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Brazil's Elevated Interest Rates: A Case of Irrational Pessimism or Guarded Optimism?

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PAGE 1

BRAZILS ELEVATED INTEREST RATES: A CASE OF IRRATIONAL PESSIMISM OR GUARDED OPTIMISM? By ED JOHNSON A THESIS PRESENTED TO THE GRADUATE SCHOOL OF THE UNIVERSITY OF FLOR IDA IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS UNIVERSITY OF FLORIDA 2006

PAGE 2

Copyright 2006 by Ed Johnson

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ACKNOWLEDGMENTS THERE was a child went forth every day; And the first object he lookd upon, that object he became; And that object became part of him for the day, or a certain part of the day, or for many years, or stretching cycles of years. Walt Whitman, Leaves of Grass (1900) This work is the product of my interactions with a great number of people over the course of the last five years, and would not have been possible without their influence, which was oftentimes unbeknownst to them. My time as a research assistant at the Federal Reserve Board helped to me ground my undergraduate training in macroeconomics and my research with David Lebow and Jeremy Rudd trained me to see the truths apparent in large, obscure datasets. It was there that I was first exposed to Phillips Curves, Taylor Rules, and the theory of rational expectations, all of which are utilized throughout this paper. While at Florida, Dr. Terry McCoy and Alex Sevilla have served as my advocates in my desire to combine my disparate disciplines, Latin American studies and finance, into a harmonious curriculum that has brought the two worlds much closer (at least for me). The faculty and staff of the Center for Latin American Studies and the Florida MBA Program have all greatly facilitated the process as well. Professionally, Eric Allred and Kathy Fitzpatrick at Johnson and Johnson in Jacksonville helped me to contextualize the Brazilian business environment better than any in-class or personal travel ever could have and my experience working with them has completely shaped my perspective in writing this paper. iii

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Working with my thesis committee has been wonderful. Dr. Terry McCoy has continued to work with me through the peaks and valleys of my research, more often than not exhibiting more confidence in me than I had in myself. He also helped me flesh out the topic after listening to one of my many anecdotes about my time living in Brazil. Dr. Andy Naranjo has provided exceptional guidance in my time here at Florida, and has made me question not just Brazils macroeconomy, but also some questions more related to my personal professional development. Time will tell if he is right. Dr. Libby Ginway has graciously offered to serve on my committee as well, despite the topic being as esoteric to her as Brazilian science fiction is to me; obrigado, Doutora. No set of acknowledgements could ever be complete without extending gratitude to those friends and family members who offer support, both financial and emotional, through any undertaking. I am especially grateful to my mother and father in those regards, as they have always supported me in my decisions, always confident that I was taking the right, if less-traveled, path. iv

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TABLE OF CONTENTS page ACKNOWLEDGMENTS .................................................................................................iii LIST OF TABLES ............................................................................................................vii LIST OF FIGURES .........................................................................................................viii ABSTRACT .......................................................................................................................ix CHAPTER 1 INTRODUCTION........................................................................................................1 2 AN ABBREVIATED HISTORY OF INTEREST RATES, INFLATION, AND MONETARY POLICY IN BRAZIL............................................................................9 Theoretical Bases for Inflation....................................................................................14 Post-War Promises......................................................................................................17 Military Rule and an (Overly) Managed Economy....................................................19 Civilian Rule and Attempted Stabilizations................................................................23 O Plano Real: Finally, a Plan that Works!.................................................................25 3 BRAZILS CURRENT INTEREST RATE DYNAMICS.........................................29 Testing for rationality in price forecasts.....................................................................30 Real Interest Rates: Comparisons and Determinants..................................................40 Apologists for Elevated Real Interest Rates...............................................................44 Historical Factors and Current Realities of High Real Interest Rates........................47 Existence and Causes of High Interest Rates..............................................................54 4 O JEITO JURDICO BRASILEIRO: COPING WITH THE PROBLEMS RESULTING FROM HIGHLY ELEVATED INTEREST RATES..........................56 Firm-Level Financing Decisions................................................................................56 Impacts on Large Firms..............................................................................................58 Impacts on Smaller Firms...........................................................................................62 Implications of Interest Rates for Individuals............................................................66 Mortgage Finance.......................................................................................................67 Everyday Financing for Individuals............................................................................69 v

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The Disparate Effects of High Interest Rates.............................................................72 5 CONCLUSIONS, RECENT OBSERVATIONS, AND FINAL REMARKS............75 A Review of the Causes of High Interest Rates..........................................................76 The Show Must Go On: Evolutions of Very Brazilian Credit Mechanisms...........78 Epilogue: Recent Data and Trends.............................................................................80 LIST OF REFERENCES...................................................................................................82 BIOGRAPHICAL SKETCH.............................................................................................88 vi

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LIST OF TABLES Table page 2.1 Annual Inflation...........................................................................................................11 3.1 Rationality Tests in Inflation Expectations..................................................................34 3.2 Comparative Nominal and Real Rates.........................................................................42 4.1 Source of Financing Constraints and Firm Capital......................................................64 vii

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LIST OF FIGURES Figure page 1.1 Ex-Ante Real Interest Rates in Brazil............................................................................6 2.1 Deficits and Public Consumption of Fiscal Debt.........................................................12 2.2 Inflation Rates, Before, During, and After Hyperinflation and the Real Plan.............14 2.3 Federal Debt/GDP Ratio..............................................................................................22 3.1 Inflations Expected and Realized Values...................................................................36 3.2 Year-over-year Inflation Rates and Rolling Volatility of Inflation.............................37 3.3 Contribution of Variables to Expected Inflation..........................................................39 3.4 Comparable Nominal Short Term Interest Rates.........................................................41 3.5 Stylized Depiction of a Bad Equillibrium................................................................45 3.6 Recent Trends in SELIC and Inflation.........................................................................48 3.7 Brazilian Balance of Payments....................................................................................52 4.1 Aracruzs Debt Structure.............................................................................................60 5.1 Flowchart of Interest Rate Determinants.....................................................................77 viii

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Abstract of Thesis Presented to the Graduate School of the University of Florida in Partial Fulfillment of the Requirements for the Degree of Master of Arts BRAZILS ELEVATED INTEREST RATES: A CASE OF IRRATIONAL PESSIMISM OR GUARDED OPTIMISM? By Ed Johnson May, 2006 Chair: Terry L. McCoy Cochair: Andy Naranjo Major Department: Latin American Studies This thesis examines interest rates in Brazil, with a focus on their historically volatile nature, the theoretical and practical reasons for their elevated levels, and the ways in which firms and individuals mitigate the negative effects of a high interest rate environment. Brazils macroeconomic history has been extremely volatile, and the country experienced triple digit inflation rates as recently as 1993. The instability of prices, as well as the existence of what has been called a weak macro regime, has necessitated interest rates which exceed those of peer nations. A cycle emerges, in which exogenous shocks are propagated into the country, making it a more risky environment for investments and raising the intrinsic risk associated with government debt, as default is seen as a more likely possibility. The nature of this cycle, as well as other determining factors of interest rates, is examined in this work. In spite of these interest rates, Brazil has experienced some periods of very impressive economic growth. The buffers between the deleterious effects of high interest ix

PAGE 10

rates and the rates of growth exhibited in the country are also examined in this work. Specifically, this thesis will answer how firms raise capital in this environment, and show the effects of firm size and nationality on the methods of financing used. The effects of high interest rates also trickle down to individuals, and decisions such as home finance and durable goods purchases, as well as more day-to-day financing of household consumption. This thesis also explores the network of informal, and oftentimes subsidized, credit that has emerged in the country. In the light of the recent economic success of the country, investors from Brazil to New York are calling for a lowering of the reference interest rates in the country. This thesis blends previous theory, survey-based research, and anecdotal evidence from the most recent data to illustrate the causal mechanism that would allow that lowering to take place, and argues that interest rates should, in fact, be lower than they actually are. x

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CHAPTER 1 INTRODUCTION For most, the word Brazil conjures up images of the Amazon, Samba, and Carnaval. The commotion and volatility that all of these images imply is not dissimilar to the thoughts of economists on the country: rampant inflation, sky-high interest rates, precarious commodity prices, and unpredictable economic growth. Brazil suffers greatly from these preconceptions. In a reciprocally causal relationship, interest rates are high because of the risk that doing business in the country implies; those high interest rates act as a continual impediment to growth and (more importantly) to economic equality in the region. Those impediments to equitable growth further fuel the level of risk that the market now assesses to investments in Brazil. Without access to credit, the middle class is stifled, inequality grows, and balanced growth is further out of reach. This paper will focus on the cost of credit in Brazil, with a specific focus on the history of volatility that has necessitated high interest rates, the theoretical and practical factors which influence their determination, and the mechanisms which have evolved to help the country function despite the inability to effectively utilize traditional debt finance. There exists no market for long-term local debt, not even for the most securitized lending such as mortgages, and only the wealthy with access to overseas funding can effectively leverage their fixed assets. In addition, as interest rates remain high, a larger percentage of government revenues continue to service the national debt, in essence paying continually for the countrys dismal economic past, instead of funding initiatives aimed at preparing Brazil for the future. In fact, the government pays the greatest cost for 1

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2 these high interest rates, as the government debt/GDP ratio remains very high, crowding out private investments. This diversion of funds cannot be stopped: any talks of a moratorium or of a restructuring of debt payments to allow for more social programs or productive investments sends shocks through financial and currency markets, raising the Brazil risk and making the debt grow instantaneously, in terms of reais, 1 as a large portion of the debt is denominated in dollars. This was evidenced most recently in October of 2002, in the run-up to now President Lulas election: with talks of profligate public spending and disregard of Brazils obligations to the international financial community, the Real hit an all-time low against the dollar of 4.03 on October 12, 2002. Since that time, the government of Lula has pursued orthodox economic policies not unlike those of his predecessor, Fernando Henrique Cardoso. The currency market has adjusted accordingly, with the Real experiencing a 15% appreciation in 2005 and a cumulative 51% appreciation since year-end 2002. Notwithstanding this impressive adjustment in currency values, the overnight bank lending rate (hereafter the SELIC rate) in Brazil remains at 18%, implying an ex-ante real interest rate of over 13%. 2 At such high levels of interest in the least risky of investments (overnight bank lending), it is easy to see why no local long-term debt market has matured. Adding factors for default, maturity, and liquidity risks, private lending rates quickly approach prohibitive levels. Despite solid growth prospects and performance, interest rates seem sticky and unbalanced growth continues, jeopardizing the future of the country. 1 Reais is the Portuguese-language plural of the Brazilian currency, the Real. 2 At year-end 2005 the expected change in the price level in the following twelve months was 4.76%, as measured by the Banco Central do Brasil and published on the Banks website. The real interest rate is simply the nominal rate less expected inflation.

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3 This vicious cycle is extremely unfortunate, as the Brazilian economy has been performing very well in recent years. Growth in real GDP was 4.9% in 2004 and is expected to be 2.44% and 3.45% in 2005 and 2006, respectively (Fundao Getlio Vargas and Latin-Focus magazines consensus estimates). These rates of growth are all above the average growth of 2.0% for the twenty year period ending in 2003. Inflation has remained essentially in check since the institution of the Real in 1994 (more on this below) and productivity growth continues to accelerate as synergies resulting from investment in the real sector and international economic liberalization are being realized. 3 In short, it appears that the pas do futuro has finally arrived into its economic promised land and that the country is performing as the economic powerhouse that many have believed it could be for so many years. In order for this transition to economic powerhouse to occur, many things must take place simultaneously. Unemployment must be low to foster economic opportunity. In Brazil the official statistics for unemployment hover around 10%, with levels of underemployment higher and the employment index for the informal economy mitigating the poverty effect from this official unemployment (according to data from various editions of the monthly employment survey from Brazils national statistical agency, IBGE 4 ). Wealth must be fairly distributed to kindle a middle class capable of entrepreneurship (the true engine of growth); in Brazil income inequality is worse than anywhere else in Latin America and on par with some countries in Africa (Bulmer3 Productivity is difficult to measure in Brazil, and is not officially published by the government. I rely on the work of Ferreira and Rossi (2003) for this generalization. 4 The survey is the Pesquisa Mensal do Emprego and the agency is the Instituto Brasileiro de Estatstica e Geografia.

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4 Thomas, 2003, p. 11). Macroeconomic fundamentals such as inflation must stay low and relatively nonvolatile in order to provide appropriate signals to markets. Another key component of economic growth is the interest rate that affects the decisions made by governments, banks, and non-financial firms. Standard economic models would suggest that the interest rates would be declining over time in Brazil. In the market based approach to interest rates, this works through two channels. First, expectations of future inflation directly influence the nominal interest rate: );()1tttEri that is the nominal rate today is approximately equal to todays real rate plus the expectation of inflation in the following period (more formally, the expected annual inflation over the term of the interest rate). 5 Another channel through which good economic performance should lower interest rates is through the country risk premium. Stylistically this is the rate at which the market assesses a premium to transactions in a country (and in a countries currency) vis--vis a base country of reference. These two mechanisms should be acting to lower interest rates in Brazil. Specifically, the expectations of future inflation should be diminishing as recent inflation performance has been below the historical average and much below the hyperinflationary levels which ended with the Real Plan in 1994. The government now operates in a new regime of inflation targeting. This regime has performed well, is transparent, politically independent, and operates with a legal mandate to control inflation (though it does not operate in an apolitical vacuum). As agents update their frameworks for evaluating inflationary expectations, the nominal interest rates should decline. Furthermore, solid 5 The same is true when monetary policy is viewed through the Taylor Rule, where expectations of future inflation are positively correlated with interest rate moves by the central bank.

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5 economic fundamentals will themselves drive non-inflationary growth. In Brazil, some decline in expectations has occurred and later in the paper the formation of expectations and inflationary memory will be discussed. Specifically the prospects of an asymmetric response function to inflationary news will be evaluated: does the market take longer to believe good news than it does to incorporate (and penalize) bad news? Most important, however, to the formation of inflationary expectations is the credibility given to the monetary policy of the government. Brazil now operates in a completely new regime from that of just a few years ago. Transparent inflation targeting in the confines of a politically independent central bank such as that done in Brazil is the state of the art in monetary policy, indeed more theoretically advanced than the regime of even the U.S. Fed, which cloaks its policy decisions in obfuscating language, and represents a clear break from the political nature of a loosely defined monetary policy in Brazils past. If this new regime is believed to be the regime going forward, expectations should not factor in the policy mistakes of previous regimes. Later this paper will address this concern as well. The so-called country risk premium should also be falling. Brazil has returned to a peaceful democracy since the end of the military dictatorships, capital markets are fully developed and fairly liquid (compared to historical norms), and capital moves freely across the border. Even the leftist politicians of years ago are pursuing orthodox economic models and are allowing for increased autonomy of the nations central bank. In short, conditions are such that inflationary expectations should not be anchored in the hyperinflationary or even high-inflation period, and the country risk premium should be converging to a more reasonable level. Furthermore, the ex-post change in the currency

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6 has implied a currency premium, and not a discount, for investing in reais. Despite the seemingly convincing case for lower real-interest rates, the precipitous decline has not occurred. As seen in the chart below, the real rate has been in a band between 10-18% since 2001, and is in the mid-point of that band now. 6 This paper will examine reasons for interest rate persistence, examine the path necessary to drive the rates lower, and to examine mechanisms which are already in place to mitigate the impact that interest rates currently have on consumers and firms. Figure 1.1 Ex-Ante Real Interest Rates in Brazil Ex-Ante Real Interest Rates68101214161820Nov-01Mar-02Jul-02Nov-02Mar-03Jul-03Nov-03Mar-04Jul-04Nov-04Mar-05Jul-05 There exists a robust literature on the subject of Brazils macroeconomic fundamentals, and much work has previously been performed on the question of the countrys interest rates. Much of the work examines one component of the interest rate, focusing on inflationary expectations or on one of the drivers of the real interest rate. Several papers seek to justify Brazils interest rate policy, and estimate Taylor rules for Brazil. Most notably, Muinhos and Nakane (2005) emply various techniques to show that Brazils interest rates are higher than those of other economies, while Bogdankski et al. (2001) estimate monetary policy rules for Brazil consistent with the level of interest rates currently present in the country. In an important contribution to the literature, Favero and Giavazzi (2002) estimate a full Taylor rule for Brazil that shows that the 6 Defined as the SELIC rate less expected change in the IPC index over the subsequent twelve months (BCB data, authors calculation and graphic).

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7 interest rate associated with non-accelerating inflation is around 17.5%. The implications of their methods and results are discussed fully in chapter three. Building on the theoretical work of Keane and Runkle (1990, 1998), Carvalho (2004) builds a complete set of tests of the rationality of the forecasters that are surveyed by the Central Bank on the future movements of inflation. Her work largely rejects rationality in the data, and similar tests (with more recent data and slightly different specifications) are reproduced in the third chapter of this work. Carvalho stops short of identifying the driving forces of expectations, focusing on their rationality. A recent contribution from Cerisola and Gelos (2005) discusses how those expectations are formed, and suggests that the relative importance of the various determinants changes over time. This work is expanded upon in this paper, in light of the most recent economic data. The question of real interest rates has also been addressed by several authors. Favero and Giavazzi (2001) point to term premia, currency aversion and the lack of independence of the central bank. The last point is also identified as a cause of inflation by Tullio and Ronci (1996), who estimate a Phillips curve with a proxy for the perceived independence of the bank. This estimation clearly shows a correlation between weak political independence and higher inflation. Palley (2004) and others have written on the weak fiscal situation of the federal government and how high interest rates are both a cause and an effect of that deficit financing. Their work is examined and critiqued in the second half of chapter three. Carneiro and Wu (2004) point to Brazils insertion into the global economy as a proximate cause of its high interest rates, a point also examined by

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8 Garcia and Didier (2000). Finally, Arida and Lara-Resende (2005) also point to the lack of local long-term debt as a reason for (and not an effect of) high interest rates. Less work has been done on the effect of high interest rates in the country. Bonomo et al.(2003) empirically verifies credit constraints at the firm level, and Terra (2003) shows that the size and nationality of the firm is a determining factor of the severity of that constraint. This paper will examine the capital structure of firms, principally using published annual reports (in the case of large firms) and survey data (in the case of smaller firms) from the World Bank (2003). Some research has been done with respect to credit constraints at the individual level, and this paper will make use of a recent survey (Brusky and Fortuna, 2002) to discuss the unmet needs of the masses with respect to everyday access to credit and capital. Fagnani (1996) and Borba (2004) discuss the lack of mortgage finance and suggest ways in which that gap could be eliminated. Finally, Pinheiro and Cabral (1999) show the major aspects of Brazils gray market for credit which allow it to flourish. This paper will act as a compendium of all of this research, bringing the previous authors disparate viewpoints together to tell, in one voice, the story of Brazils interest rates. The most recent data will be considered as well, updating some results that were written several years ago, while conjecturing either that other results are no longer valid or that the credit markets have not yet responded to a shift in the fundamentals of the Brazilian economy. In doing so, the paper seeks to answer whether Brazils credit markets are suffering from irrational pessimism, routed in the past may not repeat itself, or if they are subject to a guarded form of optimism that will require more economic austerity and good performance to result in lower interest rates.

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CHAPTER 2 AN ABBREVIATED HISTORY OF INTEREST RATES, INFLATION, AND MONETARY POLICY IN BRAZIL Brazils history of inflation, interest, and monetary policy will be extremely different for the reader solely familiar with the stable regime of the United States or the other more industrialized nations. It does not, however, differ drastically from other Latin American nations. The governments use of the inflationary taxes to finance the public deficit are not uncommon to the region, nor are rates of inflation that are meaningless in annual terms and are calculated and discussed in monthly rates, rates which, in turn, are factors of 10 above the average annual inflation rate of the most stable post-industrialized economies. To help the reader to better understand this process and its causes, this paper will review this history in order to gain insight into the causes of this interest rate dilemma. Indeed, one cannot study the history of interest rates per se in an economy such as Brazils. The series is highly discontinuous, variable, and ill-defined (even by the Central Bank). This is due almost entirely to the unpredictable nature of inflation, along with the regime changes experienced in the country over the last fifty years. The study and history of inflation is integral, then, to the study of interest rates in any country. Individual investors demand rates of return which exceed the increase in the price level; if those rates of return cannot be met, agents have strong incentives to 9

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10 consume income as it is earned, thereby lowering the savings rate. 1 Empirical evidence shows that the Taylor rule also holds in emerging economies as well as industrialized economies; as expectations of future inflation become worrisome, central banks use their policy instruments, namely interest rates, to quell inflationary pressures. 2 It is because of these linkages that this study begins with an examination of the history of inflation in Brazil. Special attention will be paid to the role of government in seeking to tame inflations course so as to steer the economy towards low-inflation economic growth and also to the various monetary policy regimes which have sought to control the rate of price acceleration. In the post-war period, inflation began at a fairly stable pace, fluctuating in a range below 20% annually until late 1959 (Bulmer-Thomas, 1993). 3 Even the low inflation of this period, however, was sparked by government policies and manipulation. By 1945 the Vargas administration had increased the tax share of GDP to 26.5%, an astonishing three-fold increase from the level just six years prior (ibid). A dual exchange rate regime also existed in this period which gave preference to exporters. This regime may have promoted export growth but had inflationary pass-through consequences because of the high exchange rate granted to importers. This sort of indirect taxing of consumer goods began a long standing tradition of government manipulation, albeit indirect, of the price level (ibid). However, beginning in the 1960s, inflation quickly got 1 When given the choice to spend R$1 today on an asset, or invest at 10% to purchase the asset in one year at R$1.15, a rational actor would spend the R$1 today (even if he/she were to hold the good and sell it in a years time). 2 See, for instance, John B. Taylor, Using Monetary Policy Rules in Emerging Market Economies, a paper presented at the 75 th Anniversary Conference of the Bank of Mexico, November 14 15, 2000 (available on-line at http://www.banxico.gob.mx). 3 As in the United States, reliable, official economic data does not exist for the pre-World War II period.

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11 out of control and became rooted in the Brazilian psyche, having long-lasting implications for the conduct of economic policy. In that decade, inflation exceeded 40% per year and grew to exceed 100% annually by 1980. By the introduction of the most recent stabilization plan, the Real Plan, inflation was running at unfathomable levels (table at right, authors calculations). Table 2.1 Annual Inflatio n Average Annual Inflation (percent) 1960-69 44.6 1970-74 20.9 1975-79 46.5 1980-84 148.0 1985-89 707.4 1990-93 1,764.9 The acceleration of inflation in the period beginning in 1960 was caused in part by the lack of a market for government debt. In fact, outside of the Banco Nacional de Desenvolvimento Econmico e Social (BNDES), there were few resources available for long-term financing. Housing finance was not available (it remains largely inaccessible to this day) and any long-term credit was restricted to a few commercial banks and finance companies. At the time, Brazil was governed by a military government (more on this below), and its response was fairly orthodox: remove the pressures on the deficit that was causing the monetization of the deficit. Prices for public services were increased (though this has some pass-through to inflation in other sectors) and expenditures were cut (Coes, 1994, p. 87). Inflation fell to below 40% a year by the late 1960s, all things considered a great accomplishment but not low enough to engender the sort of long-term lending the country needed for development purposes. To that end, the government instituted its second, much less orthodox, response: the correo monetria, literally monetary correction and now known as inflation indexation. The BNDES had long been indexing its long-term lending to offset the inflation-induced real erosion of loan repayment. Then Minister of the Economy Roberto

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12 Campos was a former president of the BNDES and suggested that indexation be used in a broader sense in the economy. 4 With the passage of the now-famous law 4.357 in 1964, financial contracts could be written to allow for ex-post revisions in their notional amounts to reflect inflation. The legislation also introduced a new type of government bond, the Obrigao Reajustvel de Tesouro Nacional (ORTN), which increased the governments ability to finance its deficit through selling new government bonds to the public, bonds which were indexed to a pre-determined index of the cost of living. 5 According to Coes (1995), public absorption of this new debt was one of the key factors in bringing down inflation after 1964 (see graph). Figure 2.1 Deficits and Public Consumption of Fiscal Debt Fiscal Deficits and Public Consumption of Government Debt(millions of current cruzeiros)(100)4009001,4001,9002,40019611962196319641965196619671968196919701971Fiscal DeficitPublic Purchases of Govt. Debt 1971 = 4,030 Indexation became a central feature of the economy, and following the ORTNs, the government began to track Unidades Patres de Capital, or UPCs, which allowed for the indexation of all debt, private and public, to the government-set levels for inflation adjustment. In addition to the ORTNs, the government also began to issue Letras de Tesouro Nacional, or LTNs, which were offered at various maturities and at marketdetermined interest rates. All of these new assets helped to create a more liquid financial market and made the more narrow monetary aggregates less important, as Brazilian 4 BNDES, 50 Years of Development. On the web at http://www.bndes.gov.br/english/book50years.asp 5 This was a relatively progressive concept. As a point of reference, the U.S. Treasury first introduced its inflation-protected securities, the TIPS series, in 1997.

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13 agents could move between inflation-adjusted and nominal currency with ease, thus blunting the monetary erosion to accumulated wealth from the inflation experienced in the period. However, outside of the financial sector notional correction was much less advanced. Salary contracts were often negotiated on annual bases and even those contracts which were indexed were corrected at a staggered pace (every six or twelve months). The government itself contributed to this lag: it wasnt until 1979 (fifteen years after the beginning of indexation) that the minimum wage was moved from an annual to a semi-annual cost of living adjustmentwith the variability that inflation exhibited in this period, even this semi-annual adjustment left much to be desired (Coes, 1995, p. 89)! Throughout the history of indexation, the government continued to manipulate the economy through its policy choices. Take for instance the choice of price index used to correct for inflation: a mining company would like its workers wages (or the price of any of its inputs, for that matter) to be corrected by the price change in the factorys output (say, iron ore), while workers would like their incomes to be adjusted vis--vis changes in the price of the basket of goods they consume. The government is essentially torn between these competing pressures and any choice of index merely manages the distortion in real prices that occurs without any indexation; it does not, however, completely solve the problem. When oil prices sky-rocketed in the 1970s, the government introduced a new price index that could be manually adjusted to control for exogenous shocks beyond the control of the national economy. The result of this

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14 manipulation was a real erosion of all assets corrected by the ORTNs, and reduced purchasing power of the adjusted cruzeiro. 6 Inflation continued to be high (despite Figure 2.2 Inflation Rates, Before, During, and After Hyperinflation and the Real Plan Annual Inflation(1-month percent change in implicit price deflator)-10%10%30%50%70%90%Jan-83Jan-87Jan-91Jan-95Jan-99 Real PlanJuly 1, 1994 indexation) throughout the 1970s and 1980s and then accelerated to astronomical levels in the late 1980s and early 1990s. Only with the introduction of the Real Plan was it slowed to manageable levels. The charts above tell the story better than words possibly can (note the scales): inflation so high, volatile, and endemic that by the mid-1980s it no longer made sense to refer to inflation in the year-over-year or annualized sense, but rather by 1-month percent changes (authors exhibits from data collected from the BCB). Despite various stabilization plans (as discussed below), it wasnt until the introduction of the Real Plan in 1994 that the problem of inflation was finally tackled. Theoretical Bases for Inflation Before examining in more detail each of the relevant periods of recent Brazilian economic history, it is useful to examine the theory behind the inflation that has plagued the country and clouded the ability of policymakers to set a clear path for the future. Specifically, what does theory tell us about these rampant (and variable) accelerations in inflation? According to the classic model, the root cause of inflation all across Latin 6 Essentially the government would decide how much of the inflation was exogenous to the country and only allow the indexation to account for the remainder. Annual Inflation (12-month percent change in implicit price deflator) 0 20 40 60 80 100 120 140 Feb Feb Feb Feb Feb Feb -45 -49 -53 -57 -61 -65 FebFebFebFeb69 73 77 81

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15 America during this period was the same: monetization of fiscal deficits. Despite the fact that external financing was important to Latin Americas growth and economic planning in this period, these high rates of inflation also suggest that much of the debt was in fact monetized. The Central Bank prints money in order to finance the balance between its deficits and new debt issuance (external and internal) in order to pay the governments bills. The so-called inflation tax arises when the government prints too much money, its real value declines, and the new, devalued currency is used to pay nominal balances owed to the governments lenders. In this monetary model, increases in the money supply are essentially treated as exogenous, meaning they are predetermined and not affected by other variables such as the change in the price level. If this were true, growth in the money supply the infamous printing of money that people oft blame for hyperinflation in Latin America would lead to a devalued currency. The policy prescription for stopping inflation would be clear: turn off the printing presses! Treating the money-printing policy decisions of the central bank as exogenous, however, does not entirely apply to the Brazilian case. If budget deficits cannot be fully financed through external funding, the bank has no choice but to increase the money supply. As Fisher and Easterly argue: Milton Friedmans famous statement that inflation is always and everywhere a monetary phenomenon is correct. However, governments do not print money at a rapid rate out of the clear blue sky. They generally print money to cover their budget deficit. Rapid money growth is conceivable without an underlying fiscal imbalance, but it is unlikely. This rapid inflation is almost always a fiscal phenomenon. (Fischer and Easterly, 1993, pp. 138-39.) The true variables of interest then, the ones driving inflation, would be the size of the budget deficit and the appetite of the investing community for government-issued debt. Furthermore, critics of the monetarist theory in Brazil note that inflation sometimes

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16 spiked at times when there was no substantial increase in the monetary aggregate, and have pointed out instability in the estimates of monetary demand in Brazil. They cite these two facts as evidence that the monetarist model is not appropriate for the Brazilian case. 7 Arguing for a structuralist approach to inflation in Brazil, opponents of monetarism say that the money supply is in fact endogenous, determined by other variables, not the least of which is the price level. According to this theory, supply constraints or excess demand causes inflation in specific prices. Seeing their purchasing power eroded, other agents in the economy also raise their prices. The central bank then is faced with a dilemma: restrict the monetary supply and foster deflation, or accommodate the price increases with increased money so as to not engender unemployment and/or recession. In short, structuralists argue money growth is the effect, and not the cause, of inflation. Which of these theories is right? It is possible that there exists a feedback mechanism wherein initial price increases prompt monetary accommodation, which in turn brings about more inflation. Coes (1995) performs Granger causality tests 8 on the general price index (IGP-DI) and various monetary aggregates (the monetary base, M1, M2, and M3). The results do not indicate that inflation causes increases in the broad monetary aggregates. For the more narrowly defined monetary aggregates, the tests are on the border line of significance (in probabilistic terms) and suggest some relationship may be present. In the case of the reverse relationship, the test results vary. For broader monetary aggregates (M2 and M3, which include highly liquid monetary substitutes), the 7 See, for instance, Cardoso (1983), Rossi (1989), and Cardoso and Fishlow (1990). 8 The test used is actually a variant of the Granger causality test which eliminates potential bias from serial correlation in the data.

