Report No. 7057-BR

Brazil: An Assessment of the CurrentMacroeconomic Situation(In 1wo) Volumnes) V( 11e il Tchni( al AnnexesDecember 1987

raziI l)DepartmentCourtry Operations DivisionLatin Ameri( and the Canibbearn Region

FOR OFFICIAL USE ONLY

Document of the World Bank

This report has a restricted distribution and may he used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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BRAZIL

FISCAL YEAR: JANUARY 1 TO DECEMBER 31

AVERAGE EXCHANGE RATES (SALES).,_____________________________

1V80 52,7 CrS/USS 1987 Jan 16586 CZS/USS1981 93.1 ' ' Feb 18.14 1982 179.5 Mar 20.90 * '

1983 577.0 a a Apr 23.72 a a1984 1848.0 M aay 30.78 0 f1985 8200.0 * £ Jun 39.44 a a

Jul 44.93 a aAug 47.13 a

1988 13.88 CzS/IIS , Sep 49.87 a a

Oct 53.41 a aNov 59.29 a

GLOSSARY OF ACRONYMS______________._____

BNDES National Economic and Social Development BankCDB Certificate of DepositFIESP Sao Paulo State Federation of IndustriesFGTS Time-On-Job Gua antee FundFGV Getulio Vargrj FoundationFINAME Special Agency for Industrial FinancingFINEP Studies anj Projects Financing AgencyGDP Gross Domestic ProductIBGE Brazilian Institute of Geography and Statistics

FoundationIBRE Brazilian Economics 'nstitute of the Getulio Vargas

FoundationICV-SP Sao Paulo Cost of L'ving IndexIDB Interamerican Development BankIFS International Financial StatisticsIGP/DI General Price Index, Domestic SupplyINPC National Consumer Pri-- IndexIPA Wholesale Price IndexIPC Consumer Price IndexLSC Central Bank BillLTN National Treasury BillLTNF Floating Rate National Treasury BondORTN Indexed National Treasury BondOTN National Treasury BondPASEP Public Employees' Financial Reserve FundPSBR Public Sector Borrowing RequirementSEPLAN Planning Secretariat of the Presidency of the

Republic (Planning Ministry)SEST Secretariat for the Control of Federal

Public EnterprisesSINPAS National Social Security SystemWPI Wholesale Price Index

/a On February 28, 1986, Brazil announced an Economic Stabilization Plan. Among theprrncipal measures adopted was the creation of a new currency, the cruzado (CzS),wort.h 1000 cruzeiros (CrS).

FOR OFFICIAL USE OnLy

BRAZIL

AN ASSESSMENT OF THE CURRENT ECONOMIC SITUATION

TECHNICAL ANNEXES (Volume II)

Table of Contents

Page No.

ANNEX I - Overall Fiscal Policy Developments andProspects (1987-88) ................................. 1-14

ANNEX II - Federal Revenue Performancc and Prospects (1987-88).. 15-19

ANNEX III - Recent Financial Performance and PricePolicies of Federal Public Enterprise .... ........... 20-30

ANNEX IV - An Evaluation of the Implementation ofMeasures to Control the 1987 Fiscal Deficit .... ..... 31-39

ANNEX V - Monetary Policy Developments and Prospects(1987) . .................................... 40-54

ANNEX VI - Balance-of-Payments Developments and ExternalFinancing Scenarios (1987-91) ....................... 55-62

ANNEX VII - Price "Flexibilizaton": An Analysis ofRecent Strategy ........................... I ......... 63-72

ANNEX VIII - Wages and Employment Developments ...... .. 73-77

ANNEX IX - Economic Indicators: The Investment Outlook ........ 78-98

ANNEX X - Fiscal Deficits, Monetary Policy and Inflation:An Analytical Evaluation ........ 82-98

ANNEX XI - Macroeconomic Adjustment: Short-Run Stabilizationand Medium-Term Structural Measures - A Taxonomywith an Application to Brazil ........ 99-104

THE MA1N REPORT in (Volume I)

This report was prepared by a team led by Gobind Nankani. Other members ofthe team were Peter Knight, Helena Cordeiro, Rui Coutinho, ArmandoPinell-Siles and Antonio Estache. The team visited Brazil in October/November 1987. A draft of the report was discussed with the Government inDecember 1987.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

' AV1W

ANNEX IPage 1 of 14

OVERALL FISCAL POLICY DEVELOPMENTS AND PROSPECTS (1987-88)

1. The overall public sector borrowing requirements (PSBR) decreasedfrom 23%/ of GDP in 1984 to 10.8% in 1986, mainly reflecting a decline inmonetary correction expenditures brought about by the .owering of inflationduring the Cruzado Plan. In addition, the operational deficit, whichexcludes expenditures from Indexation of domestic debt, was reduced from4.3% of GDP in 1985 to 3.7% in 1986 due to an improvement in theperformance of the federal public enterprises. In contrast, the positionof states and municipalities and their enterprises deteriorated furtherbecause of a large increase in expenditures. The situation of the publicsector deteriorated sharply at the beginning of 1987 with the accelerationof inflation following the failure of the Cruzado Plan. This annexan lyzes fiscal developments in 1987 and prospects for 1988. The analysisof 1987 is based upon: first, developments of early 1987; second, fiscalpoliev in the Macroeconomic Control Plan with emphasis on the evaluation ofthe measUres announced to reduce the 1987 fiscal deficit; third, Treasurybudgetary performance; and finally, public sector borrowing requirements.The prospects for 1988 are based upon the institutional reforms announcedIn order to improve control of public sector deficit and the hudgetaryproposals presented to Congress last August.

Developments of Early 1987

2. Dturing the first half of 1987 the financial performance of thepublic sector deteriorated sharply. This worsening was the result of theaccelerating inflation, which brought about increasing instability ineconomic policy, a slowing dowr of economic activity, increasinguncertaintv, and liquidity problems in the financial system. Real taxcollections started to decline, with real revenues from the main taxesfalling to levels well below those in 1986. At the same time realexpenditures increased. Preliminary estimates indicated that the PSBR inthe first half of 1987 amounted to about 16% of the GDP projected for theyear as a whole, compared with 7% in the same period of 1986.

3. The increase in expenditures due to monetary correction tomaintain the value of the public debt in a highly inflationary environment,as well as the policv of adjusting wages for inflation through the 20%trigger mechanism, accounted for most of the increase in the PSBR. Rut theoperational deficit also increased, to an estimated 2% of GDP, as comparedwitli 1.4% in the same period of 1986. The upsurge of inflation eroded thereal value of tax receipts and of the public enterprise revenues. Inaddition, decisions taken in 1986 adversely affected the fiscal performancein earlv 1987. Those decisions increased the cost of subsidizedagrictultural credit, and deteriorated the financial position of states andmunicipalities. The latter led to Central Bank intervention In order torescue some state banks.

4. In this context, the operational deficit for 1987 was projectedat 6.7k of GDP as compared with 3.7% in 1986 (Table 1). Nevertheless this

Table 1: BRAZIL - MACROECONOMIC CONTROL PLAN PROJECTIONS: PUBLIC SECTOR DORIIOIC REQUIREMENTS

(Operational Concept, 1986-R7)

(% of CDP)

Item 1986 1987

lot Semester Year Ist Sew. Year

Pre- Post- Plan'sStabilization/a Stabilization/b Targets

Central Government 0.3 1.0 0.7 2.8 2.5 1.4

State h Municipal Covernments 0.3 1.0 0.6 2.3 2.1 1.6

State Enterprises 0.5 2.3 0.3 2.0 2.1 1.0Capital Inflow from FND -0.4 -0.4

Decentralized Agencies 0.2 i 0 0 0 0

Social Security 0.1 -0.3 -0.2 1 i i

Funds & Programs 0 -o.3 0 -0.1 -0.1 -0.1

TOTAL 1.4 3.7 2.0 6.7 6.2 3.5

I = insignificant

/a Figures estimated mid-May 1981.

/h Figures estimated taking into consideration the price and wage freeze (Decree Law No. 2336 of12/6/86). The difference in relation to the preceding column is dtue to the adoption of a new parameter nfor average inflation, which affects the estimates of GDP and of certain categories of revenue and 0-4expenditure.

Source: Macroeconomic Control Plan and Central Bank

L -~~~~~~~~~~~~~~3-

ANNEX IPage 3 of 14

deficit would have been incompatible with the necessary internal adjustmentto raise savings, to support growth, and to assist monetary policy inlowering inflation. The additional pressures came mainly from the centralgovernment and from the states and municipalities. To reverse thissituation, the Government promptly announced several corrective measures onJune 12. Those measures were subsequently incorporated into a broadereconomic program for the years 1987-91, the "Macroeconomic Control Plan".

Fiscal Policy in the Macroeconomic Control Plan

5. Objectives. The main goals of the Macroeconomic Control Plan inthe fiscal area can be summarized as follows:

(a) reducing the PSBR (operational concept) from a potential6.7% of GDP to 3.5% in 1987 and 2% in 1988;

(h) raising the net tax burden from an estimated 10% for 1987 to12% in 1988 and stabilizing it at 14% in 1991; and

(c) expanding government consumption at an annual real growthrate of 3% from 1987 through 1991.

6. The impact of the price-wage freeze launched on June 12 on publicfinances reduced the public sector deficit from 6.7% of GDP to 6.2%. Thisreduction resulted mainly from the fall of the subsidies implicit in ruralcredit, and from the relative reduction in the charges on public debt--bothdue to the decline of interest rates. This gain would be mainly reflectedin the federal, and state and municipal budgets. The additional measureswere expected to bring the deficit down to 3.5% of GDP in 1987.

7. To meet the target of 3.5% of GDP for the public sector deficitin 1987, on June 12, 1987 the Government announced several measures, ofwhich only some were effectively implemented. As a result, the Governmentexpected to reduce the deficit by about 2.7% of GDP. These savings wouldcome through a 1.1% cut in the fiscal deficit (central government), a 1.1%cut in the SEST deficit, and a 0.5% cut in the deficit of states andmunicipalities.

8. Measures. The measures fall into three groups in decreasingorder of likely impact. The first group was expected to reduce the deficitby about 1.2% of GDP and consisted of: (i) the wheat subsidy reduction andwheat stock charges; and (ii) all the SEST-related savings, includingpublic tariff adjustments and cuts in investments and currentexpenditures. The second group, which consisted of the riskierimplementation-dependent measures, included expenditure cuts related to (i)subsidies and stock-financing for other agricultural products; (ii)unemployment insurance; (iii) cost of federal debt; (iv) personnelexpenditures; and (v) other current expenditures. The measures expected tohave a minimal impact amounted to 0.5% of GDP and consisted of: (i) anincrease in the government's float by delaying salary payments; and (ii)planned cuts in the deficit of states and municipalities through reductions

4

ANNEX IPage 4 of 14

in domestic and external financing. An overview of the impact of thesemeasures is discussed below while Annex IV presents an -valuation of theirimplementAr!- ind nmnert,

9. The success of the programmed fiscal effort depended on theeffective and timely implementation of the announced measures.Nevertheless the design and nature of thte measures, relying considerably on"ad hoc" instruments, had faced questions about the adequacy andsufficlency of those measures and a continigency plan had been advisable.Yet even with an effective Implementation of the announced measures, thedeficit would have been difficult to hold .o the 3.5% target. Anevaluation suggests that their implementation has been poor and, this isthe main reason for not meeting the target of the public sector deficit in1987. Some of the measures that were consicered of greater impact havebeen relatively poorly implemented or have not heen implemented at all.Among these are the elimination of the constuier wheat subsidy, increases inpublic sector tariffs, and ceilings on public sector wage expenditures. Onthe other hand, significant deficit reduction was expected to come fromhighly riskv i-mplementation measures such as changes in mimimum price andbuffer stock policies. Those changes aimed at reducing subsidies weredifficult to irrplement and their impact was also difficult to estimate.The expected savings are not going to be fully achieved. Tower-than-expected demand for agricultural products may eKplain the smaller-than--programmed sales of stocks and subsecuent the loss of revenue. Theelimination of the consumer wheat subsidy had required timely and adequateprice adjustments of wheat products which might have been adverselyaffected by lhigher-than-planned inflation.

I). Furthermore, accelerating inflation has had a negative impact onpublic finances. First, it has made it difficult to increase public pricesand tariffs in real terms, affecting the expected increase in SESTrevenuies. Puhlic orices and tariffs were significantly adjusted in June.Althouglh the Government has recently decided on sone above-inflationincreases, price a6justments hlave fallen behind inflation, except for steeland petroleum products. Second, higher inflation hlas induced wage pressurewhich is expected to lead to a further deterioration of the public deficitat all levels of the government. Finally, it has prevented the fullexpected reduction of the financial charges on public debt and hasincreased the cost of rural credit subsidy. A sign'ficant step to reducethe rural credit subsidy was taken last June when irnterest rates were set[monetary correction (OTN) + 7-12%] in order to eliminate subsidiesimplicit in new credit. Even so, the impact on the budget of the previousscheme (set during the Cruzado Plan at 10% without any monetary correctionfixed for 6 months) is still rather high in 1987. In spite of the factthat most of the budgetary subsidy had occurred during tne first half ofthe year. some will still he incurred in the second. Since interest rateshave increased, the cost for the budget, subsidizing the difference, hasalso increased. The budgetary execution indicates that through SeptemberCzS52 billion have been spent (0.4% of GDP).

11. Expenditure-Related Measures. The public sector deficitreduction program relied considerably on expenditure-related measures whichconsisted of current expenditure cuts (mainly the wage bill) and SEST

ANNEX IPage 5 of 14

investment program reductions. These measures were to complement theimpact of structural measures to reduce expenditures (e.g., elimination ofthe wheoot qobsidy). In particular the impact of wage-related measures incontrolling the public sector deficit deserves some attention. Among thestabilization measures, several decisions (mainly implemented throughdecrees) were addressed containing personnel expenditure of entities undercentral government control. These measures included: (i) ceilings forexpenditures on personnel and social charges to be made in 1987, whichapply to the federal direct administration as weli as to entities of thefederal administration which receive resources from the Treasury; (ii)cuts, during the second half of the year, compared to the first, onpersonnel expenditures by 7% in real terms and payments for third partyservices (such as consultants) by 5%; this determination is applicable tostate enterprises and other companies under direct or indirect control ofthe federal government, Central Bank of Brazil, and entities belonging tothe Social Security System; (iii) limits for maximum monthly wages forfederal government workers; and (iv) prohibition of new hiring by thecentral government.

12. Taking into account data available through Septemberl/, andforecasts up to the end of the year, the wage bill would have been keptunder the ceilings set by the Macroeconomic Control Plan, even after beingadjusted for higher than planned inflation. Nevertheless, recent decisionson wage adjustments for most public servants have reversed the situation,and a gross increase of about 0.5% 2/ of GDP will be added to the centralgovernment's operational deficit. However, when compared with the targetthe net increase will be only 0.3% of GDP. Besides the negative impact on

the 1987 public deficit, that decision increased the wage bill for 1988,thus making a restrictive policy more difficult. Furthermore, it hasaffected the government's credibility to recommend a moderate real wagepolicy to the private sector. Wage increases above the Ministry ofFinance's recommendation of 10% in real terms, originating fromfederally-owned enterprises and affecting considerably their financialsituation, n,ay also mean a risk to state and municipal administrations andstate-owned enterprises. The Government intends to reduce thz negativeimpact on 1987's deficit by delaying the pay date to December. Even if, inaccounting terms, the 1987 deficit can he somewhat reduced, the economicimpact of the real wage increase is not thereby changed.

13. The savings expected from the elimination of the consumer wheatsubsidy during the second half of 1987 were estimated to account for about0.1% of GDP while the overall net expenditures with wheat transactions forthe year as a whole were estimated to amount to 0.3% of GDP. As thesavings have not been achieved ani additional funds are necessary tofinance the purchase of wheat production, the overall net expenditures may

1/ Budgetary performance of the treasury accounts.

2/ Rough estimate reflecting a 43% increase in October, and URP (UnitPrice of Reference) adjustments for November and December.

-6-

ANNEX IPage 6 of 14

reach 0.5% of GDP. Although the figure represents a redaction compared to0.9% of GDP spent in 1986, it clearly exceeds the ceiling programmed lastJune (0.3%) and makes future elimination of subsidies more dtfficult.3/

14. The structural adjustment measures, such as the changes in wheatsubsidy policy and the reform of public tariff policy, were less vigorouslyimplemented, while the use of ceilings on expenditures or across-the-boardcuts have been, by all indications, easier to accomplish. However, theeconomic impact, as opposed to the financial impact, of these lattermeasures has probably not been positive despite their contributions toreduce public spending. Keeping expenditures within ceilings may mean, insome cases, across-the-board cuts with uneven economic effects and/ordelays in spending or in payments and not expenditure restructuring or morerational use of public funds.

15. Revenue-Related Measures. One of the main objectives of the Junemeasures was to raise public sector prices so as to increase operatingrevenues for state enterprises. Public prices were adjusted in June 1987before the price freeze, but since then the raises have generally fallenbehind inflation. Most of the adjustments have taken into account the URP,which lags behind current inflation; thus, some erosion has occurred (seeAnnex III for details). In addition, as inflation has accelerated, theerosion of real prices has been particularly severe for the last fourmonths. The revision of public tariff policy is a key element in thestructural adjustment process necessary to reduce the public sectordeficit. Greater autonomy in tariff setting is necessary to structurethe links between state enterprises and the Treasury, within a definedpolicy and budgetary framework.

16. Tax revenues have been falling considerably in real terms.Besides inflationary erosion of revenues coupled with a slowdown ineconomic activity, some fiscal measures which negatively affected taxrevenues were taken to support sectors. Aiming at improving the sales ofvehicles and halting the reduction of employment in the motor car industry,the industrialized products tax (IPI) on cars and trucks was reduced. Inother cases, to allow for correcting price distortions, taxation wasreduced. ln addition, in order to improve exports, exemptions from importtaxes and IPI were allowed.

17. With respect to the income tax, there were two important measureswhich have also affected tax revenues in 1987. The first change consistedof the elimination of the semi-annual income tax declaration. for largecorporations, which will be subject to annual declarations beginning in1988. This change explains the poor performance of corporate income tax inSeptember, since corporations could choose between 1986 and the firstsemester of 1987 results to be taxed; so part of the income tax lost in1987 will be collected in 1988. The second was represented by therestoration of the 10% withholding tax on the total yield of short-termfinancial operations involving private securities. There were also someadjustments in the income withholding tax brackets that will prevail as of

3/ For details on evaluation of these measures, see Lnnex IV.

AMNEX IPag 7 of 14

September. This change will ensure that the annual sum of the monthlywithholding tax will be equivalent to the total personal income tax due in

M 1987 This, combined with higher age during the lat quarter of theyear, will induce higher personal Income taxes but it will not be enough to

-- offset thi decrease in corporate inc. tax.

18. The 1986 Increase in revenues for the central administration wsreversed in 1987 and a decline of about 0.72 of CDP is now expected (AnnexII). In 1986 tax rev.nues represent 9.62 of CDP while in 1987 they wouldbe about 92, below the 9.72 target in the Macroeconomic Control Plan. Themain reason for that decline in 1987 ia the erosion of tax revenues due toaccelerating inflation. The above discussed changes have also beenworsening tax revenues in 1987, although corporate income tax revenues lostin 1987 will be collected in 1988. Although littie can be done to reversethe 1987 situation, additional net revenue must be obtained to meet the1988 target mainly by cutting tax expenditures. In addition, if some ofthe tax reform changes that have been proposed in the Constituent A;semblybecame effective in 1988, additional resource mobilization would berequired if the net impact on the federal deficit is to be contained. Theproposed changes lead to a revenue loss for the federal government duemainly to the increase in revenue shared with state and local governments(through Participation Funds).

Budgetary Performance of the Treasury

19. In the first nine months of 1987 the National Treasury budgetaryperformance registered a deficit of Cz$51.7 billion equivalent to 0.4% ofthe GDP for the year as a whole. But considering transfers to the CentralBank amounting to Cz$29.1 billion, there was an expansionary impact ofCz$22.6 billion in the monetary base. Fiscal revenues reache1 Cz$671.1billion compared with the current estimate of Cz$1085 for the year as awhcle, and reflected a real decline of 7% compared with the same period of1986. Or the other hand, the Cz$722.8 billion in expenditures, out of anestimate for the year of Cz$1385, also shoved a real decline of 7%.

20. From the total o" Cz$781.8 billion of authorized expendltures bythe Treasury through September, 19.2% were transferred to states andmunicipalities through revenue sharing funds (Participation Funds).Expenditures on personnel and social charges absorbed 26.7% of the total,corresponding to the most important item of the Treasury expenditures.Debt charges absorbed 10.8% of the total, while fiscal expendituresexecuted by the Central Bank represented 16%, including transfers to theCentral Bank to finance foreign end domestic public debt charges. Otherexpenditures, including capital, accounted for 27.4% of the total spent bythe Treasury. Based on this performance, the central government's accountsdo not show a tendency to exceed the target for the year as a whole (1.4%of GDP). However, in the previous years, Treasury performance Ihasdeteriorated sharply during the last quarter of the year when most of thoseexpenditures are made. In particular this year, several factors (such aswage increase, income tax losses) will explain a considerable deteriorationof the Treasury performance.

Tabl. 2: WSAUL - PUEIC UW=O 60MVflN #AUI331IT

(Operational Concept. 1986-1988)

(2 of CDP)

1"6 1987 196

Plan's Expected Plan'sItem Targets Outturn Targets

Central Administration 1.0 1.4 2.4 1.3

State & Municipalities 1.0 1.6 1.5 0.5

State Enterprises 2.3 0.6 1.9/a 0.4

Decentralized Agencies - 0.0 0.0 0.0

Social Security -0.3 - -0.1 -0.1

Ftunds & Programs -0.3 -0.1 -0.2 -0.1

TOTAL 3.7 3.5 5.5/b 2.0

/a This includes 1.6% estimates for SEST, and the Government's projection of 0.3% forstate-owned enterprises.

/ Several uncertainties could cause a higher deficit. They are likely to affectmainly Central Administration, and States and Municipalities. These uncertaintiesare related mainly to expenditures and depend on the ability to implement a veryrestrictive policy at the end of the year. Such a policy might mean more delays inpayments than cuts in spending, and consequently increase pressure oa i988'sdeficit.

Source: Macroeconomic Control Plan and mission estimates.

*'NK IPage 9 of 14

Public Sector Borrowing Requirements

21. Overview. The 1987 target for the public sector borrowingrequirements is 3.5% of GDP of which 2% had already occurred in the firsthalf of the year (Table 1). The overall outcome for 1987 is expected toexceed the target and to reach an amount equivalent to 5.5% of GDP (Table2). The estimates are based primarily on data on the financing of thepublic deficit by the Central Bank through September; and secondly, on thepoor implementation of the measures to reduce the deficit.

22. Through September. During the first semester of 1987, theoperational deficit reached 2% of GDP, of which 1.5% was financed by theCentral Bank and 0.6% by the rest of the banking system. Preliminary dataon the financing of the public deficit (operational concept) throughSeptember indicates that the Central Bank financed an amount equivalent to2.1%/ of the CDP, while up to Septembet of 1986 the Central Bank hadfinanced onlv 1. 1 of GDP and the rest of the banking system had financedanother 0.3% of GDP.

23. During the first nine months of 1987, the principal share of theoperational deficit financed at the Central Bank was taken up by financingprovided to the central government which stood at a level of 1.1% of theGDP (against nC.6% in 1986). The state enterprises borrowed from theCentral F;ank 0.7% of GDP (n.5% in 1986), and the state and localgove-nments 0.6'/ (0.2% in 1986). During the first nine months of 1987,social securitv and "funds and programs" operations produced a jointsurplus at the Central Bank of Cz$35.5 billion, corresponding to 0.3% ofthe GOIP.

24. Based on preliminary data through September, it cannot be saidthat the public sector deficit is beyond target or not under control.Hlowever, this vear, various well-identified factors might contribute tofurtlher c-terioration of the public sector finances. These factors willinfluence both revenues and expenditures. On the revenue side, theacceleration of inflation coupled with recent corporate income tax changesare likely to redtuce real tax revenue. Increased personal income taxcollecting because of both wage increases and withholding tax will not beenough to offset these losses. The possible slowdown of economic activitycouild a]so leHd to less revenue for both federal government and state andlocal goverrments. On the expenditure side, the most adverse impact isrelated to the recent wage increasr and the wheat subsidy and publicenterprise tariff developments. The wage increase is expected to affectall levels of government, and besides increasing the public deficit, islikely to feed inflationary expectations.

25. 1987 PSBR. The overall operational outcome for 1987 is expectedto reach 5.5% of GDP, which compares with 3.7% in 1986 and with the targetof 3.5%. This outcome compared to the Macroeconomic Control Plan target,reflects a weakening of the performance of the central administration andparticularly of the public enterprises. Furthermore it implies a veryrestrictive spending policy ia November and December. With respect to theposition of the states and municipalities, which has deteriorated markedlyearly in 1987, it is likely to remain within the target (1.6% of GDP), as

ANNEX IPage I0 of 14

the preliminary information from the financing side up to SeptemberIndicates. Nevertheless, some of the factors adversely affecting thecentral administration finances (wage increases and lose of revenues) couldalso negatively affect the finances of the states and municipalities.

26. Central Administration. The operational deficit of the centraladministration (Table 3), incwuding the Ipoct of fiscal expendituresexecuted by the Central Bank (but without capital transfers to SEST), islikely to reach 2.41 of GDP, while the target was 1.42. Revenues woulddecline by the equivalent of about 0.9Z of GDP. This behavior, comparedwith the projections included in the Plan, reflects Inflationary erosion aswell as the slowdown of economic activity. In addition, the finances ofthe central administration should be adversely affected by the poorImplementation of the stabilization measures and by an additional wagebill. The central administration wage bill is projected to increase by0.3% of GDP over the level reached in 1986, while programmed to decline by0.1%, and should reach 3% of GDP. Furthermore, higher costs ofagricultural credit subsidies and larger than planned expenditures withagricultural products stock policy are likely. Including capital transfersto federal public enterprises, which are now estimated at about 1.9% of GDP(Cz$239 billion), the operational deficit of the central administrationwould increase from 1.9% of GDP in 1986 to about 4.3% in 1987. Thesetransfers in the Macroeconomic Control Program were projected to reach theequivalent of 2.4% of GDP (Cz$295 billion). However, there will be noimpact on the overall PSBR from these capital transfers because theincrease in central administration borrowing requirements will becompensated by a decline in SEST borrowing requirements.

27. State Enterprises. The target for state enterprises was 1% ofGDP (before FND transfers) of which 0.7% corresponds to federal publicenterprises (SEST) and 0.3 to state-owned enterprises. The targeL fuolreducing the operational deficit of SEST to 0.7% of GDP in 1987 will not bemet. Preliminary data for the period January-September indicate acumulative deficit equivalent to 1.0% of GDP (before transfers from therest of the public sector, but including an increase in the floatingdebt). For the rest of the year, the deficit is likely to worsensignificantly because of the acceleration of inflation since September,above-inflation wage adjustments in the public sector and the erosion ofpublic sector prices by inflation. Preliminary projections through the endof 1987 indicate that, with additiona, measures recently taken(particularly price increases), the SEST operational deficit could reach1.6% of GDP, largely as the result of a substantial fall in real operatingrevenues, offset somewhat by an anticipated decline in operating expenses,other than wages and interest payments, of 0.5% of GDP. Wages and interestpayments are projected to increase slightly as a proportion of GDP. UntilSeptember 1987 state enterprises (which includes SEST and state-ownedenterprises) had borrowed 1.2% of GDP from Lhe Central Bank while duringthe same period of 1986 only 0.5% had been financed by the Central Bank.By the end of this year the Central Bank is projecting to financeope=ations carried by state enterprises amounting to 1.7% of GDP. In 1986the financing of the state enterprise operations from outside the CentralBank reached 1.2%. Although compared to 1986, a lower need for financingis expected due to cuts in expenditures, some revenue increases, and higher

- 11 - ANNEX IPage I11 of 14

Table 3: BRAZIL - CENTRAL ADMINISTRATION ACCOUNTS

(% of GDP, 1986-87)

1986 1987

Plan's ExpectedTargets Outturn

Revenues 9.6 9.7 8.8

Expenditures 13.1 12.3 12.0

Wages and Salaries 2.7 2.6 3.0/aTransfers to:State & Municipalities 2.7 2.7 2.1SEST Subsidy 0.5 0.7 0.7Social Security System 0.2 - -

Interest Payments 2.2 1.4 1.5WTheat Subsidy 0.9 0.3 0.4Other Expenditures 3.9 4.6 4.2

Net Borrowing Requirements 3.5 2.6 3.2

Operational Concept/b 1.0 1.7 2.4/c

Memo Items:Transfers of Capital to SEST 0.9 2.7 1.9/dBorrowing Requirements(Operational Concept) 1.9 4.4 4.3

/a This takes into account the recent wage increase (0.5% of GDP) and thefavorable performance on the wage hill Cargets announced in August.

