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News Summaries
CONTROLLING INFLATION IN BRAZIL
(05/97)
Brazil seems poised to start living
up to its potential. Finally, the country has attained political
stability with its competent and apparently uncorrupted president,
demonstrated economic strength with lower inflation, implementated
a wide-scale privatization plan, and opened to world trade. Today,
Brazil has the world's eighth largest economy--much larger than
Russia, Indonesia, or India. However, Brazil has so often disappointed
that many fail to expect that the current optimism will last.
For many years, especially in the
1970s, Brazil strove to be self-sufficient. Then imported oil
prices spiked, and hyperinflation and stagnation ensued. Since
the democratically-elected President Fernando Henrique Cardoso
took over in the 1990s, tariffs have fallen, state-owned businesses
have been sold to the public, and inflation has fallen sharply.
Mr. Cardoso's real plan,
named after the Brazilian currency introduced in mid-1994, has
been successful in bringing annual inflation rates to 10%, the
lowest level in 40 years. The plan is based on a strong currency,
a tight monetary policy, and a loose fiscal policy. This is a
major change for the Brazilian people, who have come to expect
high inflation year after year.
In fact, for many years Brazilians
dealt with inflation by living with the world's most extensive
and complicated system of indexation. With so many prices moving
automatically, inflation was entrenched. Since those with low
incomes did not receive timely adjustments, inflation exacerbated
income inequalities. In addition, businesses became creative
in using inflation to increase profits, often at the expense of
the consumer. Even the government exploited inflation: tax
revenues were indexed, but spending promises were not.
What are the benefits of lowering
inflation? First, roughly 8 million low income Brazilians were
lifted above the official poverty line between 1993 and 1995.
Second, many businesses have begun to focus on longer-term strategies,
investing in modern technology and globalizing. Third, sales
of consumer durables, such as cars and packaged foods, have boomed
as consumer demand has solidified.
Can the government continue to lower
inflation expectations? It may be difficult. Consider the strong
currency, overvalued by about 20%. To maintain this value, real
interest rates are a minimum of 12% above inflation rates. The
unreasonably large federal budget deficit also keeps interest
rates high. Public spending is excessive, prompting the government
to borrow (tax reforms in the 1980s prevented an increase in tax
rates). An overvalued currency encourages imports, which have
surged, worsening the trade deficit. Exports are minimal, with
the few businesses who sell to overseas markets acting more like
passive order-takers rather than aggressive marketers. Many blame
the low level of exports on high export taxes and an inefficient
state-owned infrastructure (roads and ports are inadequately maintained).
Yet, foreign investment is racing
to Brazil. The government plans to sell about $50 billion of
state assets over the next two years: foreigners will purchase
much of this. Foreign multinational companies are also building
many factories and buying out Brazilian companies. Foreign direct
investment was $9 billion in 1996.
Questions
1. Using the rule of 70, in about
how many years will average prices double if inflation continues
at an annual rate of 10%?
2. Who suffers when inflation rises
unexpectedly?
3. Why does an overvalued currency
usually result in a trade deficit?
4. Describe a tight monetary policy.
Do interest rates rise or fall? How does the central bank implement
a tight monetary policy?
5. Why does a federal budget deficit
usually cause interest rates to rise?
6. Suggest steps the Brazilian government
can take to encourage more exports, without worsening the federal
budget deficit.
Keywords:
inflation, world trade, imports, hyperinflation, stagnation,
tariffs, monetary policy, fiscal policy, indexation, consumer
durables, real interest rates, budget deficit, trade deficit,
foreign investment
Source: "Reforming
Brazil: Is It For Real?" The Economist, May 17,
1997.
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