Brazil's Economic Development Recipe

A recipe for the economic
development in Brazil
Dr. Len Mei

Current situation (2016)
• GDP contracted 3.8% in 2015 — the worst year
in 25 years. FMI forecasted similar drop in 2016.
▫ The worst sectors are industry, infrastructure,
trade and capital formation.
• Inflation and high interest rate return,
increasing public and private debt, government
deficit, high interest payment and
unemployment.

Plano real 27/02/1994
Worst recession in 24 years
Commodity boom
2009 Worldwide financial crisis

Economy contracts since July 2014

Data published by IBGE
http://www.ibge.gov.br/english/estatistic
a/indicadores/pib/pib-vol-
val_201504_3.shtm
Sector performance
• Industry -6.3%
• Trade - 8.9%
• Capital formation -14.1%

Debt is rising to all time high
%
%
public
debt
vs.
GDP

Inflation, interest rate and budget
deficit

Current account/ GDP
A positive current account balance indicates that the nation is a net lender
to the rest of the world, while a negative current account balance indicates
that it is a net borrower from the rest of the world.

The apparent reasons of symptoms of
the Brazilian economy

Factors contributing to the recession
• Worldwide commodity price fell
• Political instability
• Increase in the government deficit
• Return of inflation
• Fast debt growth
• http://www.economist.com/blogs/graphicdetail/2016/04/economic-backgrounder

Political instability
• Brazil was rocked by corruption scandals.
• Fractured political system posts a major
challenge to the structural reform

Increase in debts –
government debt, corporate debt and household debt

The impact of household debt
• The household debt service reaches 20% of the
disposable income =>
▫ Reduced the purchasing power
▫ Decimated consumer market
▫ Caused unemployment
▫ Reduces tax revenue
▫ Causes negative feedback in the economy

The impact of corporate debt
• High corporate debt means
▫ High burden for company finance
▫ Reducing company’s profit or increases company’s
loss
▫ Depriving company for future investment
▫ Driving many companies to bankruptcy
▫ Reducing government tax revenue

The impact of government debt
• High government debt means
▫ Forcing government to increase tax
▫ Reducing government ability to provide basic
services to people
▫ Increasing interest rate

The impact of debt (overall)
• High interest rate
• High tax
• High unemployment
• Low capital formation
• Recession or lower growth
• Inflation
• More poverty
• Real assets (such as real estate) tend to decrease
in value because the population becomes poorer

http://www.tradingeconomics.com/country-list/interest-rate

Debt service is debt * interest rate
• Brazil debt/GDP ratio is not
so high (66%), but the
problem is high interest rate.
• The interest payment/ GDP
= (debt/ GDP) * interest rate
• The interest payment in
Brazil is now 9.4% of GDP,
one of the highest in the
world

Is high debt a consequence of high
interest rate or vice versa?
• High debt and high interest rate have compounding effect:
▫ High debt causes high interest rate because money becomes more
scarce
▫ High interest causes higher debt because less money is available
for creating wealth, and the unpaid interest goes to the principal.
▫ Debt builds itself over long time before it has impact
▫ In 70’s, Brazil has high external debt, which led to the economic
turmoil in 80’s and 90’s.
▫ It took tremendous austerity to solve the problem, but the
problem returns in 2010’s.
▫ Selling patrimony and commodity boom provided temporarily
relief.
▫ Government policy does not address the fundamental issue.

A brief history of Brazilian economy
• Brazilian economy always reflects the boom and bust of different
commodities
▫ 1650 – sugar export peaked
▫ 1690 – discovery of gold, gold production peaked around 1750
▫ 1720 – discovery of diamonds
▫ Since 1822 – Brazil started to export cotton, sugar and coffee
▫ Slavery was abolished in 1888. Brazil started to import a lot of European
immigrants to work as labor.
▫ At the turn of 20th century, Rubber boom started. Manus flourished.
▫ The influx of immigration brought the expansion of light industry..
Textile, clothing, food industry, tobacco, beverages. However, the
development was more concentrated in the southeast and south regions
where immigrants settled.
▫ 1930 revolution abolished the Old Republic and in 1937 the coup
established the New State, which initiated sweeping reform.

• Over 1932-39, while the rest of the world was mired in the Great
Depression, manufacturing in Brazil grew at a rate of 9 % per year.
• During the 1940’s and 1950’s there was extensive state-driven
industrialization when some of Brazil’s largest public enterprises
were created, such as Companhia do Vale do Rio Doce in 1941,
Companhia Siderurgica Nacional in 1942, and Petrobras in 1952.
• There was an opening up of the economy in the 1960s and a return
to protectionism in the 1970s.
• Between the end of WWI in 1918 and 1980, GDP grew at a
compounded rate of 6.3 %, a rate comparable to East Asia’s more
recent performance.

Import Substitution Industrialization ISI
• Period of import substitution industrialization started in
1945. It established the foundation of economical
miracle period.
• Meanwhile, Brazil started urbanization. Massive people
migrated from rural areas to the cities. This changed the
nature of economy – industry became a larger portion of
the economy.
• In 1951 the newly elected government of Getúlio Vargas
enforced import licensing, giving priority to imports of
essential goods and inputs (fuels and machinery) and
discouraging imports of consumer goods.
• Although there were ups and downs in economy during
this period, in general, Brazil was progressing well.

Brazilian economic miracle 1968-1980
• The best period for Brazilian economy is from 1968 to
1980, during which the economy grew between 6%~10%
a year (1968~1973). The industry sector grew even faster
at 13% a year with high degree of modernization.
• The share of machinery industry increased from 3.2% to
10.3%.
• Much of the Brazilian industry today was created during
this period.

Brazilian economic miracle
• Between 1964 and 1984, the military government supported
the industry.
• After fiscal adjustment (1964-1967) , Roberto Campos (Ministro do planejamento no
governo de Castelo Branco) and Otavio Gouvêa de Bulhões (Ministro da fazenda no governo de
Castelo Branco) brought inflation down and balanced the country's
current account.
• The reforms led to the nationalization of key industries such
as Telebras and Eletrobrás.
• The model of national development strategy involved the
state, national entrepreneurs, and multinational corporations.
• Industrialization proceeded at a cracking pace behind high
tariff barriers through the late sixties and most of the
seventies.

Oil shock in 1973 triggered a policy
change…
• However, the oil shock in 1973 brought to the
end of self-sustained economic development.
• The high oil price led to a sharply higher import.
Trade balance was reversed.
• Export suffered due to an overvalued currency. (A
mistake committed over and over again)
• Brazil opted to continue a high-growth policy by
promoting export industry by borrowing (Another
grave mistake).

Rapid build up of industry and
infrastructures….
• From the mid-60’s the rise of the Eurodollar market and in 1973
Petrodollar flooded the world with dollars for government to expand
borrowing. (Politicians borrowed the money to do large projects and let their
successors to worry about the payments.)
• The Brazilian military government embarked on a gigantic
borrowing spree on world-capital markets to drive development.
• In the midst of a world recession 1974-1979, the Geisel government
launched an ambitious state-sponsored projects in the area of heavy
industry, with the aim of moving Brazil into the status of a
developed country before the end of the decade.
• Many large scales projects were constructed during this period:
Itaipu dam, highway Bandeirante, metro in Sao Paulo and Rio,
Anglo dos Reis 1 nuclear power plant.

Paradigm shifts against Brazil…
• Without understanding the true nature of the Petrodollar, Brazil
doubled down on the borrowing. When the tide turned, Brazil found
itself unable to pay the debt.
• What is worse, the new industry built with borrowed money was not
be able to compete in the worldwide market.
• For the reason which will be clear later that the Brazilian export
industry is not competitive, especially, facing the competition from
newly developing countries from East Asia.
• Paradigm shift #1: US interest rate skyrocketed in late 70’s. The Fed
fund rate reached 19% in 1981. This drastically increased the Brazil’s
external debt service.

Paradigm shift against Brazil…
• Paradigm #2: competition from Asia.
• For the first time, Brazil was facing serious competitions from Asia.
• Before 60’s, East Asia was engulfed in WWII. Most East Asian
countries were destroyed and poor. When the peace arrived after
Korean war, East Asia started the reconstruction.
• After 20 years of rebuilding the economy, East Asian countries saw
tremendous growth led by Japan.
• In the beginning, East Asia had the advantage of lower labor cost,
later on, has the advantage of higher productivity.
• The competition is much more than just the industry, but the overall
productivity, efficiency, policy, savings, investment and many other
factors of the country’s economy.

Double blow: second oil shock and
rising interest rate worldwide………
• Geisel’s program continued until a second oil shock in 1979 gave
another blow to the Brazilian economy.
• By borrowing money to promote the non-competitive industry, the
financial burden buried Brazilian economy.
• Since all the borrowing was in dollar, when the dollar interest rate
rose, it shacked the foundation of this policy. Brazil was unable to
service the debt.
• This is the beginning of the demise of Brazilian economy in the next
forty years, and mostly likely more.