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17 tests indicate that changes in money do induce inflation. In short, for broadly defined monetary aggregates, the monetarists argument appears to hold water. Coes asserts this distinction is due to the fact that during inflationary times (and especially after indexation began), the increasing liquidity of near-money assets implies that it is these measures which should be studied. Recent work (Feliz and Welch, 1992) indicates a neo-monetarist model is most appropriate for Brazil: prices respond to both contemporaneous and expected future changes in the money supply. Just the same, the failure to overwhelmingly reject the structuralist argument in the Brazilian data may indicate that there is some feedback mechanism which says that inflation may further fuel accommodative monetary policy. Regardless of the causes or the exact transmission mechanism, inflation remained high through various administrations and economic plans. Without knowing the exact transmission mechanism, but knowing the correlation between money supply, inflation, and growth, one should by now be asking a very relevant question: how did so many governments fail to manage inflation and control the countrys economic situation more effectively? Government policies had a direct impact on accelerating prices from the 1950s to the implementation of the Real Plan. Simultaneously, stabilization programs were put in place to mitigate the negative consequences of the governments aggressive (and oft unrealistic) development goals. Were those policies simply ineffective, ill-conceived, or were they subject to extraordinary exogeneities that rendered them futile? Post-War Promises Brazil emerged from World War II in a better position than many of the developed economies. War had generated a demand for the countrys exports, and the United States had declared Brazils coffee an importing priority during the war. As a

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18 result, at the end of the war the national coffers were full: more than half a billion dollars lay in the national reserves, and a positive trade surplus contributed much to that boon. This good fortune quickly changed course, however, as that surplus was consumed by aggressive development plans by the new administrations. Promising fifty years of progress in five, Juscelino Kubitschek began massive development projects, including the initiative to develop Brazils interior and to create a new capital, Braslia. There were some success stories which arose from his development plans: during his administration real GDP grew at an average of almost 7 percent per year, leading to a per capital increase of about 4 percent (FGV and BCB). The decrepitude of these plans, however, was the governments inability to finance them: while Vargas had increased the tax share to around 27% of GDP, this alone was insufficient to finance these aggressive plans. Furthermore, export revenues were stagnating, only partially offset by foreign capital flows (Coes, 1995). The government was left with almost no choice: they monetized a great portion of this deficit. Not surprisingly, inflation ensued, with the first bout spiking in 1959 and the annual inflation rate exceeding 30 percent. The successive administrations of Quadros and Goulart, from 1961 to 1964 imposed some conservatism, but it was too little, too late. Opponents of government manipulation favored greater reliance on market prices and feared Goularts seemingly dictatorial aspirations. Furthermore, inflation had taken root and the fiscal deficit proved harder to eradicate than one would have hoped; when the military ousted Goulart in 1964, the inflation accumulated in the twelve months prior exceeded 90 percent (as measured in the IGP; authors calculations). This paper does not posit that the principal reason for Goularts removal was economic. His attempts at stabilization ranged from highly orthodox to

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19 completely contrarian with respect to economic theory, embracing IMF lending originally, then rejecting it for a more radical nationalist strategy (Skidmore, p. 13). This move to a more nationalist strategy wasnt just economic it sought both a political and economic removal from the world scene, simultaneous with a move to the left of the political spectrum. Goulart asserted a causal relationship between the economys woes and its insertion in the global economy, as well as domestic policies. It was this turn to the left that alienated many factions within Brazilian society and prompted the formation of a shadow government consisting of various segments of society (Ibid., p. 14). The inability to control inflation, then, was symptomatic of serious division in the government and in society that was crippling with respect to any unified policy; its rampant nature helped to usher in a defining moment in Brazilian history: military rule that would last for two decades. Military Rule and an (Overly) Managed Economy The military imposed stringent measures to reign in inflation. Fiscal strategy included the raising of taxes, changes in the pricing strategy of public utilities and services, control of wages and credit, and announced targets for monetary expansion. The governments profligate spending was not corrected, however, as governments share of GDP remained at historical levels. The idea was simple: cover the existing spending with more tax and service revenue, but dont decrease spending! Government spending as a share of GDP remained essentially constant throughout the period (at around 10%, according to statistics from IBGE, 1991). However, the revenue base of government did expand and covered a greater share of these expenditures, allowing inflation to cool in the late-1960s. However, excessive government management of the economy became a staple: policies allocated resources instead of prices, and those resources were allocated

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20 based on the governments agenda. Indexation further complicated pricing, and sped the transmission of shocks between sectors of the economy (since the broadest inflation measure, the IGP, was used as the basis of indexation). A new administration, headed by Costa e Silva, took the reins in 1968 and exacerbated these difficulties by allowing for more inflation, as it viewed inflation as a trade-off with real GDP growth (Coes, 1993, p. 15). Price level management was also institutionalized, in bureaucratic Brazilian fashion, with the creation of the Conselho Interministerial de Preos (CIP), and wage adjustment was changed to reflect actual inflation in an ex-post fashion. During this administration, real output grew at over 10 percent per annum, while inflation remained around 20 percent and the public deficit was brought to below 1% of GDP for obvious reasons this period in Brazils economic history is known as the milagre. Economic sensation quickly turned into cessation with the first oil shock in 1973. At the time, Brazil was highly dependent on foreign oil (80% of the crude consumed was imported), and was especially impacted by the shock (Coes, 1995). The new governments management of the crisis was commendable, however: with Brazils economic management institutions, only about one-half of the price increase was passed on to consumers, while subsidies covered the rest. Through both monetary and fiscal restraint, the inflationary threat posed by the oil price increases was quelled. The shock to consumers was mitigated, but the effects on government remained deleterious: some increased borrowing to cover the subsidies, a negative impact on the trade balance, and a reduction in Brazils international reserves.

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21 Brazils government decided to launch a second national development plan in the period following the shock, and greatly encouraged importation of intermediate and capital goods to that end. This was prompted by the level of world interest rates: real rates on dollar-denominated loans were zero or negative throughout much of the 1970s (Coes, 1995, p. 19). Expansive monetary policy led to soaring inflation, however, and at the time the world economy was experiencing its first bout with stagflation (the phenomenon of simultaneously high inflation and low output growth), which limited the ability of Brazilians to export abroad. This led to a sharp increase in real interest rates over the period from 1977-1978 that aimed at cooling the overheating economy. By the time of the second oil crisis, inflation was still excessively high and the current account remained in significant deficit. The response of the government to the second oil shock was typically bureaucratic: strict controls on nominal interest rates, coupled with subsidized credit for certain sectors of the economy. Promulgations abounded, from pre-announced devaluations, to targets for correo monetria and expansion of the monetary base. The intent was clear: stop the inertia in inflationary expectations. The policies lacked credibility however, and after a year of record-setting inflation (110% in 1980), the government switched its mechanism of management to that of demand control, including more aggressive management of the monetary base. The government at this time also began the sale of exchange-rate indexed bonds to the Brazilian public. Due to the inordinately high levels of expected devaluations, the availability of these bonds led to an increase in real interest rates: there was no longer a transactions cost for hedging

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22 domestic currency exposure because the government would adjust returns vis--vis another currency. With domestic interest rates so high, foreign borrowing skyrocketed and by 1982, interest payments accounted for over 70% of the current account deficit and 4.2% of GDP (IBGE). Public enterprises also took part in the foreign debt markets, borrowing abroad to finance the external debt of the central bank, thereby increasing reliance of the government on foreign funding. While an increase in borrowing abroad should force down the domestic interest rate, in Brazil that did not occur. The reason for this atheoretical result is that Brazil was backed into the constraint imposed by high foreign debt. With the stock of external federal debt at the time in excess of fifteen percent of GDP (see graph), any marginal increases in the debt level further decreased the countrys credit standing, increased the drain Figure 2.3 Federal Debt/GDP Ratio Federal Debt / GDP Ratio(percent)0510152025303519641967197019731976197919821985 from debt servicing, and further exposed the country to the whims of international sentiment and exogeneities. These factors served to increase the country risk element of the real interest rate (as measured and detailed below) and counteracted any monetary expansion from the foreign borrowing. As if the situation wasnt bad enough already, in late 1982 another exogenous shock rattled the now-fragile Brazilian economy, as financial contagion from the Mexican debt crisis affected the countrys cost of capital and, for that matter, the availability of foreign lending. Though Baer and Coes (1990) argue that the lending

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23 policies had begun to disfavor Latin America before this date, this crisis increased the perceived country risk even further. Political (election-related) pressures prevented the country from borrowing from the IMF (exacerbating its cost of capital). 9 When lending finally came from the IMF (with the usual strings attached), its success, in economic terms, was so painful that the government lost much political support (per capita real income had fallen by more than 10 percent cumulatively in the years 1980-1983). This loss of support sped the transition to civilian rule and helped to usher in the government of Neves/Sarney. 10 Civilian Rule and Attempted Stabilizations Sarneys attempts to stabilize the economy were various and categorically unsuccessful. His first plan, the Plano Cruzado, began in 1986 and included price and wage freezes, along with the prohibition of indexation and a new currency, the cruzado, worth 1,000 cruzeiros. The basic aim was to eliminate inertial inflationary expectations by ending the indexation and taking the cruzeiro out of public memory. The plan worked initially, but after a few months some allocational effects became obvious. The price freezes had caught some sectors off-guard, and relative prices became skewed, resulting in shortages and rationing. In an attempt to salvage the plan, the Plano Cruzado II was announced, adjusting the prices of a gamut of goods, including automobiles, government services and agricultural products. A floating peg of the cruzado was announced, as was a return to indexation (though this time the nominal anchor was to be the return of BCB notes). In the international community, the risk level associated with the country reached 9 Bacha (1983) estimated the effect of this decision at around 320 million dollars in extra interest to be paid. 10 Tancredo Neves was elected president but died before assuming office. Upon his death, his Vice-Presidential candidate, Jos Sarney, became President-elect.

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24 new highs when the government announced it would temporarily suspend interest payments to foreign creditors in February, 1987. These measures eroded any and all confidence the government had gained; inflation returned to levels near 1,000 percent per year just eighteen months after the introduction of the plan (IBGE). A new plan followed, named after the Economy Minister who devised it, Luis Bresser. Indexation remained, the currency was allowed to devalue, but wages and prices were frozen for a period of three months (only after allowing government and agricultural prices to catch up). Real interest rates were allowed to rise, and the government announced that its deficit would not exceed 3.5% of GDP. This particular part of the plan, however, was derailed when the President authorized large wage increases for public sector employees after the initial three-month freeze. After that initial three month period, the inflation rate again approached 15% monthly and Bresser resigned. A new plan, O Plano Vero, or the Summer Plan, was announced on January 14, 1989. Real interest rates were elevated and cuts in public spending were announced. Prices were again frozen and the economy was de-indexed with a new currency unit, the novo cruzado, becoming the unit of measure (again, dropping three zeroes from the original cruzado). Two factors led to this plans demise: a nominal peg of 1:1 with the dollar was announced and public spending also spiked ahead of the presidential election, wearing away the credibility in the plans announced tenants. Inflation hit four and six percent in February and March (despite the price controls), and the exchange rate could not be maintained at 1:1. By the end of the election, which chose Collor de Mello as its leader, inflation surged to over 80% monthly (Coes, 1995).

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25 The Collor Plan was immediately announced by the new administration, and was the most drastic plan yet. It included a sharp fiscal tightening and a sudden freeze in nearly 70% of the countrys financial assets. However, there were exceptions to this freeze and those types of assets (principally short term bonds) allowed liquidity to again expand and inflation again ensued. 11 A new package, Plano Collor II, sought to re-administer the price level through a reference interest rate that served to re-index the economy and allow for more of the inertial inflation previously experienced. These plans were ultimately unsuccessful as well, as they failed to attack the principal causes of inflation: large federal deficits, deficits which were, in turn, fueled by rampant corruption which later forced Collor de Mello from office in 1992. O Plano Real: Finally, a Plan that Works! In the two year administration that followed, Franco appointed two politicians and an academic economist to the post of Finance Minister. Unsatisfied with their performance, he moved sociologist Fernando Henrique Cardoso to the Finance Ministry in May of 1993. Cardoso and three academic economists authored the stabilization plan that is still in place as of the date of this writing, O Plano Real. This plan incorporated the lessons learned from all the previous stabilization attempts and improved upon them. One of these authors described it as a three-pronged strategy to stabilize the economy: a fiscal strategy centered around a constitutional amendment, monetary reform taking place with the slow adoption of a new currency, and an opening of Brazils economy, both in the form of continued privatization, a new foreign exchange policy, and a liberalization 11 The quantity theory would suggest this result: it is the growth rate of the money supply, and not the stock, which matters for inflation. According to the theory, a sudden, one period drop in the stock of money, followed by growth would generate one-period deflation, followed by re-inflation of the economy.

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26 of the capital account (Franco, 1995). The fiscal deficit was addressed immediately with the introduction of new taxes of financial transactions, cuts in federal government spending, and the creation of a new Fundo de Estabilizao Fiscal. As a result, by mid-1994 there was a primary fiscal surplus of 2.6% of GDP. The currency adjustment and deindexation of the economy came in two pieces: first the creation of new Unidade Real de Valor (URV), which was a composite of several price indices and which emerged as the new index rate. However, with cuts in federal spending and a credible economic agenda, the URV found (as it was designed to do) a point at which the economys prices stabilized. Once that stabilization had occurred, the Real was introduced as the new currency. In terms of the foreign exchange component to the plan, the value of the Real was allowed to fluctuate in what Cinquetti (1998) has called a upper-bounded floating exchange rate regimethe cost of the Real was to never exceed one dollar, but was allowed to fluctuate downward. The success of the plan has been credited to many things, including some exogeneities. However, it was the first of the plans to allow market mechanisms to settle within a new economic framework (no price/wage freezes) and slowly removed indexation instead of a sudden, incredible regime change. Moreover, it also addressed the fundamental structural issue, the federal deficit. With the government constrained to a balanced budget and new sources of revenue, the Central Bank was no longer forced to monetize the deficit, which would have had the usual effect of fueling inflation. As mentioned above, the Real Plan continues in place today and has guided the Brazilian economy through a period of relative prosperity. It hasnt gone completely unchanged, though, and currently we are in a period which could be known as the Plano

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27 Real II if one were to follow the semantics of previous stabilization attempts. In early 1999 Brazil adopted inflation targeting, after floating the currency completely and managing a 50% devaluation. This development changed one of the fundamentals of the Real Plan: the exchange rate was no longer the nominal anchor, but rather the economy was anchored by the inflation rate. This shift has an important implication for monetary policy: the Central Bank now has an explicit target to meet in order to keep its credibility and must unabashedly use its policy instrument (interest rates) to control inflation else risk the publics confidence in the Bank. This was evidenced during the crisis of 2002, when the Bank had to decide not whether, but by how much to raise interest rates (Giavazzi, et. al., 2005). This crisis was handled well, with inflation barely exceeding its (adjusted) target, and real GDP contracting very slightly (-0.2%) in 2003, a clear success when compared to what could have happened if the contagion from Argentina would have been more fierce. The pages above convey the variability and volatility in Brazils recent economic history. Under the guise of various monetary policy regimes, political organizations, and attempts at economic stabilization, Brazil has seen inflation so high that it cannot be shown on a chart, deep business cycles, and extreme ebbs and flows of international capital. Surely this economic rollercoaster is in the minds of economic actors as they evaluate their risk tolerance with respect to the country and is implicit in the relatively high spread vis--vis U.S. Treasuries from which the country suffers. In the last ten years, however, the new monetary policy regime of the Real Plan has endured the stress test of an international liquidity crisis, capricious sentiments of what Thomas Friedman has called the electronic herd of international investors, and the

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28 continuation of orthodox economic policies by one of Brazils most left-leaning politicians, Lula da Silva. How deeply discounted must the recent performance of the economy be in light of the more distant past to justify the real interest rates experienced by the country? For how long must the regime of inflation targeting work in order to mend expectations and drive down the inflation premium in nominal interest rates? How much of a fiscal surplus must be maintained for investors to believe the debt is sustainable, in order to reduce the default risk premium? Will the past performance of the Real reduce investor aversion to the currency and eliminate the devaluationary bias implicit in the domestic interest rate? In short, what must Brazil do to lower both nominal and real interest rates, in order to achieve more balanced growth and productive investment? These are the questions that the next section of this paper will seek to answer.

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CHAPTER 3 BRAZILS CURRENT INTEREST RATE DYNAMICS Implicit in any monetary policy action or inaction is an expectation of how the future will unfold, that is, a forecast. Alan Greenspan The macroeconomic history of Brazil has been anything but stable in recent history. Specifically, only the most recent decade has been a time of relative stability in terms of the usual macro-indicators. Despite this stability, however, interest rates remain at exceedingly high levels. The basic interest rate equation, as illustrated in the introduction, will now be examined to determine the sources of the persistent gap between the yields on U.S. Treasury bonds and similar debt instruments issued by the Brazilian national government. The approximate Fischer equation, )()1 tttEri implies that there are at least two components to the nominal interest rate: the real interest rate and the premium demanded for investors to compensate for their expectations of future price inflation. 1 There are many factors which affect the real rate of interest, r: investors views of the currency, the possibility of sovereign default, the international economic environment, the equilibrium growth rate of the economy, the national financial situation, and the possible convertibility/liquidity risk for operating in a given currency (regardless of the notional exchange rate)to name a few. Many factors also influence the expected future inflation: inflationary inertia, autonomy and credibility of the central bank (or lack 1 The exact Fischer equation has an interaction term between the real rate and expected inflation. It is significant in high inflation countries such as Brazil but is ignored here because the equation is not estimated, but rather used as the basis for the organization of the paper. 29

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30 thereof), state of fiscal balances, and se ntiment vis--vis the international economic environment. Both parts of the model deal with markets perceptions and forecasts of probabilistic scenarios and futu re events. All standard ec onomic models presuppose that markets act efficiently and rationally, which means (among other things) that these expectations are based on all available info rmation and are the true best guess of the outcome of these future events. In some cases, however, rationality may not hold. It is with that possibility that this section of the paper begins, later returning to more standard components of interest rates. Testing for rationality in price forecasts The so-called New-Keynesian Phillips Curve posits that it is the deviation between expected and actual inflation that causes the short-run trade-off between inflation and employment. Consequently, em pirical models (such as those used by the Brazilian Central Bank) require the use of observable phenomena (lagged inflation, actual unemployment) as well as expectations of th e future course of those phenomena. If a systematic bias were to exist in the markets expectations of inflation, that bias would clearly have an effect on nomina l interest rates. If, for instance, the market consistently predicted inflation of 5% higher than that wh ich actually was to occur 12 months hence, the nominal interest rate would be 5% higher than it would be if the expectations did not have this bias. In Brazil, one hypothesis would be that though the Real Plan has stabilized inflation, the markets still remember the hype r-inflationary times of the early 1990s and do not believe that inflation will be as contained as it actually has been. An alternative hypothesis would be that mark ets impetuously believe the Central Banks announced target and set their expectations accordingly, not foreseeing the danger that the Bank may not be able to manage the economy (down) to the target (this would

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31 amount to accepting the target without considering evidence which may exist to the contrary of the announced policy rate of inflation). The inflation-focused rational expectations literature, pioneered by John Muth, hypothesizes that expectations about future inflation are made in such a way that incorporate all available information to the forecaster, and that errors in forecasting are nonsystematic. This implies that agents use all available information to (on average) perfectly predict inflation. In its inflation targeting regime, the Brazilian Central Bank should then pay close attention to these private inflation forecasts, reacting quickly to changes therein as these indicators truly point towards future changes in inflation. If a systematic bias is suspected, the Bank should measure that systematic bias in order to make some inference about the true private beliefs and expectations about future inflation. Incentives exist for the Bank to make inferences about true future inflation from the publics expectations, as any marginal improvement in its ability to foresee (and control) future inflation will only further bolster its credibility. There are two conditions for rationality. Unbiasedness means that the forecasts are on average centered on actual, observed inflation. Suppose t+k is the actual inflation observed in period t+k and E t ( t+k ) is the aggregate survey response to the future inflation at period t+k, using all information available up to period t. The literature then claims that if = (0,1) in the following regression, the aggregate forecast is unbiased: ktkttktE1 or that the k-period ahead forecast of inflation is equal to inflation k-periods ahead plus an error, which (in the case of rationality) is centered on zero and distributed normally. Further performing a joint test for efficiency implies that no available information could have improved the forecast. Allowing t to be the vector

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32 of information available at the time of the forecast, efficiency implies = (0 1 0 0) in the regression: kttkttktE1 Expected inflation is difficult to measure. In fact, in many cases empirical analysts assume an autoregressive process of actual inflation actually governs inflationary expectations. 2 In some other cases, actual expectations can be observed. For example, the term structure of interest rates can give some information about the markets expectations for future short term interest rates. Also, expectations surveys exist in many countries for the most basic macroeconomic variables, among them prices. The difficulty with surveys is two-fold: it is difficult to know if they are truly the same expectations which affect policymakers decisions/markets assessments and, depending on the source of the survey, it is not clear that the respondent has economic incentives to use all possible available information in making his/her forecast. Imagine a phone survey to 10,000 Brazilian homes, for instance. In many cases, the homeowners would simply answer the survey without doing the proper research and certainly without consulting their own macroeconomic models. The Brazilian Central Bank publishes the consensus forecast of professional forecasters for growth in GDP, fiscal performance, and inflation. This series mitigates the aforementioned downsides to survey-based measures. This particular measure of inflationary expectations is a part of the Relatrio do Mercado that is utilized by the Bank (and made available to the public), and the series is the average of the responses of professional forecasters who have clear economic incentives (bonuses) riding on their 2 The judgmental forecasts used in the Federal Reserves classified Greenbook are no exception; the larger FRB/US model does have an explicit role for expectations, however. See Federal Reserve (1997).

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33 accuracy. Moreover, at the Central Bank of Braz il, inflation models do in fact treat these survey based measures as rati onal expectations (Carvalho 2 004). In fact, Fraga (2003) shows that the point estimate of these expect ations in a monetary policy reaction function is over two, implying a one percent-point change in expectations tran slates to an over two percentage-point move in interest rates. It is obvious, then, that the question of rationality in this data should be examined. Near the beginning of the inflation targ eting regime, the Central Bank began to survey private forecasters on their views of in flation. Those forecasts were initially very unreliable, relying on faxes from responde nts which were later compiled in Excel spreadsheets: they suffered from low reliab ility, high variability, unpredictable response rates and (worst of all for researchers) the data was never made av ailable to the public (Carvalho, 2004). However, beginning in late 2001 the Bank bega n to utilize a webbased interface for the collection and dissemination of this information. The survey is conducted daily with the reporting institutions submissions and the means, standard deviations, and medians made available on a weekly basis. A criticism of survey based measures is that when they are analyzed in the aggregate, it is not necessarily true that each forecaster is using the same information set, as it is possible some private information exists. In the case at hand, imagine an investment bank that conducted its own point-of-sale surveys during the month to aid in its forecasting. To alleviate this proble m, this paper uses the methodology put forth by Carvalho (2004); one day is chosen of each mo nth to be representative of the entire month and that day is chosen to minimize the chance of private information. Carvalho suggests using the last day of the prior month, indicating that there is little chance that private information such as a survey could he lp an institutional forecaster foresee price

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34 changes in the following month. To make this point clear, consider this example: a forecaster reports his 12-month price forecast on 2/28/XX ; the aggregate survey response on this date will be treated as the March data point. The data refute the null hypothesis (of rationality) in many cases. An interesting, explicable result holds true: forecasters can predict short term movements in prices much better than they can longer term movements. Specifically, tests were run on the means of foreseen monthly inflation for periods 1, 3, 6, and 12 months into the future and also for inflation accumulated in the next 1, 3, 6, and 12 months (the two 1 month regressions are identical). It was only for forecasts in the 1and 3-month horizons for which the null hypothesis of rationality cannot be rejected at the 90% confidence level; this holds for both foreseen one-month price changes, as well as cumulative inflation measures (see table). This rejection of rationality may be the Table 3.1 Rationality Tests in Inflation Expectations Dependent VariableConstant Slope Coefficient on Expected InflationOne-month Inflation, t+1-0.221.6(0.15)(0.25)One-month Inflation, t+30.70.03(0.26)(0.47)One-month Inflation, t+61.27-1(0.25)(0.44)One-month Inflation, t+121.08-0.89(0.28)(0.56)Accumulated Inflation, t+30.261.15(0.72)(0.42)Accumulated Inflation, t+64.460(1.57)(0.46)Accumulated Inflation, t+1214.77-0.79(2.34)(0.34)Rationality Tests for Expectations in INPC Prices(standard errors in parentheses) result of a new monetary policy regime that is still building credibility and is also highly subject to the adverse inflation shocks that the country experienced, especially during late 2002. Keane and Runkle (1990) argue that testing the rationality of survey data is not valid when conducted on survey means because each individual forecast that contributes to the mean will differ because of differences in information sets (p. 4). While this

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35 problem is partly alleviated by the method of selecting a representativ e day to reflect the months observations, some aggregation bias may still exist, especially in times of (relatively more) uncertainty. Another way to compensate for the fact that this data comes from a survey is to utilize a wei ghted least squares estimates, employing the standard deviations of the forecast means to place less emphasis on data points about which there is less consensus. Doing so tightens the estimation of the oneand threemonth ahead forecasts, making the case for rati onality even more statistically sounds but does not allow for accepting the null of rati onality in forecasts of a longer horizon, consistent with an OLS estimation. Because these estimations do not qualitatively alter the findings, they are not reported here. The main finding, using da ta through the end of 2005, remains unchanged: forecasts in the ve ry short-term are rational and reasonable predictors of future inflation but foreca sts for time horizons exceeding three months exhibit notable flaws. This paper does not seek to be is an e xhaustive model of infla tionary expectations in Brazil. Recent work from Carvalho (2004) utilizes internal Bank data to build a panel data estimation, based on the submissions of the individual surveyors which make up the means and standard errors stud ies here. While theoretically superior, eliminating all of the biases exposed by Keane and Runkle (1990, 1998), the results do not drastically vary from those generated by the more simple estim ations put forth in this paper. Most importantly, unbiasedness is refuted for the 12-month case even when the panel is estimated accounting for the non-spherical natu re of forecast errors due to aggregate shocks which effectively correlate errors acr oss all forecasters (events like September 11, 2001 and the ensuing run-up in oil prices and the election of Lula da Silva in October

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36 2002 which caused a significant depreciation and inflation through the typical pass-through mechanism). The implication for policy-makers is clear: account for the systematic bias in inflation expectations. The Fisher equation suggests that nominal rates should reflect the real rate (to be discussed below) plus a premium for future inflation. If expectations of inflation at time t for period t+i are systematically lower than inflations realized values at time t+i, and the Central Bank knows this bias exists, there should be an additional premium for the bias in inflationary expectations; more directly, interest rates should be even higher than the casual observer of inflationary expectations would think. Indeed, this seems to be the case in Brazil. Expectations for 12-month inflation were on average 96 basis points below realized values for the period September 2003 December 2005 (standard error = 21; see chart below). Moreover, for the whole sample, 12-month-ahead Figure 3.1 Inflations Expected and Realized Values Expected Inflation (t) Realized value (t+i)-14-12-10-8-6-4-20246Nov-01Jan-02Mar-02May-02Jul-02Sep-02Nov-02Jan-03Mar-03May-03Jul-03Sep-03Nov-03Jan-04Mar-04May-04Jul-04Sep-04Nov-04Jan-05Mar-05May-05Jul-05Sep-05 12 6 3UnderpredictionOverprediction expectations were 289 basis points below the realized value (standard error = 82). Assuming the Central Bank knows this bias exists, it has a strong case for increasing the

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37 wedge between nominal and real interest rates by the amount of this bias, making up part of the difference which would appear irrational to the casual observer. Recently it appears expectations have been tracking closer to inflations realized values. Rolling regressions show point estimates in the rationality tests trending closer to one, implying rationality in the more recent forecasts, but with standard errors too large to make conclusive statistical remarks. While there is not enough evidence to make a statistical case for this argument, graphically one can see smaller errors that appear to be centered on zero in the most recent year for expectations made three and six months ahead. This may be due to the apparent success of the inflation targeting regime to control the variability of price movements. Since mid-2003 the variability in 1-month inflation has fallen precipitously, as measured by a rolling standard deviation measure in the graph below (though it has crept up in the most recent six months). At the same time, 12-month expectations of inflation have also fallen and have, on average, been closer Figure 3.2 Year-over-year Inflation Rates and Rolling Volatility of Inflation 00.20.40.60.811.26/29/20016/28/20026/30/20036/30/20046/30/20050246810121412-month ahead inflation expectations (right axis) 10-month rolling standard deviation in 1-month inflation (left-axis) to realized values as discussed above. It is the expectation of 12-month inflation which should matter the most to the Bank, as the transmission between monetary policy and

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38 inflation is estimate to have a lag of about three quarters in Brazil (Bogdanksi, et. al. 2001). If this trend continues, then, and expectations continue to accurately gauge future inflation, the Bank should clearly remove some of its wedge between actual expectations and the difference between the nominal and real rates. This study of expectations of future inflation has been instructive. By illuminating the obvious problems with expectations in the past, an excuse can be made for the high level of nominal policy-set interest rates in Brazil: policymakers knew this bias existed and set nominal rates systematically higher than the casual observer would have deemed necessary. If, however, that bias has been eliminated, as the recent data analyzed in this paper seem to suggest, a clear case can be made for eliminating the wedge between the straight theory (the Fischer equation) and the nominal interest rate set by the Central Bank. If these expectations are in fact trending down and becoming better indicators of future inflation, it is crucial for the Central Bank to understand what factors influence the expectations in order to begin to systematically lower inflation (and interest rates). Cerisola and Gelos (2005) estimate a model of inflationary expectations, estimating from mid-2000 through the third quarter of 2004. The model estimated is: tttttTttoetwagereerrpb36353433211 where the variables are (left to right) expected inflation, a constant term, lagged inflation, the target for inflation, the primary fiscal balance, the real SELIC rate, and deviations from trend of the real exchange and wage rates. The most important determinants of this model, after estimation, are the announced inflation target and the stance of fiscal policy, as proxied by the primary surplus, which serves to capture expectations of future monetization. The point estimate of the coefficient on fiscal policy, in fact, indicates that a one percentage

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39 point increase in the primary surplus coincides with a one percentage point decrease in inflationary expectations. Consistent with expectations, a positive inflationary pass-through is found with a depreciated exchange rate (as prices of imported consumer goods and also intermediate goods rises); the wage variable also exhibits the expected sign (positive), also indicating an increase in inflationary expectations due to demand pressures (the lagged nature of the variable may also indicate a labor cost of goods to consumer price pass-through as well). An important finding, uncovered through recursive estimation, is that since early 2003, and particularly during 2004, the demonstrated commitment to inflation targeting and monetary policy has begun to pay off, as expectations are [more anchored in the] target and less dependent on past inflation (Cerisola and Gelos, p. 12). In fact, as shown in the graph below, which shows the coefficients from a recursive estimation of the expectations equation, the inflation target and primary surplus now account for more than 60% of the variation in (explainable) expected inflation. This suggests Figure 3.3 Contribution of Variables to Expected Inflation Source: Cerisola and Gelos (2005), p. 15. that, along with the SELIC rate itself, the governments policies nearly completely shape inflationary expectations and that through diligent stewarding of these variables the government can lower the wedge between real and nominal interest rates.

