Do Structural Reforms Always Succeed?
Lessons from Brazil
by Jorge Saba Arbache
Over the last twenty years, Brazil has experienced profound economic changes. Following the international economic instability of the late 1970s and the debt crisis of the early 1980s, Brazil launched structural adjustment programs aimed at solving external account imbalances and controlling high inflation rates. In 1990, Brazil undertook a major break with a century-long era of import substitution strategy that left its economy especially closed towards the end of the 1980s, and introduced economic reforms involving trade and capital account liberalization, privatization of state companies, deregulation of markets, and a successful stabilization plan, the Plano Real.
Measuring the success or failure of reforms demands a sensible criterion. Indeed, the ultimate aim of structural reforms is to foster economic growth. However, in view of the very uneven income distribution by international standards, and the substantial portion of population below the poverty line, a broader reform achievement criterion seems more appropriate for Brazil and perhaps for other developing countries as well. Therefore, it seems plausible to assess the success of reforms according to the performance of the per capita GDP growth rate, but also to the performance of the poverty and inequality indices before and after the reforms.
A significant drop in poverty occurred just after the Plano Real in mid-1994, and since then the indigence and poverty lines have remained fairly stable at about 15% and 35%, respectively. Despite the various stop-and-go’s, economic crises, hyperinflation, price and wage freezes, and structural reforms, the Gini coefficient have remained quite stable pre- and post-reforms at about 0.60. These social indicators suggest so far that structural reforms hardly benefited the poor.
Figure 1 presents the fitted and actual logarithm of the per capita output. The fitted line can be interpreted as the long-term trend of the per capita output. Two points seem to emerge. First, Brazil has experienced long economic cycles over the last decades. Second, after a strong boom, the economy entered in a quite stagnant period since 1980, and the fitted-actual per capita output gap has been increasing since 1990, thus suggesting an economic depression. While the instantaneous rate of growth of the per capita output in 1964-79 was 5.7 percent, it declined sharply to 0.7 percent in 1980-2002, and in 1994-2002 it reached a disappointing 0.64 percent. Therefore, the structural reforms implemented in the 1990s were not able to change the declining output growth trend. The poor economic performance in the post-reform period implies that something went wrong, as marketoriented reforms are, a priori, understood to be pro-growth.
What went wrong?
The disappointing post-reform output growth can be explained by sequencing of policy reform issues, political economy constraints, and the timing the reforms were introduced. A critical sequencing of reforms issue in Brazil was the stabilization-cum-exchange rate nominal anchor introduced after, and not before, trade liberalization, thus opposing a long established consensus of the policy literature. The strong appreciation of the exchange rate prior to stabilization made the anti-export bias created by the nominal anchor larger than it would have been otherwise. It was subsequently reinforced by the long period of appreciation post-Plano Real. A sizeable FDI inflow favored by capital account liberalization and privatization in the aftermath of Plano Real also contributed to keep the real quite appreciated. As increase in productivity takes time and the reallocation of resources is a slow and long process, especially in a country long protected from imports as was Brazil, the trade-off between using the exchange rate to guide inflation down and to guide the reallocation of resources bounced-back against the improvement of exports. The outcome was a rapid worsening of the current accounts, which ended up constraining the output growth potential. Thus, Brazil repeated the policy mistakes committed by other Latin American countries in previous stabilization attempts, as extensively documented by Sebastian Edwards, but with the aggravated implications of undergoing a stagnant economic cycle, and exposing the economy to speculative attacks in a liberalized financial market framework.
