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Country Commercial Guides for FY 2000: Brazil Report prepared by U.S. Embassy Brasilia, released July 1999 Note*

CHAPTER II.   ECONOMIC TRENDS AND OUTLOOK

Major Trends and Outlook

World financial turmoil in the past 18 months interrupted the steady progress Brazil had been making in consolidating the stabilization program originally developed by President Fernando Henrique Cardoso when he was Finance Minister (May 1993 - April 1994). On July 1, 1994 a new currency, the "Real", was introduced whose value was initially pegged to the US dollar but which quickly appreciated against the greenback. Following the introduction of the new monetary unit and the dismantling of "indexation" mechanisms which had automatically transmitted price increases throughout the economy, domestic inflation fell abruptly. In 1998, consumer price inflation was under three percent.

However, in the absence of significant progress on needed fiscal reforms, price stability came with a steep price tag in terms of lower economic growth. In particular, Brazil's central bank had to keep real interest rates high to defend an overvalued currency, the so-called "exchange anchor" that was key to the anti-inflation fight, while at the same time attracting sufficient foreign capital to make up for dissaving by the public sector. From 5.9 percent in 1994, real GDP growth declined to 4.2 percent in 1995, 2.8 percent in 1996, and 3.5 percent in 1997. Due to the economic slowdown following the Asian Financial Crisis in late 1997, growth in 1998 was only 0.2 percent. Further economic turmoil followed the Emerging Markets Crisis after the Russian default and devaluation in August 1998 and the economy officially entered into a recession in the second half of the year. The current consensus forecast calls for a drop in real GDP of 1.0 percent in 1999 and a rebound in 2000 to nearly 4 percent growth.

The Brazilian economy is currently performing much better than expected at the beginning of the year as a loss of investor confidence forced the central bank to float the currency in mid-January. The most pessimistic forecasts were for a 6 percent contraction this year and for inflation in the 30 to 40 percent range. With a new managerial team in place at the central bank, the government raised the overnight rate to 45 percent per annum at the beginning of March and renegotiated a US$ 41.5 billion foreign assistance package that had originally been agreed upon in late 1998. At the same time, the congress completed work on major pending fiscal reforms by the end of January and the government won approval for an austere budget designed to meet its goals for a primary fiscal surplus equal to 3.1 percent of GDP in 1999.

As greater calm returned to the global capital market and investors reacted positively to progress on fiscal reform, confidence recovered quickly and by April Brazil was able to return to the international sovereign debt market after an absence of a year. News on the inflation front was also positive and a combination of weak demand, ability to engage in import substitution, and customer resistance to price increases, helped keep price increases down well below prior expectations. At midyear, the consensus forecast was for consumer price inflation no higher than eight percent for the year.

Trade performance has been disappointing, however, as export shipments failed to react quickly to the 30 to 40 percent depreciation of the currency in the first half of the year. In fact, most of the improvement to date has been due to a falling import bill and the surplus this year is not expected to exceed US$ 4 billion. Even so, this would represent a significant turnaround from the US$ 6 billion deficit the country registered last year. While some services accounts such as tourism are showing an improving trend, higher interest costs this year will keep the current account deficit around US$ 21 billion, itself a marked improvement over US$ 35 billion deficit in 1998. On the bright side, foreign direct investment inflows remain strong and the net figure may well equal the current account deficit for the current year.

At present, the principal worry is that Brazil will fail to implement fully already approved fiscal reforms and that its budgetary efforts will slacken. Should these fears materialize, the country will remain vulnerable to external shocks such as occurred in 1997 and 1998. However, the country has undertaken major economic reforms in the past four years in terms of market opening, improving the investment climate, and privatization of public enterprises. With a combination of improved competitiveness and fiscal control, the country could yet attain stable annual growth at the six percent level it requires to provide jobs for its young population.

Principal Growth Sectors

The Brazilian Statistical Institute (IBGE) has estimated that the economy grew 0.1 percent in 1998, down significantly from earlier expectations of two percent growth for the year. On a sectoral basis, agriculture grew 0.2 percent and industry contracted 0.9 percent. Within the industrial sector, mining output rose 9.2 percent while manufacturing contracted 3.3 percent. The services sector as a whole grew 0.7 percent. In the services sector, transportation and communications turned in the best performance with 6.9 and 6.3 percent growth, respectively. In contrast, commerce shrank by 3.4%. On a year-over-year basis, the economy contracted one percent in the first quarter of 1999. Although its weight in total product is relatively low, agricultural growth at 9.2 percent was the prime mover for the economy in the first part of 1999. At the same time, industry contracted by 4.6 percent and service sector output fell by 0.2%.

