TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

EXECUTIVE SUMMARY
The benchmark interes...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

Interest rates in Brazil have fallen su...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

To start, in theory, independent centra...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

above 26% for the first six months of t...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

fares, the BCB has tightened policy in ...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

where the Brazilian central bank missed...
TRENDS + VIEWS
Brazil’s central bank and the issue of independence – October 2013

TABLE 1: TRACK RECORD OF INFLATION IN M...
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Jamestown Latin America: Trends+Views: Brazil's Central Bank and the Issue of Independence

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An oft mentioned reason for elevated rates in
Brazil is the lack of independence of Brazil’s central
bank. Central bank independence is a feature in many
of Brazil’s peers, such as Chile, Colombia, Mexico, and
Peru. However, establishing true legal/constitutionally
mandated independence of the Banco Central do Brasil
(BCB) has never gained political traction and is not on
the current political agenda. Whether or not this lack
of independence influences the level of interest rates
in Brazil, and to what degree, is a complex and heated
topic.

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Jamestown Latin America: Trends+Views: Brazil's Central Bank and the Issue of Independence

  1. 1. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 EXECUTIVE SUMMARY The benchmark interest rate in Brazil recently hit a record low, and the current real rate of approximately 3% is well below the historical average. As the Banco Central do Brasil is not an independent central bank, there are bound to be concerns about political interference in its decision making. Policy makers appear to be accommodating a rate of inflation above the target, albeit still low relative to Brazil’s prior experience and many other large Emerging Markets countries. Longer-term interest rates are higher than regional peers, due to doubts about the inflationtargeting regime. Independence is not a necessary precondition for meeting inflation targets, and the recent history shows a mixed performance for independent central banks. Nonetheless, home buyers have access to mortgage rates, that on an inflation-adjusted basis, are lower than most other countries in Latin America. JAMESTOWN LATIN AMERICA Real Estate Private Equity www.jamestown-latam.com Contact: Bret Rosen – Managing Director, Research +1 212-652-2141 brosen@jamestown-latam.com Rio de Janeiro • Bogotá • Atlanta • New York
  2. 2. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 Interest rates in Brazil have fallen substantially over its Latin American peers – even though the sovereign the last decade, and indeed this has been a major rating on Brazilian debt is similar to a country such as contributor to price appreciation of real estate in recent Colombia, whose benchmark rate stands at 3.25%, 625 years. Mortgage rates, in inflation-adjusted terms, are basis points below the SELIC. comparable to those in other major economies of the There are a number of explanations for the elevated region, if not lower, which has pushed up the stock of mortgages as a share of GDP to a record high of 7.8%, according to the most recent data. The stock of mortgages is growing at more than 30% year over year, thanks in part to more reasonable financing rates, level of Brazilian rates. Economists cite reasons such as: • he relatively lax fiscal policy in Brazil, with the most T recent headline number showing a 3.1% of GDP deficit over the last twelve months. while banks are also increasingly prioritizing housing • Brazil’s relatively recent history of hyperinflation, as products. The ability of policy makers in recent years to inflation was several thousand percent, on a year create a lower and more stable inflation environment over year basis, as recently as 1994. allowed for the issuance of longer duration mortgages, which naturally reduced monthly payments and improved affordability. Controlled inflation has also been supportive of increasing real wages, which in turn encouraged housing demand. More predictable inflation rates in Brazil also allowed the sovereign government and corporations to finance themselves in local currency, for longer durations. This healthy combination of factors contributed to Brazil’s sovereign system, which can distort monetary policy and financial conditions. • Inflation inertia caused by still-significant amounts of indexation in the economy, which is a legacy of Brazil’s hyperinflation past. One example of this is the setting of the minimum wage, which is based on a prior year’s inflation rate. • The relatively high 4.5% inflation target in Brazil, debt reaching investment grade status in 2008. However, despite the decline in borrowing rates, the benchmark interest rate in Brazil is still, by far, the highest • The large role of state-held banks in the financial among which is above those in Latin American peers such as Colombia, Mexico, and Peru, where the targets range from 2%-3%. America’s Another oft mentioned reason for elevated rates in economies. Brazil is the lack of independence of Brazil’s central the bank. Central bank independence is a feature in many of of Brazil’s peers, such as Chile, Colombia, Mexico, and interest rates in Brazil Peru. However, establishing true legal/constitutionally has been a central mandated independence of the Banco Central do Brasil topic for observers of (BCB) has never gained political traction and is not on the country’s economy for years. While the benchmark the current political agenda. Whether or not this lack SELIC rate, currently at 9.5%, is well below the historical of independence influences the level of interest rates average (as recently as 2003, the SELIC was 26.5%), in Brazil, and to what degree, is a complex and heated and indeed earlier this year, the SELIC hit 7.25%, an all- topic. With a benchmark rate in single digits, the SELIC is very low by historical standards. Latin major Explaining elevated level time low, Brazil’s borrowing rates are still higher than in TRENDS + VIEWS OCTOBER 2013 PAGE 2
