Brazilian President Dilma Roussseff
© Corbis

Until recently, the government of Brazil’s President Dilma Rousseff talked glowingly about a “new matrix” of economic policies that would revive the country’s faltering growth story.

This strategy, consisting of historically low interest rates, a weakened exchange rate engineered partly through currency controls and temporary tax breaks for industry, was meant to restore Brazil to a 4 per cent growth rate.

This month, however, the death knell seemed to sound on the new economic matrix. Persistent inflationary pressures have forced Brazil’s central bank to jack interest rates back up from a record low of 7.25 per cent in 2012 to 11 per cent last week, with the possibility of more increases to come.

With growth still fragile and the government’s credibility on the line following a credit rating downgrade last month by Standard & Poor’s, the question facing investors in Brazil now is how quickly can policy makers unwind the new economic matrix and return to more orthodox ways, assuming they have the political will to do it.

“That whole thing was her [Ms Rousseff’s] attempt to really execute the Keynesian development macro-model that the guys in Unicamp had been talking about all these years but never got to put in place,” said Nomura Economist Tony Volpon, referring to the university where Ms Rousseff studied postgraduate economics (but did not finish her course).

“It didn’t work, it just made things worse, on every angle you can think of – growth, inflation and the current account.”

Most economists believe Ms Rousseff’s government began to stumble in 2012 after the start of the eurozone crisis. With the global economy still weak and the US Federal Reserve still pumping liquidity via its quantitative easing programme, the government began a campaign to reduce interest rates to what were for Brazil unprecedented lows.

At the same time, the government unleashed unorthodox measures to curb inflation which threatened to upset its strategy of low interest rates. The most prominent was to unofficially force Petrobras, the state-owned oil company, to sell fuel imported at international prices for subsidised rates in Brazil. The government also intervened to reduce electricity tariffs, and city and state governments public transport fares following street protests last year.

However, policy makers also introduced contradictory policies that stimulated inflation, such as supporting a weaker currency against the dollar, and stimulating industry and consumer demand through temporary tax breaks.

The result was a situation of low growth and high inflation. Brazil’s economy this year is set to grow at about 2 per cent, continuing one of its slowest rates of expansion since the 1990s. Meanwhile, inflation, expected to reach 6.3 per cent this year, is near the top of the central bank’s band of 4.5 per cent plus or minus 2 percentage points.

“Lacklustre growth has become the norm rather than the exception,” said the Institute of International Finance, in a report last month on Brazil.

The problem with Brazil policy makers is an obsession with cyclical issues and a lack of political will to address the country’s entrenched structural problems, said Alberto Ramos, economist with Goldman Sachs.

“The best service they could bring to the economy is to deliver low and stable inflation,” he said. “They think that fighting inflation hurts the economy but not fighting inflation hurts the economy much more.”

Among the most important structural issues is reducing the tax burden, which has risen from 27 per cent of gross domestic product in 1997 to 36 per cent in 2012. This is above Chile’s rate of about 20 per cent and higher than the average of the Organisation of Economic Cooperation and Development, a group of mostly developed economies.

The argument is Brazil needs to spend less, save more and invest a lot more – especially the government.

There are quiet signs the message is getting through – for instance, the central bank’s aggressive tightening cycle.

The government’s rhetoric in the face of such criticism, however, has remained defiant. In a speech this week, Ms Rousseff said inflation had been maintained within its official target range for nearly 12 years. Brazil has accumulated $377bn in foreign exchange reserves and the government last year auctioned 18 infrastructure concessions.

Ultimately, analysts think there is only so much Ms Rousseff can do with an election due in October. The government is probably banking on its protectionist policies to buy it enough time to get through the election. Most important, unemployment remains low.

“I think the economy must be OK because I continue to be able to earn a living and afford a beer,” said Guilherme Breno, a teacher in São Paulo.

With additional reporting by Thalita Carrico in São Paulo

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