Now entering the first difficult phase:
1985~1990
• During the second half of 80’s, Brazil tried several plans to ease the
economic pain:
▫ the Cruzado Plan (1986),
▫ the Bresser Plan (1987),
▫ the Summer Plan (1989).
• But none of these plans addressed the fundamental issues, and of
course, they did not work.
• It deemphasized the “import substitution industrialization (ISI)
policy” in favor of the so called “neoliberal policy”, which continues
until today.
• Such a change is in part to combat the economic crisis, also in part
due to the recognition of inefficiencies of ISI. [Neolibralism and its consequences in Brazil, Edmund
Amann, Werner Baer, J. Lat. Amer. Stud. 34, 945]
• Therefore, the thinking is that “We need foreign capital, knowhow,
skills to show us how to do things right.” It also coincides with the
worldwide trend of globalization.

Lesson learned: never build economy
on debt
• The debt sowed the seed of a financial disaster after 1980 when the
international interest rates rose to extremely high level, and it
brought the debt-driven development model to an abrupt end.
• Eventually, it led the weakened military regime to relinquish the
power in 1985.
• For a decade, the weak Presidencies of Sarney and Collor attempted
to revive growth and restructured country’s foreign debt under the
Brady Plan with unrealistic plans.
• As a result, there was hyper inflation and Brazil entered a period of
“the lost decade”.

Two spikes of hyperinflation addressed
by Collar Plan and Real Plan….
Collar plan
3/1990-3/1991
Real plan
7/1994- 2002
Privitization
(selling Brazilian
assets to foreigners)
Commodity rescue

Lesson learned: “save” instead of
“consume”
• To build industry and infrastructure requires large amount of
capital.
• Formation of capital has two ways: borrowing and saving
• Brazil took the route of borrowing and Asian countries took the
route of saving.
• “Borrowing” has the risk beyond one’s control.
• Brazil’s lost decade is a direct result of the heavy borrowing during
economic miracle. It should not be duplicated.
• This is the sin of “consume” before “produce”.

Collar plan
• Collar plan was introduced in 3/1990 to combat the inflation.
• The basic plan is to freeze wages and prices.
• However, freezing wages and prices could not stop inflation. It
reduced the incentives to produce and the economy shrank. The
living standard lowered dramatically.
• In one year, the government spending in dollar term shrank by 67%.
• Although, the tax revenue was also reduced, the spending was
reduced more.
• By 3/1992, the government ran a surplus by austerity (before
servicing the debt).
• However, the surplus was not enough to pay the interest, the
government still ran a deficit.
• Such a plan is apparent not fixing the root cause.

Lesson learned: wage and price freeze
do not solve the inflation problem..
• Inflation was caused by money printing.
• However, money printing reduces the value of money.
• By freezing wages and prices without stopping the
money printing effectively reduces the selling price of
products, and purchasing power in real term.
• This discourages the production. Frozen wages with
reduced value in money also makes everybody poorer.

A. H. Meltzer – Inflation and Money in Brazil 1992, Carnegie Mellon University
Collar plan
3/1990-3/1991

Plano Real – the height of
Neoliberalism
• As soon as the wages and prices were unfrozen,
the inflation returned with vengeance.
• By 1994, the inflation returned to 4,000%.
• On 1994/7/1, president Fernando Hernique
Cardoso introduced a new plan – Plano Real.
• The central idea of Real Plan is the so called
Neoliberalism – to open the market for foreign
investment. The purpose is to attract the foreign
capital and knowhow.

Policies of Plano Real
• To implement Plano Real, Brazil adapted two key
policies:
▫ to peg the new currency Real to the US Dollar to
attract foreign direct investment (FDI) by paying them
high interest, and buying Brazilian companies.
▫ to auction off large state- own company, such as
Petrobras, Vale do Rio Doce, Telebras, etc. to collect
money.
• Between 1993-2010, there are total of 7,012 merger
and acquisition of Brazilian companies with total
value of $707 billion.

With the help of FDI, Cardoso hoped that
Brazil would get much needed capital
• The Real plan aimed at the elimination of the barriers to
foreign multinational companies to enter Brazilian market,
and to enable them to participate in the privatization of state
enterprises.
• Real Plan’s central strategy was based on an overvalued
exchange rate (to boost the price of privatization) and import
liberalization.
• Cardoso hoped that FDI would
▫ help finance balance-of-payments deficits,
▫ modernize industrial structures,
▫ develop advanced technology,
▫ promote productivity and
▫ boost the international competitiveness of Brazilian exports.
▫ participate in Brazilian business rather than making money in
interest only

Lesson learned: You cannot build
economy based on wishful thinking…
• FDI is never interested in helping Brazil to develop its economy. It is
only interested in making most money out of Brazil.
• A 2007 BNDES (the Brazilian development bank) report shows that
▫ During 1970’s, 52% of the investment in Brazil is in the
transformation industry and the national infrastructure, and
▫ In 2006, this share was only 29,6%,
▫ FDI largely avoided the investment in transformation industry
and national infrastructure.

Side effect #1
• Plan Real encouraged the entry of short-term speculative
funds into Brazil to make a quick kill in an
unprecedented liberalization of the capital account and
huge interest rate differentials with the rest of the world.
• The combination of high Real exchange rate, which
makes Brazilian industry non-competitive, and import
liberalization, which allows cheap imports, effectively
killed the Brazilian industry.
• The Brazilian de-industrializtion started.
• Much of the industry built during the miracle year was
dismantled, and the Brazilian capital was displaced.

Investment in the fixed capital is at all
time low
by MYLÈNE GAULARD Revista de Economia Política
Rate of the Brazilian gross fixed capital formation (in % of the GDP), at current and constant prices (1970-2007) Source:
IPEADATA, graph made by the author.
Economic miracle
The lost decade
Deindustrilization
Fixed
capital
formation
/total
investment
%
Fixed capital is the capital to
invest in production means,
such as plants and production
equipment.

Lack of fixed capital investment
reduced shares of industry in GDP
Fernando Mattos and Bruno Fevereiro: Is Brazil becoming
deindustrialized, Revista Latinoamericana de economia, vol. 45,
number 178, 2014
The great
deindustrialization
3 decades of industrialization was dismantled within
one decade
%
of
industry
in
GDP
Lula government
20%
15%
“import substitution policy” Neolibral policy”

Service industry occupies larger
percentage of GDP
• On the other hand, services sector grew from 9% of GDP
in the 1970s to 30% in 2007.
• A country still in development should not shift the GDP
from industry and infrastructure to services. Service
sector can facilitate the economy, but does not increase
wealth of a country.

Side effect #2: Brazil at the mercy of US
interest rate
• In 1994, as Cardoso controlled the inflation, in the US, the Federal
Reserve was doubling interest rates, from 3 to 6 % in twelve months.
FDI was lured back to the US for high interest rate, fled Brazil.
• The Central Bank lost $9.8 billion of foreign reserves between the
Q4 of 1994 and Q1 of 1995, as net capital inflows were insufficient to
finance the current-account deficit, and suffered the first speculative
attack on the currency in March 1995 after a mini-devaluation.
• The cornerstone of its defense of the real was an increase of
interest rates from 42.4 % to a stratospheric 64.8 % in the first half
of 1995, provoking an immediate economic recession and ending the
consumption boom the currency had initially triggered.
• The situation was eased in 1996 not because of what Brazil did, but
because US reversed and lowered interest rates from summer 1995
through early 1996.
• That is: Brazil lost control of its economy destiny.

Brazil danced with the US interest
rate…
• In 1997, the US Federal Reserve raised interest rates again
setting off financial crisis throughout East Asia.
• In October , $17.5 billion fled the country and $8.5 billion of
foreign reserves were spent defending the real (waste money).
• Brazil responded by raising the interest rates from 22 to 43 % to
reverse outflows of foreign capital (suffocated domestic industry
and consumer in exchange for nothing).
• Fiscal screw tightened with a wage freeze and job cuts in the
state sector, throwing the economy into recession and increasing
unemployment.
• These measures temporarily halted the capital outflow (The
money still belonged to foreigners).
• Foreign reserves rose to a historic high of $74 billion the April
1998.
• However, this comes at the cost of extremely high interest, which
decimated the domestic industry.

Due to recession and high interest
rate, deficit went to all time high..
• In 1995 the public sector had a primary surplus ( before
adding debt service to expenditure) of 0.36 % of GDP,
but the interest expenditures was 5.24 %, therefore, an
operational deficit of 4.88 % of GDP.
• In 1996, the primary balance moved to a deficit of 0.09
% of GDP, and a massive bail out of domestic private
banks to the tune of R$20.8 billion.
• By 1998, the deficit had climbed to 8.02%, consisting
entirely of interest payments.

Brazil lost sovereign of monetary
policy
• Two foundations of Real Plan (dollar peg and
attraction of FDI) forced Brazil to give up its
control of interest rate.
• Every time, when US raised its dollar interest
rate, Brazil will have to raise the rate much more
to keep the two foundations of Real Plan intact.
• Otherwise, the Real Plan collapses.
• In effect, Brazil has given up it sovereign of
monetary policy voluntarily.

