Brazil: Recent Economic Developments
Author: International Monetary Fund
Publication Date:
15 Apr 1998
eISBN:
9781451805888
Language:
English
Keywords:
ISCR; CR; state; federal government; export; capital goods; supply curve; net effect; subsistence level; exchange rate appreciation; Public sector; Interest payments; Baltics
Download PDF (5.5 MB)

This paper describes major economic developments in Brazil in 1997. A number of issues were analyzed in the paper, including the slow progress being made in the negotiation of the fiscal adjustment programs with the states, the sustainability of the growing current account deficit, as well as the strength of the banking system following macroeconomic stabilization. The paper discusses the post-Real crisis in the states and the state adjustment programs being negotiated with the federal government. Privatization and the associated foreign direct investment flows are also described.

Abstract

This paper describes major economic developments in Brazil in 1997. A number of issues were analyzed in the paper, including the slow progress being made in the negotiation of the fiscal adjustment programs with the states, the sustainability of the growing current account deficit, as well as the strength of the banking system following macroeconomic stabilization. The paper discusses the post-Real crisis in the states and the state adjustment programs being negotiated with the federal government. Privatization and the associated foreign direct investment flows are also described.

VII. The Post-Real Plan Developments of Tradables and Nontradables Prices and the External Current Account139

A. Introduction and Summary

212. As with other countries following macroeconomic stabilization, Brazil experienced a strong real appreciation of the currency after the introduction of the Real Plan, accompanied by a consumption and investment boom and a worsening external current account position. Traditional models of the real effects of macroeconomic stabilization attribute these effects to the fact that economic stabilization induces a higher rate of growth of productivity in the tradable than in the nontradable sector which results in an appreciation of the real exchange rate as measured by the ratio of the price of nontradable to that of tradables (the Balassa-Samuelson effect). Such interpretations have led some observers to infer that the appreciation of the currency is sustainable in that the associated improvements in productivity will eventually lead to an improvement in exports and reverse the current account deterioration (as well as the real currency appreciation).

213. In the case of Brazil, changes in the composition of the growth of domestic demand, owing to the decline in public sector savings since 1994, also may have been an important factor explaining the appreciation of the real exchange rate (this is because a high proportion of government expenditure is on nontradables). The increase in demand will boost real incomes in the nontradable sector and, in the absence of productivity improvement, put downward pressure on profits and employment. Thus, while the real currency appreciation may be associated with both productivity gains in the more dynamic sectors it could also be associated, at the same time, with loss of competitiveness in other sectors of the economy, with less optimistic predictions for the sustainability of the current account. The subsequent slowdown in the rate of appreciation of the real exchange rate in 1997 may therefore have been influenced as much by the improvement in the public sector accounts and reduction of demand pressures as by gains in competitiveness.

214. Section B discusses the experience of the real exchange rate as measured by the ratio of the price of nontradable to that of tradables, as well as consumption and investment trends. Section C analyzes the supply side influences on the real exchange rate and Section D the impact of demand on real exchange rates and competitiveness. The final section summarizes the conclusion of the chapter.

B. Real Exchange Appreciation, Consumption, and Investment

215. The stabilization of the economy, following the introduction of the Real Plan, was associated with a strong appreciation of the real exchange rate, as measured by the ratio of nontradable to tradable prices,140 despite the general convergence of prices in the economy (Figure 37). This result is in line with the evidence of other price and cost competitiveness indicators discussed in Chapter VI. This evidence has raised concerns that the economy is losing competitiveness and, combined with a growing current account deficit, has been associated with pressures in the exchange market (see Chapter 1). Recent indications in 1997 that the rate of appreciation of the real may be beginning to slow, together with some pick-up in the rate of growth of exports, have therefore been welcomed as a sign that the measures taken to improve the competitiveness of the economy are beginning to take effect.

Figure 37.
Figure 37.

