The Brazilian Economy at a Crossroads
Executive Summary
The new government, whichever candidate wins the presidential runoff, will have to face at least four challenges: a) renewed growth; b) fiscal control; c) reduction of the current account deficit, allowing the real to depreciate; and d) control of inflation. Achieving all these goals will not be an easy task. Due to the low contribution from growth of the working-age population, it will have to raise the investment rate and productivity growth, both of which will be strongly dependent on reforms to be negotiated with Congress.
Higher investments require more confidence, which has been plunging recently, and whose restoration will depend on improved fiscal policy and the assurance of stable rules. There’s also a need for higher investments in infrastructure. The probability is high that the opposition would change the fiscal regime, by better control of spending and improvement of the tax system, but the current administration places excessive trust in tax relief measures along with higher public spending, both of which are inimical to a believable fiscal adjustment. In the field of infrastructure, an opposition government would likely allow higher rates of return to private investors, with greater use of the capital market to finance projects, while the current government, if reelected, would probably maintain the same policies as at present, meaning stronger fiscal pressures.
The current account deficits have become excessive, so an adjustment is necessary, which depends on depreciation of the exchange rate. An opposition victory would boost credibility and attract capital, raising the temptation to use a stronger real as a tool to control inflation. But this would be a fleeting gain, which would only postpone the inevitable adjustment in the current accounts. The most likely policy by an opposition government would be to resist appreciation of the currency, using instruments like gradual elimination of the sales in the future market and resumption of the purchases in the spot market. Under a reelected government, the adjustment would be more turbulent.
It will be hard to bring inflation back to the central target. If the opposition wins, convergence will likely happen, albeit gradually, and the contribution to this path coming from the expectations channel will depend crucially on the credibility of the execution of fiscal policy. In the case of a victory by the current government, the path will be much harder, with a high probability of continued leniency with regard to inflation.
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