“The tightening of the economy is already being done by inflation”

Claudia Safatle – Valor Econômico, 6/16/2014

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Former Central Bank President, Armínio Fraga: “A tidy and restructured economy will have interest rates dropping to normal levels.”

Armínio Fraga, former president of Brazil’s Central Bank, and partner at Gávea Investments, warns that “the seed of unemployment is already present, since the economy is unfortunately not growing.” To curb inflation and prevent unemployment it will be necessary to affect expectations through credible commitments and actions in the economic realm.  In an interview with Valor PRO, he said that “today, we are lacking transparency in public accounts as well as commitments to fiscal responsibility and the inflation target.”  Armínio, who is advising Aécio Neves, PSDB’s candidate for presidency, is not a fan of the “shock treatment” to bring down inflation or to adjust fiscal policy in order to lead to a higher and better primary surplus. The pace of the decline in inflation towards its 4.5% target will have to be evaluated, “in line with the understanding of the significant delays that exist for some prices.” In terms of fiscal policy, the first step to be taken should be to give transparency to the data. He believes that, if measured accurately, the primary surplus today is close to zero. “We have to get real: things are not working out. The country is not growing, and if it does not grow, frustrations will increase,” he says. It is growth, rather than income transfers to the poor, that has reduced inequalities in the country. The following are the main excerpts of the interview:

Valor: How do you see the performance of the economy until the end of this year? 

Armínio Fraga: The economy is weak, scared, and very defensive, with little investment and diminished confidence. Uncertainty has a macroeconomic dimension linked to low growth, high inflation, and current account deficit; and a micro dimension that affects each sector in a different way. In general, however, uncertainty scares off the electric and petroleum sectors, which are not the only ones but are the main ones affected. This framework has to be addressed clearly, which is not happening at the moment.

Valor: Is the lack of investments a result, primarily, from the private sector’s declining trust?

Armínio: Ultimately part of the bill always ends up in the government’s hands. There is the more macro side and another side regarding the rules of the game and the ability to run the government. It is not only the apprehension towards the quality of regulation. What we hear most is that there is a budget, but no project, or the project lacks quality and is delayed. They are large, complex projects that require multilateral actions and all you need is for one of those actions to lag, and everything falls behind.

Valor: Has the state lost its capacity to invest?

Armínio: It lost the ability to invest, although I am unsure whether it ever had it to begin with. The fact is that at this moment, it is demonstrating that it does not have it. Brazil’s lack of investment is not a recent development. However, today, the needs in infrastructure are glaring. Perhaps ten or twenty years ago, they were not. The situation got increasingly worse. The government, whoever the next president might be, will have to produce a whimsical turn in this area.

Valor: By doing what exactly? Improving and extending concessions?

Armínio: The rules and how they are being implemented will have to be examined in each sector. In addition, the government will need to be more invested in coordinating efforts in order for things to happen. Brazil as a whole will have to raise more capital. Our savings rate is almost as low as our reservoirs. Brazil has left its position as provider of savings abroad – with current account surplus – to one of savings importer, with a current account deficit.

Valor:  Is a current account deficit of almost 4% of GDP dangerous?

Armínio: I do not believe so. I believe that if the country gets back on track, there will be an increase in investment.

Valor: Former president Lula said that we must encourage more consumption in order to stimulate growth. Is it still possible, or has this process already been exhausted?

Armínio: The phase of accelerated growth coupled with consumption might have fallen behind because GDP is not growing, families became indebted, and interest rates are rising. And yet, there is a lot of space for consumption to grow. However, income has to grow as well, the cost of capital must fall and deadlines have to be stretched.

Valor: How do we move away from a pessimistic context in which the economy is slipping, and resume growth?

Armínio: In the fiscal realm, for instance, there should be efforts to promote transparency so that there are no doubts regarding “new tricks.”

Valor: What if, when giving transparency to public accounts, the situation becomes even more complicated?

