According to many market observers, a year ago Brazil was still at the verge of insolvency, but today it is once again one of the preferred options among the emerging markets. The ups and downs in the country risks and in the foreign exchange rate make that particularly clear. Temporarily, the real ratio to the dollar was at 4 real/US$, but in the meanwhile it had a considerable revaluation (3 real/US$). In October 2002, the country risk on government bonds was over 2,000 base points and currently it is around 700 base points. Above all, it was the upcoming change of government that made many doubt if the fundaments of the Brazilian economic policy (austere fiscal policy and stable price levels) would be carried on. Right now, there are only a few indications of a new destabilization of the macro economical balance. However, despite all the progress Brazil has made, strengthening its institutions, there are still some structural weak points that have to be mentioned.

With 173 million inhabitants and a GDP of about US$ 450 billion, Brazil is one of the 10 largest national economies in the world. The domestic product is mostly concentrated in large centers in the South. For example, with 22% of the population, the state Sao Paulo, the most important industrial region, produces 36% of the GDP. Aside from a relatively high percentage of industry, Brazil's economical structure is characterized by an internationally very competitive agricultural sector. In Latin America, except for Mexico, economically and politically speaking Brazil is one of the heavyweights. Despite its substantial natural resources (including oil, iron ore and agricultural products) and a relatively well-qualified population, in the last decades Brazil was not able to exhaust its growth potential. The strategy to substitute imports that started in the 50's ended in a debt crisis and was finally abolished in the late 80's. The adjustments that came with the opening of the country's democratization (since 1985) were followed by profound crisis and phases of hyperinflation.

The external debt and the public debt are some of the most urgent problems of the country. The external debt must become sustainable by further opening the national economy and increasing exports. The high public debt has to be faced with the continuation of an austere fiscal policy, but particularly through structural reforms. All these measures that lead to a productivity improvement, also mean that Brazil can partially "outgrow" its debt.

Achieved Progress

• Stability-oriented Monetary and Financial Policy

After recurring phases of hyperinflation and economical crisis in the 80's and early 90's, it was possible to significantly improve the institutional basic conditions for a stability- monetary oriented and fiscal policy, and that way bring inflation back to an acceptable level. With the law of fiscal responsibility (that also foresees a maximum limit for new debts on all levels of government), a very efficient instrument was created to control the management of public finances of the otherwise to a large degree autonomous federal states. In the financial policy, transparency increased because the primary surplus objectives for the public sector stipulated in the budget (objectives for the budget balance before interest) can be continuously controlled. In the monetary policy, the instrument of inflation targeting proved to be a transparent and efficient way to fight inflation. The last rise of inflation was obviously a temporary phenomenon, which can be confirmed by last months' inflation data. Another contribution to improving the transparency in the monetary and financial policy was certainly made by the IMF, who has verified the budget and inflation objectives on a quarterly basis through several agreements (since 1988 there have been five agreements).

• Flexible Exchange Rate System and Liberalization of Capital and Goods Traffic

After the introduction of "Plano Real" in 1994, the Brazilian currency was pegged to the US$, which led to a real overvaluation of the currency and severely limited the capacity to adjust to external shocks. Under the pressure of the markets, in 1999 the government decided to decontrol the currency. A free exchange rate system has an important role in the financial stabilization, as last year proved. The decrease in capital influx could be partially compensated through a clear exchange rate-linked (2002: 34% devaluation) increase of the balance of trade surplus.

A prerequisite for the clear adjustment in the balance of trade, which largely depends on a clear export growth, is the liberalization of the foreign trade carried out since the late 80's. While in1990 the average import customs tariff was 32%, until 1995 it had dropped to 14% (it has hardly fallen since). Not to mention the immediate benefits of the trade liberalization, the opening means mainly a clear increase in competitiveness and the possibility to import modern technologies. Both factors contributed significantly to the improvement of productivity in the Brazilian economy. However, there is still a large potential for further liberalization of the foreign trade, especially because not only customs barriers but also non-tariff trade obstacles hinder the import of many goods.

Apart from the foreign trade, capital transfer was also liberalized. Direct investments benefited from that, since they were rare until the early 90's due to the discrimination against foreign capital. With extensive privatizations (see below) and generally improved basic conditions direct investments became an important source of long-term foreign capital. In average, over the last 10 years direct investments amounted to about US$ 15 billion or 3% of the GDP, which is comparable to what Asian countries, like South Korea, attract.