/h Net borrowing requlrements adjusted for operational concept and changein float (difference between authorized and effective payments andadditional revenues not allocated).

/c Several uncertainties mainly related to expenditures could explain adifferent deficit. However, the authorities are committed to a severefiscal policy at the end of the year.

/d Those transfers include transfers of capital (Cz$77 billion) and debtconversion (Cz$162 biilion), according to Central Bank estimates.

Source: Macroeconomic Control Plan and Mission estimates

ANNPY IPage 12 of 14

transfers of capital from the Treasury, the target for SEST will beexceeded. Since no information on state-owned public enterprises isavailable, the 1.9% of GDP estimated for the state enterprise deficitreflects the Plan's target (0.32 of GDP).

28. States and Municipalities. The financing requirements of thestatec and municipalities have been expanding since 1985. In 1986, despitea substantial increase in sales tax (1CM) revenues (major source of ownrevenue for states), and in transfers from the federal government, theiroperational deficit increased from 0.5% to 1% of GDP. Prior to thestabilization measures, the projected deficit of the states andmunicipalities was about 2.1% of GDP. The large increase in the revenuesin 1986, in an election year, has led them to expand expenditures, inparticular employment. As revenues declined they became insufficient tokeep up with a higher level of spending, mainly the wage bill. In order tomeet the 1987 public deficit target, several measures were taken to bringthe needs for financing the states and municipalities to 1.6% of GDP.These measures addressed the reduction of the indebtedness of thegovernments of the states and municipalities without ensuring effectivecuts in spending or increases in local revenues. These measures included:(i) reduction in the authorized limits on rollover of external and domesticdebt; (ii) reduction in authorizations to states and municipalities toissue new bonded debt; (iii) reduction in costs of restructuring the statebanks; and (iv) reduction in special and tax revenue advance credits.

29. Preliminary data indicate that through September the netborrowing requirements of states and municipalities were within the Plan'starget. For the same period, Central Bank accounts indicate 0.6% of GDPhad financed the deficit of tie states and municipalities. However, partof the borrowing requirements of states and municipalities is providedoutside the Central Bank (official institutions such as BNDES, CEF, BB andstate and commercial banks). With respect to the rollover of externaldebt, principal and interest payments, only the latter has impact on thedeficit, and it is likely to have a smaller than projected impact. In thecase of the interest on the banking debt, the target is expected to be metsince some states and municipalities have been paying part of theircommitments with federai financial institutions thus reducing theoutstanding debt and its impact on the deficit. The issue of bonds ofstate and municipal domestic debt is within the programmed levels.

30. The operations carried by the social security system and "fundsand programs" are expected to register a joint surplus of 0.3% of GDP.This projected outcome is mainly a result of the stabilization in realterms of the wage bill and of some changes in the social securitycontributions.

Prospects for 1988

31. The proposed budget for 1988, sent to Congress for approval lastAugust, completes the unification of the budgetary process. It includesthe transfer of parafiscal operations from the Central Bank to theTreasury, thus freeing the Central Bank to devote itself to its monetary

ANNEX IPage 13 of 14

functions. These operations are included in the budget of official croditoperations and comprise disbursements and receipts for credit programs,credit subsidies, purchase of agricultural projects under the minilum priceprogram and the formation of regulatory fund*. In * iti, all *peetalfunds under federal control are for the first time included in the fiscalbudget. These important changes complete the process of unification andintegration of the fiscal and monetary budgets initiated in 198 .ith thetransfer into the budget for the Union of expenditures related to thepurchase of agricultural products, the financial charges of the publicdebt, and other costs related to the minim-- price program (transport,storage, insurance and subsidy expenditures). The measures related to the1988 budget include: (i) prohibition of subsidized operations except whenthose are provided for in the fiscal budget. Interest rates on officialcredit lines would not be below the cost of federal securities unless thesubsidy has been provided for in the budget; (ii) elimination of extrabudgetary sources of financing which implies first, the prohibition onsupplying funds via the Central Bank for any credit operations not derivingfrom the execution of monetary and exchange rate policy and second, theplacement of new federal securities only for federal debt service and tofinance the deficit foreseen in the fiscal budget; (iii) transfer from theCentral Bank to the Finance Ministry of the functions derived both from theissue or repurchase of federal securities and their control and from theadministration of developmental credit funds; and (iv) creation of thefinancing coordination committee to: (a) analyze any proposals affectingthe goals established for fiscal and monetary policy and the publicdeficit, the opening of new credit lines, and the expansion or extension offiscal incentives; (b) establish maximum limits for the provision ofresources by the federal government and for spending any revenues; and (c)estimate revenues of the federal government for revisions of the federalfiscal budget.

33. 1988 Prospects. The completion of the reordering of publicfinances and the enhancing of discipline in the public sector, effectiveJanuary 1, represents the institutional framework for achieving thereduction of the publ!c sector deficit to 2% of GDP. Associated with thisdeficit target is the goal of increasing the tax burden, net of transfersand subsidies, from 10 to 12% of GDP. The budget proposal indicates anoperational deficit for the enlarged fiscal budget of 1.3% of GDP. Thisprojected deficit results from 0.2% of GDP as net borrowing requirements ofthe traditional fiscal budget, 0.8% of the budget of official creditoperations and another 0.3% of the cost of the public debt.

34. Tax revenue has been projected to increase in 1988 reflecting ahigher level of economic activity, and the elimination of certain taxexemptions and fiscal incentives. In addition, other measures alreadyannounced would help to reduce central administration operations in 1988.In particular the elimination of the producer wheat subsidy and of therural credit subsidy would contribute to the programmed reduction.Nevertheless, measures to attain the goal of 12% of GDP net tax burden arenot spelt out in the budget proposal.

ANNEX IPage 14 of 14

35. However, developments in late 1987 are likely to make that targetdifficult to meet. The projected improvement for 1988 hinges on theeffective and timely implementation of the intended major changes. In viewof the uncertainties thot prevailed about the neceasay tax change, toimplement the tax reform designed by the Constituent Assembly, and the poorimplementation of the measures to achieve the 1987 target, an additionalfiscal effort is advisable. This fiscal effort should include significantstructural measures and be consistent with a medium-tero strategy. Thesemeasures should complement the impact of the short-run stabilizationmeasures announced by the Government. These measures may include: (i)reduction/elimination of subsidies (wheat, sugar, alcohol); (ii) reductionof fiscal incentives and tax exemptions; (iii) increase of import tariffrevenue replacing quantitative restrictions on imports; (iv) tax reform inorder to adjust to changes induced by the tax reform law in the newConstitution; (v) institutional reforms to implement the decentralizationprocess both in terms of revenue and expenditure; (vi) public employmentand wage policy; (vii) price policy for state enterprises; and (viii)revision of state finances through the reform of the financial system andin particular the state banks.

36. The target for 1988 is likely to be very difficult to meetwithout important structural measures implemented in a timely fashion. Tobring the public sector deficit down from about 5% of GDP in 1987 to 2% in1988, an important fiscal effort is required. Most of the necessarymeasures should be designed and inserted in a medium-term strategy toattain the goals spelt out in the Macroeconomic Control Plan fkir 1987-91.Furthermore, if the tax reform under preparation in Congress becomes evenpartially effective in 1988, the adjustment required at the federal levelmust be larger. The experience of 1987 showed a more effective andsuccessful implementation of short-term measures like ceilings, freezing,and across the board cuts. Nevertheless, the economic impact of this typeof measure is likely to be negative. Furthermore, some measures are once-and-for-all gains. In addition, the credibility of non-structural anti-inflationary measures In effecting the necessary adjustment is so erodedthat only a serious and consistent set of structural adjustments is likelyto reduce inflationary expectations.

-~~~~~- - -

ANNEX IIPage 1 of 5

REVENUE PERFORMANCE AND PROSPECTS (1987-68)

1. This note discusses the central and state governets' tax revemuperformAnce for 1987. It also presents projections for 198 centralgovern mt taz revenue under two sets of macroeconomic ass*utions. Theasamptions with respect to expected tax law chnges are built in and empotential discretionary changes are discussed. A brief review of the stategovernments' revenue situation concludes the note.

The Central Government Level

2. 1987. The elpected Treasury revenue performance for 1987 shows ashortfall compared to the targets established earlier in the year. Table 1gives the information as a percentage of GDP and the absolute figures aregiven in the Attachment. It is forecast using actual data up to October,assuming a GDP growth rate in 1987 of about 42, and 9.5? inflation inOctober, 12.5? in November and 15? in December. Prelimary actual data forNovember are also built in. Total gross government revenue for 1987 isforecast to be Cz$1219.9 billion or 9.9Z of GDP. This includes TaxRevenue, contributions to FINSOCIAL and all the Non-Tax revenues.

3. To get to the Net Revenue figure, Fiscal Incentives and Refundshave to be deducted. The estimates assume the same proportions of thesedeductions used by the July 1987 Macroeconomic Plan. Net FederalGovernment Revenue is estimated to be 9? of GDP. The July MacroeconomicControl Plan was less pessimistic on the gross revenue prospects because itassumed a 52 growth rate and much lower rates of inflation for the secondhalf of the year. The Plan assumed a Gross Revenue to GDP ratio of 10.62and and a Net Revenue ratio of 9.7?.

4. As of September 1987, refunds have reached Cz$23.2 billion ascompared to Cz$31.2 billion for the full year according to the Plan. Thetotal of fiscal incentives has reached Cz$39 billion as compared to Cz$65.8billion in the Plan for the full year. The government is trying to reducefiscal incentives during this last part of the year, but this is likely toprove difficult.

5. The dominant source of decline of total gross revenue from 10.9?of GDP in 1985 to 9.92 in 1987 is the drop in tax revenue. While in 1985and in 1986, gross total tax revenue (excluding FINSOCIAL and Non-TaxRevenue) represented around 9.2? of GDP, in 1987, that ratio dropped to7.8? of GDP. The loss comes essentially from the lower income tax revenuegenerated by the withholding tax. The total corporate income tax yield hasdropped from an average of 3.1? of GDP in 1985 and 1986 to 2.1? in 1987.

I I NEX II

Paso 2 of S

Table Is Federal owe rnwnt Gross levmue as Share of GM

1985 1986 1987 1987 19t 1t9"forecast Plan optil. alterma.

Iportc Tax 0.41 0.51 0.31 0.42 0.42 0.41

llp 2.11 2.32 2.42 S.01 2.5X 2.41of which Tobacco 0.51 0.52 0.62 0.62 0.51 0.51

Ince Tax 5.31 5.22 3.92 4.21 3.81 3.71Individual 0.22 0.2z 0.32 0.32 0.31 0.31Corporate 1.52 2.02 1.62 1.62 1.62 1.52Withholding 3.72 3.02 2.02 2.32 1.92 1.92

of wh. Labor 1.4? 1.0? 1.02 0.82 0.92 0.9:Capital 1.5? 1.22 0.5Z 0.72 0.52 0.52Trsf. from ROW 0.7Z 0.62 0.32 0.12 0.32 0.32

Electricity Tax 0.22 0.2? 0.22 0.2Z 0.22 0.22

Fuels Tax 0.1? 0.1? 0.2? 0.22 0.2? 0.2?

Territorial Tax O.OZ 0.0? 0.02 0.0? 0.0? 0.0?

Transport Tax 0.12 0.1? 0.1? 0.1Z 0.1? 0.12

Minerals Tax 0.1Z 0.1? 0.1? 0.1? 0.1? 0.1?

Financial Oper. Tax 0.5? 0.62 0.5? 0.6? 0.5? 0.52

Export Tax 0.2? 0.0? 0.0? 0.0? 0.0? 0.0?

Communication Tax 0.12 0.1Z 0.1? 0.10? 0.0? 0.0?

Harbor Improv. Tax 0.0? 0.12 0.0? 0.02 0.02 0.02

FINSOCIAL 0.6? 0.7? 0.6? 0.6? 0.7? 0.62

Other Revenue 1.1? 5.5? (**) 1.5? 1.12 1.6? 1.6?

TOTAL 10.9? 15.5? 9.9? 10.6Z 10.12 9.82

Additional Revenue (*) 2.52

TOTAL 10.9? 15.52 9.9? 10.62 12.6? 9.8?

Sources: - Secretaria de Receita Federal (SRF) for 85-86- World Bank Staff Estimates for 87-88

(*) 1988 - includes .5Z of 1987 revenue to be collected in 1988 (seepar. 6 and 7) and 2? representing the potential net yield of changesexpected to be implemented under the Macroeconomic Control Plan 1988objectives.(**) 1986 - the 5.5? figure reflects the inclusion of the sale ofagricultural products in Other Revenue in 1986; this procedure was droppedin 1987.

- 17 -

ANNEX IIPage 3 of S

6. The lover-than-expected performance is explained by a combinationof factors. First, it reflects mainly the poor performance of the Tax onIndustrial Production (IPI) as compared to the Plan. During the first halfof 1987. the IPI benefited from higher rates and prices for tobacco, drinksand vehicles. IPI collections have, however, beon hurt by the prize freezewhich has had a lasting effect on the price of *o industrial products.like automobiles. Lower-than-expected GDP growth has also made the Plan'sforecast an optimistic one. Second, it reflects the lower taxable profitsdue to increases in real wages in 1986. since the 1987 income tax revenuebase is 1986. Finally, the Import Tax has suffered from the restrictionsimposed at the beginning of the year. The export tax contribution remainsmarginal since the share in total exports of products exempted from taxeshas increased.

7. The 1987 performance also reflects a possible underestimation ofrevenue: depending on the results of a law suit against the Federal RevenueSecretariat regarding the attempt to reintroduce monetary correction in theincome tax system, the corporate income tax revenue may or may not beunderestimated by Cz$40 billion or 0.3? of GDP. The odds are in favor ofthe government, but this additional revenug would not be paid before 1988.

8. Overall, many of the other taxes have seen their real contributionto total revenue decrease in 1987 with the exception of the Fuel Tax. Thisis explained by the much lower real price of electricity, minerals andcommunication services as compared to 1986. The Fuel Tax has performedmuch better because it is now calculated on a higher base. A large part ofthe residual component - Other Revenue - has also yielded much less thanbudgeted. That category includes contribution to 'Education-Wagew andcharges for social welfare, sugar and alcohol, and the Merchant Marine.All of these categories have had a poor year because of the price freeze.The impact of the 20? increase in mineral prices decided in October has nosignificant impact since the tax on minerals only yields an annualrevenue of about .1 of GDP.

9. 1988. For 1988 an optimistic and an alternative case areconsidered. In the optimistic case, growth is 4.5? and inflation 6Z amonth. In the other case, growth is 2.52 and inflation 152 a month. Theforecast builds in a number of important changes in the tax system. Itincludes a better indexation of the personal and corporate income tax. Asof 1988, the payments of the income tax are expected to be made in OTNs.Improvements in collections from withholding at the source have beenimplemented at the end of 1987 and are expected to have a larger impactnext year. Since the tax reform will not have any effect until 1989 ontotal revenue, additional measures will need to be implemented to limit theoperational deficit to 2? of GDP in 1988.

10. Assuming no additional changes in the tax structure and ignoring acouple of pot ntial windfall gains, revenue as percentage of GDP hardlyrecovers from its 1987 drop in the optimistic case to 10.1Z. It dropsfurther to 9.8? in the pessimistic case. As mentioned, those ratios omit

- 18 -

ANNEX II

Page 4 of 5

the positive impact of a favorable court decision on the reintroduction ofmonetary correction. This would represent a windfall gain over 0.32 ofGDP. It also omits a one time transfer of revenue due to changes in thecorporate tax law. These two items add up to about 0.5t of GDP. Estimatesof total gross revenui for 1988 in the optimistic case without additionalmeasuree shold then oe about 10. 62.

11. No information is presently available on the additional weasuresto be implemented. The IPI is always a candidate since changes in its taxrates are easy to impleent. Some fiscal incentives cuts are proposed todecrease the losses in income taxes, import taxes and IPI. Additionaltaxation of capital incom along the lines recon ended by the tax reformproposals of the technical comittee organized by SEPLAN in 1985-86 mayalso be implemented. A successful trade liberalization vith a substitutionof quantitative restrictions by tariffs could also yield a non-negligiblewindfsll revenue gain to the federal government. New import tax rates, ifused as part of the customs tariff reform, may increase the revenue fromimport taxes used in the forecast (.3Z) by between 50 and 100X. Thesemeasures could result in a 2.0? increase in tax revenue as a proportion ofGDP. If they were implemented, the gross federal revenue-to-GDP ratiowould rise to 12.6Z.

12. A potential problem could result from an early implementation ofthe decentralization proposed by the current draft Constitution. The stategovernments have requested an increase in their shares of total tax revenueas early as next year. Nothing has yet been decided. Decentralizationwould reduce the revenue available to the central government by over 30Z inthe medium term and increase the federal deficit in proportion. Theoverall deficit would be affected by the changes if the states and localgovernment were to take the opportunity to increase real e,xpenditures andif the federal government were not able to cut its expenditures.

The State Governments

13. The most significant tax available to the State governments isstill the value-added tax on goods (ICM). Its 1987 yield has decreased inreal terms as compared to 1986 by about 11, but is still 23? higher thanit was in 1985. Through August, the ICM yielded Cz$292.5 billion which waaa 121? increase in nominal terms as compared to the collection of 1986 forthe same period. But there is a strong seasonality factor in this tax anda recovery is expected in the later part of the year. In 1987, ICM mayyield a revenue between 5Z and 5.4Z of GDP as compared to 6? in 1986 and 5Zin 1985. There have been no changes in tax rates since 1984. The erosionof 1987 is concentrated in the first semester and is explained by acombination of high levels of inflation and slow collection. The recoveryof inflation in the last quarter of 1987 is likely to have a similarimpact. In addition, the IPI tax rate cuts are likely to decrease ICMcollections, since the tax base for the ICM includes the IPI whenever itapplies. The 1988 ICM revenue should remain between 4.5 and 5?.

*D _ ~~~~~~19-_

Table It Strw Ta.hu.oth al wi rc in

15 14 10W 1w9 1 ig 1Jae/kt Total PI* otia altorut.kctul Fermat

lnwrt tU 5213 14,777 29,9 42.40 44.34 112.759 224.805

PI 24 83,392 212,75 297,o2 3 112 794214,404,2Toacco 40 I0tn V,U 71,2 4,54 143.8 314,1kOthr 2234 44,40 142,767 225,32 243.240 432,531 1,172,104

Inc Ta; 7444 191.297 359,9 470,034 463.733 1,140,0 2.244.370lsdivisaZl 2423 .144 29,290 34.90 31,733 92.704 m104%curerathOfZe 2011 '13,441 141.824 16n,404 132,520 406,304 U49,38

tzt"holdinq 51404 1,3,512 101,14 244,442 24MM344 509.M0 1,110,106Laber incou 19708 37.790 93.041 135,000 83.512 237.9M5 532,902Capital Inca"e 21279 46,081 49,830 63.057 82,332 1l0.956 312,134Transfers abroad 9771 22,730 31,017 39.163 14.572 102,619 204.822

Cther 786 4,912 7,935 9,2 0 30.200 60.248

Sole Tax on Electricitv .- 9t 7,870 14,375 19,621 20,645 52,462 96.898

Sole Tax on Minerals 1236 3,255 5,147 7.400 6,348 21,419 39,561

Sole Tax on Fuels 1508 8.536 60.104 28,511 26,685 70,710 124,829

Tirritorial Tax ?6 157 2t63 351 418 972 1,939

Transport Tax 900f 2,887 5,991 8,088 6,867 21.371 37;7,220

Tag on Financial Operations 7±82 2:,419 45,977 61,026 66,170 l68,449 336,043

Exoort Tax 3957 1,550 2,352 2-'22 3,662 7,928 15,823

Tax on Coauunications 1674 5,008 9,895 14,477 12,906 40,916 65,847

Harbor loproveeent tax 62. 1,973 3,732 5,282 5,451 14,279 28,469

SUP TOTAL 128,641 341,120 710,458 958,422 Q92,343 2,476,298 4,722,267

FINSOCIAL 8070 24,989 54,569 74,568 69,849 204 ,Q09 378,46'

Sol TOTAL 136711 366,109 765,028 1,032,490 1,062,12 ;,681,2.7 ',100,729

Cther Revenue 16'l7 203,892 149,66b 187,4'7 118.365 490,640 978,808

TOTAL 6ROSS REVENUE 152,,28 570,001 914,694 1,219,937 1,180,',57 3,171,857 6.079,5,6

9~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I i~U -

-20 - _ _

Page I of 11

ESCENT PIIUIAL MUONCI AND MCI POLICIES0?F MSAL ULC u,uRPIS

1. FTroqo several asures introded 1jaw IM *3, the @or1tintended to rede te overall de ficit (before tr_ef ee) of federa pabicenterprise to 0.71 of X In L97, cor_d wiith a prviusly uticipatedlevwl of 1.6? for the yer (sad 1.41 reistered In 19X6). Th roductionwas to )a1 Involved a current operatft& surplus Increase of 0.61 of MPand lower invewt_ent e*penditures quivalent to 0.31 of GDP. It ppearsthat the intended investment reduction will be achieved, but there will bea major shortfall on the intended increase in current operating surplus.As a result, the overall deficit is likely to be around 1.62 of GDP in1987, not substantially different from its 1986 level (Table 1).

2. The main thrust of the June program was to raise public sectorprices and tariffs so as to increase operating revenues by 0.4Z of GDP,while reducing operating expenditures by 0.32 of GDP, particularly on wagesand non-interest payments. The intended expenditure reduction will not beachieved fully, especially because of wage increases granted in the lastquarter of the year. On the revenue side, the shortfalls relative to theintended targets ore significant. Operating revenue is likely to be onlyabout 11 of GDP, compared with the June target of 12.2?. A 6.5S averageincrease in the volume of sales during 1987 is likely to be offset by afall in average real price/tariff (Table 2). leaving overall receiptslargely unchanged in real terms.1 Price/tariff increases in June 1987 weresignificant, but subsequent adjustments generally lagged behind inflation,except for the recent upturn of steel and petroleum products' prices.Quarterly prices declined in real terms as inflation accelerated during thelast quarter of the year.

3. The 1988 budget for federal public enteprises envisages investmentgrowth, and reduction of the operational deficit tr 0.5Z of GDP, which willnecessitate a considerable expansion of enterprise savings. This expansionwill require broad-ranging, economically justifiable, price increases, asdetailed below. It will also require broader mechanisms for monitoring andreviewing the performance of public enterprises to improve efficiency andreduce costs, while increasing the autonomy of the enterprises in settingprices.

Price Trends

4. Contributing to the shortfall in real operating revenues weret (a)higher-than-expected inflation rates in the second half of the year (with

1 Averages are calculated on the basis of sectoral estimates for fivemajor groups of federal public enterprises (para. 5).

--- - ------ 21-

Paso 2 of 11

1* 14 gwiesm Atmum rise, Jo" pe..a

.~4 bt4ee Atm-Ow .h.4 Suteeime-GO' Liu 1w Pigs Ph.

1. ~~~~~~~~~41.4 5681 151-, 4ft.* ON.# M0 U 46 88. 3.6 WI. 48.6

615.6 515. M, 4M. Mo m0.9 SM.2 1.4 11.4 11.1 U.SPL4 USA M.8 40.8 5.6 U2.e 13.1 3.0 1.5 1.9 1.5

19.8 10.0 6.0 15.1 U.S 86.1 4.S 0.8 0.8 0.9 0.9

U. @AW Ss11im 418.6 197.7 111.8 430.0 710.8 85n.0 1856. 12.2 10.5 11.0 11.

Waes & Saargi.;es 71.6 85.4 26.7 79. 189. 16. 165.2 1.9 2.2 1.9 2.0

laerst79.5 4". 30.4 5.6 126.2 101.7 267.9 2.2 1.S 1.9 1.9

GUim. 26.8 196.0 48.2 962.2 812.5 510.7 548.2 7.1 .6. 7.2 7.4

:u.o.el'sur U.U 77.6 44.5 20.0 54.5 110.8 99. 216.1 2.1 1.7 8.1 2.8

IV. mw40m .. M sur OF

REULC 33073P 45.6 19.8 5.2 24.7 81.0 26.0 77.0 1.2 0.6 2.7 2.?

W. CAP1TAL M. DP URE 129.6 98.4 61. 5 180.6 257.1 162.2 410-8 8.8 8.4 38. 4.1

Utwestment 109.? WA. 27.4 109.8 214.7 1816.5 851.4 8.0 2.0 2.7 8.0

Other ~~19.9 18.2 5.1 21.8 42.5 25.4 67. 9 0.8 0.5 1.1 1.1

Vt. 0P3ATIOAL SILAS -6.4 -34.4 -7.3 -41.7 .49.9 -86.4 -126.8 -0.2 -1.0 2.0 0.9

VU.FDNCDIM 6.4 34.4 7.8 41.7 59.9 86.4 12n.s 0.2 1.0 -2.0 .0.9

loreiga -89. 0 -14.4 1.1 -13.3 437.6 5.4 -32.2 -1. 1 -0.3 0.8 0.5

Domsmtic 48,4 48.7 6.2 85. 0 1I7.5 31.0 186.8 1.2 1.8 -2.8 -1..

SankinS Syat.. 41.0 41.5 6.2 47.? 105.5 31.0 189.5 1.1 1.1 -2.8 -1.4

Plest'ing Debt 4.4 7.8 7.8 19.0 0.0 19,0 0.1 0.2 0.0

#saemreadma Item:

OverstmsomlSurplus(4)eficit) -61.0 -88.9 -12.5 -6. 4 -140. 9 -62.4 -206.8 -1.4 -1.6 -0.7 -1.5

Sfc'. -Tread.eo fro Pub Ii c Secetie

Imrcmo: Siereterietk for tlho Control of Federal Public bnt.rprimem (SIST);

end oen" staff *stimtae.

Ut,I* 2- 9-. I - P44 tb PhI. b9. -;i..6...I .sd 06.2 P.1. 1.di-,

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tpiS O.W ceo0 1.57 5.6 ii 7 41.6 2010.00 1894 147.6 19.3 21b9 86001 a" 4 W.l 874 ANe em 40 4 fF? M3e .e M.0 40.4 gm# n,

Cl.4.m ig, N 0.eo ow i.4 4.84 WM6 u4.0 M0."6 UN in, ia 1 i7.8 2 its 20. 4876 440.e .m 809. e4.3. $W.$ WAm M". US., m0.i

ft 1alal 120.07 1aa.m9 1oe.s7 IGS.Y4 105.7 106.4 is.. 860 92e icc.0 118 £ in0.? ino 18.0 in to38I aM.e an0.4 'We am.g am.. 0. a

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it 1e7..1 aes44 U0..8 toe. he IA W It Si. 9 77.8 64.4 70.1 VA. 64.6 01.4 915 7.6 Ws. Me W.i 60.i 0.e so.? e.g 4.e-

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It 190.06 811 07 117.70 IO s I. 18679 a.1 ".a 77.8 at 78 4 4..a de a Wn.. to.7 607 me so 86t.? ".9. ~ m s. ~ ne t

T.I4....ti4~M I 07 1.60 a ao 7.20 Jo so 86.s 140.0 249.4 024 1 211.0 872.0 409. 4 M0 7 e"n. " " IOeTitv 718 27".8 aM.* S e, 'ee oa.

ft em O 28W.9I M.21 16.46 I" it in 7 lotI 118.5 151.6 140 1 152.6 26n.1 179.2 I00.s 121.0 1In 1831.2 186.0 381.* am i.i 0. 655

P...... ftI...e M 0 49 1 00 2.00 4.20 ii-... 86 86. 100 0 I'A.7 127 0 127 0 17160 219.1 01.6 so 607y 7 gm6 a . 886.3 so's tm.i e. m a.

it I2n 27 184.Is 2IV.6M 107.77 04.64 112.4 .9. 77 a 74.8 74.6 62.8 076 60 8 6A . 86. a6 6 a6 1 68 .1 63 8. 6 6. .

