Public Information Notice No. 02/08

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Brazil

February 7, 2002

On January, 23, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Brazil.¹

Background

Brazil's strong performance in 2000 continued through the first quarter of 2001, led by solid industrial activity. However, uncertainties mainly associated with the external environment and a domestic energy shortage, and an increase in interest rates, led to a slowdown in economic activity, with the annual rate of output growth falling to 0.5 percent in the third quarter of 2001. For the year as a whole, real GDP growth is estimated at close to 2 percent, while the average unemployment rate decreased for the year as a whole relative to 2000. Inflation in 2001 was higher than expected due to currency weakness and adjustments in administered prices, with consumer prices increasing at a 12-month rate of 7.7 percent at end-year.

Brazil's competitiveness—as measured by the CPI-weighted real effective exchange rate—improved in 2001, reflecting mainly the strong depreciation of the real. Together with the deceleration in economic activity, improved competitiveness led to a substantial improvement in Brazil's trade balance. The current account deficit accumulated in January-December reached US$23.2 billion, almost entirely financed by net foreign direct investment.

Despite the turbulence in international markets that affected emerging market economies in particular, capital inflows to Brazil remained adequate throughout 2001. Foreign direct investment amounted to about US$23 billion in 2001, a particularly strong figure given the volatile external environment and the absence of large privatization auctions during the year. Brazil also continued to enjoy good access to the sovereign bond market in 2001, with issuances totaling US$6.7 billion. Net international reserves, as measured under the Stand-By Arrangement with the Fund, stood at US$27.8 billion at end-year, US$7.8 billion above the program floor, while gross international reserves reached US$35.8 billion.

Financial market indicators were volatile though most of 2001 but performed strongly at the end of the year. The events of September 11 were followed by a sharp depreciation of the real, a rise in bond spreads, and a significant fall in the stock market index. However, Brazil's strong macroeconomic policies and the substantial adjustment in the trade balance helped increase investor confidence and capital inflows, leading to a reversal in the deterioration of Brazil's financial variables in the last two months of the year. As of mid-January, the exchange rate and stock index stood at their strongest levels since July 2001, while bond spreads were only about 100 basis points above their level at the start of 2001.

Fiscal performance in 2001 was strong at all levels of government. The 12-month accumulated primary surplus of the consolidated public sector reached 3.75 percent of GDP in December, well above the end-December program target of 3.35 percent of GDP. Nonetheless, net public debt rose to 53.3 percent of GDP at end-December 2001 from 49.4 percent of GDP at end-2000 reflecting primarily the depreciation of the real. The end-year indicative ceiling for the net public sector debt was met with a margin.

The central bank continued its cautious conduct of monetary policy. To help contain inflationary pressures arising from the strong depreciation of the real, it gradually raised the overnight (SELIC) rate by 375 basis points between March and July 2001. Subsequently, it used small pre-announced daily interventions in the spot foreign exchange market to ensure market liquidity. In the period following September 11, it tightened prudential regulations on banks' use of their liquidity and increased the issuance of foreign exchange-indexed debt to reduce exchange rate pressure from the heightened demand for hedging instruments.

Brazil continued to make progress on the structural reform agenda in 2001. Congress approved a new corporate law strengthening the rights of minority shareholders and enhancing the autonomy of the stock market regulatory agency. Congress also approved a constitutional amendment introducing the explicit taxation of petroleum products, a key step toward the full liberalization of the domestic oil market in 2002. Less progress has been made in advancing in other reforms and in the privatization program.