• Extensive Privatizations

Due to the extensive privatization process that started in the early 90's, the role of the Federal Government in the economy was significantly reduced. While in 1990 38% of the 100 largest enterprises were still state-owned, in 1998 this percentage went down to only 12%. The sale of steel and telecommunication companies and of state-owned banks was basically successful. Particularly, a transparent regulatory context was created for each sector, which gave the enterprises more security when planning. At the end though, the privatization process came to a standstill. We believe that the inclusion of the private industry is particularly necessary for the electricity sector in order to expand its capacities and avoid bottlenecks like the ones that were observed during the energy crisis in 2001.

Mature Democratic Institutions

After Luiz Inacio Lula da Silva won the presidential elections in October 2002 there was a political change due to the exemplary respect of democratic rules. We see that as a proof of the stabilization of democratic institutions.

Structural Weaknesses
Structural Weaknesses at the Public Finances Level

Not only the amount of the public debt, but also its structure have made Brazil vulnerable towards shocks. About 25% of the public debt is external debt. About 35% of the domestic debt is pegged to the US$ and 45% pay variable interest (linked to the overnight-interest Selic). The average term of traded domestic bonds is currently 22 months. In the past, because of these relationships one could often observe negative spirals that questioned the macro economical stability of the country: devaluations of the real led to an increase of the public debt in a % of the GDP. The devaluation went hand in hand with a heightened inflation and accordingly higher interests, which in turn worsened the debt situation. The consequence was a stronger withdrawal of foreign capital (out of fear of insolvency), an increased devaluation of the currency, etc. The government set the extension of the terms and the increase of the percentage of fixed-interests and inflation-linked bonds as objectives. Compared to the early 90’s there has been progress in this respect, but lately this progress has been only slow and followed by drawbacks.

The targeted decrease of public debt is hindered by a deficient pension system, which every year represents a burden of 5% of the GDP to the budget, mostly due to the pension system for public servants. While the pension system for private employees was already revised by the Cardoso administration and there are no indications of dangerous dynamics in this regard, the privilege- loaded pension system for public servants has hardly been touched. This April, the Lula administration submitted a reform package to Congress concerning this issue. In the meanwhile, a large part of the legislative process has been overcome without any significant cuts to the reform and we believe that the government stands a good chance of passing this law until the end of the year. The reform foresees, among other things, the rising of the retirement age for men and women in 7 years, i.e. to 60 and 55 years, respectively. Also, in the future pensions will be taxable and a maximum limit for pensions (R$ 2,400. -) will be introduced. These measures will offer a long-lasting relief for the public budget.

From the fiscal point of view, with its 25% tax bracket (2002), the tax system can become more favorable if compared to that of other emerging markets, but from the macro economical point of view it is worth mentioning that the value of the tax bracket (considering the relatively low level of public services the population receives in return), as well as the complexity of the tax system and the multitude of seemingly distorting taxes, significantly limit the country's growth potential. The value-added tax ICMS (main income source of the federal states) is the one that most needs a reform. The ICMS-brackets differ from state to state and from one product group to another. There are also taxes on financial transactions that, by nature, seem distorting. Last, one would have to mention the several social security contributions that are basically levied on almost all levels of the production process as a type of value-added tax, without the possibility of deducting previously paid taxes. This April, the Lula administration submitted a tax reform to Congress that shall address the above-mentioned problems (the core is the simplification of the value-added tax ICMS). Here negotiations prove to be a bit complicated because the interests of federal states and communities are directly affected. However, even in this concern important progress has been achieved in the legislative process and the reform stands a good chance of passing still this year Overall, it can only be regarded as an important first step.

• Social Problems

Brazil has one of the most uneven income distributions in the world. According to the World Bank, 20% of the population with higher income concentrates 63.8% of the total domestic product. The lower 20% of the population is entitled to only 2.5% of the domestic product. For sake of comparison, in the USA the values are 46.4% and 5.2%, respectively.

Having an uneven income distribution as a background, it is not surprising that criminality has increased in the last decade. The murder rate in Brazil went from 19.1 per 100,000 inhabitants in1992 to 26.2 in 1999. In Sao Paulo, only in 1999, it reached the figures of 57.8 murders per 100,000 inhabitants. There are no indications that the situation might have improved since. The number of kidnappings has also increased severely. And to make matters worse, in addition to the social problems, an inefficient justice and police apparatus also facilitate the situation. The precarious security situation is a decisive obstacle that hinders mostly foreign investors to invest (more heavily) in Brazil. The tourism industry is also directly affected by the situation.

