IMF Executive Board Concludes 2006 Article IV Consultation with BrazilPublic Information Notice (PIN) No. 06/69
June 19, 2006
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On May 31, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Brazil.1
Since the last Article IV consultation, the Brazilian economy has continued to expand, albeit at a more moderate pace than in 2004. Real GDP growth is expected to rise by some 3½ percent in 2006, up from 2¼ percent growth in 2004. Inflation has also converged toward the official target of 4½ percent, providing room for a sustained gradual easing of monetary policy starting in September 2005.
Brazil's external position has strengthened further. Favorable global market conditions, including buoyant demand and rising commodity prices have contributed to high trade and current account surpluses. At the same time, positive financial market sentiment, ample global liquidity, and high domestic interest rates have boosted capital inflows. Sovereign bond spreads have narrowed to all-time lows, stock prices have risen to historic highs, and the real has appreciated to its highest level since early 2001, although the recent bout of volatility in world markets has reversed some of these gains. The central bank has taken advantage of these favorable conditions to build official international reserves and retire external debt—including through the early repurchase of all outstanding obligations to the Fund and repayments to Paris Club creditors, as well as buybacks of private external debt. Brazil's external debt has declined to its lowest ratio to exports in more than twenty five years. The authorities have also taken advantage of favorable external conditions to deepen Brazil's domestic financial markets and enhance their integration with global markets, by liberalizing foreign exchange regulations and eliminating the withholding tax on foreign holdings of public securities.
In 2005, Brazil's non-financial public sector primary surplus reached a record high, 4.8 percent of GDP—well above the target of 4¼ percent. In the first few months of 2006, the 12-month primary surplus declined to around 4.4 percent of GDP, reflecting more subdued revenue growth and a steady increase in spending. The 2006 Budget approved by Congress and the 2007 Budget Guidelines Law (LDO) submitted to Congress maintain the existing fiscal framework, including the target for the primary surplus.
Net public debt declined from 54¼ percent of GDP at end-2004 to around 51¾ percent in 2005, reflecting the combined effects of the primary surplus and exchange rate appreciation. At the same time, debt management operations have eliminated exchange rate-linked domestic debt and almost doubled the maturity of new domestic issues of floating-rate and fixed-rate debt.
Executive Board Assessment
Executive Directors welcomed Brazil's good economic performance, noting the continued economic expansion, the convergence of inflation toward official targets, and the considerable strengthening of the external position. They stressed that vulnerabilities have been reduced, as external debt has been brought down to its lowest ratio to exports in more than 25 years, international reserves built up to more comfortable levels, and the composition of domestic debt improved. Directors saw these developments as conducive to greater stability and long-run growth. They also welcomed the decline in unemployment and the significant progress made in alleviating poverty and inequality, including through active social policies.
Directors stressed that this favorable performance testifies to the benefits of disciplined macroeconomic management. The maintenance of high primary surpluses has helped to lower public debt, while active asset and liability management has substantially improved its structure, notably by virtually eliminating exchange rate risk from the public sector balance sheet. The central bank's skillful and resolute approach to monetary policy in the inflation-targeting framework has also played a vital role by anchoring inflation expectations. While near-term prospects are favorable, the rise in global risk aversion toward emerging markets in recent weeks highlights the importance of maintaining a prudent policy framework and continuing to reduce vulnerabilities.
Directors discussed the policy issues associated with Brazil's strong external position. They noted that the real appreciation of the real over the past year mainly reflected the strong macroeconomic fundamentals and current account performance. Directors generally supported the authorities' pragmatic response to the recent large foreign exchange inflows—taking advantage of a favorable external position to build international reserves and to reduce external debt, while allowing the currency to move in response to market conditions. At the same time, some Directors considered that the quasi-fiscal costs of sterilized intervention imposed limits on further reserve accumulation. Directors also stressed that the authorities should continue to look for opportunities to liberalize external trade and foreign exchange market regulations, which would encourage the continued integration of the Brazilian economy with the world economy.
Directors considered unlocking Brazil's growth potential to be the most important challenge. While per capita growth has recovered and is now on a more solid footing, Brazil can do much better. Directors believed that boosting medium-term growth prospects will require consolidating macroeconomic stability, by solidifying the institutional underpinnings of policies, improving the efficiency of the public sector, and further strengthening the public sector balance sheet. At the same time, it will be important to push ahead an ambitious set of broader structural reforms aimed at improving financial intermediation, encouraging a more open economy, and strengthening the business environment. Such a combination of policies would help lower real interest rates and provide conditions conducive to higher productivity growth and investment, setting the stage for continued progress in tackling high poverty and income inequality.
