Brazil's Second-Best Financial Strategy
Can smart monetary policy revive investment?
In November 2009, the cover of The Economist showed the iconic Christ statue overlooking Rio de Janeiro blasting off into outer space. This image, along with the cover headline, "Brazil Takes Off," represented the Carnaval-like euphoria about Brazil that infected journalists and financial markets at the time, buoyed by the country's impressive economic performance in the wake of the 2008 global financial crisis.
But since then, giddiness has turned to gloom. As the country's economy begins to cool, Brazil bears are on the rise. Downbeat assessments, such as Nomura Bank's recent prediction that Mexico will overtake Brazil as Latin America's largest economy in the next decade, have cooled investor enthusiasm. GDP growth has screeched to a sudden stop, falling from 7.5 percent in 2010 to 2.7 percent in 2011 and 0.9 percent in 2012. Between January and November 2012, Brazil experienced a $7.1 billion net outflow in portfolio investments, compared to a $14.3 net inflow for the same period in 2011.
Brazil's critics blame flat productivity growth, high taxes and low-quality public services for the country's weakened performance. They have called for reduced government spending, tax reform and an improved business environment. None of these are on President Dilma Rousseff's political agenda, and they are unlikely to be meaningfully addressed in the near future.
Brazil is a middle-income country with an expensive European-style welfare system. Government spending is approximately 40 percent of GDP, a high figure for a developing country. The average rate in South America, excluding Brazil, is 26 percent.
Nearly 75 percent of government revenue, excluding borrowing, is earmarked for specific social programs by the country's constitution and cannot be reduced without an amendment approved by a two-thirds majority of both legislative chambers. With little wiggle room for reform, skeptics argue that Brazil is condemned to sub-par economic growth for the foreseeable future.
Despite capturing many of Brazil's realities, this pessimistic view overlooks a potentially tectonic economic shift: the fall of real interest rates.
The government is sidestepping complicated fiscal issues and rolling out a second-best solution to boost economic growth. That policy is using monetary policy to achieve much-needed structural reform.
Will it work?
A History of High Interest Rates
Brazil is famous for having the highest interest rates of any major economy-a dubious honor that inhibits economic activity. While benchmark rates were approaching zero in the major Western economies, they were 12.5 percent in Brazil in 2011. The interest rates on bank loans available to businesses and consumers often exceed 50 percent a year, and pose a huge economic challenge.
It is difficult to pinpoint the reason for the elevated rates, but often-cited causes include low domestic savings rates, high fiscal indebtedness, a legacy of high inflation, price indexation, and high levels of subsidized credit.
Regardless of the reason, high rates impose huge costs.
In 2008, the last year for which data are available, families paid $85 billion on interest payments, or 5.7 percent of GDP. The cost of capital compels the government to intervene in the markets and to direct subsidized credit to certain areas of the economy, a situation that is far from ideal.
Financial systems have two general vehicles for channeling credit of longer duration throughout the economy. Commercial banks can issue loans to clients directly, or investment banks can work with private businesses to issue securities in the form of bonds or stocks. In Brazil, the private sector fails to provide either type of funding in sufficient quantities.
Instead, the country relies on a state-owned development bank, the Banco Nacional de Desenvolvimento Econômico e Social (BNDES), to disburse long-term credit to companies. In 2011, the BNDES provided 72.4 percent of all bank loans for maturities of three years or more. Other state-owned banks supplied another 14.8 percent, which means that the private sector provided only 12.8 percent of long-term bank financing. Corporate bonds financed 17 percent of investment in industry and infrastructure. Equities provided a measly 1 percent.
The BNDES is one of the reasons that the country can continue to invest and grow in a high interest rate environment. It receives subsidized funding sources from the government and, in turn, provides credit to its clients at a below-market rate.
Relying on one institution to finance nearly all of the economy's investment needs is far from ideal. The BNDES' monopolistic position in the financial system reduces incentives for innovation and other efficiency-enhancing behavior, with critics arguing that the development bank crowds out private-sector lending.
Furthermore, public banks alone cannot provide the levels of investment required for Brazil to grow. The Rousseff administration understands that private-sector participation is needed to boost investment, and in 2012 it set a goal of attracting $1 trillion in private investment by the year 2032.