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40 This paper has now made one case for lowe ring interest rates: lower expectations of future inflation coupled with improved pr edictive power of thos e expectations vis-vis inflations realized values. If this improvement is sustainable, the Bank should pay it credence, lowering rates in lockstep with the improved (predicted) inflation outlook. Indeed, as the epithet to this chapter suggests, a central banks actions are influenced heavily by forecasts. As those forecasts proj ect a more benign inflationary environment and as they become more reliable, the bank should feel comfortable taking a more accommodative stance in its monetary policy. This does not address the question of real interest rates, however. The remainder of this chapter will seek to a) discover whether real interest rates are high in Brazil when compared to comparable countries and b) decompose the real interest rate half of th e Fischer equation into its relevant subparts, looking both at historical levels of these variables and their drivers, as well as expected future levels to estimate the effect of each going forward on the Banks policy decisions. Real Interest Rates: Comparisons and Determinants Interest rates in Brazil are high by any standard. Despite the countrys recent economic success, rates exhibit stickiness with respect to historical levels. Comparing the country to economic comparables sheds so me light on the subjec t. The graph below shows short term interest rates in five countries, including Brazil. 3 In the case of Chile the rate presented in this exhibit is the po licy rate set by the Cent ral Bank of Chile (the TPM), while in the case of Argentina, Israel and Turkey the rates presented are the oneday BAIBOR rate (for Argentin a) and the interest rate on deposits held within the Banks of Israel and Turkey, respectively. These c ountries are all good comparables for Brazil, 3 The countries in this analysis have not been selected at random. Others have compared this group due to their analogous episodes with hyperinflation and stab ilization. See, for instance, Beckerman (1992).

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41 and even if we were to aggregate the rates, the average interest rate lies nearly monotonically below that of Brazil in the post-Real Plan era. Figure 3.4 Comparable Nominal Short Term Interest Rates Memo: 2005 Inflation and Debt/GDP RatiosInflationDebt / GDP RatioArgentina12.070%Israel2.7101%Chile3.68%Turkey7.768%Brazil6.250%Source: CIA World Factbook and The Economist 0102030405060708090Jan-02May-02Sep-02Jan-03May-03Sep-03Jan-04May-04Sep-04Jan-05May-05Sep-05ArgentinaTurkeyBrazilChile Israel Comparable Nominal Short Term Interest Ratespercent The persistence of Brazils high interest rates is striking in this graph, especially when considered side by side with the hyperinflationary experience and economic crisis of 2002 in Argentina (the contagion from which didnt affect Brazil nearly as badly as the initial crisis affected Argentina), and the relatively recent conquest of hyperinflation in Israel and Turkey (early 1980s and 1999, respectively). The countries (even Turkey) have returned to nominal rates well below Brazils and are relatively indistinguishable at present from industrialized economies (with the exception of Turkey). The experiences of these countries seems to have completely been forgiven by investors, as rates were high for a short-period of time and have since returned to the levels one would expect in the absence of dire financial crises: except in the Brazilian case, where one could look at

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42 these relatively risk-free rates (this is the overnight lending rate used between banks!) and suspect that the country was in the midst of a financial meltdown. An oft-cited reason for Brazils high interest rates is its level of public debt. In this peer group, Brazil fairs very well in that category, with a lower public debt / GDP ratio than all but Chile, and half of that of Israel (CIA World Factbook data). Indeed, this common explanation does not hold water when attempting to justify Brazils high interest rates. Nor do differences in inflation explain the difference in these interest rates. Furthermore, while not theoretically correct, if one were to use past inflation as a rough proxy for expectations, it is easy to back-out a real rate for each of these countries (table below). Without a doubt, the real rate in Brazil at year-end 2005 was exorbitant when compared to its peers, two of which exhibit negative real interest rates! Table 3.1 Comparative Nominal and Real Rates Nominal RateInflation"Real" RateArgentina5.812.0-6.2Israel1.22.7-1.5Chile4.33.60.7Turkey10.07.72.3Brazil18.06.211.8Note: Inflation rates as reported in The Economis t December 24 2005, and are year-over-year changes to Nov. 2005 with the exception of Turkey (Dec.). Muinhos and Nakane (2005) give some statistical footing to this assertion about the high level of real interest rates. They employ various measures, including (but not limited to) a HP-filter smoothing, and I/S curve extraction, and an extraction from estimating the marginal product of capital to find significant differences between Brazils equilibrium real interest rate and that of other economies. Their work does not seek to explain the difference in rates, only to validate the assertion that the wedge does in fact exist statistically. In every specification of their models, the rate for Brazil is significantly higher than that of its peers.

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43 Standard international economics textbooks posit that the real ra te of interest is intertemporally equalized across countries. 4 The evidence at hand suggests this is not the case, as the striking difference of Brazils nominal interest ra te in the graph above is not accounted for solely by differences in inflation. This point would be even more clear if the above chart were to include fully indus trialized economies, which exhibit nominal rates categorically lower than the countries in the above panel. All of these standard economic mode ls make some simplifying assumptions which do not hold in the Brazilian case. Specifically, they assume that long-run purchasing power parity holds, meaning that inflation rates between nations either converge or are equalized through exchange rate movements. They assume that default risk is the same across countries, that perfect convertibility between currencies exists, and that there is no liquidity c onstraint on government securi ties. A sustainable fiscal position is assumed in standard models, and these models also assume perfect jurisdictional certainty, meaning that disputes over contract values will be adjudicated in a predictable fashion and that there is no rele vant adjudication risk in the country; this hypothesis in particular builds on the original sin work de veloped by Hausman, et. al. (2003), which says that once countries begin to dollarize their fina ncial liabilities it is difficult to de-dollarize them, in part b ecause of the aversion of local currency denominated debt due to this jurisdictional risk. The relevant data on Brazil indicates that none of these simplifying assumptions has held in the past and that while some of them do in fact hold today, there is still a wedge between theory and practice due to what for Brazilian Central Bank head Arminio Fraga has called weak macro regimes and a long history of misbehavior (Fraga, 2005, p. 297). 4 Most include a footnote or caveat to this statement, but it is seldom emphasized. See, for instance, Husted and Melvin (1998).

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44 Apologists for Elevated Real Interest Rates Three basic hypotheses explain the persistenc e of high real intere st rates in Brazil: the bad equilibrium, insufficient fiscal adjustment, and sequence of negative shocks. In the bad equilibrium argument, monetary policy is seen to ha ve been necessarily conservative in the pegged exchange rate re gime (1994-1998) in order to compensate for the high (and accurate) risk of devaluation. In this case the economy was using a foreignexchange anchor that lacked credibility a nd perceived sustainability. However, the nominal target was changed to the inflation rate with the maxi-devaluation in 1999 and the move to inflation targeting. In the post-float, inflation-ta rgeting regime (1999present), the appropriate adjustment was not made in interest rates at the time of the float and now policy is not able to suddenly shift them down. Th e basic tenant is that very high real interest rates raise the level of risk on government debt, and so a lower real interest rate brings down the possibility of default and thereby justifies a lower country risk premium and a lower interest rate. This theory deserves some attention because if applied properly, it describes the Brazilian case fa irly well. It is easiest to portray this multiple equilibrium model graphically (and not algebraically), so consider the graph below: the horizontal axis is the domestic in terest rate, and vertical axis is the riskadjusted return on foreign assets in local cu rrency terms, (1 + i* + z). The non-linear function (that appears to be a sine wave) is the expected return on domestic financial instruments, including an adjustment for po ssible default. This function is non-linear because initially higher interest rates imply hi gher expected returns but if they raise too much, increased bankruptcy risks due to hi gher debt service burdens increase the bankruptcy risk. However, as the interest rate gets too hi gh the possible default risk may go down, as the government acts to alter pe rceived default risk (through IFI lending or

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45 through the creation of a budget surplus). At certain prohibitively high levels of interest, however, unstable debt dynamics dominate and the expected return plummets. Regardless of where on the curve interests rates are, in equilibrium, this function must intersect the exogenously-set international rate of interest. In this model, point A is the stable, low interest rate equilibrium, B has a low interest rate but is unstable, C is the high interest rate equilibrium, and D is an unstable high interest rate locus. Imagine the economy was operating at point A when it was hit with an external interest rate shock, that temporarily moved the foreign interest rate relationship from the solid to the dotted line. Once this shock was removed, the economy would move to point C, not to point A. This is the argument of the bad equilibrium hypothesists, some of whom use the 1997 Asian Financial Crisis as Figure 3.5 Stylized Depiction of a Bad Equillibrium this exogenous shock (Palley, 2003). The challenge in their minds is to move Brazil from point C to point A. This theory amounts to a sort of chicken-and-egg E(R), (1 + i + z) D (1+i*+z) B 1+i*+z C E(R) A Domestic interest rate argument, and in their oft-cited work on Brazilian interest rates, Favero and Giavezzi (2002) argue that Brazil should not rely on a transition happening automatically (p. 6). Instead, Brazil should follow the example of other countries that have made a similar transition: endure a large primary surplus for a protracted time in order to justify the lowering of the SELIC rate.

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46 This prescription follows logically into the second hypothesis, which says that fiscal adjustment is not yet complete. Despite a sizeable primary surplus, the debt/GDP ratio remains high enough to continue to crow d out private sector f unding needs (as that debt is rolled over before it is retired), which raises the market interest rate. The policy prescription here is the same: continue to run a fiscal surplus in or der to bring down rates by reducing the amount of gove rnment debt outstanding. The adverse shock hypothesis claims th at shocks to the economy such as the U.S. stock market, 9/11, Lula, and the Ar gentinean meltdown have forced the Central Bank to use interest rates to smooth volatility that otherwise woul d have crippled the economy (notwithstanding the crippling effect of the high interest rates). Proponents of this theory would then argue th at in the absence of further shocks, interest rates will soon begin to move to lower levels. In essence, the argument is that ex post rates are high (because inflation has not picked up, nor did the risks to the economy really materialize), but ex ante they are in line with theory and the prevailing risk assessment at the beginning of the terms of the rates. While theoretically sound, the analysis of the data presented earlier reveals a non-sequitur in this argument: the economies that actually had the fall-outs have already seen their ra tes recover and Brazils rates (ex-ante and ex-post real rates as well as nominal rates) are pers istently high (see introduc tion and this chapter, above). Apologists for the theory counter that Brazils case was peculiar: monetary policy had to be excessively tight to make sure credibility was maintained for the incipient inflation targeting regime, as well as to defect the excha nge rate. Evidence to that point is that the real money stock from Sept 2000 Mar 2001 fell by 3.8%, though it had increased 8.6% the previous year (Vieira de Faria, 2003). Furthermore, an exchange rate-based response to these crisis may not ha ve worked because of the dollarized nature

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47 of the countrys public and private liabilities: the effect of a depreciation is indeterminant as exports are increased but ne t financial liabilities increase as well. Because of these points, Central Bank autonomy in the process of setting its key inte rest rate is more theoretical than real (Vieira de Faria, 2003, p. 46). Even if Brazil s interest rates should have recovered from these shocks three ye ars hence, a dedollarization of financial liabilities would help the countercyclical natu re of exchange rate adjustments become more effective in the future, thereby putting le ss pressure on monetary authorities to alter the basic cost of capital. Historical Factors and Current Realit ies of High Real Interest Rates The challenge, then, is to identify what measurable factors are influencing the real interest rate and to suggest policies which will influence t hose mechanisms in order to justify a lower real interest rate. This section of the paper lends heavily on the vast literature, pioneered by Favero and Giavazzi (2001) and mentioned in the introduction which seeks to explain various components of the real interest rate. The goal will be to act as a compendium of that research and to look at the curren t performance of the Brazilian economy and how it fits into the models estimated by these economists. In their work, Favero and Giavazzi find that there are two major factors which influence the countrys interest rates: moneta ry policy and term premia. They estimate a Taylor rule for Brazil, noting this simple rule explains the actions of the bank very well. Furthermore, they estimate that the equilibrium policy rate (the rate consistent with zero accelerating inflation) is around 17.6 percent. This rate, called the neutral rate by some economists is extremely high (for reference, the Federal Reserve estimates the neutral rate in the United States to be between three and five percent 5 ). A first read of this paper 5 While not an official estimate, numerous Fed Governors and staff have put the estimate in this range. See, for instance, money.cnns interview with St Louis Fed President William Poole (11/10/2004).

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48 may leave the impression that this is an open-and-close case: interest rates are high out of necessity to stabilize inflation. Indeed, the average SELIC rate in 2004-2005 was 17.7% and inflation has essentially been stabilized in those two years, as indicated in the chart at right (through Dec. 05). What this expost modeling misses, however, is why the rates have to be so high in the first place. Indeed, the oscillations in the SELIC rate in the last two years, indeed in the six years of inflation targeting, have accurately shaped expectations of future inflation and have helped to control inflation during this time. Could the same oscillations not occur in a range of 8-10%, or 5-7%? Why must the level of interest rates be so high if it is the change in rates that controls inflation by Figure 3.6 Recent Trends in SELIC and Inflation 0510152025Jan-04Apr-04Jul-04Oct-04Jan-05Apr-05Jul-05Oct-05-1234567891012-mo. inflationSelic rate marginally curtailing or encouraging activity? Favero and Giavazzi argue that one important factor pushing up the high neutral rate is fact that the BCB enjoys none of the institutional guarantees that other central banks have in their mandates; we know of no other central bank that successfully operates an inflation targeting regime and is not formally independent (p. 5). This point cannot be stressed enough; in their work on Brazilian inflation in the pre-Real Plan era, Tullio and Ronci (1996) estimate that a Phillips Curve that includes a proxy for the lack of political independence of the Central Bank 6 that shows that it is strongly correlated 6 Their proxy is determined by the turnover in Central Bank governors and chairmen.

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49 with inflation and accounts for a portion of the rampant inflation this period. 7 This lack of independence, then, directly influences the real rate, as argued by Favero and Giavazzi, as well as pushes up the nomina l rate through increased inflationary expectations. The importance of indepe ndence has a long history in the economics literature and its conclusions are summed up very well by Alan Blinder, who writes: Monetary policy requires long time horiz ons because the lags through which interest rate changes affect output and inflation are ty pically long. If monetary policy decisions were left to politicians on a day-by-day basis, the temptation to reach for short term gains at the expense of the future (that is, to inflate too much) would be hard to resist, especially in the run-up to an election. Knowing this, many governments wisely try to depoliticize mone tary policy by, e.g., putting it in the hands of unelected technocrats with long terms of office and insulation from the hurly-burly of politics. (Blinder, 1998, pp.56-57.) As discussed, Brazil does not belong to th is wise group of nations with depoliticized central banks. Recent changes and stirrings in Brasilia towards increased Central Bank independence should be applaude d, then, and will be discussed in more detail in the conclusion of this work. In terms of longer policy rates, they em ploy a system of equations to simulate future SELIC rates in order to give estimates of theoretical rates of longer maturities that are based solely on monetary policy rates. 8 Their conclusion is th at almost all (95%) of the spread between observable long-term rates and this theoretical ra te is explained by term premia and not by uncertainty about monetary policy. Their conclusion is valid based on their assumptions, but incorporati ng the work of Cerisola and Gelos (2005, discussed above) on inflationary expectations shows that those same fundamentals and 7 One could make the reverse argument: high inflation causes turnover (i.e. the firing) of Central Bank officials. Tullio and Ronic report Granger causality tests which refute this alternative interpretation. 8 Their dynamic simulation is based on a simple Taylor rule and is closed by an equally uncomplicated model of inflationary expectations, which is based sole ly on the target rate of inflation and its recent performance. Their model is overly simple and ignores the factors which affect expectations, as discussed in the previous part of this chapte r. However, this simple specification does fulfill their goal, which is a simulation of ceteris paribus future policy rates.

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50 debt dynamics are also an important part of agents expectations of inflation and should not be ignored when analyzing short-term inte rest rates. Because of that important transmission channel, Favero and Giavazzis fi ndings on long term rates can be extended to considerations of the Selic rate as well. Since these term premia are not affected by devaluation expectations, Favero and Giavazzi conclude that the spread is cau sed by macroeconomic fundamentals and debt dynamics. Specifically they point to the leve l of government debt and the volatility of international financial markets as influencing the perceived risk of government default. When internal financing rates are widely determined by international markets, and the government debt is large, the default risk is highly affected by the correlation of the growth rate of output (which in turn affects the level of the primary surplus) with financial spreads. This additional consider ation in the Brazilian case implies that a larger-than-otherwise necessary surplus is re quired to make the debt sustainable and to bring down the cost of capital. Favero and Giav azzi point to the experi ence of Italy in the mid-1990s when a one-year primary surplus in excess of 6% of GDP was interpreted as a commitment to a more responsible fiscal policy and which began a virtuous cycle that helped move the country towards a permanently lower cost of debt. The driving forces identified thus far are a large and unmanageable (not to mention dollar-denominated) national debt and the lack of institutional independence granted to the Central Bank. While the work of Favero and Giavazzi and others in this area is accurate, this particular policy mix alone will not bring about the pa nacea of lower real interest rates that the country so desperatel y needs. More recent work points to other factors which need to be considered as well in order to bring about the level shift in the countrys cost of capital.

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51 In fact, some of this work refutes the analysis of Favero and Giavazzi to a limited extent. Writing in 2003, Thomas Palley notes Brazils current debt situation implies dynamics that cannot avoid default at existing real interest rates, the surplus needed to stabilize the debt would need to be 5.1% of GDP in order to stabilize the debt, alternatively noting that in the growth of national debt as a percentage of GDP is given by the following equation: ./yYDgdYYdig At the time of his writing, the domestic interest rate, i=18%, the deficit/GDP ratio, d/Y = -3.75%, the GDP/Debt ratio Y/D = 1.67% and GDP growth g(Y) = 3.5%, implying that interest rates, i, needed to fall to 9.75% just to stabilize the debt ratio (Palley, 2003). At the time of this writing, the relevant indicators were i=17.25%, the deficit/GDP ratio, d/Y = -5.6%, the GDP/Debt ratio Y/D = 2.59 and GDP growth g(Y) = 2.5%, implying that interest rates needed to fall to around 12% to make the debt sustainable. While this is slightly more palatable than the estimate above, it is still clear that the current 17.25% interest rate prohibits debt sustainability. This same doomsday scenario was put forth in a 2002 critique of new IMF lending from the Washington-based Center for Economic and Policy Research, which argues that [assuming the most optimistic of scenarios] .. stabilizing the debt-to-GDP ratio through primary surpluses would not be potentially achievable (Weisbrot and Baker, 2002, p. 3). These scenarios have not, as of yet, played out because of the aggressive debt management policies of Lula, which will be considered in the conclusion of this work. Fiscal concerns are not the only ones that affect the real interest rate, however. Arguing for a broader Monetary Conditions Index, Carneiro and Wu point out that small countries in the global economy often times have a peculiar combination: high real interest rates and deficits in the current account. Using panel data, they show that (on

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52 average) every 1% increase in the current account deficit (as a percentage of GDP) is associated with an increase in real interest rates of 20 to 30 basis points (2004, p. 304). 9 Furthermore, they report a strong statistical relationship between the size of the current account deficit and the real interest rate (measured ex post). The theory here is relatively straightforward: increases in the current account deficit create an external funding need which can only be satisfied in the risk-adjusted rates of return for new (marginal) borrowing are sufficient. To the extent that Brazil ran significant trade in the period through 2003, this explanation is valid. However, the argument looses validity when considering the persistent trade surpluses generated by the country since mid-2003 (see chart below). To their credit, Carneiro and Wu only consider data through 2000 (though Figure 3.7 Brazilian Balance of Payments Foreign direct investments (FDI), Current transactions (CT) &External financing requirements (EFR)Accumulated in 12 months-40-32-24-16-808162432401999200020012002200320042005 FDI CT Deficit EFRUS$ billion their work was published in 2004). Is this the break-down of a previously persistent statistical (and theoretically sound) relationship, or did the work suffer from misspecification? It seems unlikely that this misspecification would hold true across a panel of 20 countries, as Carneiro and Wu estimate. More likely than not, as Nobel prize winning economist Joseph Stiglitz writes, Brazils financial markets today are probably a good example of excessive pessimism (Esterl, 2002). As argued in the inflation 9 My translation of the original text, written in Portuguese.

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53 expectations section, it is the position of this paper that the markets are persistently slow to adapt to the evolving insertion of the Brazilian economy into th e global marketplace. This basic idea is supported further by th e decomposition of what are called the cousin risks, the country risk and the curr ency risk, so-called because of their highly cointegrated nature (Garcia and Didier, 2001). This work has shown that one of the components of Brazil risk, that of convertibil ity risk, was very important through the time of the international financial crisis of the late-1990s but no longer has statistical significance. In fact, this decomposition has shown than in the post-inflation targeting period, the currency risk can be estimated at above 5% per year, while the explicit Brazil risk is less than 3% (Garcia and Dider, 2001, p. 32). 10 The irrationality hypothesis, then, is supported in light of the 18-month rall y of the Real vis-vis the dollar though December 2005, along with the strongly e xport-driven current account surplus, juxtaposed with the persistence of high real interest rates. If the market had foreseen this performance, interest rates would have dropped significantly, but they didnt. Another persistent aspect of the Braz ilian economy which contributes to high interest rates is the so-called jurisdictional uncertainty. No long-term market for credit exists in the country, and the onl y long-term credit available outside of the country is that which is denominated in dollars. Arida et. al. (2005) argue that this inability has produced an important new risk element in the country, that of uncertainty over the adjudication of contracts, as well as enhanced currency risk in light of the dollarization of financial liabilities. The authors argue that a policy aimed at correc ting this uncertainty would lower interest rates through an increa se in convertibility (or liquidity) of the 10 Admittedly, this estimate came before the explosio n in the country risk premium associated with the Lula election, but as levels have returned to normal since that time, the author feels the statement is still valid.

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54 currency, as well as a reduction in the effo rt costs of the Central Bank to artificially lengthen the maturity of that portion of the national debt that is denominated in local currency. The perception of the riskiness of Brazils currency and the inability of agents to enter into long-term financia l contracts in their home juri sdiction adds to the interest rate dilemma, then, by increasing demand for short-term credit and making the future even less easy to predict. Existence and Causes of High Interest Rates In short, interest rates are high in Brazil because of perceptions and expectations. Inflationary expectations are the major driver of interest rates, and Brazils volatile past with respect to inflation rates have left a permanent scar on economic agents ability to foresee the future. Furthermore, it may be in light of this inability that monetary policy has been excessively punitive, in order to curb inflation in a wo rse-case scenario sense (i.e. when realized inflation is even greater than the prevailing exp ectation). Real interest rates are also high. When compared to other countries that have similar macroeconomic fundamentals and problems and have weathered, (or even caused) some of the shocks that flustered the Brazilian economy, th e prevailing interest rate in Br azil is persistently higher. The economys debt position, including its leve l, its indexation to the dollar, and its growth, all contribute to the inherent risk of lending in the country. A net importing position has also added to those external financing requirements, further altering perceptions of the sustainabil ity of the economic model the c ountry is pursuing and raising the cost of capital. It is the assessment of markets that neces sitate these high interest rates and no sudden change in the rate would be acc epted instead it would cause capital flight and currency depreciation, as the country would be deemed even more risky. But expectations take time to evolve. The conclusion of this paper will examine the most

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55 recent Brazilian economic data and argue that a fundamental change has occurred, one that is still awaiting the approbation of the international financial community.

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CHAPTER 4 O JEITO JURDICO BRASILEIRO: COPING WITH THE PROBLEMS RESULTING FROM HIGHLY ELEVATED INTEREST RATES Interest rates have been extremely high in Brazil even given the highly unpredictable economic environment and to attempt to control inflation, which has rocked the countrys stability since the late 1950s. As argued by da Cunha and Ferreira (2004), the cost to individuals of this punitive monetary policy is equally extremely detrimental to individuals who do not have access to long-term credit. These same costs are experienced by firms, which must forecast their performance (and that of the overall macroeconomy) when deciding their optimal capital structure and in making financing decisions. The consistently high interest rates (from which ex post real rates are difficult to accurately forecast) implies a business environment that inhibits balanced growth. However, during that time Brazil has had impressive periods of growth and has seen industrialization and wealth creation for many of its citizens. The mechanisms that have allowed this growth to occur despite cripplingly high real interest rates are the subject of this chapter. First this paper will examine the peculiarities of Brazilian finance at the firm level, later turning to peculiarities more personal in nature. Firm-Level Financing Decisions The large overhang of government debt (a true hang-over from times of large budget deficits) has a deleterious impact on Brazilian firms. Government issuance of debt needs to be purchased by investors: this pushes out the demand curve for capital and, in doing so, increases the equilibrium interest rate in the economy (as discussed in 56

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57 the previous chapter). The result is known as crowding out, in which government debt, by definition less risky than debt of Brazilian national firms without access to international funding, takes available, investable savings out of the system. The result is a credit crunch for Brazilian firms, that is to say a scarcity of capital and the de facto imposition of capital constraints for firms. These capital constraints have been verified empirically by many scholars, most recently Bonomo et al.(2003) and Terra (2003). Both papers examine sales accelerator investment models of investment. In this model, if all the factors that influence investment are accounted for, cash flow should not affect investment decisions. Stylistically, if a firm has no credit constraints and subsequently a project exhibits an expected return above the marginal cost of capital, it should be pursued regardless of the firms cash flow position at that time. However, if the cash flow variable explains some part of investment decisions, then there is evidence that the firm faces a credit constraint and can only make those decisions in economic good times of high cash flow. In both papers, significant levels of credit constraint are shown for all Brazilian firms. Terra (2003) bifurcates the analysis by using panel data and aggregating the regression results by firm type and also by the level of dependency each firm shows with respect to external financing. The tested hypothesis is that firms that are more international in nature will exhibit less credit constraint. A second hypothesis is that firms that are more dependent on external finance will invest more when capital inflows are high (and consequently firms access to credit is less constrained). A perhaps obvious result follows: firms that are multinational and/or larger in nature show less credit

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58 constraint than more domestic/smaller firms, particularly in periods of high capital in-flows. The implication of this result is made obvious when comparing the composition of private, corporate sector debt: firms that are large and multinational comprise more than half of private sector debt and that share increases in times of rising or elevated inflation (Tullio and Ronci, 1996). Large firms, generally less risky, are more able to handle the disclosure costs of debt finance, and can marginally raise debt finance at less of an impact to the cost of equity. 1 Moreover, these firms can more easily tap international debt markets, sometimes borrowing at rates that are preferential to those that the government receives (more of this below). Impacts on Large Firms Size is also an interesting component to the equity financing of these firms: 2 in the post-Real Plan era, over 70 Brazilian firms have directly listed their stocks on the New York Stock Exchange through the American Depository Receipt program, or ADRs (State Department, 2005). ADRs allow the firms to sell their equity on U.S. markets in shares that are denominated in dollars, both improving liquidity and removing investor-level uncertainty over foreign exchange effects. This cross-listing has made their stocks more liquid and has forced upon them US GAAP reporting standards, both measures presumably serving to lower the cost of capital of these firms by increasing the desirability of their equity issues. This increase in ADRs coincides with the opposite phenomenon in the So Paulo stock exchange, the BOVESPA, as the number of firms 1 Consider a firm with R$ 1 million in equity and a firm with R$ 100 million in equity. A R$1 million debt issuance makes the equity in the first case much more risky, all else equal. 2 This is, of course, inextricably linked to the interest rates through the CAPM relationship.

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59 listed on the BOVESPA fell 15% from 2001 to 2003 (BOVESPA data). In bypassing the Brazilian equity markets and raising money abroad, this subset of Brazilian corporations hopes to be able to raise money at rates that are effectively lower than the risk-free rate in Brazil. Raising this money in foreign markets should lower the aversion of the typical international investor, as ADRs are, by their very nature, free of foreign exchange rate risk. This hope has not materialized, however. The cost of capital for firms that list as ADRs does not materially differ from those that only list in So Paulo (Hail and Luez, 2005), 20.0% vs. 21.4%. However, this result does not hold across companies from all countries (the panel is of over 30 countries), but is largely consistent for all countries in Latin America. 3 This result implies, then, that the cost of increasing a firms dollar based equity (though revenues are principally in reais) is not always justified by a lower cost of capital. However, these firms do exhibit common characteristics which explain their propensity to cross-list on the NYSE. De Medeiros and Tiberio (2005) employ a logit model which proves that the propensity to cross-list is governed by some important principles. Firms that are larger, as noted, tend to cross list, as do firms that are highly active issues on the BOVESPA. Firms with a high market-to-book ratio also experience an increased propensity to cross-list, perhaps because the benefit to doing so is greater (because their stocks are worth more). Also, firms with better corporate governance standards exhibit greater probabilities of being cross-listed. All of these relationships are as expected, and may relieve some of the credit constraints of these firms, but do not remove the fundamental result of Hail and Luez (2005), which is that these firms do not enjoy significantly lower cost of capital, despite their ability to raise equity abroad. 3 Indeed, WACC estimates for Brazil vary by more than the other Latin America nations, which exhibit the same similarities in sample means (Hail and Luez, 2004).

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60 Indeed, something systematic (and, as noted, outside of currency considerations) is raising the cost of capital for these firms; they seem to suffer greatly from the same Brazil risk that haunts the governments key interest rates. These ADRs are just one piece of a complex financing strategy that helps large firms try to evade the problems associated with costs of constrained capital. Firms often employ multi-tiered financing strategies. In addition to listing both on the NYSE and the BOVESPA, paper-marker Aracruz diversifies its debt structure across many interest rate mechanisms and currency denominations (chart at right, below). 4 The firm has interest rates that are tied not only to the SELIC rate (those contracts which are indexed to the Taxa de Juros de Longo Prazo, Brazils government-set long term interest rate), but also to the LIBOR rate and to the movements of a basket of currencies. Importantly for the firm as well is the fact that it issues debt in both reais and dollars, Figure 4.1 Aracruzs Debt Structure Foreign Currency Denomination and Interest Rate Determination of Aracruzs Debt Structure Local, Fixed0.1%Local, TJLP 14%Local, Forei g n currency basket3%Forei g n, LIBOR26%Forei g n, Fixed57% Source: 2005 SEC Filings, EDGAR database creating a natural hedge for its dollar-denominated revenues. 5 One impressive facet of this debt finance is the low interest rates associated with the various tranches of the firms long term debt. The local currency denominated tranches are financed mainly through bonds linked to the TJLP and the spread over the TJLP that Aracruz pays implies yields on these bonds of less than 10%, markedly better 4 This section relies solely on the authors analysis of the firms 2005 20-F Filing with the SEC, available on-line from the SEC EDGAR database. 5 In 2005 the firm reported that 98% of its revenues were denominated in dollars (company form 20-F).