Brazil: Tradable and Non-Tradable Prices, July 1995-September 1997

(12-month percentage changes, unless otherwise specified)

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Sources: Brazilian authorities, and Fund staff estimates.

216. Strong real appreciation of the currency, together with strong consumption and investment growth, has been seen in many countries in Latin America following macroeconomic stabilization and more recently in the Baltics, Russia and other former Soviet Union countries.141 As illustrated in Figure 38, Brazil was no exception, with a surge in consumption after the introduction of the Real Plan in mid-1994 reflecting the reduction in the inflation tax, the relaxation of liquidity constraints and increased access to credit brought about by financial liberalization. The boom in private consumption is illustrated by monthly data on retail sales for São Paulo which surged after mid-1994, before declining in the second half of 1995 when credit controls were imposed. The marked increase in consumption was accompanied by a pick-up in investment, although the strong growth in investment activity appears to have been driven mainly by structural factors (privatization and financial liberalization) and actually started before the Real Plan took effect. The strong growth of domestic demand has spilled over into the external sector with imports of consumer durables and nondurable goods rising particularly rapidly (imports of automobiles increased more than five-fold from the first half of 1994 to the first half of 1997), contributing to a deterioration of the current account.

Figure 38.
Figure 38.

Brazil: Consumption and Investment, 1994-1997

(Indices 1991=100)

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Source: Central Bank of Brazil, and Fund staff estimates.

217. An assessment of the effect of economic stabilization on the real exchange rate in Brazil is complicated by other structural changes that have been taking place in the economy. Since 1990, Brazil has made substantial progress in the areas of trade liberalization, privatization and financial and investment deregulation, all of which have had a significant impact on the pattern of consumption, investment, and the balance of payments. At the same time, the decline in public sector savings has also influenced domestic demand and the external current account position. If, as conventional models of the impact of macroeconomic stabilization on the real exchange rate predict, the appreciation of the real is associated with productivity growth and the restructuring of the economy, this would be expected to result, eventually, in stronger export performance and the stabilization of the external current account. If, on the other hand, the appreciation of the real is mainly a reflection of disequilibrium in the public sector accounts and/or loss of competitiveness, either the rate of growth of demand would have to be reduced and/or the exchange rate would need to adjust to restore the external current account.

218. In this chapter we attempt to assess the relative importance of these influences on the real exchange rate drawing on the recent literature on the real effects of stabilization programs. It is shown that the appreciation of the real exchange rate since the introduction of the Real Plan is a reflection of both of the effects mentioned, with supply and demand effects acting together to influence the appreciation of the real exchange rate. Indeed, the empirical evidence presented suggests that demand factors, largely due to the widening public sector deficit, have had a major influence on the appreciation of the real exchange rate in the short-run (and the recent slowdown in the appreciation of the real possibly having as much to do with the improvement in the public sector accounts as with productivity gains). This is in line with expectations as structural change is usually a slow process, and factor productivity gains in the traded goods sector are only likely to have a positive effect on the real exchange rate over a couple of years or so. This is so because the productivity gains in the traded goods sector leads to wage and price increases in the nontraded goods sector and to an appreciation of the real exchange rate measured by the relative price of nontradable goods.

C. Supply-Side Influences on the Real Exchange Rate

219. Most of the initial models of stabilization programs concentrated on supply-side effects (and differential productivity growth) to explain the effects of stabilization programs on the real exchange rate. While differing in their explanation of the initial consumption boom following stabilization,142 the majority of these models rely on the Balassa-Samuelson effect to explain the impact on the appreciation of the real exchange rate. That is, the appreciation of the real exchange rate, in economies undergoing adjustment, is due largely to differential productivity growth rates in the tradable and nontradable sectors. With the reduction of inflation, consumption will initially increase in response to higher current and/or expected real incomes, and part of the increase will spillover to the demand for nontradables. Because productivity growth in the nontradable goods sector is lower than in the tradable sector (which, in the case of Brazil, has benefited from the opening up of the economy), the relative price of nontradables must rise to bring about the required increase in investment and output in the nontradables sector (that is, the real exchange rate will appreciate). The increase in consumption and investment initially exceeds the productive capacity of the economy so the country runs a current account deficit in anticipation of higher future output levels. Once the new investment takes place and output increases, the economy adjusts to a new current account equilibrium. The stylized path of the real exchange rate, consumption, investment, and the current account following economic stabilization under this scenario is shown in Figure 39.