Armínio: Reality is what it is. To initiate a conversation, it is important to show what the reality is and discuss how to address it. You have to provide a certain level of security and assurance and bring down inflation to the target rate through a model that will lead to a tangible downtrend – it won’t happen overnight. Inflation has been high, yet controlled, for many years now.

Valor: When presidential candidate Eduardo Campos (PSB) spoke of reducing the inflation target to 3.5% percent in 2019, President Dilma Rousseff reacted by saying that this would imply a rise in unemployment to more than 8% percent. Is unemployment unavoidable in this scenario?

Armínio: The seed of unemployment is already present, since the economy is unfortunately not growing. To reduce inflation and avoid unemployment, we will need to reshape expectations.  Today, we are lacking transparency in public spending and accounts as well as commitments to fiscal responsibility and the inflation target. The pace of the decline in inflation will have to be assessed in line with the understanding of the significant delays that exist for some prices.

Valor: There are projections of 7.5% percent inflation for 2015.  But this depends on the adjustment of fixed prices, doesn’t it? 

Armínio: The market has agreed on a number above 7% percent. If a partial correction is made, this initial shock can be avoided, but you are left with a bill to pay over time. To delay things does not mean you are solving the issue. I have still not formed an opinion. Although I am advising senator Aécio Neves (PSDB-MG), I am not thinking about this at the moment. I do not think it is time yet.

The seed of unemployment is already present, since the economy is not growing. We will need to reshape expectations.”

Valor: In an interview with foreign journalists, President Dilma, when questioned about why the country is growing so little, replied, “I do not know.” Do you know why?

Armínio: Looking through an accounting lens, the country is investing very little. To grow, you need to invest, and invest well. In order to invest, you need to have savings. It is even possible to grow for a while using foreign savings.

Valor: Did our external savings of $85 billion Reais, which is the current account deficit, not go towards investments?

Armínio: Apparently not.

Valor: How about the more than $400 billion Reais that the National Treasury transferred to BNDES (Brazilian Development Bank) to finance the expansion of investments?

Armínio: That too apparently did not go towards investment. Perhaps, without the $400 billion Reais, investment would have been lower. The end result is a very low rate of investment in a country where needs are visible. Our education is not improving at the proper pace. This is a long term investment, but also the best investment.

Valor: Does this happen because our education system lacks resources?

Armínio: For Brazil to invest 6% percent of its GDP in education is not the same as Germany investing 6% percent of its GDP, because there, as opposed to here, the per capita GDP is much higher. Experts also believe there is a management problem. Any explanation for low growth has to include the education factor.  It is true that the schooling rates have increased over the past 25 years.  More children are in school today, but many do not finish primary school, leaving as illiterates, which is shocking, and most do not finish high school.

Valor: French economist Thomas Pikkety brought inequality to the forefront of the international economic debate in the book, “Capital in the XXI century”.

Armínio: The issue of poverty and inequality is historical and is taken seriously among economists.

Valor: How can a more distributive growth be achieved? With more cash transfers and more education?

Armínio: Yes. There are two lines of work that should not be ideological. One relates to equality of opportunity. Even the most liberal of liberals tends to defend equal opportunity. Of course, many liberal see a role for government in the provision of education and public health, but not necessarily in production. I saw this, for instance, in an interview with Ricardo Paes de Barros [Undersecretary of the Secretariat of Strategic Actions]. The government is responsible for providing education, health, security, a decent judiciary, good quality public transportation. This is the basis for a society where people have opportunities, where the child of a poor person is not doomed to be poor too. This is a goal for Brazil, it is in our constitution and the government should be delivering more in these areas. This is a very powerful response to the question posed by Piketty. 

Valor: What is the other line of work?

Armínio: It is at the opposite end, which is to deter illicit enrichment that comes from corruption by the state. I recently saw an interesting fact in a publication by Professor Rozane Siqueira, from UFPE. She calculated the Gini coefficient for Brazil and the UK, before and after taxes and transfers. Usually, people’s gross income is used in this calculation. When the Gini coefficient was calculated based on net income, improvements in Brazil were minimal, but in the UK they were quite large. This indicates that, even with all the efforts put forth by the state, the results in distributive terms are still modest.

