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The Emerging Brazilian Economic Convergence

Posted: 01/12/12 04:39 PM ET

Brazil has joined China and India among middle income countries to forge ahead towards closing the income gap between the North-South disparities and take advantage of the shift in the distribution of economic growth in favor of middle income countries. With annual per capita income growth rate three times faster than the United States over the last decade, foreign investment up 26% in the past five years and promising expansionary projects entering construction stages, prospects are bullish for Brazil.

Although the per capita income of developed countries dwarfs that of Brazil ($10,800), its recent 7.5% economic growth rate coupled with its stable democratic political climate have created optimism that the nation is poised to complete its meteoric rise to the First World. The future is bright: playing host to the 2014 World Cup and 2016 Olympics promises substantial financial gain. Oil discoveries, ironically paired with Brazil's top-ranked dedication to renewable energy, ensure Brazil's economy will maintain its swagger for decades to come. But how does the Brazilian economy continue to expand while many of its neighbors wallow in volatility and stagnation? The answer is sound macroeconomic policy. While Brazil's economy hurtles toward economic convergence with the Western world, other underdeveloped countries would do well to examine the economic strategy that fostered its ascent. Brazil's current status is the culmination of several stages in its economic succession.

Brazil's first step toward economic success was independence in 1822, which annulled the country's prohibition of foreign trade and industrialization as enforced by Portugal. However, Brazil's history of cash crop economics rendered it helpless in the early 20th century, as the demand for its burgeoning luxury exports like coffee was eradicated by the onset of the Great Depression. To maintain some semblance of an economy, Brazil diversified into other industries like clothing, textiles, and beverages. While these fledgling industries provided necessary infrastructure and jobs, stagnation persisted. Brazil needed widespread diversification and prudent macroeconomic strategy to revitalize its hamstrung economy. As the left-wing president and Communist sympathizer Joao Goulart began trying on economic policies like so many party hats, stagnation continued and the country began to call for a coup by the newly-popular Armed Forces.

The Armed Forces assumed control of the government in March 1964, creating a Junta Militar, or military dictatorship. While the junta abolished media, restricted freedom of speech, quashed political opposition and engaged in torture, executions and human rights violation, its reforms resulted in the Brazilian Miracle, an annual economic growth rate of 11.1% from 1968-1973. The implementation of import-substitution industrialization proved the impetus for this skyrocketing growth, as Brazil produced many of its goods domestically instead of acquiring them through imports. But although this system diversified the Brazilian economy and laid the groundwork for many of the sectors that thrive today, import-substitution industrialization was only a mirage. The policy of import substitution had to give way to an open economy. With government officials borrowing to maintain high rates of growth, Brazil sank deeper into debt. High interest rates increased the foreign debt while an oil shock exacerbated the country's disparity in balance of payments. While these factors are known to induce inflation, it was Brazil's system of financial indexation to account for inflation that sent its economy into a tailspin. Hyperinflation peaked at 5000% while economic growth tumbled to 2.9%, introducing Brazil to the economic quandary of stagflation. This stagnation-inflation marriage along with constraints on human rights provoked a renewed desire for democracy in Brazil, which the junta surprisingly allowed in March 1990. Although the junta seemed miraculous for six years, its import-substitution industrialization experiment culminated in failure.

The newly elected democratic government, headlined by President Itamar Franco and his Minister of Finance Fernando Henrique Cardoso, introduced sweeping reforms aimed at creating an open economy. The government sought to induce trade liberalization, deregulation, and foreign investment with its stabilization plan. The strategy, called the Plano Real, was composed of a new currency, a balanced budget, and a new system of indexation.

Commissioned in 1994 by Cardoso, the plan sought to eliminate inflationary expectations with a new balanced budget, as the system of indexation realigned relative prices in order to implement monetary reform. While prior indexation attempts had resulted in economic chaos, officials hailed their 'URV' (Real Unit of Value) system as a super-index, with values pegged to the dollar to retain stability. The URV allowed sufficient time for all economic agents to realign their prices, where its predecessors had created havoc by inducing price controls and imbalances. The indexation system determined the value of the new currency, the Brazilian real, as both worked in concert with tight monetary and fiscal policy to augment stability and curb inflation. By restricting foreign expenditures and boosting domestic interest rates in 1998, Cardoso succeeded in attracting foreign capital and managing a balanced budget.

The Plano Real was a landmark success: in June 1994, inflation registered at 50%, by July it measured 5.5%. Not only has open economic strategy curbed chronic inflation in Brazil, but the trustworthy Brazilian Real has stabilized prices and given purchasing power back to the lower echelons of society. Moreover, the free market has redistributed wealth, not only nurturing a growing middle class but suturing a fragmented society.
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*Nake M. Kamany is professor of economics at the University of southern California and Director of Program in Law and Economics. Danny Jacobs is a Research Associate in the Department of Economics at USC and a member of Global Per Capita Convergence Group (GPC-G) in Los Angeles.