RIO DE JANEIRO -- The Brazilian government is enjoying sunnier days than in late October and early November when it spent $9 billion to defend its currency, the real, from speculative attacks, but the country's economy remains vulnerable.
A package of tax increases and spending cuts making its way through Congress, a set of administrative reforms passed in the lower house of Congress and a doubling of interest rates to 3% per month have boosted foreign investor confidence in Brazil. But that confidence has not been restored to the level the country enjoyed before recent market turmoil, according to analysts.
The hiked interest rates, combined with the fiscal package, will cause growth to slow to less than 2% next year from 4% this year. This economic slowdown should have a positive affect on the high current account deficit, now at 4.3% of the gross domestic product.
But, while Brazil's macroeconomic situation should improve next year, the market perception of Brazil has changed to that of a country where there is considerably increased risk, according to Eduardo Giannetti, an economist and a professor at the University of Sao Paulo. As such, there still remains a strong chance that if the government's current economic strategy isn't sustainable, Brazil will be forced to devalue the currency. This would kick the monetary foundation out from under its hard-won victory over inflation and trigger a deep recession, Mr. Giannetti said.
The current economic strategy might not be sustainable for several reasons. First, the mid-November fiscal package, although meant to slash the federal budget deficit, won't likely do so. That package mainly consists of firing 33,000 civil servants and eliminating 70,000 vacant jobs; increasing 1998-1999 income taxes by 10 percentage points and limiting deductions to 20% of the tax due; higher import taxes, utility rates and fuel prices; excise taxes on cars and liquor; overhauling state-owned companies and expanded privatizations; and reduced credit lines to state governments.
The fiscal package was needed because the doubling of interest rates, through higher public debt servicing costs, will eat up an amount equal to 1.5% of the GDP, according to analyst estimates. But while the fiscal package was meant to save the government some $18 billion in fiscal 1998, analysts expect the package to save only $11 billion. And the resulting economic slowdown will considerably reduce tax revenue.
In addition, Congress might not approve all of the measures. And the government will have a hard time firing civil servants. Because of the red tape involved in doing so, and because 1998 is an election year, those firings likely won't begin until 1999.
The fiscal package won't really slash the public deficit as a percentage of GDP, said Jose Carlos Faria, a macroeconomic analyst with ING/Barings in Sao Paulo.
By saving $11 billion, or 1.5% of the GDP, the package simply will offset the amount lost to the doubling of interest rates, he said. This means a high public deficit problem must still be dealt with.
The government pushed administrative reform through the Chamber of Deputies, the lower house of Congress, in late November, as a way of further reducing the budget deficit. That reform will reduce government payrolls by putting a ceiling on civil servant salaries, allowing for the firing of poorly performing civil servants and by forbidding federal, state and local governments from spending more than 60% of their budget on personnel. The reforms are still need to be passed by the upper house.
The administrative reform will, in cutting the public deficit by less than 1% of the GDP, not have a big effect in reducing that deficit, at least, not in the short run, said Andre Loes, a macroeconomic analyst with the Banco Bozano Simonsen, Rio de Janeiro, one of Brazil's biggest investment banks.
Although the reform sends the market the message that Brazil is beginning to promote structural reforms, the market also looks at the numbers, said Mr. Loes. And, when the government starts firing workers, it initially will spend much of what it intends to save on workers' compensation payments, he said.
While Congress is expected to pass social security reform by early next year, it will only tackle the most important structural reform, tax reform, in 1999 well after the 1998 elections. Only a simplification of the tax structure to increase tax revenue and give states more tax-spending responsibilities, along with administrative and social security reforms, really slash the public budget deficit, analysts say.
While the economic slowdown should reduce the current account deficit perhaps to between 3.5% and 4% of the GDP, the government's privatization program -- the sale of $50 billion in energy and telecommunications firms in the next two to three years -- may not bring in enough to finance that deficit, at least not in 1998. Also, once the government lowers interest rates and economic growth picks up, perhaps by mid- to late 1998, the current account deficit, still fueled by an overvalued currency, will resume widening, according to Mr. Giannetti.
"A relatively unchanged public budget deficit and a lower current account deficit in 1998, along with a still overvalued currency, may not be enough to change the market's increased risk perceptions and expectations about Brazil," he said.
"And because, in Brazil, perceptions and expectations are as important as facts, the market might perceive the government's current economic strategy as not being sustainable. That's why I think Brazil will need a lot of luck to avoid a currency devaluation next year."
