Brazil’s Growth Conundrum

SANTIAGO – Brazil needs to grow more. That is what the country’s president, Dilma Rousseff, keeps telling Brazilians. With the economy nearly stagnant in 2011 and the first half of 2012, faster growth is a political necessity for her. But her admonition also reflects a broader national preoccupation with economic might, befitting a vast country with continent-size aspirations.

That outlook sets Brazil apart in a region where politicians – from Argentina and Chile to Ecuador and Venezuela – often seem more concerned with handing out slices of natural-resource wealth than with creating new sources of prosperity.

To be sure, Brazil’s economic growth over the last decade owed much to the commodity boom that has also benefitted its South American neighbors. In 2010, growth reached an impressive 7.5% clip, as highly expansionary fiscal and monetary policies, implemented in response to the global financial crisis, lifted the economy out of harm’s way.

Today, similar policies are again doing the trick, with GDP growth picking up in the second half of 2012 and expected to reach more than 4% in 2013. But can Brazil move beyond these stop-and-go cycles and ensure steady growth?

One obvious constraint is a lack of investment in physical capital, as anyone who has used Brazil’s maddening airports and roads can attest. Brazil wants to compete with Asian giants like China and India, but its investment rate, at just 19% of GDP, is decidedly un-Asian. And, even at such a low level of investment, Brazil’s current-account deficit is more than 2% of GDP, exposing an alarming paucity of domestic savings.

With Brazil’s new middle class focused on the consumption patterns commensurate with its status, the additional savings must come from the public sector – a task that previous governments found politically unmanageable. Now, however, the country’s improved macroeconomic picture is creating greater room for maneuver.

Brazil’s central bank has brought interest rates to record lows, and has vowed to keep them there for a long time. For an indebted government, that is just what the doctored ordered. Ilan Goldfajn, the chief economist at Itaú Unibanco, estimates that a sustained drop of one percentage point in the short-term interest rate saves the government the equivalent of 0.5% of GDP.

The political challenge for Rousseff’s administration is to channel those savings to new public investment or to tax incentives for private investment, rather than adding to current expenditures. That is why she adopted a hard line in a recent protracted wage dispute with public-sector workers – in which she ultimately prevailed, despite opposition within her own party.

But even if new financing for investment can be found, it remains unclear which samba troupes can lead Brazil’s economic carnival in the future. Brazil has spawned some world-class companies – for example, aircraft manufacturer Embraer – but most industrial sectors remain focused on the internal market and are not internationally competitive.

High production costs, particularly in energy, are one key obstacle. The government has recently used its regulatory power to push down rates for both households and firms. But, in the long term, Brazil will have to invest more in generation – and those investments, as every government in Latin America knows, are increasingly controversial for political and environmental reasons.

The exchange rate is another essential issue. Brazil has quietly dropped its decade-long commitment to floating its currency, and has moved to a de facto semi-fixed regime, with the exchange rate allowed to move only within a narrow band slightly above two reals to the US dollar.

Brazilian authorities have tried to fix the exchange rate before, but these attempts tended to be short-lived, because the financial costs of sterilizing the central bank’s currency-market interventions are too high. Intervention costs have been limited so far, owing to uncertainty in Europe, capital controls, and lower interest rates at home. But another wave of global liquidity, prompted perhaps by a third round of quantitative easing in the United States, could upset this delicate equilibrium.

The Rousseff administration is also creating incentives (subsidies, directed credit, and even some new import tariffs) aimed at developing certain sectors. Enthusiasts describe it as a new brand of modern industrial policy that can help to push Brazil beyond its traditional role as a commodity exporter. Critics call it a misguided effort that will only create more distortions and retard growth.

In my view, the intellectual case for activist policies – as made, for example, by Dani Rodrik and Ricardo Hausmann of Harvard – is strong. Markets for innovation and new ideas work poorly and governments can help to address those market failures.

But Rodrik and Hausmann also show that getting such policies right implies exacting requirements. Countries must create institutions to ensure that support is given – and withdrawn – only with expected productivity in mind, not as a way to reward friends or political allies. If Brazil can get it right, it would rival a victory in the 2014 World Cup for the country’s football team as a badge of national pride.