A.#t.o 061. M oil2 I.S7 2.86 60 I 2 0.7 608 7 096 104.1 115.8 141.0 IT7 e 287 6 648 Us. 867.6I am a 7 in?7 tW$ up's SW-& a..6 8.o 4W.1

ft 160 47 286.86 179.70 170.57 am2 n 12868 867 6.0 *D.2I W5 I 67 I 9182 W f. .91aiIs6 I9 86 0 86.6 o 41 .9.0 6r.1 W?.? 6-0.0 .

A~g?~~(*3c..i M a 00 I.86 8.14 1.00 18."0 40.20 100.6 216I8 1461 a 1829 201.7 276 1 8000 410.0 am 7 48607 en7 W.? 001,SC 8 a. s t Avs.8 40? Ma

ft 172.54 160Of 249.60 tn5.n 122 44 116.2 97 ".9. 86.0 86.0 106.2 106.2 116.1 11t0 Ill.? ,7 206 I18.9 am 4 2640 .S m. we's aM- ass.i

Oh.i" 414.. O : .b"liw.. (.Wd.0.. p'9Je4044 1 OW.1.2 i.4~ to.co.A.10'-i

006,0

- 23 -

Page 4 of 11

projected GDP deflator for the year about 121 higher than estimated inJune), and (b) lags in price/tariff adjustments, partly as a result of newprocedures established in June for modifying controlled prices. Followinga price freeze of up to three months beginning in mid-June, prices (andwages) would be adjusted uniformly over each of the next three months onthe basis of the Price Reference Unit (U P), defined as the geometricaverage monthly inflation, meaeured by the official coneumr price index(IPC), during the freeze. In practice the freeze lasted less than threemonths, so the first URP was defined as average inflation in July andAugust (4.71), with July's inflation being particularly low given thechanges in the base period ef *he IPC which took place that month.Beginning in December 1987, the URP is to be fixed for three-month periodsbased on the average IPC change aver the immediately preceding threemonths, i.e. the URP for De -rzjr 1987, January 1988, and February 1988 isdef:sed as the geometric average of the IPC increases in September-November1987 (9.2Z). Larger price adjustments would be allowed in sectors thatfaced relative price disequilibrium at the time of the price freeze;sectors which suffered variations in cost of production or productivitycould be granted price increases above or below the URP, depending on thecircumstances. In a situation of stable or decelerating inflation, URPadjustments would have prevented the erosion of real prices. But with theacceleration of inflation since September, the backward-looking URP methodbecame increasingly inadequate and had to be complemented by discreteadjustments, which were revertheless insufficient to maintain real pricesin most cases. Average real prices during July-December are projected tobe 5Z lower than in July (the peak month in the year) and about 19Z lowerthan would have been required to achieve the targeted increase in operatingrevenues (with monthly inflation rates of 9.5Z. 12.52 and 15Z,respectively, in the last three months of the year, Tables 1 and 2).

5. Federal public enterprises comprise a large and diverse group of157 companies, but most of these are part of five major and distinctsectors--petroleum, electricity, telecommunications, steel, and ferrousmining--which largely determine overall trends since together they accountfor about 84Z of total sales. Price/tariff trends in nominal and realterms (deflated by the general price index for domestic supply, IGPIDI) foreach of the major five sectors over the period 1980-87 are presented inTable 2. Operating revenues for the year were projected on the basis ofactual aggregate receipts for January-September, monthly price data for1987 (with actual price/tariff increases through December 4 and URP-basedadjustments for the rest of December) and assumed volume growth. Thesectoral prices/tariffs were aggregated into an average price/tariff usinrg1986 sectoral sales as constant weights over the entire 1980-87 period; anaverage excluding petroleum products has been estimated to capturedifferences in trends and to project revenues for companies outside thefive major groups.

6. Average real prices/tariffs show a strong downward trend in 1981-86, even if petroleum products are excluded, and even given the fact thatin 1986 the IGP/DI is recognized to have underestimated actual inflation.

-24-

_________________ - - V1FigueUT IL-3 o

BRAZIL: SELECTED REAL PL'ILIC SECTOR PRICES/TARIFTS820~ ~ ~~t0

210 -

a..

&sO, -

I

X 1.30_ cn ingPrdc

1t20

I tooi

* lo1Z0

110

£960 1961 1962 1983 *964 1965 19*

Year

220 -

210 -ZO 0 roeu Dertvat£e

O 190 *zJ v.ld

40

970 - /a-

170 Seepdcluing esinceu198 influenecyptoempiedcie

A'9 160

140-

* 130

100.

110

100

90 £980 196£ £962 £963 1964 1965 10

Year

/a Steep decllne since 1984 influenced by petroleum price decline.

Source; Table 2

25 ---

FIgure 2

BRAZIL: SELECTED REAL PUBLIC SECTOR PRICES/TARIFFS

,~~~~~~~~~~~~~o 1.?

1 .0

100

160

o Mainl ro,

Jan Fob Mar Apr may Jus Jul Aug S&p Oct Now Dec

1967

120 -

110

100 Smse vrgs/

A

Petro 0 F-b Jluml *uctN

N000

Jan Fob M*r Apr may Jun Jul Aug Sop Oct Nov Doc

1967

/a Semester averages derived using Overall Average Index.

Source: Table 2

- 26 -

Annex IIIPage 7 of 11

Particularly pronounced was the fall in real telecomnication tariffs,which can be only portly explained by cost reductions steming fromeconmies of scale and technological developamts. Sigificant but moremoderate price declines applied to steel, ferrous mining products andeloctricity over the same period (Figure 1). Petroleum product pricesdeclined slightly in 1984 and abruptly in 1"5, in parallel withinternational trends.

7. The sonthly trends of real prices/tariffs during 1987 showconsiderable instability (Figure 2). The average price/tariff excludingpetroleum products started the year about 10S below the March 1986 level,rose to over 15 above that level in June-July and declined since then;with estimated end-year level only about 51 higher than in March 1986.Petroleum product prices also experienced considerable variations duringtho first seven months of the year, but became more steady subsequently.Such large shifts generate unsteady real revenues to the enterprises andare bound to have disruptive effects on the rest of the er'onomy, settingunpredictable cost-push forces in motion. With the exception oftelecommunications and electricity tariffs, which rose above theirrespective average 1986 levels, the erosion of real public sector pricescontinued unabated in 1987. However, prices/tariffs were on average higherin the second half of the year than in the first part. The projected year-end level is about 15? higher than the January 1987 level, which wasabnormally low largely because of protracted or insufficient priceadjustments during 1986 under the Cruzado Plan.

Financial Performance

8. Generally lower real prices/tariffs in the last quarter of theyear are likely to have a major impact on the financial performance offederal public enterprises, which will also be affected (on a smallerscale) by rising interest, wages, and other operating expenditures.Interest payments fell in real terms in the first half of the year, androse subsequently as enterprises expanded their use of short-term credit tofinance their growing deficits. The wage bill rose because of real wageincreases during the last quarter of the year, and also because employmentin federal public enterprises was 4S higher than in 1986, reaching a totalof 642,700 persors. From January to September the cumulative deficit(before capital transfers from the rest of the public sector) of theseenterprises was equivalent to about 12 of GDP; in the last four months ofthe year it is estimated to reach 0.6?, for a yearly total of 1.6? of GDP.

9. Through significant cuts in investments under the June Program,particularly in the petroleum sector, the investment of federal publicenterprises is likely to remain at about the same level as in 1986,representing a small decline relative to GDP. Investments in petroleum andelectricity togethei absorb more than half of the total, followed bytelecomunications (17?), steel and mining (1 each), as reflected in the1987 budget of federal public enterprises (approved in August 1987).External financing is significantly lower than expected in the budget, butthe Government has extended bridge-financing to some of the affected

-27-_______ ~~ ~~~ ~~- ------- ------ - … - - - 2 7

Annex IIIPage 8 of 11

sectors --particularly electricity --to protect critical investmentprograms the postponement of which vould be either costly or disruptive oflong-term plans for capacity expansion and grovth. There has also been asignificant increase in floating debt to suppliers (Cz$19 billion inJanuary-September) which is predominantly investment-related.

Prospects for 1988 and Potential Areas for Government Action

10. The failure to reduce significantly the operational deficit offederal public enterprises during 1987 poses serious questions for the 1988target of lowering it to 0.3? of GDP (as intended in the June Plan) or 0.51(as revised in the recently approved 1988 Budget). While the objective ofreducing the overall fiscal deficit in 1988 is crucial, the specific targetfor public enterprises must recognize the need for critical investments aswell as the need for economically-justifiable prices for public enterpriseoutputs. The June Plan intended to increase real investment by 92 in 1988;considering that there has been some postponement of investments in 1987,the 1988 Budget aims at a 11? real increase (equivalent to about 0.22 ofGDP). Investments in 1988 will be concentrated on electricity (342),petroleum (27Z) and telecommunications (18Z). These sectors will absorbclose to four-fifths of the total.

11. The intended investment increase and the deficit reduction targetwill require a significant expansion of enterprise savings, equivalent to1.32 of GDP. A program of efficiency improvements could contribute toreducing unit costs and enhancing savings, but such a program may not beable to yield results quickly, perhaps only 0.22 of GDP in net savingsduring 1988. Hence, the bulk of the intended saving gains in the shortterm would stem from additional revenues, which would have to increase byat least 15t in real terms during 1988. The prospects for increasingrevenues vary considerably across sectors. As explained below, there isscope for substantial prices/tariff increases in electricity, steel,ferrous mining products, and telecommunications. If 1988 average realprices/tariffs in these sectors were 15? higher than in 1987--for instance,through real monthly increases of 2.5Z-- annual revenues could increase by0.62 to 0.82 of GDP, depending on volume. This would fall short (by 0.32to 0.52) of the 1.12 needed to achieve the targetted deficit reduction.Hence, real price increases for petroleum would also be needed, but thesewould have to be accompanied by changes in petroleum products' relativeprices, which remain distorted despite recent improvements (as explainedsubsequently) and have negative effzcts on economic efficiency and growth.

12. By far the most important revenue earner is the petroleum sector,which accounts for more than half of total sales by federal publicenterprises. Additional revenues to the sector should accrue through amodest expansion of domestic production and, more significantly, bystepping up price adjustments o'r selected products. In particular, effortsshould be made to maintain domestic retail prices of petroleum products ator above international prices (which represent the opportunity cost to theeconomy for tradeable oil products). As in other countries, the retail

- 2*

Amex IIIPago 9 of 11

prices of sm petrolem products contain a significaut elment oftaxation, for fiscal and eu.rgy-conservation purposes. Currently only theprices of naphtha and liquified gas (which is ued by 22 million low-incomfamilies) are substantially below international prices. There are mplicitcross subsidies iwmlved in the operations of Petrobras, the petroleumsector eaawy, particularly in the a1ca1 ffel c s pr _esr wichus alcohol In a 20-222 blend with psoline. As a result of losses, nalcohol ad oil Imports (the latter becauso of lago in adjusting petrolemproducts' prices In correspondence with the depreciation of the crusado),Potrobras failed to transfer proceeds from taxes and surcharges to theRational Deoelopment Fund (D); its cumulative *rreare reached C&$19billion at the end of September. Rlgher alcobol prices (currently set at65 of gasoline prices) would be needed to reduce the subsidy on hydrousalcohol, which was Cz$l.9 billion in October (and could reach, on an annualbasis, up to 0.2: of GDP). A recent Government Coemittee Report on theAlcohol Program (May 1987) concluded that the program has been generallysuccessful, particula7ly in reducing import dependence and enabling anexpansion of diesel pkoduction. According to the report, an expansion ofthe program would be economically justifiable at international petroleumprices (cif) of US$20.5-USS23.2 per barrel (with a shadow exchange rateabove 302 the current exchange rate), somewhat above current prices.Subsidy reductions and the scale of operations of the program merit furtherreview.

13. Selective taxes on different petroleum products have contributedto distorting their relative price structure. Indirect taxes account forabout one-third of the retail price of gasoline; the most significant oneis a 28Z surcharge (compulsory *loan') on retail prices introduced in 1986.Retail prices for basoline in Brazil are at about the median level in asample of about 60 countries, but are generally lower than in WesternEuropean countries. Gasoline prices are above import parity prices,2

while prices of liquified gas, fuel oils and naphtha remain substantiallybelow import parity (despite higher rates of price increases than forgasoline during 1987). Diesel prices were adjusted to more realisticlevels recently but they remain lows equivalent to only 42S of gasolineprices whereas 70-80? would be a more appropriate ratio. This hasdistorted consumption/ production patterns, requiring substantial gasolineexports.

14. To reduce interfuel distortions and facilitate overall pricemanagement, the current system of selective taxes could be replaced by asurtax on all fuels (which could be modulated in terms of the demandelasticity for each petroleum product); especially since the newConstitution is likely to disallow the compulsory loan surcharge ongasoline and alcohol. There is scope for significant price/tax increaseson naphtha, and for more moderate ones on liquified gas because of social

2/ Import parity prices refer to ex-refinery prices based on importedpetroleum costs plus taxes and other charges (including distributionand transport margins).

_ _ - 29

Awiex IIIPage 10 of 11

considerations. Fuel oil should also be taxed but at a more moderate ratethan gasoline because of its wide use in industry and the noed to avoiddemand distortions. Revenue objectives for the petroleu sector shouldalso be given adequate consideration, especially if Petrobras' inmestmentprogram (currently about US$2 billion per year) continues to be financedlargely with Intrnally-gemnrated fuad. If the maasures to redwcealcohol-related subsidies and real price increases for diesel, liquifiedgas, fuel oils and naphtha fail to produce the intended revenues, g aolineprice adjustments my be advisable although the objective of reducingexcessive disparities in the relativ price structure of petroleum productsshould also be given adequate consideration.

15. The four other major groups of federal public enterprises needprice/tariff increases in 1988. Despite recent increases, steel pricesremain substantially below international prices (currently at depressedlevels) and could be increased further. Such an increase would reducelosses by Siderbras, the government's steel company, and contribute to amuch needed financial rehabilitation program aimed at restoring itsprofitability. There is also scope for raising domestic prices of ferrousmining products to reverse the severe downturn started in 1982, prompted inpart by international m&rket trends. Telecommunication tariffs could beincreased further, so tnat the sector can self-finance a greater proportionof its large investment requirements over the next few years.

16. Electricity tariff increases are also needed to raise thefinancing capacity of the sector (and achieve the legally prescribedminimum return of 10), as well as to reflect more closely long-runmarginal costs. The current system of uniform prices throughout thecountry for petroleum derivatives, alcohol, and electricity provides littleincentive to improve efficiency. Its replacement by a more market-orientedsystem should be given serious consideration by the Government,particularly in the case of electricity, which is not operating as planned.State electricity companies with rates of remuneration higher than thesector average are required to contribute to an equalization fund (whichsupports less profitable companies) but are refusing to do so on thegrounds that their rate of remuneration remains below the legallyprescribed 10; the fund's shortfall of about Cz$30 billion (0.2Z of GDP)during 1987 has required federal government support, contributing to thepublic sector deficit.

17. A number of institutional measures appear to be needed tostrengthen the operations of public enterprises, both internally and inrelation to the rest of the economy. At present the Secretariat for theControl of Public Enterprises (SEST) exercises substantial control on theoperations of federal public enterprises, from approving their budgets todefining parameters for policy changes (in consultation with theenterprises themselves and governing cowsittees), with the significantexception of wage policy (recent wage increases exceeded guidelines by aconsiderable margin). The 1988 budget for federal public enterprises--approved on November 30, 1987--identifies ceilings on the expected nominal

-30 - _

Annex IIIPage 11 of 11

deficit (in terms of GDP) and global expenditure of each major group ofenterprises. There is the risk that the budgetary process may undulyreduce the autonomy that these enterprises require to operate efficientlyand respond effectively to changing circumstances. The rationale formaintaining budgetary ceilings on various expenditure categories is muchless compelling in the case of productive activities thbm nhen referred togovernment administration; particularly because it is only in relation tolevels of production that a given expenditure could be indicative ofperformance.

18. More emphasis on economic criteria and on indicators ofperformance appears to be needed to complement and strengthen budgetarysriteria. It would not be desirable to simply raise prices to compensatefor a high cost structure with underlying inefficiencies. In particular,w ere is scope for streamlining employment (which is budgeted to increase;y 2Z) and labor costs. SEST is in the process of developing a system of1-ysical and economic indicators to monitor performance. An important.,mplement to it would be the definition of a program of efficiency--provements (including reduction of unit costs, particularly labor costs)> d underlying economic policies for the major enterprises. This would be;1 important step to strengthen and widen current government efforts on)-ivatization and liquidation of some public enterprises or theirc bsidiaries. Adequate monitoring is also needed to avoid investment:)stponements or reductions which would not be consistent with growth-,ectives. There appears to be a need to strengthen SEST itself, which:,s suffered a substantial loss of its staff--in part as a result of its-ansfer from the Planning Secretary to the Ministry of Finance and the-,wer remuneration levels that this shift has entailed.

Once an effective monitoring and review program is implemented byST, it would be desirable to increase the autonomy of these enterprisesi pricing policies. In the past, price adjustments tended to benfrequent and at times excessively large, but often failed to generate theitended revenues in real terms. While SEST could establish goals in termsreal price adjustments for each sector for the next year, it would be

X sirable for the enterprises to have the authority to adjust prices-iriodically (and on a regional basis), thereby reducing the need for pricelocks which can have destabilizing effects on the economy.

Conclusion. The medium-term gc^l of reducing the operational.rficit of public enterprises is critical. To attain the deficit reduction..ojectives, broad price increases appear to be needed in major sectors,.-icluding petroleum products (but with more moderate adjustments forgasoline prices). The phasing of price increases would need to be!drefully worked out to balance short-run stabilization objectives with

ediur-term adjustment considerations. It would also be desirable toexpand SEST's monitoring and review functions on efficiency,cost-reductionograms and investment implementation, while increasing the autonomy ofe enterprises in pricing policies.

ANNEX IVPage I of 9

EVALUATION OF MEASURES TO REDUCE THE Pl1BLIC SECTOR DEFICIT

Overview

1. Faced with threats of hyperinflation and deep recession, in June1987 the government announced a set of measures which were laterincorporated into the Macroeconomic Control Program. The evaluation of*pecific measures to reduce the 1987 deficit suggests that they are notbelng adequately implemented. The insediate objective of such measures wasto reduce the public sector deficit, which was estimated at 6.7% of GDP in1987. Specific measures were announced to meet the target of 3.5% GDP forthe public aector deficit in 1987 and broad measures were indicated for a2% target In 1988. The announced target for 1987 represented a significantreduction from the expected deficit, by about 2.7% of GDP (from 6.2% to3.5%). These savings were estimated to be obtained through a 1.1% cut inthe Central Government budget deficit, a 1.1% cut in the SEST deficit, and0.5% in the deficit of the states and municipalities.

2. The measures to reduce the public deficit included cuts inexpenditures (mainly at the federal government level, including the wagehill, subsidies and other expenditures), cuts in capital expenditures (SESTinvestment program), increases in revenues through Increases in publicsector tariffs (SEST budget and state-owned enterprises), and limits onthe borrowing requirements of states and municipalities through ceilings ondebt (roll-over and limits on new indebtedness). Because the non-federalcomponent of the public sector remains the more difficult to monitor, somemeasures represent an attempt to control the growth of spending rather thana spending cut as such. The impact of these measures depends on howeffectively they are implemented. This knnex evaluates the implementationof the announced measures and their impact on the reduction of the 1987deficit. First, the measures are discussed according to their nature:short-term, structural, or institutional. Second, the measures (which aredivided into three groups) are evaluated according to their impact ondeficit reduction and tneir implementation risk. Finally, a detaileddescription of the institutional reforms for 1988 completes the Annex.

Nature of the Measures

3. The measures to reduce the public sector deficit may be dividedinto three groups according to their nature--short-run/ad hoc, structuralmeasures, and institutional reforms. The first group consists mainly ofexpenditure cuts related to: (i) personnel expenditures; (ii) cost offederal debt; (iii) subsidies and stock-financing of agricultural productsunder the minimum price program and regulatory stock policy; (iv)investment programs; and (v) other current expenditures on SE'T and fiscalbudgets. Also, the measures taken in 1987 to limit the expansion ofindebtedness of states and municipalities may be considered of short-termnature. Second, structural adjustment measures include: (i) elimination

:~~~~~~~~ 3 2 .- = _ _ = _ _ _ _ _ _

ANNEX IVPage 2 of 9

of the consumer wheat subsidy in 1987, to be followed by gradualelimination of the remaining producer subsidy over a period of three years;(ii) introduction of a partial finance scheme of unemployment benefils byemployers and employees, instead of full finance by Treasury allocations;(ili) changes In the rules for setting publie prlce.; (t}) establisthwnt ofthe financing coordination committee to control the public deficit; and (v)reduction of fiscal incentives and tax exemptions to implement in 19.38 andbeyond. The third group includes the Institutional reforms to covup2 te thereordering of the federal public finances which are to become effective InJanuary 1988.

4. The design of the measures to reduce the deficit in 1987 'eliedheavily on measures of an ad hoc nature. Most of the expected impa.-t indeficit reduction was attributed to those measures. In addition, most .vthem consisted of administrative rules, expenditure ceilings or freezes,and across the board cuts which, beyond their potential positive impact onreducing the deficit, risk inducing a less than rational use of s-arceresources. The expected impact from structural measures was smaller Interms of 1987 deficit reduction, but would have had a major effect lrisetting the stage for reducing the fiscal deficit in 1988, and contri)Ltingto fiscal balance thereafter. The most important structural measure to beundertaken in 1987 was the elimination of the consumer wheat subsidy,although its impact on 1987 deficit reduction would have been only abouL0.07% of GDP. Nevertheless, that eliminatiun would have created thec-aditions for future broader elimination/reduction of subsidies includingwheat, alcohol, and sugar.

5. Taking into account what was effectively implemented in order toreduce the 1987 fiscal deficit, the poor implementation of structuralmeasures explains a large part of the ditficulty in reducing the deficit.At the same time, some ad hoc measures were better implemented andsucceeded, but savings from them will be partially offset by the impact ofunplanned wage increases. The implementation of timely and effectiveexpenditure reduction policies is crucial for attaining stabilization andfor generatiig long-term growth. It may be concluded that the design ofthe package (relying almost exclusively on ad hoc measures), and fewstructural measures explain the difficulties encountered in controlling andreducing the deficit. Some of the structural adjustment measures, like theelimination of the wheat subsidy, may negatively affect inflation, althoughthey have a positive effect on the public deficit by decreasingexpenditures. Thus, it is critical to take into account the stabilizationimpact of structural measures in the design of an economic programcombining short-term stabilization and medium-term structural measures.

6. The institutional reordering of public finances to becomeeffective in January 1988 includes: (i) completion of the unification ofmonetary and fiscal budgets, with the inclusion into the fiscal budget(OGU) of the parafiscal expenditures that have been executed by the CentralBank (monetary budget) and of all special funds under federal control; (ii)

ANNEX IVPage 3 of 9

prohibition on carrying out subsidized operations, except where these areprovided for in the fiscal budget; (ili) elimination of extra-budgetarysources of financing; and (iv) transfer from the Central Bank to theMinistry of Finance of the functions related to the issue and repurchase offederal securities and their control, and to the admlnlstration ofdevelopmental credit funds. The 1988 budgetary elaboration was undertakenunder this new institutional framework and the Budget of the Union (fiscalbudget) ircludes the budget of official ciedit operations. These creditoperations are related to disbursements and receipts for credit programs,credit subsidies, acquisition of agricultural products under the minimumprice program and formation of regulatory stocks. The cost of public debtis also included in this enlarged fiscal budget. These reforms arepresented in more detail in the last section of this Annex.

Impact/Implementation Risks

7. The measures to reduce the public deficit in 1987 fall into threegroups in decreasing order of implementation risk and credibility. Thefirst group of measures estimated to account for a cut of about 1.3% ofGDP, consists of: (i) the elimination of the consumer wheat subsidy andwheat stock savings (equivalent to 0.1% of GDP); and (ii) the SEST-relatedsavings (amounting to 1.1% of GDP). The second group which consists ofthe more risky implementation-dependent measures, was projected to reducethe deficit by 1% of GDP and included expenditure cuts related to: (i)subsidies and stock financing for other agricultural products; (ii)personnel expenditures; (i,ii) cost of federal debt; (iv) other currentexpenditures; and (v) unemployment insurance. The third group includedmeasures most likely to have a minimal impact, amounted to 0.5% of GDP andconsisted of: (i) an increase in the government's float by delayed salarypayments; and (ii) planned cuts in the needs of financing of states andmunicipalities.

High Impact/Low Risk

8. An assessment of the impact of these measures on reducing thefiscal deficit in 1987 is discussed below based on the partial informationavailable. The evaluation shows a smaller-than-planned impact suggestingthat poor implementation has been an important source in the deteriorationof the public sector's performance. The measures considered of higherimpact (wheat subsidy and SEST-related savings) either have not been fullyimplemented or their impact has been neutralized by the undertaking ofother measures.

9. Wheat Subsidy. The announced elimination of the consumer wheatsubsidy required a gradual increase in the price of flour, bread and otherderivatives in a timely fashion. Although on June 12 the Governmentannounced the elimination of the consumer wheat subsidy, the priceincreases planned at that time would have only reduced it. In fact, priceadjustments that have taken place have been insufficient to eliminate thatsubsidy. Consequently, the consumer subsidy has only been partiallyremoved.

ANNEX IVPage 4 of 9

The announcement of the consumer wheat subsidy elimination was perceived asa first step in structural adjustment, and would have created theconditions for a reduction/elimination of other subsidies. These subsidiesare considered income-regressive and economically Inefficient. Inaddition, they absorb large mounts of scarce fiscal rsourcas.Expectations about the gradual elimination of the producer wheat subsidystarting in 1988 are adversely affected by recent developments in theconsumer subsidy and an unplanned increase in the real producer price forthe 1987 crop. So far three major issues about government wheat policyremain: first, the role of govenmental monopoly on wheat marketing;second, elimination of wheat subsidies; and third, transparency in the useof public funds related to wheat transactions.

10. The overall net expenditure with the wheat transactions for 1987was projected to reach 0.3% of GDP. An updated governmental estimateindicates higher spending which includes additional financing of thepurchase of domesticaly produced wheat. Net expenditures on wheattransactions are now estimated to account for 0.4% of GDP in 1987 comparedto 0.9% in 1986.

11. SEST-Related Measures. Through several measures introduced inJune 1987, the Government intended to reduce the overall deficit (beforetransfers) of federal pub'in enterprises to 0.7% of GDP in 1987, comparedto a previously anticipated level of 1.8% for the year1/ (and 1.4%registered in 1986). The reduction was to have involved a currentoperating surplus increase of 0.8% of GDP and lower investment expendituresequivalent to 0.3% of GDP (through public price increases). It appearsthat the intended investment reduction will be achieved, but there will bea major shortfall in the intended increase of the current operatingsurplus. As a result, the overall deficit will exceed the target and iseven likely to be higher than it was in 1986.

12. The main thrust of the June program was to raise public sectorprices and tariffs so as to increase operating revenues by 0.4% of GDP,while reducing operating expenditures by 0.3Z of GDP, particularly on wagesand non-interest payments. The intended expendit"re reduction will not beachieved fully, especially because of wage increases granted in the lastquarter of the year. On the revenue side, the shortfalls related to theintended targets are quite significant. Despite an average real increasein the volume of sales, overall receipts are expected to remain largelyunchanged in real terms as a result of a fall in the average realprice/tariff. Price/tariff adjustments in June 1987 were quitesignificant. More recently the Government has authorized above-inflationincreases for steel and petroleum products. Even so, public tariffadjustments have generally fallen behind inflation with the exception ofsteel and petroleum products.

