Public Information Notice No. 05/166

Public Information Notice: IMF Executive Board Concludes 2005 Post-Program Monitoring Discussions with Brazil

December 16, 2005

On December 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded Post-Program Monitoring discussions with Brazil based on the information available through that date.¹

Background

Notwithstanding the difficult political context since May 2005, macroeconomic performance has remained robust, underpinned by strong macroeconomic policies and favorable external conditions. After slowing in the fourth quarter of 2004 and the first quarter of 2005, economic activity rebounded strongly in the second quarter, before declining markedly in the third quarter of 2005, mainly reflecting inventory decumulation. As a result, real GDP grew by an average of 2½ percent (year-on-year) during the first three quarters of 2005. Growth has remained supported by private consumption—reflecting steady gains in real incomes and employment, and rapid growth in household credit—and by net exports.

The strong fiscal performance of recent years has continued, with the consolidated primary fiscal surplus above the 2005 target. This improvement reflects continued strong tax collections—particularly income taxes—as well as higher primary surpluses of subnational governments and public sector enterprises. However, pension imbalances have continued to grow. The prudent tightening of monetary policy initiated in September 2004 and the appreciation of the exchange rate helped bring the 12-month headline inflation down from a peak of 8 percent in May to 6.4 percent in October. With inflation pressures abating and inflation expectations virtually converging to the end-2005–06 targets, the central bank has lowered its policy interest rate since September, by a total of 125 basis points to 18½ percent.

The balance of payments position has remained strong. Export performance has continued to exceed expectations, supported by rapid global growth and high commodity prices, notwithstanding the appreciation of the real in real effective terms since early 2005. Private capital inflows have also strengthened, driven by higher foreign direct investment and renewed portfolio net inflows. Brazilian corporates have continued to deleverage and external debt has declined further.

Public sector net debt has declined further and its structure has improved further. Several important steps were taken to improve the maturity profile and extend the duration of public debt, including the issuance for the first time of a US$1.5 billion 10-year real-denominated external sovereign bond in September. Nevertheless, the share of floating-rate domestic debt remains high and, while improving at the margin, the average duration of public debt is still short. The central bank resumed intervention in the foreign exchange market in early October aimed at further building up international reserves, which have continued to rise relative to short-term external debt.

Against this backdrop, financial market sentiment has remained favorable, albeit with bouts of volatility. The real attained its highest level since early 2001, sovereign bond spreads narrowed to all time lows, and stock prices reached historical highs. Since mid-October, Moody's upgraded Brazil's sovereign credit rating in line with other credit rating agencies, while other credit rating agencies have upgraded the outlook from stable to positive.

The strong macroeconomic performance, together with the increased coverage of the Bolsa Familia program, has led to a significant reduction in poverty and income inequality between 2002-04. The poverty rate has declined to its lowest level since 1992, with the share of people below the poverty line declining to 25.1 percent in 2004, from 27.3 percent in 2003, well below the 35.9 percent rate in 1992. The strengthening of the Bolsa Familia program, along with higher employment in the formal labor market, allowed for a significant improvement in the income of the poorest groups and for a reduction in the income gap between formal and informal workers for the first time in the decade. Income inequality has also declined to its lowest level since 1981.

Executive Board Assessment

Executive Directors commended the Brazilian authorities for the impressive performance of the economy since the end of the stand-by arrangement. Directors attributed this performance to the authorities' commitment to sustain and strengthen the macroeconomic policy framework and to the comprehensive reforms implemented over the past several years, together with supportive external conditions. The combination of high public sector primary surpluses, inflation targeting, and a flexible exchange rate regime has proven highly successful in reducing vulnerabilities and keeping financial market confidence high, despite uncertain political conditions. Directors also commended the authorities for the significant progress made in reducing poverty in recent years, thus enabling Brazil to continue lowering income inequality and to make progress toward achieving the Millennium Development Goals.

Directors viewed the Brazilian economy as well placed for continued favorable economic performance. Following buoyant economic growth in 2004, the economy has expanded at a more sustainable pace in 2005. Export performance has remained strong, notwithstanding the marked appreciation of the real, while on the domestic side rising employment and real incomes have boosted consumer expenditures. Directors noted the unfavorable outcome for GDP in the third quarter, but observed that this seemed to reflect mainly inventory adjustment and other specific factors, and that the underlying trend of domestic demand remains positive.