Valor: Is it possible to increase spending on social issues?

Armínio: I believe there is a lot of room for improvement using the limited spending model, that Gustavo Franco, for example, calls the “entrepreneur fund,” and focusing on areas that show more results, such as education and public health. In short, the use of public money needs more justification. It is misallocated, and not just in terms of poor production allocation, but in distribution too.

Valor: Are subsidized loans a way of producing concentrated wealth?

Armínio: Yes, but I do not believe BNDES should not subsidize. That is not what this is about. I recently wrote an article with Marcos Lisboa advocating for transparency and discretion. I think there is room for subsidies, but it is necessary to understand where the externality is and what the difference between social and private returns is. It must be justified, have transparency, and have a way to measure results. For a few years I was on the advisory committee of the World Bank. Everything the World Bank does has to be outlined with clear objectives and in a way that makes it possible to measure results.

Valor: Is industrial policy showing results?

Armínio: I do not know; there is no data available. But given the low growth rate, I suspect it is not.

Valor: Is there some other structural problem that hinders the country from growing more?

Armínio: To the contrary. Brazil has a per capita income equivalent to 20% percent of the income of the richest countries. It is very possible to have a 4-5% annual growth rate. It depends on the rest of the world as well, but there is nothing you can say that is caused by a structural issue exclusive to Brazil. What is the structural issue? Do you think Brazilian children are incapable of learning?

Valor: For several years now interest rates are higher here than in the rest of the world…

Armínio: This goes back to the military regime. The remuneration of savings by inflation plus 6%, net tax, came from them. Someone thought a 6% interest rate was good. A well-positioned economy will experience interest rates falling to a more normal rate. Interest has to be accepted at face value. It is not a direct result from someone’s individual desire or decision, but, undoubtedly, the right conditions can be created so that the country can move towards more normal interest rates.

Valor: For this to be possible, would a larger primary surplus be necessary?

Armínio: Our surplus today, if accurately measured, is close to zero. Surplus is necessary to stabilize the debt dynamic and get it out of people’s minds.

Valor: Would the surplus have to return to 3% percent of GDP?

Armínio: I do not know. It depends on how much the country will be growing. In a moment of exacerbated populism, which is the hallmark of this year’s elections campaign, fiscal policy has become a delicate topic.

Valor: The government tried to work with an inflation of 6% percent or even more…

Armínio: Food prices are growing at double digits. People know that there are fixed prices and that they do not last long. Everyone has experienced this before, and those who are too young to have experienced it, speak to their parents and grandparents. When they see prices spike, they come along with interest rates and corrections. It is useless.

Valor: Is it possible to resume a process of “dis”-inflation?

Armínio: There must be a sequence. First, we must reach a situation of normal prices that are not repressed, bring inflation to its target rate, and then decide how to proceed. I believe the target should drop a little, and slowly.

Valor: So it will first get worse, and then improve?

Armínio: Yes, but it will be a slow process.

Valor: In Brazil, election years usually pose a stress to the markets. Do you think the speculation with the exchange rate, interest rates, and taxes will happen again, much like it did in the Central Bank during the 2002 elections?

Armínio: I hope it does not, but I believe it will.

Valor: In 2002 the dollar reached $4 Reais and inflation rose. Would something similar happen this time around?

Armínio: Not at that level. That was a more extreme case in which uncertainty was strong because there was a written version of what was intended to be done, which was the Workers’ Party’s plan. The Workers’ Party evolved and Lula discarded that plan.

Valor: The Worker’s Party claims Aécio Neves’ (PSDB) campaign is committing political suicide through too much sincerity when pointing out the problems in the economy and indicating that harsh measures could be implemented. Does this not scare the electorate?

Armínio: I do not believe it is political suicide due to sincerity, but rather, due to honesty. We have to be truthful, things are not working out. The country is not growing, and if it does not grow, frustrations will increase. Scholars such as Ricardo Paes de Barros and Marcelo Neri [Minister of the Secretariat for Strategic Affairs] have written and stated, over the years, that a high percentage of reduction in poverty and inequality came from growth. From growth. That is, not the income transfer programs like Bolsa Família [family allowance]. You are speaking to someone who is not ashamed of saying he is a liberal at heart. Yes, it is important for the country to grow and spend more wisely.