Another critical issue of policy reforms in Brazil is related to fiscal accounts. Serious fiscal adjustment was left for after stabilization. Therefore, the fiscal adjustment required during the aftermath of the Plano Real was huge and difficult to be realized. It appears that the Do Structural Reforms Always Succeed? Lessons from Brazil by Jorge Saba Arbache15 government overplayed its capacity to control fiscal accounts and to pass bitter fiscal reforms in the Congress. Rather than surpluses, the post-Plano Real period witnessed explosive operational public deficits. The rise in interest rates to finance balance of payment deficits with portfolio capital affected public accounts, aggravating the fiscal disequilibria. The unwillingness of politicians to approve necessary measures to achieve fiscal discipline delayed the required reforms, thus increasing the costs of adjustment. The ‘way out’ for fiscal adjustment was not to resort to inflation tax, as in previous decades, but to take advantage of the success of Plano Real to resort to funding from both local and foreign financial markets, at the expense of worsening fiscal and current accounts. The delay of fiscal adjustment and conflicts among policy reforms created a scenario of unsustainable macroeconomic deterioration in the country which, of course, could not last long. Accordingly, the spread of C-Bonds – the risk premium on Brazilian government international bonds – jumped from 400 base points in October 1997 to 1150 base points at the end of 1998.
The rising uncertainties about the sustainability of the Plano Real had stringent effects on the prospects of growth. From the end of 1997 onwards, the investment-to-GDP ratio initiated a period of contraction, being the immediate cause of vulnerability of the real. After the collapse of the real in early 1999, rising costs of investment and input goods, very high interest rates, the implementation of an enormous fiscal adjustment, and an unfinished regulatory system for utilities and infrastructure, compound the main causes of investment stagnation
It is noteworthy that only after the aggravation of economic crisis, collapse of the real, and depletion of international reserves that fiscal measures were taken. The recurrent postponements of reforms highlight a stringent war of attrition, and suggest that Brazil is perhaps a good illustration of the Danny Rodrik’s point on how a combination of high income inequality and weakness of institutions of conflict management can be counterproductive for a society in handling and responding adequately to macroeconomic problems.
The rapid pace in which the structural reforms were introduced in Brazil was perhaps a reaction of policy makers to foreseeing strong pressures against policy changes. Speedy reforms, however, are costly, as the chances of committing mistakes increase; short run unemployment and bankruptcy go up; and the burden tend to be unevenly distributed. The rising informality and unemployment, and the drop in real wages observed over the second half of the 1990s and 2000s are consistent with the abrupt adjustment imposed to the productive sector and with the empirical evidence on rationalization and turnover at the firm sector level.
The timing in which Brazil implemented structural reforms also appears to have contributed to their effectiveness. On the one hand, many potential competitors introduced similar reforms at the same time; on the other hand, institutional constraints to pro-export policies, along with protectionism of developed countries, mitigated the benefits reforms were supposed to bring for output growth. Besides this, Brazil was experiencing an extended period of economic stagnation. Of course, in such an environment the efforts required for growth have to go much beyond the introduction of standard market-oriented reforms, thus shedding light on how challenging it is for developing countries to achieve sustainable economic growth in nowadays.
It appears that the delay of fiscal reforms and mismanagement of policies contributed decisively to offset the potential benefits of reforms to output growth, at least in the short and medium terms. To the extent that political economy issues determine the delay of reforms and policy design, policies aiming at sustainable growth in Brazil have to tackle the sources of political economy constraints. Of course, an obvious starting point is reducing poverty and inequality.
Over the last twenty years, Brazil has experienced several attempts of improving sustainable growth through stabilization programs, and more recently, structural reforms in line with the Washington Consensus Agenda. The results, however, have been disappointing, as per capita output growth has been quite below its historic trend, and poverty and inequality remain at high levels. A concerning implication of successive failures is society's reform fatigue. It is also unclear whether never-ending economic and political crises will provoke disillusionment with the young re-democratization process and with Brazil’s future.
The main lesson of Brazil’s attempt of economic reform is that policies aiming at promoting growth and tackling poverty have to overcome the domestic economic and institutional constraints. Were standard market-oriented reforms enough to boost growth, Brazil would have grown at higher rates. Therefore, market-reforms are not panacea. They may contribute to growth if accompanied by microeconomic policies tailor-made to the country's needs, and by appropriate macroeconomic, institutional and political environments. To the extent that no autarkic country maintained high growth performance for a long period, it seems proper to consider market-reforms as necessary, but not sufficient conditions, for sustainable growth.
Jorge Saba Arbache is professor of economics at the University of Brasilia. He was a Sabbatical Fellow at WIDER during February-April 2004.