Executive Board Assessment

Executive Directors commended the Brazilian authorities for maintaining strong macroeconomic policies and responding swiftly in the face of a significant deterioration in the external environment. In particular, Brazil's sustained progress toward fiscal consolidation and the improved external current account outlook have bolstered investor confidence and laid the groundwork for a resumption of more rapid economic growth. Directors noted that Brazil's floating exchange rate regime plays an important role in allowing the economy to adjust to shocks. Given large (though declining) external financing requirements, Brazil remains nevertheless exposed to a volatile international environment and, in this connection, Directors highlighted in particular the need for continued close monitoring of regional developments that could affect the Brazilian economy. It is therefore important that the authorities maintain the proactive policy approach that has served the country well in recent years. Directors agreed that the maintenance of strong fiscal discipline and of a floating exchange rate regime, as well as the continued use of traditional monetary policy instruments, and intensified efforts on the structural reform agenda, provide the best means of helping the economy absorb future external shocks.

Directors praised the authorities' continued strong fiscal performance, with the public sector primary surplus exceeding the program target. They welcomed the authorities' commitment to maintain the program's original primary surplus targets in 2002, which is an ambitious objective given the downward revision of initial growth expectations and the spending pressures that could emerge in 2002 as the presidential election draws near. Nevertheless, Directors noted that the good fiscal track record of the current administration, as well as the strengthened
rules-based institutional framework, particularly the Fiscal Responsibility Law, give considerable confidence that fiscal performance will not be weakened. Also, the authorities' commitment with the fiscal targets of the Budgetary Guidelines Law, including the willingness to offset underperformance at the subnational government level, provides additional assurance that the primary surplus target for 2002 will be reached. Directors noted, however, that the large share of the public debt that is linked to the exchange rate makes the overall fiscal balance and the debt-to-GDP ratio highly sensitive to exchange rate movements. While commending Brazil's overall prudent debt management policies, Directors therefore encouraged the authorities to reduce the share of exchange rate-indexed debt as market conditions allow. Directors noted favorably the findings of the Fiscal Transparency Report on the Observance of Standards and Codes (ROSC) , and looked forward to further improvements in public expenditure management that the authorities are considering in line with the report's recommendations.

Directors welcomed the authorities' strong commitment to maintain the inflation targeting regime, and their floating exchange rate policy. They noted that substantial supply and external shocks in 2001 contributed to inflation in excess of the official target. They emphasized the importance of keeping monetary policy geared towards achieving the inflation target in 2002. Directors welcomed, in this connection, the rebalancing of the mix of monetary and intervention policies, and supported the authorities' intention to have only exceptional recourse to spot market intervention and net sales of foreign exchange-indexed debt.

Directors were encouraged that Brazil's banking system appears fundamentally sound, with low levels of nonperforming loans and solid provisioning. They welcomed the restructuring of the federal banks as well as the recent completion of the revision and upgrade to international standards of the plan of accounts for financial institutions. Directors also welcomed the authorities' commitment to participate in the Financial Sector Assessment Program.

Acknowledging Brazil's overall structural reform record, and the significant progress in the areas of corporate law, complementary pension funds, and the taxation of petroleum products, Directors noted the importance of reinforcing efforts towards approving structural reforms requiring legislation. They noted the importance of continued efforts aimed at improving economic efficiency to ensure sustained large foreign direct investment inflows over the medium term. While recognizing that the limited time remaining on the congressional calendar could constrain the scope for further reforms, Directors encouraged the authorities to make every effort to progress on key remaining reforms.

Directors welcomed that the continued successful implementation of the government's energy saving plan, combined with better-than-expected rainfall and reduced demand due to the slowdown in economic activity have allayed concerns about the impact of the energy shortage. They cautioned, however, that this should not weaken the authorities' determination to make further progress in strengthening the energy regulatory framework and encouraging private investment in the sector.

Directors praised the authorities' continued pursuit of trade liberalization on a bilateral, regional, and multilateral basis. They also suggested that liberalization through regional arrangements be accompanied by reductions in Brazil's average tariffs on imports from nonpreferential partners, which remain relatively high. Directors regretted that most industrial country markets continue to maintain tariff peaks and nontariff barriers to imports of many products for which Brazil has comparative advantage, and urged Brazil's trading partners to pursue trade liberalization in favor of Brazil and other developing countries.

It is expected that the next Article IV consultation with Brazil will be held on the standar 12-month cycle.