Since I am currently at home in Washington, DC waiting for a visa to return to Brazil, I have no new updates for this blog about my work with the catadores. I did think it would be interesting, however, to write another more general piece about the Brazilian economy, focusing on the country’s potential ascension to “developed country” status.
Industrialization and the "Middle-Income Trap"
In the 1930s, Brazil represented a classic low-income country. It had a highly agrarian society composed primarily of illiterate peasants. Its income per head was 12% of that in the U.S. and the country was extremely fragmented, with little intranational trade between its geographic regions. Then, Brazil experienced an economic boom. Productivity growth in agriculture resulted in large-scale migration of peasants to cities. In 1945, roughly 33% of Brazilians lived in cities. By 1980, this number was 66%. (Today, about 90% of Brazilians live in cities, making it one of the most urbanized countries in the world, ahead of even the U.S. and Western Europe.) This rural to urban migration led to a surge in industrialization and explosive economic growth. From 1945 to 1980, Brazil’s GDP grew by roughly 7% per year, including a China-like 8.9% growth between 1968 and 1980. GDP per capita grew from under $200 in 1945 to nearly $2,000 by 1980. Brazil was hailed as a “country of the future”, an emerging global powerhouse.
This economy, however, was not built on a sustainable model. Like most of Latin America, Brazil had implemented an “Import Substitution Industrialization” approach that aimed to promote domestic manufacturing by erecting protective barriers to foreign imports and using domestic demand to fuel economic growth. While the policy resulted in rapid development over a long period of time, ISI masked the uncompetitive nature of Brazilian industry with respect to the world economy. Furthermore, the accumulation of debt to pay for imported machinery eventually became too much to bear. The economy collapsed in 1980, leading to a prolonged period of hyperinflation and a rapid decline in income per head. The 1980s became Brazil’s lost decade.
A series of reforms in the 1990s stabilized the situation, bringing inflation under control and creating a stronger foundation for economic growth. Sound fiscal and monetary policy put the country on more even footing to combat future inflationary pressures. And despite the failure of the ISI model, there is no question that the country had made enormous progress during the 1945-1980 period. Brazil had followed the classic path of development originally pioneered in England and the U.S. and currently exemplified by China. Large rural to urban migrations had allowed the country to industrialize and greatly increase its overall economic activity. Then, increases in disposable income combined with huge improvements in basic education and health care shifted power to consumers, creating strong domestic demand to power future growth. Despite the stagnation of the 1980s, Brazil had successfully moved from low-income country to middle-income country.
Ever since this accomplishment, however, Brazil has hit a wall. This is essentially due to a very simple problem. Having already achieved middle-income status, Brazil is too rich to attract large-scale cheap manufacturing. With a minimum wage law and labor regulations in place, it cannot lure jobs away from China or other growing low-wage manufacturing hubs such as Vietnam. At this stage in the game, there is no simple formula for fast economic growth. This phenomenon is what economists refer to as the “middle-income trap.”
What separates Brazil from many of its middle-income peers is its abundance of natural resources. Despite the fact that its industry continues to languish in the middle-income trap, the economy has grown at a respectable 3.7% rate since 2000, mostly due to its exports of agricultural products, minerals and, increasingly, oil. With ample supplies of fresh water and energy sources, Brazil is not likely to encounter any resource scarcity-related roadblocks in the near future. But, as I have written in a previous column, this is not enough to achieve convergence with developed economies any time relatively soon. Brazil needs a different approach if it is to escape the middle-income trap.
To address this issue, Brazil’s economy must become more productive. A somewhat vague economic term, productivity generally refers to how efficiently businesses utilize the labor and capital that they have. Productivity gains are normally the key to economic growth. During the urbanization process that tends to form the first stage of traditional development, productivity increases rapidly as agriculture is consolidated and peasants move to factories and begin working with machines. As population centers expand, a large service sector begins to spring up in health care, education, product delivery (sales), and other sectors. Moving from subsistence agriculture to specialized occupations in concentrated urban areas makes society more productive overall. (Although it is important to note that this process tends to result in the marginalization of unproductive members of society, creating an urban underclass that I have discussed previously.) Once in the middle-income trap, however, productivity becomes more complex, and more elusive.
Identifying Key Economic Reforms
Overall, Brazil’s “total factor productivity” remains extremely weak compared to the developed countries it aspires to join. From 1980 to 2009, productivity actually shrank by 1.13%. A variety of reforms are needed, especially in the areas of infrastructure, tax collection, education, corruption, and ease of doing business.
