BRASILIA (Reuters) - Dilma Rousseff is staking her presidency on achieving a “historic” decline in interest rates, betting that is the best strategy for reviving Brazil’s economy in the medium term, members of her economic team told Reuters.
Her decision to focus on bringing down rates, rather than flooding the economy with government spending, could eventually help Brazil return to the robust pace of growth it enjoyed in recent years. But it may also condemn the country to another subpar economic performance in 2012, and it could backfire in the form of high inflation with no guarantee of a solution to the country’s other deep-seated structural problems.
The benchmark Selic lending rate stands at 8.5 percent, a record low for Brazil although still very high by global standards. The central bank has cut the rate by 4 percentage points since August, hoping to jump-start an economy that is now in its fourth straight quarter of stagnant growth.
The policy lynchpin that has permitted rates to fall is Rousseff’s commitment to fiscal austerity, which helps keep a lid on inflation. Her government has set a relatively ambitious primary budget surplus target - revenue minus expenditures, not including debt interest payments - of about 3.1 percent of gross domestic product this year.
The continued weakness of Brazil’s economy, plus financial contagion from the crisis in the euro zone, has increased pressure from labor unions and even some government-allied legislators for Rousseff to relax her budget target and flood the economy with new spending and other stimulus measures.
Yet the officials, speaking on condition of anonymity, said that Rousseff remains fully committed to the austerity goal. They said she believes Brazil’s rates are still too high, and that bringing them down will pay dividends by the time she’s up for reelection in 2014 - and possibly secure her a legacy similar to other recent Brazilian presidents who have helped modernize the economy.
“She sees this as a historic opportunity, and she’s committed to doing her part to ensure we take advantage of it,” said one official who participates in regular economic policy meetings with Rousseff. “It might mean another mediocre year (of economic growth), but she’s ready to accept that.”
“There has been no serious discussion of modifying the (primary surplus) goal,” a second senior official said.
While Rousseff is expected to announce further stimulus efforts in coming weeks, their scale is likely to be limited because of the need for fiscal restraint, the officials said.
Because Brazilian interest rates are generally believed to have a lag effect of about six months before they trickle into the economy by stimulating credit growth, Rousseff’s decision may seal another year of weak economic growth. Markets now expect growth of only 2.3 percent in 2012, compared to a 2.7 percent expansion in 2011.
The officials declined to say whether Rousseff has a target in mind for the Selic, although their comments implied she expects rates to fall further than markets currently anticipate. Economists expect the Selic to end the year at 7.5 percent, according to the median forecast in a weekly central bank poll.
Brazil’s central bank does not enjoy formal independence. Since Rousseff took office in January 2011, most analysts believe she has allowed central bank chief Alexandre Tombini to set rates as he sees fit, but she has also made her wishes known in public as well as in private meetings.
The big risk to Rousseff’s plan is that the structural factors that make Brazilian interest rates so high have not totally disappeared. The Selic rate exceeded 25 percent as recently as 2003, and a previous drive to sustain a single-digit Selic in 2009 fell short when inflation flared up again.
Many contracts throughout the economy - rent, transportation, and salaries among them - are automatically adjusted every year according to price expectations, a legacy of Brazil’s hyperinflationary past in the 1980s and 1990s.
That “indexation,” plus other pressures caused by bad infrastructure and a tight labor market, mean that Brazil could end up with both high inflation and low growth if Rousseff’s effort fails - a scenario that would erode her popularity and her reputation as a competent, results-minded administrator.
“I don’t see changes that would warrant a dramatic decline in rates,” said Alexandre Schwartsman, an economist and former central bank board member. “Are we making a huge effort on the fiscal front? No. Are we dramatically improving infrastructure? No. Are we educating people much better? No. ... Even if we were, it would take years for those changes to pay dividends.”
Tombini reaffirmed on Tuesday his belief that “structural” changes in Brazil’s economy have allowed the Selic to fall without causing a spike in prices. He has also cited the disinflationary effect of the euro zone crisis.
Inflation was 4.99 percent in the 12 months through May, down from 6.5 percent at the end of 2011, a seven-year high. The central bank targets inflation of 4.5 percent, with a “tolerance band” of two percentage points in each direction.
Citing continued low investment rates and struggling manufacturing activity, Credit Suisse on Wednesday lowered its economic growth forecast for 2012 to 1.5 percent from 2 percent, putting it near the low end of market expectations.
Schwartsman said that, if the central bank cuts rates too aggressively, inflation could spike back to above 6 percent in 2013 with economic growth remaining below 4 percent.
Despite the potential dangers, the benefits of lower interest rates would help address many of the economic bottlenecks currently holding Brazil back, the government officials who spoke to Reuters said.
Credit has greatly expanded in Brazil in recent years, but consumers still pay an average in excess of 30 percent interest for loans - effectively pricing many people out of the credit market. Rousseff has actively pressured Brazilian banks to lower their lending rates in tandem with the Selic, accusing them of having some of the world’s highest “spreads.”
The officials believe a meaningful decline in consumer lending rates could still give the economy a jolt, despite rising defaults and other recent data suggesting many people don’t have room to take out more loans. The average duration of consumer debts in Brazil is about 400 days, short by international standards, meaning that families who are currently stretched may be able to free themselves up relatively quickly.
Rousseff has been criticized for relying too much on consumer credit and demand to stimulate Brazil’s economy, instead of taking steps to enable higher investment.
But a structural shift toward lower rates could also cause a massive reallocation in Brazilian investment portfolios, which are weighted toward government debt to an unusually high degree by international standards.
As debt yields less, officials believe banks will shift funds to more productive investments such as long-term infrastructure financing, in which the private sector’s role is currently negligible. Technology, and therefore productivity - also a recent problem for Brazil - may also get a boost.
If those predictions come true, Rousseff might be able to claim a place in the pantheon of recent Brazilian presidents who beat deep-seated, seemingly insurmountable economic obstacles. Fernando Henrique Cardoso slayed hyperinflation during his 1995-2002 presidency, while Luiz Inacio Lula da Silva helped reduce stubborn inequality and pull 30 million Brazilians from poverty during his 2003-10 administration.
“She’s constantly asking us: What will our legacy be? What will the country look like in 2014?” the first official said. “She has decided that interest rates are our opportunity to cause an economic revolution, something that could open up a new cycle of strong Brazilian growth.”
Editing by Todd Benson and W Simon