Noting that sustained fiscal discipline must be the bedrock of any growth strategy, Directors welcomed the authorities' commitment to maintain the primary surplus targets stipulated in the draft Budget Guidelines Law through 2009. While a number of Directors suggested that aiming for an even higher primary surplus in 2006 would help accelerate debt reduction and provide greater room for monetary easing, many others considered that overperformance in any one year should not be viewed as a benchmark for fiscal policy implementation going forward. Directors supported the authorities' strategy of reducing public balance-sheet vulnerabilities by substantially reducing the share of floating-rate debt and lengthening maturities, welcoming both the substantial progress already made and the authorities' continued efforts in this direction.
Directors emphasized that steps to improve the quality of fiscal policies are an essential complement to medium-term fiscal consolidation. In particular, they recommended scaling back revenue earmarking and mandatory spending requirements—including the growing imbalance of the social security system—and phasing out tax distortions and inefficiencies. In addition, explicit medium-term goals for debt reduction and an effective strategy to contain expenditure and revenue trends would further strengthen the fiscal framework. Such a multi-year framework would provide a context within which to set annual primary surplus targets and to properly sequence fiscal reforms needed to achieve these objectives.
Directors congratulated the authorities for successfully guiding inflation toward its targets and supported the central bank's continued cautious monetary easing. They noted that formal central bank autonomy could help solidify the monetary framework. While some Directors suggested modifying the inflation targeting framework by moving to rolling targets and narrowing the band, several other Directors thought that such modifications should be considered only after extending the track record of consistently meeting the current targets to further strengthen the credibility of the framework.
Directors welcomed recent measures to deepen financial markets while stressing that more needs to be done. While recent credit-market reforms in Brazil have contributed to a substantial rise in intermediation, many Directors considered that reducing high reserve and directed lending requirements, as well as phasing out financial transaction taxes, would further deepen financial intermediation and provide a more efficient allocation of resources. Many other Directors, however, cautioned that the scope for reducing reliance on directed lending would depend on progress in developing domestic capital and credit markets. Directors encouraged the authorities to bolster the prudential framework, notably to ensure that potential risks related to new financial products, such as payroll-linked loans and derivatives, are well monitored and contained. They welcomed the reduction of taxes on foreign investment in domestic public securities, which increased market liquidity for longer-term bonds, and encouraged the authorities to continue reducing impediments to deepening domestic financial markets and extending the longer end of the local yield curve.
Directors noted that structural reforms in other areas were important to foster growth, including further steps to enhance the business environment to boost productivity growth and investment. They emphasized that reducing the heavy tax and regulatory burden on employment in the formal sector can play a key role in reducing labor market informality, thus promoting productivity and growth. With regard to trade liberalization, Directors encouraged the authorities to continue to play a leadership role toward achieving a successful Doha round, as well as taking other steps to deepen Brazil's integration with the global economy.
Directors also reviewed the ex post evaluation report on Brazil's experience with exceptional access under the 2002-05 Stand-By Arrangement. They noted that the Fund had taken a calculated risk in providing exceptional access to Fund financing to support Brazil's policy program in 2002 that had proved highly successful in helping Brazil to respond to its liquidity crisis. Directors attributed this mainly to the sound policies implemented—notably the primary fiscal surplus target, the inflation targeting framework for monetary policy, and skillful debt management to reduce vulnerabilities. They stressed the importance of strong ownership in underpinning the authorities' excellent track record of program implementation. A range of views were expressed on the role of conditionality in the program. On the one hand, a few Directors noted that more extensive conditionality would have provided stronger safeguards for the Fund in a risky situation, and that more ambitious goals for structural fiscal reforms would have reduced fiscal rigidities and enhanced growth prospects. On the other hand, many Directors believed that the relatively parsimonious conditionality had helped to ensure program ownership. With regard to the phasing of access under the program, a number of Directors considered that the backloading of the access to financing had appropriately promoted policy discipline and the restoration of market confidence, while some other Directors expressed the view that such backloading had limited the benefits of providing exceptional access in addressing adverse liquidity conditions.