Brazil’s infrastructure remains woefully inadequate. Only 10% of roads in the country are paved, compared to 78% in South Korea, a country that successfully sprung the middle-income trap. Major commercial roads tend to be narrow and dangerous, with little maintenance. The country’s train network is also highly limited, although a recent line connecting the Southeast and Northeast and a planned high-speed rail project between São Paulo and Rio represent steps in the right direction. On average, the country has slower internet connections than Haiti, Ethiopia, Pakistan and Papua New Guinea. The hope is that the upcoming 2014 World Cup and 2016 Olympics will result in significant infrastructure improvement projects, but the impact of these initiatives is likely to be too limited to create large-scale productivity gains. Plans to privatize the country’s major airports show that the government is willing to raise private capital to assist in this effort, but it still must devote a much larger percentage of expenditures to these projects. It must also cut down on red tape and simplify its policy procedures in order to more quickly execute vital projects in transportation, sanitation, electricity transmission and telecommunications.
Another factor weighing down Brazil’s productivity is its tax regime. While infrastructure investment has stagnated, tax collection has risen rapidly, climbing from 22% of GDP in 1993 to 36% by 2008. This is a tax burden comparable to the U.K. and Spain, and much higher than in peer countries such as Mexico and Chile. Exorbitant taxes on consumer goods, imports, exports, and other business transactions create a complex labyrinth for consumers and entrepreneurs, causing a significant drag on economic activity.
Worse yet, rising tax receipts have not led to greater government investment in the economy. While fiscal spending has increased in recent years, the primary driver of that growth has been wages and pensions in the public sector. Even these benefits have not been evenly distributed among government employees. Recent strikes and protests of police officers, firefighters and teachers in Bahia, Rio and Minas Gerais have highlighted the growing disparity between the wages of low-level public workers such as teachers and police officers and the “super-salaries” of high-ranking officials such as judges and congressional representatives. The latter group, often composed of well-connected insiders with access to privileged government positions, remains the principal beneficiary of Brazil’s current tax structure. The country is in urgent need of tax reform to create a reasonable, progressive tax regime that encourages business transactions and promotes investment in strategic areas of the economy, as well as a salary reform that rewards hard-working public employees who provide important government services while eliminating excessive, unnecessary benefits resulting from rent-seeking behavior by politicians.
The education system remains very weak, although there are glimmers of hope. The Bolsa Familia conditional cash transfer program has helped to increase school enrollment in poor communities. The growing international reputation of top universities such as the federal universities of São Paulo and Minas Gerais is setting a new standard of excellence for tertiary education in Latin America. But overall, the country continues to lag in its goal to achieve OECD average scores in reading, math and science. Increased spending has led to minor improvements, but more comprehensive reform efforts are needed. As in the U.S., the solution may lie in innovative projects pioneered in local school districts. Programs in São Paulo state and the city of Rio have some potential and, if successful, should serve as building blocks for reform efforts implemented at the national level.
Corruption also continues to be a huge drag on the economy, undermining the level playing field needed for businesses to thrive and improve their competitive ability. On this measure, Brazil has not improved noticeably over the last decade, slipping from 4.0 in 2002 to 3.8 in 2011 on Transparency International’s “Corruption Perceptions Index.” (Chile and Uruguay, by comparison, received scores of 7.2 and 7.0, respectively.) There are bright spots on this front. The rise of social media has greatly increased citizens’ ability to mobilize against perceived political corruption, evidenced by a successful online protest campaign against the Belo Horizonte city council’s attempt to raise its own salaries by a whopping 61.8%. President Dilma Rousseff has engaged in an aggressive “cleaning house” campaign, forcing the resignation of 7 cabinet ministers due to corruption charges within her first year. Hopefully, these developments are a harbinger of good news to come in Brazilian citizens’ fight against institutionalized corruption.
Overall, Brazil maintains a complex bureaucracy that weakens businesses’ productivity. The World Bank’s famous “Ease of Doing Business Index” puts Brazil at 126 of 183, well behind its regional peers Chile (39), Mexico (53) and Uruguay (90). Here is a breakdown of Brazil’s ranking, including comparison with the previous year’s analysis:
Starting a Business 120th (2011: 125th)
Dealing with Construction Permits 127th (2011: 133)
Getting Electricity 51st (2011: 53rd)
Registering Property 114th (2011: 109th)
Getting Credit 98th (2011: 96th)
Protecting Investors 79th (2011: 74th)
Paying Taxes 150th (2011: 148th)
Trading Across Borders: 121st (2011: 116th)
Enforcing Contracts: 118th (2011: 118th)
Resolving Insolvency: 136th (2011: 137th)
As these rankings show, Brazil’s electricity supply is an area of relative strength, which makes sense given that the country’s natural resources tend to be its strongest economic asset. Tax collection, as mentioned previously, remains the major impediment to the country’s business climate. In general, a variety of reforms are needed to reduce unnecessary bureaucracy and improve the economy’s productivity. Permitting, property rights, access to credit, interstate trade barriers, and judicial contract systems all need to be upgraded.
In the future, I hope to be able to speak more in depth about the business climate in Brazil based not only on statistics and macroeconomic analysis, but also on my own personal experience in trying to build the CATAUNIDOS commercialization network.
Foreign Direct Investment: The Key to Salvation, or a Crisis Waiting to Happen?