With balance sheet vulnerabilities still a concern and the risks posed by the external and domestic environment, Directors welcomed the authorities' commitment to sustain strong policies. Public debt remains high and of relatively short maturity, with a large share still linked to short-term interest rates. Along with sizable external borrowing needs, these factors still leave the Brazilian economy exposed to abrupt changes in global conditions and the domestic political scene.

Directors commended the prudent conduct of monetary policy in the context of inflation targeting and a flexible exchange rate policy. Inflation is expected to continue to decelerate, reflecting the convergence of expectations to the official end-2006 target and the modest adjustment in administered prices expected for 2006. Directors considered that the benign inflation outlook provides significant scope for further steady easing of the monetary policy stance, but maintaining the cautious approach adopted by the Central Bank—given the need to consolidate the gains against inflation, the uncertainties surrounding the transmission mechanism of monetary policy, and the risks in the environment. In this context, Directors noted the reforms to the credit market and the improvements in central bank liquidity management that have strengthened monetary policy, and encouraged the authorities to continue with these reforms. A number of Directors also suggested that the present favorable macroeconomic conditions provide a good opportunity to simplify further and reduce reserve requirements, and thus help reduce the high costs of financial intermediation. Directors welcomed the staff's conclusion that the banking sector remains sound; nevertheless, they advised keeping under close monitoring the rapid growth in credit.

Directors commended the authorities for the prudent conduct of fiscal policy in 2005, and encouraged the authorities to preserve the strong stance of fiscal policy in the period ahead. Most Directors agreed that the primary fiscal balance should remain the key policy target, and stressed the importance of maintaining the strong observed performance with regard to the consolidated primary surplus, in order to maintain the progress toward debt reduction, provide full scope for monetary policy easing, and protect economic performance from unexpected volatility in 2006.

Directors stressed the importance of lowering the tax burden, simplifying the tax system, and reducing spending rigidities while continuing to lower public indebtedness. In this regard, Directors encouraged the government to develop an agenda for comprehensive fiscal reforms. They noted that the new ceilings on expenditure and revenue, introduced in the 2006 budget guidelines law, signal the authorities' desire to contain the steady rise in the tax burden and public spending, while helping to shift expenditure priorities to needed infrastructure and to build a consolidated fiscal structure for the future. At the same time, some Directors observed that the ceilings could imply greater complexity in budgetary management. A number of Directors also viewed the introduction of a countercyclical adjustment in the 2006 budget guidelines law as premature. A few Directors, however, saw the mechanism for countercyclical adjustments more favorably, if implemented with needed safeguards. Directors stressed that a key element in a package of fiscal reforms would be to increase budget flexibility, while reducing tax distortions.

Directors commended the authorities' prudent debt management and the buildup of international reserves, which have contributed to reducing vulnerabilities. They welcomed the progress made in prefinancing sovereign external needs, improving the structure of public debt, and developing domestic capital markets—including with the recent issuance of the real-denominated sovereign bond and the substantial overall reduction in the public sector's exposure to currency risk. With reduced macroeconomic volatility and a downward sloping yield curve, Directors felt that conditions are favorable for a significant improvement in the structure of public debt, and particularly for further gains in overall debt maturity. Directors encouraged the authorities to continue their efforts to develop domestic capital markets by further facilitating access to foreign investors and by phasing out taxes on financial transactions. They also welcomed the authorities' commitment to continue building up international reserves, while preserving a flexible exchange rate regime.

Directors commended the authorities for the progress made with their poverty reduction agenda. They welcomed the evidence that sustained growth, lower inflation, higher formal employment, and the expansion of social programs have led to a significant improvement in social conditions and living standards. Directors commended the reduction in the poverty rate and in income inequality in 2004 to their lowest levels since 1992 and 1981, respectively.

Directors urged the authorities to reinvigorate the reform agenda to boost medium-term growth and to help further reduce poverty and inequality. They regretted that the political situation in 2005 has delayed the government's reform agenda in congress, while they foresee further limitations to progress in the runup to the general elections in 2006. In this regard, they encouraged the authorities to make efforts to advance key reform priorities, including with respect to the harmonization of the state value added tax system; the establishment of formal central bank autonomy; the implementation of regulations for complementary pension funds for civil servants; and steps for further improvement in the business climate.