The Exchange Rate/Interest Rate Dilemma in Brazil

One of the major economic policy discussions in the Brazilian Presidential campaign will certainly be the relationships and dilemmas between the level of the exchange rate and the level of nominal interest rates. The opposition argues that the country is presently in a trap, where a very high level of real and nominal interest rates is being maintained, under the inflation targeting regime, and contributing to produce an overvalued exchange rate.

Last Monday, Jose Serra, Presidential candidate from the Opposition Party, said explicitly that it should be possible to have a different combination of interest rates and exchange rates, arguing that nominal interest rates could be much lower in Brazil, while at the same time the exchange rate between the Brazilian real and the US dollar could be in an entirely different position in favor of exporters and against importers of goods and services.

It is somewhat surprising that the Government Party (PT) – normally considered more leftist than the Opposition – seems to prefer an economic policy which favors inflation control and Central Bank independence and which has produced precisely this “anti-growth” combination of high interest rates and overvalued exchange rates for the last 8 years. It is even more surprising that this issue is being raised precisely in 2010, when the country will probably and finally grow more than 7%, in spite of the “anti-inflationary” combination of 10% nominal interest rates and (probably) 30%/35% overvaluation of the currency.

The technical (and political) question to be raised is the following: is it really possible – in order to raise and maintain economic growth at 5/6% per year for a longer time – to have a much better exchange rate for the current account balance (let us say, 2.5 against the present 1.8) and, at the same time, a lower nominal interest rate (let us say, 5% as opposed to 10% per year), without igniting inflationary pressures in the Brazilian economy?

The answer – as always in macroeconomics – is maybe yes. It all depends on inflation expectations, exchange rate expectations, monetary and fiscal policy.

Any simple macromodel normally suggests that, in an open economy, inflation is determined by expectations of inflation, the output gap and the rate of exchange devaluation. Additionally, it is well known that the interest rate differential with respect to the rest of the world tends to reflect the expected rate of exchange devaluation. Furthermore, economic growth depends on the existing output gap, as well as monetary and fiscal policy ( in addition to long-term trends, of course, such as productivity and demographics).

Even a simple model like this shows that the major challenge is to promote a devaluation of the currency ( under fixed-but-adjustable rates or under dirty-floating rates) which might be able to bring the expected rate of future exchange devaluations to zero or even “negative” figures. And, at the same time, it must represent a real devaluation, with a small impact on domestic inflation. Is that possible? Again: maybe yes.

A restrictive fiscal policy is the key to get out of the dilemma. Government spending must be cut dramatically, particularly because the other restrictive avenue – raising taxes – is practically forbidden, given the very high level of taxation in Brazil.

But then another dilemma seems to appear: how to reconcile cuts in Government spending with economic growth?

Here, a clear distinction has to be made between short-term economic growth and long-term economic growth. Lower interest rates, better exchange rates, declines in the growth of Public debt, as well as a huge output gap (accumulated after 25 years of mediocre growth rates) are much more important for true long-term sustainable economic growth than aggregate demand incentives generated by public spending (and – worse – current public spending with salaries, pensions and free benefits).

It seems to us that this major shift of economic policy reflects what is beginning to be presented as an alternative economic policy for the Brazilian Economy by the Opposition Party.

Naturally, it is a risky proposition, particularly in a country that has been so successful in stopping hyperinflation and maintaining inflation at low levels since 1994. On the other hand, it is a proposition that at least deserves to be discussed, because – after all – there is no doubt that the amazing growth dynamics of Brazil of the last century (particularly 1900-1980) was lost in the last 30 years. Moreover, many people fear that the excellent prospects for growth in 2010 are not sustainable exactly because nowadays in Brazil: Government spending is growing too fast (together with taxes and Government debt), the exchange rate is clearly overvalued (as opposed to China), and interest rates in nominal and real terms are certainly very high.