Lower Rates to the Rescue
Recognizing that the current set-up is unsustainable for robust, long-term growth, the government is currently engaged in a campaign to drive down interest rates. While the process is far from complete, the government has achieved meaningful gains. The overnight interest rate fell from 12.5 percent in July 2011 to 7.25 percent in December 2012. Real interest rates-the nominal rate minus inflation-fell from 5.8 percent to slightly less than 2.0 percent in the same period.
In October 2012, Finance Minister Guido Mantega explained why high rates are not justified in the current environment: "Average rates of 40 percent to 50 percent per year are a lot for an economy that has inflation of 4.5 percent and 5 percent."
The twin approach of lowering interest rates and boosting private sector lending is a process with four moving parts. First, the monetary committee of the Brazilin central bank, which is responsible for setting the benchmark interest rate, took advantage of the global economic slowdown to reduce rates while inflation pressures remained subdued. In August 2011, Brazil's central bank was one of the first in the world to initiate an easing cycle, presciently grasping the severity of the euro crisis and its impact on global demand. It cut rates several months before Brazil's inflation peaked and has thus far managed to lower rates by 525 basis points.
Second, the Rousseff administration is doing its part to support the central bank, cutting costs and averting the need for a rate hike. The government launched a program to reduce energy prices by 28 percent for businesses and 16 percent for consumers through tax cuts and contract renegotiations with private power supply companies. It pressured state-owned oil company Petrobras to delay fuel price increases until 2013.
Given its determination to reduce rates, the government is likely to find other areas to cut prices if inflation continues to breach the upper end of the official 2.5 to 6.5 percent target.
Third, the government removed an impediment to lower rates when in 2012 it amended rules governing savings accounts, which guaranteed an annual rate of 6 percent. While a great deal for the country's savers, the accounts effectively set a floor to the benchmark rate. If the rate approached the yield on savings accounts, investors would be inclined to dump government bonds and transfer their money to these special accounts.
The government changed the rules so that the accounts would only yield 70 percent of the benchmark rate if it were 8.5 percent or lower, allowing the central bank to reduce rates as much as it deemed appropriate.
Fourth, the government has pressured private banks to lower the spread-the difference between a bank's borrowing and lending costs-in an attempt to pass on the benefits of lowered rates to consumers.
At 30 percent, Brazil has some of the highest spreads in the world; Mexico, by contrast, has spreads of 4.1 percent. In the first half of 2012, the government ordered state-owned banks Banco do Brasil and Caixa Econômica Federal to lower rates charged for consumer and business loans, pressuring private banks to follow suit or risk losing customers. Between July 2011 and December 2012, average annual rates fell from 121 to 88.8 percent for individuals and from 61 to 47.5 percent for businesses.
While this may seem like excessive government interference, there is evidence suggesting that private banks could offer more competitive rates without jeopardizing their financial health. The banking sector is the most profitable sector in the economy, generating large returns by simply investing in high-yield government bonds rather than lending to the private sector.
The easy profits mask high levels of inefficiency. While revenues per employee are broadly in line with international standards, Brazilian private banks need twice as much staff to manage similar volumes of lending operations as banks in Europe and the United States.
Benefits for the Overall Financial System
Lower interest rates yield short- and long-term effects. In the short term, the currency has depreciated nearly 40 percent against the dollar as lower yields reduced investor demand for the Brazilian real, making exports more competitive.
The International Monetary Fund reports that 23 percent of disposable income goes to paying down interest on debt. The government hopes that reduced credit costs will free up income to spend on other goods.
The long-term effects have the potential to restructure the existing financial system. A lower interest rate environment alters the incentives that currently govern the financial system, encouraging savers to seek higher investment returns via riskier assets like equities and long-term debt. In a high interest rate environment, an individual could receive 6 to 7 percent by placing her money in a risk-free savings account, reducing the incentive to invest in riskier assets.
These incentives have changed with lower rates: in 2012, saving accounts yielded only a 0.6 percent real return. Banks and individuals must find new places to park their money if they want higher investment returns.
The new incentive scheme that accompanies the interest rate reduction also has the potential to increase private-sector participation in the financial system and improve efficiency.
