The very fast growth of internal public
debt in Brazil since the inflation stabilisation plan of 1994 ("Plano
Real") is a direct consequence of the economic policy decision to
maintain extremely high domestic interest rates for many years. The purpose
of this policy of "dear money" was to attract foreign capital
flows and keep the nominal exchange rate relatively stable. This, in turn,
was supposed to prevent cost inflation and to obtain a real exchange rate
revaluation, which would provide the shock of foreign competition to the
formerly protected Brazilian industrial sector. However, the effect has
been rather different in practice: an explosion of imports, ballooning
of the current account deficit, increasing net external liabilities and
the loss of competitiveness of Brazilian exports. As a consequence, growth
in the subsequent period has been both mediocre and unstable.
Recently, it has become fashionable to argue that the growth in internal
public debt was a result of an excessively expansionary fiscal policy
in the first term in office of President Cardoso (up to 1998). However,
as the average primary public sector deficit (excluding interest payments)
over the 1995-1998 period was only 0.2% of GDP, this interpretation simply
makes no sense at all.
It is important to stress that there was no compelling economic reason
for the maintenance of such high domestic rates of interest in the past.
The Brazilian basic domestic rate of interest has been kept for years
well above the sum of the international interest rate plus the sovereign
risk premium plus the market expected rate of exchange devaluation (currency
risk) that determines the safe floor for nominal interest rates in a context
of high short-term capital mobility.
One reason that has been advanced for this policy is that the interest
rate was connected to the need to contract credit, and, through its negative
effect on consumption expenditures and housing investment, to reduce the
expansion of the economy and the associated further deterioration of the
current account. This explanation must be discarded. It would have been
easy to achieve this goal without entailing such a high cost for the Treasury,
through other measures such as higher compulsory deposits by banks (which
act as a tax that increases the private loan rates without affecting the
basic rate paid by the government) along with more realistic and less
irresponsible tariff and real exchange rate policies.
In Brazil, the high rate of interest is not caused by the growth of internal
debt. On the contrary, it is the growth of internal public debt that is
the result of a policy decision of the Brazilian central bank to keep
very high interest rates.
It is important to bear in mind that, contrary to fears, the record growth
of the public debt did not lead directly to any major adverse consequences.
Rather, the insistence that the internal debt should not be growing (which
was obviously incompatible with the high real interest rate policy that
added to the interest burden so significantly) had the very unfortunate
consequence of making the Brazilian government focus its fiscal policy
exclusively on obtaining large and growing primary fiscal surpluses at
any cost.
Years of high real interest rates have discouraged investment in the export
sectors, which could not pass the high financial costs to prices. In the
non-tradeable sectors, high real interest rates certainly have contributed
to the maintenance of very high gross profit margins and to a worsening
of the functional distribution of income (the wage share fell below the
share of property income) and of the already very unequal distribution
of wealth.
More recently, the internal debt has continued to grow for two reasons.
While real interest rates are lower than in the nineties, they remain
quite high. Also, an increasing proportion of internal debt bonds is now
indexed to the dollar exchange rate. With the large real exchange rate
devaluation since 1999 (and especially in the last few months of instability)
the internal debt to GDP ratio has not stopped growing despite the growing
primary fiscal surpluses, which have been obtained through massive increases
in the gross tax to GDP burden. It is highly improbable that a fiscal
reform, which is desirable in its own right for distributive and export
incentive reasons, could lead to further substantial increases in the
tax to GDP ratio.
The problem of the internal debt thus comes from record high real interest
rates, slow growth of the economy and, more recently, the excessively
devalued exchange rate relative to the dollar. The question is how to
reduce the rate of interest and stabilise the exchange rate at a more
sensible level, now that the country has gone through yet another external
liquidity crisis and approached the IMF for more money.
Of course, it would be very difficult to drastically reduce domestic interest
rates overnight. Luckily, this is by no means necessary. As already noted,
the growth of the internal public debt does not, by itself, cause any
big tragedy. Further, as long as the domestic interest rate remains above
the safe floor defined above, there is no reason to fear capital flight
and a run for the dollar.
Thus, the domestic interest rate can be reduced gradually as the determinants
of the floor rate are reduced. This process will make the internal debt
ratio first grow more slowly and then enter a sustainable trajectory,
without the need for large primary fiscal surpluses. The sovereign risk
spread will tend to fall substantially if the newly elected government
works seriously and quickly towards import substitution and export promotion.
Currency risk can be greatly reduced if the central bank amply supplies
the market with dollar indexed domestic bonds to meet its demand for an
exchange rate hedge, without having to use up its foreign reserves. The
central bank can also put much tougher capital requirement margins on
exchange rate speculation operations by Brazilian banks.
In order to avoid these recurrent problems, it is also important that
in the future at least a minimum of control in speculative capital inflows
should be introduced, something that could easily be done by selective
and differential taxation of undesirable flows of foreign capital which,
incidentally, are often driven by Brazilian nationals sending money to
tax havens abroad.
In short, the problem of internal public debt in Brazil comes primarily
from very high real interest rates. These can and will only fall substantially
if the government adopts suitable structural policies that help to improve
the basic balance of payments situation.