To understand Brazilian Finance Minister Antônio Palocci Filho, it helps to know something about sewer systems. As the mayor of prosperous Ribeirão Preto in São Paulo state in the mid-'90s, Palocci -- a doctor whose specialty is preventive medicine -- arranged for private companies to bid to run the city’s sanitation system as a money-making concession.
“Investors said it wouldn’t work,” Palocci, 42, recalled during a recent interview with Institutional Investor(see page 26). “City sewage wasn’t a source of income.” But by awarding the contract to the lowest bidder, which in turn charged modest user fees in exchange for refurbishing and maintaining the sewers, Ribeirão Preto not only lowered costs for its citizens but also upgraded the sanitation system and improved public health. Impressed, Brazil’s development bank imitated the scheme and extended it throughout the country.
Being innovative in accomplishing a public good while still being fiscally responsible remains Palocci’s brief, but now the good doctor is operating on a national scale and the problems dwarf Ribeirão Preto’s sanitation worries. Palocci must reassure businessmen,
investors and lenders that his boss -- leftist President Luiz Inácio Lula da Silva -- is committed to sound fiscal and monetary policy, while simultaneously demonstrating to Brazil’s poor, Lula’s natural constituency, that the president can pursue ambitious welfare aims.
This experiment is being closely monitored, from Buenos Aires to Washington to Kuala Lumpur. If Brazil accomplishes its dual agenda -- combining largely conservative macroeconomic policies with very liberal social policies -- it could transform the world’s approach to development, superseding the discredited Washington consensus (see page 115). Throughout Latin America a new generation of pragmatic leftist leaders in the Lula mold is paying close attention to Brazil for cues about how to achieve sustainable growth and fight poverty and inequality without jeopardizing stability and scaring off foreign capital (see page 39).
The burly, affable Palocci probably has the toughest job in Brazil, maybe the toughest in Latin America. Lula can hold forth on grandiose social policies -- eliminating hunger, for example -- in vague rhetorical terms, but Palocci must figure out a way to achieve those laudable ends without bankrupting the country or frightening investors and creditors. “The government has two levels of communication,” says portfolio manager Mirela Rappaport of Tatica Asset Management in São Paulo. “There’s a very rhetorical level, where Lula and some ministers come out and say whatever they want. But then at the end of the day, Antônio Palocci intervenes to put everything back on track.”
The finance minister has done a remarkable job so far of keeping both macroeconomic policy and his boss in line. And Lula appreciates it. He recently told Brazilian news magazine Vega that “Palocci has my complete confidence. He isn’t here because he wants to be, but because I want him to be.” (Rumors that Palocci was about to resign swept Brazil’s financial markets on August 5, but they turned out to be false -- a ploy by interested parties, it seems, to block the government from lowering interest rates, which would have hurt banks’ profitability.) The Finance minister’s standing with both Wall Street and Avenida Paulista, São Paulo’s financial hub, is high. Brazil’s Bovespa stock market index was up about 30 percent in mid-August. “Palocci is the best surprise in Brazil in terms of a policymaker in a long time,” declares Mário Mesquita, chief Brazilian economist for ABN Amro.
In fact, critics in Palocci’s own party can be harder on him than either foreign commentators or domestic political opponents. “He should dare a little bit more to attain the objectives of accelerating growth and guaranteeing an increase of job opportunities and more effectively attacking social problems,” complains São Paulo Senator Eduardo Suplicy, who is well to the left of the Finance minister within the ruling Partido dos Trabalhadores, or Workers Party. Another prominent PT radical, Congressman Joao Batista de Oliveira Araújo, known as Babá, accuses Palocci and the government of “confronting workers to please the banks.” Since Lula took office, he says, 586,000 workers have lost their jobs, and social spending has been slashed to meet budget surplus targets.
Such complaining shows Palocci’s clout. He and José Dirceu, Lula’s chief of staff, are the twin pillars of the administration. Together they have nudged the radical PT toward the center-left; both belong to Articulação, the party’s moderate wing (as does Lula himself). “I don’t see a power dispute between Palocci and Dirceu,” says Pedro Martins, vice president for Latin America equity market strategy at J.P. Morgan Chase & Co. in São Paulo. “Their business plans are the same -- the commitment to market-friendly policies perceived as necessary to deliver on sustainable growth.”
