Brazil and the IMF
Country's Policy Intentions Documents
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Brazil—Letter of Intent
Mr. Horst Köhler
1. Having taken office two months ago, the administration has already started to fulfill its mandate to strengthen macroeconomic stability, accelerate economic growth, and improve social conditions. While the realization of our goals will take time and involve a comprehensive policy effort in many directions, the main task now is to strengthen confidence in economic policies and address the most urgent social needs. This letter describes the immediate policy priorities of our administration.
2. In 2002, Brazil weathered a strong economic shock from a deteriorating international environment and market doubts about the conditions of the Brazilian economy. The economy responded to these pressures with a rapid 3 percent of GDP adjustment of the current account balance, led by a sharp improvement in the trade surplus as the private sector responded swiftly to changing macroeconomic conditions. Exports grew 8 percent in volume, more than offsetting a deterioration in the terms of trade, while the financial sector proved its resilience in the face of adverse conditions. Remarkably, the adjustment in the trade balance was achieved without a recession: GDP grew 1.5 percent while employment rose by about 2 percent. The sharp depreciation of the real, however, led to a burst of inflation in late 2002, the effects of which have spilled over into 2003.
3. Table 1 summarizes the key macroeconomic parameters underlying the program. The strong policies adopted so far and the agenda of structural changes outlined by the government are expected not only to help growth, but also to reduce perceived vulnerabilities. This is important because, while market sentiment has improved, the global situation remains fragile. In particular, the prospect of war in Iraq has dampened the global economic outlook and aggravated the increased risk aversion caused by the burst of the asset bubble and a wave of corporate governance problems in developed countries.
Table 1. Macroeconomic Parameters
4. The 2002 fiscal outturn once again over performed relative to program targets, registering a primary surplus over 3.9 percent of GDP and net debt of the public sector of 56 percent of GDP at year-end prices. Following a review of the outlook for debt sustainability, the government has decided to tighten fiscal policy further, targeting a primary surplus of 4¼ percent of GDP in 2003, some ½ percent of GDP above the previous target. A budget execution decree has already been issued adjusting the limits on discretionary federal spending in line with this new target. State governments and public enterprises will also contribute to this adjustment, in line with trends in their revenues and, in the case of public enterprises, also new management practices. In our view, this move goes a long way toward fundamentally strengthening public finances, and we believe that the revised target is robust. As a result of this decision, the performance criteria for the primary balance of the consolidated public sector and the indicative ceilings on public debt for the remainder of the program period, and the procedure for quarterly reassessment of the primary surplus target, are being adjusted as proposed in Box A. Nevertheless, debt sustainability prospects and fiscal targets will be kept under our continuous review. The government intends to generate primary fiscal surpluses over the medium term sufficient to ensure a steady reduction of the public debt to GDP ratio. Toward this end, specific fiscal targets for 2004-06 will be presented to Congress in April as part of the Budget Guidelines Law. To lessen any fiscal vulnerabilities, we also aim, as market conditions permit, to lengthen debt maturities, reduce exposure to exchange rate-indexed instruments, and increase the share of fixed rate debt. This process was resumed in January, with a doubling of the maturity of new issues and a decline in the share of dollar-linked debt.
5. The new administration has confirmed its full commitment to a floating exchange rate and the inflation targeting framework. In line with this framework, and following the exchange rate-driven rise in inflation, the central bank published an open letter describing the reasons inflation exceeded its target, the outlook ahead, and the monetary policy response in 2003. The central bank is also sending a separate letter to the Fund, as end-2002 inflation exceeded the upper limit of the consultation band under the program. Monetary policy has remained vigilant. The central bank has responded to the pick-up in inflation with higher reserve requirements for banks and a cumulative 850 basis point increase in policy interest rates since October, in order to avoid the propagation and perpetuation of the exchange rate shock of 2002. The goal is to guide inflation towards a declining path consistent with the adjusted targets. Given the inflation already in train, and the sizeable economic costs of fully disinflating in one year, we have chosen to achieve our inflation targets of around 4 percent over a longer horizon, and have thus set an operational inflation target of 8.5 percent for end-2003. Correspondingly, the inflation consultation band for end-March, end-June, and end-September is modified as proposed in Box A. The operational inflation target is consistent with lower quarterly inflation, although the 12-month rate remains high on account of the carryover of inflation from the last quarter of 2002. The BCB will continue to set monetary policy in a forward-looking manner, based on its inflation forecast, and to act promptly to achieve the operational inflation target.