Figure 39.
Figure 39.

Brazil: Expected Adjustment Path After Economic Stabilization

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Sources: Fund staff projection.

220. The Balassa-Samuelson effect has been formalized in a number of models that show how faster productivity growth in the tradable than the nontradable sector leads, via wage equalization, to a decline in the relative price of tradables. In this presentation we use the model developed by Gregorio et al (1994).

Consider the following production functions for the two sectors:

YT=θTLTαTLT1-αT(1)

and

YN=θNLNαNKN1-αN(2)

where the subscripts T and N denote tradable and nontradable goods, Y denotes output, L labor input, θ productivity, and K capital. Under perfect competition prices in each sector are derived by duality as

PT=(1/θT)WαTR1-αTαTαT(1-αT)-(1-αT)(3)

and

PN=(1/θN)WαNR1-αNαNαN(1-αN)-(1-αN)(4)

where W is the unit cost of labor and R the rate of return on capital. Consider the case of a small open economy with perfect capital mobility, and expressing all prices in terms of tradable goods (PT is the numeraire). Defining P as the relative price of nontradable goods and log differentiating the expressions for prices it can be shown that

P^=θ^T-θ^N+(αN-αT)W^(5)

where the ^ denotes the rate of change.

221. Given R and PT, equation (3) uniquely determines wages. Given both W and R, equation (4) then determines the price of nontradables, that is the relative price is determined exclusively by technological conditions and, given the assumptions, is independent of demand conditions (that is, the supply curve is flat). Substituting equation (3) into equation (5) yields an expression for the relative price of nontradable goods

P^=(αN/αT)θ^T-θ^N(6)

The intuition for a positive link between faster productivity growth in the tradable goods sector and the relative price for nontradables given by equation (6) is straightforward. An increase in tradable goods productivity (θT) is matched by a real wage increase which keeps the marginal cost of tradables constant, but increases the marginal cost of nontradables.

222. One of the restrictive assumptions of these models, which we relax in the next section, is that the supply curve is flat (this is illustrated in Figure 40 where the flat supply curve is denoted by SI). That is, the real exchange rate is independent of demand conditions so that inflation will accelerate if the authorities attempt to depreciate the real exchange rate (Calvo et al, 1995). This would undermine attempts to achieve a real depreciation or improvement in competitiveness through a nominal depreciation of the currency as in countries attempting real exchange rate targeting. These models also suggest that the appreciation in the exchange rate is not incompatible with an improvement in competitiveness measured on the basis of relative unit labor costs or relative profitability.143

Figure 40.
Figure 40.

Brazil: Equilibrium Relative Price and Production of Nontradable

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

D. Impact of Demand on Real Exchange Rates and Competitiveness

223. While most models of real exchange rate appreciation have relied on supply side effects to explain the impact of macroeconomic stabilization on the real exchange rate as illustrated in the model above, the impact of demand shocks on the real exchange rate has been stressed in several recent studies of real exchange rate appreciation. In particular, an increasing share of government expenditure (particularly on the wage bill) which tilts demand toward nontradables can also result in an appreciation of the real exchange rate (see De Gregorio, Giovanni, and Wolf). In Brazil, most of the deterioration of the current account since 1994 has been associated with a decline in public sector savings suggesting that demand side effects may have had a role in explaining the appreciation of the exchange rate (Figure 41). The impact of government expenditure on the relative demand for nontradables would have both direct and indirect effects. The government directly produces a range of nontradable commodities, ranging from health care to public safety. In addition, the financing of increased expenditures reduces disposable private income. If the overall decline in private sector spending on nontradables falls short of the increase in government expenditure on nontradables, the net effect of an increased public sector share may be a shift in relative production and consumption toward the nontradables sector.144

Figure 41.
Figure 41.