1/ The 1987 target for state enterprises (SEST and state-ownedenterprises) was 1% of GDP compared with 2.1% lfore measures to reduceit and with 2.3% in 1986.

ANNEX IVPage S of 9

Moderate Impact/Risk

13. Agrlcult4ral Subsidies. Savings related to changes In the

eininum price program and buffer stock policy were estiwated to amount toC-20 billi or 0.2Z of GMP. Thes savlngs uml4d cme from a 501reduction In the planned net outlays for regulatory stocks because ofreductions In the planned net outlays, and lncreasee In prices at whlch

planned govern ental ales would take place. The adjustments in selling

prices of agricultural products that have taken place (which meant higherrevenues from sales, thus smaller net expenditures under the minim priceprogram) are expected to allow for the foreseen savings and to prevent anyincrease in subsidies beyond the ones implied by that minimue priceprogram. As far as regulatory stocks, the expected savings may not beachieved since the quantity of stocks sold has been smaller than planned

due to lack of denand for agricultural products. Although in some cases

the prices at which the government stocks have been sold are higher than

anticipated, they would not totally offset the reduction of stocks sold.

Therefore, the increase of net outlays for regulatory stocks corresponding

to lower-than-planned sales, may partially eliminate the projected

savings. The expected savirngs (which were difficult to estimate) were

based upon changes in policy which were also difficult to implement. In

addition, demand for agricultural products is lower than planned. So, the

overall net expenditures on agricultural products--which include, in

addition to minimum price programs and regulatory stocks, transactions with

coffee and sugar--are now projected to amount to v.7% of GDP.

Nevertheless , additional pressure might occur, mainly from largerpurchases of coffee and sugar and from regulatory stocks.

14. Wage-Related Measures. Several decrees were signed by the

President to implement the projected decreases in personnel and other

current expenditures which amounted to 0.4% of GDP. The expected savings

will not be achieved because of higher-than-planned inflation, which has

implied higher wage adjustments than defined by planned monthly adjustments

by the URP (Price Reference Unit). On the contrary, the recent wage

increase for public servants will produce additional pressures on the

deficit. A preliminary estimate of the additional wage bill accounts for

0.5% of GDP, which reflects a 43X increase for October and adjustments

followi' ae URP for November (10%) and December (15%). Furthermore, any

personnel expenditure cuts accomplished in SEST will be offset by the

recent wage increase authorized to the Bank of Brazil, Central Bank,PETROBRAS, and probably scaon to be extended to other state enterprises.

However, it is expected that the state enterprises will not be able to cut

other current expenditures sufficiently to accomodate such negative factors

as lower real tariffs and a higher wage bill.

15. Domestic Debt Cost. Savings in the cost of domestic debt, which

were expected to account for 0.1% of GDP in the planned deficit reduction,

in fact occurred during the first two months following the adoption of the

stabilization program. But subsequently, real interest rates went up again

and made the projected expenditure cuts difficult. The cost of

agricultural credit subsidies has been adversely affected too. Although a

significant step to reduce overall credit subsidy was taken last June,

ANNEX IVPage 6 of 9

when interest rates were set (konetary correction + 7-122) the impact onthe budget of the previous scheme (set during the Cruzado Plan as 10% fixedfor six montho) is still rather high in 1987. Though most of the budgetarysubsidy had occurred during the first half of 1987, some still would beincurred during the second half. Since interest rates have increased, thecost of subsidizing the difference has also Increased. Nevertheless,interest rates set In June have eliminated the need for Treasury subsidieson new credit.

16. Other Current Expenditures. The analysis of Treasury accounts upto September suggests a tight expenditure policy (including expendituresunder PROFIE-BACEN,2 / other PROFIE,3/ PIN/PROTERRA, FINSOCIAL and otherexpenditures) belovwmonthly cellings, which were set in lIne with theMacroeconomic Control Plan targets. However, past experience shows thatmost of these expenditures are made in the last quarter of the year.Despite the spending limits submitted to Congress under the revisedinflation-corrected federal budget, leading to lower allocations in realterms than those previously adopted, the Treasury has been trying toimplement a more restrictive fiscal policy aiming at spending below theapproved date targets. Nevertheless, in the context of acceleratinginflation and low credibility about the ability to implement the announceddeficit reducing measures, the Treasury ceilings may be exceeded by the endof the year.

17. The structural measures announced in June to influence the 1987deficit include the introduction of partial financing of unemplovmentbenefits by employers and employees instead of full financing throughTreasury allocations. This measure was expected to have a small impact onthe 1987 deficit reduction, but could have set the pace for furtherimprovements in 1988. Nevertheless, no modification took place in themeantime, and the expected savings of Cz$5 billion will not occur. On thecontrary, due to the decline in industrial employment, additional funds maybe necessary to pay unemployment benefits.

Low Impact/High Risk

18. Float. Among the measures to reduce the fiscal deficit in 1987,the authorities decided on an increase in the float (difference betweenspending authorizations and effective payments) by delaying payments, inparticular salary payments which would be paid at the end of the month.This change, if effectively implemented, would be a one-time gain.Although the financial impact of this measure may affect the overall publicsector deficit in 1987, the economic impact is negligible since thisadditional expenditure would be carried into 1988. However, in today'scontext of accelerating inflation and a higher December wage bill, theincrease in float might have a contractionary effect on private

2/ PROFIE-BACEN includes expenditures related to service of the domesticand external debts and agricultural credit.

3/ Other PROFIE includes FINEX and alcohol and sugar subsidies.

ANNEX IVPage 7 of 9

consumption. The delay in salary payments was expected to reduce the netborrowing requirements of the central administration by about 0.42 of GDP.This reduction is not taken into account in the 1987 deficit scenariosdiscussed in Annex I. Treasury authorities are currently expecting a largeincrease In float which will reduce the 1987 central aditnistration'sdeficit, although no delay in salary payments is planned. Neverthelessthis increase in float will put increased pressure on 1988 spending. Thefloat has been a discretionary tool used by the Treasury to containexpenditures. Delaying transfers of funds to the spending entities has, toa certain extent, contributed to a restrictive fiscal policy discouragingexpenditures and encouraging a more rational use of resources. However,under more strict budgetary programming the room for delaying transferstends to become smaller, and gains from increasing the float andconsequently reducing the deficit will gradually disappear.

19. States and Municipalities-Related Measures. In light of theGovernment's concern about the expansion of indebtedness of states andmunicipalities, measures to reduce their borrowing requirements by 0.5% ofGDP were taken. These savings would be obtained from a reduction in theauthorized limits for roll-over of domestic and external debt as well asfor bond issue. This type of measure is likely to have a minor impact dueto a lack of effective measures to cut spending and/or increase their ownrevenue. Therefore, the monitoring of net borrowing requirementsrepresents an ex-post measurement of part of the deficit. Arrears withsuppliers may be building up. However, preliminary data indicate thatthrough September the net borrowing requirements of states andmunicipalities remain in line with the 1.6% of GDP target. External debthas been rolled over (principal and interest) as planned and its impact onthe public deficit (interVst payments) has been re-estimated downwards.The impact on the deficit of rolling the domestic debt (interest payments)is not expected to exceed the target because some states have beenservicing their debts with official financial institutions.

20. Nevertheless, several factors might lead states andmunicipalities to not meeting their targets. Revenues could decline inresponse to the slowdown of economic activity and acceleration ofinflation. Transfers from the federal government could be adverselyaffected by the decline in real revenue of the central administration.Furthermore, the wage bill could be larger, reflecting a higher-than-planned inflation adjustment and the wage increases recently granted tofederal workers and probably to be extended to other civil servants.

Institutional Reforms

21. The creation of the Financing Coordination Committee to controlthe public deficit, and evaluate every program in the project withadditional impact on federal spending, has played a key role in controllingadditional pressure on the deficit. Its role is expected to bestrengthened in 1988.

22. Several institutional reforms announced in June 19F7, to becomeeffective January 1988, would ease monitoring and controlling of publicexpenditure. When fully implemented they would represent significant steps

ANX IVPage 8 of 9

in the institutional re-ordering of federal public finances. The principLimeasures are the following:

(a) completion of unification of monetary and fiscal budgets.Thus, the budgetary proposal for 1988 includes all revenuesand expenditures of the federal government including: (1)the Budget of Official Credit Operations which comprisesdisbursement and revenue for credit programs, creditsubsidies, acquisition of agricultural products under theminumum price program and the formation of regulatorystocks; and (ii) all the special funds under federalcontrol;

(b) prohibition of realization of subsidized operations exceptwhen these are provided for in the fiscal budget. Nooperation of official credit lines at costs below the costof federal securities is allowed except if the subsidy hasbeen provided for in the budget;

(c) elimination of extrabudgetary sources of financing by: (i)prohibition on supplying funds via the Central Bank directlyor indirectly, for the realization of any credit operationsnot derived from the execution of monetary and exchange ratepolicy; and (ii) placement of new federal securities onlyfor federal debt service and to finance the deficit foreseenin the fiscal budget;

(d) transfer from the Central Bank to the Ministry of Finance ofthe following functions: (i) services related to the issueor repurc-nase of public securities and their control; and(ii) administration of developmental credit funds;

(e) creation of the Financing Coordination Committee to: (i)issue an obligatory opinion on any proposals affecting thegoals established for fiscal and monetary policy and thepublic deficit, opening of new credit lines, and expansionor extension of fiscal incentives and exemptions; (ii)estahlish maximum limits for the provision of resources bythe federal government of public funds and programs for.-pending any revenue; and (iii) estimate the revenue of thefederal government for revisions of the federal fiscalbudget.

23. These measures are intended to complete the institutionalarrangements that make public expenditure more transparent and accountableand allow for a better management of economic policy. Institutionsinvolved in economic policy will be better equipped to carry out theirresponsibilities. Beginning January 1, 1988, the Central Bank, free ofits responsibility for certain official developmental programs and foragricultural credit and regulatory purchase operations, would perform thetraditional functions of monetary and exchange rate policy.

ANNEx IVP ge 9 of 9

24. Although these institutional changes may make It easier tocontroll the public sector deficit, they should be complemented by otheratructural adjustment measures. The deterioration of public sectorperformance during 1987 require. prospt policy *ctiom to reduc theoperational deficit of the public setor. In vsew of the uncertaintiesthat prevail about the tax reform that the Constituent Assembly may beginimplementing from 1988, additional measures would be advisable. Besidesome tax revenue increases, the authorities are saeeking additional taxmea8ures to be ent to Congres before the end of 1987. Major changesshould come from expendlture cuts Including tax expenditures (fiscalincentives) and various subsidies (wheat, alcohol, sugar). In addition,other policies (e.g. replacement of quantitative restrictions on imports bycustom tariffs and public price polIcies) can help reduce the deficit.

25. This evaluation of specific measures undertaken in the context ofthe Macroeconomic Control Program suggests that poor implementation hasbeen an important cause for exceeding the target. In addition, some of thecurrent difficulties facing the short-run stabilization effort result fromlow credibility concerning the government's ability to ensure effectiveimplementation of its decisions. Though mo3t measures were of a short-runnature and sought expenditure decreases, they were not fully implemented.Despite their positive impact on the deficit, some measures, like the thewheat subsidy and public tariff increases, were adversely affected by theirimpact on inflation. The 1987 fiscal effort package relied very little onstructural measures, and the lessons from its implementation point out howthe design of future actions is critical for their success.

Page 1 of 15

MONETARY POLICY

The Conduct of Monetary Policy

1. The effectiveness of monetary policy has been hampered in recentperiods by (i) an inconsistency betwes the fiscal *tance and other ucroeconomic objectives and (ii) widespread indexation that, with the exceptionof a brief period in 19S6, has been a characteristic of the Brazilianeconomy. Indexation mechanisms strongly reduce the ability of monetarypolicy to lower inflation. In an attempt to cut the inertial component ofinflation, resulting from the existence of indexed contracts, the CruzadoPlan abolished Indexation of most financial instruentr, sharply sodifiedthe wage adjustment system, and imposed a price freeze. But theinconsistency between the several macro objectives, particularly pricestability and low real interest rates, and fiscal stance resulted in anundesirably large monetary expansion. This expansion contributed, lateron, to a gradual acceleration of inflation, and, following a tightening inmonetary and fiscal policy in November 1986 (Cruzado II), to a reneweddemonetization of the economy as inflation reached near hyperinflationarylevels of 23% in May and 26? in June 1987.

2. To restore the credibility of monetary policy in the context of anew stabilization program, the Macroeconomic Control Plan, the Governmentin mid-1987 established nominal targets for both the monetary base and themoney supply, (Ml). These targets were set to allow for a modestremonetization of the economy consistent with a much lower inflation targetand relatively high interest rates intended to prevent renewed overheatingof consumption and the accumulation of speculative stocks. But thetargets, which were presented as only monetary policy guidelines, werequickly exceeded, damaging the credibility of the policy. By the end ofthe third quarter the target for the monetary base had been exceeded by31.8? and the target for Ml by 14.7Z. The continuing financing needs ofthe public sector account for a significant part of the increase in thebase, as does the increase in reserves associated with the sharpimprovement in the trade balance beginning in April.

Recent Trends in Monetary Aggregates

3. In the last year and a half Brazil's narrow money stock, (Ml),showed large fluctuations relative to GDP (Table 1). Three distinctperiods can be observed. In the first, covering the months of March toDecember 1986, the index of narrow money balances (monthly average of dailybalances) to GDP expanded by 207? compared with February 1986, partlyreflecting a shift from other assets towards money balances (Table 2) as aresult of the decline in the opportunity cost of holding money balances.The second phase covers January to June 1987 and it is characterized by asteady decline in real balances induced by a rapid increase in inflationand a tight monetary policy. As of June, the index of money balances toGDP had declined 69? relative to its December 1986 value, standing 4? belowits February 1986 level. The remonetization process which occurred duringthe period of the Cruzado had been more than fully reversed. Finally, inthe third phase, which started in late June, there has been a significantremonetization, with average balances in October 17.5? above their Junelevel relative to GDP. Overall, these fluctuations are the result of

Table 1: BRAZIL: INDEX OF FINANCIAL ASSETS DIFrLATD RY GR PROXY(Monthly Averages of Daily Balances, F.bruary 1986 - 100)1l

Monetary Ml Tit. Pub. M2 Savings Ms3 TAme M4,DATE Base, Av. Av. Fed. Av. Av. Dep. Av. AV. Dep. Ai. Av.

1986I 111.13 126.03 107.11 112.16 103.11 10S,51 99.94 lC7.70II 18?.62 229.48 115.87 146.19 98.57 126.9$ 95.06 121.74III 253.40 282.13 106.25 153.20 98.19 131Q.0 100.74 126.71IV 271.29 303.39 94.42 150.20 96.01 128.34 127.70 130.871987I 200.00 194.25 94.19 120.90 92.78 109.55 120.83 113.66II 119.84 118.94 102.15 106.63 98.47 103.34 88.47 101.54III 113.69 110.90 98.69 101.96 112.23 106.10 74.63 100.66Jul 99.58 105.82 98.26 100.28 108.74 103.69 77.03 99.28Aug 116.60 113.79 98.98 102.93 114.90 107.76 77.18 102.54Sep 124.90 113.09 98.82 102.67 113.03 106.83 69.70 100.16Oct 126.78 112.90 103.69 106.15 108.58 107.13 60.92 98.42

_Sources Central Bank of Brazil

Note: /a Assumes 8.22 annual GDP Growth (0.6434Z per month) in 1986 and4.0?annual GDP growth (0.3274Z per month) in 1987, deflation by IGPIDI.

I.'

-42

Pag 3 of 15

Tabljs BRA.IL - FNANCIAL ASSETS AS A PERCENTAGES OF TOTAL ASSETS

- .tgme 1.0 m1. WU ?. WSI...M." in.4 MA IW. .

.u-a a- 3dm "M.~ Wes 10gq..6 *,aia1b a M *-W4 ~P43e1 _40 _1. a," 1.41 i e. to t.U 4.4 9W" 057 .4 U.

SW _se e.am . 7 _14 _. . *.W ., t W, es

uz t 8..e S." WU . ~n u1 a -a in.. 4W1 lIes 1. 15.7 .4 W'..

Lv, ... m '1 5 .34 5.44 a. ." 1.41 3.0 Cm 4 ., 0.06 am ~a. *.a

u I.01 *-. 1W." L.S- 11 3.3 CM" WW.0 4 1.0. 0. 11" o .a M.0

tit *.Pe so4 is.1P 13 4 14 t41 U 1 V 01 *.36 1u.0 0so. W. a .

Jol 2 3 14 1 36 t1.1? 1s." =W 1 t4 00at S s 1$.14 0 00 18.34 too 1.

_0 2?? 3 3 10 67 S3 1 114 3 01 I1" 0 0t 5to 1144 0 090 311W 100.0s

1~ 200 s 43 11.31 13.91 13.41 46? 143 0* O 2t *4 11 so 0 2106t a 1C 00

44* 50G 2n 104 13.00 12.61 3143 236 00t 4" 114 0.00 22M 1.ft 10000

Source: Central Bank of Brazil

changes as well as shifts in the demand for money associated with large

swings in the opportunity cost of money.

4. The monetary base, which experienced fluctuations similar to M1,

increased rapidly in the months following the Bresser Plan. The increasein the base (average of daily balances) between June and October amounted't.o 971; currency increased by 612 and bank reserves by 1482. The largeincrease in bank reserves was the result of a higher demand for demandc'eposits and, starting in August, a 152 increase in compulsory reserves.As of end-October the main factors which accounted for the accumulatedexpansion of the base weret credit to the Bank of Brazil for rural credit

at below-market rates, acquisition of agricultural products under theminimu price program, and advances to state and municipal govermnentsagainst future tax receipts; foreign operations (including an increase inreserves beginning in May and the provision of bridge loans [MP-09] to

finance foreign debt service by public sector agencies and firms);operations linked to Funds and Programs (the largest being for financialrehabilitation of state-level official banks); special credit programs forsmall and medium enterprises facing firancial distress as the result ofinvestments undertaken during the heyday of the Cruzado Plan); and Treasurycash operations (Table 3). On the contractionary side, voluntary depositsat the Central Bank by the institutions of the Brazilian Savings and LoanSystem (SBPE), facing limited demand for housing loans and reluctant tofinance new mortgages until reforms of the Housing Finance System (SIB) are

undertaken, and net sales of federal government securities contributed tolimit the expansion of the base. So did Central Bank resources, whichinclude the net returns from liquidity loans, purchase and sale of foreiGn

exchange, and direct expenditures on personnel, etc.

-43-

I ~~ ~ ~ ~ ~ ~ ~ ~ A VPap 4 of 15

Table 3s BRAZIL - FACTORS AFFICTING TUY MONETARY BASETHROUGH OCTOBER 1987

Cz$ billions(+) Expansion C-) Contraction

National Treasury 46.3

Foreign operations 147.3

Operations of Funds and Programs 121.6

Provisions to the Bank of Brazil 193.6

Special charge on foreigntravel and exchange -6.1

Compulsory loans (DL 2288) -37.5

Liquidity loans to financial institutions 1.9

Central Bank own resources -92.2

Purchase of gold on domestic market 15.4

Compulsory deposits, SBPE -3.0

Voluntary deposits, savings & loan system -95.8

Compulsory reserves on time deposits . -16.2 A

Operations with micro and small enterprises 22.9

Purchase o, FND bonds 37.4

Net sale of securities -146.1

Other accounts 4.9

Monetary Base (sum of above) 194.3

Paper mor.ey 78.2Bank Reserves 116.1

Source: Central Bank of Brazil

- 44 -

Page 5 of 15

5. The post-Jon rsosetixtion was of a lessor magmitwd thm thatfollowing tho Crusado Plam. Durin the first for full mthe of thehecroeconamic Control Plan. Ei (end-month balances) Increased by 432 whilethe roughly comparable figure for the Crusado Plan vas 16724/. Tkisdifforence may be eplaind by a more cutious attitude of the privatesector, the result of a learnin process following the failure of theprevious stabilisation atteot, widespread skepticim coerning theabIlty _ ity of the Govemint to asatats - lo w isfi-ttio atevithout using price controls. and. finally, high real Interest rates.

6. Broad r mointary aggresates* whibC Include various forms ofindexed assets (mainly overnight deposits bseed on letter of repwurchebacked by both govrernmst securities rd tim deposits held by finamcialinstitutions, and passbook savings accounts) have sbown greater stabilityrelative to GDP (Table 1). In essence what has occurred has been a shifttowerd currency and demand deposits following sharp reductions in the rateof inflation, followed by a shift back toward these indexed a*sets wheninflation accelerates (Table 2). though there was clearly an increase inthe total of financial assets relative to GDP during the Cruzado Plan.This increase peaked in October 1986 at 261 above the level of end-February 1986, when the Cruzado Plan was announced.2/ These shifts in thecomposition of financial assets are facilitated by the high degree ofliquidity of indexed issets. Overnight deposits are de facto indexedmoney. Passbook savings accounts accrue interest and monetary correctionmonthly rather than daily, but by holding multiple accounts with differentmaturity dates, large depositors can increase the liquidity of passbooksavings deposits to close to that of overnight deposits. Savings deposits,which are the most accessible form of indexed asset for small savers, wereby end-October 1987 the second most important single asset in the financialsystem, accounting for 31.92 of total assets (Table 2), up from theirrecent low of 21.OZ in December 1986. Federal government securitiesoutside the Central Bank are the largest asset, with 34.4Z of the total,though roughly one third of these federal government securities are held bythe public sector (extramercado). Time deposits have fallen from almost232 of the total in January 1987 to 12.6Z in October, given their lowerliquidity and the increase in uncertainty.

7. Again taking total financial assets, between end-June and end-October 1987 there has been an increase of 3.8Z relative to GDP. Takingmnnthly averages of daily balances, MI (which includes Ml, federalsecurities outside the Central Bank, time deposits, and passbook savingsaccounts) rose by 3.3Z relative to GDP between June and October 1987,considerably less than during the Cruzado Plan (a 23Z expansion by June1986 compared with February 1986) but nevertheless representing an increasein overall liquidity which fell just short of restoring the level existingimmediately prior to the Cruzado Plan.

1/ The figures are only roughly comparable, since the Cruzado Plan wasannounced at the end of February 1986, whereas the MacroeconomicControl Plan was announced in mid-June 1987. M1 increased by 31.52during the month of June 1987.

2/ The increase is probably overstated by the underestimation of inflationover this period, just as the subsequent decrease is probablyoverstated.

- 45 -

AX VPage 6 of 15

Monetary Proiections for End-1987

8. The increase in the money supply for the rest of the year willdepend in large measure on the combination of the pressures from the fiscalside and on inflationary trends. A new monetary program prepared by theCentral Bank in late November 1987 projected end-year balancse for themonetary base and Ml respectively at Cz$463.5 billion and CZ$890.1 billion.These projections, however, cannot be directly compared with the targets inthe October 1987 update of the Macroeconomic Control Plan, which are*xpressed in monthly averages of daily balances. Using a World Bank moneydemand function for Brazil, and assuming IGP/DI inflation of 12.51 inNovember and 152 in December, the December average balances for MI and themonetary base were projected as shown in Table 4. These projections showan increase of M1 of almost 105Z for the year, compared with the target of85Z. The projected increase in the monetary base is 159Z, compared withthe target of 130Z. These projections could be exceeded if an even largerexpansion of the base turns out to be necessary to finance the fiscaldeficit.

Table 4: BRAZIL - MONETARY PROJECTIONS FOR 1987

Cz$ Bil (Z) Plan'sMonetary Aggregate Sep. Dec. Dec./Sep. Dec./Dec. Targets/a

Ml 567.9 926.2 63.1 104.8 85.0

Monetary Base 286.0 462.4 61.7 158.6/b 130.0

Notes: /a As revised in October; the July targets for M1 and the monetarybase were originally 40.5? and 53.5?, respectively.

/b Monetary base growth as a percentage of GDP would

Credit To the Private and Public Sectors By the Banking System

9. Total outstanding credit to the private sector relative to GDPpeaked two months after the volume of financial assets at end-December 1986at 36Z above the level at the beginning of the Cruzado Plan at end-Februaryof that year (Table 5). With the tightening of monetary policy it thenfell 33Z by end-June 1987 to 92 below the level at the beginning of theCruzado Plan, and by end-October 1987 was still lower, some 12Z below theend-February 1986 level. The shares of different segments of the financialsystem in credit to the private sector have also changed significantlysince February 1986, the principal changes being (i) a fall in the sharefor the institutions making up the Housing Finance System (SFH) from over

- ~~~~~~~~~~- 46 -

Pop 7 of 15

SSZ of the total to - 242 at md4October 1967. (1i) an increase In theshare of the Du of Drail fra Aoer 11 to 192, 0i1i) - lsreeee Inother comcmal b rks frm 272 to 33. andu fall In the share of cass rcredit agencies ( hi lIsa) of about thre percetep points to 4.5t.since the Dresser PIa ws ann ed, the mt 1WOrtaat ch_ s in s areshave bee an inrXee of over siz percentaSe points for the Dank of Brziland a fell eof almot to.o.. v.ls. fo th fl ititutiame (lb"

Table 5 hAuL - LOMN TO tIE PIZAII SCTOI DY FNAL Lua AsP33CM OF TOTAL

am _ _ C -w Fi.mwu sua. _ su tw.

m ; ' . _ _

t m s..m766 a s. 6.7 16 5 6 4.16 18.76 56.7 66.7 f." t.e6 e.e8 USG

iV 13.71 340. :y %I la-r S. to, 76.00 8.6 1.6 s.Ut 0.66 36.00

it 11.66 W.6" 6.58 4 76 15.76 4.01 6.90 56.7 56.35 S." S." 0.13 100.00

hi 13.26 3.S 6 06 4,4416I." 4.n* 10.07 76.66 *6.6 3.91 8.e 0.1* 100.00

A.S 14.41 7.66 6.61 417 18575 4 00 *.Wn 56.76 26. 3.67 4.16 0.12 106.66

5. 182 2.6 7.66 S25 14.4 36 0 6.11 * Y.76 17.76 8 36" 6 " 0.12 1e0.66

oct 16.0e s 6.16 Bi 64 1319 2 57 6.z9 26.66 26.66 S." 3.0 0.18 1.06

Source: Central Bank of Brazil

- 47 -

ANNEX VPage 8 of 15

Table 6: BRAZIL - INDEX OF LOANS TO THE PRIVATE SECTOR DEFLATED BYGDP PROXY (FEBRUARY 1986 = 100)/a

01 ~ Ss of CoqI 1stqt #inc* C ES C6s Ct,AP Sf4 S ta t,.S. 05 8WCC TOTAL

e,&K I 8.. 92M., qa

19" 1 102 13 102 74 102 14 06 16 107 58 00 43 106 24 106 14 103 20 101 72 6 98 103 28

if 136 67 117 IS 100 60 6e 09 106 14 00 25 102 1i 102 s0 102 59 104 16 71 67 100 73

III 161.58 142 62 101 03 8 " 106 SI 90 66 103 00 104.48 103 36 103 1 " 07 l11 62

TV L6s 15 173 01 133 43 " 60 116 61 101 26 90 Ie 107.72 106 54 08 5S 70 89 133 43

106 1 150.6U 150 33 13100 74 22 105 10 113 47 600 006 10 eo l 4J 63 30 110 6

tt 123 78 120 57 108 S3 53 04 107 72 t06 17 7r 00 0 63 100 61 10108 50 s 103 40

tlz 140 03 100 40 S 78 4 06 74 59 83.71 5 15 89 23 117 24 130.61 84 62 00 31

JAl 127 31 106 11 93 93 42 54 18.38 7 59 60 66 72.53 116.4 110.14 64 23 84 64

Av< 130 04 110 89 00 47 45 29 75 26 84 20 56 6I 60.82 117 27 140.53 6B 02 01 16

I.e 153.74 100 18 61 04 S0 33 70 11 79 26 55 16 65 34 116 12 162.13 64 61 00 12

06t I1U 12 106 36 83 03 60.04 B3.75 72.65 50.05 50.60 116.60 110 08 64 88 22

Source: Central Bank of Brazil

Note: /a Assumes 8.22 annual GDP growth (0.6434Z per month) in 1986 and4.0? annual GDP growth (0.32742 per month) in 1987, deflation byIGP/DI

10. The fall in credit to the private sector relative to GDP has beenaccompanied by a rise in c-edit to the public sector through the financialsystem as well as through the issue of government securities. BetweenDecember 1986 and June 1987 credit to the public sector expanded some 4.4X'in real terms (see Annex X).

11. What are the prospects for further crowding out of Lhe privatesector through the end of 1987? This may be derived from a projection ofthe consolidated balance sheet of the banking system (see Annex X). It wasassumed that public sector financing has priority over the demands of theprivate sector.3/ Consequently, for a given credit availability, anincrease in public borrowing from the banking system will reduce the amountof credit available to the private sector. When this occurs, creditrationing in the traditional sense of non-price rationing occurs.

3/ Credit by the banking system to the public sector is assumed to beequal to the projected 1987 operational PSBR of 5.5? of GDP minusfederal government securities shown in the Central Bank's monetaryprogram dated October 22, 1987 for end-December 1987 compared with end-December 1986 minus the increase in net foreign assets taken from thebalance of payments projections in Annex 2. In these projections,IGPIDI inflation for the last three months of 1987 is projected at 9.5?a month, which is the optimistic projection.

- 48 _

ANNEX VPage 9 of 15

Table 7: BRAZIL - PROJECTED CREDIT TO THE PRIVATE AND PUBLIC SECTOR

Nominal 87 Increase in DeflatedReal Growth Rates Increase End-Year Stocks /aDec 87/Dec 86 (Percentages of GDP)

Total Credit -13.9 48.1 -8.3

Private Sector -35.0 20.8 -11.4

Public Sector 23.9 27.3 3.1

Sources: Central Bank of Brazil and mission projections

Notes /a End-year stocks of credit deflated to average year prices usingIGP/DI

12. The projections shown in Table 7 show that, given the projecteddemand for money and the net inflow of foreign resources, the total stockof credit is projected to decline by 13.9? in real terms. In real termsthe stock of credit to the private sector is projected to decline by 35?,and credit to the public sector to increase by 24Z. The increase in creditto the public sector, measured as the change in deflated (to average pricesfor each year) end-year stocks is 3.12 of GDP, while using the samemeasuremerst, the fall in credit to the private sector is 11.4? of GDP.

13. The above real growth rates are somewhat distorted as a result oflast year's price controls. In 1986 the real stock of credit increased byabout 381. But, as a consequence of the price freeze, the widespreadpremiums paid on most goods were not captured in the official priceindexes, including the IGD/DI used as the price deflator in this analysis.When price controls were lifted beginning in November, the above premiumsbegan to be incorporated in the price indexes, leading to a rapidacceleration in inflation. Consequently, because 'actual prices' areunderestimated by the IGP/DI index, the increase in real terms of thecredit stock is overestimated for 1986. Although the above bias in pricemeasurements may explain some of the magnitude of the fluctuations in thereal stock of credit, it should not affect the main thrust of the aboveconclusions.

Attachment

49

~~~~~~~~~~~~~~~~~~vPage 10 of 15

ATTACKItNT

The Future Conduct of Monetary Policy

1. A discussion of the future role of monetary policy should takeinto account three mai factor- (i) the lIaited ku1vledg available regarding the impact of policy changes in the real sectors (ii) the degreeof consistency between the macro objectives and the fiscal stance; end(iii) the future institutional framework of the financial markets such asthe degree of indexation. eztent of segmentation of the credit markets, andparticular regulations over the setting of interest rates.