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61 than the overnight Selic rate discussed above. Even more impressive, though, is that the yield on the foreign currency denominated bonds is less than 6%, similar to average risk North American firms. How does Aracruz borrow at rates preferential to those of the Brazilian national government? One answer to this question is that a large portion of these loans come from the National Economic and Social Development Bank (the BNDES) and is effectively subsidized: the Brazilian government lends the money at rates that are below its own cost of capital. This subsidy is somewhat recovered by the Bank through the large equity stake that the BNDES holds in Aracruz. The firm also benefits from below market-rate debt financing from the World Bank and the International Finance Corporation, both at rates below 6%. Thirdly, the scope and dominance of Aracruz in its sector may imply that indeed its operations justify a smaller risk premium than that assessed to the national government. Aracruz is not alone with respect to Brazilian firms that seek to lower their cost of capital through international debt issuance and other financing activities. An analysis of other Brazilian mega-firms will reveal similar patterns: financing subsidized by the BNDES (who is often a large equity holder in the firms), ADRs that serve to increase equity liquidity, and loans from multi-lateral financial institutions that offer loans at highly preferential rates. State oil firm Petrobrs issues long term debt at much better rates than the federal government, with coupon rates on its bond ranging from 3.7 9.7% 6 In the notes to its financial statements, the firm remarks that its long term borrowings consist primarily of the issuance of securities in the international markets, debentures in the domestic capital markets, financing from the BNDES, and facilities guaranteed by 6 As of this writing, the bonds were trading at values immaterially different from their book values, so this comparison is valid.

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62 other multilateral agencies (Petrobrs Form 20-F, 2005, p. 105). It adds that short term credit is derived mainly from commercial banks including trade lines of credit and commercial paper, and that interest rates on its short term instruments range from 2.866.01% (Ibid., p. F-20). This firm, then, shows no capital constraint and can easily tap into international markets, perhaps even more easily than the Brazilian government itself. The interest rates that it pays are comparatively low (though the reader should be reminded that they are essentially free of foreign exchange risk, since they are denominated in dollars). These two mega-firms can effectively bypass the problems associated with high domestic interest rates by raising capital internationally (though the question remains to be answered with respect to the overall cost of capital, implying highly irregular equity risk premiums this question is beyond the scope of this work, though). 7 The cases of Aracruz and Petrobrs are not unique, however. An examination of any of the Brazilian megafirms will reveal similar characteristics (low interest rates, liability dollarization) and perplexities (why does the government subsidize so much of these firms capital?). Impacts on Smaller Firms A more interesting question, however, is the manner in which firms that are smaller can raise capital for their operations. Terra (2003) and others have shown that firms that do not fall into this category show significant credit constraint and oftentimes cannot undertake profitable projects because of the scarcity of capital. Yet these firms 7 The cost of capital for a firm is determined by: w e *k e + w d *k d or the sum of the products of the portions of capital and equity in the firms capital structure with their respective after-tax costs. This analysis is mainly concerned with the term k d while the observation made here refers to a high cost of equity, k e.

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63 continue to exist and, in many cases, to gr ow. What is the source of their financial constraint, and how do they finan ce themselves in order to grow? In 2003 the World Bank and the Internati onal Finance Corporation charted the World Business Environment Survey. Its missi on is to assess the business environment of member nations with respect to opport unities and limitations fo r growth, government intervention, corruption, financ ing decisions, and expectations for the future. The dataset is rich, striating firms across countries and by size. 8 The table on the next page was generated from this survey and speaks to tw o important questions: what is the source of financial constraint and how ar e firms financed? It reveals differences across firms sizes that may, by now, seem obvious to the read er. A striking differe nce is the problems posed by high interest rates. 90% of sma ll firms identify interest rates as a problem, while only 73% of large firms do so (which ad mittedly is still a high proportion). This difference does not even fully capture the imp act of these rates, how ever, since a firm of 500 employees counts equally as a large fi rm as does a firm of 15,000 employees. Within the large firms there is a negative co rrelation between the value of a firms fixed assets (as a proxy for size with in the group) and the extent to which high interest rates are an inhibitor. Interestingly enough, high interest rates ar e not the only variable for which there is a significantly different effect across firm size. For small firms, paperwork related to financing is a problem for over 55% of firms, while only 30% of large firms feel this constraint. This may, in turn, be related to the higher reported lack of non-bank equity, foreign bank lending, and export and lease fina ncing available to smaller firms. If a 8 This dimension is a categorical variable: small is 1-49 employees, medium is 50-499 employees, while large is 500 or more employees.

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Table 4.1 Source of Financing C onstraints and Firm Capital # of FirmsCollateralPaperwork Interest Rates Special ConnectionsMoney Foreign Banks Non-Bank Equity Export Finance Lease FinanceCredit Small 3043.3%56.7%90.0%26.7%16.7%10.0%23.3%10.0%6.7%10.0% Medium 14144.0%41.8%83.7%27.0%9.2%9.2%14.9%9.2%3.5%10.6% Large 3043.3%30.0%73.3%30.0%13.3%6.7%10.0%6.7%3.3%10.0% # of Firms Retained EarningsEquityLocal BankDevelopment Bank Foreign Banks Family Members Money Lenders Supplier Credit (A/P)Leasing Public SectorOther Small 2558.4%0.0%11.6%0.0%0.4%14.4%4.0%6.2%1.0%0.0%4.0% Medium 12338.1%6.8%23.0%2.1%3.5%3.9%0.3%12.2%6.1%2.1%1.9% Large 2437.9%4.3%21.8%1.3%14.0%0.8%0.0%7.2%8.3%2.1%2.4%Note: Not all firms answered questions regarding the source of firm capital Source: Author's Calculations from World Business Environment Survey, from the World BankFinancial Constraints Imposed by (a lack of): Source of Firm Capital 64

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65 copious amount of compliance and disclosure is required, in addition to the bureaucratic costs for loan processing, it is easy to understand why smaller firms are not more externally financed. The same is true of subsidized credit from the BNDES, which would be included here as non-bank equity or as credit, depending on the arrangement. The lesson, then, would be to reduce the bureaucracy as much as possible in order to open up these preferential sources of capital to smaller and more medium sized firms. It is these smaller firms that truly need capital, but if the costs are too high and only a large firm can bear them (due to economies of scale), development initiatives are thwarted and credit is not optimally distributed. The survey also illuminates some differences in the source of firm capital, all of which naturally follow from the implications of the sources of financial constraint. A notable gap is in the financing which occurs through retained earnings. This internal financing implies a firm can only grow once it gets going, financing projects through profits. Nearly 60% of the capital of small firms is generated through retained earnings, while only 37.9% of the capital of large firms comes from this internal source. Local banks are also notably less important to small firms, accounting for twice as much of the capital of larger firms. There is a reversal between the categories of foreign banks and family members, with the former disproportionately financing large firms, and the latter being important nearly exclusively in the case of small firms. This capital structure has important implications. In the case of large firms, they can expand through external financing, even when they are not growing organically. This option is not as available to smaller firms, who must wait for positive cash flows (and net income) to finance themselves through profits. Financing through family

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66 members is an option, but it comes with an important theoretical concern: markets are not allocating these resources to the firms, rather it is familial allegiances that act as guarantors of the borrowed assets. While this is arrangement commonly provides capital to firms, there is no mechanism to filter out bad investment ideas: presumably the funds are granted in a less stringent fashion than, say, a loan officer or private equity investor would undertake. A more competitive marketplace for smaller firms to bid for capital, then, would lower the cost of that capital for profitable projects and assess (and account for) the risk implicit in other, not as lucrative, endeavors. With more financing available in a competitive marketplace, entrepreneurs without the access to the special connections that makes financing easier for some will also be able to finance their ideas. Access to capital is one of the most important facets of successful new business development and a more market-oriented allocation would help Brazil to more efficiently allocate its relatively scarce capital. It is in this direction that the evolution of capital markets in Brazil should move. Implications of Interest Rates for Individuals If small firms are ill-prepared to pay high interest rates to finance their endeavors, individuals are even more poorly equipped to bear the cost of financing. The lack of long term markets denominated in reais discussed by Arida et. al. (2005) not only affects the level of interest rates through the jurisdictional uncertainty argument, but also affects the day-to-day financing decisions of Brazilian individuals. The implication is that finance is not available for things that citizens of other countries take for granted: mortgages have not achieved the penetration of economies with lower interest rates, automobiles and other consumer durables are largely purchased vista (or for cash), and purchases on

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67 credirio, 1 or in stores financed in at 6x sem juros, or in equally divided monthly installments (usually up to six months) to credit cards without any difference in the purchase price. All of these alternatives to traditional credit have evolved to fill a gap created by the unattractive nature of typical interest-laden installment contracts. Mortgage Finance In the case of mortgage finance, there are two systems which have evolved to help allocate capital to potential homeowners. An official government entity known as the Sistema Financeira da Habitao, the Housing Finance System or SFH, is the main system in the mortgage market. This system sets strict limits on the value of houses available for finance, and on the value and conditions of the loans. The financing for this system comes largely from the Fundo de Garantia, a compulsory savings account akin to Social Security in the United States. The original idea for this system was to offer below-market level interest rates for housing finance for lower income Brazilians. The reality, as documented by Fagnani (1996), is that a regressive allocation of housing finance resulted, with upper-middle class and upper class Brazilians receiving most of the subsidies. The fund also experienced cash-flow cyclicalities: with contributions for fresh capital stemming from the workers fund and performance of loans linked to the unemployment rate, during the volatile periods of the 1980s and 1990s the fund was not able to provide necessary financing for homes (Borba, 2004). Because capital in the system became more scarce, interest rates remained high, despite an explicit government guarantee of the fund, and are now set at the reference rate plus twelve percent, which 1 To the best knowledge of the author, this arrangement does not exist in the English-speaking world; accordingly, the Portuguese word will be used throughout the text when discussing this form of borrowing.

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68 currently amounts to over thirty percent annually (Pinheiro and Cabral, 1999, and current BNDES data). The joint effects of the cronyism with which funds were distributed and the cyclical nature of fund availability has left an unmet demand equivalent to 15% of the existing housing capacity, 84% of which comes from families which earn less than three minimum salaries a month and 81% of which consists of urban households, who seek funding to no avail (Borba, 2004). In short, the reality of this system has been to crowd out and/or raise the cost of home financing even more for that segment of society least able to bear its costs. The second system, known as the Carteira Hipotecria, or Mortgage Portfolio, allows Brazilian banks to set the conditions of loans. The costs are even higher for these mortgages, as they are funded through popular savings accounts in the commercial banks that issue them and mortgage rates have historically averaged 14 to 16 percent above the reference rate, with the difference in rates between the Carteira Hipotecria and the SFH stemming from typical commercial banking spreads and the absence of the effective government subsidy in the administration of the loans (Pinheiro and Cabral, 1999). The problems with the Carteira Hipotecria are even more pronounced with respect to availability, as one must first have an account with a bank to receive a mortgage. In Brazil commercial banking penetration is below 50% and more than 1/3 rd of individuals who would like a bank account do not have one (World Bank, 2003). In response to these difficulties, the state of So Paulo has initiated its own program. Financed through a 1% supplementary tax, the Sao Paulo Housing and Urban Development Corporation has a statutory obligation to provide housing programs and

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69 finance to families that earn between one and three minimum salaries per month, with preference to those earning three or fewer. In the years following the implementation of the policy, new production of houses in So Paulo state approached 300,000 units, with 75% of that production benefiting the lowest tier of income earners (Borba, 2004). This subsidized finance was subject to manipulation however, driving applicants to report lower household incomes in order to receive more subsidies (Borba, 2004). While the government is actively seeking to correct these distortions at the time of this writing, programs such as this should be replicated and improved upon in the rest of Brazil to mitigate the effects of high interest rates on the housing sector. Everyday Financing for Individuals In addition to the impact seen in mortgage finance, high interest rates and credit inaccessibility have impacts on the more day-to-day financing activities of individuals. To better understand these effects, the BNDES charted a survey in late 2001 in the cities of So Paulo and Recife to capture the demand for financing instruments and the methods people in the lower classes use to satisfy those demands (Brusky and Fortuna, 2002). This section leans heavily on their work, and extends it by looking at more recent data sources. They find that the credit most used by individuals can be categorized along the lines of formal, semi-formal, and informal, with a second difference existing between monetary credit and parceled credit, or credit that is extended for the explicit purchase of an asset. The most formal credit offerings include loans from banks, personal lines of bank credit, cash advances on credit cards, and loans from microfinance organizations (in the case of monetary credit), and credit card, post-dated checks, and credirio (equally spaced charges to a credit card for a fraction of the purchase price) in stores. These

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70 formal lines of credit are governed (as one would expect) by the rules of the Brazilian financing system, and to some extent, by the same rules as corporate lending. Individuals must be registered with the federal government, show proof of residency, show proof of income in the formal sector, and have good credit standing (as measured by the credit protection services SPC and Usecheque) (ibid., p. 17). Loans from this formal mechanism vary in duration from 1 to 36 months, with interest rates varying between 0 and 11.5% per month. Because of their more stringent conditions, and high interest rates, this method of financing is the least used by the lower classes of society. 2 The semi-formal sector is much more utilized, especially in the case of parceled credit. Very few documents are required, and a clean credit history is not required, as the credit agencies are rarely consulted. What is much more important in this type of arrangement is the personal relationship between lender and borrower, with the types of instruments including loans from employers, adiotas (or loan sharks), loans from employee funds, supplier credit (in the case of small firms), and also credirio in lojinhas, or company stores. The terms are generally shorter (one to four months in duration), with interest rates running from 0 to 45% per month. While the rates are at times higher, this form of credit is more utilized because of the less stringent conditions under which it is granted. The most commonly used method of financing for the masses is that of informal credit, as classified by Brusky and Fortuna. These instruments include loans from parents and friends, as well as take-now, pay-later schemes (fiado, or on faith, in 2 An important exception is the case of credirio, which the authors note is so important that even those who do not meet the conditions of use still manage to utilize it, often purchasing products in the names of the friends or parents. (My translation, ibid., p. 21).

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71 Portuguese), the use of the credirio of others, and the use of sorteio, or group savings plans in which members pool their funds for a determined amount of time, then take turns spending the accumulated funds. A reader less familiar with the Brazilian economy may ask why these funds are administered by groups, instead of being deposited in personal savings accounts that can be managed by each of the individuals. The reason is that these funds exist predominantly in the subsection of society that cannot legally have accounts at financial institutions. The terms of all of these arrangements are favorable, with interest rates between 0 and 5% per month, for one month, and no required documentation. The downside is that the limits of borrowing are generally lower, with notional amounts rarely exceeding R$200. Despite these small amounts, it is much more common for individuals to borrow in this form than in more formalized mechanisms. Despite the high level of interest rates in Brazil, the Brazilian economy has largely overcome the crippling nature of high interest rates with respect to the credit offerings. There exist instruments to mitigate this effect and to spread its cost around the economy (in the case of credirio, for instance, the real value of the purchase is eroded by interest-free installments). Pinheiro and Cabral (1999) identify three main institutions that allow these irregular credit offerings to flourish: a well-developed informational infrastructure (which essentially allows for the use of credirio and post-dated checks), the presence of public banks (which subsidize the cost of capital), and the use of group mechanisms to ensure repayment (which lower risk of lending to unsecured individuals). These mechanisms should continue to be utilized, as their existence will allow for even lower levels of interest rates once the central bank begins to inject more monetary stimulus into the economy. And until interest rates do decline, it should be the priority of all parties to

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72 ensure that these mechanisms only become stronger to ensure some form of credit is available to those excluded from the formal sector. The Disparate Effects of High Interest Rates Brazils high interest rates have effects on all segments of society and on all sectors of the economy. Multinational firms must be much more creative in their financing decisions in order to lower their cost of debt, issuing securities in multiple currencies. These liabilities create a mismatch in revenues and expenses (unless natural hedges exist) that must either be insured or factored in to the cost of debt. Because of their scope and size, however, these firms are best equipped to deal with the challenges of prohibitive domestic credit markets. Small firms do not enjoy the same fortune. Oftentimes their lending is constrained, and expansions are limited to those which can be undertaken out of the firms retained earnings or from additional paid-in capital from principal investors (most notably family members). Access to foreign banks is limited for this group, and family members and other allegiance-based arrangements oftentimes fill the financing gap in a less-than-efficient fashion. High interest rates also have a strong impact on individuals. The mortgage market is largely unfinanced (due to the risk-laden nature of fixed-rate, long-term contracts) and undesirable (mortgages exceeding 25% annually need incredible land appreciation rates to be justifiable!). Even the purchases of domestic appliances and clothing are affected by these high interest rates, which (through the reference rate of the economy) affect the APRs on credit cards and other consumer debt instruments. Due to this otherwise activity-stopping effect, the economy has evolved with respect to consumers. Certain debt instruments rely on family or personal allegiance to lower the

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73 perceived risk for the creditor, while other arrangements use group collateral or savings plans to spread the risk across individuals. Out of the necessity to sell their merchandise, department stores also become financing organizations, selling merchandise on credirio, allowing consumers to pay in installments, while transferring possession to (though not title of) the merchandise on the day of the sale. The burgeoning nature of these arrangements should be supported and will help to foster an even more diverse financing environment once interest rates move to more tolerable levels. 3 The Brazilian economy has learned to cope with the reality of high interest rates. Without a doubt, however, these rates still have significantly negative effects on the economy. It is a testament to the spirit of the Brazilian people that economic growth has occurred in spite of the high cost of capital. One can only imagine what the ingenious Brazilian spirit could do in a more fertile economic environment. 3 Some of these instruments will likely disappear, as well, as there will be little or no need for certain of these instruments at lower levels of interest.

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CHAPTER 5 CONCLUSIONS, RECENT OBSERVATIONS, AND FINAL REMARKS This paper has shown that Brazils economic history and structure have historically demanded the persistence of high nominal and real interest rates. Those rates have principally been necessary to combat inflation, though in periods of fiscal expansion they have, at times, fallen pro-cyclically, with expansions in the money supply merely accommodating the aggressive fiscal stance of government. The economy has been rocked by major shocks, not the least of which were the oil crises of the 1970s and 80s and, more recently, turmoil in emerging markets that all threatened contagion. These shocks have propagated through the real sector of the economy, as well as adding inflationary pressures. The political economy has been a veritable laboratory for economic theory and practice. Incredible attempts at expansion and development led to overheating because of lack of external financing. The internal financing necessitated by this otherwise unfinanced policy resulted in hyper-inflation that was combated both with orthodox (austerity) and heterodox (manipulative) measures. Various attempts at stabilization failed by not addressing the most endemic problems of the economy, which could all be traced to theoretically apparent relationships: budget deficits, lack of regime credibility, self-fulfilling expectations and inflationary inertia. The plan under which the economy operates at the time of this writing has succeeded in stabilizing the economy in the last eleven years, bringing low-inflation growth, coupled with productivity advancements. 74

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75 A review of the causes of high interest rates Interest rates have not fallen from their historical levels. This paper has shown that the rates, whether measured in nominal or real terms, exhibit stickiness with respect to economic fundamentals and when measured vis--vis other economies with similar economic histories. In fact, countries whose crises have influenced the level of interest rates in Brazil seem to recover to neutral policy rates following those crises more quickly than does Brazil (which is only affected through contagion). When measured in nominal terms, they highly reflect the publics expectations of future inflation. Those expectations have historically been overly optimistic, though recently there is evidence that they are more centered on inflations true, ex-post realized values. These expectations are driven by past inflation (the inflationary inertia effect) and by other observable economic phenomena. More recently, however, they have been dominantly determined by government policies such as the fiscal stance, the announced inflation target, and the governments inter-bank reference rate, a taxa Selic. This suggests that the factors determining inflation are well within the governments control, which in turn suggests that the level of nominal interest rates could be lowered following the proper macroeconomic recipe at the very least by lowering the publics expectation of inflation. Several factors influence the real interest rate as well. Some have argued that monetary policy needs to be highly contractionary in order to quell inflation. These theorists point to an equilibrium, non-accelerating inflation rate of interest of nearly 18%. These statements are derived from an ex-post analysis of the data, and do not give us any insights into why interest rates have to be so high in the first place. Along the same lines, some have argued that the weak constitutional independence of the Brazilian Central Bank requires that interest rates be maintained at levels higher that those which would be

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76 otherwise required, in order to send clear signals to the market of the Banks commitment to the often politically unpopular fight against inflation. This effect has been quantified both on its influence on interest rates and indirectly on its influence on inflation. Braslia would be wise, then, to grant the bank constitutional independence, giving governors and the President of the Bank irrevocable terms of service that do not coincide with the political cycle. More analysts of this question have pointed to the fiscal stance of government and the debt dynamics of the nation when seeking to explain high interest rates. Because public indebtedness is high, a high default probability is assessed, pushing up the endemic country risk. Furthermore, as a large portion of that debt is denominated in dollars, and the real has not been stable, the implied revenue/liability mismatch further adds to perceived risk. There is no doubt that the level of government debt is high in the country, and the government should continue to maintain primary surpluses in order to pay down that debt. The insertion of the Brazilian economy into the global economic scene has long been cited as a cause of high interest rates. Maintaining a current account deficit puts significant downward pressure on the exchange rate, endangering price stability through exchange rate pass-through and adding to the equilibrium level of external financing requirements of the economy. The low-liquidity of Brazilian currency internationally has also been cited historically as a cause of high interest rates, but work using more recent data has rejected that assertion. Finally, there is significant evidence from Brazil and other emerging economies that there is an original sin from issuing government debt denominated in dollars.

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77 Once that dollar debt is available, aversion to local currency issuance lowers the liquidity of the existing debt, and raises the market-clearing interest rate for that debt as well. In the Brazilian case, it is argued that this effect has been so strong as to eliminate the possibility of long-term, local currency-denominated debt. Existing debt, moreover, is deemed so unattractive as to raise the risk associated with adjudication and valuation, a risk known in the literature as jurisdictional uncertainty. In Brazil, the institutions that would eliminate that adjudication risk are weak and should be strengthened in order to set the stage for a robust local, long-term market for credit. All of the relevant determinants of interest rates are brought together in the flowchart at right. The model is an extremely interconnected one, and steps to delink these causal mechanisms will take time. Building regime credibility, for instance, will only lead to lower interest rates once the public factors that credibility into its expectations, and once those new expectations lead to lower inflation, which will in allow the Central Bank to lower interest rates. Figure 5.1 Flowchart of Interest Rate Determinants

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78 The Show Must Go On: Evolutions of Very Brazilian Credit Mechanisms The marketplace has evolved in Brazil to mitigate the effects of these high interest rates. Large firms effectively bypass the problem by raising money abroad. Those with access to these loans often times make acquisitions abroad just to diversify their asset base and to be able collateralize new obligations in dollars. These same firms often qualify for sub-market rate loans from development banks and organizations, most notably the Brazilian state-run national development bank, the BNDES. These mechanisms allow these firms to lower their cost of debt and continue to finance their activities. Smaller firms are somewhat more constrained. Expansion in these firms is somewhat limited by profitable activities; investment activities in these firms are disproportionately financed from retained earnings. Furthermore, relationship finance (family members, friends, etc) is extremely important to these firms. The implication of this finance is clear, however: there is no market mechanism or due diligence to filter out bad investment ideas and the resulting allocation of credit is often times highly inefficient. For individuals, access to credit is varied. Bank penetration is low, and is often times limited to those individuals in the formal sector of the economy. Mortgage credit is often subsidized but ironically limited to the wealthy, or those with special connections because of the bureaucratic nature in which the credit is issued. There is evidence, however, that this is improving, as mortgage funding increased 55% in 2005 from the previous year, though still not enough to cover the housing deficit (PREI, 2006). Lending has increased an average of 40% annually since 2003, when the Central Bank began to put the pressure on commercial banks to provide funding (Inter-American

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79 Dialogue, February 2006). This growth cannot continue ad infinitum, however, especially if interest rates do not fall further. Smaller financing decisions by individuals are also affected by these interest rates. Low bank penetration has obviated the use of extensive use of credit cards, though those that have bank accounts often times finance through post-dated checks, credit cards, and lines of credit. Those that do not make use of store finance options, use collective arrangements, or use the credit of family and friends. While all of these options have enabled the economy to continue to function, lower interest rates coupled with increased personal banking would allow the economy to perform much more efficiently and would lead to more equality of economic opportunity. Epilogue: Recent Data and Trends 1 In the most recent economic data, there is reason to believe that the forces are in play to enable a measured lowering of the key interest rate in Brazil. Inflation has been low, well within the range of the Central Banks targets since early 2004, with consensus estimates for inflation in 2006 in the mid-point of the Banks range. Year-over-year real GDP growth continues to be strong, with the most recent reading of 3.1% in third quarter of 2005 almost 75% driven by internal demand. Unemployment was categorically lower in all of 2005 than in the previous four years, with the December reading of 8.3% the lowest Brazil has seen in that entire period; formal job creation exceeded 1.5 million in the 12-months to December 2005, while an expansion of investment created expanded industrial output without inflation-building pressures on capacity, which saw utilization of 81% in the most recent data. The announced targets for inflation are 4.5 for the next 1 This section presents data that is public and widely available, most readily from the website of the Brazilian Central Bank ( www.bcb.gov.br ).

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80 two years, and the Bank seems to have achieved credibility, as consensus IPCA data is for inflation of 4.7 and 4.5% in 2006 and 2007, respectively; expectations have exhibited a nearly monotonic decline since 2004 and are now approaching levels of more advanced economies. The strengthening in the real has continued, with an additional 10% appreciation since the beginning of 2006. This has not affected the exportability of the Brazilian economy, however, as export prices have nearly doubled since the beginning of 2003 and export growth has accelerated markedly, creating a current account surplus for the first time in recent history in 2003; that surplus has been sustained since 2003 and hit a record of 45.4 billion dollars in 2005. Public debt management is also improving. 2005 saw a primary surplus of 4.8% of GDP, and the average for this surplus was 4.5% in the period 2004-2006. The debt/GDP ratio closed the year at 51.6%, down from a ten-year high of over 60% in 2002. Market expectations are for a further improvement, with forecasts of around 45% by 2009. The portion of the debt that is linked to foreign currencies is declining, and is quickly approaching zero: reductions of 9.4, 25.7, and 25.3 billion dollars in the most recent three years have brought the level of foreign currency denominated debt to less than 5%, down from over 40% in 2002. This has not entirely taken place through the retirement of the debt, as part of this reduction has been achieved through the roll-over of that debt into local-currency denominated bonds, the first one being issued in September of 2004. This is a significant achievement for Brazil, which previously suffered from the original sin of dollar-denominated debt (Hausman et al., 2003). This change has greatly improved Brazils resilience to exchange rate shocks: the Central Bank now estimates that a 1%

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81 change in the exchange rate would have less than a 5 basis point impact of the debt/GDP ratio, down from a high of 35% in 2002 (Bevilaqua, 2006). There is some evidence that interest rates have begin to fall. The market-measured Brazil risk is now half of what it was in early 2004 and the real interest rate (as measured by 360-day swaps) is near 11%, down from an average of 15.2% for the same measure in 2000-2003. The January 2006 meeting of the monetary council lowered the Selic rate from 18% to 17.25%, followed by another cut in March 2006 to 16.5%, with indications that further rate cuts may follow. Time will tell if these rate cuts materialize and make rates in the country more comparable to that of its peers. Brazils commitment to sound policies may be rewarded in the long-run, then, and may soon be a textbook example of slow adjustment rather than one of irrational pessimism and undue punishment.

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87 The State Department of the United States of Amrica. 2005. The 2005 Investment Climate Summary for Brazil. http://www.state.gov/e/eb/ifd/2005/41988.htm Last accessed March, 2006 Tabata, Alcia and Benjamin Miranda Tabak. 2004. Testes do contedo informacional das decises de poltica monetria. Pesquisa e Planejamento Econmico, 34:2 (Aug 2004), 207-249. Tejada, Csar Augusto O. and Marcelo Savino Portugal. 2001. Credibilidade e inrcia inflacionria no Brasil, 1986-1998. Estudos Econmicos, 31:3 (July-Sept 2001), 459-494. Toledo, Joaquim Eli Cirne de. 2002. Risco-Brasil: o efeito-Lula e os efeitos-Banco Central. Revista de Economia Poltica (Brazil), 22:3 (July-Sept 2002), 138-145. Tullio, Giuseppe and Mrcio Valrio Ronci. 1996. Brazilian Inflation from 1980 to 1993: Causes, Consequences, and Dynamics. Journal of Latin American Studies, 28:3 (Oct 1996), 635-666. The World Bank. 2003. Access to Financial Services in Brazil. A presentation given to the Banco Central do Brasil, November 10, 2003. http://www.bcb.gov.br/pre/SeMicro/Palestras/02_3_Suzana.ppt Last accessed March, 2006.

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BIOGRAPHICAL SKETCH Ed Johnson will graduate in May, 2006 from the University of Florida with a Master of Business Administration, with concentrations in finance and competitive strategy, and with a Master of Arts in Latin American studies, with a concentration in the Latin American business environment. His passion is Latin America; he has made several trips to the region and speaks Spanish and Portuguese. Before graduate school, he was a research assistant for the Federal Reserve Board of Governors in Washington, DC, working on macroeconomic forecasting and analysis for the Federal Open Market Committee. While at Florida he has worked for ExxonMobil Corporation and Johnson and Johnson, principally on inventory and supply chain initiatives. Upon graduation he will join Deloitte Consultings Atlanta-based Strategy and Operations practice as a Senior Strategy Consultant. He holds a B.A. in economics and Spanish from the College of William and Mary in Williamsburg, VA. A native Virginian, Ed currently resides in Gainesville, FL. 88


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BRAZIL' S ELEVATED INTEREST RATES: A CASE OF IRRATIONAL PESSIMISM
OR GUARDED OPTIMISM?














By

ED JOHNSON


A THESIS PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
MASTER OF ARTS

UNIVERSITY OF FLORIDA


2006

































Copyright 2006

by

Ed Johnson
















ACKNOWLEDGMENTS

THERE was a child went forth every day;
And the first object he look'd upon, that object he became;
And that object became part of him for the day, or a certain
part of the day, or for many years, or stretching cycles of years.
Walt Whitman, Leaves of Grass (1900)

This work is the product of my interactions with a great number of people over the

course of the last five years, and would not have been possible without their influence,

which was oftentimes unbeknownst to them. My time as a research assistant at the

Federal Reserve Board helped to me ground my undergraduate training in

macroeconomics and my research with David Lebow and Jeremy Rudd trained me to see

the truths apparent in large, obscure datasets. It was there that I was first exposed to

Phillips Curves, Taylor Rules, and the theory of rational expectations, all of which are

utilized throughout this paper.

While at Florida, Dr. Terry McCoy and Alex Sevilla have served as my advocates

in my desire to combine my disparate disciplines, Latin American studies and finance,

into a harmonious curriculum that has brought the two worlds much closer (at least for

me). The faculty and staff of the Center for Latin American Studies and the Florida

MBA Program have all greatly facilitated the process as well. Professionally, Eric Allred

and Kathy Fitzpatrick at Johnson and Johnson in Jacksonville helped me to contextualize

the Brazilian business environment better than any in-class or personal travel ever could

have and my experience working with them has completely shaped my perspective in

writing this paper.