Government Role in the Economy

Under the development policies of previous Brazilian administrations, the government established a tradition of being the dominant force in shaping economic growth by means of planning and management. Its influence was felt not only directly through the day-to-day activities of government entities, but also through governmental wage, price, and credit policies, and subsidy and fiscal incentive programs. While the central government retains an important economic role, the policies of the Cardoso administration have aimed at reducing the government presence in economic activities and concentrating on its role in areas such as public health, safety, and education. The government is emphasizing creating greater economic opportunities for the private sector through privatization, deregulation, and removal of impediments to competition. Thus, the engine of Brazilian economic growth is more and more the private sector.

The petroleum and telecommunications sectors were constitutionally-mandated federal monopolies. In 1995, the Brazilian Congress approved constitutional amendments opening these sectors to private sector participation. In 1996, the Congress passed general implementing regulations to permit foreign investment in the power sector, and a "minimum telecommunications law" allowing private investment in some non-public communications services. Legislation has been approved ending the Petrobras petroleum monopoly and the state-run fixed telephone system was privatized in mid-1998. In addition, the 1995 concession law and subsequent legislation is creating further opportunities for the private sector in purchasing state-owned firms in the power generation and distribution sectors. For more extensive information from the Brazilian bank on privatization, please see the BNDES website www.bndes.gov.br

Balance of Payments Situation

Due to market opening, an overvalued exchange rate, and pent-up demand for capital and consumer goods, Brazil's trade position underwent a radical transformation under the Real Plan. The merchandise balance dropped sharply from a surplus of $10.5 billion as late as 1994 to a deficit of $3.1 billion in 1995, $5.5 billion in 1996, $8.4 billion in 1997, and US$ 6.3 billion in 1998. Despite earlier hopes that the devaluation would improve export competitiveness and help produce a substantial surplus in 1999, a number of factors have retarded progress from the Brazilian point of view. While a more realistic exchange rate acts as a stimulus to exports, countervailing factors in Brazil's case have included increased economic uncertainty, exchange rate volatility, scarcity of export credit, weak demand in key foreign markets, and the sheer amount of time it takes to merchandise and ship products. As a result, the country's trade balance still registered a deficit of US$ 500 million as of May 1999, smaller than the comparable figure for 1998 by some 55 percent but still disappointing to many. In fact, both exports (down 16.5 percent) and imports (down 20 percent) fell in the first four months of 1999, with the drop in the latter accounting for most of the improvement in Brazil's trade position so far this year. The consensus projection for the trade surplus in 1999 is currently US$ 4.5 billion but some analysts expect as small a surplus as US$ one billion in view of reviving domestic growth and thus demand.

Brazil ran a US$ eight billion balance of payments deficit in 1998 as a deteriorating capital account could not offset a growing current account deficit which ended the year at US$ 35 billion or 4.5 percent of GDP. For the first four months of 1999, the balance of payments was in approximate balance.

The United States ran a trade surplus with Brazil in 1995 for the first time since 1980 at $3.1 billion. The surplus widened further to $3.9 billion in 1996 and to $6.3 billion in 1997 on a U.S. customs basis before falling to US$ 5 billion in 1998. U.S. merchandise exports to Brazil reached $15.2 billion last year, a 4.7 percent drop from 1997, while imports from Brazil rose 5.1 percent to US$ 10.1 billion. Brazil remained our 11th largest export market in 1998. U.S. and Brazilian trade figures correlate closely but diverge for various reasons. For example, in 1998 Brazil recorded a $3.7 billion trade deficit with the United States, 27 percent less than the U.S. surplus based on U.S. Government figures.

Infrastructure

Most products reach Brazil by sea and must pass through Brazil's inefficiently run seaports. Costs are high and turn-around time is long. Port reform legislation, enacted in 1993, has not yet significantly improved port conditions. The Brazilian government has promised to privatize the port system. To complicate matters, the longshoreman's unions are attempting to maintain their current labor monopoly to the point of blockading the factory and (private) port of one company which had hired non-union port workers. Esp’rito Santo is the only port with privately run berths along the southeastern coast. Costs are lower and turnaround time shorter there.

Internal transportation is primarily by truck. Highways are adequate, but only reach first world standards in the state of S‹o Paulo and the south. Fuel costs are high, and add significantly to the cost of transportation. Rail transportation is limited; however, the entire rail system has now been privatized and the operators have started to upgrade their rolling stock and other equipment. Geographical constraints and environmental concerns have limited river transport development.

Electric power generation is barely adequate, but needed investment in new capacity has been limited by the precarious financial situation of the government. The government has passed implementing regulation and is in the process of privatizing most generation and distribution capacity, as well as allowing for independent power production and co-generation. The Brazilian federal government has created a new independent regulator for the sectory. Three state-level companies have already been privatized; another state company has just sold a significant share of its stock to private sector operators; and a majority of other state governments are preparing their electric companies for privatization by the end of 1999.

The government is also restarting work on a number of stalled hydroelectric projects and has plans to install transmission systems linking independent systems within Brazil and linking Brazil to its neighbors and allowing Brazil to buy electricity from them. Nonetheless, there is a risk of power shortages in Brazil's South and Southwest regions due to delays in installation of new generation and transmission capacity.