  3. 3. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 To start, in theory, independent central banks can the central bank is essentially an arm of the executive make monetary policy decisions based on their actual branch, and carries out monetary policy in accordance mandate, whether that is an inflation target or some with the political goals of an administration. Argentina other metric or goal. Decisions can be taken, presumably, would be an example, where the Central Bank finances without worry that politicians will interfere in the policy the Treasury, and its fiscal deficit at the behest of the making process or feel apt to remove a central bank Kirchner government, even when this policy mix leads governor that makes a decision that could compromise to major inflationary consequences. short-term economic outcomes. The mission of the Banco Central do Brasil is “to ensure Central banks that lack independence are more at risk the stability of the currency’s purchasing power and a of political pressure, which undermine their ability solid to implement policy decisions based on mandates financial and objectives, such as inflation targeting. Politicians through an inflation presumably prefer monetary policy to be less restrictive targeting as a means of encouraging lending, consumption, and which began in 1999.1 economic growth. Most standing governments prefer, In Brazil’s case, the all things equal, a lower interest rate to a higher one. current There are essentially three models of arrangements target is 4.5%, with for central banks. The first is one where the central bank is legally and constitutionally independent, where decisions can be taken without fear of major political repercussions. Within Latin America, Chile stands out in this regard, for example. The second model is one where the central bank is de facto independent, but subject to risk of government intervention; Brazil fits this category. Finally the third category is one where CHART 1: REAL INTEREST RATES IN BRAZIL (SELIC – ACTUAL INFLATION) a and efficient system, ” system, inflation tolerance During the Lula government, the central bank operated a very disciplined approach to monetary policy. band of 2% to each side of this central target. Under a true inflation targeting regime, the central bank would adjust the policy rate in accordance with its expectations for future inflation, and lower or raise the benchmark rate to enhance its chances of achieving the target. However, in recent years the track record of Brazil’s Central Bank in delivering its inflation target has been less than stellar. The most recent September reading on the benchmark IPCA index showed an inflation rate of 5.9% for example, which was 15% the first report in 2013 where year over year inflation 12% was below 6%. 9% Under the government of President Lula (2003-11), the Central Bank appeared to enjoy functional independence, 6% despite fears that Lula would intervene in its policy 3% making. Indeed, after assuming office, then Central Bank President Henrique Meirelles raised interest rates 0% 2000 2002 2004 2006 2008 2010 2012 2013 substantially in 2003 and kept the benchmark rate at or Source: Bloomberg 1 Banco Central do Brasil website: www.bcb.gov.br TRENDS + VIEWS OCTOBER 2013 PAGE 3
  4. 4. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 above 26% for the first six months of the government. case, as Europe’s sovereign debt crisis represented a While this policy approach led to contracting economic major economic headwind for Brazil and that Tombini, activity, it showed that the administration was serious by easing when he did, proved to be well ahead of his about fighting inflation, resulting in a stabilized exchange peers. rate, which had weakened markedly in the months Indeed, the current Board of the Central Bank has leading up to the election. Inflation, which reached 17.2% in May 2003, fell to 5.2% by May 2004, helping create the necessary conditions for an improvement in business confidence in the years that followed. Longterm interest rates fell substantially, as the Central Bank was viewed as being a strong inflation fighter, and Meirelles was seen as holding a “hawkish” attitude toward inflation, even with a left-of-center government in office. In May 2007, inflation fell below 3%, and even as late as 2009, inflation ended the year at 4.3%, below the official target. faced a challenging backdrop over the last 1-2 years, with a challenging external environment, slower than normal domestic economic growth, but an elevated inflation rate. Market participants believe that the central bank is not necessarily targeting the official goal of 4.5% inflation. When growth and inflation are both low, the typical