• Insufficiently Developed Banking Systems

The Brazilian banking system barely fulfils its original function - to channel the population's savings to the most productive activities. With 28%, the intermediation degree in Brazil is considerably lower than, for example, that of the relatively well-developed banking market of Chile (68%). Long-term loans are hardly ever granted (it is basically the state-owned development bank BNDES that grants long-term loans). Another indicator of the bank sector's underdevelopment are the high interest rates. At the end of 2002, the interests charged for credits to consumers were above 70% p.a. and for enterprises over 40% p.a. The main reason for that is the high demand of this sector by the Federal Government (about 30% of all bank assets are government bonds). Another reason is the bankruptcy law that also needs an urgent reform, since it makes the collecting of collateral a very difficult process. The Lula administration plans to reform the bankruptcy law still during this legislative period. Despite the previously mentioned problems, the banking systems in Brazil are very profitable and - due to the strict regulation - a stable sector/ which will not be a source of financial crisis.

Will the Situation Change?

Currently the Brazilian national economy is in recession. In the first two quarters, the GDP fell compared to the previous quarter. However, the path is properly set for a quick revival of the good scenario. The new government's political-economical course reestablished the macro economical stability, which seemed to have gotten lost last year. Excluding the austere fiscal policy and a clever inflation-fighting monetary policy, the structural reforms (including pension and tax reforms) are the ones that - through a great deal of political skill - already overcame important obstacles in the legislative process. Another factor for the macro economical stabilization is the exemplary adjustment of the balance of payments to the reduced flows of capital without leading to a significant recession. While in 2001 the balance of payments deficit was still at 4.6% of the GDP, in the last year it came to 1.7% of the GDP. This year we are even counting on a surplus, the first one since 1992. This development strengthened the Brazilian currency. All that partially reestablished the investors' confidence, which they had lost last year. The risk on Brazilian government bonds, which in October were stratospheric 2,400 points, fell below 700 points. Brazilian enterprises were accordingly able within the last months to place longer-term loans at the international capital market with acceptable spreads. The Federal Government also became active at the international capital market. On the other hand, the granting of private foreign loans is still relatively low, what can be seen in the slowly recovering lines of credit for the foreign trade. This year, direct investments will probably amount to US$ 9.4 billion, while last year they were still almost US$ 17 billion. We believe that it can be explained by the globally weak direct investments and the fact that the decisions about direct investments are made months in advance and at the beginning of the year investors were still haunted by the ghost of a Brazilian default. However, since July we have been noticing a clear revival of direct investments. For the next year we expect it to increase to US$13 billion. Another good prerequisite for the revival of the favorable situation is the reduction in the interest rates. Since the end of last year, we have observed a clear decrease in the domestic interest rates for one to three-year contracts. Since June, the Central Bank has followed suit reducing the overnight-interest Selic, which defines consumer credits (decrease of 450 base points to 22%). Further interest reductions are on their way, so for the end of the year we can count on a Selic- interest of 19%. The extremely interest-dependent consumption (durable consumption goods in Brazil are almost always bought on credit) that has been dropping since last year should experience a revival in the next couple of months due to the reduction of the interest rates. This should reflect on a higher industrial production, which should also benefit from the revival of the global development.

This mid- to long-term development depends on Brazil bringing its external and public debts to a sustainable level, and consequently becoming less vulnerable to internal and external shocks.

In the case of the external debt, a definite positive trend can be observed. Since 1998, it went from 380 %f exports of goods and services to 282%. We assume that the export growth will continue at a slower pace in the next years and that until 2010 the external debt will be reduced to 170% of exports. This way, the debt seems to be bearable.

The public net debt, however, increased over the last years from 42% of the GDP in 1998 to almost55% of the GDP this year. The prerequisites to bring the public debt to a sustainable level are a lasting growth of the national economy and other finance-political structural reforms that would allow the generation of a long-lasting high primary surplus (budget surplus before interests), without having to make further social cuts, which would become increasingly more difficult to implement politically. The pension and tax reforms created good conditions in this respect.

Conclusion

By setting the right priorities, the new Brazilian government was able to address the structural reforms that are indispensable for a long-lasting growth in productivity, since they relieve the burden placed on the enterprises and offer a bigger macro economical stability. The continuation of this stability-oriented economic policy - reflected in these reforms - that could already be observed in the last administration, is an important reduction policy. That and the revived capital flows should shortly bring a moderate upswing. prerequisite for the Central Bank to continue its interest- Next year, there should be a solid growth of 3.5%.

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