Working with my thesis committee has been wonderful. Dr. Terry McCoy has

continued to work with me through the peaks and valleys of my research, more often than

not exhibiting more confidence in me than I had in myself. He also helped me flesh out

the topic after listening to one of my many anecdotes about my time living in Brazil. Dr.

Andy Naranj o has provided exceptional guidance in my time here at Florida, and has

made me question not just Brazil's macroeconomy, but also some questions more related

to my personal professional development. Time will tell if he is right. Dr. Libby Ginway

has graciously offered to serve on my committee as well, despite the topic being as

esoteric to her as Brazilian science fiction is to me; obrigado, Doutora.

No set of acknowledgements could ever be complete without extending gratitude to

those friends and family members who offer support, both financial and emotional,

through any undertaking. I am especially grateful to my mother and father in those

regards, as they have always supported me in my decisions, always confident that I was

taking the right, if less-traveled, path.



















TABLE OF CONTENTS


IM Le

ACKNOWLEDGMENT S ................. ................. iii........ ....

LIST OF TABLES ................ ..............vii .......... ....

LI ST OF FIGURE S ................. ................. viii............

AB STRAC T ................ .............. ix

CHAPTER

1 INTRODUCTION .............. ...............1.....


2 AN ABBREVIATED HISTORY OF INTEREST RATES, INFLATION, AND
MONETARY POLICY IN BRAZIL ................. ...............9................

Theoretical Bases for Inflation ................. ...............14................
Post-W ar Promises .................. .... ........ .. ...............17.....
Military Rule and an (Overly) Managed Economy .............. ....... .............1
Civilian Rule and Attempted Stabilizations............... .............2
O Plano Real: Finally, a Plan that Works! ............. ...............25.....

3 BRAZIL' S CURRENT INTEREST RATE DYNAMICS ................... ...............2


Testing for rationality in price forecasts ......____ ..... ... .__ .....__ ..........3
Real Interest Rates: Comparisons and Determinants................ .............4
Apologists for Elevated Real Interest Rates ............... ...... ........ ..........4
Historical Factors and Current Realities of High Real Interest Rates ......................47
Existence and Causes of High Interest Rates ......____ ..... ... .__ ........__......5

4 O JEITO JURIDICO BRASILEIRO: COPING WITH THE PROBLEMS
RESULTING FROM HIGHLY ELEVATED INTEREST RATES ................... .......56

Firm-Level Financing Decisions .............. ...............56....
Impacts on Large Firms .............. ...............58....
Impacts on Smaller Firms .................. ....... ..............6
Implications of Interest Rates for Individuals ................ .............. ...............66
Mortgage Finance ............... ....... ...............67
Everyday Financing for Individuals............... ..............6











The Disparate Effects of High Interest Rates ................. ..............................72

5 CONCLUSIONS, RECENT OB SERVATIONS, AND FINAL REMARKS ............75

A Review of the Causes of High Interest Rates.................................. .............. .76
The Show Must Go On: Evolutions of Very "Brazilian" Credit Mechanisms ...........78
Epilogue: Recent Data and Trends .............. ...............80....

LIST OF REFERENCES ............_ ..... ..__ ...............82...

BIOGRAPHICAL SKETCH .............. ...............88....


















LIST OF TABLES

Table pg

2. 1 Annual Inflation ........._._. ._......_.. ...............11....

3.1 Rationality Tests in Inflation Expectations ........._.._.. ....._.. .......__. .......3

3.2 Comparative Nominal and Real Rates ...._.._.._ ........._.._......_ ..........4

4. 1 Source of Financing Constraints and Firm Capital ........._.._.. ....._.._ ................64



















LIST OF FIGURES


figure pg

1.1 Ex-Ante Real Interest Rates in Brazil ................. ...............6............ .

2. 1 Deficits and Public Consumption of Fiscal Debt ................. ................. ........ 12

2.2 Inflation Rates, Before, During, and After Hyperinflation and the Real Plan.............14

2.3 Federal Debt/GDP Ratio ........._ ....... __ ...............22..

3.1 Inflation's Expected and Realized Values ......___ ..... ..__. .. ...._ .......3

3.2 Year-over-year Inflation Rates and Rolling Volatility of Inflation ..........................37

3.3 Contribution of Variables to Expected Inflation ................. ................. ..........39

3.4 Comparable Nominal Short Term Interest Rates ................. ................. ..........41

3.5 Stylized Depiction of a "Bad Equillibrium" ............. ...............45.....

3.6 Recent Trends in SELIC and Inflation............... ...............48

3.7 Brazilian Balance of Payments ............ ......_ ...............52

4.1 Aracruz' s Debt Structure .............. ...............60....

5.1 Flowchart of Interest Rate Determinants ...._.._.._ ..... .._._. .... .._._.........7
















Abstract of Thesis Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Master of Arts

BRAZIL' S ELEVATED INTEREST RATES: A CASE OF IRRATIONAL PESSIMISM
OR GUARDED OPTIMISM?

By

Ed Johnson

May, 2006

Chair: Terry L. McCoy
Cochair: Andy Naranjo
Major Department: Latin American Studies

This thesis examines interest rates in Brazil, with a focus on their historically

volatile nature, the theoretical and practical reasons for their elevated levels, and the ways

in which firms and individuals mitigate the negative effects of a high interest rate

environment. Brazil's macroeconomic history has been extremely volatile, and the

country experienced triple digit inflation rates as recently as 1993. The instability of

prices, as well as the existence of what has been called a "weak macro regime," has

necessitated interest rates which exceed those of peer nations. A cycle emerges, in which

exogenous shocks are propagated into the country, making it a more risky environment

for investments and raising the intrinsic risk associated with government debt, as default

is seen as a more likely possibility. The nature of this cycle, as well as other determining

factors of interest rates, is examined in this work.

In spite of these interest rates, Brazil has experienced some periods of very

impressive economic growth. The buffers between the deleterious effects of high interest









rates and the rates of growth exhibited in the country are also examined in this work.

Specifically, this thesis will answer how firms raise capital in this environment, and show

the effects of firm size and nationality on the methods of Einancing used. The effects of

high interest rates also trickle down to individuals, and decisions such as home Einance

and durable goods purchases, as well as more day-to-day Einancing of household

consumption. This thesis also explores the network of informal, and oftentimes

subsidized, credit that has emerged in the country.

In the light of the recent economic success of the country, investors from Brazil to

New York are calling for a lowering of the reference interest rates in the country. This

thesis blends previous theory, survey-based research, and anecdotal evidence from the

most recent data to illustrate the causal mechanism that would allow that lowering to take

place, and argues that interest rates should, in fact, be lower than they actually are.















CHAPTER 1
INTTRODUCTION

For most, the word "Brazil" conjures up images of the Amazon, Samba, and

Calrnaval. The commotion and volatility that all of these images imply is not dissimilar

to the thoughts of economists on the country: rampant inflation, sky-high interest rates,

precarious commodity prices, and unpredictable economic growth. Brazil suffers greatly

from these preconceptions. In a reciprocally causal relationship, interest rates are high

because of the risk that doing business in the country implies; those high interest rates act

as a continual impediment to growth and (more importantly) to economic equality in the

region. Those impediments to equitable growth further fuel the level of risk that the

market now assesses to investments in Brazil. Without access to credit, the middle class

is stifled, inequality grows, and balanced growth is further out of reach. This paper will

focus on the cost of credit in Brazil, with a specific focus on the history of volatility that

has necessitated high interest rates, the theoretical and practical factors which influence

their determination, and the mechanisms which have evolved to help the country function

despite the inability to effectively utilize traditional debt Einance.

There exists no market for long-term local debt, not even for the most securitized

lending such as mortgages, and only the wealthy with access to overseas funding can

effectively leverage their Eixed assets. In addition, as interest rates remain high, a larger

percentage of government revenues continue to service the national debt, in essence

paying continually for the country's dismal economic past, instead of funding initiatives

aimed at preparing Brazil for the future. In fact, the government pays the greatest cost for










these high interest rates, as the government debt/GDP ratio remains very high, crowding

out private investments. This diversion of funds cannot be stopped: any talks of a

moratorium or of a restructuring of debt payments to allow for more social programs or

productive investments sends shocks through financial and currency markets, raising the

"Brazil risk" and making the debt grow instantaneously, in terms of reais, as a large

portion of the debt is denominated in dollars. This was evidenced most recently in

October of 2002, in the run-up to now President Lula's election: with talks of profligate

public spending and disregard of Brazil's obligations to the international financial

community, the Real hit an all-time low against the dollar of 4.03 on October 12, 2002.

Since that time, the government of Lula has pursued orthodox economic policies

not unlike those of his predecessor, Fernando Henrique Cardoso. The currency market

has adjusted accordingly, with the Real experiencing a 15% appreciation in 2005 and a

cumulative 51% appreciation since year-end 2002. Notwithstanding this impressive

adjustment in currency values, the overnight bank lending rate (hereafter the SELIC rate)

in Brazil remains at 18%, implying an ex-ante real interest rate of over 13%.2 At such

high levels of interest in the least risky of investments (overnight bank lending), it is easy

to see why no local long-term debt market has matured. Adding factors for default,

maturity, and liquidity risks, private lending rates quickly approach prohibitive levels.

Despite solid growth prospects and performance, interest rates seem "sticky" and

unbalanced growth continues, j eopardizing the future of the country.



Reais is the Portuguese-language plural of the Brazilian currency, the Real.

SAt year-end 2005 the expected change in the price level in the following twelve months was 4.76%, as
measured by the Banco Central do Brasil and published on the Bank's website. The real interest rate is
simply the nominal rate less expected inflation.










This vicious cycle is extremely unfortunate, as the Brazilian economy has been

performing very well in recent years. Growth in real GDP was 4.9% in 2004 and is

expected to be 2.44% and 3.45% in 2005 and 2006, respectively (Fundagdo Getuilio

Vargas and Latin-Focus magazine's consensus estimates). These rates of growth are all

above the average growth of 2.0% for the twenty year period ending in 2003. Inflation

has remained essentially in check since the institution of the Real in 1994 (more on this

below) and productivity growth continues to accelerate as synergies resulting from

investment in the real sector and international economic liberalization are being realized.3

In short, it appears that the "pais do future" has finally arrived into its economic

"promised land" and that the country is performing as the economic powerhouse that

many have believed it could be for so many years.

In order for this transition to economic powerhouse to occur, many things must

take place simultaneously. Unemployment must be low to foster economic opportunity.

In Brazil the official statistics for unemployment hover around 10%, with levels of

underemployment higher and the employment index for the informal economy mitigating

the poverty effect from this official unemployment (according to data from various

editions of the monthly employment survey from Brazil's national statistical agency,

IBGE4). Wealth must be fairly distributed to kindle a middle class capable of

entrepreneurship (the true engine of growth); in Brazil income inequality is worse than

anywhere else in Latin America and on par with some countries in Africa (Bulmer-



3 Productivity is difficult to measure in Brazil, and is not officially published by the government. I rely on
the work of Ferreira and Rossi (2003) for this generalization.

4 The survey is the Pesquisa Mensal do Emprego and the agency is the Instituto Brasileiro de Estatistica e
Geografia.









Thomas, 2003, p. 11). Macroeconomic fundamentals such as inflation must stay low and

relatively nonvolatile in order to provide appropriate signals to markets. Another key

component of economic growth is the interest rate that affects the decisions made by

governments, banks, and non-financial firms.

Standard economic models would suggest that the interest rates would be declining

over time in Brazil. In the market based approach to interest rates, this works through

two channels. First, expectations of future inflation directly influence the nominal

interest rate: i, r, + E(Fr, ,); that is the nominal rate today is approximately equal to

today's real rate plus the expectation of inflation in the following period (more formally,

the expected annual inflation over the term of the interest rate).5 Another channel

through which good economic performance should lower interest rates is through the

country risk premium. Stylistically this is the rate at which the market assesses a

premium to transactions in a country (and in a countries currency) vis-a-vis a base

country of reference.

These two mechanisms should be acting to lower interest rates in Brazil.

Specifically, the expectations of future inflation should be diminishing as recent inflation

performance has been below the historical average and much below the hyperinflationary

levels which ended with the Real Plan in 1994. The government now operates in a new

regime of inflation targeting. This regime has performed well, is transparent, politically

independent, and operates with a legal mandate to control inflation (though it does not

operate in an apolitical vacuum). As agents update their frameworks for evaluating

inflationary expectations, the nominal interest rates should decline. Furthermore, solid

5 The same is true when monetary policy is viewed through the Taylor Rule, where expectations of future
inflation are positively correlated with interest rate moves by the central bank.









economic fundamentals will themselves drive non-inflationary growth. In Brazil, some

decline in expectations has occurred and later in the paper the formation of expectations

and "inflationary memory" will be discussed. Specifically the prospects of an

asymmetric response function to inflationary news will be evaluated: does the market

take longer to believe good news than it does to incorporate (and penalize) bad news?

Most important, however, to the formation of inflationary expectations is the credibility

given to the monetary policy of the government. Brazil now operates in a completely

new regime from that of just a few years ago. Transparent inflation targeting in the

confines of a politically independent central bank such as that done in Brazil is the "state

of the art" in monetary policy, indeed more theoretically advanced than the regime of

even the U.S. Fed, which cloaks its policy decisions in obfuscating language, and

represents a clear break from the political nature of a loosely defined monetary policy in

Brazil's past. If this new regime is believed to be the regime going forward, expectations

should not factor in the policy mistakes of previous regimes. Later this paper will

address this concern as well.

The so-called country risk premium should also be falling. Brazil has returned to a

peaceful democracy since the end of the military dictatorships, capital markets are fully

developed and fairly liquid (compared to historical norms), and capital moves freely

across the border. Even the leftist politicians of years ago are pursuing orthodox

economic models and are allowing for increased autonomy of the nation' s central bank.

In short, conditions are such that inflationary expectations should not be anchored in the

hyperinflationary or even high-inflation period, and the country risk premium should be

converging to a more reasonable level. Furthermore, the ex-post change in the currency










has implied a currency premium, and not a discount, for investing in reais. Despite the

seemingly convincing case for lower real-interest rates, the precipitous decline has not

occurred. As seen in the chart below, the real rate has been in a band between 10-18%

since 2001, and is in the mid-point of that band now.6 This paper will examine reasons

for interest rate persistence, Figure 1.1 Ex-Ante Real Interest Rates in Brazil

Ex-Ante Real Interest Rates
examine the path necessary to dnive i

the rates lower, and to examine

mechanisms which are already in 12

place to mitigate the impact that s

interest rates currently have on 8 8 8 8 8 8 B B B B B

consumers and firms.


There exists a robust literature on the subj ect of Brazil's macroeconomic

fundamentals, and much work has previously been performed on the question of the

country's interest rates. Much of the work examines one component of the interest rate,

focusing on inflationary expectations or on one of the drivers of the real interest rate.

Several papers seek to justify Brazil's interest rate policy, and estimate Taylor rules for

Brazil. Most notably, Muinhos and Nakane (2005) emply various techniques to show

that Brazil's interest rates are higher than those of other economies, while Bogdankski et

al. (2001) estimate monetary policy rules for Brazil consistent with the level of interest

rates currently present in the country. In an important contribution to the literature,

Favero and Giavazzi (2002) estimate a full Taylor rule for Brazil that shows that the



6 Defined as the SELIC rate less expected change in the IPC index over the subsequent twelve months
(BCB data, author's calculation and graphic).









interest rate associated with non-accelerating inflation is around 17.5%. The implications

of their methods and results are discussed fully in chapter three.

Building on the theoretical work of Keane and Runkle (1990, 1998), Carvalho

(2004) builds a complete set of tests of the rationality of the forecasters that are surveyed

by the Central Bank on the future movements of inflation. Her work largely rej ects

rationality in the data, and similar tests (with more recent data and slightly different

specifications) are reproduced in the third chapter of this work. Carvalho stops short of

identifying the driving forces of expectations, focusing on their rationality. A recent

contribution from Cerisola and Gelos (2005) discusses how those expectations are

formed, and suggests that the relative importance of the various determinants changes

over time. This work is expanded upon in this paper, in light of the most recent

economic data.

The question of real interest rates has also been addressed by several authors.

Favero and Giavazzi (2001) point to term premia, currency aversion and the lack of

independence of the central bank. The last point is also identified as a cause of inflation

by Tullio and Ronci (1996), who estimate a Phillips curve with a proxy for the perceived

independence of the bank. This estimation clearly shows a correlation between weak

political independence and higher inflation. Palley (2004) and others have written on the

weak fiscal situation of the federal government and how high interest rates are both a

cause and an effect of that deficit Einancing. Their work is examined and critiqued in the

second half of chapter three. Carneiro and Wu (2004) point to Brazil's insertion into the

global economy as a proximate cause of its high interest rates, a point also examined by









Garcia and Didier (2000). Finally, Arida and Lara-Resende (2005) also point to the lack

of local long-term debt as a reason for (and not an effect of) high interest rates.

Less work has been done on the effect of high interest rates in the country.

Bonomo et al.(2003) empirically verifies credit constraints at the firm level, and Terra

(2003) shows that the size and nationality of the firm is a determining factor of the

severity of that constraint. This paper will examine the capital structure of firms,

principally using published annual reports (in the case of large firms) and survey data (in

the case of smaller firms) from the World Bank (2003). Some research has been done

with respect to credit constraints at the individual level, and this paper will make use of a

recent survey (Brusky and Fortuna, 2002) to discuss the unmet needs of the masses with

respect to everyday access to credit and capital. Fagnani (1996) and Borba (2004)

discuss the lack of mortgage finance and suggest ways in which that gap could be

eliminated. Finally, Pinheiro and Cabral (1999) show the major aspects of Brazil's

"gray" market for credit which allow it to flourish.

This paper will act as a compendium of all of this research, bringing the previous

authors' disparate viewpoints together to tell, in one voice, the story of Brazil's interest

rates. The most recent data will be considered as well, updating some results that were

written several years ago, while conj ecturing either that other results are no longer valid

or that the credit markets have not yet responded to a shift in the fundamentals of the

Brazilian economy. In doing so, the paper seeks to answer whether Brazil's credit

markets are suffering from irrational pessimism, routed in the past may not repeat itself,

or if they are subj ect to a guarded form of optimism that will require more economic

austerity and good performance to result in lower interest rates.















CHAPTER 2
AN ABBREVIATED HISTORY OF INTEREST RATES, INFLATION, AND
MONETARY POLICY IN BRAZIL

Brazil's history of inflation, interest, and monetary policy will be extremely

different for the reader solely familiar with the stable regime of the United States or the

other more industrialized nations. It does not, however, differ drastically from other

Latin American nations. The government' s use of the inflationary taxes to finance the

public deficit are not uncommon to the region, nor are rates of inflation that are

meaningless in annual terms and are calculated and discussed in monthly rates, rates

which, in turn, are factors of 10 above the average annual inflation rate of the most stable

post-industrialized economies. To help the reader to better understand this process and

its causes, this paper will review this history in order to gain insight into the causes of this

interest rate dilemma. Indeed, one cannot study the history of interest rates per se in an

economy such as Brazil's. The series is highly discontinuous, variable, and ill-defined

(even by the Central Bank). This is due almost entirely to the unpredictable nature of

inflation, along with the regime changes experienced in the country over the last fifty

years .

The study and history of inflation is integral, then, to the study of interest rates in

any country. Individual investors demand rates of return which exceed the increase in the

price level; if those rates of return cannot be met, agents have strong incentives to










consume income as it is earned, thereby lowering the savings rate.l Empirical evidence

shows that the Taylor rule also holds in emerging economies as well as industrialized

economies; as expectations of future inflation become worrisome, central banks use their

policy instruments, namely interest rates, to quell inflationary pressures.2 It is because of

these linkages that this study begins with an examination of the history of inflation in

Brazil. Special attention will be paid to the role of government in seeking to tame

inflation's course so as to steer the economy towards low-inflation economic growth and

also to the various monetary policy regimes which have sought to control the rate of price

acceleration.

In the post-war period, inflation began at a fairly stable pace, fluctuating in a

range below 20% annually until late 1959 (Bulmer-Thomas, 1993).3 Even the low

inflation of this period, however, was sparked by government policies and manipulation.

By 1945 the Vargas administration had increased the tax share of GDP to 26.5%, an

astonishing three-fold increase from the level just six years prior ibidd). A dual exchange

rate regime also existed in this period which gave preference to exporters. This regime

may have promoted export growth but had inflationary pass-through consequences

because of the high exchange rate granted to importers. This sort of indirect taxing of

consumer goods began a long standing tradition of government manipulation, albeit

indirect, of the price level ibidd). However, beginning in the 1960s, inflation quickly got


SWhen given the choice to spend R$1 today on an asset, or invest at 10% to purchase the asset in one year
at R$1.15, a rational actor would spend the R$1 today (even if he/she were to hold the good and sell it in a
year' timee.

2 See, for instance, John B. Taylor, "Using Monetary Policy Rules in Emerging Market Economies," a
paper presented at the 75" Anniversary Conference of the Bank of Mexico, November 14 15, 2000
(available on-line at httpl u\ \\ l\banxico.gob.mx).

3 As in the United States, reliable, official economic data does not exist for the pre-World War II period.









out of control and became rooted in the Brazilian psyche, having long-lasting

implications for the conduct of economic policy.

In that decade, inflation exceeded 40% per year and Table 2.1 Annual Inflation
Average Annual
grew to exceed 100% annually by 1980. By the Inflation (percent)
1960-69 44.6
introduction of the most recent stabilization plan, the Real 1970-74 20.9
1975-79 46.5
Plan, inflation was running at unfathomable levels (table 1980-84 148.0
1985-89 707.4
at right, author's calculations). 1990-93 1,764.9

The acceleration of inflation in the period beginning in 1960 was caused in part

by the lack of a market for government debt. In fact, outside of the Banco Nacional de

Desenvolvimento Econdmico e Social (BNDES), there were few resources available for

long-term Einancing. Housing Einance was not available (it remains largely inaccessible

to this day) and any long-term credit was restricted to a few commercial banks and

Einance companies. At the time, Brazil was governed by a military government (more on

this below), and its response was fairly orthodox: remove the pressures on the deficit that

was causing the monetization of the deficit. Prices for public services were increased

(though this has some pass-through to inflation in other sectors) and expenditures were

cut (Coes, 1994, p. 87). Inflation fell to below 40% a year by the late 1960s, all things

considered a great accomplishment but not low enough to engender the sort of long-term

lending the country needed for development purposes.

To that end, the government instituted its second, much less orthodox, response: the

correCdo monetaria literally "monetary correction" and now known as inflation

indexation. The BNDES had long been indexing its long-term lending to offset the

inflation-induced real erosion of loan repayment. Then Minister of the Economy Roberto










Campos was a former president of the BNDES and suggested that indexation be used in a

broader sense in the economy.4 With the passage of the now-famous law 4.3 57 in 1964,

financial contracts could be written to allow for ex-post revisions in their notional

amounts to reflect inflation. The legislation also introduced a new type of government

bond, the Oly1 igaz Isti Reajusta~vel de Tesouro Nacional (ORTN), which increased the

government' s ability to finance its deficit through selling new government bonds to the

public, bonds which were indexed to a pre-determined index of the cost of living.'

Figure 2. 1 Deficits and Public Consumption of Fiscal Debt
According to Coes (1995),
S2,400 Fiscal Delicits and Public Consumption of Government Debt
(millions of current cruzeiros)
public absorption of this 1,900
Public Purchases of
new debt was one of the 1,400 Gort. Debt 197
4,0:
900
key factors in bringing M~scal Defieit
400
down inflation after 1964
(100)
(seegrah).1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 19



Indexation became a central feature of the economy, and following the ORTNs, the

government began to track Unidadesdddddddd~~~~~~~~ Patries de Capital, or UPCs, which allowed for the

indexation of all debt, private and public, to the government-set levels for inflation

adjustment. In addition to the ORTNs, the government also began to issue Letra~s de

Tesouro Nacional, or LTNs, which were offered at various maturities and at market-

determined interest rates. All of these new assets helped to create a more liquid financial

market and made the more narrow monetary aggregates less important, as Brazilian


SBNDES, 50 Tears ofDevelopment. On the web at http://www.bndes.gov.br/english/book50year~s

SThis was a relatively progressive concept. As a point of reference, the U.S. Treasury first introduced its
inflation-protected securities, the TIPS series, in 1997.


1
30


71










agents could move between inflation-adjusted and nominal currency with ease, thus

blunting the monetary erosion to accumulated wealth from the inflation experienced in

the period.

However, outside of the financial sector notional correction was much less

advanced. Salary contracts were often negotiated on annual bases and even those

contracts which were indexed were corrected at a staggered pace (every six or twelve

months). The government itself contributed to this lag: it wasn't until 1979 (fifteen years

after the beginning of indexation) that the minimum wage was moved from an annual to a

semi-annual cost of living adjustment--with the variability that inflation exhibited in this

period, even this semi-annual adjustment left much to be desired (Coes, 1995, p. 89)!

Throughout the history of indexation, the government continued to manipulate the

economy through its policy choices. Take for instance the choice of price index used to

correct for inflation: a mining company would like its workers' wages (or the price of any

of its inputs, for that matter) to be corrected by the price change in the factory's output

(say, iron ore), while workers would like their incomes to be adjusted vis-a-vis changes in

the price of the basket of goods they consume. The government is essentially torn

between these competing pressures and any choice of index merely manages the

distortion in real prices that occurs without any indexation; it does not, however,

completely solve the problem. When oil prices sky-rocketed in the 1970s, the

government introduced a new price index that could be manually adjusted to control for

exogenous shocks beyond the control of the national economy. The result of this











manipulation was a real erosion of all assets corrected by the ORTNs, and reduced

purchasing power of the adjusted cruzeiro.6 Inflation continued to be high (despite


Figure 2.2 Inflation Rates, Before, During, and After Hyperinflation and the Real Plan

140
Annual Inflation 0%Annual Intlation
120 (12-month percent change in Imphicit price deflator) (1-month percent change in implicit price deflator)
100 1\. 70% i Real Plan
July 1, 1994
50%

30%

20, 10% \nr

Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Jn8 a-7 Jn9 a-5 Jn9
45 49 53 57 61 65 69 73 77 81
indexation) throughout the 1970s and 1980s and then accelerated to astronomical levels

in the late 1980s and early 1990s. Only with the introduction of the Real Plan was it


slowed to manageable levels. The charts above tell the story better than words possibly


can (note the scales): inflation so high, volatile, and endemic that by the mid-1980s it no


longer made sense to refer to inflation in the year-over-year or annualized sense, but

rather by 1-month percent changes (author' s exhibits from data collected from the BCB).


Despite various stabilization plans (as discussed below), it wasn't until the introduction

of the Real Plan in 1994 that the problem of inflation was finally tackled.

Theoretical Bases for Inflation

Before examining in more detail each of the relevant periods of recent Brazilian

economic history, it is useful to examine the theory behind the inflation that has plagued


the country and clouded the ability of policymakers to set a clear path for the future.


Specifically, what does theory tell us about these rampant (and variable) accelerations in

inflation? According to the classic model, the root cause of inflation all across Latin



6 Essentially the government would decide how much of the inflation was e \ogen oui" to the country and
only allow the indexation to account for the remainder.









America during this period was the same: monetization of Eiscal deficits. Despite the fact

that external Einancing was important to Latin America's growth and economic planning

in this period, these high rates of inflation also suggest that much of the debt was in fact

monetized. The Central Bank prints money in order to finance the balance between its

deficits and new debt issuance (extemal and internal) in order to pay the government' s

bills. The so-called inflation tax arises when the government prints too much money, its

real value declines, and the new, devalued currency is used to pay nominal balances owed

to the government' s lenders. In this monetary model, increases in the money supply are

essentially treated as exogenous, meaning they are predetermined and not affected by

other variables such as the change in the price level. If this were true, growth in the

money supply the infamous printing of money that people oft blame for hyperinflation

in Latin America would lead to a devalued currency. The policy prescription for

stopping inflation would be clear: turn off the printing presses!

Treating the money-printing policy decisions of the central bank as exogenous,

however, does not entirely apply to the Brazilian case. If budget deficits cannot be fully

financed through external funding, the bank has no choice but to increase the money

supply. As Fisher and Easterly argue:

Milton Friedman's famous statement that inflation is always and everywhere a
monetary phenomenon is correct. However, governments do not print money at a
rapid rate out of the clear blue sky. They generally print money to cover their
budget deficit. Rapid money growth is conceivable without an underlying fiscal
imbalance, but it is unlikely. This rapid inflation is almost always a fiscal
phenomenon. (Fischer and Easterly, 1993, pp. 138-39.)

The true variables of interest then, the ones driving inflation, would be the size of

the budget deficit and the appetite of the investing community for govemnment-issued

debt. Furthermore, critics of the monetarist theory in Brazil note that inflation sometimes










spiked at times when there was no substantial increase in the monetary aggregate, and

have pointed out instability in the estimates of monetary demand in Brazil. They cite

these two facts as evidence that the monetarist model is not appropriate for the Brazilian

case.' Arguing for a structuralist approach to inflation in Brazil, opponents of

monetarism say that the money supply is in fact endogenous, determined by other

variables, not the least of which is the price level. According to this theory, supply

constraints or excess demand causes inflation in specific prices. Seeing their purchasing

power eroded, other agents in the economy also raise their prices. The central bank then

is faced with a dilemma: restrict the monetary supply and foster deflation, or

accommodate the price increases with increased money so as to not engender

unemployment and/or recession. In short, str-ucturalists argue money growth is the effect,

and not the cause, of inflation.

Which of these theories is right? It is possible that there exists a feedback

mechanism wherein initial price increases prompt monetary accommodation, which in

turn brings about more inflation. Comes (1995) performs Granger causality tests on the

general price index (IGP-DI) and various monetary aggregates (the monetary base, Ml,

M2, and M3). The results do not indicate that inflation causes increases in the broad

monetary aggregates. For the more narrowly defined monetary aggregates, the tests are

on the border line of significance (in probabilistic terms) and suggest some relationship

may be present. In the case of the reverse relationship, the test results vary. For broader

monetary aggregates (M2 and M3, which include highly liquid monetary substitutes), the


SSee, for instance, Cardoso (1983), Rossi (1989), and Cardoso and Fishlow (1990).

SThe test used is actually a variant of the Granger causality test which eliminates potential bias from serial
correlation in the data.









tests indicate that changes in money do induce inflation. In short, for broadly defined

monetary aggregates, the monetarists' argument appears to hold water. Comes asserts this

distinction is due to the fact that during inflationary times (and especially after indexation

began), the increasing liquidity of near-money assets implies that it is these measures

which should be studied. Recent work (Feliz and Welch, 1992) indicates a neo-

monetarist model is most appropriate for Brazil: prices respond to both contemporaneous

and expected future changes in the money supply. Just the same, the failure to

overwhelmingly rej ect the structuralist argument in the Brazilian data may indicate that

there is some feedback mechanism which says that inflation may further fuel

accommodative monetary policy.