2. The difficulties associated vith the istimation of the tim lagsand the extent of the effects that changes in nonetary policies have in thereal sector result from the past instability of the main relationshipsbetween money and the real sector. Starting in 1980, a downward shift inthe demand for money occurred as the sharp increase in inflation andinterest rates induced firms and individuals to economize on their moneyholdings. The gradual increase in liquidity of some interest-bearingassets further facilitated the move out of Ml and into savings and timedeposits. Between 1975 and 1985 there was a threefold increase in thevelocity of money. Recently the demand for money experienced furthershifts. Throughout the 1980's the velocity of the broader monetaryaggregates, such as M3 and M4, displayed a more stable pattern than that ofMl, largely because a significant portion of the changes in Ml werecompensated for by changes in time and savings deposits or bonds.

3. An increase in the effectiveness of monetary policy as astabilization tool will require a much higher degree of consistency betweenfistal stance and overall macroEconomic goals. In a scenario in which thepast combination of stop-and-go policies continues, the fiscal issues arenot appropriately addressed, and a price freeze is used from time to timeto reduce inflation, there is not much room left for monetary policy.

4. Alternatively, a scenario can be envisioned in which theconsistency between monetary and fiscal objectives is attained. The goalsof monetary policy should be to contribute to the overall macroeconomicstability and to support a sustained growth path in a low inflationenvironment. In this context some form of a monetary rule could be used toguide the conduct of policy. During a transition phase in which the fiscaldeficits are brought under control and inflationary pressures reduced, atight monetary policy would be required to maintain real interest rates ata level necessary to control aggregate demand and discourage theaccumulation of speculative stocks. During this phase, nominal targets forthe main aggregates upon which the authorities have some degree of controlwould be announced. These targets would have to be respected in order toreinforce the credibility of the program.

5. Afterwards, as economic stability is attained, monetary policycould follow some rule linking the growth of the monetary aggregate chosenas the intermediate target, for example Ml, to the growth of nominal GDP.This framework would constitute a sharp departure from the excessive finetuning which has been a main feature of recent policies. But its successwill require a strong support from the fiscal side.

- 50

ANNEX VPage 11 of 15

6. The past volatility of the monetary aggregates and thedifficulties associated with the evaluation of the channels through whichmonetary policy affects the real economy complicate the choice of policyinstruments. A real interest rate rule, in addition to the difficultiesassociated with the definition of the target interest rate. may not providea sufficient anchor to attain price stability. In the case of a moneyrule. stability of the relationship betw.on this aggrgate and a voriablerepresenting the monetary policy target is important. Thus, this criterionwould point towards the choice a broad monetary aggregate such as M3 or H4as the preferred intermediate target. However, to be properly implementeda money rule requires that the monetary authority have some control overthe path of the chosen aggregate. In this case a narrower aggregate suchas M1 becomes preferable.

7. An aggregate such as the Central Bank "broad liquidity', thatincludes Ml and federal securities held outside the Central Bank (thecurrent Brazilian definition of M2), poses several conceptual problems.Because changes in interest rates have opposite effects on the demand forthe two components of this aggregate, it will be difficult to forecast theevolution of interest rates from its behavior. An exchange of bonds fordemand deposits would not affect the broad liquidity aggregate but wouldlikely influence intere.t rates. Interest rates will be a function of thecomposition rather than the level of the aggregate. Moreover, in a morestable policy environment the average degree of maturity of public debtshould be expected to increase thus sharply differentiating money andbonds. In this case it would not correct to aggregate the two assets.

8. The role for monetary policy will depend on the degree ofindexation. In this scenario, if the existing backward-looking indexationrules are maintained, restrictive monetary policies will have a greaterimpact on output than prices. In this case monet'ary policy becomes arather ineffective anti-inflationary tool.

9. In sum, the choice of the policy instrument to guide monetarypolicy is complicated by the real and financial shocks which have recentlyaffected the Brazilian economy. Most of the problems encountered in theconduct of monetary policy result from the absence of support from thefiscal side. Furthermore, the excessive fine tuning, which hascharacterized the conduct of monetary policy, becomes counter-productivebecause it reduces the credibility of the announced policy measures. Withan adequate fiscal stance, a steadier monetary policy more directed towardslong-run goals of price stability and steady giowth is to be preferred.

Interest Rates

10. The Cruzado Plan had important effects on the financial markets.Monetary correction, widespread in Brazil, was suspended for one year forall assets except passbook savings accounts and compulsory savings. Thesubsequent shift towards non-interest-bearing assets led to financialproblems for institutions with different maturity structure of assets andliabilities. The Central Ban': responded by creating an interbank marketfor short-term funds, changing reserve requirements so that 102 could be

- 51 -

ANNEX VPage 12 of 15

held in interest-bearing govemrment securities, allowing ai increase infees for financial services. and changing rules governing compulsorylending.

11. To increase the flexibility of monetary policy, a Central Bankbill (LBC) vith up to one year maturity was created in May 1986. Thissecurity mat exempted from incom tax withholding and its yield was toreflect the average overnight rate. The LBC became the main instrument foropen market operations, and by end of 1986 LBCe accounted for 562 of thevalue of federal securities held outside the Central lank. This proportionhad risen further to 672 by end-October 1987.

12. For the authorities, the substitution of National Treasury Bonds(OTN,) and bills (LTNs) by LeCs had two main advantages. The first was toimprove the compatibility of the maturity structure of security dealers'assets and liabilities, thus reducing their vulnerability to interest ratechanges and thereby enhancing the flexibility of monetary policy. Thesecond was to reduce the cost of the domestic public debt, because the LBCpaid a lower interest rate than the OTN.

13. As inflation started f accelerate during the last two months of1986 and that acceleration continued through the first six months of 1987,interest rates rose quickly. To reduce the impact on the financial system,the Central Bank created special low-interest lines of credit targeted totroubled financial institutions, reduced the taxation of financialinstruments, and allowed the banking system to shorten the maturity of someinstruments and place them at freely-negotiated interest Lates. ByFebruary 1987, monetary correction, which was already being widelypracticed, was officially re-introduced.

14. As the economy returned to two-digit inflation and overalluncertainty regarding the future course of economic policy increased, therewas a marked reduction in the average term of financial assets. Since theinitiation of the Bresser Plan, the Central Bank has maintained the LBCrate above the official inflation rate, and until October 1, each month'smonetary correction of many financial instruments (including passbooksavings accouPts) was fixed at the higher of LBC or OTN. In September 1987the National Monetary Council decided to reintroduce the OTN, beginningOctober 1, as the reference for monetary correction for all types offinancial operations and contracts, in place of the LBC. At that timecommercial, investment, and development banks were allowed to receive timedeposits, with or without issue of a certificate of deposit, with a minimumholding period of 60 days, correction according to the variation of theOTN, and with freely negotiated interest rates. Exchange bills (issued byfinanceiras largely to finance durable goods) and debentures can also beissued under these conditions. Financial institutions were also authorizedto carry out lending operations on the same basis.

15. Thus, the LBC ceased to serve as an indexing mechanism andregained the function for which it was originally created, that is to serveas an instrument for the conduct of monetary policy. The effect was topermit the return on LBCs to rise above or fall below the rate of inflation,without directly affecting the return. on indexed financial instruments andcontracts.

- 52 -

=~~~~~~~~~~~~~M Page 13 of IS

16. The real interest r*te in Brasil is difficult to define andmeasure due to the segmented and partially administered nature of thefinancial system, only parts of which operate at market-determined fates.and to the presence of tax wedges between borrowing and lending rates insome segments of the system.

17. Recent trends of the most relevat short-tern interest ratesmirror the large srings in inflation. The LIC rate, an overnight rate,constitutes one anchor of the whole intereot rates structure. Changes inthe level of overnight rate have rapid repercussions throughout the ternstructure of interest rates. Because successful operations requireaccurate inflation forecasts, the daily evolution of this short-term rateis a good indicator of expected inflation for a given month.

18. The cost of funds to the borrower in the free segment of thefinancial system is determined by the evolution of cost of funds to thefinancial system plus the existing taxes and a financial markup. However,because Brazilian financial markets are highly segmented, there is a widedispersion of lending rates. Segmentation results in very high interestrates in the free segments of the financial markets.

19. The rate on passbook savings accounts, fixed at 0.5Z a month(6.2Z a year) plus monetary correction, is another anchor of the interestrate structure. The existence of this fixed real rate restricts somewhatthe flexibility of monetary policy to affect real interest rates. In theshort run monetary policy can move interest rates. But, if over a longenough period they remain "too high", they may lead to significant outflowsof funds from passbook savings accounts towards the overnight market or toCertificates of Deposit (CDBs), although CDBs are offered mainly in largedenominations. Taking into account differences in tax treatment as well asin other features of the several assets, if the rate of return on passbooksavings accounts (exempt from income tax) is lower than the net-of-tax rateon alternative assets, a significant outflow of funds from the SBPE couldlead to instability in the financial eystem.

20. As discussed above, a notable feature of Brazilian financialmarkets is the scarcity of long term financial instruments. Theauthorities, through tax incentives, have attempted to induce investors tohold assets of longer maturty, i.e.90 days to 130 days, and to lay a basisfor the development of a longer-term market for financial instruments.These tax incentives, including those announced in October 1987> consistmainly of raising tax rates on financial operations with a maturity of lessthan 63 days. However, these attempts have not achieved the desiredresults. In the prevailing volatile economic environment, investors do notseem to regard the tax incentives as offering enough compensation for theadditional risks associated with a portfolio of assets having a longeraverage maturity.

21. Real interest rates in Brazil have been positive in recentmonths, with some notable exceptions (e.g. rural credit in the North andNortheast), but unless the tax factors are taken into account, the returnto the lender and the cost to the borrower are overstated. Sixty daycertificates of deposit earned monetary correction plus an average of 30.22

- 53 -

ANUIIR VPage 14 of 15

(subject to income tax) on an annualized basis over August-November 1987when deflated by the IPC. Thp cost of borrowing to the federal governmentfor LBCs averaged 13.2Z above inflation over the same period, but thilaverage conceals a much lower rate since the beginning of October and amuch higher one over August-September. The annualized real cost of 60 dayworking capital, again deflating by the IPC, was almost 742 over August-November. The high real rates for CDJs and working capitsl and the largespread between them reflect tax wedges in the system. default risk, andhigh costs of intermediations. Real interest rates have not only beenhigh, but quite variable from month to month--they hve been negative forsome instruments several months this year. and at various points in timemonetary correction has been below some measures of inflation, while inothers it has been above the IPC, particularly in the first three monthsfollowing the announcement of the Bresser Plan.

22. Positive real rates of interest help to restrain capital fligntduring aperiod of economic and political uncertainty. How much investmentdisincentive the high real interest rates represent is, however, an openquestion. High rates make financial investments more attractive thaninvestments in directly productive capital. But investment decisions focuson a broader set of variables than interest rates. These decisions takeinto account the expected level of demand and general economic conditions,among other factors, that in turn also influence interest rates. It isunlikely that a a decline in interest rates alone could result in asignificant increase iii investment unless the overall level of econom.c andpolitical uncertainty is sharply reduced.

21. In sum, the level of real interest rates is a reflection of theoverall macro environment, the result of the several shocks that haveaffected the economy and widespread expectations that others may beforthcoming. Real rates are influenced by actual as well as expectedpublic sector borrowing needs, volatile inflation rates, over-reliance onfine tuning the economy as reflected in frequent changes in the regulationsgoverning financial markets, and overall uncertainty over the future courseof economic policy.

Interest Rates and Economic Policy

24. Interest rate trends are largely determined by monetary andfiscal policies. An optimistic scenario can be envisioned in which fiscalpolicy is brought under control and, in the context of a consistent andcomprehensive economic program, inflation is brought to a lower and stablelevel. In this scenario interest rates are likely to decline. Theexpectation of much lower future fiscal borrowing needs, and consequentlylower real rates, would exert downward pressure on interest rates.

25. In the alternative more pessimistic scenario, public sectorborrowing will continue to absorb a substantial part of savings, crowdingout the private sector through high real interest rates. The inflation taxwill continue to represent an important source of revenue and themacroeconomic environment will be conditioned by a set of "stop-and-go'policies. The inflation rate will periodically accelerate, requiring sometype of shock to stabilize it temporarily. In this scenario it is

54-

Paeg 15 of 15

difficult to expect a decline in real interest rates; instead it is morelikely that they will increase.

26. For several reasons this scenario is not sustainable over themedium-term. The private sector will perceive the inconsistencies ofeconomic policy and in anticipation of an eventual price freeze, firmn willincrease prices, leading to demand for wag. increases. The likely outcomis an acceleration in the rate of inflation. Moreover. a policy ofperiodic shocks will have diminishing returns, and any eventual pricefreeze will become more and more difficult to enforce.

27. The mathematics of debt accumulation is another elementcontributing to the unsustainability of this strategy. Whenever theinterest rate is higher than the growth rate of GDP, both measured in realterms, unless the required adjustment is performed on the primary deficit,the debt-to-GDP ratio will increase. Even if adjustments are made, theshare of interest payments in total government spending will increase,reducing the authorities' flexibility cut expenditures. If economic agentsare forward- looking and they see little prospect of fiscal adjustment,they will require a higher interest rate to absorb the additional publicdebt, further contributing to the deterioration of the fiscal situation.Furthermore, to increase its flexibility, the private sector will convertits debt holdings into instruments of shorter maturity. In this case,changes in interest rates will quickly lead to higher interest payments.

28. The evolution of interest rates and the complex combination ofsavings and investment decisions cannot be separated from an analysis ofthe paths of the domestic and external debts. As the sources of externalfinancing dried up, the absence of the necessary fiscal adjustment impliedthat domestic debt would have to be issued to replace the lost source offinancing. To protect the private sector from the effects of domesticcurrency devaluation, the public sector took over many of the privatesector's external liabilities. Some public sector tariffs and prices wereheld below inflation, increasing the borrowing needs of the public sector.Iile public sector also provided some debt relief to both itself and theprivate sector by holding monetary correction below inflation in 1980,1983, and 1986, though whenever this was anticipated, interest rates tendedto rise to compensate for the perceived risk. The required issue of newdomestic public debt raised interest rates and crowded out the privatesector. The inflation tax was used as a source of revenue, but because thedebt was indexed, inflation could not reduce the debt burden in real terms.In the final analysis, the issue remains one of fiscal adjustment.

PA" 1 of S

BALANCE OF AYMNTS

Introduction

f 1. By far th mt demaic succes In the execution of theMacroeconomic Control Plan has been the cantinuation and enhancemnt of theturarround In the trade balance which began In FTbruary 1967 adaccelerated beginins In April. In each of tle four *mths b*ginning ineJue the trade balance has exceeded US$1.4 billion for a record US$3.8billion total which suests that even the rewist 1967 target of US$10.2billion (up from US$8.6 blllion projected in the Macroeconomic Control Plan- P01) will be exceeded, and a level of about US$lO.S-11.2 billion will beattained.

2. This impressive performance has resulted from cooling domesticdemand and real exchange rate depreciation maintained through frequentminidevaluations even during the price freeze of June 12-September 12. Thesuccess on the trade front contrasts markedly with the deterioration whichoccurred in the second half of 1986, when the economy became overheated andthe real exchange rate was allowed to appreciate.

3. This success has not been matched by developments on the servicesor capital accounts. Direct foreign investment is likely to be negativefor the second year running, negative net disbursements by themultinational institutions are likely in 1987, and while there hasapparently been some recovery of reserve3, the current uncertainty couldgive rise to capital flight.

4. The outlook for the medium term is clouded even on the trade sideby prospects for a deterioration in the international economic situationand by the risk of failure in the attempt to stabilize the domesticeconomy.

Exchange Rate

5. Between the February 1983 maxi devaluation and the Cruzado Plan(February 1986), the Brazilian authorities pursued a policy of frequentsmall devaluations of the domestic currency with respect to the US dollar.During the initial stages of the Cruzado Plan the cruzado dollar exchangerate was fixed. A small devaluation, (1.82), occured in October 1986 andon November 24 the authorities reintroduced the pre-Cruzado policy of smalldevaluations of the cruzado/dollar exchange rate in line with domesticinflation. During 1987 two additional devaluations of the Cruzado werecarried out, the first (7.5Z) on May 4 and the second (8.5Z) on June 12.

6. The policy of continuous exchange rate adjustments sucessfullyprevented the erosion of external competiveness in the face of highdomestic rates of inflation. Although in late 1984 and early 1985 therewas a real appreciation of the real effective exchange rate resulting fromthe dollar appreciation via a vis the other major currencies, after March1985 the trend of the effective exchange rate was reversed as the dollarstarted to depreciate. In February 1986 the real effective exchange rate

Page 2 of &

against the US dollar vas at about the level after the 1983 msxidevaluation vtie the domestic deflator used is hourly wages in Sao Paulmanufacturing industry, but had appreciated by some 92 measured apginst thewholesale price index for industrial products.

Table lt BRAZIL - REAL EFFECTYVC EXCHANGE RATCS. 1982-1987

(February 1986 - 100)

Domwstic IGPIDI IPA/DI IPAIPI FIRSP sourlyDeflator wae

USS Basket US$ Basket US$ Basket US$ basket

1982 87.3 82.4 93.5 88.2 80.2 75.7 66.7 63.0

1983 111.5 106.3 114.7 109.4 107.0 102.0 98.8 94.2

1984 114.0 107.8 113.0 106.8 108.2 102.3 114.3 108.0

1985 116.9 113.3 116.7 113.1 111.1 107.6 112.6 109.1

1986 102.7 104.0 104.1 105.4 105.5 106.9 92.3 93.4

1 104.5 104.5 104.5 104.5 103.8 103.8 100.2 100.2II 105.4 106.9 106.8 108.4 107.5 109.0 95.4 96.8III 102.5 104.5 104.2 106.3 105.9 108.0 91.8 93.6IV 98.9 100.5 101.2 102.8 104.9 106.6 84.1 85.4

1987Jan 92.9 95.7 96.4 99.4 102.1 105.2 83.2 85.7i-eb 94.4 97.5 101.4 104.6 105.1 108.5 85.5 88.2Mar 95.3 98.7 103.1 106.8 103.9 107.6 83.9 86.8Apr 90.2 93.4 96.9 100.4 94.8 98.2 81.2 84.2May 92.5 95.8 97.0 100.5 94.0 97.4 88.5 91.7Jun 94.6 97.2 98.9 101.6 95.4 98.1 92.9 95.5Jul p 99.1 101.2 103.1 105.3 101.3 103.5 105.0 107.3Ago p 99.5 101.5 104.3 106.4 104.7 106.8 105.0 107.1Sep p 97.8 100.4 103.0 105.6 104.6 107.3

Source: Central Bank of Brazil

Note: External Deflator for all indexes is WPI (IFS line 63)

7. During the Cruzado plan there was some real appreciation of thedomestic currency, the extent depending on the domestic price deflator usedand whether it is measured against the US dollar or an export-weightedbasket of currencies (Table 1). However, because the existing priceindices do not fully capture the illegal premia paid on most goods during

Page 3 of 8

period* of price controls, the extent of the actual appreciation is likelyto be underestimated. The return to a policy of daily exchange rateadjustments and the two devaluations mentioned above reversed the erosionof real competiveness. Using the FIESP hourly wage as the domesticdeflator, the real effective exchange rate against the USS depreciated 13?in July, bringing the improvement in the competitive position as measuredby this indicator up some 25? since the last quarter of 1986. Thecorresponding d.preciation against an export-weighted basket of currenciesin July was slightly less, 12.41. These respective real wage-adjustedexchange rates in July represented 52 and 7? depreciations from theirFebruary 1986 levels, with a slight appreciation against tne dollar levelin 1984-85 and about the same level as the level for the basket over thesame two years.

8. Some indication of the adequacy of the exchange level can beobtained from the trends of the parallel market, a well developed althoughillegal exchange market. Given the limitations imposed on the purchase offoreign currency for travel abroad as well as other transactions thismarket 'Las remained very active. The absence of good documentation on thesize of the market, the effects that seasonality and other factors have onmarket fluctuations somewhat restricts the usefulness of this indicator forvery short-term analysis. However, the comparision of the differentialbetween the parallel and the official market over an extended period offerssome indication of exchange rate pressures. During 1986 the parallelmarket premium increased from about 322 in February to a maximun of almost100? in November, when the sustainability of the exchange policy wasclearly perceived in danger and the rumors of a forthcoming maxidevaluation were widespread. With the change in policy the differentialdeclined reaching about 22Z in September 1987. Given the taxes onpurchases of foreign currency for travel abroad now in effect, a premium ofabout 25% should be considered "normal'.

9. Although it is difficult to estimate with precision the'equilibrium" exchange rate, the different indicators do not point to anymajor issue with respect to exchange rate policy. In the bILg run,exchange rate policy is relevant to determination of resource allocationthrough its effects on the relative price of traded and nontraded goods andit should be set consistent with a sustainable external equilibrium,including a financeable current account deficit. Changes in commercialpolicy, terms of trade or capital flows will then require appropriateadjustments in the real exchange rate.

Trade Balance

10. In 1987 the shift in exchange rate policy in conjunction with thedecline in domestic demand has contributed to the improvement in thebalance of merchandise trade. In 1986 the combination of expansionarydemand policies, capacity limitations and loss in competiveness led to adecline in the trade surplus from US$ 12.5 billion in 1985 to US$8.3billion. Cooling demand and the real exchange rate adjustment contributedto export recovery. The monthly trade surplus increased from an average ofUS$ 192 million in the first quarter to US$ 961 million and US$ 1,446million in the second and third quarters respectively (Table 2).

- 58 -ANNEX VIPage 4 of 8

11. The 1987 trade surplus will be about US$11 billion, higher thanthe Central Bank's projection of US$10.2 billion, which was revised upwardin the PCM update of October 1987. The Central Bank projection for 1987 isbased on a rapid fall in exports without any corresponding rise in importsover the last quarter.

Table 2: BRAZIL - EXPORTS, IMPORTS, AND TRADE BALANCE, 1985-1987

(Millions of US$)

Exports Imports Trade Balance1985 1986 1987/a 1985 1986 1987/a 1985 1986 1987/a

I 4,997 5,819 4,148 3,094 3,353 3,565 1,903 2,466 583

II 6,557 6,463 6,501 3,017 2,760 3,611 3,540 3,703 2,890

III 6,759 6,165 8,376 3,132 3,661 3,992 3,627 2,504 4,384

IV 7,326 3,946 7,075 3,910 4,270 3,932 3,416 -324 3,143

Tot 25,639 22,393 26,100 13,153 14,044 15,100 12,486 8,349 11.000

Source: Central Bank of Brazil and World Bank Projections.

Note: /a Last quarter projected.

12. Table 3 presents projections of the balance of payments for theyears 1987-91. For the years 1988-91, an optimistic domestic policyscenario is assumed, which assumes a significant liberalization of importsas well as favorable developments on the external debt negotiations. Underthese assumptions, the trede balance is projected to stay at roughly its1987 level over the next four years, averaging US$ll billion per year.

Current Account

13. The principal change in the service account in 1987 is thatinterest charges on Brazil's foreign debt are projected to be lower than in1986 by some US$800 million. This is because of the fall in internationalinterest rates, which benefitted Brazil this year. The projections assumethat principal payments to bilateral agencies and commercial banks arerefinanced, LIBORs of 8.5, 8.12, 7.42, and 6.6? for 1988, 1989, 1990, and1991 respectively, and a spread of 0.875Z. The current account deficit isprojected at US$1.6 billion in 1987 and to average about US$3.5 billion ayear over the next four years, or about 1? of GDP.

Page 5 of S

Capita! Flovs

14. Direct foreign investmnt (excluding reinvested profits) isprojected to increase from a negative net flow of US$108 million in 1986 toa positive flow of US$600 in 1987, of which only US$116 had been realized

F as of Jume. This ref lects expected debtIequLty ccawursois rather thansignificant *new' inflows. In addition, reinvestment of profits onexisting investment is expected to add another US$300 sillion. lote that1986 was the first year in the past two decades wben an outflow occurred.A high priority should be placed on turning this around. and the baselinebalance of payments projections shown in Table 3 show a progressiveincrease in direct foreign investment over the five year period 1987-91.

15. The increase in Brazil's external liabilities for 1987 isprojected at US$2 billion, including arrears. Total external financingrequirements for the 1987-89 period are projected at US$12.0 billion, ofwhich US$8.2 billion would finance current account deficits, and US$3.8billion would offset expected capital account outflows. The totalfinancing gap of US$21.2 billion for 1987-91 is assumed to be covered bysome combination of financing from the multilateral institutions (IBRD,IDB, IMF), biliateral agencies, suppliers' credits, and commercial banks.A decrease of one full percentage point over the projected level of LIBORwould reduce external financing requirements on the order of US$1 billionper year over the next four years.