Lula’s overarching economic and social aspiration is to promote sufficient growth to achieve “social inclusion,” a phrase popular with administration officials. “We are building a new social contract in which all the forces of Brazilian society will be represented,” the president has said. The idea is to bridge the enormous gap dividing Brazil’s few haves from its many have-nots -- overcoming educational lags, health deficiencies, racial discrimination and blatant income inequality. The top 1 percent of Brazilians earn more of the national income than do the bottom 50 percent, according to the Brazilian Institute for Geography and Statistics. “All the economic policies that we are going to develop will always be with a view to the small businessman, small citizen, small firm,” vows Palocci.
Nevertheless, since taking office on January 1, the finance minister has had to administer a strong dose of altogether conventional macroeconomic medicine to Brazil’s sickly economy. To tame hyperinflation Palocci has kept a tight grip on government spending, and the central bank (which is ultimately under his control) has maintained steep interest rates. Brazil’s current agreement with the International Monetary Fund, worked out by Lula’s predecessor, Fernando Henrique Cardoso, in his last year, calls for a budget surplus equal to 3.75 percent of GDP; Palocci has raised the ante by getting Congress to approve a 4.25 percent annual target for 2003'06, and the government appears to be on its way to exceeding it for this year. “That’s a very important commitment,” notes economist Mesquita. Bank analysts now expect dizzying price rises to slow to about 11 percent annually by year-end; late last year they were projecting 40 percent inflation for 2003.
In little more than six months, Palocci has reassured the markets that Brazil has not forsaken fiscal responsibility, despite its lurch to the left. He has put in place a team of sophisticated, market-attuned economists; lowered the country’s debt-to-GDP ratio; told state governors unequivocally that they can’t renegotiate their debts to the federal government until Congress passes tax reform; and prepared to reap the budgetary benefits of the Social Security Ministry’s wholesale reduction of public pension provisions. Parliament’s initial approval of those social security reforms, in a contentious August 5 vote, was a major political coup for Lula and a boon to Brazil’s fiscal condition.
Despite Palocci’s impressive start, he still must contend with an economy that will need even more preventive medicine before it can accommodate modest -- much less lavish -- social policies. The central bank predicts GDP growth of only 1.5 percent this year; the economy needs to grow 3.5 to 4 percent annually just to absorb the 800,000 entrants into the labor force each year. The country is feeling its way back from last fall’s panic among foreign investors, precipitated in large part by the prospect of a certified leftist like Lula, a onetime lathe operator and a hard-core trade unionist, becoming the head of state of Latin America’s biggest country. But Lula’s surprisingly mild tone -- and Palocci’s prudent actions -- have reassured investors.
Brazil’s benchmark overnight interest rate, however, remains at 22 percent and lending continues to stagnate; foreign investment is down more than 60 percent from last year’s $16 billion; and Brasília can’t prime the economic pump with additional government spending because of Palocci’s ambitious surplus target. The country’s public sector debt (domestic and foreign) of $298 billion -- equal to half the country’s $596 billion GDP -- is a constant drag on growth. Next month Palocci must come to terms with the IMF over whether or not to pursue a new borrowing agreement. Meanwhile, unemployment tops 20 percent in industrial São Paulo and 12.6 percent nationwide, causing further restiveness among Lula’s backers. On top of it all, the government’s immediate social to-do list contains such items as underwriting the Zero Hunger program (whose aim is to eradicate hunger in Brazil by the end of 2005), providing financial support to families to prevent kids from dropping out of school and ensuring that all school-age Brazilians get an education.
THE MAN WHO MUST JUGGLE ALL THESE challenges, says a longtime friend, “is not an average politician who suddenly was put in the Ministry of Finance and by a miracle does things well.” Neither is he the kind of technocrat one might expect to find in the job of chief economic officer of a developing country. While at medical school at the Universidade do São Paulo in Ribeirão Preto, Palocci got interested in politics, co-founding the local PT party (as well as becoming involved with a Trotskyite movement, Liberdade e Luta, that later disbanded).