Regardless of the causes or the exact transmission mechanism, inflation remained

high through various administrations and economic plans. Without knowing the exact

transmission mechanism, but knowing the correlation between money supply, inflation,

and growth, one should by now be asking a very relevant question: how did so many

governments fail to manage inflation and control the country's economic situation more

effectively? Government policies had a direct impact on accelerating prices from the

1950s to the implementation of the Real Plan. Simultaneously, stabilization programs

were put in place to mitigate the negative consequences of the government' s aggressive

(and oft unrealistic) development goals. Were those policies simply ineffective, ill-

conceived, or were they subj ect to extraordinary exogeneities that rendered them futile?

Post-War Promises

Brazil emerged from World War II in a better position than many of the

developed economies. War had generated a demand for the country's exports, and the

United States had declared Brazil's coffee an importing priority during the war. As a









result, at the end of the war the national coffers were full: more than half a billion dollars

lay in the national reserves, and a positive trade surplus contributed much to that boon.

This good fortune quickly changed course, however, as that surplus was consumed by

aggressive development plans by the new administrations. Promising "fifty years of

progress in five," Juscelino Kubitschek began massive development proj ects, including

the initiative to develop Brazil's interior and to create a new capital, Brasilia. There were

some success stories which arose from his development plans: during his administration

real GDP grew at an average of almost 7 percent per year, leading to a per capital

increase of about 4 percent (FGV and BCB). The decrepitude of these plans, however,

was the government's inability to finance them: while Vargas had increased the tax share

to around 27% of GDP, this alone was insufficient to finance these aggressive plans.

Furthermore, export revenues were stagnating, only partially offset by foreign capital

flows (Coes, 1995). The government was left with almost no choice: they monetized a

great portion of this deficit. Not surprisingly, inflation ensued, with the first bout spiking

in 1959 and the annual inflation rate exceeding 30 percent. The successive

administrations of Quadros and Goulart, from 1961 to 1964 imposed some conservatism,

but it was too little, too late. Opponents of government manipulation favored greater

reliance on market prices and feared Goulart' s seemingly dictatorial aspirations.

Furthermore, inflation had taken root and the fiscal deficit proved harder to eradicate than

one would have hoped; when the military ousted Goulart in 1964, the inflation

accumulated in the twelve months prior exceeded 90 percent (as measured in the IGP;

author' s calculations). This paper does not posit that the principal reason for Goulart' s

removal was economic. His attempts at stabilization ranged from highly orthodox to










completely contrarian with respect to economic theory, embracing IMF lending

originally, then rej ecting it for a more "radical nationalist" strategy (Skidmore, p. 13).

This move to a more nationalist strategy wasn't just economic it sought both a political

and economic removal from the world scene, simultaneous with a move to the left of the

political spectrum. Goulart asserted a causal relationship between the economy's woes

and its insertion in the global economy, as well as domestic policies. It was this tumn to

the left that alienated many factions within Brazilian society and prompted the formation

of a shadow government consisting of various segments of society (Ibid., p. 14). The

inability to control inflation, then, was symptomatic of serious division in the government

and in society that was crippling with respect to any unified policy; its rampant nature

helped to usher in a defining moment in Brazilian history: military rule that would last for

two decades.

Military Rule and an (Overly) Managed Economy

The military imposed stringent measures to reign in inflation. Fiscal strategy

included the raising of taxes, changes in the pricing strategy of public utilities and

services, control of wages and credit, and announced targets for monetary expansion.

The government' s profligate spending was not corrected, however, as government' s share

of GDP remained at historical levels. The idea was simple: cover the existing spending

with more tax and service revenue, but don't decrease spending! Government spending

as a share of GDP remained essentially constant throughout the period (at around 10%,

according to statistics from IBGE, 1991). However, the revenue base of government did

expand and covered a greater share of these expenditures, allowing inflation to cool in the

late-1960s. However, excessive government management of the economy became a

staple: policies allocated resources instead of prices, and those resources were allocated









based on the government' s agenda. Indexation further complicated pricing, and sped the

transmission of shocks between sectors of the economy (since the broadest inflation

measure, the IGP, was used as the basis of indexation).

A new administration, headed by Costa e Silva, took the reins in 1968 and

exacerbated these difficulties by allowing for more inflation, as it viewed inflation as a

trade-off with real GDP growth (Coes, 1993, p. 15). Price level management was also

institutionalized, in bureaucratic Brazilian fashion, with the creation of the Conselho

Interministerial de Prepos (CIP), and wage adjustment was changed to reflect actual

inflation in an ex-post fashion. During this administration, real output grew at over 10

percent per annum, while inflation remained around 20 percent and the public deficit was

brought to below 1% of GDP for obvious reasons this period in Brazil's economic

history is known as the milagre.

Economic sensation quickly turned into cessation with the first oil shock in 1973.

At the time, Brazil was highly dependent on foreign oil (80% of the crude consumed was

imported), and was especially impacted by the shock (Coes, 1995). The new

government' s management of the crisis was commendable, however: with Brazil's

economic management institutions, only about one-half of the price increase was passed

on to consumers, while subsidies covered the rest. Through both monetary and fiscal

restraint, the inflationary threat posed by the oil price increases was quelled. The shock

to consumers was mitigated, but the effects on government remained deleterious: some

increased borrowing to cover the subsidies, a negative impact on the trade balance, and a

reduction in Brazil's international reserves.









Brazil's government decided to launch a second national development plan in the

period following the shock, and greatly encouraged importation of intermediate and

capital goods to that end. This was prompted by the level of world interest rates: real

rates on dollar-denominated loans were zero or negative throughout much of the 1970s

(Coes, 1995, p. 19). Expansive monetary policy led to soaring inflation, however, and at

the time the world economy was experiencing its first bout with stagflation (the

phenomenon of simultaneously high inflation and low output growth), which limited the

ability of Brazilians to export abroad. This led to a sharp increase in real interest rates

over the period from 1977-1978 that aimed at cooling the overheating economy. By the

time of the second oil crisis, inflation was still excessively high and the current account

remained in significant deficit.

The response of the government to the second oil shock was typically

bureaucratic: strict controls on nominal interest rates, coupled with subsidized credit for

certain sectors of the economy. Promulgations abounded, from pre-announced

devaluations, to targets for correCdo monetaria and expansion of the monetary base. The

intent was clear: stop the inertia in inflationary expectations. The policies lacked

credibility however, and after a year of record-setting inflation (1 10% in 1980), the

government switched its mechanism of management to that of demand control, including

more aggressive management of the monetary base. The government at this time also

began the sale of exchange-rate indexed bonds to the Brazilian public. Due to the

inordinately high levels of expected devaluations, the availability of these bonds led to an

increase in real interest rates: there was no longer a transactions cost for hedging










domestic currency exposure because the government would adjust returns vis-a-vis

another currency.

With domestic interest rates so high, foreign borrowing skyrocketed and by 1982,

interest payments accounted for over 70% of the current account deficit and 4.2% of

GDP (IBGE). Public enterprises also took part in the foreign debt markets, borrowing

abroad to Einance the external debt of the central bank, thereby increasing reliance of the

government on foreign funding. While an increase in borrowing abroad should force

down the domestic interest rate, in Brazil that did not occur. The reason for this

theoretical result is that Brazil was backed into the constraint imposed by high foreign

debt. With the stock of external Figure 2.3 Federal Debt/GDP Ratio
35 Federal DeMI/ GDP Ratio
federal debt at the time in excess of (p percent)

Eifteen percent of GDP (see graph), 25

any marginal increases in the debt 1s

level further decreased the country's t

credt sandngincrase th drin 1964 1967 1970 1973 1976 1979 1982 1985



from debt servicing, and further exposed the country to the whims of international

sentiment and exogeneities. These factors served to increase the country risk element of

the real interest rate (as measured and detailed below) and counteracted any monetary

expansion from the foreign borrowing.

As if the situation wasn't bad enough already, in late 1982 another exogenous

shock rattled the now-fragile Brazilian economy, as Einancial contagion from the

Mexican debt crisis affected the country's cost of capital and, for that matter, the

availability of foreign lending. Though Baer and Coes (1990) argue that the lending










policies had begun to disfavor Latin America before this date, this crisis increased the

perceived "country risk" even further. Political (election-related) pressures prevented the

country from borrowing from the IlVF (exacerbating its cost of capital).9 When lending

finally came from the IlVF (with the usual strings attached), its success, in economic

terms, was so painful that the government lost much political support (per capital real

income had fallen by more than 10 percent cumulatively in the years 1980-1983). This

loss of support sped the transition to civilian rule and helped to usher in the government

of Neves/Sarney.10

Civilian Rule and Attempted Stabilizations

Sarney's attempts to stabilize the economy were various and categorically

unsuccessful. His first plan, the Plano Cruzado, began in 1986 and included price and

wage freezes, along with the prohibition of indexation and a new currency, the cruzado,

worth 1,000 cruzeiros. The basic aim was to eliminate inertial inflationary expectations

by ending the indexation and taking the cruzeiro out of public memory. The plan worked

initially, but after a few months some allocational effects became obvious. The price

freezes had caught some sectors off-guard, and relative prices became skewed, resulting

in shortages and rationing. In an attempt to salvage the plan, the Plano Cruzado II was

announced, adjusting the prices of a gamut of goods, including automobiles, government

services and agricultural products. A floating peg of the cruzado was announced, as was

a return to indexation (though this time the nominal anchor was to be the return of BCB

notes). In the international community, the risk level associated with the country reached

9 Bacha (1983) estimated the effect of this decision at around 320 million dollars in extra interest to be
paid.

"' Tancredo Neves was elected president but died before assuming office. Upon his death, his Vice-
Presidential candidate, Jos6 Sarney, became President-elect.









new highs when the government announced it would temporarily suspend interest

payments to foreign creditors in February, 1987. These measures eroded any and all

confidence the government had gained; inflation returned to levels near 1,000 percent per

year just eighteen months after the introduction of the plan (IBGE).

A new plan followed, named after the Economy Minister who devised it, Luis

Bresser. Indexation remained, the currency was allowed to devalue, but wages and prices

were frozen for a period of three months (only after allowing government and agricultural

prices to "catch up"). Real interest rates were allowed to rise, and the government

announced that its deficit would not exceed 3.5% of GDP. This particular part of the

plan, however, was derailed when the President authorized large wage increases for

public sector employees after the initial three-month freeze. After that initial three month

period, the inflation rate again approached 15% monthly and Bresser resigned.

A new plan, O Planzo Verdo, or the Summer Plan, was announced on January 14,

1989. Real interest rates were elevated and cuts in public spending were announced.

Prices were again frozen and the economy was de-indexed with a new currency unit, the

novo cruzado, becoming the unit of measure (again, dropping three zeroes from the

original cruzado). Two factors led to this plans demise: a nominal peg of 1:1 with the

dollar was announced and public spending also spiked ahead of the presidential election,

wearing away the credibility in the plan's announced tenants. Inflation hit four and six

percent in February and March (despite the price controls), and the exchange rate could

not be maintained at 1:1. By the end of the election, which chose Collor de Mello as its

leader, inflation surged to over 80% monthly (Coes, 1995).









The Collor Plan was immediately announced by the new administration, and was

the most drastic plan yet. It included a sharp fiscal tightening and a sudden freeze in

nearly 70% of the country's financial assets. However, there were exceptions to this

freeze and those types of assets (principally short term bonds) allowed liquidity to again

expand and inflation again ensued."l A new package, Plano Collor II, sought to re-

administer the price level through a "reference interest rate" that served to re-index the

economy and allow for more of the inertial inflation previously experienced. These plans

were ultimately unsuccessful as well, as they failed to attack the principal causes of

inflation: large federal deficits, deficits which were, in turn, fueled by rampant corr-uption

which later forced Collor de Mello from office in 1992.

O Plano Real: Finally, a Plan that Works!

In the two year administration that followed, Franco appointed two politicians and

an academic economist to the post of Finance Minister. Unsatisfied with their

performance, he moved sociologist Fernando Henrique Cardoso to the Finance Ministry

in May of 1993. Cardoso and three academic economists authored the stabilization plan

that is still in place as of the date of this writing, O Plano Real. This plan incorporated

the lessons learned from all the previous stabilization attempts and improved upon them.

One of these authors described it as a three-pronged strategy to stabilize the economy: a

fiscal strategy centered around a constitutional amendment, monetary reform taking place

with the slow adoption of a new currency, and an opening of Brazil's economy, both in

the form of continued privatization, a new foreign exchange policy, and a liberalization


The quantity theory would suggest this result: it is the growth rate of the money supply, and not the
stock, which matters for inflation. According to the theory, a sudden, one period drop in the stock of
money, followed by growth would generate one-period deflation, followed by re-inflation of the economy.









of the capital account (Franco, 1995). The fiscal deficit was addressed immediately with

the introduction of new taxes of Einancial transactions, cuts in federal government

spending, and the creation of a new Fundo de EvaN/~ii.4l tio Fiscal. As a result, by mid-

1994 there was a primary fiscal surplus of 2.6% of GDP. The currency adjustment and

deindexation of the economy came in two pieces: first the creation of new thridadeddddddddd~~~~~~~~ Real

de Valor (URV), which was a composite of several price indices and which emerged as

the new index rate. However, with cuts in federal spending and a credible economic

agenda, the URV found (as it was designed to do) a point at which the economy's prices

stabilized. Once that stabilization had occurred, the Real was introduced as the new

currency. In terms of the foreign exchange component to the plan, the value of the Real

was allowed to fluctuate in what Cinquetti (1998) has called a "upper-bounded floating

exchange rate regime"--the cost of the Real was to never exceed one dollar, but was

allowed to fluctuate downward. The success of the plan has been credited to many

things, including some exogeneities. However, it was the first of the plans to allow

market mechanisms to settle within a new economic framework (no price/wage freezes)

and slowly removed indexation instead of a sudden, incredible regime change.

Moreover, it also addressed the fundamental structural issue, the federal deficit. With the

government constrained to a balanced budget and new sources of revenue, the Central

Bank was no longer forced to monetize the deficit, which would have had the usual effect

of fueling inflation.

As mentioned above, the Real Plan continues in place today and has guided the

Brazilian economy through a period of relative prosperity. It hasn't gone completely

unchanged, though, and currently we are in a period which could be known as the "Planzo









Realll"' if one were to follow the semantics of previous stabilization attempts. In early

1999 Brazil adopted inflation targeting, after floating the currency completely and

managing a 50% devaluation. This development changed one of the fundamentals of the

Real Plan: the exchange rate was no longer the nominal anchor, but rather the economy

was anchored by the inflation rate. This shift has an important implication for monetary

policy: the Central Bank now has an explicit target to meet in order to keep its credibility

and must unabashedly use its policy instrument (interest rates) to control inflation else

risk the public's confidence in the Bank. This was evidenced during the crisis of 2002,

when the Bank had to decide not aI hehrlrll, but by how much to raise interest rates

(Giavazzi, et. al., 2005). This crisis was handled well, with inflation barely exceeding its

(adjusted) target, and real GDP contracting very slightly (-0.2%) in 2003, a clear success

when compared to what could have happened if the contagion from Argentina would

have been more fierce.

The pages above convey the variability and volatility in Brazil's recent economic

history. Under the guise of various monetary policy regimes, political organizations, and

attempts at economic stabilization, Brazil has seen inflation so high that it cannot be

shown on a chart, deep business cycles, and extreme ebbs and flows of international

capital. Surely this economic rollercoaster is in the minds of economic actors as they

evaluate their risk tolerance with respect to the country and is implicit in the relatively

high spread vis-a-vis U.S. Treasuries from which the country suffers.

In the last ten years, however, the new monetary policy regime of the Real Plan has

endured the stress test of an international liquidity crisis, capricious sentiments of what

Thomas Friedman has called the "electronic herd" of international investors, and the










continuation of orthodox economic policies by one of Brazil's most left-leaning

politicians, Lula da Silva. How deeply discounted must the recent performance of the

economy be in light of the more distant past to justify the real interest rates experienced

by the country? For how long must the regime of inflation targeting work in order to

mend expectations and drive down the inflation premium in nominal interest rates? How

much of a fiscal surplus must be maintained for investors to believe the debt is

sustainable, in order to reduce the default risk premium? Will the past performance of

the Real reduce investor aversion to the currency and eliminate the devaluationary bias

implicit in the domestic interest rate? In short, what must Brazil do to lower both

nominal and real interest rates, in order to achieve more balanced growth and productive

investment? These are the questions that the next section of this paper will seek to

answer.















CHAPTER 3
BRAZIL'S CURRENT INTEREST RATE DYNAMICS

Implicit in any monetary policy action or
inaction is an expectation of how1 the future
Trill unfold, that is, a forecast.
-Alan Greenspan

The macroeconomic history of Brazil has been anything but stable in recent

hi story. Specifically, only the most recent decade has been a time of relative stability in

terms of the usual macro-indicators. Despite this stability, however, interest rates remain

at exceedingly high levels. The basic interest rate equation, as illustrated in the

introduction, will now be examined to determine the sources of the persistent gap

between the yields on U.S. Treasury bonds and similar debt instruments issued by the

Brazilian national government.

The approximate Fischer equation, i, = r, + E(Fr,,, z), implies that there are at least

two components to the nominal interest rate: the real interest rate and the premium

demanded for investors to compensate for their expectations of future price inflation.l

There are many factors which affect the real rate of interest, r: investors views of the

currency, the possibility of sovereign default, the international economic environment,

the equilibrium growth rate of the economy, the national financial situation, and the

possible convertibility/liquidity risk for operating in a given currency (regardless of the

notional exchange rate)-to name a few. Many factors also influence the expected future

inflation: inflationary inertia, autonomy and credibility of the central bank (or lack


SThe exact Fischer equation has an interaction term between the real rate and expected inflation. It is
significant in high inflation countries such as Brazil but is ignored here because the equation is not
estimated, but rather used as the basis for the organization of the paper.

29









thereof), state of fiscal balances, and sentiment vis-a-vis the international economic

environment. Both parts of the model deal with markets' perceptions and forecasts of

probabilistic scenarios and future events. All standard economic models presuppose that

markets act efficiently and rationally, which means (among other things) that these

expectations are based on all available information and are the true "best guess" of the

outcome of these future events. In some cases, however, rationality may not hold. It is

with that possibility that this section of the paper begins, later returning to more standard

components of interest rates.

Testing for rationality in price forecasts

The so-called New-Keynesian Phillips Curve posits that it is the deviation

between expected and actual inflation that causes the short-run trade-off between

inflation and employment. Consequently, empirical models (such as those used by the

Brazilian Central Bank) require the use of observable phenomena (lagged inflation, actual

unemployment) as well as expectations of the future course of those phenomena. If a

systematic bias were to exist in the markets' expectations of inflation, that bias would

clearly have an effect on nominal interest rates. If, for instance, the market consistently

predicted inflation of 5% higher than that which actually was to occur 12 months hence,

the nominal interest rate would be 5% higher than it would be if the expectations did not

have this bias. In Brazil, one hypothesis would be that though the Real Plan has

stabilized inflation, the markets still "remember" the hyper-inflationary times of the early

1990s and do not believe that inflation will be as contained as it actually has been. An

alternative hypothesis would be that markets impetuously believe the Central Bank' s

announced target and set their expectations accordingly, not foreseeing the danger that

the Bank may not be able to manage the economy (down) to the target (this would









amount to accepting the target without considering evidence which may exist to the

contrary of the announced policy rate of inflation).

The inflation-focused rational expectations literature, pioneered by John Muth,

hypothesizes that expectations about future inflation are made in such a way that

incorporate all available information to the forecaster, and that errors in forecasting are

nonsystematic. This implies that agents use all available information to (on average)

perfectly predict inflation. In its inflation targeting regime, the Brazilian Central Bank

should then pay close attention to these private inflation forecasts, reacting quickly to

changes therein as these indicators truly point towards future changes in inflation. If a

systematic bias is suspected, the Bank should measure that systematic bias in order to

make some inference about the true private beliefs and expectations about future

inflation. Incentives exist for the Bank to make inferences about true future inflation

from the public's expectations, as any marginal improvement in its ability to foresee (and

control) future inflation will only further bolster its credibility.

There are two conditions for rationality. Unbiasedness means that the forecasts are

on average centered on actual, observed inflation. Suppose Ent+k is the actual inflation

observed in period t+k and Et(Ent+k) is the aggregate survey response to the future inflation

at period t+k, using all information available up to period t. The literature then claims

that if 0 = (0,1) in the following regression, the aggregate forecast is unbiased:


4+k t( EirkI ji, Or that the k-peariod aheadforecasto nltoseult


inflation k-periods ahead plus an error, which (in the case of rationality) is centered on

zero and distributed normally. Further performing a joint test for efficiency implies that

no available information could have improved the forecast. Allowing 9, to be the vector










of information available at the time of the forecast, efficiency implies P = (0 1 0 ... 0) in


the regression: Frtk E,1t+k t+k .




Expected inflation is difficult to measure. In fact, in many cases empirical

analysts assume an autoregressive process of actual inflation actually governs inflationary

expectations.2 In Some other cases, actual expectations can be observed. For example,

the term structure of interest rates can give some information about the market' s

expectations for future short term interest rates.

Also, expectations surveys exist in many countries for the most basic

macroeconomic variables, among them prices. The difficulty with surveys is two-fold: it

is difficult to know if they are truly the same expectations which affect policymakers

decisions/markets' assessments and, depending on the source of the survey, it is not clear

that the respondent has economic incentives to use all possible available information in

making his/her forecast. Imagine a phone survey to 10,000 Brazilian homes, for instance.

In many cases, the homeowners would simply answer the survey without doing the

proper research and certainly without consulting their own macroeconomic models. The

Brazilian Central Bank publishes the consensus forecast of professional forecasters for

growth in GDP, fiscal performance, and inflation. This series mitigates the

aforementioned downsides to survey-based measures. This particular measure of

inflationary expectations is a part of the Relatorio do M~ercado that is utilized by the

Bank (and made available to the public), and the series is the average of the responses of

professional forecasters who have clear economic incentives (bonuses) riding on their


2 The judgmental forecasts used in the Federal Reserve's classified Greenbook are no exception: the larger
FRB/US model does have an explicit role for expectations, however. See Federal Reserve (1997).









accuracy. Moreover, at the Central Bank of Brazil, inflation models do in fact treat these

survey based measures as rational expectations (Carvalho 2004). In fact, Fraga (2003)

shows that the point estimate of these expectations in a monetary policy reaction function

is over two, implying a one percent-point change in expectations translates to an over two

percentage-point move in interest rates. It is obvious, then, that the question of

rationality in this data should be examined.

Near the beginning of the inflation targeting regime, the Central Bank began to

survey private forecasters on their views of inflation. Those forecasts were initially very

unreliable, relying on faxes from respondents which were later compiled in Excel

spreadsheets: they suffered from low reliability, high variability, unpredictable response

rates and (worst of all for researchers) the data was never made available to the public

(Carvalho, 2004). However, beginning in late 2001 the Bank began to utilize a web-

based interface for the collection and dissemination of this information. The survey is

conducted daily with the reporting institutions submissions and the means, standard

deviations, and medians made available on a weekly basis.

A criticism of survey based measures is that when they are analyzed in the

aggregate, it is not necessarily true that each forecaster is using the same information set,

as it is possible some private information exists. In the case at hand, imagine an

investment bank that conducted its own point-of-sale surveys during the month to aid in

its forecasting. To alleviate this problem, this paper uses the methodology put forth by

Carvalho (2004); one day is chosen of each month to be representative of the entire

month and that day is chosen to minimize the chance of private information. Carvalho

suggests using the last day of the prior month, indicating that there is little chance that

private information such as a survey could help an institutional forecaster foresee price










changes in the following month. To make this point clear, consider this example: a

forecaster reports his 12-month price forecast on 2/28/XX ; the aggregate survey response

on this date will be treated as the March data point.

The data refute the null hypothesis (of rationality) in many cases. An interesting,

explicable result holds true: forecasters can predict short term movements in prices much

better than they can longer term movements. Specifically, tests were run on the means of

foreseen monthly inflation for periods 1, 3, 6, and 12 months into the future and also for

inflation accumulated in the next 1, 3, 6, and 12 months (the two 1 month regressions are

identical). It was only for forecasts in the 1- and 3-month horizons for which the null

hypothesis of rationality Table 3.1 Rationality Tests in Inflation Expectations
Rationality Tests for Expectations in INPC Prices
cannot be rej ected at the (standard errors in parentheses)
Slope Coefficient on
90% confidence level; this Dependent Variable Constant Expected Inflation!
One-month Inflation, t+1 -0.22 1.6
holds for both foreseen (0.15) (0.2.5)
One-month Inflation, t+3 0.7 0.03
(0.26) (0.47)
one-month price changes, One-month Inflation, t+6 1.27 -1
(0.25) (0.44)
as well as cumulative One-month Inflation, t+12 1.08 -0.89
(0.28) (0.56)
inflation measures (see Accumulated Inflation, t+3 0.26 1/ 1.15
(0.72) 04
table). This rejection of Accumulated Inflation, t+6 4.46 0
(1.57) (0.46)
Accumulated Inflation, t+12 14.77 -0.79
rationality may be the
(2.34) (0.34)

result of a new monetary policy regime that is still building credibility and is also highly

subj ect to the adverse inflation shocks that the country experienced, especially during late

2002.

Keane and Runkle (1990) argue that testing the rationality of survey data is not

valid when conducted on survey means because each individual forecast that contributes

to the mean "will differ because of differences in information sets" (p. 4). While this










problem is partly alleviated by the method of selecting a representative day to reflect the

months' observations, some aggregation bias may still exist, especially in times of

(relatively more) uncertainty. Another way to compensate for the fact that this data

comes from a survey is to utilize a weighted least squares estimates, employing the

standard deviations of the forecast means to place less emphasis on data points about

which there is less consensus. Doing so tightens the estimation of the one- and three-

month ahead forecasts, making the case for rationality even more statistically sounds but

does not allow for accepting the null of rationality in forecasts of a longer horizon,

consistent with an OLS estimation. Because these estimations do not qualitatively alter

the findings, they are not reported here. The main finding, using data through the end of

2005, remains unchanged: forecasts in the very short-term are rational and reasonable

predictors of future inflation but forecasts for time horizons exceeding three months

exhibit notable flaws.

This paper does not seek to be is an exhaustive model of inflationary expectations

in Brazil. Recent work from Carvalho (2004) utilizes internal Bank data to build a panel

data estimation, based on the submissions of the individual surveyors which make up the

means and standard errors studies here. While theoretically superior, eliminating all of

the biases exposed by Keane and Runkle (1990, 1998), the results do not drastically vary

from those generated by the more simple estimations put forth in this paper. Most

importantly, unbiasedness is refuted for the 12-month case even when the panel is

estimated accounting for the non-spherical nature of forecast errors due to aggregate

shocks which effectively correlate errors across all forecasters (events like September 11,

2001 and the ensuing run-up in oil prices and the election of Lula da Silva in October











2002 which caused a significant depreciation and inflation through the typical pass-

through mechanism).

The implication for policy-makers is clear: account for the systematic bias in

inflation expectations. The Fisher equation suggests that nominal rates should reflect the

real rate (to be discussed below) plus a premium for future inflation. If expectations of

inflation at time t for period t+i are systematically lower than inflation' s realized values at

time t+i, and the Central Bank knows this bias exists, there should be an additional


premium for the bias in inflationary expectations; more directly, interest rates should be

even higher than the casual observer of inflationary expectations would think. Indeed,

this seems to be the case in Brazil. Expectations for 12-month inflation were on average

96 basis points below realized values for the period September 2003 December 2005

(standard error = 21; see chart below). Moreover, for the whole sample, 12-month-ahead

Figure 3.1 Inflation's Expected and Realized Values


Expected Inflation (t) -Realized value (t~i)

Overprediction









Underprediction
-8 12 6 *3

-10

-12

-14



expectations were 289 basis points below the realized value (standard error = 82).

Assuming the Central Bank knows this bias exists, it has a strong case for increasing the











wedge between nominal and real interest rates by the amount of this bias, making up part

of the difference which would appear irrational to the casual observer.


Recently it appears expectations have been tracking closer to inflation's realized


values. Rolling regressions show point estimates in the rationality tests trending closer to


one, implying rationality in the more recent forecasts, but with standard errors too large

to make conclusive statistical remarks. While there is not enough evidence to make a


statistical case for this argument, graphically one can see smaller errors that appear to be


centered on zero in the most recent year for expectations made three and six months


ahead. This may be due to the apparent success of the inflation targeting regime to


control the variability of price movements. Since mid-2003 the variability in 1-month


inflation has fallen precipitously, as measured by a rolling standard deviation measure in


the graph below (though it has crept up in the most recent six months). At the same time,

12-month expectations of inflation have also fallen and have, on average, been closer


Figure 3.2 Year-over-year Inflation Rates and Rolling Volatility of Inflation

1.2 14





0.8
12-month ahead inflation
0.6 expectations (right axis) 8




10-month rolling
standard deviation In
0.2 1 -month Inflation (left-
axis) ~u2

0 0
612912001 612812002 613012003 613012004 613012005

to realized values as discussed above. It is the expectation of 12-month inflation which


should matter the most to the Bank, as the transmission between monetary policy and










inflation is estimate to have a lag of about three quarters in Brazil (Bogdanksi, et. al.

2001). If this trend continues, then, and expectations continue to accurately gauge future

inflation, the Bank should clearly remove some of its wedge between actual expectations

and the difference between the nominal and real rates.

This study of expectations of future inflation has been instructive. By

illuminating the obvious problems with expectations in the past, an excuse can be made

for the high level of nominal policy-set interest rates in Brazil: policymakers knew this

bias existed and set nominal rates systematically higher than the casual observer would

have deemed necessary. If, however, that bias has been eliminated, as the recent data

analyzed in this paper seem to suggest, a clear case can be made for eliminating the

wedge between the straight theory (the Fischer equation) and the nominal interest rate set

by the Central Bank.

If these expectations are in fact trending down and becoming better indicators of

future inflation, it is crucial for the Central Bank to understand what factors influence the

expectations in order to begin to systematically lower inflation (and interest rates).

Cerisola and Gelos (2005) estimate a model of inflationary expectations, estimating from

mid-2000 through the third quarter of 2004. The model estimated is:

ri, ao + Pl <-1 + Pz rtT + P3pb,_3 + P4r,_3 + p,reer,_3 + p06g, t- t,, Where the

variables are (left to right) expected inflation, a constant term, lagged inflation, the target

for inflation, the primary fiscal balance, the real SELIC rate, and deviations from trend of

the real exchange and wage rates. The most important determinants of this model, after

estimation, are the announced inflation target and the stance of fiscal policy, as proxied

by the primary surplus, which serves to capture expectations of future monetization. The

point estimate of the coefficient on fiscal policy, in fact, indicates that a one percentage










point increase in the primary surplus coincides with a one percentage point decrease in

inflationary expectations. Consistent with expectations, a positive inflationary pass-

through is found with a depreciated exchange rate (as prices of imported consumer goods

and also intermediate goods rises); the wage variable also exhibits the expected sign

(positive), also indicating an increase in inflationary expectations due to demand

pressures (the lagged nature of the variable may also indicate a labor cost of goods to

consumer price pass-through as well). An important finding, uncovered through

recursive estimation, is that "since early 2003, and particularly during 2004, the

demonstrated commitment to inflation targeting ...and monetary policy has begun to pay

off, as expectations are [more anchored in the] target and less dependent on past

inflation" (Cerisola and Gelos, p. 12). In fact, as shown in the graph below, which

shows the coefficients Figure 3.3 Contribution of Variables to Expected Inflation

from a recursive estimation laoo

of the expectations c, n

equation, the inflation

target and primary surplus

now account for more than

60% of the variation in 20 iaonrre

(explainable) expected ass
2000Mill 2001MO04 2001M09 2002MO2 2002Mi07 ZW2002M2 2003MC05 2003M10 2004MO3 2004MO8
Source: Cerisola and Gelos (2005), p. 15.
inflation. This suggests


that, along with the SELIC rate itself, the government's policies nearly completely shape

inflationary expectations and that through diligent stewarding of these variables the

government can lower the wedge between real and nominal interest rates.