Roller coaster ride continues….
• However, the problem of Brazil did not end in April 1998.
• Russian default in August 1998, and the plunge on Wall Street that
autumn brought another crisis to Brazil - Brazil’s foreign reserves
were slashed in half to defend the real (wasted money again), in
just two months. Interest rates went back up to 49.75 % in
September.
• IMF bailed out Brazil with $41.5 billion loan to postpone the now
inevitable collapse of the currency (In essence, Brazil spent the
borrowed money to defend Real).
• IMF’s intervention worsened the underlying situation. The Fund’s
intention was not to save Brazil rather to protect foreign lenders by
preventing Brazil from default.
• When IMF comes in to bail out a Third World economy, it always
calls for austerity squeeze the country to pay back its debts.
• Brazil became hostage of IMF, and could not pursue its own
economic policy anymore.

Lesson learned: defending currency is
throwing money away…
• In mid-January 1999, with billions of dollars a day pouring
out of the country, forced the government to abandon the
defense of the currency and allow it to float on world markets
(All the reserves used to defend Real are now officially lost).
• The exchange-rate anchor, the centrepiece of the Plano Real,
was blown away, and with it $50 billion in foreign
reserves wasted on its defense since August. (It would
be wiser to use this $50 billion to pay external debt.)
• After giving up the dollar peg, the Real plummeted by 40%
against the dollar.
• The premises of Cardoso’s economic strategy lay in ruins.

FDI understands Brazil’s problem better
than Brazilian government…
• In 1998 and early 1999, many FDI fled. They were aware
of the extreme fragility of Brazil’s financial situation,
since the stratospheric interest rates needed to prop up
the currency could only lead to a dramatic rise in the
servicing costs of the domestic public debt.
• Investors thus had every reason to fear that the
government might be unable to keep up interest
payments and be forced to default on its domestic debt,
with knock-on effects on its dollar-denominated debt.

Lesson learned: asking for help without self-
improving does not work for long term
• The devaluation helped Brazilian export and Brazilian
GDP grew to 4.4 % in 2000. This should have been done
long time ago. The benefit of lower Real came at a cost
of many billion dollars.
• But from late 2000, as Brazil was hit by a series of
international shocks—the deteriorating global
conjuncture, looming default in Argentina, a domestic
energy crisis triggered by investment cuts and a badly
managed privatization program—the inflow of foreign
capital contracted sharply and the currency fell further.
• The government responded by raising interest rates
again in early 2001, and begging the IMF for further
support.

• In August 2001 a new Agreement was signed with the
IMF, for $15 billion loan (This is peanut comparing to
the $50 billions thrown away.)
• This package did not do much as expected.
• The economy deteriorated markedly in 2001. GDP
growth fell from 4.4 % in 2000 to 1.5%.
• Even with the seal of IMF help, the influx of foreign
capital dropped by a third.

Lesson learned: raising rates to attract FDI
increases domestic debt burden dramatically. It
does not pay…
• By the end of 2001, FDI was down to $22 billion. Real
had lost 44 % of its value between January and October.
• The result was a further escalation of the internal public
debt, which rose from 49.4 to 53.3 %of GDP—R$563 to
R$661 billion—and of the operational deficit, which
jumped from 4.5 to 8 %of GDP in 2001.
• The slow down in consumer market and scale of
devaluation cut imports, generating the first-ever trade
surplus since the Plano Real was proclaimed, however,
there was no improvement in the current account due to
the service of debt.

Lesson learned: Hard earned money from export
was used to pay interest to foreigners just to
keep the money in Brazil…
• Earnings of $2.6 billion on the trade balance were
dwarfed by Brazil’s debt-service obligations.
• All interests paid to FDI are in dollars.
• The un-sustainability of Cardoso’s neoliberal model had
never been so plain.

How did FDI create public debt?
• When FDI brings foreign currency to Brazil, the government keeps
the foreign currency in the reserve, and exchange Reais to the
foreign investors.
• During this process, the government borrows money (reais) from
public by issuing bonds instead of printing reais to avoid excess
liquidity.
• Such bonds are linked to the exchange rate or overnight interest, so
that the government transfers the risk of exchange rate or interest
rate to the bond holder.
• The more external funds are converted into reais, the more the
government sells treasury bonds.

• Therefore, the influx of FDI became one of the most important
forces behind the rise of the internal public debt.
• According to the IMF, by May 2002 over three-quarters of the
domestic public debt was linked either to the overnight interest rate
or to the exchange rate. In other words, three-quarters of the
domestic public debt was generated by FDI.
• The increase in public debt greatly increases the debt burden. The
government had to pay bondholders the interest.
• The primary surpluses were not nearly enough to cover the interest
payments on a public debt that continued to grow, from 28.1 % of
GDP (R$192 billion) when Cardoso came to power in 1994 to 56 %
by May of 2002 (R$708.5 billion).
• And such payment came from taxation.

Brazil was essentially looted by FDI…
• Taxation jumped from 28 % of GDP in 1995 to 29.7% in 1998
and to 35.9 % in 2004, the highest level in Latin America.
• This increase in tax was not used to benefit people, or improve
public services. It was used to pay interests to the foreigners.
In fact, the infrastructure, health, education and public safety
all deteriorated.
• The tax increases were both direct, hitting the working and
middle classes, and indirect, which weighs heavily on the
competitiveness of national products, at home and abroad.
• The social impact of indirect taxation on goods and services
transactions is also highly regressive.
• While families that have a monthly income of up to two
minimum wages lose 26.48 % of their income in indirect
taxation, families whose income is above 30 monthly
minimum wages lose only 7.34 %.

Lesson learned: Big sacrifice for small
gain…
• Cardoso exercised fiscal discipline to achieve primary
surplus to offset the impact of interest payments on the
public deficit and restore the confidence of foreign and
domestic investors by slashing public expenditures and
raising revenues through taxes, cutting personnel and
retirement benefits, and privatizing strategic state
enterprises in the infrastructure and service sectors.
• These austerity packages greatly sacrificed Brazilian
people but making foreign investors happy.

Lesson learned: Never incur debt that
you cannot pay..
• With great sacrifice, the government was able to
produce primary surpluses R$31.1 billion (3.2 %
of GDP) in 1999; R$38.2 billion (3.5 %) in 2000,
and R$43.6 billion (3.7 %).
• By any measure, Brazil is now one of the most
severely indebted countries in Latin America.

8% of GDP pays interest..
• The IMF’s World Economic Outlook for 2002 reveals
that between 1996 and 2000 Brazil’s overall interest
payments amounted to 8 % of GDP and 20.5 % of total
public expenditure.
• The IMF has pointedly warned the Cardoso government
of the vulnerabilities of the Brazilian economy.
• With all negative aspects of FDI, if FDI could put into
constructive use to build up more industry as it was
envisioned by Cardoso, it might have some benefit.
• But it did not.

Lesson learned: Brazil was on fire
sale..
• Mergers and acquisitions of private firms have been central to the
restructuring of the Brazilian economy promoted by Cardoso.
• They have operated as a mechanism of de-nationalization.
• Between 1995 and 1999 there were 1,233 mergers and acquisitions
in which multinational corporations acquired control or
participation in Brazilian industries—the devaluation of the real
since 1999 making such purchases cheaper.
• A KPMG survey reveals that 70 % of all acquisitions in Brazil during
the same period were undertaken by multinationals, to the tune of
some $50 billion of FDI inflows. (Why not using $50 billion lost to
defend Real to buy these domestic industries??)
• Rapid import liberalization and sky-high interest rates have been
the most important factors in the displacement of local capital,
forcing large numbers of Brazilian firms, including major industrial
groups, either to close down, ally with or sell out to multinationals.

Lesson Learned: FDI did not come to
invest in Brazil, they came to devour
Brazil..
• With all the sacrifices Brazil made, not only FDI did not help
Brazilian economy, but it had devastating impact.
• Most overseas investors have not geared their investment to build
new plants, expanding production and boosting employment, but
rather to acquire existing ones, either by taking over private firms or
buying up state enterprises put on the auction block.
• Between 1995 and 1998 FDI accounted for 42.1 %of the value of
privatizations. Telebras was 66.7% owned by FDI originally, and
increased later when Globo and Bradesco disposed of their share to
Telecom Italia.
• Cardoso regime has unknowingly assisted this displacement of
domestic capital: in 1999, for instance, the BNDES advanced half
the purchase price ($360 million) of the São Paulo energy company
CESP-Tietê to the American Company AES, cutting out the Brazilian
group Votorantim controlled by Antônio Ermírio de Moraes.

Lesson learned: Profits of these
companies were siphoned to their
foreign owners…
• Foreign acquisitions were particularly intense in such sectors as
autoparts, banks, steel, food, drinks, dairy products, hygiene and
cleaning, electronics and chemicals.
• Between 1995 and 2000, many traditionally powerful Brazilian
ownership disappeared:
▫ Metal Leve of the Mindlin family was bought out by the German
firm Mahle,
▫ Autoparts company Cofap was bought by the Italian Magneti
Morelli,
▫ the steel company Villares by the Spanish Sidenor;
▫ In the banking sector, Excel Economico was picked up by the
Banco de Bilbao,
Foreign acquisitions were particularly intense in such variegated sectors as autoparts, banks, steel, food, drinks, dairy products, hygiene and cleaning, electronics and chemicals

▫ Garantia by Crédit Suisse,
▫ Bamerinduis by HSBC, Real by the Dutch ABM-Amro.
▫ Such local brand names as Arisco, Pullman, Lacta, Aymore, Cica or Café
Pilão in the food industry have disappeared, annexed respectively by
Goldman Sachs, Bunge International, Philip Morris, Danone and Sara
Lee;
▫ in the electrodomestic, supermarket and clothing sectors, it has been the
same story—Arno, Eldorado, Pão de Açucar and Renner falling to the
French firms Seb, Carrefour, Casino and J. C. Penney.
• As VEJA magazine, an unflagging supporter of Cardoso’s regime, puts it:
‘The history of capitalism has seen very few transfers of control as intense
as this, over a short period of time.’
• Brazil industrial landscape becomes a semi-conlony.