A common critique of BNDES is that it displaces private sector activity; with its access to subsidized finance it can offer lower interest rates on loans and outcompete private banks. If the bank is really crowding-out private- sector activity, the answer is to have the government reduce lending levels and wait for private financial institutions to move in. In other words, the credit needs of the country would be met if the government allowed market forces to work on their own.
As long as interest rates remain elevated, though, this is an unlikely scenario for two reasons.
First, private banks have no incentive to lend for long durations because they enjoy a lucrative business purchasing government bonds. Any long-term loan would have to yield a return that is significantly higher than the short-term rate, making the cost of credit prohibitively expensive for borrowers. For this reason, 75 percent of the money invested in industry and infrastructure comes from the BNDES money and from retained corporate earnings.
Second, the idea of reducing BNDES lending to create space for the private sector is politically unrealistic. If the development bank, the primary source of long-term funding, were to significantly reduce credit, the country's investment level would substantially decline.
The end result would be a period of subdued investment levels that would jeopardize the economy's productive capacity. The private sector would eventually supply the credit, but subdued lending would be seen before banks offered the credit needed.
Lower interest rates change the outlook of this scenario. Not only would the private sector be more inclined to offer credit at longer durations, they would also demand a lower rate of return, making capital more affordable. As privately sourced financing flows toward long-term investment, BNDES would be able to reduce its dominant position.
Will It Really Happen?
The central bank lowered rates rather quickly, but increasing the private sector's role in credit markets will take time. Banks must reorient their business strategies, create new financial products and alter investor behavior. Developing a liquid corporate bond market will take years.
There are hopeful signs that banks are starting to lend in longer maturities. Several banks have created tax-exempt funds that invest in long-dated infrastructure projects and offer savers greater yields. The volume of issuances in the capital debt markets increased 31 percent in 2012.
Lower rates do create a window of opportunity, but the results are far from guaranteed. Private sector actors will continue their risk-averse behavior if the government fails to provide a stable and secure investment climate. Despite all the rhetoric about enticing private money, the government has thus far failed to define the rules for investment. For example, port operators claim $22 billion in investment has been stalled. The share value of Brazil's energy companies declined 30 percent in late 2012 when the government strong-armed these companies into renegotiating their contracts.
Investors are weary of committing their money in a country where they consider government intervention to be haphazard. Lower rates incentivize businesses to invest in longer-term projects, but the government must be willing to accept a more hands-off approach to economic management.
The BNDES must also actively take steps to reduce its role in certain sectors of the economy. The most likely scenario is that lending volumes will decrease in relative rather than absolute size. The bank's vice president, João Carlos Ferraz, said as much to the Financial Times last September: "Is there a trend for the bank to become smaller in absolute terms? No. But is there a tendency for the bank to become smaller in relative terms? Yes."
The fact that the BNDES understands it has a limited role in the country's capital markets and is taking steps to boost the private supply of longer-dated credit is a hopeful sign.
The bank has a history of launching successful programs that support capital market development. The asset management arm of the bank, BNDESPAR, helped established a venture capital market. The bank is now promoting a number of initiatives designed to crowd in private sector investment and support the development of the local bond market.
Finance as a Second-Best Solution
President Rousseff has aggressively pursued an effort to reduce interest rates, hoping to lower the cost of financing and boost private-sector participation in the financial system. Fiscal reform-rather than the current monetary focus-might do more to boost growth prospects, but this is more politically complicated.
Most people agree about the need for fiscal reform, but not on how to do it. Promoting reform through the financial sector is much easier because the costs fall on the banks.
The second-best solution is not unique to Brazil. The U.S. has relied on monetary policy to stimulate a weakened economy, while the European Central Bank has injected liquidity into struggling banks to keep the system afloat.
Lower interest rates may not be the best way to increase Brazil's growth potential, but they should not be discounted. Taxes remain high and regulation continues to be overly complicated, yet one of the major structural constraints is being addressed and government intervention in the financial markets will subside.
Cheaper credit will spur investment, reduce the cost of doing business and allow the government to reduce its role in financial markets. The economic distortions associated with high interest rates will decrease, and Brazil's financial system will start to resemble those found elsewhere.
With abundant natural resources and a large population, the country is a latent economic powerhouse. As the Rousseff government addresses a major constraint to growth-costly credit-Brazil's blast-off is not imminent, but it is closer than it was before.
Published by America's Quarterly.
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