16. The outlook for external debt indicators is summarized in Table 4.It demonstrates that under the optimistic policy scenario, Brazil'screditworthiness indicators improve systematically over 1987-91. The debt-to-export ratio declines from 4.46 in 1986 to 3.32 in 1991, while the debt-to-GDP ratio declines from 41? in 1986 to 32Z in 1991, and the interestservice ratio declines from 41Z to 25? over the same period. The interest-to-GDP ratio delcines from 3.8? in 1986 to 2.3? in 1991.

AIR VIPaR 6 of a

- - - -------------- -. 3- - - --------- --- -_.

im .lue. .6 Pa3 pwt. Smimry_ _~~~ -____________________-- _--__--_____--- _-- _- --------------------- _- _________________________________.-

Trmd blanc* 0.3 11.0 10. 11.0 11.0 11.8

s.rviec (Not) 1/ -13.1 -12.6 -13.9 -14.5 -14.3 -14.S

af which;

Gro. Intreet -10.4 -9.s -10.3 -10.4 -10.0 -9.I

Current Account balance -4.8 -1.6 -3.2 -3.8 -8.5 8.5

Not Direct Foreign 0.3 0.9 1.3 1.6 1.6 1.9

Inv-etent 1/

other Capitol 2/ 0.7 -0.8 -1.2 -1.3 -1.6 -1.5

Projected incrs&oe in

n*t external li;bilixigs (A) 3/ -0.1 2.0 4.0 4 4 3.9 8.9

Available linancinC, nec (S) 4/ -1.7 -0o3 -0.6 -0.3 0.0

Financing Cop, not (A-8) 3.7 4.3 3.0 4.2 8.9

OCenge i* Crose R_ervee 3.9 -0.5 -0.9 -1.1 -0.7 -0.9

( iner -) S

L; her 8.5 8.1 7.4 S.6

Spreed 0.875 0.875 0.675 .67S

Coroe srves to Import ratio

(mnths of MOM) 4.6 4.8 4.7 4.6 4.6 4.5

1/ Include. reinvested profits.

2/ Includes ot4er cpibal * error& and or_i-sion-. short term capitai and reiiMan lendifg abroad.

3/ For 1986 and 1967 includes arreare.

4/ Eetimted not pipetine dimburseaent frog multi ltetel and bi lateral source end upph iere. Comercial banks r-tinanein of prim-

CipIl is aum_d,

5/ Change in roerve e4u ival*nt to one third of the increase in imports of gc-da end non factor aervices.

p * preliminary date

Table 4: BRAZIL - DEBT INDICATORS, 199

1/

I--------- ------- Actual -------------------- I Preliminary l--------------e ------ ----

1960 1981 1982 1983 1904 196i 1968 I"? l11S son low 181

External DObt Indicator.

Total DOD (in U6 *i II ioen) 2/ 64244 73,96S3 8U.i4 93.S86 102,0J9 106,126 110.769 112,79 118.790 3I.U* 136.6 13,60

(of Uhich hF) --- --- 680 2.644 4.16 4.619 4.490 3.420 2., 1,40 1.1 on

0D0/XOS 2/ 2.76 2.78 3.64 3.64 3.38 3.89 4.46 3." .ye 4.11 1.47 O.M0

O0D/W 2/ 0.268 0.279 0.316 0.487 0.486 0.454 0.406 0.376 0.366 0.361 *.a

Debt Servico (in LOW *ill l iorn) 2/ 14.14" 17.801 20.7S6 18,409 19,998 22,319 24,243 25.207 94.061 1.SW MWM 31*W

Debt Serv;-/XO6 0.61 0.66 0.89 0.76 0."6 0.76 0." 0.11 0.61 0.89 8.1 O."i

Debt Sorvice/0P 0.069 0.067 0.077 0.090 0.095 0.096 0.089 0.014 0.076 0.06 0.606 Ca0l

Interest/X08 2/ 0.S20 0.363 0.533 0.422 0.379 0.364 0.414 0.824 0.36 0.161 O.Wm ,1111

Inter.e0t0P 2/ 0.01 0.089 0.047 0.060 0.085 0.060 o.038 0.061 O.-O 0. 9.411 ._

(1) H;istrical fiurs bhaW an I2E national aceeunte Jata, June 1967.

(2) Include. *he Dr.

, .. JvEAR.Xa.L~~~U.b ....... .. ......

Pasg 8 of 8

Reserves

17. For August 1987, the Central Bank has reported reserves ofUS$4,120 million (cash concept) and USS7.340 million (internationalliquidity concept). Using the variation in the gothers' account of the"coat&s cambiais' in the monetary accounts to estimto reserve accuwlationsince then and converting to dollars at the overag official exchang ratefor September, October, and November, the reserve buildup through Octobermay be roughly estimated as follows (cash concept).

(US$ millions)

Reserve Increase Cash Reserves

September 87 483.6 4,603.1October 268.5 4,871.6November 479.1 5,350.7

This would mean an increase in reserves over the level at end-1986 of aboutUS$766 million, which is somewhat above the $500 million increase projectedfor the year. Reserves are projected to continue to increase by an averageof US$900 million per year over 1988-91 to maintain gross reserves at anaverage of 4.6 months of imports.

A=VIIPage 1 of 10

PRICE FLEXIBILIZATIONt AN ANALYSIS OF RECENT STRATEGY

Introduction

1. This annex first reviews the background, the legal context, and thestratey underlying the flexibilization. This review is followed by aquantitative analysis of the speed of adjustment and of the changes in themajor relative prices. The annex concludes with an evaluation of the recentprice flexibilization implemented as part of the June 1987 Plan. No attempt ismade to compare this year's price flextbilization with that which took placefollowing the *Cruzado II measures in November 1986. It should be noted,however, that the June 1987 Plan's price freeze was (a) preceeded by a periodof anticipatory price increases which provided some price 'slack, (b) moreflexible from conception (it did not involve fixing the nominal exchange rate),and (c) limited to a maximum of three months, whereas the freeze in the CruzadoPlan had no time limit and was maintained intact with few exceptions for somenine months.

Background

2. Since 1984, the Brazilian government has tried to move toward a pricesystem characterized by a combination of three price-setting mechanisms.First, the prices of the major wage-goods are to be controlled sufficiently tomaintain the purchasing power of lower income groups. This control affectsmany agricultural products. 1/ The prices of oligopolistic and monopolisticindustries are to be maintained under supervision to avoid abuses of theirmarket power. And third, the prices of other goods are to move freely undernormal circumstances but may have to be temporarily controlled duringtransitions of relative price changes to shocks like droughts. General orpartial price freezes have however altered the system in recent attempts tocontrol inflation, and resulted in some distortions in relative prices. Thelast of these freezes was part of the 'Bresser" Plan.

3. Or. June 12, a three month price freeze was initiated to control theacceleration of inflation observed between April and June. The second phase ofthe plan began in September. It consists of a gradual liberalization and'flexibilization' of prices. Liberalization aims at freeing prices whileavoiding a new acceleration of inflation. 'Flexibilization' will changerelative prices to reduce distortions induced by inflation and lags in priceadjustments due to controls or contracts. The gradual liberalization and the3flexibilizationw is expected to be concluded for the majority of retail goodsand services by the end of the year and later next year for production goods.

1/ It should be noted that this policy, when effective, tends to depress theincome of small agricultural producers and landless agricultural laborersgroups which include large numbers of very poor families. (see Pfefferman,G.P. and R. Webb, "The Distribution of Income in Brazil", World Bank StaffWorking Paper No 356, 1979)

_ _ _ _ _ _ _ _ _ _ _- 64 - _ _ _ _ _ _ _ -= -=_

Page 2 of 10

4. Four types of prie^- are included in the second phase: agriculturalprices, producer goods pric. , consumer goods prices and public sector prices.Public Sector prices are dealt with in Annex I1. The readjustments of pricesof goods and services follow some general rules to be implemented by theInterministerial Price Council (CIP) for industrial products prices, by theNational Supply Superintendency (SUAb) for retail prices, and by a joint teamof the Fnance Ministry and Agriculture Ministry for agricultural prices.Similar sets of rules apply to the various types of prices.

The Legal Framework

5. On August 27, the Finance Hinistry provided the framework for theliberalization and 'flexibilizatton' of prices (Portaria No 297). Two typesof prices were defined: wholesale prices and consumer goods prices.Technically, all prices were freed as of September 1 except for a list given asan annex to the law for the producer goods prices controlled by CIP and in aTable published by SUKAB for consumer products. Goods are grouped into fourcategories according to the degree of freedom given to their prices. The listis revised weekly. Some items are added, some are dropped and some areswitched from one category to another. Items that are potential sources ofproblems in terms of inflation are added to keep them under control. Items nolonger expected to pull inflation up are dropped and have their prices freed.The current tendency is to drop items. At its peak the list included over 600items representing about 100 consumer and producer goods. The list has beenreduced by 30Z since September.

6. Wholesale prices are grouped as follows: (i) fully controlled prices(requiring a detailed cost structure) ; (ii) controlled prices (which do notrequire the detailed cost structure information); (iii) prices subject to aceiling of variation equal to the percentage change in Price Reference Unit(URP), which, for September, October and November is equal to the geometricaverage monthly change in the official consumer price index (IPC) in July andAugust (the freeze period) and as of December will be fixed for a three monthperiod as the geometric average of the immediately preceding three months; and(iv) free prices.

7. Retail products were also divided into four categories: (i) tabledprices, (ii) prices for which a markup is determined over cost, (iii) pricessubject to a ceiling on increases equal to the percentage change in URP and,(iv) free prices.

8. Minimum agricultural prices are set jointly by the Finance Ministryand the Agriculture Ministry. The present monthly correction of the minimumprice for changes in OTN has been extended until next July. The governmentwill continue its interventions through sales from regulatory stocks. It hasset boundaries within which agricultural prices will be allowed to float. Ifprice changes tend towards the limits, the government intervenes by buying orselling inventories to bring the price within the limits. Presently, thegovernment is only buying since the market prices have not reached the minimumprices.

- A YIIPage 3 of 10

The Early Iplwemntation

9. Flesibilization is not considered by SURAS as a pure second phaseproblm. It was actually initiated betwa Jume and August. Some gradualrelative price adjustments took plece during that period, but the largest wereIalemeted on Jue 12 sad reached or to 3901. In July d August , ua .uWrlimit of 120 on all adjustments was Imposed. In most cases the limit wasrespected. In some others, the increase were mor than 101 but consistentwith the *flexibiliaationo policy officially Initiated in September. Table 1gives a summary of the types of price increases granted.

Table 1: Number of Changes in Prices betwoen June 12 and August 30

Price Change (inm) Number of Items Items included

1 - 10 19 Chicken, rice, coffee, meats...11 - 20 15 Cookies, corn starch, gas...21 - 30 8 Fresh milk,...31 - 40 9 French bread,phone service,cars41 - 50 4 Electricity, harbor fees,...

> 50 21 Powdered milk. cheese, wheat,...Total 72

The Implicit Strategy Underlying the Adjustment

10. The implicit strategy reflects the objective of avoiding a resurgenceof high inertial inflation. The list of controlled prices attached to the lawcovers the products considered as the most important for the economy or themost likely to be a source of inflation. The relevant consumer and produceritems are categorized according to the four categories mentioned earlier.

11. The most competitive products were the first to be liberalized at boththe producer and consumer goods levels. The last items expected to be fleed atthe retail level are the goods considered to be an essential part of theworkers' consumption basket. Essential consumer goods include food, hygiene,and cleaning products. The consumer goods likely to be liberalized last arewheat, bread, milk, soft drinks, and beer. At the production level, essentialinputs for the rest of the economy and outputs of monopolistic or oligopolisticsectors are likely to be the last to be freed. Non-competitive sectors includeboth public and private enterprises in the steel, petrochemicals, energy,automobile, beer, and tobacco sectors. No date is available for their priceliberalization. This decision is presently being challenged by the automobileindustry. During the first week of November, that sector has unilaterallydecided to free its prices. The matter is now in the hands of courts. Adecision favoring the automobile sector could lead to a general protest by alloligopolistic industries and may result in a immediate failure of the'flexibilization' policy.

ir ~~~~~ ~ ~ ~~ ~66 - _ ..................

12. As part of the strategy, and in order to avoid a situation in whichthe price increases of the first liberalized products would lead to higherinflation, most of the products liberalized had a low weight in the officialprice index. The relevant products include clothing, furniture, toys and non-essential goods or items hard to control.

13. The last consumer goods are expected to be liberalized by the end of1987. Wheat, bread, milk, soft drinks and bear may remain controlled for alonger period. For producer prices, the deadline is less clear and thedecisions are taken on a more ad-hoc basis. An effort is made to identify thepriorities consistent with the macroeconomic objectives of the government. Butlobbies are playing an important role in the choice of priorities. Thepressure of cost increases is often used to claim a price increase by manyproducers. Price increases are often spread over a period of several months toavoid excessive pressure on inflation. This results in further adjustment lagsin real price changes.

14. For highly seasonal products, like agricultural products, theadjustinent also tends to be spread over time. Most crops will be harvestedafter February and will benefit from a higher minimum producer price. To avoida sudden price shock then, the government is allowing prices to rise graduallyevery month and thereby reducing the spread between retail and minimum producerprices. Real retail prices end up leading inflation.

The Speed of Adjustment

15. The speed of adjustment has been quite rapid. The freeing process isfirst taking place within the list since more and more consumer and producergoods have their prices defined is free (fourth category in parag. 6/7). Thelist of all products controlled has now reached its peak and a large share of,hose products listed but allowed to move freely are likely to be dropped fromthe list. Between September 2 and October 14, 611 producer and consumer itemswere categorized by SUNAB and CIP. About 762 of these items were categorizedon September 30, and about 132 during the first half of October. As of the endof November, only about 190 items were still controlled by CIP which is alreadylower than the number of items controlled in April/May 1987. By mid-December,only 8 products representing about 70 items will still be controlled by SUNAB.The Adjustment in Relative Prices

16. This section analyses the recent evolution of the relative prices ofproducer and consumer goods, and agricultural and industrial products. Thereare two ways of looking at the adjustment in relative prices. The first isover time, and the second is within a given period. The comparisons are basedon the wholesale price index (IPA). The base period is the second semester of1984. The price structure during that period is comes closest to beingrelatively stable and control free.

17. Table 2 shows the adjustment of relative wholesale prices over time.The relative price of consumer goods to producer goods and the relative priceof agricultural products to industrial products increased between 1984 and1986. A trend reversal is observed in the General Indicators between December

-67 - ANNEX VII

1986 and May 1987. The three-month freeze started in June has maintained thenew trend for the relative price of consumer goods to producer goods. Thefreeze has however restored the initial trend favoring the relative price ofagricultural products to industrial products. Some seasonality in the secondhalf of 1987 may also explain the strong recovery of agricultural prices aswell as the desire of the government to close the gap between consumer andproducer prices for agricultural products. Overall the major terms of trade

'- remain quite different from the 84185 period.

18. The relative price drop of consumer goods to producer goods observedin 1987 is consistent with the implicit government policy of increasing thepurcha ing power of lower-income earners, since the consumer goods correspondto the largest share of their consumption basket. The composition of theconsumer goods price index indicates, however, that the relative price ofdurable to non-durable goods has decreased during the freeze. This occurs eventhough durables are not considered as basic needs for the low-income earners.This suppression of durable goods prices could prove highly detrimental tomedium-term behavior through its potential negative effects on industrialprofitability.

19. The evolution of the terms of trade between agricultural andindustrial products illustrates the efforts to stimulate the production ofagricultural goods by increasing their relative prices. The low ratios in thebeginning of 1987 may reflect the procedures followed to set the prices ofagricultural goods. The prices may also reflect the large crop harvested in1986/87 as cowpared to the low one induced by the drought of the previous year.The prices of agricultural products have increased since the freeze and shouldincrease more between September and February, when the new crop will beavailable and the new minimum producer prices will be in place.

20. For producer goods, the ratios indicate that the construction sectorwas favored between 1984 and May 1987 compared to raw materials and machinery,vehicles and equipment. The raw material sector has benefited the most fromthe freeze while the machinery and equipment sectorhas been the major loser.This may be explained by the evolution of imports of that type of goods or byan investment slump during the freeze period.

Table 2: Adjustments over time of relative prices(Price index for the second half of 1984 = 100)

(Indice de Preco por Atacado)

1984 1985 1986 1986 1986 1987 1987 1987mean mean mean Mar Dec May Aug Sep

GENERALConsumer/Producer 101.5 105.2 127.7 126.6 138.9 127.8 118.8 118.4Agricultural/Industrial 103.3 107.2 133.3 126.7 142.1 99.9 118.6 124.6CONSUMERDurable/Non Durable 97.6 116.8 107.5 109.0 114.3 129.0 116.6 111.4PRODUCERRaw Mater./Constr. Mater. 100.4 97.2 95.5 94.4 90.3 68.8 80.0 82.2Raw Mater./Machin.& Equi, 101.7 85.6 ?6.5 74.4 78.0 45.9 58.7 60.4Constr./Machin. & Equipm. 98.7 113.6 124.7 126.9 115.8 149.8 136.3 136.2

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21. It is also useful to compare the adjustmmnts within a given year.This can be done by observing the dispersion of adjustments of the variouscomponents around the mean adjustment of the period. The upper part of Table 3gives this general dispersion index. The base is the IPA-OG or IPA-DI index(Indice de Precos por Atacado - Oferta Global or Disponibilidad Interna). Aproduct with an index higher than 100 has benefited from a larger than averageprice adjustment during that period. Tbe opposite is true for inde*xs lowerthan 100.

Table 3: Dispersion of product price adjustmentsProducts type compared Relative price - Period Average (March 1986 - 100)

(Indice de Preco por Atacado - Disponibilidade Interna)

1984 1985 1986 1986 1986 1987 1987 1987mean mean mean Mar Dec May Aug Sep

RATIO OF EACH COMPONENT TO THE RELEVANT WHOLESALE PRICE INDEX IN EACH PERIOD

IPA- DI 100 100 100 100 100 100 100 100CONSUMER GOODS 101 102 111 111 117 111 106 107Durable 98 118 119 120 132 138 121 118Non-Durable 101 101 111 110 115 107 104 106

PRODUCTION GOODS 99 97 87 87 84 87 89 90Raw Materials 100 95 84 84 71 79 79 81Construction Materials 98 110 110 113 104 155 135 134Mach., Vehic. & Equip. 100 97 88 89 90 103 99 98

IPA - OG 100 100 100 100 100 100 100 100Agricultural Products 102 105 122 118 128 98 112 116Industrial Products 99 98 92 93 90 98 94 93

DISPERSION OF COMPONENTS AROUND THEIR MEAN IN EACH PERIOD

IPA-DIConsumer goods 0 5 126 114 297 128 39 50Producer goods 1 8 166 159 244 166 112 92

Total 1 13 292 273 541 294 151 142

IPA-OGAgricultural 6 25 498 310 800 5 140 260Industrial 1 4 69 51 95 5 33 47

Total 6 29 567 361 895 10 173 307

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22. Consumer goods prices increased more than the average since 1966 butlose since the freeze. The prices of durables have been very dynamic since thefreeze as compared to the prices of non-durables. Producer goods prices havechanged by less than the average since 1984. Their relative price changes are,however, getting closer to the average since the freeze. As illustrated byTable 2, the construction sector has benefited from the most dynamic prices andhas hardly been affected by the freeze. The trend is confirmed in 1987 so far.Agricultural prices have incre sed more than the average betwen 1984 and 19.8Tuey are likely to increase by more in 1987 too. The low May 1987 figure mayreflect the seasonality factor. The relative price of industrial products hasremained fairly stable over the whole period.

23. In the lower panel of Table 3, the dispersion of the major componentsof the two average price indices, IPA-DI and IPA-OG, around their mean iscalculated. Using the indices of the upper part of the table, the totaldispersion is calculated by summing the qquare of the difference of the majorcomponents to their mean. The higher th- figure obtained for the aggregateprice index the more different the new relative price structure is from thesecond half of 1984 reference structure. The results indicate stabledispersion levels for 1984 and 1985 as well as for May 1987. This suggest thatthe inflation of the beginning of 1987 brought relative prices back in linewith their level during the second half of 1984. The freeze has increased thedistortions and brought relative prices back to their March 1986 compositionfor industrial and agricultural products. This reflects the decision to adjustagricultural prices progressively before the new crops come to the markets inFebruary 1988. The freeze has managed to maintain the relative prices ofconsumer and producer goods under control but has allowed producer goods pricesto adjust more than consumer goods.

Evaluation of the Implementation of "Flexibilization'

24. The implementation of the "flexibilizatior.1 has not been withoutcosts. Sectoral allocation distortions and undesirable macroeconomic effectsmay have resulted. Part of this is explained by the fact that some learninghas occured while trying to adjust prices in the right direction, although somemistakes may have been made. Part of it is due to difficulties with thestrategy followed.

25. Sectoral Allocation Effects. The changes in relative prices observedso far may have important sectoral effects, especially if the liberalizationphase is delayed much further. While the rapidly accelerating inflation of thebeginning of the year was reversing the recent historical trend and favoringthe industrial sector, the freeze has restored the relative advantage of theagricultural sector. The reversal of the terms of trade between agricultureand industry in favor of agriculture initiated in June 1987 will persist as theretail prices of agricultural products are being brought closer tc the minimumproducer prices. Agricultural prices are likely to increase by more than theaverage until the February crop.

70 -

26. If the decrease in the relative ptice of machinery and other equipnntto other production goods were to be only temporarily reversed by the fraes ,two consequences are possible. The first one is a negative effect onemployment to the extent that substitution between labor and capital occurs.It may result in an increase in the productivity of the relevant sectors. Thesecond effect may lead to a partial substitution of imports by domesticproduction of capital goods. These are of course long-r-run te*dencies. Inthe ohort run, the prices of equipment and machinery are likely to rise fasterthan the average.

27. Macroeconomic Effects. In the shorter run, a further increase in thedistortion of relative prices may lead to shortages of the basic goods thegovernment wants to guarantee to the lower-income earners. This is likely tolead to inflationary pressures and to the development of black markets. Bothfactors erode the tax revenue base and add to the deficit problem. Inaddition, the stimulus given to inflationary expectations is likely to increaseinterest rates with possible negative consequences on macroeconomicperformance.

28. In the case of agricultural products, the margins between the producerand retail prices drive the volume of stocks the governme.kt has to purchasefrom the producers. Large amounts of stocks to purchase are likely to add tothe deficit problem.

29. An Evaluation of the Strategy. The freeze seems, to a large extent,to have returned relative prices to their March 1986 structure. The relativeprices of agricultural and industrial products are now further away from their1984 composition but this reflects partially the decision to adjustagricultural prices. For consumer and producer goods, the freeze has onlyconfirmed the trend observed in the first half of 1987. The only majordifference in the second half of 1987 is the slower adjustment in the price ofconsumer goods. This increase the real purchasing power of low-income earnersresulting from the "flexibilization' is obtained at the cost of increaseddistortions in relative prices compared to the chosen base period.

30. The second problem results from the first one. By maintaining atemporary control on prices, but by failing to correct relative prices, thesecond phase of the plan builds up an inflationary potential. This may explaina large part of the October inflation figure of about °.5Z. The inflation mayreflect the catching up of the large number of items liberalized. It may alsoreflect inflationary expectations and expected increases it aggregate demanddue to higher real wages in the second half of 1987.

71 -

31. A third problem i that to meet its inflation targets, CIP and SUNABare forced to fine-tune. Price increases cannot be granted fully at the timeof the request and inflation inertia is thereby built into the system, whilerelative prices are not corrected as they should be. Some prices, likeagricultural prices, lead inflation during certain periods of the year, butmany industrial products lag it. If at the end of the Oflexibilization phaseand the beginning of the full liberalization phase, relative prices have notb adjueted, price catchig-up will be one of the major objectives ofproducers and retailers and an inflationary spiral is likely to result.

32. The agricultural sector illustrates a fourth problem mentionedearlier. If the minimum prices are raised to stim$late production and demandis not sufficient, the goverment will pay a high price when buying the excessstocks. On the other hand, if the retail price is set too low, the wrongsignal is sent to consumers. excess demand and shortages result. Either waythe government loses revenues.

33. For many agricultural products, both the retail price and the producerprice are believed to be too low as compared to world prices. When theseproducts are also intended for exports, an additional distortion is introducedsince the exporters get a different price in the domestic (the minimum price)and the foreign markets (the world price).

Conclusions

34. The 'flexibilization' cum liberalization policy approach is well-suited to a phased lifting of the price freeze. Unless the liberalizationphase is rapidly introduced, implementation of the current policy is not likelyto lead to a stable set of relative prices for a number of reasons:

i. the implementation of the system is building up potential inflation byspreading price adjustments over time; catching up will be an important sourceof inflation when prices are fully freed and this is worsened by the recentcost-push pressure induced by the increase in real wages;

ii. the strict control of the prices of oligopolistic industries for a muchlonger period than most of the other industries will increase any distortionsin relative prices already existing, and lead to shortages in their outputs, toaddition to the overall public sector deficit when the enterprises are public,and increased unemployment for the other enterprises;

iii. the macroeconomic effects are to a large extent negative; by using'flexibilization' to keep the typical consumption basket relativelyinexpensive, the government manages to increase the real wage of workers in theshort run and as long as it is able to control prices; once liberalization iscomplete, the teal wages will tend to fall and to reach a lower level ifovershooting occurs in price adjustments; distortions in relative prices acrosssectors and within sectors are likely to result also; uncertainty may increaseand investment is likely to be negatively affected;

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Page 1.0 of 10

lv. the price freesz already has had significant negative Lopacts on taxrevenues (1CI and IPI); hence, it bas contributed to the deficit problemindirectly to the extent that the negative revenue effect was only partiallyoffset by the positive effect induced by the lor costs of public sectorpurchasoe; the slower the liberalisation, the larger the revenue loss is likelyto be.

AM= VIIIPate 1 of 5

MMt AM LiO# T DBVllSS=

r. WAGES

Background

1. In high inflation enviromet, real wage trends are largelyinfluenced by wage legislation rgulating the frequency of waadjustuets. Fra 1979 until the Crusado plea, wage adjueststts were madeevery six months. The adjustment bad two parts; one a free bargaiednegotiable cooponent and the other the indexation component, fixed by law,that could vary across wage brackets. Under this system, the indlvidualreal wage would reach its peak following the renegotiation and woulddecline thereafter until a new wage recomposition was implemented sixmonths later. Because the decline in the real wage between recompositionswas a function of the inflation rate, as the latter accelerated in late1985, strong pressures appeared for quarterly wage adjustments.

2. In February 1986. with the Cruzado Plan, the wage law underwentsignificant changes. First, wages were readjusted to their average realvalue of the previous six months plus a bonus. Secondly, wage negotiationsreturned to an annual basis with only a partial compensation for inflationmandated by the law and the residual subject to free negotiation. Thirdly,the law established that wages would be automatically readjusted by 20Zwhenever the the accumulated inflation since the last adjustment reachedthat value. This wage trigger mechanism, intended to work in a lowinflation environment, became a destabilizing force when inflationaccelerated in early 1987. The activation of the trigger fueledinflationary expectations and led to antecipatory price increases by firms.Moreover, as a result of the one month lag between the activation of thetrigger and the increase in wages this mechanism failed to insulate realwages from inflation erosion.

3. In the months following the introduction of the Cruzado Plan, theacceleration of the pace of economic activity increased the demand forlabor, raising real wages and lowering unemployment (Table 1). The peakfor the purchasing power of wages was attained in September-1'ovember 1986(at between 15Z and 35Z above their levels immediately preceding theCruzado plan depending on the measure chosen) declining thereafter as aresult of the acceleration of inflation and decline in economic activity.Because the official price indices did not adequately capture the illegalpremia paid on the purchase of many goods they underestimate actualinflation during the Cruzado Plan. With the official end of the pricefreeze following the Cruzado II measures in November 1986, the inclusion ofthese premia in the official price indices resulted in the indicesoverestimating the acceleration in inflation which followed.