Brazil: Saving and Investment, 1994-1997

(Percent of GDP)

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Sources: Brazilian authorities, and Fund staff estimates.

224. The direct impact of demand effects on the real exchange rate is illustrated in the model below (Gregorio et al, 1994) which shows that an increase in demand can result in an increase in the share of nontradables in consumption due to the differing income elasticities of demand in the tradable and nontradable sectors. To analyze the demand side of the economy, we consider the case of a representative consumer maximizing the present discounted value of

U(CN,CT)=Cnβ(CT-CS)1-β(7)

where CN and CT denote the consumption of nontradables and tradable goods, respectively. The parameter CS represents the subsistence level of consumption of tradable goods yielding a less than unitary demand elasticity for tradable goods. The consumer is assumed to maximize utility (7) subject to a budget constraint (expressed in terms of the tradable good)

I=CT+P.CN+P.G(8)

where I is total income, and G is total government expenditure, falling entirely on nontradable goods145.

The corresponding demand functions are given by

CT=βCS+(-β)(I-P.G)(9)

and

CN=(β/P).[I-P.G-CS](10)

These equations show that, where the subsistence level of consumption of tradables is positive, the income elasticity of demand for tradables falls short of unity while that for nontradables exceeds unity. Thus, an increase in income will result in an increase in the consumption share of nontradables.

225. The share of public consumption in GDP is shown in Figure 42. In addition to the direct effects of higher public sector expenditure on the relative price of nontradables, an increase in aggregate demand resulting from the public sector deficit will have different effects on the tradable and nontradable sectors. In the case of tradables, as the price is determined by external conditions, the adjustment is through an increase in production or higher imports. On the other hand, nontradable prices would increase resulting in an appreciation of the exchange rate. As the nontradable sector is in general labor intensive, the increase in demand results in an increase in real wages and consequently, in the absence of an increase in productivity, on downward pressure on profits and investment in the economy. In the short run, if prices are rigid, there will be unemployment associated with an overvalued exchange rate and a worsening of the current account balance. Thus, it may well be that real exchange rate appreciation is a sign of both productivity gains in some sectors and loss of competitiveness in others. That is, the real appreciation may reflect in one sense increased competitiveness in the dynamic sector of the economy and, at the same time, it may also correspond to pressures from the more inefficient sectors of the economy, reflecting structural adjustments in the economy following macroeconomic stabilization.

Figure 42.
Figure 42.

Brazil: Share of Public Consumption in GDP

(Percent of GDP, constant prices)

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Source: IBGE, and Fund staff estimates.

226. The appreciation of the real exchange rate may therefore be a reflection both of productivity gains in the tradable sector and of increasing demand. The trends in the real exchange rate, relative productivity growth and central government primary balance are shown in Figure 43. The relationship between the relative price of nontradables and the share of nontradables (proxied by services) in GDP is shown in Figure 44. There was a sharp increase in the share of services in GDP following the initial sharp appreciation of the real exchange rate, suggesting that demand pressures were initially important. Since 1995, however, the share of services has fallen suggesting that the sector may have come under pressure due to erosion of profits as costs increased.

Figure 43.
Figure 43.

Brazil: Trends in the Real Exchange Rate, Relative Productivity, and Primary Balance 1

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Source: Fund staff estimates.1/ Primary balance of the central government (accumulated in previous 12 months).
Figure 44.
Figure 44.

Brazil: Changes in the Share and Relative Price of Nontradables, 1994-1997

(Indices)

Citation: IMF Staff Country Reports 1998, 024; 10.5089/9781451805888.002.A007

Sources: Brazilian authorities, and Fund staff estimates.