Lesson learned: through privatization,
Brazil lost control of many national
industries and banks…
• Exceptions: There are some Brazilian groups took advantages to
acquire monopoly positions using foreign capital during the course
of the privatization process.
▫ An outstanding case is the largest Brazilian private group, Steinbruch,
which bought a majority stake in the state mining giant, Vale do Rio
Doce, in partnership with overseas capital and financial support from the
American NationsBank.
▫ Others, such as Odebrecht and Mariani in petrochemicals, Vicunha in
steel, and Bradesco, Itau and Bozanno in the financial sector, are
representatives of a newly internationalized capitalists that has profited
hugely from the privatization.
• However, in general, displacement of local by foreign capital, rather
than association with it, has been the hallmark of the Plano Real.

Did foreign owners bring
modernization to their acquired
companies?
• One might argue that the foreign ownership can bring more efficient
management and expand the overseas market. How far has this
denationalization been compensated by a productive modernization
of the Brazilian economy?
• The import-intensive service sector offers one answer. Between 1995
and 2002, the share of total FDI in this sector increased from 43.4
% ($18.4 billion) in 1995 to 76.6 % 2002 ($97.3 billion).
• The deregulation and privatization of electricity and
telecommunications, and a torrent of acquisitions and mergers,
accelerated the abandonment of local R&D for intra-company
technological imports. The bill for capital goods from abroad
jumped from $7.5 billion in 1994 to $14.8 billion in 2001, and for
intermediate goods from $15.6 to $27.3 billion for the same years.

• Since Telebras was privatized in 1998, multinationals have been
importing 97 % of the components required to upgrade Brazil’s
antiquated phone system.
• The price tag for electronic components alone— especially chips—
reached $5 billion in 2000.
• As one economist has remarked: ‘While the consumption pattern of
information technology in the developed countries was diffused in
Brazil in the nineties, there was an undeniable regression in
production.
• The strategy of foreign corporations in Brazil has been perfectly
rational. You cannot rely on multinationals to perform the role of
national development.

Lesson learned: You cannot expect
foreigners to come to upgrade Brazilian
industry. They are here to make money…
• ECLAC economist Michael Mortimore’s case study of FDI in Brazil’s
service sector shows that the major goal of multinationals is usually
to gain access to the national market, not to maximize export, let
alone employment, and is achieved primarily by purchasing existing
assets, not creating new ones. While meeting the objectives of
corporate strategies, the growth and development goals of the host
countries were not.’
• Rubens Ricupero, Secretary-General of UNCTAD, echoes him: ‘the
commercial objectives of foreign owned companies and the
development objectives of host economies do not necessarily
coincide’.

Lesson learned: Multinationals discouraged
local development, but rather imported
parts from their home countries…
• In the case of the automotive and autoparts industries, Ricupero
notes that major national enterprises known for their capacity for
technological innovation—Metal Leve, Freios Varga, Cofap—
suffered immediate degradation after being sold to multinationals.
Here the import penetration rose from 8 % in 1993 to 25 % in 1996.
• The story has been the same in the telecommunications and
computer sectors, where multinationals have largely suspended
local research and development and transferred engineers from
labs to marketing, production, sales and technical assistance.
• In these conditions, Ricupero comments, ‘it is not surprising that
the import penetration jumped from 29 % in 1993 to 70 % in 1996’.

Lesson learned: Foreign money did not
want to invest in plants and equipment
• Despite the huge inflow of FDI, fixed capital investment
in Brazil has been miserable—even well below the level
of the supposedly disastrous eighties, when it was at 22.1
% of total investment.
• By contrast, in 1999, when FDI hit an all-time peak of
$30 billion, the fixed capital investment dropped to 18.9
% of total investment.
• Not only FDI did not invest in the fixed capital, its
impact on the interest rate depressed domestic
investment in doing so.

Lesson learned: Brazil already had precious few
industries, and yet they were destroyed by FDI..
• Another study has found that between 1994 and 1997,
local production of capital goods fell overall by 10 %.
• De-nationalization, in other words, has been
accompanied by a real measure of de-industrialization.
• The multinationals has not promoted higher rates of
capital accumulation nor greater international
competitiveness.

Critiques of Real Plan
• The Real Plan was disastrous for the country’s foreign
accounts and public finances: from a fairly orderly
balance of foreign accounts in 1994 the country went to a
deficit of $33 billion in 1998 and the ratio of net public
debt/GDP went from 30 % to 43 % in just four years!
• The country’s external vulnerability made it highly
sensitive to the foreign crises that shook the world’s
finances starting in the late 1990s and forced Brazil to
tighten its economy.

Is FDI all bad?
• However, we cannot say that FDI’s are all bad. After all,
China has been the largest recipient nation of FDI for
many years. Just in the first six months of 2012, China
received $59.1 billion FDI. [www.reuters.com/article/us-china-us-
investment-idUSBRE89N0EZ20121024]
• And China has successfully uses FDI to boost its domestic industry.
• FDI is only one element of the investment. If FDI can buy parts in
Brazil cheaper, there is no reason for them to import.
• The bottom line is whether you can provide competitive advantages
to the FDI.

Fortunately, Brazil still has
commodities….
• After the deindustrialization, Brazil’s exports remain
concentrated in traditional commodities—agricultural,
agro-industrial and mineral—and the country has been
unable to increase its share in world-manufacturing
exports.
• A 2002 UNCTAD study shows that between 1980 and
1997, Brazil’s share in world exports of manufactures
remained the same, 0.7 %, and, significantly, that its
share in value added world manufacturing fell from 2.9
% to 2.7 %.

Brazilian industry expansion during
Miracle years and Plano Real years
Agriculture Industry Services GDP GDP per cap
1957 4.6 9.9 8.3 7.7 4.5
1958 –2.2 21.4 5.9 10.8 7.6
1959 2.1 16.0 8.1 9.8 6.6
1960 13.5 7.2 10.0 9.4 6.2
1961 5.7 11.6 11.7 8.6 5.6
1968 4.4 13.3 – 11.2 8.1
1969 3.7 12.1 – 9.0 6.8
1970 1.0 10.3 – 8.8 5.8
1971 11.4 14.3 – 13.3 10.2
1972 4.1 13.3 – 11.7 8.7
1973 3.5 15.0 – 14.0 10.8
1995 4.1 1.9 4.5 4.2 2.8
1996 4.1 3.7 1.9 2.7 1.2
1997 –0.2 5.8 2.7 3.3 1.9
1998 1.9 –1.4 1.1 0.1 –1.2
1999 7.4 –1.6 1.9 0.8 –0.5
2000 3.0 5.0 3.9 4.4 3.0
2001 5.1 1.5 2.5 1.5 0.2
Sources:
•For 1957–61, Lincoln Gordon, Brazil’s Second Chance,
Washington, DC 2001, pp. 37, 45.
•For 1968–73, Werner Baer, The Brazilian Economy, Growth and
Development, New York 1989, p. 81; figures for services are not
available.
•For 1995–2001: Banco Central do Brasil, Relatório Anual 1996–
2000; IPEA, Boletim de Conjuntura no. 57, April 2002.

Commodity came to rescue (Lula)……
• Lula was lucky because his reign (2003~2011) coincided
with the commodity boom.
• The large trade surplus allowed the foreign debt as a % of
GDP to fall from 45.87 % to 21.28 % in December 2005.
In the same period, the foreign debt service fell from
10.09 % of GDP to 6.11 %, interest payments shrank
from 3.33 % to 1.97 %.
• In late 2005, the government paid off its debt to the IMF
in full, two years ahead of schedule. After decades as the
largest foreign debtor among emerging economies,
Brazil became a net creditor for the first time in January
2008.
• His government achieved budget surplus in the first two
years, as required by the IMF.

Brazil balance of trade
Record trade surplus

• Thanks to the commodity boom, the foreign debt as a
%age of GDP fell from 45.87 % in 2002 to 21.28 % in
December 2005. In the same period, the foreign debt
service fell from 10.09 % of GDP to 6.11 %, interest
payments shrank from 3.33 % to 1.97 %.
• Brazil in 2005 shows much improved financial and
economic indicators, has greatly reduced its external
vulnerability, and is seen by the markets as being well on
the way to fiscal soundness.
• However, while the world’s economy has grown by 4.3
%, Brazil’s grew by just 2.3 %. Brazil has not been using
its better economic fundamentals and the better
international situation to restore its economic
foundation.

