Will Brazil’s Good Times Roll On?

WASHINGTON, DC –These are the best of times for Brazil. The country has emerged as Latin America’s clear leader and a key global player. Its economy was among the first to rebound strongly from the recent financial crisis, and has since maintained impressive growth. Poverty has been drastically reduced, and income inequality is declining, as the middle class swells. And, thanks to the discovery of vast offshore oil reserves, Brazil not only has become energy-sufficient, but is poised to become a major oil exporter.

Yet, despite all the good news, Brazilians should be worried, because the good times will last only if Brazil addresses a host of mounting economic-policy challenges. Some concern short-term issues; most are of a medium-term nature.

In the short term, it is essential to prevent economic overheating: annual real GDP growth exceeded 10% in 2010, owing to expansionary fiscal and monetary policies and favorable terms of trade. Ensuring that domestic demand decelerates to a more sustainable pace is necessary to moderate the upward pressure on prices that threatens the credibility of the inflation-targeting monetary-policy framework – indeed, in April, the 12-month consumer inflation rate breached the upper limit of the central bank’s tolerance band. Likewise, Brazil must cool its overheated labor market and stem the deterioration in the external balance (which has swung from a small surplus to a deficit of more than 2% of GDP over the last three years, despite a large gain in the terms of trade).

Moderating domestic demand requires, first and foremost, fiscal tightening, because further increases in interest rates, which are already relatively high, would only fuel further capital inflows and put even more upward pressure on the real, which is already over-valued. The authorities have taken initial steps to tighten fiscal policy by announcing significant cuts in the approved budget, but it is estimated that even then, central-government spending will rise by about 4% in real terms in 2011 from its historically high level in 2010. The authorities are complementing moderate fiscal tightening with macro-prudential credit-restraining measures and an array of (mostly tax-based) capital controls.