“Palocci is a very, very intelligent person and a charismatic leader,” says Neyri Primo Alessi, a physician who worked with him in the mid-1980s examining farm workers in the vicinity of Ribeirão Preto, an agribusiness center, as part of a government-sponsored ambulatory health service. It was about this time that Palocci, then in his mid-20s, dropped out of the PT’s far-left wing while remaining within the party.
Palocci’s conversion to what might be dubbed the flexible center-left became manifest when in 1993 he was elected mayor of Ribeirão Preto, where he ran his medical practice and lived with his family. Defying socialist orthodoxy, he promptly opened Ribeirão Preto’s publicly owned phone company to private investment. (The sewage venture came later.) “There was a lot of criticism of him at the time,” remembers Fernando Alessi, public works secretary to then-mayor Palocci. “But he calculated that the city needed the money.” Palocci directed the funds raised to child care centers and hospitals. “We were pioneers in the concession model,” he boasts today. “We did a lot of projects in public-private partnerships.”
In his two terms as mayor (1993'96 and 2000'03), he also showed that he could make tough decisions to balance a budget. Just before taking office for his second term, Palocci asked his aides to come up with the deepest budget cuts they could think of to head off a deficit. Then, at 11:00 on the night before his inauguration, he increased the aides’ supposedly draconian cuts by a substantial amount. “I cut 25 percent in staffing simply by not using the positions allotted for senior advisers, and I cut investments in the first year,” he says. Social programs, however, were spared. Ribeirão Preto ended the year with a surplus, says Nelson Rocha Augusto, who served as Palocci’s planning secretary and is today president of BB DTVM, the asset management arm of Banco do Brasil, Brazil’s largest bank. Palocci “has got 14 years immersed in economic affairs,” Augusto notes.
The doctor from Ribeirão Preto was elected to the Camara de Disputados, or lower house, in 1997. His political stature soared during the 2002 national election campaign when Lula picked him to coordinate the formulation of the PT electoral program. The campaign sought out more than 300 companies, unions and nongovernmental organizations for advice on the party platform. “We made broad consultations to design the program,” says Palocci. “We also got close to the capital markets, and it was the first time that a PT campaign not only talked with businessmen but also developed policies jointly with them.”
After the PT’s victory Palocci helped to oversee a smooth transition between Cardoso’s departing administration and Lula’s incoming one. “Because he did so well coordinating human efforts and organizing ideas, Lula chose him to be minister of Finance,” says the PT’s Suplicy.
Since Palocci isn’t an economist himself, he took special pains to assemble a team of first-rate, mostly foreign-trained and largely nonpartisan academics and technocrats to advise him. Now he gives them ample scope to shape policy. “Their role is crucial in defining proposals,” says Andrei Spacov, an economist at Unibanco in São Paulo. Adds banker Augusto, “He has a gift for motivating experts in different themes to work for a common project under his direction.”
Palocci’s Ph.D. brain trust includes University of Pennsylvaniatrained Marcos Lisboa as secretary for economic policy and University of Chicagoschooled economist and former IMF analyst Joaquim Levy as secretary for the Treasury. Secretary for international affairs Otaviano Canuto holds a Ph.D. from the Universidade de São Paulo, along with a master’s in economics from Concordia University in Montreal. “I’m the only medical doctor on the team,” jokes Palocci.
Policy-framer Lisboa, a former professor at Rio de Janeiro’s prestigious Fundaçao Getulio Vargas, studied at that city’s Universidade Federal de Rio de Janeiro under influential leftist economist Maria da Conceição Tavares, a staunch advocate of the import-substitution model. But during his master’s program in Rio, Lisboa says, “I steadily changed from heterodox to orthodox -- that’s why I went to Penn.”
Lisboa was the principal architect of a major policy paper that the Lula administration released in June titled “Road Map for a New Agenda of Economic Development.” Meant to represent a consensus across ministries, the paper sets the objective of sustainable economic growth with improved education and health and more equitable income distribution. It proposes increasing exports through greater competitiveness, expanding and improving infrastructure and stimulating production in Brazil’s most dynamic sectors, such as textiles, shoes, coffee and manufacturing. Among other recommendations: letting the public invest in Brazil’s infrastructure; operating highways and railroads as private concessions; and forming public-private partnerships to run water and sanitation systems. The document is serving as a guide for development policy.