• In 2006, Lula announced the new Growth
Acceleration Program (the Programa de Aceleração
de Crescimento, or PAC), aimed to solve the
problems that prevent the Brazilian economy from
expanding more rapidly.
• PAC includes investment in the creation and repair
of roads and railways, simplification and reduction
of taxation, and modernization on the country's
energy production to avoid further shortages. PAC
had a forecasted budget of 250 billion dollars over
four years.

Did Lula do a good job?
• Lula’s achievement should not be judged by the
economic recovery, which was largely due to the
commodity boom, but rather how much he did to take
the advantage of this once-in-a-life opportunity to
restructure the Brazilian economy fundamentally.
• From this point of view, Lula’s government has done
nothing to alleviate the deindustrialization and
denationalization.
• This is one of the reasons that Brazil enters the worst
recession in decades, even worse than that of the lost
decade when commodity busted.

Lula continued with Neoliberailsm..
• Before becoming president, Lula had been a critic of privatization
policies.
• However, since Lula took office, he opted for a neoliberal program
and even added social program (to address the income disparity
problem).
• Since Lula’s economic policy was not different fundamentally from
Cardoso’s program, and with the added burden of social program,
the extra windfall of commodity sales went to paying down the debt
and social program. Nothing is left for industrialization.

Luisz Inacio Lula da Silva
Fernando Henrique Cardoso
End of commodity boom

• The Cardoso government had to face a series of international and
domestic economic storms that checked growth, including
▫ the Mexican financial crisis (1995),
▫ the crisis in Southeast Asia (1997),
▫ the crisis in Russia (1998)
▫ the cooling of the U.S. economy and the effect of the 9/11 attacks (2001),
▫ the crisis in Argentina,
▫ the energy crisis (2001)
• However, during Lula’s government, the international economy was
relatively calm, except the 2009 financial crisis, and he received the
windfall of high commodity price. And yet, the growth has remained
low and difficult.
• In particular, he was not able to reverse the trend of
deindustrialization. In fact, in 2012, Brazil’s industry output as a
percentage of GDP is much worse than 1947.

Industrialization – the key to
prosperity

One picture says all:
Shares of industry in GDP
Fernando Mattos and Bruno Fevereiro: Is Brazil becoming
deindustrialized, Revista Latinoamericana de economia, vol. 45,
number 178, 2014
The great
deindustrialization
3 decades of industrialization was dismantled within
one decade
%
of
industry
in
GDP
Lula government
20%
15%
“import substitution policy” Neolibral policy”

Great debate – how did the industry go
away?
• Three decades of industrialization was undone
within one decades.
• There is no dispute of the fact of
deindustrialization, but how it happened is a
subject of great debate.
▫ [O futuro da indústria no Brasil: desindustrialização e O futuro da indústria no Brasil:
esindustrialização em debate, José Alderir Silva, Indicadores Economicos FEE, v. 41, n. 2]

Most economists agree
• Reason #1: High interest rates.
• Reason #2: Deindustrializatrion as a direct result of mis-use
of FDI.
• Reason #3: High taxs.. raise the “Brazil cost,” lower profit
margins, and cool off the domestic market by taking away
income from the population.
• Reason #4: Cuts in public expenditure.. has fed recession and
kept the government from making investments in the
infrastructure that could improve private-sector expectations
and kick in new investments by convincing businessmen that
there would be wider limits to their expansion.
• Reason #5: Cuts on investments, health and education. Public
investment reduced to a mere 0.5 % of GDP.

• Reason #5: Low investment..Brazil has a rate of
investment that is below that of every major region in
the world, according to research carried out by Brazil’s
National Confederation of Industries (CNI). While the
world has registered an average investment rate of 22.1 $
of GDP from 1995 to 2004, Brazil has registered one of
just 19.3 %. The Asian emerging economies invested an
average of 32.6 % of their GDPs per year, followed by the
Eastern and Central European countries with 23.9 %.
• However, these reasons are the reaction to the problem,
not the root cause of the problem. Brazil has to work to
eliminate these “reasons”.

http://monthlyreview.org/2007/02/01/the-brazilian-economy-under-lula-a-balance-of-
contradictions/

• Brazil has fallen behind developed economies, emerging
economies, and even other economies in Latin America
in growth in GDP per capita.
• There is no justification for the lack of growth from the
commodity boom period.
• The only explanation is that the economic foundation
was not strengthened during the commodity boom years.
• The country once again missed the golden opportunity to
correct many of its asymmetries and problems.

Looking forward..
• In 2016, the international financial situation does not look good.
▫ The US enters 8th year of a weak recovery, and yet the fundamentals are
weak. Public debt hits $20 trillion, more than doubled in the last 8 years,
and the interest rate is near zero. It can only go up. Recently, treasury
bond yield jumped up fast.
▫ China’s growth rate is slowing down, which reduces its commodity
purchase.
▫ Japan continues in its depressed state with huge debt due to population
aging.
▫ Europe is also in bad shape. Several countries are in the default states.
▫ Both Europe and Japan have printed more money than the US.
▫ Trade protectionism and nationalism are on the rise.
▫ Widening gap of rich and poor in every corner of the world.
▫ Population aging in developed countries put stress on the economy
• All these events are not in favor for Brazilian economy to grow.

• For Brazil, to reconstruct the industry is urgent.
• Without rebuilding the industry, Brazil’s economy will depend
largely on commodity, and will subject to impact on
international interest rate, which may go up substantially.
• Last time, it took 30 years. It will take longer, if the world
economic environment is favorable.
• Meanwhile, the world is not standing still. The new industries
are springing up, which will leave Brazil even further behind.
• The European Industrie 4.0, China Manufacturing 2025, and
the US IoT and Big Data Program all require highly
sophisticated technology and manufacturing base. To play
catch up and finding a cut-in point can be difficult.

• However, even in the difficult environment, a
single step moving in the right direction will
make the economy one step forward.
• We will propose steps Brazil must be taking to
get out of this vicious cycle.
• But first, let us understand how economy works.

Economic activities
• Economic activities require
an exchange of product/
service for money:
▫ Product is made from raw
materials. Such a
transformation requires
technology and knowhow.
▫ Service is a specific form of
act, which also requires
knowhow.
▫ Money is a stored value.

Transactions and economic activities
• GDP is the sum of all economic activities in a
country during a year
• Some transactions do not generate economic
activity, such as
▫ Interest payment
▫ Donation
▫ These transactions do not contribute to GDP

Efficiency of the economy
• Economy efficiency derives from specialization
and division of labor, and the use of money as a
medium of exchange
• Efficient economy requires an efficient monetary
system, the use of machinery and capitals, the
institution to channel savings into capital goods.
• These institutions include banks, capital market
and money market, etc. (the financial system)

High interest rate means insufficient
money in circulation
• Like anything else, the cost of money (interest
rate) depends on the supply and demand of
money in circulation
• The important concept is “circulation”, not the
actual “supply”
• The money not in circulation is not available for
transaction.

Money is a measure of value
• Since money is used to exchange goods, it is a
measure of value, or price
• When the price level changes, it has negative
impact on the economy

Money Velocity
• It is not only the supply of money that matters,
the velocity of the money also impacts the
economy.
• The velocity of money is
▫ Total demand (nominal GDP) / money supply (M1
or M2),
▫ It is the rate of turnover in the money supply
M
GDP
V =

Velocity of US M2 Money Supply
1997

US GDP Growth
GDP growth slows down from 1950 to 2015

US Money Supply M2
http://www.tradingeconomics.com/united-states/money-supply-m2
1997
M2 starts to accelerate
Slow M2 growth
period

Money velocity and economy
• When an economy is healthy, money tends to flow
fairly freely.
• But when economic conditions start to get tough,
people start to hold on to their money. That means
that money doesn’t change hands as quickly and the
velocity of money goes down. When a recession
ends, the velocity of money normally starts going
back up.
• Except a few cases, such as interest payment,
donation, money exchanges hands only when there
is an economic activity.

• In the US, the money velocity goes down from 1997
to 2016. This is because the money supply M is
increasing faster than GDP or the economic
activity.
M
GDP
V =
 US growth rate continues to drop while money supply
increases exponentially
 The fact is that even when M increases drastically, it is
not exchanging as fast, therefore, GDP stays more or less
the same.

From velocity and M2, we can
calculate GDP growth
• Take the velocity and money supply numbers from the charts
and use the V= GDP/M equation, we can determine the US
GDP growth rate.

• GDP is the total economy of a country. It can also be
expressed as the product of price and product or service, if we
consider GDP is a sum of all the transactions or trades
involving products and services.
M
D
P
M
GDP
V /
*
=
=
● P is the price and D is the demand.

Inflation
• Inflation is price increase to obtain a product
or service, or higher P in the equation.
• It is caused by either increasing V*M or
decreasing D.
• When there are more money chasing a fixed
amount of goods and services, price goes up.
• When there is less goods and services available
for purchase, price also goes up.
D
M
V
P
or
M
D
P
V
*
/
*
=
=

Inflation
• Conceptually, a large money supply can cause inflation.
• However, money supply is only one of the many factors that
cause inflation.
• When increased money supply M is matched by the decreased
velocity V, V*M stays the same, there is no inflation.
• When the interest rate goes up, people tend to keep more
money in the bank, velocity goes own. Therefore, interest rate
increase is effective in combating the inflation.
• There is a limit how much V can go down, because when V
goes to zero, no trade happens (nobody buys or sells
anything). This is impossible.
• However, there is no limit to the increase of M for the fiat
money. Loose money policy may lead to hyper-inflation.