Pae. 2 of 5

Ta le 1: UAZI. - PtRCHASING POEM OF WAGES IN SAO PAtULO AND IN TENATTU"lIPmucTIwe I lD4 t AND OPE WUWLOTlENT IN METRPOLITAN ARS

(lds Numbe., Februry 19" a 1)

PW fl_ F ue UK Labor Cm& average veceg aweto satiemat Tymet

F tr Zrt^ f~~~~~~~~o icXtor lz1 0- 4*9o@|* * ~sctor *1I t1mbetry/* Wstbr plIlts.k "^1~~~~~~~~ierlg/S e_ley.dI Arsa

I0 X 112.0 1M1.4 1A4.7 In5.$ 194.5 4.5116.0 9119. 1106. 119.1 111. 4.6

KUIII 115.4 118.7 117.6 121.6 126.2 *.4IV 11i.9 115.1 112.6 126.9 1U.9 2.6

1907I 90.0 98.3 96.6 103.6 125.6 3.3II 92.9 96.3 60 6 83.4 16.# 8.9III 95.3 98.1 74.2 76.3 166.9 4.1

Jan 104.9 103.1 101.6 119.9 120.6 3.2Fob 97.0 97.6 96.2 101.6 126.9 8.4Mar 97.0 95.9 92.1 98.1 12.56 3.3Apr 99.2 101.9 86 1 90.9 109.7 3.4May 92.1 93.9 80.4 84.6 104.4 4.6Jun 87.2 96.2 74.9 76.2 103.8 4.0Jul 93.0 160.9 73.8 73.9 101.8 4.5Aug 9650 97.8 74.2 77.9 100.0 4.2Sep 93.0 965. 74.6 77.1 161.1 4.0

Sources: FIESP, DIESSE, FGV, and ISGE

Notes: /I Nominal wage bill index divided by hours worked index, montht-1, deflated by ICV/SP (FIPE/USP), month t.

/b Nominal wage bill index divided by workers employed index,month t-1, deflated by ICV/SP, month t.

/c Formal sector wages, household survey, month t-1 deflated byDIESSE cost of living index, month t

/d Earnings from all sourcos of employment, household survey,month t-1, deflatod DIESSE cost of living index, month t.

/ Index of labor cost from National Construction Cost Index(FOV), month t, deflated by INPC, month t. Constructionworkers are assumod to be paid woekly.

/f Weighted aterage for Rio do Janeiro, SSo Paulo, BSlo Horizonte, PortoAlegr-, Salvador and Recif-.

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AM= VIIIPage 3 of 5

Recent DeveloMents

4. The Bresser Plan modified the wage legislation. First, tbe agetrigger was abolished. Secondly, the June increase in wages was limited toHay's wage trigger plus any increase resulting collective vage agreementsdue to be effective in June. Thirdly, wages vere frozen for a parid ofthree months at their new June level. After the freeze wages would bemonthly adjusted according to the UtP (Price Reference Unit) that is basedon the average inflation rate for the previous quarter. According to theserules, losses in real purchasing power resulting from differences betweenthe monthly inflation rate and the URP determined wage adjustment were tobe recovered at the time of the annual wage negotiations. In principlethis formula is more beneficial to workers than the pre-Cruzado rules.since the latter did not contemplate any wage recomposition betweenconsecutive wage adjustments.

5. In the labor area, the Bresser Plan is now in a decisive phase.September to November are traditionally months during which important wagenegotiations are conducted that coincide this year with the flexibilizationphase of the Plan. The Finance Ministry has indicated that in relation totheir June level labor contracts subject to renegotiation during theSeptember-November period should not incorporate real wage increases ofmore than 10?. This increase is equivalent to about a 27Z nominal wageincrease. However, recently completed wage agreements approved by theGovernment and the labor courts have exceeded the ceilings announced by theauthorities. The wage increase for Petrobras and some state enterprisesamounted to about 40Z, for Bank of Brazil and Central Bank 442, and 41? forthe military (with 112 more in January in addition to monthly URPadjustments), with similar increases for federal civil servants.

6. The principal issue separating the labor unions and theauthorities is to which base the present level of real wages should becompared. From a macroeconomic point of view, the peak level of real wagesin 1986 was unsustainable. The Bresser Plan, by freezing wages at theirJune level, incorporating only May's trigger, attempted to set real wagesto a level more compatible with price stability. Because the wage paid atthe end of one month is spent throughout the following month for mostirdustrial and commercial workers, the combination of June's nominal wageix.crease and the decline in inflation in July resulted in an increase inthe purchasing power of wages in July (Table 1) according to the wage datacollected by the the Slo Paulo Federation of Industries (FIESP) using thecost of living index of the University of SAo Paulo as the deflator. Butthe increase did not show up in the national construction industry, wheremost workers are paid weekly, nor in the data collected by the InterunionDepartment of Socio-economic Statistics and Studies (DIESSE), which collectdata at the household level, including price information for its own costof living index. The DIESSE data do show an increase in August andSeptember compared with June, however, both for formal sector workers andfor all workers (including the self-employed). Nevertheless, data throughSeptember 1987 in Table 1, indicate that in the months following the Planno major change in real purchasing power had yet occurred throughSoDtember.

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_~- Z - s v- - -_-s . - - =

AM=l VIllPage 4 of 5

7. The decline in purchasing power is evident If the base used is thesecond half of 1986 rather than June 1987. A return to those levels wouldrequire an additional nominal increase of about 202, roughly June's INPCinflation, except if one accepts DIESSI's data and price index, in whichthe requtred increase would be on the order of 552. Using IDON data onavrage real incm of eapl.yed workers In mtropolUtan U o Paulo. the fallby July 1967 compared with the peak leel of December 1986 was 39? forformal sector wage workers. 411 for informal sector wage workers, and 44?for self-employed workers (deflation by the IC). These wage statisticsprovide the base for the labor unions' argut that the government

L forgot' the inflation of June.

8. The recoposition of today's real wages to their levels of of thesecond of 1986 will have strong negative repercussions on inflation. Sucha level of real wages is too high to be consistent with macro economicequilibrium.

9. These high stakes explain the attention with which the authoritiesand the financial markets, have been following the ongoing labornegotiations. If the recent wage agreements are extended to other segmentsof Brazil's labor markets they are likely to trigger a rapid accelerationof inflation that will constitute the signal that the authorities' lateststabilization attempt has not succeeded. The results of the recent labornegotiations help explain the sharp increase in inflationary expectationsdocumented in financial markets.

II. EMPLOYMENT

10. Employment statistics in Brazil leave much to be desired. Sinceunemployment insurance has only partial co rage and has been availableonly since May 1986, very few members of the Brazilian labor force canafford to remain long unemployed.1 Nevertheless it is possible to detectemployment trends related to the business cycle in the unemploymentstatistics for six metropolitan areas (Rio de Janeiro, Sao Paulo, BeloHorizonte, Porto Alegre, Salvador, and Recife) published monthly by IBGE.

11. The highest level of open unemployment registered by this serieswas reached in April 1983, 8.3X. From that time, as the recovery fromBrazil's worst recession began, unemployment trended downward despiteoccasional seasonal increases (they are normal in the first months of theyear) until May 1987. The all-time low was 2.22 in December 1986. Clearsigns of a new recession appear by May 1987, but the increase in real wagesoccasioned by the Bresser Plan in July, which appears to have lominated thenegative impact of expenditure cuts, may be responsible for the slightdecline in August and September compared with July. DIESSE's unemploymentdata for the Greater Slo Paulo area shows an increase from a recent low of7.3X in December 1986 and January 1987 to 10.1? in September 1987 with nowfall after the announcement of the Macroeconomic Control Plan.

1/ Individualized balances from the Time-on-Job Guarantee Fund (FGTS) arealso available to formal sector workers who lose their jobs.

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ap S of 5

12. The monthly index of formal sector eaployment maintained by theMinistry of Labor shows virtually no change in the level of emloyment ofDecember 1986 through August 1987, at about *Z above the averae levelpraevIling in 1985.

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ECONMIC MDICA?OIa TM IN3!3 OUTLOOK

1. A sharp acceleration of inflation is under way, fueled by a muchlarger-than-planned public sector deficit and a wage shock. To this mustbe added attempts to raise public sector tariffs and grain prices fasterthan the rate of inflation, the prospects of a new agricultural price shockin the meat complex over the next few monthe (the result of a prematureslaughter of pigs, including breeding stock, occasioned by a sharp rise incorn prices, together with the freeing of exports of beef), and attempts bythe fix-price sector of industry to raise prices in anticipation of a newprice freeze. This suggests that a new effort at stabilization will haveto be made before long, and uncertainty about the nature of that effort aswell as to the outcome of the political transition also under way isleading to a wait-and-see attitude on the part of those in a position tocarry out investment in new productive capacity. This suggests that theinvestment targets of the Macroeconomic Control Plan for 1987 are unlikelyto be realized, threatening economic grow h in 1988 and beyond.

2. Nevertheless, imports of capital goods during the first eightmionths of 1987 were up almost 24Z compared with the same period in 1986,.)oosted in part by the arrival of new Boeing jet airliners in July. Over,he first nine months of the year capital goods production was 0.2? lessthan over the first nine months of 1986 (comnared with an increase of 2.8?for industry as a whole). Interviews with buzinessmen suggest that most ofwhe investment currently under way represents the execution of investmentilready committed during the Cruzado Plan. And each month since June theiomestic production of capital goods has fallen below the level of 1986.;hile some private businessmen say that they are proceeding with investment)rojects, most of these appear to be expansions or replacements ofcquipment rather than new plants. The fall in credit to the private sectorin recent months also suggests that private sector investment is now on the'ecline, and the decrease in cement production compared with the secondialf of 1986 also suggests a downturn (Table 1).

3. The most important single source of investment credit in Brazil isthe National Economic and Social Development Bank (BNDES). Table 2zresents data on the real value of disbursements, conmmitments, prioritiesgranted, and consultations by the BNDES System (including its subsidiariesBNDESPAR and FINAME), allowing a view how investment activity has evolvedat progressively earlier stages in the investment cycle. Data for 1987show that disbursements are running below the average monthly .evel of1986, but have increased each quarter and in October were running 23? abovethe average for 1986. BNDES System disbursements of ordinary resources,ver the first nine months of 1987 were 70Z to the private sector, up from562 over the first nine months of 1986. The largest real increase byindustrial sector was for capital goods and components, up by 122? comparedwith 1986. Committments showed a sharp increase in the third quarter to65? above the average for 1986, though the peak was achieved in August,rlth declines ocurring in September and October. Nevertheless, the Octoberlevel was still 18Z above the average for 1986. Priorities granted andonsultations were also unambiguously above their 1986 level over the firstten months of 1986, but have been falling since July.

Paw I of '

Table Is BRAZIL - INVKSTN I ICATORs, 1986 and 1987

I niWl,1 PrOdKtio=. IlNluports o4 11911.100) 1iss of Cruit C_lft

iqrts f : Cital Clod ------- to tl ProductionC4ita lod I nd" /I Capital IfitareWite: Private Swts,r 2Vl IBM

N Sllim) :{hNd 19 100): 6oods oods ' (Mbrch 19x1001) (.1911100)- - -- - -. - -- - -- - -- - - - - --- - - - - -- - --------- -----

1914 Jan 23, 9 66.0 91.8 120.2 110.5 8 92.4Fit 220 61.6 91.2 111.7 106.9 ' 73.7Nar 352 100.0 9 94.9 116.5 100.0 . 76.5Apr 257 73.5 105.5 117.9 106.1 84.8may 249 71.0 102.5 123.3 . 110.6 . 99.0Jun 25) 73.6 116.5 128.7 117.3 94.2Jul 331 , 94.9 117.4 138.5 119.7 ' 103.2Aug 275 79.0 113.5 139.3 122.7 108.8Sep 279 90.0 123.1 166.7 129.9 ' 107.0Oct 314 P?.8 12 L7.2 149.7 138.5 114.2Nov 301 86.0 114.7 132.2 142.2 110.7Dec 389 111.2 . 97.3 124.7 145.6 108.8

1987 Jan 282 80.0 . 100.6 126.7 134.7 . 107.4Feb 283 79.9 103.5 123.0 . 124.9 9 96.6Mar 216 60.9 109.4 129.4 1 126.1 ' 8.0Apr 286 . 80.0 109.1 127.8 . 126.0 : 90.7May 305 9 84.7 109.4 129.7 . 112.2 . 96.5Jun 355 98.1 . 110.0 131.2 99.8 1 83.0Jul 603 . 169.0 107.7 134.1 ' 98.3 ' 94.1Aug 371 103.7 99.7 134.3 ' 100.3 1 104.3Sep 1 107.6 137.9 99.5 104.1Oct 97.7 '

I Index of Capital 6oods deflated by the US wholesale price index (IFS, line 63).2/ Index of Credit to the private sector deflated by the I6PIDI.

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Table 2: BRAZIL - MNDES SYSTDKs INDEX OF REAL DISSUDSD6ITK S,COHMITMENTS, PRIORITIES GRANTED, AND CONSULTATIONS. 1982-86

(1986 Average - 100)/a

--- YTar v Disburewnts Comnitents Priorities Comiultations

1982 &vs. 90.9 69.3 34.7 31.21963 avg. 89.5 65.9 69.4 120.01964 avg. 79.3 81.9 71.1 51.11985 avg. 86.6 77.7 60.5 63.61986 avg. 100.0 100.0 100.0 100.0

1986 I 53.6 36.6 65.3 55.0II 65.9 81.8 77.0 87.7III 94.1 114.2 114.5 130.7IV 176.0 157.0 136.9 120.6

1987 I 78.7 78.4 137.9 114.0II 92.5 73.9 115.9 183.4III 95.6 164.6 283.4 186.8

Jul 83.9 111.8 493.2 226.0Aug 100.0 223.0 203.2 173.6Sep 101.8 157.3 171.8 164.3Oct 123.7 118.0 110.9 142.1

Note: Ia Average monthly levels, deflated by the IGPIDI

Source: BNDES

4. What emerges from an analysis of this BNDES data is again a rathermixed picture. Disbursements have been rising since the announcement ofthe Macroeconomic Control Plan, but will run below the level of 1986 forthe full year given the low level of the first two quarters. Cosiittamntscould be about equal to 1986 for the year, but have been falling sinceAugust, while indicators of potential future investment, priorities grantedand consultations, are far above their 1986 level for the first threequarters of 1987, but have been falling since July.

5. Capacity use in industry is falling back toward the 81-822 levelof early-to-mid 1986, down from a peak of 862 in October 1986, and privatesector consumption appears to have fallen to to about 612 of quarterly CDPin the quarter ending in June 1987, about 7 percentage points below thelevel of the previous year, lower than any quarter since 1976, even thoseduring the recession. This estimate, based on auarterly indexes ofconsumption and GDP by Professor Francisco Lope., is supported by a sharpfall in retail sales in Sao Paulo (down some 402 from a peak at the end of1986) and over a 102 fall in the National Consumption Indicator issued by

-81 - UPage 4 of 4

the Ministry of Industry and Ca_rce for the first seven mr ths of 1987compared with the first seven ouths of 1986. The fall has been sharpestfor consumr durabless1

6. mile It was not possible to obtain any reliable quatitativeestiat-es of capital flight, contacts in the business and financial

canaities assert that It Wam sctalertAd. fter amr fears that s on mleveI of doastic investment and capital flight can lead to technologicalstagnation and a loss of international competitiveness in the industtrialsector. MIltinatioual corporations are particularly wary about increasinginvestmnt unless the new constitution defines acceptable rules of the gamefor forelgn capital and it appears that these rules will be stablea.

11 Boletim Hensal Hacrometrica, October 1987, pages 2.10-2.20.

-5z- ,JjN x-

Page 1 of 17

FISCAL DEFICITS, lONETARY POLICY AND INFLATION:AN ANALYTICAL EVALUATION

Introduction

1. The consistency between the fiscal deficit and the other macroeconomic targets is analysed below adapting a methodology set forth InAnnex 2 of the recently publiahsd report Brazil: A MacroeconomicEvaluation of the Cruzado Plan.': The deficit financing can be obtainedfrom three sources: external financing, monetary financing and by issuingdomestic interest bearing debt. The set of macro-economic targets, i.e.,CDP growth, inflation, to mention only a few, imply a set of restrictionson each of the above financing sources. Taking these restrictions intoaccount, a financeable deficit can be estimated which represents the upperlimit of a fiscal stance consistent with a given debt strategy and aninflation rate target. If the actual deficit is higher than the aboveceiling, then the different targets are inconsistent. Therefore, eitherone of the non-fiscal targets will have to be adjusted or, alternatively,the fiscal deficit will have to be reduced to insure overall consistency ofthe macro economic targets.

2. The financeable deficit is determined from the financing side.The first step in the analysis of the consistency of the several targets isthe estimation of the increase in the monetary base which is consistentwith the inflation and growth targets. The second-step is the estimationof the increase in domestic and external interest bearing debt that wouldmaintain constant their respective debt-to-GDP ratios. The above amountsof financing determine a financeable deficit. Because no optimizationcriteria are associated with the choice of a particular debt-output ratio,the assumption of a constant debt-to-GDP ratio should only be taken as aninitial working hypothesis. In the short run, given a specific economicsituation, policies that result in changes in the value of the ratios maybe desirable. Alternatively, if external financing is expected to be lowerthan the amount consistent with a constant debt-output ratio, then thisconstraint on the availability of external financing will reduce thefinanceable deficit. External financing constraints notwithstanding, thefinanceable deficit represents a reference point describing a scenario inwhich government interest-bearing liabilities increase at the same rate ofoutput. If in the long run, the wealth-output ratio remains constant, theunchanged debt-to-GDP ratio implies a constant share of governmentliabilities in private sector wealth.

3. In the long run, the above strategy implies a constant degree ofcrouding out per unit of output and a constant real interest rate.Alternatively, if the actual fiscal stance results in an increase in theshare of government debt in private sector wealth, the consequence of aseries of fiscal deficits higher than their financeable limits, it willhave a negative impact on investment. In order to divert a larger share of

1/ Washington, D.C.: The World Bank, 1987.

<! r~~~~~~~~~-83- AR ; -i; Page 2 of 17

private savings towards the financing of public deficits the interest rateon government debt will have to increase, thus negatively affecting privateinvestment and resulting, in the long run, in a lower stock of capital andoutput per capita. Furthermore, higher interest rates will reduce thedemand for money and will decrease the share of the deficit the CentralBank can moretize without surpassing the inflation target. Thus, for the

* *ase deficit target, a larger share of debt financing will be required tocomplete the deficit financing.

4. The relevant deficit measure is the inflation-adjusted oroperational deficit rather than the nominal deficit. The use of aninflation-adjusted deficit, in which interest payments are evaluated atreal rather than nominal interest rates, assumes that economic agents donot suffer from money illusion and that their behavior is determined byreal rather than nominal variables, i.e., agents are rational and theyrespond to an inflation-induced decline in their real wealth by fullyrestoring the value of their portfolio of assets. If the change in thenominal interest rate fully captures the higher inflation rates, then thehigher interest payments and the subsequent increase in the debt holdersnominal income will offset the decline in the real value of their holdingsof government debt.

5. There will be no change in private sector claims on the publicsector if the additional income is used to purchase additional debt, suchthat the share of public debt in private wealth remains constant. Becausereal income, properly defined, real interest rates and real wealth willremain constant and these variables are the main determinants of privatespending, investment and consumption will not be affected. In this casethe government borrowing necessary to finance the inflation component ofinterest payments does not increase public sector absorption of privatesavings and it is consistent with a constant degree of financial crowdingout pressure. In sum, the inflation-adjusted deficit, which adjustsinterest payments for their inflation component, is a more relevantindicator of the fiscal stance and of its effects on economic activity.

6. Although the discussion so far has been restricted to a deficitmeasured "above the line", these arguments are relevant to such cases asBrazil's in which, ex-post, the deficit is measured by the increase inpublic debt and government interest-bearing liabilities are inflationindexed. In this case, the inflation-induced increase in debt, i.e., themonetary ,orrection, should be subtracted from the total change in publicdebt to obtain an estimate of the inflation-adjusted deficit.

Page 3 of 17

7. The above argument assues the neutrality of the inflationcomponent of interest payments. However, non-neutralities can occur ifinflation is either a new phenomenon or was not fully antlcipated, or somesegments of the private sector are liquidity constrained. Moreover, if asa result of the acceleration of Inflotion and the continued aceinulation ofrubllc debt the government is forced to pay a risk predm on Its new debtissues, the real intereat rate will iucrease. In this case, the issue ofadditional debt necessary to finance the Inflation component of theinterest payments will have an impact on the private sector and theinflation-adjusted deficit would undereatimate the true effects onfinancial markets. 2/

The June Macro Economic Control Plan

8. For 1987, the objectives set in the June Plan were: a) anoperational deficit of 3.5%; b) a GDP growth rate of 52; and c) a reductionof the average monthly inflation rate from above 20% during the firstsemester to about 4-5% in the second half of 1987 for an annual Inflationrate of 2402. Targets for the money supply (Ml) and the monetary base werealso presented. In the case of the base, an increase equivalent to 0.9% ofGDP was forecasted. To complete the def,cit financing, the Plancontemplated increases In domestic and external debt equivalent to 1.7% and0.9% of GDP, respectively (Table 1).

2/ If the inflation rate is not one of the independent variables in ademand for bonds function, it indicates that the private sector iswilling to hold in its portfolio a given amount of these assetsindependently of the value of the rate of inflation. Therefore, thegovernment could sell to the private sector additional bonds in anamount equivalent to the decline in the real value of the existingstock without changing their rate of return as well as the economy'sliquidity conditions. No changes would occur in the private's sectorreal spending. In a demand for bonds equation estimated for Brazil theinflation variable turned out to be statistically significant thusraising the possibility thet inflation is not completely neutral.Inflation may reduce the demand for bonds in real terms for severalreasons. First, as inflation reaches a higher plateau, the privatesector may increase the probability it attaches to the possibility ofsome degree of default on the domestic debt, i.e. monetary correctionlagging behind actual inflation, thus requiring a higher real interestrate. Secondly, for a given tax structure, a higher inflation rate mayreduce the after tax rate of return on public debt. To maintain thesame real after tax rate of return, real interest rates will have toIncrease. In these cases the financing of the inflation component ofinterest payments is not neutral.

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Given the recent shifto in the dead for money nd themcertaintie surroundlng the future trends ln Inflation and interestrates, any forecast of the dend for a givn monetary aggregate beems a_osardous eercle. Because the failure of the Crusado Plan h somewhatred a the CowermI' a cradTiblty to achieve a Ie IzflaIi.. taret. Itwas reasonable to assume at the time of the preparation of the Plan thatthe private sector muld follow a cautious approach regarding e entualincrease In its money holdings. In other words, the remnetiation processwidbh occurred during the initial *ntha of the Crusado Plan m unlikelyto be repeated.

10. The uncertainties associated with the forecast of the demand formoney notwithstanding, and given the Plan's Inflation and growth targets,It is estimated that an Increase in the monetary base equivalent to about1.5Z of GDP would be feasible. 3 / However, the assumed increase in thebase, the result of a higher demand for money following the forecasteddecline in inflation, would only materialize if the private sector believedthat the lower inflationary plateau would be maintained after pricecontrols were lifted.

3/ The following procedure was used to estimate the demand for themonetary base: first, for the period 1970-85 and using quarterly data,separate equations were econometrically estimated for the demand forcurrency and sight deposits. The demand for each asset was specifiedin real terms as a function of GDP, the interest rate, the rate ofinflation, the lagged value of the dependent variable and, to accountfor seasonal effects, a fourth quarter dummy variable. All variableswere defined in logarithmic terms. Secondly, the monetary base wasobtained as the sum of currency and bank reserves. Reserves wereestimated taking into account the demand for sight deposits and thepast value of the ratio of reserves to demand deposits, the formerbroadly defined to include "vault cash". This ratio was constructed onthe basis of monthly data adjusted to account for the August increasein reserve requirements. This specification was preferred over singleequation methods given the lower root mean square error obtained inseveral in-sample simulations. Using actual data for the first threequarters of 1987, the fourth quarter demand for currency and sightdeposits was estimated performing a static simulation. The value ofthe base was obtained as the sum of the forecasted demand for currencyand the estimated bank reserves obtained as the product of the reserveratio and the forecasted demand for sight deposits.

86 Page 5 ~j~of 17

11. In practice to reinforce the Plan's credibility, in the initialmonths of the Plan, rather than initial accomodation by the Central Bonk,a sore catiouetw oppach regarding monetary expansion wou! * have beedeirable. Given the deficit target and the llimted poaIbUtlti forextau finmizo, the siary &%*berIti bad to at: to beline therisk that an excessive remonetisation would reignite Inflation, against thenegative effecta that * likely increse in Interest rats would bave anecooAmic activity if a larger share of the deficit would have to befinanced through domsctic borrowing.

Table 1: DISFCIT FINANCING FOSSIDILITIES; JUNE TARGS(% of GDP)

RevisedPlin's Proposed Financeable Financeable

Financing Deficit4/ Deficit5/

Increase inMonetary Base .9 1.5 1.5

Increase inDomestic Debt 1.7 .7 .7

Increase inExternal Debt .9 1.3 .9

TOTAL 3.5 3.5 3.1

Assumptions; GDP growth 5%Inflation, 240% per annumReal interest rates, 17% per annumNet domestic debt to GDP ratio, .14Net external debt to GDP ratio, .27

4/ Assumes an increase in external debt consistent with a constant debt tooutput ratio.

5/ Assumes an inflow of net external resources equal to the Plan'sestimate.

-87- Pag 6 of 17

12. For comparison purposes a financeable deficit is shown in Table 16/, Given the Plan's growth Target of 52 for 1987, an increase in

meotic debt equivalent to about 0.72 of CDP, 1.32 in the case of externaldebt, would saintain the debt to output ratios constant. A comparisonbetweae the composition of the financing progre_ d for the Plan's deficitnd the frtnceSble deftelt tndicated that the hevy weliance of the fo2meron domestic financing wm likely to result in an upward pressure ininterest ratoe. The analysis of the financeable deficit suggests that (1)a sllghtly larger expansion of the base could have been attained withoutjeopardixing the inflation target, particularly if carefully conducted overtime, (11) larger-than-forecasted inflows of external resources would havebeen necessary to prevent a crowding out of the private sector.

13. In sua, the composition of the Plan's deficit financing showedtoo such reliance on domestic debt to be consistent with the other macrotargets. The deficit size did not allow for any slippages in fiscaleffort. The projections made at the time of available external financing,indicated that external inflows were likely to be below the amount shown inthe financeable deficit. Taking the plan's figure as the upper limit ofavailable external financing, and assuming that the base could increase by

6/ The government budget constraint evaluated at real interest rates canbe represented as:

x + r.b + (r* + q).b* h + (y + p).h + b + y.b + b*.y + b*

where x is the primary deficit as a ratio to GDP, i.e., the deficitexcluding interest payments; r and r* are the domestic and externalreal interest rates, respectively; y is the real growth rate of GDP; pis the inflation rate; q is the rate of real depreciation of thedomestic currency; and h, b and b* represent the ratios to output ofthe monetary base, domestic debt and external debt, respectively. Adot, (.) over a variable represents an increase in the variable.Maintaining the debt-to-output ratios constant, h-b=6*=O, thegovernment budget constraint becomes:

x + r.b + (r* - q).b* - (y + p).h + y.b + y.b*

The primary deficit plus real interest payments on the debt, externalplus internal, can be financed through debt issues at a rate equal toy.(h + b + b*) plus the inflation tax, h.p. A real depreciation of thedomestic currency increases external interest payments and deterioratesthe fiscal deficit. To maintain the debt output ratios constant,savings in the primary deficit are necessary in order to reduce theborrowing requirements. If the real rate of output is 4% per year, areal depreciation of the same magnitude would reduce to zero the roomfor external financing. The capital losses resulting from the realdepreciation of the domestic currency would be offset by the reductionin the debt output ratio ensuing from the 4% output growth and noexternal borrowing.