Treasury Secretary Levy was an engineer before he became an economist. He did research on Western Europe for the IMF and served as a visiting economist at the European Central Bank before returning to Brazil in 2000 to be deputy secretary for economic policy at the Finance Ministry and then moving over to the Ministry of Planning, Budget and Management as chief economist. International affairs secretary Canuto was a professor at the Universidade de São Paulo’s Campinas branch, widely known for its heterodox economic views. He doesn’t, however, sound like the usual leftist academic: “We believe the major hindrance to growth in Brazil comes from government itself and is the proportion of public indebtedness to GDP.”
Those liabilities are hard to ignore in fashioning economic policy. Brazil’s public debt stands at 53.6 percent of GDP, and it fuels the world’s highest interest rates. “The real rate is brutal,” says Maurice Costin, CEO of the Federação das Indústrias do Estado de São Paulo, Brazil’s chief industrial association. Banks charge corporations 50 to 60 percent on loans. “A company cannot pay that rate -- it’s a very large risk,” says Costin.
Almost half the public debt is linked to Brazil’s real-dollar exchange rate, making for alarming volatility. The preelection market panic a year ago caused public debt to surge to 62.5 percent of GDP. The bulk of these sovereign bonds and loans are domestic and denominated in Brazilian reals, but Brazil’s foreign debt is still a staggering $65 billion, most of it in dollars.
Unlike many past Brazilian governments, the Lula administration appears to be trying to decrease the debt, not add to it. Treasury Secretary Levy has begun to reduce dollar-indexed liabilities by arranging buybacks and extending maturities. He has also converted some of Brazil’s Brady bonds into global bonds to enhance the debt profile and lower servicing costs.
“Debt is falling very rapidly, and exposure is also declining,” says Levy. He notes that the ratio of public debt to GDP is down more than 3 percentage points from last December’s 56.5 percent. The administration’s efforts are being rewarded with a continued decline in domestic interest rates; analysts expect to see them drop as low as 19 percent for the benchmark overnight rate by year-end. “Debt dynamics have improved tremendously,” says José Barrionuevo, director of emerging-markets strategy for Barclays Capital in New York. But he warns that Brazil remains “vulnerable to sharp devaluations in the currency and to high interest rates.”
The words “Brazil” and “debt” are usually found in the same sentence as “IMF,” and Palocci must soon come to terms with the country’s longtime lender of last (and sometimes first) resort. The $30 billion, one-year lending facility that helped Brazil ride out last year’s financial storm concludes in December. The finance minister says that if Brazil does pursue another IMF accord, it would want to fashion one that moves beyond emergency assistance into a recovery-and-growth mode.
“We are going to work to not need an agreement,” Palocci told II in July. “If it were necessary, we would have no difficulty in seeking to build a new agreement with the Fund.”
In late August the local press was reporting that Brazil would push to exclude investment in commercially run state enterprises, like oil company Petrobrás, from regular budget calculations, to permit greater flexibility in stimulating the economy. For its part, the IMF is said to be prepared to accept explicit social goals as part of a new loan agreement, in a sign of the agency’s shift in policy postWashington consensus.
Most analysts see some sort of accommodation with the Fund as unavoidable. Brazil still needs the IMF’s good-housekeeping seal to reassure foreign investors and creditors, suggests ABN Amro’s Mesquita, but that is becoming less important as Palocci’s economic team gains more and more credibility. What the government does want, though, the economist says, is that “enlarged, [IMF-supplied] reserve for another year.”
Any recourse to the Fund, however, and its meddlesome ways is sure to rankle many PT radicals. Perhaps, though, resistance to the IMF can be softened by a new Fund policy that designs “ownership” into its programs: Instead of imposing economic terms by fiat as the price of its loans, the new, enlightened IMF seeks to persuade recipient countries to help devise appropriate programs and thus embrace, say, austerity measures as their own.