Inflation and Deflation
• When demand exceeds supply, the price level
goes up and it is inflation
• When supply exceeds demand, the price level
goes down and it is deflation
• However, if the money supply increases, it will
also increase price level
• Therefore, when the money supply changes in
sync with the demand, price level can be
maintained.

High Interest Rate
• High interest rate may combat inflation but it is
detrimental to the business because the cost of credit
goes up. More money needs to serve the debt rather than
paying salary or invest in the equipment.
• Many business cannot survive in the high interest
environment and can go under. This in turn reduces the
services and goods available to the market and drives up
the price more.
• The efficiency of economy also goes down because of the
disruption of the supply chain. For example, if the price
of fuel goes too high, it may not be economically feasible
for farmers to haul their products to the market and let it
rotten in the field. Factory may not find the components
available to make its own products.

Money Velocity and Economy
Efficiency
• High interest rate reduces money velocity,
because it discourages lending
• Low efficiency or productivity also reduces
money velocity.
▫ Since money changes hands only when transaction
occurs, when there is nothing to transact, money
does not change hands.
▫ Therefore, a transaction requires also a product or
service.

Example
• In a restaurant of 20 tables,
▫ If it takes 30 minutes, from ordering to finishing
serving, in one hour, there can be 60 transactions.
(assuming that there is no shortage of customers)
▫ If it takes one hour from order to serve, there can
only be 30 transactions.
• The efficiency in the 1st case is 2x of the 2nd case.
The money velocity is also 2x. The 1st case
economy is 2x of that of the 2nd.

• When everything else being equal, higher
productivity means larger money velocity.
• Since the restaurant charges the same price per
serving, 2*V means that demand must be
doubled (or 2x more people served)
• If the demand stays the same in both cases, the
velocity stays the same.
• That means, even the restaurant serves faster,
since the demand does not change, the
transactions stay the same.
P
M
V
D /
*
=

• In an economy, then productivity increases,
more products and services are offered, people’s
income also rises, which increases demand.
• At constant price P (no inflation) and money
supply M, demand D will increase in sync with
the velocity V.

Money Velocity and Interest Rate
• Since velocity is determined by the transaction
rate, fewer transaction means slower velocity.
• For example, if it takes 20 days to haul $1 m
products to market, instead of 10 days, this $1 m
will stay in the bank for 10 more days, and not in
circulation.
• For a country with low efficiency, and fixed
money supply, the money in circulation will be
more scarce.

• When the money is more scarce, it will cost more to
borrow the money, and thus, the interest rate will be
higher.
• In Brazil, the interest rate is always high because of
its low velocity, which is due to low turn over rate.
• The low turn over rate is due to low efficiency in the
economy.
• To solve the problem of scarcity of money in
circulation, Brazilian government resolved to
increase money supply, this in turn caused rampant
inflation.

Why the velocity of money is
important?
• Case 1 - $100,000 capital that turns in 2 months
and each turn generates a profit of $10,000
• Case 2 - $100,000 capital that turns once a year
and each turn generates the same profit
($10,000)
• In case 1, the total profit per year is $60,000.
• In case 2, the total profit per year is only
$10,000

What if scenario of Brazilian
economy..

What if Brazil had a truly competitive industry
before and during the economic miracle?
• Brazil started industrialization relatively early comparing to most
Asian countries. For example, General Motors do Brasil was
founded in 1925, only 17 years after the founding of GM in the US
and opened its first factory in 1930. It is the largest subsidiary of the
General Motors in South America and the second largest operation
outside the United States.
• Although Brazil was a relatively high income country comparing to
East Asian countries, its labor was still much cheaper than the
developed countries.
• In the 60’s, multinationals started to do outsourcing to reduce the
cost of their products. With well established base of industry, it is
conceivable that Brazil should be the first choice of outsourcing, not
for the labor intensive products, but for higher value products. This
would allow Brazil to move up the food chain. If this had happened,
Brazil could have been well on its way to the second phase of
industrialization.

What if Brazil had accumulated a lot of saving
during the years of economic miracle?
• If Brazil had large savings during the economic
miracle, it would need to borrow less money
from foreigners, it could be self-sufficient in
capital for the development during the Geisel
administration.
• Without so much debt, Brazil would be free from
the impact of high dollar interest rate in early
80’s. It would not have to be in the sink hole as it
found itself in during the lost decade.

What if Brazil let its currency to
devaluate?
• Without artificially popping up its currency,
Brazilian industry would be more competitive. It
could export more and import less (for
consumer goods). The currency would naturally
balance out the effect of high interest rates.

What if Brazil restricted FDI in
investment scope?
• Instead of letting FDI to freely buy existing Brazilian
industry, Brazil could restrict FDI to build new
plants, to be used only as fixed capital to buy plants,
equipment or any productive means, or continue to
enforce import substitution policy, or even better to
create special economic zones for the export only
industries, as most of Asian countries did, and
prohibit FDI to make quick gains in the financial
market or interest?
• It is true that FDI would be reduced, so be it.

What if Brazil had set up value added
commodity industry?
• Instead of exporting raw iron ores, Brazil could
have built iron and steel mills to process raw
materials and export irons and steels instead.
• Brazil had good metallurgical industry, and
setting up more raw materials processing
factories was not an issue.
• Brazil could have maintained higher level of
industrialization and received much more than
just exporting raw materials.

Principles
• Manufacturing is the foundation of economic
growth, the key to higher living standards and the
future of the middle class.
• Adam Smith was the first to realize that the Wealth
of a Nation was not in the accumulation of
commodities nor in the resource reserves that a
nation may happen to possess. But rather wealth
exists in the productive knowledge of its people. The
ability to efficiently transform resources (factor
inputs) into desired goods and services represents
the true source of a nation's wealth.

Industrialization and productivity
• Based on the above discussion, we understand that the
productivity is the base of a sound economy.
• A nation, which produces more than consumes, will
accumulate wealth.
• A nation, which consumes more than produces, will
accumulate debt.
• Money facilitates the exchange of goods and services. It
is a lubricant to help creating wealth by production.
Without creating the real wealth through production, no
money can help.

Industrialization is the key to wealth..
• The highest priority Brazil need to attend is the
restoration of its industry.
• To do it, Brazil needs
▫ Capital
▫ Efficiency
▫ Knowhow
• Apparently, to obtain any of these three
conditions are difficult, but Brazil has to start
somewhere.

Gross capital formation of %GDP
(China vs. Brazil)
Brazil
China
Source: World Bank national accounts data, and OECD National Accounts data files.

• To achieve rapid industrialization, the formation of
capital needs to be at least 30% of GDP.
• To reach such a goal, debt service must be drastically
reduced – this means that the debt as well as the interest
rate has to be reduced.
• Currently, Brazil spends 9% GDP to service the debt. If
Brazil can reduce it from 9% to 5% and added the saving
to the capital formation, the capital formation can be
increased from 17.7% to 21.7%.
• This can be achieved by reducing both the debt and
interest rate by 25% from current level.

• This is a gigantic task that Brazil was not able to do in
the last 30 years. But if it is not done, Brazil will be
slipping backward more and more.
• The debt level should be reduced without increasing the
taxation.
• In fact, export industries should be the target of tax
reduction to improve international competitiveness.
• Any improvement in trade balance generates capitals.
• Government policy should encourage savings, for
example, tax deferred retirement saving accounts.
Savings should be channeling toward the capital for
industrialization.

• Priority should be given to create export oriented industries. Setting
up special economic zone (SEZ) is a way to go.
• A SEZ is an area in which business and trade laws differ from the
rest of the country. Therefore, it is relatively easier to implement
because it does not touch the policies and laws of the country.
• SEZs are usually located near country’s major logistic centers, where
the infrastructures are excellent to promote efficiency. The aims are
to increase trade, investment, job creation and have effective
administration.
• To encourage businesses to set up in the zone, government should
provide special financial policies with regard to investing, taxation,
trading, quotas, customs etc. Companies may be granted a period of
lower taxation.
• The benefits a company gains by being in a special economic zone
may mean it can produce and trade goods at a lower price, aimed at
being globally competitive.

• Industrial parks with special incentives should be set up in the
major industrial zones, such as Sao Paulo or Rio with foreign
investment.
• Brazil’s Manaus Free Trade Zone is an example of SEZ. However,
geographically, it is too far away from the major logistic centers, so
that it loses the many advantages of efficiency and productivity.
Furthermore, the large population cannot be benefited from the job
creation in Manaus.
• China set up its first SEZ in Shenzhen in 1980, and later on
expanded to five cities. It helped China tremendously, and it is still
expanding today.

