Brazil: Time to Release the Brakes on Growth

The Central Bank of Brazil trimmed the SELIC benchmark rate by one percentage point, 25 basis points more than expected by market analysts, to a record low 9.25 percent on Wednesday, June 10. However, it also said that from now on further reductions would be carried out "more parsimoniously". Markets applauded this bold move with the Real continuing to appreciate against the Dollar.

So far this year, the Central Bank slashed 450 basis points off the SELIC benchmark rate, in an unusually aggressive move that is intended to support the ailing Brazilian economy, which is witnessing its first recession since 2003. As a matter of fact, the economy shrank 0.8 percent in January-March from the final three months of 2008, which saw a 3.6 percent decline from the previous quarter.

While this monetary easing is much welcome, we believe that the Central Bank should go further, reducing the SELIC rate down to potentially as low as 6.5%. At a time of faltering inflation, the Central Bank has now a historical opportunity to turn its focus temporarily away from an orthodox inflation targeting policy to a pro-growth policy, while preserving the hard-won benefits of macroeconomic stabilization, that have been acquired since the early 2Ks.

Even at 9 percent, the benchmark interest rate is still the highest in the world among the major economies. It is important to recall that this high interest rate was the price that Brazil had to pay for decades of economic mismanagement that resulted in skyrocketing inflation rates and brought down the country several times on the brink of collapse.

But with inflation expectations now robustly anchored below 5%, the largest Latin American Economy could not afford any longer to keep this monetary burden on growth at a time when it needs the most to support its domestic demand.

One of the key arguments often pushed forward by Brazilian policymakers to justify such a high interest rate is the "confidence risk". According to this thesis, Brazilians still remember the decades of lost growth associated with hyper-inflation much in a similar way as Germans are almost anti-inflationist by nature with memories of the post WWI hyperinflation still deeply rooted in their minds.

This "confidence risk" is also related to foreign investors' appreciation of the Brazilian economy, which triggers the fear of so called "sudden stops" in foreign capital inflows. But this story belongs to the past. International investors are now more concerned about the huge US deficit than about the current state of the Brazilian economy, which has shown quite a remarkable resilience in the wake of the worst global economic crisis since the Great Depression.

In addition, one technical explanation behind high interest rates in the context of inflation targeting, is the allegedly high pass-through from the exchange rate to domestic inflation, which is reinforced by the volatility of the exchange rate.

However, recent studies have shown that the pass-through from the exchange rate to inflation has been substantially reduced in Brazil over the last few years. With commodity prices surging again, there should be no reason to keep confiscatory interest rates solely for the purpose of self-insurance against a potential exchange rate crisis. Again, this is an old story.

The real challenge for Brazil now is to accelerate its transformation from an economy that is still highly reliant on commodity exports, into a diversified industrial economy, and further down the road into a knowledge-based post-industrial economy.

Lowering the interest rate to "decent" levels would be one important step in this direction. It is not just good for the markets, it is critical for the long term growth of the Brazilian economy.

Disclosure: Long on MSCI Brazil.

Comments

[Plant the s...:]

Good points about the future. In here and now, Brazil is still a commodity economy dependent on global demand (China, US) and likely to suffer unless those trends recover. The strength of the Real if excessive can also affect export competitiveness.

Sep 16 12:14 PM