“The Fund is concerned to stimulate countries to help create their own policies for the economy and even for the macroeconomy,” Palocci says. Brazil might try to capitalize on its recent clean record of fiscal and monetary management -- it has met all of its Fund targets -- to press for new arrangements to facilitate investment.
If Brazil wants to attract foreign investment to supplement its IMF dole, the Lula government needs to revamp the country’s confusing company rules. “The idea is to have a good regulatory framework to encourage investment -- a good, stable set of rules that provide certainty and make sure competition occurs, and a good set of stable incentives,” explains Palocci deputy Lisboa. He says that the timetable for redoing the rulebook is year-end and that the new regulatory regime will need congressional approval.
The administration is also trying to stimulate business by doing away with so-called cascading taxes -- as many as seven taxes on a single product. Brasília also intends to grant greater autonomy to the central bank to enhance monetary independence and vigilance. A series of capital markets reforms now making their way through Parliament are aimed at expanding credit and reducing borrowing costs. For instance, a new bankruptcy law drafted by Palocci’s office would make it easier for lenders to exercise loan guarantees and rescue failing companies.
Palocci is pursuing bold ideas to energize Brazil’s nascent export sector. The country has the smallest amount of trade relative to its size of any major country. Brazil’s $60 billion of exports last year amounted to just 10 percent of GDP, compared with a 31 percent share for Mexico and 43 percent for Chile. “We believe increasing trade will be beneficial to our sustainable growth path,” says international affairs secretary Canuto. “We need more exports, and that will mean more imports. We would like to have a free-trade system.”
Washington applauds that idea, and the U.S. has been pressuring Brazil to negotiate entrée to the Free Trade Agreement of the Americas by 2005. Lula, however, has said that his priority is to revitalize Mercosur, the old South American customs union, so that Brazil can enter into trade talks with the U.S. on more advantageous terms, as the leader of a sizable regional trade bloc.
In early August, when the rumors surfaced that the Finance minister was about to resign because of his supposed frustration with the pace of reform and the unrelenting opposition of hard-core left-wingers in his own party, Lula sought to to quell the speculation by telling Brazil’s biggest weekly that “whoever bets against Palocci is going to lose.” To those on the hard left and the hard right, consider that fair warning.
II’S FALL 2003 COUNTRYCREDIT RATING
COUNTRY CREDIT RATING
37.1 SIX-MONTH CHANGE
1.0
ONE-YEAR CHANGE
2.8
The more analysts and investors get to know Brazilian President Luiz Inácio Lula da Silva the more they seem to like him. Voters in Institutional Investor‘s latest Country Credit survey (see page 73) have raised Brazil’s score by 1 point since March, to 37.1; in the preceding six-month period, they had cut the country’s rating by 3.8 points. At that time voters had yet to take the measure of Lula, a left-leaning former union leader. “He has shown to the market that he has very open economic policies,” says Karla Valverde Quevedo, banking analyst at Centura SAB in Lima, Peru. She adds that despite the recent strength of the country’s currency, Brazil’s export engine is revving up, thanks in part to a revived Argentina, a key trade partner. Brazil’s public debt, much of it dollar- denominated, remains worrisome. It represents nearly 55 percent of GDP, with about half the liabilities linked to overnight rates. Warns one credit analyst, “Brazil’s got to be careful that it doesn’t find its debt ballooning due to dollar or inflation linkage.”
‘WE HAVE A BIG AGENDA’
An ex-Trotskyite and a medical doctor, Antônio Palocci Filho seems an odd figure to be minister of Finance of the world’s ninth-largest economy. But the economy is that of Brazil, where politics can be as colorful as Rio de Janeiro’s Carnaval.
Palocci himself is performing a daring juggling act. He must persuade business leaders, investors and lenders that his boss -- leftist President Luiz Inácio Lula da Silva -- is wedded to conservative fiscal and monetary policy, and at the same time, he must reassure Brazil’s masses, Lula’s most ardent supporters, that the government is pursuing an am- bitious social policy agenda.
Palocci spoke recently with Institutional Investor Contributing Editor Lucy Conger.
Institutional Investor: What caused Brazil’s financial crisis last year?
