Is Brazil Growing Too Fast?

Fraga's job now may be to rein in its economy

Arminio Fraga must have experienced a powerful sense of deja vu when Turkey precipitously devalued its currency on Feb. 22. Fraga, the 43-year-old chief of Brazil's central bank, watched foreign investors turn savagely bearish, pummeling Turkey's currency. The government was forced to devalue, and the lira lost one-third of its value virtually overnight. That's the same agony Brazilians lived through in January, 1999.

The remarkable thing is that Turkey will be lucky if it bounces back as fast as Brazil did. The devaluation of the real eased pressures on the currency and forced the government to tackle its intractable budget deficit. The result has been a surprisingly robust recovery amid declining inflation.

Much of the credit for this turnaround goes to Fraga. Drafted by the President to sort out the devaluation mess, the former George Soros hedge-fund manager had the credibility needed to calm the markets. Fraga also showed he was capable of decisive action. "I won't deny we were scared," he says. "But we knew what we had to do." In what to some looked like reckless daring, the central banker allowed the currency to float and announced that inflation--not the exchange rate--would become the focus of monetary policy. It worked: The real weakened by 30% but then held firm. Even after two years, Wall Street is still impressed: "The market view has been that Arminio Fraga walks on water," says Francis Freisinger, chief Latin American economist at Merrill Lynch & Co. in New York.

Can Fraga go on living up to his rave reviews? The challenges he faces now are in many ways just as difficult as the ones he faced when he first came on the job. The economy has rebounded, thanks in large part to Fraga's rapid-fire rate cuts. But analysts are wondering how much growth Brazil can handle without running into trouble. "That's the big question we ask ourselves every month," admits Fraga.

Fraga reckons Brazil will grow by 4.5% in 2001, as do most private analysts. Yet if experience is any guide, that's as close to the highest level of growth the local economy can sustain without setting off alarm bells. True, that scourge of old--inflation--does not appear to be making a comeback. It ended 2000 right on target, at 6%, and is expected to fall to 4% this year. The bigger worry now is Brazil's current account, which is slipping deeper into the red as domestic demand sucks in imports. The deficit was $24.6 billion in 2000, or more than 4% of gross domestic product, and may top $27 billion this year.

The burgeoning gap could put downward pressure on the real, sharply limiting Fraga's scope for deeper cuts in the benchmark rate, which now stands at 15.25%. The deficit also renders Brazil "extremely vulnerable to external and internal shocks," warns Walter Molano, head of Latin American research at BCP Securities Inc. in Greenwich, Conn. An emerging-market crisis is one possible danger. Happily, the fallout from the Turkish devaluation on Brazilian securities markets has been limited so far.

Brazil's persistent current-account deficit shows the administration of President Fernando Enrique Cardoso has work to do. "Brazil still needs structural reforms to boost competitiveness, but we're seeing very little movement," says Marcelo Carvalho, chief economist at J.P. Morgan Chase & Co. in Sao Paulo. Three years after the government started reforming the bankrupt public-pension system, for example, it still needs a major overhaul.

Fraga claims that changes enacted thus far will slash the pension deficit--now equal to more than 4% of GDP--in half over the next 15 years. Perhaps, but in the meantime, the government will have to keep covering the shortfall. That's money that might be better spent on education or infrastructure. Besides, a modern and efficient pension system would boost Brazil's domestic savings rate, which at 16% of GDP is about half that of Asian countries. And building up a large pool of local savings is crucial if Brazil is ever to break its dependence on foreign capital.

TAX CODE WOES. Reform of the country's archaic tax code is another pending item. Companies complain that the country's cascading tax system, in which levies are applied at various stages of production, is a drain on competitiveness. For instance, Brazilian manufacturers are burdened by an array of social security contributions, which add about 6% to the cost of exports on average.

With presidential and congressional elections scheduled for October, 2002, the window of opportunity for a renewed reform push will soon close. One irony: The central bank's success at stabilizing the economy has in fact reduced the sense of urgency. Fraga is hopeful that there will be progress on tax reform before the elections, but few outside government share his optimism. "Fraga is totally with us on this, but there's a lot of political resistance," says Luiz Murat Jr., financial director at Sadia, a large Brazilian food processor.

So what's a central banker to do? Pension and tax reform are not part of his job description, yet Fraga's success has earned him a voice in policymaking. "People in government want to hear what he has to say," notes Andre Loes, chief economist at Banco Santander Central Hispano (BSCH) in Sao Paulo. "That can only be a good thing."

One potential stumbling block is that Brazil's central bank is not autonomous: It reports to the Finance Ministry. Fraga desperately wants independence, but he won't get it any time soon. That means that if the economy does overheat, Fraga could come under political pressure not to hike rates in an election year.

Fraga is aware of the dangers, but he's hoping the Brazilian economy has changed enough to dampen the risk of runaway inflation. "The speed limits seem to be higher than they were," he says. "And they should get higher going forward." In support of this thesis, Brazil's central bank chief points to the transformative powers of foreign direct investment, now running at near $30 billion a year. Multinationals have invested heavily to modernize Brazil's manufacturing base. And privatization has made former state monopolies, such as the phone system, more efficient. "A few years ago, you had to pay $5,000 for an analog line that hardly worked," says Fraga. "Now you get a high-speed digital line, and it's virtually free."

A SUNNY SCENARIO. The result of all these advances, Fraga says, is that total-factor productivity is now growing at more than 1% a year--well above Brazil's historic rate, which was actually negative in the 1980s. More efficient companies don't have to resort to price hikes to increase profits. The result, theoretically, is a more benign environment for inflation. Analysts, however, don't entirely buy this sunny scenario. Says BSCH's Loes: "There are no solid data on productivity at all."

Such doubts aside, the faith of most investors in Fraga remains unwavering. "If Fraga continues to do what he's been doing, Brazil will be very well served," says Sadia's Murat. But the truth is that while the crisis days may be over, Brazil's central bank chief still has some hectic ones ahead of him.

By Jonathan Wheatley in Rio de Janeiro

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