This paper has now made one case for lowering interest rates: lower expectations

of future inflation coupled with improved predictive power of those expectations vis-a-

vis inflation's realized values. If this improvement is sustainable, the Bank should pay it

credence, lowering rates in lockstep with the improved (predicted) inflation outlook.

Indeed, as the epithet to this chapter suggests, a central bank' s actions are influenced

heavily by forecasts. As those forecasts project a more benign inflationary environment

and as they become more reliable, the bank should feel comfortable taking a more

accommodative stance in its monetary policy. This does not address the question of real

interest rates, however. The remainder of this chapter will seek to a) discover whether

real interest rates are high in Brazil when compared to comparable countries and b)

decompose the real interest rate half of the Fischer equation into its relevant subparts,

looking both at historical levels of these variables and their drivers, as well as expected

future levels to estimate the effect of each going forward on the Bank' s policy decisions.

Real Interest Rates: Comparisons and Determinants

Interest rates in Brazil are high by any standard. Despite the country's recent

economic success, rates exhibit stickiness with respect to historical levels. Comparing

the country to economic comparable sheds some light on the subject. The graph below

shows short term interest rates in five countries, including Brazil.3 In the case of Chile

the rate presented in this exhibit is the policy rate set by the Central Bank of Chile (the

TPM), while in the case of Argentina, Israel and Turkey the rates presented are the one-

day BAIBOR rate (for Argentina) and the interest rate on deposits held within the Banks

of Israel and Turkey, respectively. These countries are all good comparable for Brazil,



3 The countries in this analysis have not been selected at random. Others have compared this group due to
their analogous episodes with hyperinflation and stabilization. See, for instance, Beckerman (1992).










and even if we were to aggregate the rates, the average interest rate lies nearly

monotonically below that of Brazil in the post-Real Plan era.




Figure 3.4 Comparable Nominal Short Term Interest Rates

90 percent Comparable Nominal Short Term Interest Rates

80 Argentina Memo: 2005 Inflation and Debt/GDP Ratios
Inflation Debt /GDP Rati
70 IArgentina 12.0 700
60 Israel 2.7 10100
Chile 3.6 80
50 .Israel Turkey 7.71 680
Turkey Brazil 6.2 5000



Brazil
20
Chile



Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05


The persistence of Brazil's high interest rates is striking in this graph, especially

when considered side by side with the hyperinflationary experience and economic crisis

of 2002 in Argentina (the contagion from which didn't affect Brazil nearly as badly as the

initial crisis affected Argentina), and the relatively recent conquest of hyperinflation in

Israel and Turkey (early 1980s and 1999, respectively). The countries (even Turkey)

have returned to nominal rates well below Brazil's and are relatively indistinguishable at

present from industrialized economies (with the exception of Turkey). The experiences

of these countries seems to have completely been forgiven by investors, as rates were

high for a short-period of time and have since returned to the levels one would expect in

the absence of dire financial crises: except in the Brazilian case, where one could look at










these relatively risk-free rates (this is the overnight lending rate used between banks!)

and suspect that the country was in the midst of a financial meltdown. An oft-cited

reason for Brazil's high interest rates is its level of public debt. In this peer group, Brazil

fairs very well in that category, with a lower public debt / GDP ratio than all but Chile,

and half of that of Israel (CIA World Factbook data). Indeed, this common explanation

does not hold water when attempting to justify Brazil's high interest rates. Nor do

differences in inflation explain the difference in these interest rates. Furthermore, while

not theoretically correct, if one were to use past inflation as a rough proxy for

expectations, it is easy to back-out a real rate for each of these countries (table below).

Without a doubt, the real rate in Brazil at Table 3.1 Comparative Nominal and Real Rates
Nominal Rate Inflation "Real" Rate
year-end 2005 was exorbitant when Argentina 5.8 12.0 -6.2
Israel 1.2 2.71 -1.5
Chile 4.3 3.6 0.7
compared to its peers, two of which exhibit
Turkey 10.01 7.71 2.3
Brazil 18.0 6.2 11.8
negative real interest rates!i Note: Inflation rates as reported in The Economist,
December 24 2005, and are year-over-year changes
to Nov. 2005 with the exception of Turkey (Dec.).

Muinhos and Nakane (2005) give some statistical footing to this assertion about

the high level of real interest rates. They employ various measures, including (but not

limited to) a HP-filter smoothing, and I/S curve extraction, and an extraction from

estimating the marginal product of capital to find significant differences between Brazil's

equilibrium real interest rate and that of other economies. Their work does not seek to

explain the difference in rates, only to validate the assertion that the wedge does in fact

exist statistically. In every specification of their models, the rate for Brazil is

significantly higher than that of its peers.









Standard international economics textbooks posit that the real rate of interest is

intertemporally equalized across countries.4 The evidence at hand suggests this is not the

case, as the striking difference of Brazil's nominal interest rate in the graph above is not

accounted for solely by differences in inflation. This point would be even more clear if

the above chart were to include fully industrialized economies, which exhibit nominal

rates categorically lower than the countries in the above panel.

All of these standard economic models make some simplifying assumptions

which do not hold in the Brazilian case. Specifically, they assume that long-run

purchasing power parity holds, meaning that inflation rates between nations either

converge or are equalized through exchange rate movements. They assume that default

risk is the same across countries, that perfect convertibility between currencies exists, and

that there is no liquidity constraint on government securities. A sustainable fiscal

position is assumed in standard models, and these models also assume perfect

jurisdictional certainty, meaning that disputes over contract values will be adjudicated in

a predictable fashion and that there is no relevant adjudication risk in the country; this

hypothesis in particular builds on the "original sin" work developed by Hausman, et. al.

(2003), which says that once countries begin to dollarize their financial liabilities it is

difficult to de-dollarize them, in part because of the aversion of local currency

denominated debt due to this jurisdictional risk. The relevant data on Brazil indicates

that none of these simplifying assumptions has held in the past and that while some of

them do in fact hold today, there is still a wedge between theory and practice due to what

for Brazilian Central Bank head Arminio Fraga has called "...weak macro regimes ..

and a long history of misbehavior" (Fraga, 2005, p. 297).

4 MOst include a footnote or caveat to this statement, but it is seldom emphasized. See, for instance, Husted
and Melvin (1998).










Apologists for Elevated Real Interest Rates

Three basic hypotheses explain the persistence of high real interest rates in Brazil:

the "bad equilibrium," insufficient fiscal adjustment," and "sequence of negative shocks."

In the "bad equilibrium" argument, monetary policy is seen to have been necessarily

conservative in the pegged exchange rate regime (1994-1998) in order to compensate for

the high (and accurate) risk of devaluation. In this case the economy was using a foreign-

exchange anchor that lacked credibility and perceived sustainability. However, the

nominal target was changed to the inflation rate with the maxi-devaluation in 1999 and

the move to inflation targeting. In the post-float, inflation-targeting regime (1999-

present), the appropriate adjustment was not made in interest rates at the time of the float

and now policy is not able to suddenly shift them down. The basic tenant is that very

high real interest rates raise the level of risk on government debt, and so a lower real

interest rate brings down the possibility of default and thereby justifies a lower country

risk premium and a lower interest rate. This theory deserves some attention because if

applied properly, it describes the Brazilian case fairly well. It is easiest to portray this

multiple equilibrium model graphically (and not algebraically), so consider the graph

below: the horizontal axis is the domestic interest rate, and vertical axis is the risk-

adjusted return on foreign assets in local currency terms, (1 + i* + z). The non-linear

function (that appears to be a sine wave) is the expected return on domestic financial

instruments, including an adjustment for possible default. This function is non-linear

because initially higher interest rates imply higher expected returns but if they raise too

much, increased bankruptcy risks due to higher debt service burdens increase the

bankruptcy risk. However, as the interest rate gets too high the possible default risk may

go down, as the government acts to alter perceived default risk (through IFI lending or










through the creation of a budget surplus). At certain prohibitively high levels of interest,

however, unstable debt dynamics dominate and the expected return plummets.

Regardless of where on the curve interests rates are, in equilibrium, this function must

intersect the exogenously-set international rate of interest. In this model, point A is the

stable, low interest rate equilibrium, B has a low interest rate but is unstable, C is the high

interest rate equilibrium, and D is an unstable high interest rate locus. Imagine the

economy was operating at point A when it was hit with an external interest rate shock,

that temporarily moved the foreign interest rate relationship from the solid to the dotted

line. Once this shock was removed, the economy would move to point C, not to point A.

This is the argument of the bad equilibrium hypothesists, some of whom use the 1997

Asian Financial Crisis as Figure 3.5 Stylized Depiction of a "Bad Equillibrium"

this exogenous shock
E(R, (1 + i + z)
(Palley, 2003). The
(1+i*+z)'
challenge in their minds iS B
1+i*+z
to move Brazil from point C

to point A. A E(R)

This theory amounts to
Domestic interest rate

a sort of chicken-and-egg

argument, and in their oft-cited work on Brazilian interest rates, Favero and Giavezzi

(2002) argue that Brazil "should not rely on a transition happening automatically" (p. 6).

Instead, Brazil should follow the example of other countries that have made a similar

transition: endure a large primary surplus for a protracted time in order to justify the

lowering of the SELIC rate.









This prescription follows logically into the second hypothesis, which says that

fiscal adjustment is not yet complete. Despite a sizeable primary surplus, the debt/GDP

ratio remains high enough to continue to crowd out private sector funding needs (as that

debt is rolled over before it is retired), which raises the market interest rate. The policy

prescription here is the same: continue to run a fiscal surplus in order to bring down rates

by reducing the amount of government debt outstanding.

The "adverse shock" hypothesis claims that shocks to the economy such as the

U. S. stock market, 9/11, Lula, and the Argentinean meltdown have forced the Central

Bank to use interest rates to smooth volatility that otherwise would have crippled the

economy (notwithstanding the crippling effect of the high interest rates). Proponents of

this theory would then argue that in the absence of further shocks, interest rates will soon

begin to move to lower levels. In essence, the argument is that ex post rates are high

(because inflation has not picked up, nor did the risks to the economy really materialize),

but ex ante they are in line with theory and the prevailing risk assessment at the

beginning of the terms of the rates. While theoretically sound, the analysis of the data

presented earlier reveals a non-sequitur in this argument: the economies that actually had

the fall-outs have already seen their rates recover and Brazil's rates (ex-ante and ex-post

real rates as well as nominal rates) are persistently high (see introduction and this chapter,

above). Apologists for the theory counter that Brazil's case was peculiar: monetary

policy had to be excessively tight to make sure credibility was maintained for the

incipient inflation targeting regime, as well as to defect the exchange rate. Evidence to

that point is that the real money stock from Sept 2000 Mar 2001 fell by 3.8%, though it

had increased 8.6% the previous year (Vieira de Faria, 2003). Furthermore, an exchange

rate-based response to these crisis may not have worked because of the dollarized nature









of the country's public and private liabilities: the effect of a depreciation is indeterminant

as exports are increased but net financial liabilities increase as well. Because of these

points, "Central Bank autonomy in the process of setting its key interest rate is more

theoretical than real" (Vieira de Faria, 2003, p. 46). Even if Brazil's interest rates should

have recovered from these shocks three years hence, a dedollarization of financial

liabilities would help the countercyclical nature of exchange rate adjustments become

more effective in the future, thereby putting less pressure on monetary authorities to alter

the basic cost of capital.

Historical Factors and Current Realities of High Real Interest Rates

The challenge, then, is to identify what measurable factors are influencing the real

interest rate and to suggest policies which will influence those mechanisms in order to

justify a lower real interest rate. This section of the paper lends heavily on the vast

literature, pioneered by Favero and Giavazzi (2001) and mentioned in the introduction

which seeks to explain various components of the real interest rate. The goal will be to

act as a compendium of that research and to look at the current performance of the

Brazilian economy and how it fits into the models estimated by these economists.

In their work, Favero and Giavazzi find that there are two maj or factors which

influence the country's interest rates: monetary policy and term premia. They estimate a

Taylor rule for Brazil, noting this simple rule explains the actions of the bank very well.

Furthermore, they estimate that the equilibrium policy rate (the rate consistent with zero

accelerating inflation) is around 17.6 percent. This rate, called the "neutral rate" by some

economists is extremely high (for reference, the Federal Reserve estimates the neutral

rate in the United States to be between three and five percent'). A first read of this paper


SWhile not an official estimate, numerous Fed Governors and staff have put the estimate in tlus range.
See, for instance, money.cnn's interview with St. Louis Fed President William Poole (11/10/2004).










may leave the impression that this is an open-and-close case: interest rates are high out of

necessity to stabilize inflation. Indeed, the average SELIC rate in 2004-2005 was 17.7%

and inflation has essentially been stabilized in those two years, as indicated in the chart at

right (through Dec. 05). What this ex- post modeling misses, however, is why the rates

have to be so high in the first place. Indeed, the oscillations in the SELIC rate in the last

two years, indeed in the six years of inflation targeting, have accurately shaped

expectations of future inflation
Figure 3.6 Recent Trends in SELIC and Inflation
and have helped to control
25 10

inflation during this time. Could Slert

the same oscillations not occur in

a range of 8-10%, or 5-7%? Why
10 4

must the level of interest rates be
5 2

so high if it is the change in rates
Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05
that controls inflation by

marginally curtailing or encouraging activity?

Favero and Giavazzi argue that one important factor pushing up the high neutral

rate is fact that the BCB enj oys none of the institutional guarantees that other central

banks have in their mandates; "we know of no other central bank that successfully

operates an inflation targeting regime and is not formally independent" (p. 5). This point

cannot be stressed enough; in their work on Brazilian inflation in the pre-Real Plan era,

Tullio and Ronci (1996) estimate that a Phillips Curve that includes a proxy for the lack

of political independence of the Central Bank6 that shows that it is strongly correlated


6 Their proxy is determined by the turnover in Central Bank governors and chairmen.










with inflation and accounts for a portion of the rampant inflation this period.' This lack

of independence, then, directly influences the real rate, as argued by Favero and

Giavazzi, as well as pushes up the nominal rate through increased inflationary

expectations. The importance of independence has a long history in the economics

literature and its conclusions are summed up very well by Alan Blinder, who writes:

Monetary policy requires long time horizons because the lags through which
interest rate changes affect output and inflation are typically long. If monetary
policy decisions were left to politicians, on a day-by-day basis, the temptation to
reach for short term gains at the expense of the future (that is, to inflate too much)
would be hard to resist, especially in the run-up to an election. Knowing this, many
governments wisely try to depoliticize monetary policy by, e.g., putting it in the
hands of unelected technocrats with long terms of office and insulation from the
hurly-burly of politics. (Blinder, 1998, pp.56-57.)

As discussed, Brazil does not belong to this "wise" group of nations with depoliticized

central banks. Recent changes and stirring in Brasilia towards increased Central Bank

independence should be applauded, then, and will be discussed in more detail in the

conclusion of this work.

In terms of longer policy rates, they employ a system of equations to simulate

future SELIC rates in order to give estimates of theoretical rates of longer maturities that

are based solely on monetary policy rates.8 Their conclusion is that almost all (95%) of

the spread between observable long-term rates and this theoretical rate is explained by

term premia and not by uncertainty about monetary policy. Their conclusion is valid

based on their assumptions, but incorporating the work of Cerisola and Gelos (2005,

discussed above) on inflationary expectations shows that those same fundamentals and

SOne could make the reverse argument: high inflation causes turnover (i.e. the firing) of Central Bank
officials. Tullio and Ronic report Granger causality tests which refute this alternative interpretation.

STheir dynamic simulation is based on a simple Taylor rule and is closed by an equally uncomplicated
model of inflationary expectations, which is based solely on the target rate of inflation and its recent
performance. Their model is overly simple and ignores the factors which affect expectations, as discussed
in the previous part of this chapter. However, this simple specification does fulfill their goal, which is a
simulation of ceteris paribus future policy rates.









debt dynamics are also an important part of agents' expectations of inflation and should

not be ignored when analyzing short-term interest rates. Because of that important

transmission channel, Favero and Giavazzi's findings on long term rates can be extended

to considerations of the Selic rate as well.

Since these term premia are not affected by devaluation expectations, Favero and

Giavazzi conclude that the spread is caused by macroeconomic fundamentals and debt

dynamics. Specifically they point to the level of government debt and the volatility of

international financial markets as influencing the perceived risk of government default.

When internal financing rates are widely determined by international markets, and the

government debt is large, the default risk is highly affected by the correlation of the

growth rate of output (which in turn affects the level of the primary surplus) with

Financial spreads. This additional consideration in the Brazilian case implies that a

larger-than-otherwise necessary surplus is required to make the debt sustainable and to

bring down the cost of capital. Favero and Giavazzi point to the experience of Italy in the

mid-1990s when a one-year primary surplus in excess of 6% of GDP was interpreted as a

commitment to a more responsible fiscal policy and which began a virtuous cycle that

helped move the country towards a permanently lower cost of debt.

The driving forces identified thus far are a large and unmanageable (not to mention

dollar-denominated) national debt and the lack of institutional independence granted to

the Central Bank. While the work of Favero and Giavazzi and others in this area is

accurate, this particular policy mix alone will not bring about the panacea of lower real

interest rates that the country so desperately needs. More recent work points to other

factors which need to be considered as well in order to bring about the level shift in the

country's cost of capital.









In fact, some of this work refutes the analysis of Favero and Giavazzi to a limited

extent. Writing in 2003, Thomas Palley notes Brazil's current debt situation implies

dynamics that cannot avoid default at existing real interest rates, the surplus needed to

stabilize the debt would need to be 5.1% of GDP in order to stabilize the debt,

alternatively noting that in the growth of national debt as a percentage of GDP is given by

TdY~
the following equation: gD, T v I-I-g At the time of his writing, the domestic
Yldl

interest rate, i=18%, the deficit/GDP ratio, d/Y = -3.75%, the GDP/Debt ratio Y/D =

1.67% and GDP growth g(Y) = 3.5%, implying that interest rates, i, needed to fall to

9.75% just to stabilize the debt ratio (Palley, 2003). At the time of this writing, the

relevant indicators were i=17.25%, the deficit/GDP ratio, d/Y = -5.6%, the GDP/Debt

ratio Y/D = 2.59 and GDP growth g(Y) = 2.5%, implying that interest rates needed to fall

to around 12% to make the debt sustainable. While this is slightly more palatable than

the estimate above, it is still clear that the current 17.25% interest rate prohibits debt

sustainability. This same doomsday scenario was put forth in a 2002 critique of new IlVF

lending from the Washington-based Center for Economic and Policy Research, which

argues that "[assuming the most optimistic of scenarios] .. stabilizing the debt-to-GDP

ratio through primary surpluses would not be potentially achievable" (Weisbrot and

Baker, 2002, p. 3). These scenarios have not, as of yet, played out because of the

aggressive debt management policies of Lula, which will be considered in the conclusion

of this work.

Fiscal concerns are not the only ones that affect the real interest rate, however.

Arguing for a broader "Monetary Conditions Index," Carneiro and Wu point out that

small countries in the global economy often times have a peculiar combination: high real

interest rates and deficits in the current account. Using panel data, they show that (on











average) "every 1% increase in the current account deficit (as a percentage of GDP) is

associated with an increase in real interest rates of 20 to 30 basis points" (2004, p. 304).9

Furthermore, they report a strong statistical relationship between the size of the current

account deficit and the real interest rate (measured ex post). The theory here is relatively

straightforward: increases in the current account deficit create an external funding need

which can only be satisfied in the risk-adjusted rates of return for new (marginal)

borrowing are sufficient. To the extent that Brazil ran significant trade in the period

through 2003, this explanation is valid. However, the argument looses validity when

considering the persistent trade surpluses generated by the country since mid-2003 (see

chart below). To their credit, Cameiro and Wu only consider data through 2000 (though


Figure 3.7 Brazilian Balance of Payments

Foreign direct investments (FDI), Current transactions (CT) &
External financing requirements (EFR)
US$ billion Accumulated in 12 months
40
32
24
16
8,

-16 *
-24 1_
-32 FDI -CT Deficit - EFR f
-40
1999 2000 2001 2002 2003 2004 2005
their work was published in 2004). Is this the break-down of a previously persistent

statistical (and theoretically sound) relationship, or did the work suffer from

misspecification? It seems unlikely that this misspecification would hold true across a

panel of 20 countries, as Cameiro and Wu estimate. More likely than not, as Nobel prize

winning economist Joseph Stiglitz writes, "Brazil's financial markets today are probably


a good example of excessive pessimism" (Esterl, 2002). As argued in the inflation


9 My translation of the original text, written in Portuguese.










expectations section, it is the position of this paper that the markets are persistently slow

to adapt to the evolving insertion of the Brazilian economy into the global marketplace.

This basic idea is supported further by the decomposition of what are called "the

cousin risks," the country risk and the currency risk, so-called because of their highly

cointegrated nature (Garcia and Didier, 2001). This work has shown that one of the

components of Brazil risk, that of convertibility risk, was very important through the time

of the international financial crisis of the late-1990s but no longer has statistical

significance. In fact, this decomposition has shown than in the post-inflation targeting

period, the currency risk can be estimated at above 5% per year, while the explicit Brazil

risk is less than 3% (Garcia and Dider, 2001, p. 32).10 The irrationality hypothesis, then,

is supported in light of the 18-month rally of the Real vis-a-vis the dollar though

December 2005, along with the strongly export-driven current account surplus,

juxtaposed with the persistence of high real interest rates. If the market had foreseen this

performance, interest rates would have dropped significantly, but they didn't.

Another persistent aspect of the Brazilian economy which contributes to high

interest rates is the so-called jurisdictional uncertainty. No long-term market for credit

exists in the country, and the only long-term credit available outside of the country is that

which is denominated in dollars. Arida et. al. (2005) argue that this inability has

produced an important new risk element in the country, that of uncertainty over the

adjudication of contracts, as well as enhanced currency risk in light of the dollarization of

financial liabilities. The authors argue that a policy aimed at correcting this uncertainty

would lower interest rates through an increase in convertibility (or liquidity) of the


'O Admittedly, this estimate came before the explosion in the country risk premium associated with the
Lula election, but as levels have returned to "normal" since that time, the author feels the statement is still
valid.









currency, as well as a reduction in the effort costs of the Central Bank to artificially

lengthen the maturity of that portion of the national debt that is denominated in local

currency. The perception of the riskiness of Brazil's currency and the inability of agents

to enter into long-term financial contracts in their home jurisdiction adds to the interest

rate dilemma, then, by increasing demand for short-term credit and making the future

even less easy to predict.

Existence and Causes of High Interest Rates

In short, interest rates are high in Brazil because of perceptions and expectations.

Inflationary expectations are the maj or driver of interest rates, and Brazil's volatile past

with respect to inflation rates have left a permanent scar on economic agents' ability to

foresee the future. Furthermore, it may be in light of this inability that monetary policy has

been excessively punitive, in order to curb inflation in a worse-case scenario sense (i.e.

when realized inflation is even greater than the prevailing expectation). Real interest rates

are also high. When compared to other countries that have similar macroeconomic

fundamentals and problems and have weathered, (or even caused) some of the shocks that

flustered the Brazilian economy, the prevailing interest rate in Brazil is persistently higher.

The economy's debt position, including its level, its indexation to the dollar, and its

growth, all contribute to the inherent risk of lending in the country. A net importing

position has also added to those external financing requirements, further altering

perceptions of the sustainability of the economic model the country is pursuing and raising

the cost of capital. It is the assessment of markets that necessitate these high interest rates

and no sudden change in the rate would be accepted instead it would cause capital flight

and currency depreciation, as the country would be deemed even more risky. But

expectations take time to evolve. The conclusion of this paper will examine the most






55


recent Brazilian economic data and argue that a fundamental change has occurred, one that

is still awaiting the approbation of the international financial community.















CHAPTER 4
O JEITO JURIDICO BRASILEIRO: COPING WITH THE PROBLEMS RESULTING
FROM HIGHLY ELEVATED INTEREST RATES

Interest rates have been extremely high in Brazil even given the highly

unpredictable economic environment and to attempt to control inflation, which has

rocked the country's stability since the late 1950s. As argued by da Cunha and Ferreira

(2004), the cost to individuals of this punitive monetary policy is equally extremely

detrimental to individuals who do not have access to long-term credit. These same costs

are experienced by firms, which must forecast their performance (and that of the overall

macroeconomy) when deciding their optimal capital structure and in making financing

decisions. The consistently high interest rates (from which ex post real rates are difficult

to accurately forecast) implies a business environment that inhibits balanced growth.

However, during that time Brazil has had impressive periods of growth and has seen

industrialization and wealth creation for many of its citizens. The mechanisms that have

allowed this growth to occur despite cripplingly high real interest rates are the subj ect of

this chapter. First this paper will examine the peculiarities ofBrazilian finance at the

firm level, later turning to peculiarities more personal in nature.

Firm-Level Financing Decisions

The large overhang of government debt (a true hang-over from times of large

budget deficits) has a deleterious impact on Brazilian firms. Government issuance of

debt needs to be purchased by investors: this pushes out the demand curve for capital

and, in doing so, increases the equilibrium interest rate in the economy (as discussed in










the previous chapter). The result is known as "crowding out," in which government debt,

by definition less risky than debt of Brazilian national firms without access to

international funding, takes available, investable savings "out of the system." The result

is a credit crunch for Brazilian firms, that is to say a scarcity of capital and the de facto

imposition of capital constraints for firms. These capital constraints have been verified

empirically by many scholars, most recently Bonomo et al.(2003) and Terra (2003). Both

papers examine sales accelerator investment models of investment. In this model, if all

the factors that influence investment are accounted for, cash flow should not affect

investment decisions. Stylistically, if a firm has no credit constraints and subsequently a

proj ect exhibits an expected return above the marginal cost of capital, it should be

pursued regardless of the firm's cash flow position at that time. However, if the cash

flow variable explains some part of investment decisions, then there is evidence that the

firm faces a credit constraint and can only make those decisions in economic "good

times" of high cash flow. In both papers, significant levels of credit constraint are shown

for all Brazilian firms.

Terra (2003) bifurcates the analysis by using panel data and aggregating the

regression results by firm type and also by the level of dependency each firm shows with

respect to external financing. The tested hypothesis is that firms that are more

international in nature will exhibit less credit constraint. A second hypothesis is that

firms that are more dependent on external finance will invest more when capital inflows

are high (and consequently firms' access to credit is less constrained). A perhaps obvious

result follows: firms that are multinational and/or larger in nature show less credit









constraint than more domestic/smaller firms, particularly in periods of high capital in-

flows.

The implication of this result is made obvious when comparing the composition of

private, corporate sector debt: firms that are large and multinational comprise more than

half of private sector debt and that share increases in times of rising or elevated inflation

(Tullio and Ronci, 1996). Large firms, generally less risky, are more able to handle the

disclosure costs of debt finance, and can marginally raise debt finance at less of an impact

to the cost of equity.' Moreover, these firms can more easily tap international debt

markets, sometimes borrowing at rates that are preferential to those that the government

receives (more of this below).

Impacts on Large Firms

Size is also an interesting component to the equity financing of these firms:2 in the

post-Real Plan era, over 70 Brazilian firms have directly listed their stocks on the New

York Stock Exchange through the American Depository Receipt program, or ADRs

(State Department, 2005). ADRs allow the firms to sell their equity on U.S. markets in

shares that are denominated in dollars, both improving liquidity and removing investor-

level uncertainty over foreign exchange effects. This cross-listing has made their stocks

more liquid and has forced upon them US GAAP reporting standards, both measures

presumably serving to lower the cost of capital of these firms by increasing the

desirability of their equity issues. This increase in ADRs coincides with the opposite

phenomenon in the Sho Paulo stock exchange, the BOVESPA, as the number of firms


SConsider a firm with R$ 1 million in equity and a firm with R$ 100 million in equity. A R$1 million debt
issuance makes the equity in the first case much more risky, all else equal.

2 This is, of course, inextricably linked to the interest rates through the CAPM relationship.









listed on the BOVESPA fell 15% from 2001 to 2003 (BOVESPA data). In bypassing the

Brazilian equity markets and raising money abroad, this subset of Brazilian corporations

hopes to be able to raise money at rates that are effectively lower than the risk-free rate in

Brazil. Raising this money in foreign markets should lower the aversion of the typical

international investor, as ADRs are, by their very nature, free of foreign exchange rate

risk. This hope has not materialized, however. The cost of capital for firms that list as

ADRs does not materially differ from those that only list in Sho Paulo (Hail and Luez,

2005), 20.0% vs. 21.4%. However, this result does not hold across companies from all

countries (the panel is of over 30 countries), but is largely consistent for all countries in

Latin America.3 This result implies, then, that the cost of increasing a firm's dollar based

equity (though revenues are principally in reais) is not always justified by a lower cost of

capital. However, these firms do exhibit common characteristics which explain their

propensity to cross-list on the NYSE. De Medeiros and Tiberio (2005) employ a logit

model which proves that the propensity to cross-list is governed by some important

principles. Firms that are larger, as noted, tend to cross list, as do firms that are highly

active issues on the BOVESPA. Firms with a high market-to-book ratio also experience

an increased propensity to cross-list, perhaps because the benefit to doing so is greater

(because their stocks are worth more). Also, firms with better corporate governance

standards exhibit greater probabilities of being cross-listed. All of these relationships are

as expected, and may relieve some of the credit constraints of these firms, but do not

remove the fundamental result of Hail and Luez (2005), which is that these firms do not

enj oy significantly lower cost of capital, despite their ability to raise equity abroad.

SIndeed, WACC estimates for Brazil vary by more than the other Latin America nations, which exhibit the
same similarities in sample means (Hail and Luez, 2004).










Indeed, something systematic (and, as noted, outside of currency considerations) is

raising the cost of capital for these firms; they seem to suffer greatly from the same Brazil

risk that haunts the government' s key interest rates.