Palocci: Three things coincided: First, it was a time of great contraction in the world economy -- in the richest countries, too -- and of withdrawal by investors. Second, Brazil’s fundamentals were fragile following a long period of no growth. Third, there was the election uncertainty. Those three things generated panic in investors.
For a onetime Trotskyite, you seem to be pursuing pretty orthodox economic policies.
I was a Trotskyite in the remote past. What you call our orthodox policy sets out basic goals: a stable monetary policy, a primary budget surplus sufficient to reduce Brazil’s debt-to-GDP ratio, a floating exchange rate. And it avoids things that may appear to be solutions but in real life are not: managed exchange rates, capital controls on inflows and outflows. These don’t help. When you force capital, it says good-bye.
What has been your top priority?
Combating inflation. We didn’t want to let inflation take over our agenda, because Brazil is a country with an inflation memory -- many economic sectors adore inflation. So we waged a strong fight against it. But that doesn’t mean this is a government of economic orthodoxy.
So how would you describe your policies?
We like to say that in economics we work with three coexisting styles: We are serene in macroeconomic matters, creative in development policies and daring in foreign trade. The macro- economy doesn’t demand creativity; it demands stability. Development policies demand creativity because every country has its own dynamic. And foreign trade demands a lot of energy in negotiations.
How do you promote growth along with “social inclusion,” as President Lula wants?
That is an important issue. Brazil hasn’t redistributed income in 30 years. This is not only an ethical issue, but also an economic one, because when you have a society with so much inequality, the economic equilibrium is compromised. Most modern economists, especially Americans, have demonstrated that inequal societies are much more susceptible to shocks. So we are interested not just in growth but in growth with income distribution.
But what would be the mechanism for such distribution?
All economic policy has to be set out with a view to the small entrepreneur. When the president launched the agricultural harvest program, 32 billion reais ($11 billion) went to agribusiness, but fully R5.4 billion was set aside for family farms. When we began dealing with credit, the first credit package was microcredit.
What about strengthening contract law?
We’re preparing laws to modernize the credit system with effective guarantees so that we can guarantee judicial and legal security for credit and insurance activities. We have a big agenda.
Some say the government backtracked on its public pension reforms and that the final savings will be less than promised.
That’s not true. A new social security system is being built that will put a ceiling on public pensions, but above that ceiling public servants will have the right to a complementary [self-financed] pension.
You’ve said that if you negotiate a new agreement with the International Monetary Fund, you’ll ask for new terms and more flexibility.
If it were necessary to do a new agreement, we would base it on Brazil’s agenda today: economic growth. The agreement we have now corresponded to a serious economic situation. Brazil’s possibilities are different now. We want autonomy to formulate economic policy. We don’t want a ready-made recipe. We are going to make our policy. The Fund has given us that vote of confidence, and after six months our relationship has improved a lot.
How so?
Two things changed to facilitate an understanding. The government of Brazil changed to one that doesn’t believe that a conjunction of emergency measures can be the only economic recipe. Second, the Fund changed, based on a series of difficult experiences.
Do your foresee a new agreement?
If a new agreement were not necessary, that would be better for Brazil and better for the Fund. The Fund exists to support countries in difficulties. If you don’t need an agreement, then you are having fewer difficulties. We are going to work to not need an agreement. But it’s too early to say.
How do you view the Washington consensus?
The Washington consensus arose from a mistaken premise: that economic models can be repeated and adapted to any situation. They can’t. Brazil is a continental country, and it has very large income inequality. That has to be considered in the economic model of Brazil, not only in the social model. Second, the Washington consensus said that achieving financial balance -- equilibrium in accounts, reduction in inflation -- would necessarily bring development. Various countries tested this model, and a good part of them achieved equilibrium but did not get growth. Growth doesn’t spring forth from spontaneous generation. That has been discovered in medicine but apparently not yet in economics. Growth needs action: planning, coordination, construction of regulated sectors, dialogue with investors, judicial security -- a series of things.
Are you surprised by how well your efforts have been received on Wall Street?
No. What causes investors to have a lack of confidence in a strong country like Brazil is our not having adequate policies, so if you apply adjusted, adequate policies, investors will look favorably on Brazil. It isn’t that they like me; they like Brazil.