Investment has been pouring into Brazil, reaching consecutive annual records of US$48 billion in 2010 and US$65 billion in 2011. However, the “hot money” crises of Mexico in 1994, East Asia in 1997, Russia in 1998, and Argentina in 2001 show that this money can quickly become a double-edged sword. Luckily, Brazil has learned from these lessons and is installing capital controls to lessen the risk of the money flow being able to quickly change directions.
But even if the investment does stay in Brazil long-term, it is up to the Brazilians to figure out how to put it to good use and build a more productive economy. The Southern economies of the Eurozone offer a warning on this front. As this article shows, despite steady flows of foreign direct investment from their Northern European partners, the countries of Portugal, Spain, Greece and Italy actually saw their productivity fall over the last twenty years. (Eastern Europe, on the other hand, has taken full advantage of investments from the North to drastically improve its productivity.) Simply taking in the investment is not enough. Brazil must combine it with a series of reforms to improve competitiveness and put itself on more stable economic footing for the long term.
For now, it is hard to tell if this foreign investment will produce significant dividends for Brazil. Most of it seems destined to reinforce Brazil’s dependence on exporting raw materials; the money is flowing in not to Brazil’s economy as a whole but particularly to the mining, agriculture and oil sectors. Most of the new cash flows have been limited in particular to developing Brazil’s massive “pre-salt” oil reserves off the coast of Rio and São Paulo. If the oil does not begin to flow quickly and in the quantity expected by the international financial community, the results could be disastrous for Brazil. But nevertheless, the investment could pay off in the long run, if it helps the country to improve its national infrastructure and gain a competitive advantage in offshore crude oil production. It is up to Brazil’s leaders, however, to guarantee that this investment produces the intended spill-over effects that make the economy as a whole more competitive.
Moving Forward – Can Brazil Live up to its Potential?
It has become abundantly clear in recent years that Brazil is emerging as one of the most important countries in a new world economic order. The country has many strengths that will allow it to prosper in the global market:
- Abundance of natural resources, including energy and water
- The “demographic dividend”, wherein a rapidly falling birth rate has created a bulge in the working age population relative to dependents (the elderly and children)
- Stable political climate, resulting from continued strengthening of democratic institutions
- Enormous size, which allows Brazil to take advantage of economies of scale and a strong domestic market as well as to project its influence internationally
While these factors essentially guarantee that Brazil will play an increasingly important role in international affairs, it is important not to become complacent. The country has many challenges ahead of it, and its past difficulties should serve as a cautionary tale for those who assume that Brazil’s rise is inevitable. As long as the country continues to shirk needed reforms in infrastructure, taxes, education, corruption and ease of doing business, it will operate far below its potential. While the steady 4% annual growth projected by economists is certainly positive (especially considering the economic stagnation of the U.S., Europe and Japan), it is far below the 7.3% annual growth between 1984 and 1998 that turned Chile into the most successful country in Latin America. Brazil can do better.
There are also more short-term threats lurking on the horizon. Recent rises in inflation and a persistent current account deficit serve as reminders that Brazil still has work to do to stabilize its fiscal and monetary situation and prevent a repeat of the financial shocks of 1980 and 1997. Rapidly escalating real estate prices suggest that a bubble is forming in the housing sector, which is often the starting point for financial contagion. Extremely aggressive expansion of credit by public sector banks, especially the National Development Bank (BNDES) is another cause for concern. The period after the 2014 World Cup and 2016 Olympics could be especially dangerous, as construction projects would be likely to slow at that point. Furthermore, recent reports show that Brazil has little wiggle room to employ counter-cyclical measures to stimulate the economy in the event of a global economic downturn caused by recession in Europe, meaning that contagion in the Eurozone could quickly drag down the country’s already sluggish economy. In another scenario, a slowdown in China caused by the country’s “rebalancing” of its economy could cause a drop in demand for raw materials, upon which Brazil's economy is heavily dependent. These foreign and domestic threats could easily hamper Brazil’s economic outlook, and in the short term much remains beyond the control of policymakers in Brasília.
Overall, I remain cautiously optimistic about Brazil’s economic future. The country has made impressive strides over the last twenty years. It has drastically improved its fiscal and monetary policy framework, stabilizing the macroeconomy. It has improved its comparative advantage in agriculture, mining, and, increasingly, oil production, becoming a major commodity supplier in the international market. It has made tremendous progress on its social welfare programs, helping to reduce inequality and elevate millions out of poverty, thereby creating a fairer and more cohesive society. It has grown into a vibrant, diverse democracy with strong political institutions. But much of the hard work remains to be done. For Brazil to take the next step forward in its economic development, it must escape the middle-income trap, improving its productivity in order to become competitive in the global marketplace in a wide variety of sectors. This will require a series of difficult and complicated reforms as well as a strong commitment to full engagement in the international marketplace from both policymakers and the public at large. I am confident that Brazil is up to the challenge.