Valor: Does the government always spend incorrectly?

Armínio: I think Brazil has to spend way better than it spends today. This is never questioned because everything the Workers’ Party ever says becomes the dogma of the left. Honesty is lacking. All you need is to calculate the Gini index to realize that something is not right, despite all the efforts made by Fernando Henrique, Lula, etc. In a presentation made by Marcelo Neri and Minister Tereza Campello, six months ago, their findings stated the same: growth is important and the government should spend public money better. A portion of this money goes towards the poor, but it is not that large.

“Our education is not improving at the proper pace. This is a long term investment, but undoubtedly the best.”

Valor: Do you think that the wrongful spending of public money has to do with the structure of governance that has been established, in which each sector of the public administration has to go to each party in the governing coalition?

Armínio: I believe so. Marcos Mendes discusses this in his book, “Why Brazil Grows Slightly”. The direct response is that Brazil is not investing enough and what it is investing does not seem to be of good quality. This has to do with physical capital, intellectual capital, the most basic human capital. This is where we are debtors. Why does the government not generate this response? I think it is a combination of ideology and incompetence. A part of this comes from a lack of transparency; people are not seeing exactly where the money is going. The proposal for transparency is the basis from where the answers will come. Do you want to subsidize? Go for it, but show transparency, include it in the budget, explain it. The budget exists to force this discussion to take place. When parallel budgets are created, it is difficult to provide the correct answers.

Valor: How can the influx of resources given to BNDES by the treasury, which tripled from 2009 to today, be reduced?

Armínio: Gradually. I am not sure what level it should go back to, and I believe this falls within a broader discussion about what the country needs, how much it will cost, etc. I do not believe in “shock treatments” unless it is regarding transparency, in order to respect the Law of Fiscal Responsibility and find a lower interest rate. That is where I would start. The rest is guerilla warfare. There will have to be several task forces, people seeking solutions, maintain the capacity of the State to exercise its role as watchdog, regulator, and that does not inhibit or hinder the influx of internal and external capital. Domestic savings will have to increase over time.

Valor: Are there people who advocate for raising taxes? Would the country endure this?

Armínio: A growing number of people believe that a middle-income country with 36-37% percent of GDP is enough for the state to successfully carry out its responsibilities within the social-democratic model we have here. This is an important discussion to be had, but should not be solved by a technocrat. The country should have growth limit for public spending so that it stop growing more than GDP. The government invests very little and almost all of its expenses are cash transfers, although part of the responsibility for the increase investment should lie with the government. When you look at the budget, you can see that there are limitations. This is a political discussion. There are signs that the tax burden today is high enough to transform Brazil into a less competitive country.

Valor: Do you believe the increase in minimum wage was excessive?

Armínio: I think wages in Brazil are ridiculously low because Brazilians are not well educated and are somewhat unproductive. This is why wages here correspond to 20% of wages in rich countries. There are some work areas that earn similar wages, but the average salary here is very low because we are a poor country. Why are we poor? Because the country is not growing. Salaries have to correlate, to some extent, with productivity. This is in the minutes of the Monetary Policy Committee of the Central Bank and in the best minds that are in government. The country is not growing; we have to be realistic about this. Whatever I say, they will interpret it as more squeezing while the tightening is already there, caused by inflation.

Valor: In the financial market, it is said that a growing number of Brazilians are sending money out of the country. Do you see this movement happening?

Armínio: Brazilians like their country, they like living here, investing here. However, the degree of uncertainty today is such that people are considering investment elsewhere, and are even considering leaving Brazil. There is a fear that goes beyond the economy; it’s a political fear as well. There is a sense of fear that people are afraid to openly express. Fear of an attitude against freedom of press, against democracy.

Read original article [IN PORTUGUESE].

Translated by Carolina Cardenas, edited by Erica Kliment. 

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