-~~ 8

Page 7 of 17

1.5% of GDP without jeopardizing the inflation obj:-tives, the financeabledeficit becomes 3.1% of GDP. The higher estimate of the feasible increasein money financing assumes that the inflation targets are achieved. But ifhigher monetary expanslon is necessary to complete the deficit financing,then the inflation target will be exceeded. Because private sectorexpectations conerning the ftture path of inflation vill be formed tekinginto account the likely outcome of the fiscal deficit and its monetaryImplications, the inconsistency between the fiscal stance and the othertargets was expected to have a further negative impact on wage and pricesetting and, consequently, on inflation.

The October Revision of the Plan

14. By the end of the third quarter of 1987 It became clear that theoriginal targets for the year were in serious jeopardy. First, themonetary expansion had been larger than planned; secondly, in spite of theprice controls, inflation was slightly higher than anticipated and showingsigns that a rapid acceleration was possible; thirdly, several Indicatorssuggest that the GDP growth rate for the year is likely to be lower than5%; and finally, preliminary analysis suggested that in spite of the Augustmeasures, the fiscal deficit would exceed the 3.5% target.

15. The October revision of the Plan's targets showed an expansion ofthe monetary base for the year equivalent to about 1.8% of GDP. Althoughthe Plan maintained the deficit target at 3.5% of GDP, it is estimated thatthe fiscal deficit will be about 5.5% of GDP (see Annex I). Furthermore,our estimates indicate a growth rate of domestic output of 4%, below theoriginal Plan target of 5%. Finally, external financing (includingarrears) is projected to amount to 0.7% of GDP. Given the above amounts ofexternal and money financing as well as the estimated fiscal deficit, tocomplete the deficit financing, an expansion of domestic debt equivalent to3% of GDP is necessary (Case 1, Table 2).

16. As before, and for comparison purposes, a financeable deficit wasestimated taking into account the lower GDP growth rate, (Case 2, Table2). The increase in the monetary base is estimated at about 1.9% of GDP,roughly the same order of magnitude of the increase in the base shown inthe October revibion of the Plan. With the lower GDP growth an expansionof the external and domestic debt equivalent to 1.1% and .6% of GDP,respectively, would maintain both debt-to-GDP ratios constant. In thiscase, with a higher rate of Inflation than before, the financeable deficitis estimated at 3.6% of GDP, a figure well below the projection of thelikely deficit. Taking into account the external financing constraint, therevised financeable deficit becomes 3.2% of GDP.

17. Two points need to be emphasized. First, and as discussedpreviously, given the output and inflation targets, the financeable deficitrepresents the maximum deficit consistent with a desired demand for money,constant debt-to-output ratios and, consequently, an unchanged degree ofcrowding out pressure. In the short run a lower deficit target would bedesirable to increase the flexibility of monetary and fiscal policies, toreduce the debt ratios, to diminish the pressure on interest rates and to

-89- Pago of 17

reduce the future burden of interest payments. Thus a deficit below thelevel would be important to enhance the probability of success of thestabilization prograu.

18. Secondly, no real depreciation of the domestic currency mmnconsidered. Because a real depreciation raises the cost of servicing theforeign debt, to maintain the external debt-to-GDP ratio constant externalborrowing should be decreased relatively to a non-devaluation scenario.Thus, for a given fiscal deficit a real depreciation would shift the burdenof financing towards domestic sources. For example, a 42 real ('evaluationwould require no external borrowing to maintain a constant externaldebt-to-GDP ratio. In this case, the financeable deficit in Table 2 wouldbe equivalent to 2.5% of GDP an amount well below both the announced targetand our forecast of the fiscal deficit. 7 /

Table 2: DEFICIT FINANCING POSSIBILITIES OCTOBER REVISION(% of GDP)

Case 1 Case 2 Case 3 Case 4

Increase inMonetary Base 1.C 1.9 2.3 2.5

Increase inDomestic Debt 3.0* .6 2.5 1.9

Increase inExternal Debt .7 .7 .7 .7

TOTAL 5.5 3.2 5.5 5.5

Assumptions: GDP growth 4XReal interest rates, 17X per yearNet domestic debt to GDP ratio, .14Net external debt to GDP ratio, .27

* Amount necessary to close the deficit financing

7/ For an analysis of the effects of a real devaluation see footnote 3

90 Page 1jTof 17

19. Cases 3 and 4 in Table 2 show two hypothetical deficit financingscenario. in which, in order to reduce the increase In domestic debtrequired to complete the deficit financing (3.01 of GDP in Case 1), alarger expansioan of the base (2.3S and 2.5Z r-spectively of GDP) iscotJflatedT. In both cases the *ount of external fin acing Is projectedat 0.72 of GDP, the balance of payments estisate. Although the externalfinacing compatible with a constant dobt-output ratio 1 1.1S, it is Iwalikely that this aount of external resources can be obtained end thusthe cholce of the balance of payment estimate. In either case, thelncrease In domestic debt would exceed the mount that would saintain a

V constant debt output-ratio, likely resulting in a crowding out the privatesector.

20. Using the demand for money equations, it is estimated that anexpansion of the monetary base in the last quarter of 1987 leading to anincrease of the base for the year of 1.9% of GDP, (Case 2), would beassociated with an implicit inflation rate of about 9-10% per month.Similarily, an increase in the base of 2.3% of GDP, Case 3, would beassociated with an inflation rate of about 12% per month. The increase inthe base has only been occurring since June. Between December 1986 andJune 1987 the monetary base declined by 5% in nominal terms, 66% in realterms. This demonetization process represented the adjustment of privatesector real balances in the aftermath of the excessive monetary expansionwhich occurred last year and the subsequent rapid acceleration of inflationduring the first half of 1987.

21. An expansion of the base of 2.5% of GDP, as envisioned in Case 4,is likely to be inconsistent with a stabilization of the inflation rate.Given the growth rate of GDP, for the private sector to increase itsdesired holdings of real balances by an additional 0.6% of GDP, thedifference between the financeable deficit and Case 4, the opportunity costof money would have to decline. However, at this time there is no reasonto expect a decline in either inflation or nominal interest rates. Thus,the excess supply of money is likely to result in an acceleration in therate of inflation. On the basis of recent trends such increase could pushthe inflation rate to 13 to 17% range per month.8/

22. In summary, a fiscal deficit of 5.5% of GDP is inconsistent withthe revised price and growth paths envisioned in the Plan. If the deficitfinancing is obtained issuing debt, tre subsequent private sector crowdingout will negatively affect the investment recovery envisioned in the Planand consequently future output growth. If, as illustrated in Cases 3 and4, the financing is obtained from monetary sources it will lead to stronginflationary pressures. In other words, the present fiscal stance isexpected to result in a combination of high inflation and private sectorcrowding out.

8/ See Attachment.

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23. External financing can reduce the effects of budget deficits oncapital formation. However, unles8 the economy can borrov at real ratesbelow the growth rate of GDP, the inflow of external resources can not inthe long run spare it from using an increasing share of private savins tofinance the deficit. Moreover, if external capital flows are partly basedon the deficit as an indicator of economic stability, then it is likelythat the access to and the conditions of external financing will bedependent on the fiscal stance, somewhat neutralizing the smoothing effectsof potential external financing.

24. Rather than being employed to finance additional governmentexpenditures, a part of the future external savings could be used to retiresome domestic debt issued at high real interest rates thereby helping toreduce the domestic debt-to-GDP ratio and real interest rates.Alternatively, external savings could be used to complement private savingsand to foster a necessary increase in domestic private investment. In thelong run, such a fiscal stance would reduce the external interest paymentscomponent of the deficit and furthermore would be consistent with thereduced relative role of the public sector envisaged in the MacroeconomicControl Plan.

Credit and Crowding Out

25. The previous analysis does not establish the amount of availablecredit and its decomposition between private and public credit. Theestimated trend of credit available to the private sector is a goodindicator of potential crowding out pressures. In the long run, and for agiven amount of savings, for the private sector to absorb a larger share ofgovernment debt, the interest rate would have to increase. If the privatesector views government debt and capital as substitutes, the required rateof return on capital will increase thereby having a negative effect oninvestment. Because the agents that generate savings are not necessarilythe same as those who undertake investments, financial instrumentsfacilitate the exchange of resources between savers and investors,providing the former with a menu of assets that satisfy their portfoliopreferences and the latter with the desired resources.

26. The inclusion of a banking system allows for the analysis of theinvestment/savings links from the point of the borrowing and lendingactivities. The basic relationship is the consolidated balance sheet ofthe banking system. It snows that the ex-post increase in the demand formoney, broadly defined to include quasi-money, will be equal to theincrease in domestic credit plus the increase In net foreign assets. For agiven demand for money, an excessive expansion in domestic credit wouldresult in a decline in net foreign assets; or alternatively if domesticabsorption is excessive, the Balance of Payments will deteriorate.

-92 Page 1 of 17

I-

27. Given the CD and inflation targets, the demand for amoy maprojected on the baens of econometrically estimated dend equations forcurrency, sight deposits, and time and savings depocits. The change in notforeign assets was forecast taking Into account the halance of paymentsprojectlons. In the case of the re£ining components of the banking

L system, balance sheet projections of the individual item were based on theL most recent available data and their past trends. Credit availability us

obtained as a residual. Furthermore, it was assuaed that public sectorfinancing has priority over the demands of the private sector.Consequently, for a given credit availability, an increase in publicborrowing from the banking system will reduce the amount of creditavailable to the private sector. When available credit is below thedesired amount, credit rationing in the traditional sense of non-pricerationing occurs.

28. Credit rationing is a powerful mechanism with which to influenceaggregate demand and supply. By limiting credit to investment, creditrationing will reduce capital accumulation and, consequently, the long runpotential output. Also, by reducing the availability of short-term fundsfor working capital and/or consumption credit, it will reduce output andemployment.

29. In the case of credit rationing it is the supply rather thandemand for credit that is estimated. Because the latter is not specified,it is difficult to estimate the amount of credit (e.g., consumption,working capital and investment credit) needed to support a given growthpath. However, because these components are closely related to GDP, toevaluate if the credit available to the private sector is sufficient tosupport a desired output growth, in this analysis a rate of real creditexpansion equal to the GDP real growth rate will be taken as the lowerbound of the required credit growth path.

30. Using this methodology, two stimulations were performed with theresuits confirming previous inferences, i.e., the crowding out of theprivate sector. In the first simulation it was assumed for 1987: (a) aGDP growth rate of 4%; (b) an average monthly inflation rate of 9.5% forthe last quarter; (c) an annual real interest rate of 17%; (d) a fiscaldeficit of 5.5% of GDP. Net placement of securities was equal to theamount programmed by the Central Bank. In the second simulation theincrease in credit availability was estimated assuming that the Junetargets were met.

Poge 12 of 17

31. In the first simulation, for each financial asset the end-of-period stock was estimated using the respective demand function andassueptions (a) to (c). Credit availability wv obtained based an thetotal demand for financial asets, the end-of-period value of the stock ofnet external assets and the estimated value of the other components of thebalance sheet. Public sector borrowing from the banking system is obtainedasa the difference between total borrowing requirements and the availablefinanclng from non-banking sources. Credit available to the public sectoris then calculated as the difference between total available credit andpublic sector borrowing from the banking system. Total credit is estimatedto decline by 13.92 in real terms (Table 3). Also In real terms, the stockof credit to the private sector is expected to decline by 352 and thecredit to the public sector to increase by 242. Therefore, the estimatedexpansion of credit to the priv-te sector is well below the growth rate ofGDP which, as discussed above, is a good reference point to evaluate thecredit expansion consistent with given growth path.

32. In a second simulation, "consistent scenario", it was estimatedwhat would be the increase in the stock of credit to both the private andpublic sector for a deficit of 3.5% of GDP and a monthly inflation rate of6% in the last quarter of 1987. The above trends, although less noticeablestill remain, e.g., a decline in real terms in private sector credit and anincrease in public sector credit.

33. In 1987, the decline in real terms of overall credit availabilityresults from the decrease in the demand for money not compensated by aninflow of foreign resources in the form of medium- and long-term externallending. In the first scenario the demand for money and quasi-money (M3)is forecast to decline by 27% in real terms. Given the decline in realterms of available credit, a higher public sector demand for creditwill reduce even more the resources available to the private sector.

34. The above real growth rates are somewhat diatorted as a resutlt oflast year's price controls. In 1986 the real stock of credit increased byabout 38%. But, as a consequence of the price freeze, the widespreadpremiums paid on most goods were not captured in the official priceindices, including the IGP/DI used as the price deflator in this analysis.When price controls were lifted in late November, the above preniums beganto be incorporated in the price indices, leading to a rapid acceleration inInflation. Consequently, because "actual prices" are underestimated by theIGP/DI index, the increase in real terms of the stock of credit isoverestimated for 1986. Conversely, the decline in 1987 of real credit isoverestimated. Although the above bias in price measurements may explainsome of the magnitude of the fluctuations in the real stock of credit itshould not affect the main thrust of the above conclusions.

Table 3: CREDIT TO Til PRIVATS AND PUIUIC SECTORS:REAL GRWO U RATS (Z)gI

June 67/December 86 December 87/December

Total Credit Growth -21.9 -13.9(consistent)

Private Sector -29.8 -35.0

(consistent)* -29.0

Public Sector 4.4 23.9

(consistent)* 14.3

* Assumes a fiscal deficit of 3.5% of GDP and an inflation rate of 6% permonth for the last quarter cf 1987.

35. A final technical point refers to the use of the same deficitestimate in both methodologies. The 5.5% of GDP deficit estimate refers tothe operational deficit. The coverage of the public sector used in thisdeficit concept differs theoretically as well as in practice from thecoverage of the public sector used in the net debt analysis. The CentralBank is included in the public sector in the latter, but excluded in theoperational concept. Moreover, the procedures employed to estimate theinflation adjustment are also different. The use of the same deficitestimate in both analysis is a simplification which should not influencethe main conclusion - the inconsistency between the fiscal policy and theremaining targets of the program.

Stock of credit deflated by IGP/DI.

+~~~M x

-9S - Pago 14 of 17

Sumary and Conclusiona

36. Using either the financeable deficit or the credit availabilityapproach. the results of the above analysis showed that tbe fiscal stanceof the J=Swis "tero Plan me. iiamteteit with tbe Inflation and growthtargets. This conclusion io even sore valid In the light of recentestimatos of the flscal deficit. Given the excesive borrowingraqulrements of the publlc sector and In the absence of significant amountsof external financing, the alternative is large domestic borrowing. ToIssue 2omestic debt above its feasible llmts wlll raise interest rates,crowd out private sector investment, and jeopardise the growth target. Tofinance the deficit through a monetary expansion above its feasible limitswill raise inflation above the desired targets. The obvious, but sometimesneglected, conclusion of this analysls is that without adequate fiscalsupport, it is unlikely that stabilization programs aimed at growth cumprice stability will succeed.

Attachment

D27ICITS, NONKTAiY UXPANSIOK AND IFU 0

l. The reltlnships boetween inflation and the dmnetary basepraeunted in cases 2 and 3, (table 2), were obtained by first, asuming -inflation rate for the remainder of the year, secondly, estimatlng thedemand for money, MI, consistent with that inflation rate and finally,projecting the value of the monetary base eonsistent with the estimatedvalue of MI. However, because the financing of the estimated defirit willrequire large amounts of domestic resources, the pussibility that monetaryexpansion will exceed the values presented in cases 3 and 4 should not beigaored. In this context, an interesting albeit difficult topic Involvesthe analysis of the inflationary impact of a given monetary expansion.

2. To analyze the link between money expansion and inflation, &simple simulation framework was prepared in which inflation in a give.iperiod is a function of the excess supply of money, inflationaryexpectations and exogenous shocks. The purpose of this framework is not toforecast the monthly inflation rate but rather to provide a conceptual toolto discuss the links between deficit financing and inflation. In anindexed economy like Brazil's, in addition to an eventual excess supply ofmoney, many other factors influence the inflation rate.

3. The inflation equation is:

p = d.(MS/Y - MD/Y) + pe +s (1)

where p is the inflation rate, MS and MD are, respectively, the supply anddemand for money, (monetary base), expressed as a ratio to nominal GDP, Y;pe is the expected inflation rate and s is a variable representingexogenous shocks. The desired demand for money, MD, in equation (1) wasformulated as:

MD/Y - a.exp(-bp) (2)

4. The money supply is exogenously determined by the deficitfinancing requirements. For simplicity, expectations of inflation weremade a function of past inflation:

pe - g.p(-1) (3)

5. In a given period, the rate of inflation is influenced byexogenous shocks such as changes in wage legislation that reduced theperiod between wage adjustments, agricultural price increases, oil shocksand so on. These factors can be cLptured by changing the level of the avariable.

L ~~6. The demand for msoney was estimated In the form shown In equation(2) usins quarterly dote for the 1975485 period. To che... the veins of-the aiustmus perimee., 4, 4~4tl 1uie1, ~.i~~e~h-

L ~above model using 1985 dote and different vaue of the coefficient. Theva-lue of the coef fiienmt uhidc yielded a forecast of lafletions that mws theclosest to the actual Inflation path wee chostm for next set ofsimulations. The value of this parmetier indicates that a 1! excess supplyIn the mma3tary baee would result tin an additional 0.82 of inflation In thesame period. Unquestionably, this Is a rather subjective estimate, but asit will be shown below, the Inflation estimates are not too sensitive tochanges in the value of the adjustment coefficient.

7. To complete the simulation model it was assumed that: (a) duringthe August/September period there was no excess supply of money; and (b)the base-to-GDP ratio in this period was, on an annual basis, equivalent toabout 1.9% (period averages). The result obtained simulating the model foralternative expansions of the monetary base are shown in Table A. If thebase is increased during the September-December period at a rate that willresult into a 2% of GDP expansion for the year, inflation will climb to 9%1,.r month by the end of the year. For an expansion of 3% of GDP inflationwill reach 17%. Higher deficit financing through monetary expansion willresult in higher inflation rate.

8. To evaluate the sensi*.ivity of the model's results to changes inthe value of some key parameters, some additional simulations wereconducted using Case B as a reference point. The results obtained suggestthat the inflation projections are not too sensitive to changes in thevalue of the adjustment parameter. A two-thirds reduction in the value ofd, indicating a smaller impact of an excess supply of money balances oninflation, will lower the inflation rate for December by only 1%. However,for a very large value of d the model becomes unstable. Exogenous shocks,

that is a value of s larger than zero, or anticipatory price increases,a larger than one, w';ill, as expected, lead to an acceleration of inflation.

9. The objective of this exercise was to analyze the likely impacton inflation of rates of monetary expansion above the value consistent viththe announced inflation target, rather than to obtain point estimates ofinflation for a given month. In this model the inflationary impact of anexcessive monetary expansion is not immediately felt but rather it isspread over time. An excess supply of money results in higher inflationthat reduces real balances, and for appropriate parameters, moves theeconomy to a new equilibrium at a lower per capita level of real balances.As the base for the inflation tax is reduced, a higher inflation rate isnecessary to attain the same level of revenue, thus establishing a majorlink between fiscal deficits and inflation.

TsblA, xXnATIO L

Ia.. (2 f GD) (2por amoth)OCT NWV DEC

Case A 2.0o 8 9Case B 2.3 9 11 11Case C 2. 5 11 12 13Case D 3.0o 13 1 5 1 7

SENSITIVITIES CASE B

Case B 9 1

(g - 1.2 s -oJ 10 1 3 1 5

lg -i s -. 02) 10 13 14d -250

9 10 11

d - 200 9 10 1i

d -100o 9 9 10

d- -400 10 11 12

* 0g 1d - 300

: ~ - * ,tZ s, ,-,- -~- -. _ _ _____

IF, Z -_------------: . , _:_

R&. I ; f 6

SHORT-RUN STABILIZATION AND MIDIUN-TKRN STRUCTURAL KIASURES

r 10- 1 .5hroud dt1 co ai4Macroeconomic djwust Is am recog.aws as Rv@J.VU

stabtlisatiou Uth grwth, withil a couisletet ndl t fruoprk.-Sort-rua stqli11at ion relies prlmrily on fiscas, mtary, _a e-c.eugrate policies to influence aggregate desnd. Medium-term mreecodoweiadjustment requires p licies that Iufluence the structure of regatedemand and aggregate supply and thus Involve structural weasures.Structural measures say be classified as: incentive-related, publicpolicy-related and institutional. The incentive-related measures aregenerally microeconomic in nature, but have macroeconomic impacts (e.g.,tariff reform and elimination of credit subsidies). The publicpolicy-related measures attempt to influence the structure of policiesunderlying public expenditure and revenue performance. And institutionalmeasures aim at re-structuring the organizational framework within whichprivate incentives and/or public policies operate.

2. The major difficulty involved in defining a medium-termmacroeconomic adjustment program is the choice ard sequencing oftraditional demand management policies on the one hand, and measures thatinfluence the structure of aggregate demand and/or supply. The specificproblems involved are:

(i) structural measures have longer lags, i.e. take longer tohave their expected effects, while traditional aggregatedemand-related measures are relatively quick to have theireffects;

(ii) structural measures may affect internal balance andexternal balance in different (i.e. sometimes opposite)ways; and

(iii) structural measures may also affect real and financialvariables in different ways.

3. As a result of these possible characteristics of structuralmeasures, it becomes critical to take account of the stabilization impactof structural measures when medium-term macroeconomic adjustment programsare being designed to ensure that:

(i) beneficial structural measures that have positivemediur-term effects but negative short-term stabilization

X~-- - zE Wa

_+ ,, : ~t~-... .. , .iy, . w. . .. .

p ~~~~~~ ~~~~~~~AaM XI >. ~~~~~~~ ~ ~~~~~PW 2 of 6 q

refects wtic mimat be roferred to es Typ I (or the . R ofType measuaeress, metoff f t i n the abort-t eb:r

. (1i) *erwetedturlwzs hl -i O M Tpl+ *~~~~~~tructural mesres that hai pocltILv dort- ls

~~~ ncF~~"stiSe O"Lmtor offe£t (T" III orft}

F~~4 Um l_1 of T* I mesresa tax roform_ itml a rdctiLonan simplificatioa of tax rates, tartiff reduction d simplifieAtion, bothof whieh culd decrerme wrve.w in the *aert-run, but result In liportantresource allocation change !' the medlum-term. xzamples of Type IImeasures are recoval of interest rate subsidies, reduction of the wheatsubsidy, removal of tax exemptions, all of which decrease expenditures inthe short-run and also improve medium-term resource allocation. Examplesof Type III measures are a shift from QRs to equivalent tariffs, or atemporary increase in tax rates or tariffs, which would increase revenue inthe short-run but do not improve resource allocation over the medium-term.

5. The critical design issue for medium-term macroeconomic adjustmentprograms is to seek to ensure that the policy package takes account of themix and sequencing of aggregate demand measures on the one hand, and of thethree types of structural measuresl/ on the other. A well-designed andbalanced policy package would balance these two sets of elements. It wouldthus be superior to a pure aggregate demand based largely on ad hocmeasures and with no underlying structural measures, since such a packagewould be subject to the risk of policy reversal, and would not ensuremedium-term macroeconomic adjustment. A balanced package would also besuperior to a pure structural adjustment package that tends to ignoreshort-term stabilization performance, and is subject to the risk of failureon account of inadequate progress on short-run stabilization. Theseadvantages of a balanced macroeconomic policy package notwithstanding, ithas to be recognized that the difficulties associated with quantifying theeffects of alternative structural policy measures imply that the process ofdesigning such a package will involve a mix of quantitative and qualitativeanalysis.

1/ In principle there Ls a Type IV (or -/-) measure, with negativeshort-run and medium-term effects, but it is unlikely that suchmeasures will be a part of a rationally designed medium-termmacroeconomic adjustment package. An example of a Type IV measurewould be an across-the-board (i.e. untargetted) increase in subsidies.

ftructural Measure* Currently Under Inpe.naio:A Qualitative Analysls

6* ~ It is useul to review the structural aurmuv currnmtly under*latati in l. reat to mee... tb. degee to *1ch the Oort-rua

-I Ct~~hgt~ ti iinptj K at I I 1.L. Lwtb 2.ek el an Wieq-t ly balanced policy packape /The table. below clmilfieeiassow ea curvt)y moder lupUinostatla a ccording T bo u tber, to term af thIs

bqpoft an ~~they are of Type I (-/+), Type It (+/+) or 2ype IIIA slallar coul be une tahen for exteru alance

TELIL!2T_yve.I (+1 ) TY"e III (+-Ilustitutional Institutional Public Sector

-state bank - integration of Policy Reforminterventions monetary and fiscal -external borrow-

budgets ing to supportthe transition

Macroeconomic Financial Sector period for- real exchange rate Reform structuraldepre~ciation - reductions in

subsidized credit- tight monetarypolicy Agricultural Sector

Reform- removal of wheatsubsidy (consumerand producer)

- removal of interestrate subsidies

Public Sector PolicyReform- rationalized andstreamlined publicinvestment program

- state enterprisepricing reform

- reduction and simpli-fication of selectedtaxes

2/A more comprehensive list of structural measures that have been referredto in recent public statements on policy reform possibilities is analyzedin the Attachment to this Annex.

We-~~~~~~~~~~ 10 -

-ap4 Of 6

Clearly the.e is no r face bias In favor of Type I iaaures hlich tendto have nqative abort- r fcts, wil the presence of Type II measuresis significant. Whil, the true impact of these structural saeaures oniat*ral blace Oa oly aaaed whan they are quactifled, the aboi

qtsil---fi-aUht *tha 14TaType TI urs ---

have a stronger quantitative Imct tha the Type II sesres; or (11) theimplesetot i.e of the Type I measures ha bees poor or (iii) both.

7. Th evaluatiOt of the Ipact of specific masures on the ovrall flcal deficit In Annex IV suggests that poor Implementation has been animportant source of the current difficulties facing the short-runstabilization effort.

Attachment

f_ u'-- - 7"' '- '' _ . -7

J'' SllU ~~~~~~~~~~A = xi

P 5 of 6

ATTACHMENT

STRUCTURAL HASURI S RUEtNTLY INLIVNTED 01 UNRDE CONSIDERATION IN BRAZIL

~~-1- l eta iwet -- enm etOmW -r COsl 1 4 - v--particularly since thu Introduction of the Mcroeonomic Coutrol Plan, inJune 1967, nurous structural asures have b1m laplemmted or are beingconsidered for poalble laplemtation In 1988 nd beyond. Poeibl area sof reform mnat4o!od have leluded.:

(1) institutiloal reform.;(ii) macroeconomic structural easures;

(Mi) wage and income policy;

(iv) financial sector reform;

(v) trade policy reform;

(vi) tax reform;

(vii) agricultural sector reform;

(viii) industrial policy reform;

(ix) public sector reform; and

(x) social sector reform.

2. The table below classifies selected measures in these areas

according to whether, in terms of their impact on internal balance, they

are of Type I (-/+) or Type III (+/-). A similar analysis could be

undertaken for external balance.

3. The composition of the twenty six measures classified above

according to their impact on internai balance is as follows:

No. of Measures

Type I (-/+) 10

Type II (+/+) 13

Type III (+/-) 3

Of course, their impact on internal balance depends on their relative

quantitative strengths, which will need to be assessed using available

parameters and the analyst's best judgments. In terms of their numbers, it

is noteworthy that a slight majority of the measures art- of the Type II

(+/+) variety, and could therefore be used to offset the internal balance

impact of the similarly large number of Type I (-/+) measures. It is also

noteworthy that the Type III (+/-) variety are few in number, and there is

less of a likelihood of many such measures being kept on for long periods,

and thus working to the disadvantage of the medium-term results of the

adjustment effort. Type III (+/-) measures do, however, perform an

important temporary function, and the greater their number, the more the

scope for designing balanced policy packages. Clearly this analysis could

be extended by assessing thosese measures for their impact on external

balance and equity.

N S~~~~~~~~~~~~~~~~~~~~~

.~ ~li .. I. w

~~* ii ~~~~ Ii ~~~ *;j 11$ ~~~~~1 I

Iifj 'iiI * !j7 77j7 jXj ii |j 1

tf& } It. JUlffi I! tjj

______________ _______ _________- ____ . 4tiiiS A L;, il ix. iL I ! aIY;X! W ;,