policy prescription is to ease. However, When Dilma Rousseff took office in 2011, she appointed when growth is low and inflation is high, a central bank Alexandre Tombini, an experienced technocrat, as cannot usually attack both problems simultaneously. Central Bank Governor. However, under the present Federal Reserve Chairman Paul Volcker faced facing administration, questioned a similar low growth, high inflation quandary in whether the Central Bank enjoys the same de facto the late 1970s and early 1980s, and opted to tighten independence that it enjoyed under Lula. Rousseff, who policy dramatically, which sent the US economy into holds an economics degree from the Federal University a recession, but ultimately led to lowering inflation of Rio Grande do Sul, is perceived by many observers to and longer-term interest rates, setting the stage for be more intrusive than Lula. These observers question a subsequent impressive economic recovery in the whether or not Rousseff might have pressured the BCB United States. In Brazil, the Central Bank, until recently, Board, pointing to BCB policy decisions that might kept the policy rate at an all-time low, even with inflation confirm their suspicions. For example, in October 2011, well above its target. The BCB’s current policy mix of even though the most recent report had showed IPCA low interest rates in spite of high inflation in a slow inflation above 7.3%, the monetary authority lowered growth environment is compromising the Central the SELIC rate by 50 basis points. This decision alarmed Bank’s credibility as an inflation targeter and may result some investors now concerned that the Central Bank in longer-term interest rates, if markets perceive that the might not be a true inflation targeter. Easing policy could BCB might not be targeting 4.5% inflation, but perhaps a have led to elevated inflation expectations moving well higher rate, if not another metric (such as GDP growth). above the upper limit of the target band’s range, and Recently, with inflation becoming a more politically some investors have maybe even providing a sign of political intervention in the Bank’s processes. However, others have also argued that the BCB was particularly prescient in this charged topic in Brazil, especially in the wake of the June protests, which were ignited over the increase of bus TRENDS + VIEWS OCTOBER 2013 PAGE 4
  5. 5. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 fares, the BCB has tightened policy in an effort to ward growth, while more heterodox ones, such as Brazil’s off any potential inflation spikes. Since April, the SELIC Finance Minister, seem to think that allowing a bit more rate has been lifted from 7.25% to 9.5%, with the market inflation (via lax fiscal and monetary policy) contributes looking for several more hikes in the near term. Indeed, to stronger growth. The Taylor Rule indicates that the interest rate markets price in another 50 basis points hike policy rate should be increased in a rising inflation at the November meeting, with several more 25 basis environment, but the Central Bank in Brazil has not points hikes to follow in early 2014. The recent moves necessarily followed this model, and one can argue that have especially important implications as Brazil heads Brazil’s economy is now paying the cost, as inflation into an election year. Recent comments from Central expectations, even according to its own forecasts, are Bank Track record of independent Latin America central banks in fighting inflation is mixed. Directors, for expected to remain well above the 4.5% target for the example stating that foreseeable future.2 there is much work However, in spite of the arguments favoring more for monetary policy to do to curb inflation, seemed to temporarily lessen concerns that government pressure might be a factor behind the recent policy decisions in Brazil. However, such doubts, due to the BCB’s penchant for easing policy over the last couple years even as inflation surged well above the target rate have already been cast. central bank independence, such independence is not always a necessary condition to bring down longerterm interest rates, even though legally mandating independence does enhance credibility. Where the central bank does have legal independence, the track record for achieving inflation goals has generally been better, as countries such as Colombia and Chile demonstrate, where inflation in each is currently below their respective 3% targets. However, independence is no guarantee of achieving an inflation target, as The net result of these worries about central bank the Mexico case shows, where inflation has remained independence is that longer-term interest rates in Brazil stubbornly above its 3% target. Indeed the track record are presumably higher than in other countries in part for the major Latin American central banks of meeting because the market has some doubt about the inflation their inflation targets is mixed. In the below chart, we fighting resolve of the BCB. Indeed, longer-term rates take the five major Latin American central banks, and in Brazil are in the double digits, and the yield curve is display the year over year inflation for each country at steep, relative to many other large emerging markets. the end of each calendar year, since 2003. We note that The supposed “neutral” interest rate, i.e. the real Brazil, whose central bank is not officially independent, interest rate that neither stimulates nor restrains activity, met its inflation target in three of the last ten years, for a is also estimated to be higher in Brazil, at perhaps 4%, success rate of 30%. Chile in contrast met its goal 60% compared to around 2% in a country such as Colombia. of the period, while Mexico – even with its independent The inflation-growth tradeoff is a tricky one for policy central bank – has not satisfied its inflation target once makers. Orthodox economists argue that allowing during this time frame. more inflation does not necessarily result in more If we extend the analysis however, we see that in years 2 The Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. The rule is named after renowned economist John Taylor, currently a professor at Stanford University. TRENDS + VIEWS OCTOBER 2013 PAGE 5