227. Preliminary empirical estimates of the impact of relative productivity growth as well as a proxy for public sector demand pressures (central government primary balance) on the real exchange rate were unable to confirm that the appreciation of the real exchange rate reflects relative factor productivity growth. On the other hand, the results suggested a rather more prominent role for demand side effects than indicated by the literature on real exchange rate appreciation. The coefficient on the central government demand proxy had the expected sign and was statistically significant. These results must be treated with caution, however, given the short sample period used and the difficulty of measuring productivity growth in the tradable and nontradable sectors. However, the results strongly suggest that the importance of demand effects should not be underestimated in explaining the appreciation of the real exchange rate in Brazil.

E. Conclusion

228. The above analysis suggests that it is dangerous to ignore the effects that the demand side has had on the appreciation of the real exchange rate. The main difficulty with explanations of exchange rate appreciation that rely exclusively on productivity changes to explain relative price movements (the Balassa-Samuelson effect) is that they ignore the fact that virtually any variable that has real effects will affect the real exchange rate. The equilibrium exchange rate level in very general terms is that which attains internal and external equilibrium. Internal equilibrium means that the nontraded goods market clears. External equilibrium is attained when current account balances are compatible with sustained capital flows. Relying on the Balassa-Samuelson effect to explain the real appreciation of the exchange rate may also lead to rather optimistic predictions relating to the sustainability of current account deficits and rigid conclusions regarding the exchange rate policy (that is, a depreciation of the exchange rate will have immediate implications for inflation in these models). We have shown that the demand effects have also been important in explaining the appreciation of the exchange rate, with implications for the conduct of both demand management and exchange rate policies. As demand conditions are likely to have been an important determinant of the equilibrium exchange rate (the supply curve does not appear to be flat), this would suggest that a mix of demand and exchange rate policies, as adopted by the Brazilian authorities, would be an appropriate response to address the current account deficit.

Table 26.

Brazil: Macroeconomic Flows and Balances

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Sources: Brazilian Institute of Geography and Statistics (IBGE); and Fund staff estimates.

Includes changes in stocks.

Table 27.

Brazil: GDP and Real GDP per Capita

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Source: Brazilian Institute of Geography and Statistics (IBGE).
Table 28.

Brazil: National Accounts at Current Prices

(In millions of reais)

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Source: Brazilian Institute of Geography and Statistics (IBGE); and Fund staff estimates.

Includes changes in stocks.

Table 29.

Brazil: National Accounts at Constant Prices

(In 1980 millions of reais)

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Sources: Brazilian Institute of Geography and Statistics (IBGE); and Fund staff estimates.

Includes changes in stocks.

Table 30.

Brazil: Industrial Production

(Annual percentage change)

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Source: Brazilian Institute of Geography and Statistics (IBGE).

Production in the January-August 1997 period compared to that of the same period of the previous year.

Table 31.

Brazil: Retail Sales in the São Paulo Metropolitan Area

(Seasonally Adjusted)

(1988 = 100)

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Source: State of Sao Paulo Commerce Federation.

Includes durable, semidurable and nondurable goods.

Table 32.

Brazil: Price Statistics

(Monthly percentage change)

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Sources: Brazilian Institute of Geography and Statistics (IBGE); and Getulio Vargas Foundation.
Table 33.

Brazil: Consumer Price Index

(IPC-FIPE) 1/

(Monthly percentage change)

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Source: Brazilian authorities.

Consumer price index of São Paulo.

Table 34.

Brazil: Public Sector Prices and Tariffs

(Average 1991=100) 1/

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Source: Central Bank of Brazil.

Deflated by the IGP-DI price index.

Table 35.

Brazil: National Unemployment Rate

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Source: Brazilian Institute of Geography and Statistics (IBGE).
Table 36.

Brazil: Employment and Real Wages in Industry in São Paulo

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Source: Central Bank of Brazil.