6. A fundamental strengthening of the economy requires deep structural reforms. While we are still in the process of formulating specific measures, we have established clear objectives for 2003 as set out in the following paragraphs. Importantly, the government has begun to build a broad consensus for these reforms. In this context, a big step forward has been an agreement with the governors of all 27 states on the guiding principles for pension and tax reforms. These principles are set out in the Brasilia Letter of February 22, 2003.
7. A key fiscal problem facing the country now is that of the pension system for the public sector. The government reform aims to increase the fairness of the social security system and put the long-term finances of the pension system of the public sector system on a sounder footing. The government is examining various options, including, among other things, a review of the retirement age, the minimum period in public service entitling civil servants to a pension, as well as new rules for survivor pensions, and will send a detailed proposal to Congress by mid-year aimed at significantly reducing over time the civil servants' pension deficit. The envisaged reform aims chiefly at correcting the regressive redistribution of income through the pension system and improving the system's medium-and long-term finances. To the extent that there are costs to the changeover, including from the complementary pension funds for new civil servants, the reforms will be made consistent with the government's medium-term fiscal goals. The passage of the enabling legislation for complementary pension funds (PL9), remains among our priorities and will be part of the proposed reform (Box B).
8. To improve the structure of taxation, the government is working on a tax reform proposal focused on reducing regressivity, the bias against exports, the level of revenue earmarking, tax competition among states, administrative costs, and tax evasion. The reform will seek to be revenue-neutral, maintaining the value of revenues at all levels of government, while improving the efficiency of the economy. As such, tax reform will be an important companion to the pension reform, contributing to a structural change in the fiscal outlook of the country. The government is also alert to the need to offset any reduction in tax revenues arising from the scheduled decline in the CPMF rate and the impending expiration of de-earmarked federal revenues (DRU). A proposal for tax reform consistent with the Brasilia Letter, and addressing the issues related to the CPMF and the DRU, will be submitted to Congress by end-June. Accordingly, Box B sets a new benchmark on tax reform that replaces the end-March structural benchmarks on those issues.
9. We intend to pursue our structural agenda on several other fronts. First, the government will aim to secure early congressional approval of the constitutional amendment facilitating the regulation of the financial sector—a necessary step to pass the intended central bank law formalizing the operational autonomy and increasing the accountability of the central bank. Second, the government continues its efforts to move ahead with the sale of the remaining four federalized state banks, for which the structural benchmark is proposed to be reset to end-June, 2003. Third, to reduce interest rate spreads and increase the availability of credit for investment, the government intends to secure passage of a modern bankruptcy law. This law aims to help viable businesses to continue to operate while transferring ownership, and to better define the rights and seniority of creditors in distributing business assets.
Social Policies and Growth
10. Resumption of growth, together with a better distribution of income, is the principal objective of the new administration. Therefore, in addition to the measures described above, the government intends to take steps to increase competitiveness and improve the climate for long-term growth. To this end, it will aim to facilitate international trade, among other things, working with trade partners to eliminate barriers. The government is also working on initiatives to raise the supply of credit to small and medium-size enterprises, including by private institutions and by credit unions under prudential rules and transparent mechanisms. In this connection, the government has published a provisional measure
11. A reduction of the large inequities in the distribution of income in Brazil is a core theme of this government's policy. While higher growth will help, given the urgency of Brazil's social problems, it will not be enough to eliminate extreme poverty. Therefore, the government has developed a Zero Hunger program under the aegis of a dedicated ministry. While the Zero Hunger program is an important first step, the government will outline, over the coming months, a broader reform of government transfers and existing social programs. To coordinate the social program, the government has created a new Ministry of Assistance and Social Development that is reviewing existing programs and seeking ways to integrate these to eliminate duplication and deliver more to the truly needy. These reforms will enable all of Brazil's people to participate more fully in the country's wealth and potential.
12. We expect implementation of this policy agenda will guarantee a stable economic environment with equitable and sustainable growth and, over time, will lead to a reduction in poverty and improvements in social and human capital indicators. As always, the government stands ready to take additional policy measures needed to ensure attainment of its objectives. We will also maintain the usual close policy dialogue with the Fund.
Box B. Structural Benchmarks