Import Substitution Industry
• With the failure of neoliberalism, Brazil should re-establish
the ISI policy.
• This is specially urgent today because even the traditional
industries, such as lighting, TV, cell phone industries are gone
due to the technology evolution.
• Re-establishment of ISI policy using SEZ can quickly build up
ISI, and lure back FDI using large Brazilian market rather
than high interest rate.
• ISI policy can set up industries without regards to its
international competitiveness initially. The industry efficiency
improves when the scale becomes larger. With the size of
Brazilian market, once ISI fully satisfies Brazilian internal
market, the scale is large enough to reduce cost.

Foreign Exchange Certificate (FEC)
• FEC is a tool for foreign exchange control in countries where the
national currency is subject to exchange controls or is not
convertible. Some of the main types of FEC are:
• A certificate for purchasing foreign currency at a specified rate,
often for a specified purpose, such as financing imports. This type of
certificates were required in many European countries after World
War II.
• A certificate denominated in local currency, which the foreign
citizens are required to use for some or all of their purchases. The
exchange rate may be more favorable for the visitor than the official
commercial rate. The purpose is to channel the foreign exchange to
the state coffers instead of the black market. This type of FEC's were
in use in China in 1980–1994.

Foreign Exchange Certificate (FEC)
• A certificate denominated in foreign currency, to which the local
citizens are required to exchange any foreign currency they manage
to get possession of. These certificates may be accepted as payment
in specific stores, or zones. This type of FEC's were applied in the
Soviet Union in 1961–1991.
• For Brazil, the use of FEC in SEZ can avoid the problem that
government needs to issue public debt, which has negative effect as
discussed.
• By doing so, FDI will not cause public debt problem, and will be
limited to SEZ, which is easy to monitor and administer, to
determine whether certain FDI meets its specific goals.

• In this case, Brazil can maintain low Real exchange rate
to promote export and yet attract FDI without sacrificing
the domestic impact of FDI, since the circulation of FEC
is limited in the SEZ.
• With low tax, good logistics, and ample supply of skilled
labor, there is no reason the SEZ would not be
successful, initially as ISI, and later on for export.
• Since SEZ requires FDI to set up new factories, the pitfall
that FDI buys existing Brazilian industry and use it as
platform to enter Brazilian market without bringing new
knowhow and fixed capital will not happen.

China SEZ experience -1
• The SEZs and industrial clusters have made crucial contributions to China’s economic
success. The first few SEZs successfully tested the market economy and new institutions
and became role models for the rest of the country to follow.
• SEZs have contributed significantly to national GDP, employment, exports, and attraction
of foreign investment.
• The SEZs have also played important roles in bringing new technologies to China and in
adopting modern management practices.
• It is estimated that as of 2007, SEZs accounted for about 22% of GDP, about 46% of FDI,
and about 60% of exports and generated in excess of 30 million jobs.
• In 2007, the 54 HIDZ’s (Hitech Industrial Development Zone) hosted about half the
national high-tech firms and science and technology incubators. They registered some
50,000 invention patents in total, more than 70 % of which were registered by domestic
firms. They also hosted 1.2 million R&D personnel (18.5 % of HIDZ employees) and
accounted for 33 % of the national high-tech output.
• Over the 15 years since the formation of HIDZs, they have accounted for half of China’s
high-tech gross industrial output and one-third of China’s high-tech exports. In addition,
the ETDZs are also responsible for another one-third of China’s high-tech industrial output
and exports.
http://blogs.worldbank.org/developmenttalk/china-s-special-economic-zones-and-industrial-clusters-success-
and-challenges

China SEZ experience -2
• The key experiences of China’s SEZs and industrial clusters can best
be summarized as gradualism with an experimental approach;
▫ a strong commitment;
▫ active, pragmatic facilitation of the state,
▫ pragmatism from the top leadership;
▫ preferential policies
▫ broad institutional autonomy;
▫ strong support and proactive participation of governments, especially in
the areas of public goods and externalities;
▫ public-private partnerships;
▫ foreign direct investment and investment from the Chinese diaspora;
▫ clear goals and vigorous benchmarking, monitoring, and competition;
business value chains and social networks;
▫ continuous technology learning and upgrading.

Brazil should learn from China
• The advantages of SEZ are many. It is easy to implement as compared to
the change of a nationwide economic policy. The cost is also relatively small
due to its small area. However, due to its high concentration of industries,
its potentials can be huge.
• Many industries use the same infrastructures, such as power, water, road,
airport, custom, natural gas, waste treatment. The cost of providing a world
class infrastructure in a small area is also much less. The fact that they
share the infrastructure also reduces the cost of infrastructure.
• Many industries are also in the same supply chain. Having these industries
together greatly reduces supply chain management issue.
• SEZ also attracts large pool of skill labor, since the job opportunity is
abundant.
• Since the policy is for a small zone, regulation and legislation are easy to
pass. If there is any negative impact, the impacted areas are small and easy
to correct. It is the best approach for a large country such as China and
Brazil to try different economic policies.

Joint Ventures
• If FDI is well “managed”, it should be allowed to
set up factories outside of the SEZ. The best way
to “manage” FDI is to form joint venture with
local industry. Either FDI injects directly into an
existing Brazilian company, or it forms a JV
subsidiaries with a Brazilian company.
• In either case, such a partnership guarantees
that FDI will perform its desired function:
providing fix capital.

JV in China
• FDI plays a major role in linking China’s national economy to the global economy.
• The World Investment Report (UN 1997) records that among developing countries
China has been the recipient of the largest FDI inflow, amounting to some $57 billion
in 1997.
• FDI has made a significant contribution to the Chinese economy by improving local
production, management and marketing systems.
• This is achieved through a portfolio of inputs, which include capital, technology,
management and marketing know-how.
• The success of China in attracting FDI lies in an investment climate characterised by
growing markets, increasingly favourable regulatory frameworks and the possibility
of establishing joint ventures (Beamish 1983).
• China has already become the world’s second largest economic power in terms of
GDP. This achievement is based on rapid growth, a huge population and a large
domestic market.
• IJVs are encouraged by the Chinese government, as they present an ideal form for
securing rapid access to capital, technology and export markets within a competitive
and rapidly changing global economy (Harrigan 1986).

• During the last 20 years, 195 000 foreign-funded enterprises have come
into operation and 360 000 projects have been approved in China.
• A total of over US$ 300 billions of foreign direct investment had been
committed in China by the end of 1997.
• Surveys, reported by Zhou (1997), suggest that most foreign investment
companies are satisfied with the performance of their joint ventures, as they
are meeting the financial objectives originally envisaged.
• As the joint venture is becoming a favourable investment entry mode and is
making a significant contribution to the Chinese economy, it has become
particularly relevant to gain a greater understanding of its nature.
• Joint ventures in China have their own distinctive characteristics, covering
almost the whole range of business sectors and engaging partners of many
different foreign nationalities. They range from relatively minor foreign
equity

Why China did not suffer high interest
rate due to FDI?
• China received FDI in 2015 around $250 billion.
• However, its outflow (China invests in other countries) is
also significant. In fact, its outflow exceeded inflow in
2013 (net transfer).
• Even in the earlier years, when China’s net transfer was
still positive (more inflow capital), when it compares to
trade surplus, it is a very small portion.
• Since trade surplus expands the economy, and China can
increase money supply to satisfy the expanding
economy, there is no need to raise debt for the capital
inflow.

• In addition, most of FDI to China is fix capital
investment in the form of JV or in SEZ), it is put into
productive use.
• Example: GM China has two wholly owned subsidiaries,
11 JV’s, a R&D center and a very large proving ground.

Brazil should improve productivity
• Having implementing the right policy does not
help if the execution is substandard.
• Even with the best policy in the world, if Brazil
does not improve productivity, nothing will
work.

Evidence of low productivity in Brazil
• Following is a series of piece-wise evidence of
low productivity in Brazil
• They are typical and representative
• Brazilian productivity is stagnant for the last 30
years, so is the real wage

Low productivity causes labor shortage
Brazilian Journal of Political Economy, vol 34, no. 2, pg 212, A.G. Maia and E. Menezes

Implication of productivity
• It is obvious that what the value that average
worker can produce per hour does not increase,
their pay will not be able to increase.
• The GDP of a country is the average productivity
per worker * working population * 1 year
• The increase of working population is called the
population dividend.
• Productivity can be increased in two ways:
▫ To produce more of the same product per hour
▫ To produce more of the product with higher value

Low productivity leads to low
unemployment
• During the boom years from 2000 to 2012, Brazilian economy grew
by around 5%, and yet the labor was already in shortage
(unemployment less than 5%).
• This means the economic growth is labor constrained.
• Since 1980, the Brazilian labor productivity is stagnant, while that of
the US increases by 50%.
• It is not that Brazilian workers work less, but they need to spend
much more effort to perform the same task as in the country such as
US or China.
▫ Case in the point: Brazilian Department of Vehicle does not accept payment, but
rather issue a voucher for customers to pay in the bank and come back with a
receipt. A task which can be done in 1 minute now turns into hours, depending on
the distance to the bank, and the queue in the bank.
▫ Case in the point: Doctor’s office issues a form of approval to the patient to take to
the insurance company to get approval for a medical test, instead of requesting for
approval directly to the insurance company.
▫ Case in the point: to start a company in Brazil, you need to go through the
registration three times: city, state and federal.