  6. 6. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 where the Brazilian central bank missed its target, to this question is uncertain. Brazil’s 6% inflation rate the average ‘miss’ has been by 2.18%. Chile actually actually compares favorably to other large EM countries displayed the largest ‘misses,’ due to the commodity such as South Africa, Indonesia and Turkey, all of which price shock that impacted that small, open economy have legislated central bank independence and are in 2007-08. Since Chile imports nearly all of its oil, its struggling with similar internal and external conditions. inflation rate proved very susceptible to the move to Some researchers have argued that the independence $150/barrel in oil during that time frame. Meanwhile, of the U.S. Federal Reserve has been eroded in recent Mexico which never actually hit its 3% inflation target, years, through its policy of quantitative easing, which is showed the smallest average inflation ‘miss’ during the a form of “cooperating with the Treasury and engaging time frame examined. in fiscal policy. 3 These outcomes could lead one to ” If we go another step further, and look at the 2010-13 time suggest that maybe central bank independence just frame, which encapsulates the period of Dilma’s election doesn’t matter as much as some economists perceive. followed by her appointment of the current economic In Brazil, while the BCB is not legally independent, it policy leadership, we see that Brazil has missed on its is important that the institution make strides toward target in all four of these years (assuming that 2013 fulfilling its inflation-targeting mandate. Achieving inflation is in line with the Bloomberg consensus more credibility is a necessary condition toward forecast of 6.2%). The average deviation from the 4.5% reducing longer-term interest rates, which can unleash target over this time frame has been 1.61%. Mexico and even further demand for mortgages and other longer Peru have been within 1% of their target on average, duration financial products. Should mortgage rates while Chile and Colombia have on average remained fall to the mid-single digits as a result, as has occurred below their 3% targets over this time frame. in the developed world, the real estate market would Is Brazil’s inability to meet its inflation target in recent obviously feel the benefit. years due to any change in the de facto independence of We would further the notion that what matters more the Central Bank? Indeed in recent years one can point than independence is political will. Central bankers, to a number of factors exogenous to monetary policy whether they have true independence or not, need that also contribute toward higher rate of inflation in to have the political will to offset pressures that may Brazil, including the 1) weakness of the real over the come within government, the private sector or society last 18 months; 2) lax fiscal policy; and 3) expansion of at large, to manage monetary policy according to their credit from state owned banks. When one adds other mandate – whether that mandate be price stability or factors that contribute to structural inflation such as the some other goal. high degree of indexation that still exists in the Brazilian economy, as well as infrastructure and issues related to red tape, one might conclude that the BCB’s job of achieving its inflation target is especially difficult Would an independent central bank have been able to satisfy the 4.5% target under such conditions? The answer 3 John Taylor, “The Effectiveness of Central Bank Independence Versus Policy Rules. Stanford Institute for Economic Policy Research. January 2013. ” TRENDS + VIEWS OCTOBER 2013 PAGE 6
  7. 7. TRENDS + VIEWS Brazil’s central bank and the issue of independence – October 2013 TABLE 1: TRACK RECORD OF INFLATION IN MAJOR LATIN AMERICAN COUNTRIES INFLATION (%) TARGET (%) BRAZIL TARGET SINCE INDEPENDENT 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 4.5 4.5 since 2005* No 9.3 7.6 5.7 3.1 4.5 5.9 4.3 5.9 6.5 5.8 6.2 CHILE 3 2000 Yes 1.1 2.4 3.7 2.6 7.8 7.1 -1.4 3.0 4.4 1.5 1.8 COLOMBIA 3 2002 Yes 6.5 5.5 4.9 4.5 5.7 7.7 2.0 3.2 3.7 2.4 2.4 MEXICO 3 2002 Yes 4.0 5.2 3.3 4.1 3.8 6.5 3.6 4.4 3.8 3.6 3.7 PERU 2 2002** Yes 2.3 3.7 1.3 2.0 1.8 5.8 3.0 1.5 3.4 3.7 2.7 *Target was 5.5% + or - 2.5% in 2003-04. Chile independent in 1989. **Was 2.5%, lowered to 2% in 2007 Source: Bloomberg TABLE 2: ABILITY OF LATIN AMERICAN COUNTRIES TO MEET INFLATION TARGETS IS MIXED (2003-2012) SUCCESS RATE IN YEARS MISSED AVG. DEVIATION 2010-2013 AVG. DEVIATION BRAZIL 30% 2.18% 1.61% CHILE 60% 2.76% -0.33% COLOMBIA 20% 2.49% -0.06% MEXICO 0% 1.22% 0.87% PERU 50% 1.61% 0.82% Source: Jamestown Latin America calculations TRENDS + VIEWS OCTOBER 2013 PAGE 7

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