal level; and (iii) the utilization of the financial transactions tax (CPMF) as a minimum tax, deductible against other federal levies (possibly the income tax). This proposal aims at eliminating current distortions in the tax system, greatly simplifying its structure, and limiting the scope it currently affords for evasion and erosion of the indirect tax base. The reform is designed to be revenue-neutral ex-ante, but its successful implementation should yield fiscal dividends over time, especially by facilitating effective enforcement.

  5. A draft of the proposed Fiscal Responsibility Law, along the lines set out in paragraph 15 of the previous memorandum of economic policies, was unveiled by the government in December 1998, and comments on it are being sought from state and local governments, and from the community at large, as well as from international organizations. A revised draft incorporating these comments is to be sent to congress shortly.

  6. The government intends to accelerate and further broaden the scope of its privatization program--already one of the most ambitious in the world. In 1999 it intends to complete the privatization of federal electricity generation companies, and in 2000 it will begin the privatization of the electricity transmission network. At the state level, most remaining state-owned electricity distribution companies are expected to be privatized in 1999. The government has also announced the intention to sell in 1999 its remaining shares of previously privatized companies (notably Light and CVRD), as well as the remaining portion of the noncontrolling share of Petrobrás. The legislative framework for the privatization or leasing of water and sewage utilities is being prepared. The government also intends to accelerate the privatization of toll roads and the sale of its redundant real estate properties. Total receipts from privatization are projected at around R$27.8 billion (nearly 2.8 percent of GDP) (of which R$24.2 billion at the federal level) in 1999 and at R$22.5 billion over the period 2000-2001.

  7. As the memorandum of economic policies of November 1998 explains, Brazil's economic and financial statistics are in many respects very well developed. Nonetheless, there are weaknesses in certain areas, particularly national income accounting, which the government intends to address. Consequently, it has asked the Statistics Department of the Fund for assistance in making a diagnosis of these weaknesses, and advising on improvements needed to subscribe to the SDDS. A mission is planned in the first half of this year.