Low efficiency is because of low
productivity
• Reasons for low efficiency
▫ Bureaucracy, red tape
▫ Insufficient infrastructure
▫ The labor force is not productive
• Example:
▫ Average wait time for ship to dock in Santos Port is 15 to 20
days, while in Singapore, it is 7 hours, Shanghai and
Qingdao around 15 hours. The cost is high when ships wait,
and the money tied to the goods in containers is dead
money.
▫ (http://www.reuters.com/article/soy-shipping-brazil-idAFL2E8DSBGO20120228)
(https://www.porttechnology.org/news/average_ship_waiting_times_at_global_ports)
(https://www.porttechnology.org/news/busan_leads_with_lowest_waiting_times)

Low productivity causes the
government to swell
• Brazilian government spending is a large percentage
of GDP
• To pay such cost, the tax is high, so that
▫ It reduces the purchase power of people
▫ It increases the burden of business
▫ It reduces the capital formation for investment
• All these reduce the driving force for economic
growth
• When the commodity price is high, the effect is not
obvious. However, when the commodity price drops,
all the symptoms show up.

Brazilian government expenditure to
GDP ratio

Brazilian government spends more than twice than the
world average.

• Brazilian government spends 40% of GDP in
comparison with the average of 17.5% in other
countries.
• The extra spending is made up from taxes
• The taxes are heavy so that people have little money
to spend and companies have little money to invest.
• People tend to use credit cards more so to pile up
huge debt.
• Companies need to either borrow or postpone
investment.
• Debt accumulates in the private sector that further
dampens the economy

Low efficiency of the social fabric
• The inefficiency is embedded in the society
• Many daily routines require double/ triple effort

• Results are:
▫ Lowered quality of public services including
education, public hospital
▫ Middle class sends kids to private school for better
education
▫ High tax: In Brazil, people work 150 days per year
to pay tax as compared to 102 days in the US
▫ Per Instituto Brasileiro de planejamento
tributário, among 30 countries, Brazil is in the last
place in terms of the quality of citizen services
received for the tax paid.

Economy suffers because of the low
productivity -
Cycles since 1980’s

• In 1990, the inflation in Brazil reached 6000%
annually, and the money supply increased by
10,000%.
• The apparent root cause of the hyper inflation
period in Brazil is the government deficit spending.
The government printed money to pay the
government expenses.
• The tax revenue was not sufficient.
• The problem was aggravated by servicing the foreign
debt, which had high interest rate in the 80’s.

• The influx of hard currency from commodity exports
strengthens Real.
• At the height of Brazil’s boom, Goldman Sachs declared
Brazil’s currency, the real, the world’s most overvalued.
• Brazilian monetary policy made Real insanely expensive.
In those years, movies and taxis in Brazil were more
expensive in dollar terms than in New York.
• For Brazilian companies exporting the same amount in
dollars received less in Real, while all the costs are paid
in Real. This decimated the profits of Brazilian
companies, there is no money left to invest.
• Brazil’s manufacturers began contracting.
High Real exchange rate kills the
industry….

Real to Dollar Exchange Rate
Exchange rate zone that decimates Brazilian industry
Reasonable exchange rate zone (MacDonald meal costs the
same as in US)

Industry needs continuous investment
• When the commodity boom was over in 2011, Brazil
found itself with reduced commodity export and
obsolete industry.
▫ Old tube TV factories closed down, but Brazil does not have
flat panel TV technology.
▫ Old incandescent lamp factory closed down, but Brazil does
have LED lamp factory.
▫ Old telephone factory closed down, but Brazil does not
make cell phones.
• Any economic policy, which does not favor industry
renovation, is doomed to chock off future growth

• From 2003 to 2012, commodities’ support of the
economy allowed Brazilian leaders to put off
addressing certain problems that had long
bedeviled the nation, such as a political system
that tended to breed corruption and a
bureaucracy that stymied business innovation.
• Instead, the precious money was spent on non-
productive items

• Another anti-business policy is
the overhead of employment to a
company.
• Brazil ranks number 1 in the cost
of employee in the world.
•For salaries of USD 300,000,
employment costs in the most
expensive country – Brazil – are
40 times higher than those in the
cheapest country – Denmark.
Brazilian employers must pay an
extra USD 172,667 on top of a
gross salary of USD 300,000
(57.6% of gross salary), while
Danish employers must pay an
extra USD 4,332 (1.4%).
• The take home pay of the
employee is still subject to further
income tax
• Such a policy places a huge
burden to the companies, and
makes Brazil extremely non-
competitive.
http://www.uhy.com/employers-
now-pay-average-employment-
costs-worth-nearly-25-of-
employees-salaries/

• Eric Waidergorn, Director of UHY Moreira and
member of UHY in Brazil, says: “Brazil’s
employment costs are exceptionally high, which will
hold back new business development and job
creation and could encourage informal employment
arrangements. While direct personal taxes are low,
compared to developed countries and BRICs, high
employment costs are a significant hurdle to Brazil’s
economic development.”
• Of course, this high cost is the tax that government
needs to receive to sustain its spending.

The vicious cycle of Brazilian economy
Low
efficiency
Low
productivity
Slow money
turn over
High
interest rate
High cost to
society
Less capital
formation
for
investment
• In the end, Brazilian economy
is moving in the vicious cycle
with negative feedback loop,
which sees no ending.
• To do fundamental change,
this cycle must be broken.

• Brazil cannot continue to sell patrimony to raise money.
Sooner or later, all valuable patrimony will all be sold.
• Each recession set Brazilian economy backwards many
years
• Without fundamental changes, Brazil cannot hope to
escape the vicious cycle, except hoping for another
commodity boom, which is beyond the control of Brazil
• So far, all the policies in the last thirty years failed to
address the fundamental problems of Brazilian economy.
• It is about the time to rethink about the strategy.

• A sole proprietor operating a small restaurant uses raw materials in
the form of food ingredients, capital in the form of a stove or oven,
and labor input in the form of his own time.
• The proprietor creates a meal that is valued by his customers over-
and-above the value of the individual inputs.
• This added value is created by his talents and know-how as a cook
or chief combined with the physical capital of the restaurant.
• Wealth in this case is not only in the materials or factors of
production but also in the proprietor's knowledge of preparing a
meal.
• Over time this human capital will generate a stream of income for
the proprietor for as long as he operates the restaurant and as long a
there is a demand for his product.
• In order to attract customers, his meal must be better and cheaper
than his competitors.
• A nation operates on the same principle.

• "Manufacturing is the mightiest wealth-creation
engine ever devised by man.

Plans to fix Brazilian economy

To fix the low efficiency, low
productivity problem
• Re-engineering the practices to streamline all
operational procedures:
▫ The governments (federal, state and local) must
review its business practices and re-engineer to
improve the efficiency
▫ Business and private industry must do the same
• Invest in infrastructures (roads/ railroads/
airports/ ports/ power plants)
• Policies to incentivize business to investment
new equipment, new technology

Infrastructure
• Infrastructure projects can immediately
generate a lot of jobs
• Infrastructure projects improve economic
efficiency and provide potential for future
growth

Devaluate currency
• Devaluate currency makes country’s industry
more competitive, and brings more revenue and
profits for the exporting companies

Government policy
• Re-allocate government budget to areas which
promote future growth rather than social
warfare
• Provide incentives to industry in productivity
improvement, such as the purchase of new
equipment
• Setting up special economic zone in major urban
centers to promote high tech industry

Making it right for Brazil
• Making it right for Brazil requires to fix the
productivity problem in a grand scale.
▫ Reducing government bureaucracy
▫ Build up infrastructure
▫ Build up human resources
▫ Avoid wrong economic policies

Formation of capital
• Formation of capital is the number one priority.
• Without capital, one cannot build industry.
• Government can form capital by assigning capital
formation as the higher priority over other
spending.
• Government policy should encourage people to save
rather than spend.
• Saving from people can create large pool of capital.
• Large savings also help to reduce the interest rate
• Less is the interest burden, more money can be
available for capital spending

Build infrastructures
• Infrastructures include roads, railroads, ports,
airports, power plants, other public utilities,
communication networks, etc.
• Large scale infrastructure projects can
immediately generate jobs.
• Infrastructures improve economic efficiency,
and productivity.

Devaluate Real
• Cheap Real helps exports, also discourages
imports.
• Cheap Real has the negative points: makes the
essential imports more expensive, such as
machinery, servicing the foreign debt more
expensive, etc. Its impact needs to be studied.

Reengineering government
bureaucratic system
• Simplifying and streamling all government
procedures.
• It can reduce the size of government, the time
and energy wasted in dealing with the
government.

Set up industrial parks
• Set up industrial parks near major metropolitans
to encourage foreign high tech companies to set
up production centers.
• Learn from the special economic zone policies
from China

Cultivate human capital
• Enhance the education system of primary and
secondary schools.
• Set up professional schools to train technical
professions in modern technology

Brazil's Economic Development Recipe

Recommended

Recommended

More Related Content

Similar to Brazil's Economic Development Recipe

Similar to Brazil's Economic Development Recipe (20)

More from Len Mei

More from Len Mei (10)

Recently uploaded

Recently uploaded (20)

Brazil's Economic Development Recipe