These ADRs are just one piece of a complex financing strategy that helps large

firms try to evade the problems associated with costs of constrained capital. Firms often

employ multi-tiered Einancing strategies. In addition to listing both on the NYSE and the

BOVESPA, paper-marker Aracruz diversifies its debt structure across many interest rate

mechanisms and currency denominations (chart at right, below).4 The firm has interest

rates that are tied not only to the SELIC Figure 4.1 Aracruz's Debt Structure

rate (those contracts which are indexed to Foreign Currency Denomination and Interest
Rate Determination of Aracruz's Debt Structure

the Taxa de Juros de Lon~goPrazo, Brazil's Incal, TJLP_ Incal, Fixed
14% 0.1%
government-set long term interest rate), but
Foreign, Incal, Folvign
also to the LIBOR rate and to the LIBOR Ib currency
26% B basket
movements of a basket of currencies.
Foreign,
Fixed
Importantly for the firm as well is the fact \ ,

that it issues debt in both reais and dollars, .ore 05SCI ECA aa~s

creating a natural hedge for its dollar-denominated revenues.'

One impressive facet of this debt finance is the low interest rates associated with

the various trenches of the firm' s long term debt. The local currency denominated

trenches are financed mainly through bonds linked to the TJLP and the spread over the

TJLP that Aracruz pays implies yields on these bonds of less than 10%, markedly better


SThis section relies solely on the author's analysis of the firm's 2005 20-F Filing with the SEC, available
on-line from the SEC EDGAR database.

SIn 2005 the firm reported that 98% of its revenues were denominated in dollars (company form 20-F).









than the overnight Selic rate discussed above. Even more impressive, though, is that the

yield on the foreign currency denominated bonds is less than 6%, similar to average risk

North American firms. How does Aracruz borrow at rates preferential to those of the

Brazilian national government? One answer to this question is that a large portion of

these loans come from the National Economic and Social Development Bank (the

BNDES) and is effectively subsidized: the Brazilian government lends the money at rates

that are below its own cost of capital. This subsidy is somewhat recovered by the Bank

through the large equity stake that the BNDES holds in Aracruz. The firm also benefits

from below market-rate debt financing from the World Bank and the International

Finance Corporation, both at rates below 6%. Thirdly, the scope and dominance of

Aracruz in its sector may imply that indeed its operations justify a smaller risk premium

than that assessed to the national government.

Aracruz is not alone with respect to Brazilian firms that seek to lower their cost of

capital through international debt issuance and other financing activities. An analysis of

other Brazilian mega-firms will reveal similar patterns: financing subsidized by the

BNDES (who is often a large equity holder in the firms), ADRs that serve to increase

equity liquidity, and loans from multi-lateral financial institutions that offer loans at

highly preferential rates. State oil firm Petrobras issues long term debt at much better

rates than the federal government, with coupon rates on its bond ranging from 3.7 9.7%6

In the notes to its financial statements, the firm remarks that its long term borrowings

"consist primarily of the issuance of securities in the international markets, debentures in

the domestic capital markets, financing from the BNDES, and ...facilities guaranteed by

6 As of this writing, the bonds were trading at values immaterially different from their book values, so this
comparison is valid.










other multilateral agencies" (Petrobras Form 20-F, 2005, p. 105). It adds that short term

credit is "derived mainly from commercial banks including trade lines of credit and

commercial paper," and that interest rates on its short term instruments range from 2.86-

6.01% (Ibid., p. F-20). This firm, then, shows no capital constraint and can easily tap

into international markets, perhaps even more easily than the Brazilian government itself.

The interest rates that it pays are comparatively low (though the reader should be

reminded that they are essentially free of foreign exchange risk, since they are

denominated in dollars).

These two mega-firms can effectively bypass the problems associated with high

domestic interest rates by raising capital internationally (though the question remains to

be answered with respect to the overall cost of capital, implying highly irregular equity

risk premiums this question is beyond the scope of this work, though).' The cases of

Aracruz and Petrobras are not unique, however. An examination of any of the Brazilian

megafirms will reveal similar characteristics (low interest rates, liability dollarization)

and perplexities (why does the government subsidize so much of these firms' capital?).

Impacts on Smaller Firms

A more interesting question, however, is the manner in which firms that are

smaller can raise capital for their operations. Terra (2003) and others have shown that

firms that do not fall into this category show significant credit constraint and oftentimes

cannot undertake profitable proj ects because of the scarcity of capital. Yet these firms





SThe cost of capital for a firm is determined by: we"ke + Wd*kd Or the sum of the products of the portions of
capital and equity in the firm' s capital structure with their respective after-tax costs. This analysis is
mainly concerned with the term kd, while the observation made here refers to a high cost of equity, ke










continue to exist and, in many cases, to grow. What is the source of their financial

constraint, and how do they finance themselves in order to grow?

In 2003 the World Bank and the International Finance Corporation charted the

World Business Environment Survey. Its mission is to assess the business environment

of member nations with respect to opportunities and limitations for growth, government

intervention, corr-uption, financing decisions, and expectations for the future. The dataset

is rich, striating firms across countries and by size.8 The table on the next page was

generated from this survey and speaks to two important questions: what is the source of

financial constraint and how are firms financed? It reveals differences across firms' sizes

that may, by now, seem obvious to the reader. A striking difference is the problems

posed by high interest rates. 90% of small firms identify interest rates as a problem,

while only 73% of large firms do so (which admittedly is still a high proportion). This

difference does not even fully capture the impact of these rates, however, since a firm of

500 employees counts equally as a "large" firm as does a firm of 15,000 employees.

Within the large firms there is a negative correlation between the value of a firm's fixed

assets (as a proxy for size within the group) and the extent to which high interest rates are

an inhibitor.

Interestingly enough, high interest rates are not the only variable for which there is

a significantly different effect across firm size. For small firms, paperwork related to

financing is a problem for over 55% of firms, while only 30% of large firms feel this

constraint. This may, in turn, be related to the higher reported lack of non-bank equity,

foreign bank lending, and export and lease financing available to smaller firms. If a

SThis dimension is a categorical variable: "small" is 1-49 employees, "medium" is 50-499 employees,
while "large" is 500 or more employees.






















# of Interest Special Foreign Non-Bank Export Lease
Firms Collateral Paperwork Rates Connections Monev Banks Equitv Finance Finance Credit
Small 30 43.3% 56.7% 90.0%1 26.7% 16.7% 10.0% 23.3% 10.0%1 6.7% 10.0%
Medium 141 44.0% 41.8% 83.7%1 27.0% 9.2% 9.2% 14.9% 9.2%1 3.5% 10.6%
Large 30 43.3% 30.0% 73.3%1 30.0% 13.3% 6.7% 10.0% 6.7%1 3.3% 10.0%


Table 4. 1 Source of Financing Constraints and Firm Capital
Financial Constraints Imposed by (a lack of):


Source of Firm Capital


# of Retained Foreign Family Money Supplier Public
Firms Earnings Eqiy Local Bank Deveomn Bank Banks Members Lenders Credit (A/P) Leasing Sector Other
Small 25 58.4% 0.0% 11.6% 0.0% 0.4% 14.4% 4.0% 6.2%/ 1.0% 0.0% 4.0%
Medium 123 38.1% 6.8% 23.0% 2.1% 3.5% 3.9% 0.3% 12.2%1 6.1% 2.1%1 1.9% o
Large 24 37.9% 4.3% 21.8% 1.3% 14.0% 0.8% 0.0% 7.2%1 8.3% 2.1%1 2.4%
Note: Not all firms answered questions regardmg the source of firm capital

Source: Author's Calculations from World Business Environment Survey, from the World Bank










copious amount of compliance and disclosure is required, in addition to the bureaucratic

costs for loan processing, it is easy to understand why smaller firms are not more

externally financed. The same is true of subsidized credit from the BNDES, which would

be included here as non-bank equity or as credit, depending on the arrangement. The

lesson, then, would be to reduce the bureaucracy as much as possible in order to open up

these preferential sources of capital to smaller and more medium sized firms. It is these

smaller firms that truly need capital, but if the costs are too high and only a large firm can

bear them (due to economies of scale), development initiatives are thwarted and credit is

not optimally distributed. The survey also illuminates some differences in the source of

firm capital, all of which naturally follow from the implications of the sources of

financial constraint. A notable gap is in the financing which occurs through retained

earnings. This internal financing implies a firm can only grow once it "gets going,"

financing projects through profits. Nearly 60% of the capital of small firms is generated

through retained earnings, while only 37.9% of the capital of large firms comes from this

internal source. Local banks are also notably less important to small firms, accounting

for twice as much of the capital of larger firms. There is a reversal between the

categories of foreign banks and family members, with the former disproportionately

financing large firms, and the latter being important nearly exclusively in the case of

small firms.

This capital structure has important implications. In the case of large firms, they

can expand through external financing, even when they are not growing organically.

This option is not as available to smaller firms, who must wait for positive cash flows

(and net income) to finance themselves through profits. Financing through family









members is an option, but it comes with an important theoretical concern: markets are not

allocating these resources to the firms, rather it is familial allegiance that act as

guarantors of the borrowed assets. While this is arrangement commonly provides capital

to firms, there is no mechanism to filter out bad investment ideas: presumably the funds

are granted in a less stringent fashion than, say, a loan officer or private equity investor

would undertake. A more competitive marketplace for smaller firms to bid for capital,

then, would lower the cost of that capital for profitable proj ects and assess (and account

for) the risk implicit in other, not as lucrative, endeavors. With more Einancing available

in a competitive marketplace, entrepreneurs without the access to the "special

connections" that makes Einancing easier for some will also be able to finance their ideas.

Access to capital is one of the most important facets of successful new business

development and a more market-oriented allocation would help Brazil to more efficiently

allocate its relatively scarce capital. It is in this direction that the evolution of capital

markets in Brazil should move.

Implications of Interest Rates for Individuals

If small firms are ill-prepared to pay high interest rates to finance their endeavors,

individuals are even more poorly equipped to bear the cost of financing. The lack of long

term markets denominated in reais discussed by Arida et. al. (2005) not only affects the

level of interest rates through the jurisdictional uncertainty argument, but also affects the

day-to-day financing decisions of Brazilian individuals. The implication is that finance is

not available for things that citizens of other countries take for granted: mortgages have

not achieved the penetration of economies with lower interest rates, automobiles and

other consumer durables are largely purchased "d ,irisia" (or for cash), and purchases on










crediario, or in stores financed in "atd 6x sem juros," or in equally divided monthly

installments (usually up to six months) to credit cards without any difference in the

purchase price. All of these alternatives to traditional credit have evolved to fi11 a gap

created by the unattractive nature of typical interest-laden installment contracts.

Mortgage Finance

In the case of mortgage Einance, there are two systems which have evolved to help

allocate capital to potential homeowners. An official government entity known as the

Sistema Financeira da Habitagdo, the Housing Finance System or SFH, is the main

system in the mortgage market. This system sets strict limits on the value of houses

available for Einance, and on the value and conditions of the loans. The Einancing for this

system comes largely from the Fundo de Garantia, a compulsory savings account akin to

Social Security in the United States. The original idea for this system was to offer below-

market level interest rates for housing Einance for lower income Brazilians. The reality,

as documented by Fagnani (1996), is that a regressive allocation of housing Einance

resulted, with upper-middle class and upper class Brazilians receiving most of the

sub sidies.

The fund also experienced cash-flow cyclicalities: with contributions for fresh

capital stemming from the worker' s fund and performance of loans linked to the

unemployment rate, during the volatile periods of the 1980s and 1990s the fund was not

able to provide necessary Einancing for homes (Borba, 2004). Because capital in the

system became more scarce, interest rates remained high, despite an explicit government

guarantee of the fund, and are now set at the reference rate plus twelve percent, which

STo the best knowledge of the author, this arrangement does not exist in the English-speaking world;
accordingly, the Portuguese word will be used throughout the text when discussing this form of borrowing.









currently amounts to over thirty percent annually (Pinheiro and Cabral, 1999, and current

BNDES data).

The j oint effects of the cronyism with which funds were distributed and the cyclical

nature of fund availability has left an unmet demand equivalent to 15% of the existing

housing capacity, 84% of which comes from families which earn less than three

minimum salaries a month and 81% of which consists of urban households, who seek

funding to no avail (Borba, 2004). In short, the reality of this system has been to crowd

out and/or raise the cost of home financing even more for that segment of society least

able to bear its costs.

The second system, known as the Calrteira Hipotecdria, or Mortgage Portfolio,

allows Brazilian banks to set the conditions of loans. The costs are even higher for these

mortgages, as they are funded through popular savings accounts in the commercial banks

that issue them and mortgage rates have historically averaged 14 to 16 percent above the

reference rate, with the difference in rates between the Carteira Hipotecdria and the SFH

stemming from typical commercial banking spreads and the absence of the effective

government subsidy in the administration of the loans (Pinheiro and Cabral, 1999). The

problems with the Carteira Hipotecdria are even more pronounced with respect to

availability, as one must first have an account with a bank to receive a mortgage. In

Brazil commercial banking penetration is below 50% and more than 1/3rd of individuals

who would like a bank account do not have one (World Bank, 2003).

In response to these difficulties, the state of Sho Paulo has initiated its own

program. Financed through a 1% supplementary tax, the Sao Paulo Housing and Urban

Development Corporation has a statutory obligation to provide housing programs and









Einance to families that earn between one and three minimum salaries per month, with

preference to those earning three or fewer. In the years following the implementation of

the policy, new production of houses in Sho Paulo state approached 300,000 units, with

75% of that production benefiting the lowest tier of income earners (Borba, 2004). This

subsidized finance was subj ect to manipulation however, driving applicants to report

lower household incomes in order to receive more subsidies (Borba, 2004). While the

government is actively seeking to correct these distortions at the time of this writing,

programs such as this should be replicated and improved upon in the rest of Brazil to

mitigate the effects of high interest rates on the housing sector.

Everyday Financing for Individuals

In addition to the impact seen in mortgage Einance, high interest rates and credit

inaccessibility have impacts on the more day-to-day Einancing activities of individuals.

To better understand these effects, the BNDES charted a survey in late 2001 in the cities

of Sho Paulo and Recife to capture the demand for financing instruments and the methods

people in the lower classes use to satisfy those demands (Brusky and Fortuna, 2002).

This section leans heavily on their work, and extends it by looking at more recent data

sources. They find that the credit most used by individuals can be categorized along the

lines of formal, semi-formal, and informal, with a second difference existing between

monetary credit and "parceled" credit, or credit that is extended for the explicit purchase

of an asset.

The most formal credit offerings include loans from banks, personal lines of bank

credit, cash advances on credit cards, and loans from microfinance organizations (in the

case of monetary credit), and credit card, post-dated checks, and crediario (equally

spaced charges to a credit card for a fraction of the purchase price) in stores. These










formal lines of credit are governed (as one would expect) by the rules of the Brazilian

Einancing system, and to some extent, by the same rules as corporate lending. Individuals

must be registered with the federal government, show proof of residency, show proof of

income in the formal sector, and have good credit standing (as measured by the credit

protection services SPC and Usecheque) ibidd., p. 17). Loans from this formal

mechanism vary in duration from 1 to 36 months, with interest rates varying between 0

and 1 1.5% per month. Because of their more stringent conditions, and high interest rates,

this method of Einancing is the least used by the lower classes of society.2

The semi-formal sector is much more utilized, especially in the case of parceled

credit. Very few documents are required, and a clean credit history is not required, as the

credit agencies are rarely consulted. What is much more important in this type of

arrangement is the personal relationship between lender and borrower, with the types of

instruments including loans from employers, a~diota~s (or loan sharks), loans from

employee funds, supplier credit (in the case of small firms), and also crediario in

lojinhas, or company stores. The terms are generally shorter (one to four months in

duration), with interest rates running from 0 to 45% per month. While the rates are at

times higher, this form of credit is more utilized because of the less stringent conditions

under which it is granted.

The most commonly used method of Einancing for the masses is that of informal

credit, as classified by Brusky and Fortuna. These instruments include loans from

parents and friends, as well as take-now, pay-later schemes (fiado, or on faith, in



2 An important exception is the case of crediairio, which the authors note is "so important that even those
who do not meet the conditions of use still manage to utilize it, often purchasing products in the names of
the friends or parents." (My translation, ibid., p. 21).









Portuguese), the use of the credidrio of others, and the use of sorteio, or group savings

plans in which members pool their funds for a determined amount of time, then take turns

spending the accumulated funds. A reader less familiar with the Brazilian economy may

ask why these funds are administered by groups, instead of being deposited in personal

savings accounts that can be managed by each of the individuals. The reason is that these

funds exist predominantly in the subsection of society that cannot legally have accounts

at financial institutions. The terms of all of these arrangements are favorable, with

interest rates between 0 and 5% per month, for one month, and no required

documentation. The downside is that the limits of borrowing are generally lower, with

notional amounts rarely exceeding R$200. Despite these small amounts, it is much more

common for individuals to borrow in this form than in more formalized mechanisms.

Despite the high level of interest rates in Brazil, the Brazilian economy has largely

overcome the crippling nature of high interest rates with respect to the credit offerings.

There exist instruments to mitigate this effect and to spread its cost around the economy

(in the case of credidrio, for instance, the real value of the purchase is eroded by interest-

free installments). Pinheiro and Cabral (1999) identify three main institutions that allow

these irregular credit offerings to flourish: a well-developed informational infrastructure

(which essentially allows for the use of credidrio and post-dated checks), the presence of

public banks (which subsidize the cost of capital), and the use of group mechanisms to

ensure repayment (which lower risk of lending to unsecured individuals). These

mechanisms should continue to be utilized, as their existence will allow for even lower

levels of interest rates once the central bank begins to inj ect more monetary stimulus into

the economy. And until interest rates do decline, it should be the priority of all parties to










ensure that these mechanisms only become stronger to ensure some form of credit is

available to those excluded from the formal sector.

The Disparate Effects of High Interest Rates

Brazil's high interest rates have effects on all segments of society and on all sectors

of the economy. Multinational firms must be much more creative in their Einancing

decisions in order to lower their cost of debt, issuing securities in multiple currencies.

These liabilities create a mismatch in revenues and expenses (unless natural hedges exist)

that must either be insured or factored in to the cost of debt. Because of their scope and

size, however, these firms are best equipped to deal with the challenges of prohibitive

domestic credit markets.

Small firms do not enj oy the same fortune. Oftentimes their lending is constrained,

and expansions are limited to those which can be undertaken out of the firm's retained

earnings or from additional paid-in capital from principal investors (most notably family

members). Access to foreign banks is limited for this group, and family members and

other allegiance-based arrangements oftentimes fill the Einancing gap in a less-than-

efficient fashion.

High interest rates also have a strong impact on individuals. The mortgage

market is largely unfinanced (due to the risk-laden nature of fixed-rate, long-term

contracts) and undesirable (mortgages exceeding 25% annually need incredible land

appreciation rates to be justifiable!). Even the purchases of domestic appliances and

clothing are affected by these high interest rates, which (through the reference rate of the

economy) affect the APRs on credit cards and other consumer debt instruments. Due to

this otherwise activity-stopping effect, the economy has evolved with respect to

consumers. Certain debt instruments rely on family or personal allegiance to lower the










perceived risk for the creditor, while other arrangements use group collateral or savings

plans to spread the risk across individuals. Out of the necessity to sell their merchandise,

department stores also become financing organizations, selling merchandise on crediciio,

allowing consumers to pay in installments, while transferring possession to (though not

title of) the merchandise on the day of the sale. The burgeoning nature of these

arrangements should be supported and will help to foster an even more diverse financing

environment once interest rates move to more tolerable levels.3

The Brazilian economy has learned to cope with the reality of high interest rates.

Without a doubt, however, these rates still have significantly negative effects on the

economy. It is a testament to the spirit of the Brazilian people that economic growth has

occurred in spite of the high cost of capital. One can only imagine what the ingenious

Brazilian spirit could do in a more fertile economic environment.

























3 Some of these instruments will likely disappear, as well, as there will be little or no need for certain of
these instruments at lower levels of interest.















CHAPTER 5
CONCLUSIONS, RECENT OB SERVATIONS, AND FINAL REMARKS

This paper has shown that Brazil's economic history and structure have historically

demanded the persistence of high nominal and real interest rates. Those rates have

principally been necessary to combat inflation, though in periods of fiscal expansion they

have, at times, fallen pro-cyclically, with expansions in the money supply merely

accommodating the aggressive fiscal stance of government. The economy has been

rocked by maj or shocks, not the least of which were the oil crises of the 1970s and 80s

and, more recently, turmoil in emerging markets that all threatened contagion. These

shocks have propagated through the real sector of the economy, as well as adding

inflationary pressures.

The political economy has been a veritable laboratory for economic theory and

practice. Incredible attempts at expansion and development led to overheating because of

lack of external Einancing. The internal Einancing necessitated by this otherwise

unfinanced policy resulted in hyper-inflation that was combated both with orthodox

(austerity) and heterodox (manipulative) measures. Various attempts at stabilization

failed by not addressing the most endemic problems of the economy, which could all be

traced to theoretically apparent relationships: budget deficits, lack of regime credibility,

self-fulfilling expectations and inflationary inertia. The plan under which the economy

operates at the time of this writing has succeeded in stabilizing the economy in the last

eleven years, bringing low-inflation growth, coupled with productivity advancements.









A review of the causes of high interest rates

Interest rates have not fallen from their historical levels. This paper has shown that

the rates, whether measured in nominal or real terms, exhibit stickiness with respect to

economic fundamentals and when measured vis-a-vis other economies with similar

economic histories. In fact, countries whose crises have influenced the level of interest

rates in Brazil seem to recover to neutral policy rates following those crises more quickly

than does Brazil (which is only affected through contagion). When measured in nominal

terms, they highly reflect the public' s expectations of future inflation. Those

expectations have historically been overly optimistic, though recently there is evidence

that they are more centered on inflation's true, ex-post realized values. These

expectations are driven by past inflation (the inflationary inertia effect) and by other

observable economic phenomena. More recently, however, they have been dominantly

determined by government policies such as the fiscal stance, the announced inflation

target, and the government's inter-bank reference rate, a taxa Selic. This suggests that

the factors determining inflation are well within the government' s control, which in turn

suggests that the level of nominal interest rates could be lowered following the proper

macroeconomic recipe at the very least by lowering the public's expectation of inflation.

Several factors influence the real interest rate as well. Some have argued that

monetary policy needs to be highly contractionary in order to quell inflation. These

theorists point to an equilibrium, non-accelerating inflation rate of interest of nearly 18%.

These statements are derived from an ex-post analysis of the data, and do not give us any

insights into why interest rates have to be so high in the first place. Along the same lines,

some have argued that the weak constitutional independence of the Brazilian Central

Bank requires that interest rates be maintained at levels higher that those which would be









otherwise required, in order to send clear signals to the market of the Bank' s commitment

to the often politically unpopular Eight against inflation. This effect has been quantified

both on its influence on interest rates and indirectly on its influence on inflation. Brasilia

would be wise, then, to grant the bank constitutional independence, giving governors and

the President of the Bank irrevocable terms of service that do not coincide with the

political cycle.

More analysts of this question have pointed to the fiscal stance of government and

the debt dynamics of the nation when seeking to explain high interest rates. Because

public indebtedness is high, a high default probability is assessed, pushing up the

endemic country risk. Furthermore, as a large portion of that debt is denominated in

dollars, and the real has not been stable, the implied revenue/liability mismatch further

adds to perceived risk. There is no doubt that the level of government debt is high in the

country, and the government should continue to maintain primary surpluses in order to

pay down that debt.

The insertion of the Brazilian economy into the global economic scene has long

been cited as a cause of high interest rates. Maintaining a current account deficit puts

significant downward pressure on the exchange rate, endangering price stability through

exchange rate pass-through and adding to the equilibrium level of external Einancing

requirements of the economy. The low-liquidity of Brazilian currency internationally has

also been cited historically as a cause of high interest rates, but work using more recent

data has rej ected that assertion.

Finally, there is significant evidence from Brazil and other emerging economies

that there is an "original sin" from issuing government debt denominated in dollars.











Once that dollar debt is available, aversion to local currency issuance lowers the liquidity


of the existing debt, and raises the market-clearing interest rate for that debt as well. In


the Brazilian case, it is argued that this effect has been so strong as to eliminate the


possibility of long-term, local currency-denominated debt. Existing debt, moreover, is

deemed so unattractive as to raise the risk associated with adjudication and valuation, a


risk known in the literature as jurisdictional uncertainty. In Brazil, the institutions that


would eliminate that adjudication risk are weak and should be strengthened in order to set


the stage for a robust local, long-term market for credit.


All of the relevant determinants of interest rates are brought together in the


flowchart at right. The model is an Figure 5.1 Flowchart of Interest Rate Determinants


extremely interconnected one, and
Lack of Regime Lack of Central Ifainr
Credibility / Bank
steps to delink these causal Regime Incipience Independence Mmr

mechanisms will take time. Public
Perceptions of
Inflation / Fiscal
Building regime credibility, for Policy
International
Reserves
instance, will only lead to lower
Pass- I Inflation 0
interest rates once the public factorS ~, hrough
Exchange
.Rate
that credibility into its expectations,

Inflation Aggregate
and once those new expectations Target /' IDemand
Capital Flows
lead to lower inflation, which will

in allow the Central Bank to lower
Interest Rate

interest rates.










The Show Must Go On: Evolutions of Very "Brazilian" Credit Mechanisms

The marketplace has evolved in Brazil to mitigate the effects of these high interest

rates. Large firms effectively bypass the problem by raising money abroad. Those with

access to these loans often times make acquisitions abroad just to diversify their asset

base and to be able collateralize new obligations in dollars. These same firms often

qualify for sub-market rate loans from development banks and organizations, most

notably the Brazilian state-run national development bank, the BNDES. These

mechanisms allow these firms to lower their cost of debt and continue to finance their

activities.

Smaller firms are somewhat more constrained. Expansion in these firms is

somewhat limited by profitable activities; investment activities in these firms are

disproportionately financed from retained earnings. Furthermore, relationship finance

(family members, friends, etc) is extremely important to these firms. The implication of

this finance is clear, however: there is no market mechanism or due diligence to filter out

bad investment ideas and the resulting allocation of credit is often times highly

inefficient.

For individuals, access to credit is varied. Bank penetration is low, and is often

times limited to those individuals in the formal sector of the economy. Mortgage credit is

often subsidized but ironically limited to the wealthy, or those with special connections

because of the bureaucratic nature in which the credit is issued. There is evidence,

however, that this is improving, as mortgage funding increased 55% in 2005 from the

previous year, though still not enough to cover the housing deficit (PREI, 2006).

Lending has increased an average of 40% annually since 2003, when the Central Bank

began to put the pressure on commercial banks to provide funding (Inter-American









Dialogue, February 2006). This growth cannot continue ad infinitum, however,

especially if interest rates do not fall further.

Smaller financing decisions by individuals are also affected by these interest rates.

Low bank penetration has obviated the use of extensive use of credit cards, though those

that have bank accounts often times finance through post-dated checks, credit cards, and

lines of credit. Those that do not make use of store finance options, use collective

arrangements, or use the credit of family and friends. While all of these options have

enabled the economy to continue to function, lower interest rates coupled with increased

personal banking would allow the economy to perform much more efficiently and would

lead to more equality of economic opportunity.

Epilogue: Recent Data and Trendsl

In the most recent economic data, there is reason to believe that the forces are in

play to enable a measured lowering of the key interest rate in Brazil. Inflation has been

low, well within the range of the Central Bank' s targets since early 2004, with consensus

estimates for inflation in 2006 in the mid-point of the Bank' s range. Year-over-year real

GDP growth continues to be strong, with the most recent reading of 3.1% in third quarter

of 2005 almost 75% driven by internal demand. Unemployment was categorically lower

in all of 2005 than in the previous four years, with the December reading of 8.3% the

lowest Brazil has seen in that entire period; formal job creation exceeded 1.5 million in

the 12-months to December 2005, while an expansion of investment created expanded

industrial output without inflation-building pressures on capacity, which saw utilization

of 81% in the most recent data. The announced targets for inflation are 4.5 for the next

SThis section presents data that is public and widely available, most readily from the website of the
Brazilian Central Bank (www.bcb.gov.br).










two years, and the Bank seems to have achieved credibility, as consensus IPCA data is

for inflation of 4.7 and 4.5% in 2006 and 2007, respectively; expectations have exhibited

a nearly monotonic decline since 2004 and are now approaching levels of more advanced

economies. The strengthening in the real has continued, with an additional 10%

appreciation since the beginning of 2006. This has not affected the exportability of the

Brazilian economy, however, as export prices have nearly doubled since the beginning of

2003 and export growth has accelerated markedly, creating a current account surplus for

the first time in recent history in 2003; that surplus has been sustained since 2003 and hit

a record of 45.4 billion dollars in 2005.

Public debt management is also improving. 2005 saw a primary surplus of 4.8% of

GDP, and the average for this surplus was 4.5% in the period 2004-2006. The debt/GDP

ratio closed the year at 51.6%, down from a ten-year high of over 60% in 2002. Market

expectations are for a further improvement, with forecasts of around 45% by 2009. The

portion of the debt that is linked to foreign currencies is declining, and is quickly

approaching zero: reductions of 9.4, 25.7, and 25.3 billion dollars in the most recent three

years have brought the level of foreign currency denominated debt to less than 5%, down

from over 40% in 2002. This has not entirely taken place through the retirement of the

debt, as part of this reduction has been achieved through the roll-over of that debt into

local-currency denominated bonds, the first one being issued in September of 2004. This

is a significant achievement for Brazil, which previously suffered from the "original sin"

of dollar-denominated debt (Hausman et al., 2003). This change has greatly improved

Brazil's resilience to exchange rate shocks: the Central Bank now estimates that a 1%










change in the exchange rate would have less than a 5 basis point impact of the debt/GDP

ratio, down from a high of 35% in 2002 (Bevilaqua, 2006).

There is some evidence that interest rates have begin to fall. The market-measured

"Brazil risk" is now half of what it was in early 2004 and the real interest rate (as

measured by 360-day swaps) is near 11%, down from an average of 15.2% for the same

measure in 2000-2003. The January 2006 meeting of the monetary council lowered the

Selic rate from 18% to 17.25%, followed by another cut in March 2006 to 16.5%, with

indications that further rate cuts may follow. Time will tell if these rate cuts materialize

and make rates in the country more comparable to that of its peers. Brazil's commitment

to sound policies may be rewarded in the long-run, then, and may soon be a textbook

example of slow adjustment rather than one of irrational pessimism and undue

puni shment.

















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BIOGRAPHICAL SKETCH

Ed Johnson will graduate in May, 2006 from the University of Florida with a

Master of Business Administration, with concentrations in finance and competitive

strategy, and with a Master of Arts in Latin American studies, with a concentration in the

Latin American business environment. His passion is Latin America; he has made

several trips to the region and speaks Spanish and Portuguese. Before graduate school,

he was a research assistant for the Federal Reserve Board of Governors in Washington,

DC, working on macroeconomic forecasting and analysis for the Federal Open Market

Committee. While at Florida he has worked for ExxonMobil Corporation and Johnson

and Johnson, principally on inventory and supply chain initiatives. Upon graduation he

will join Deloitte Consulting' s Atlanta-based Strategy and Operations practice as a Senior

Strategy Consultant. He holds a B.A. in economics and Spanish from the College of

William and Mary in Williamsburg, VA. A native Virginian, Ed currently resides in

Gainesville, FL.