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Brazil - Economic Briefing August 2003

Improved Inflationary Setting Prompts Monetary Easing

TThe spike in inflation observed at the beginning of the year appears to have been left behind, which has encouraged the Central Bank to lower interest rates and adopt further monetary policy measures to spur on the ailing economy. While the external sector is proceeding favourably, domestic demand continues to feel the effects of a tight credit setting and a weaker exchange rate.

Inflation moderating amid slowdown in economic activity and strengthening currency
In July, consumer prices rose 0.2%. The July figure was above the 0.15% monthly decline observed in June but was well below market expectations and confirmed the emerging trend to lower inflation observed since March of this year. An upward adjustment in regulated prices, particularly electricity tariffs in São Paulo and telephone rates nationwide, was the key driver behind the July consumer price increase. The more moderate increases in fuel and food prices were insufficient to affect the upward pressure of regulated prices. As a result of the July increase, annual inflation dropped for the second consecutive month - from 16.6% in June to 15.4% in July. Inflationary pressures, induced by depreciation and higher oil prices, finally appear to have been left behind. The current decline in inflationary expectations is the result principally of the strong appreciation in the currency observed in the first six months of this year. The Central Bank anticipates that the current slowdown in growth - gross domestic product (GDP) is seen as expanding just 1.5% this year - and greater currency stability will help contain inflation further. Monetary officials expect inflation to exceed the current 8.5% central inflation target for this year but see inflation contained within the +/-2.5% target band. Panellists are less optimistic about inflation prospects, expecting a much higher rate of 10.7% for this year. Furthermore, inflation next year is also expected to exceed monetary authorities’ stated target of 5.5% with the figure more likely to come in at 6.9%.

Central Bank cuts benchmark rate amid more favourable inflation prospects
At its monthly meeting on 23 July, the Central Bank decided to lower the benchmark SELIC interest rate by 150 basis points to 24.5%. The July interest rate cut followed upon a more moderate 50 basis point cut in June and confirmed that monetary officials are confident that the inflation bout observed at the beginning of the year has been left behind. The rate cut should help bolster the fledgling economy, which has seen activity slow notably in recent months. Participants see the SELIC rate dropping further this year to close at 20.9% by year-end. This month’s figure is 0.7 percentage points below last month’s. According to the Consensus, monetary authorities are seen easing the monetary reins further next year, bringing down the SELIC rate to 15.9% in 2004.

Currency weakens amid new Central Bank measures
The real depreciated 3.1% in July, the highest monthly depreciation. The July weakening contrasted with the 3.3% appreciation observed in the previous month. Despite the depreciation in July, which brought the exchange rate to 2.96 reais to the US$, the currency remains 19.2% stronger than at the end of last year. Given that domestic demand has remained subdued in the first half of the year, the external sector is currently the only growth engine behind the economy. Officials remain concerned that additional strengthening may erase the competitiveness gained in the wake of the depreciation. The improved inflationary outlook has encouraged the Central Bank to adopt additional monetary measures to spur the lagging domestic economy. In July, the Central Bank eased monetary restrictions to enable banks to increase their US$ holdings and cut bank reserve requirements on checking accounts from 60% to 45%. Participants expect the currency to depreciate an additional 9.8% this year from July levels to close the year at 3.19 reais to the US$ - an annual appreciation of 10.7%. Currency stability will persist into next year with the real expected to reach 3.42 to the US$ by the end of 2004.

Government complies with IMF fiscal targets
The primary government surplus reached 3 billion reais (US$ 1.0 billion) in June, which was up from the 4.3 billion reais figure observed in May. The June figure raised the accumulated primary surplus for the first six months of the year to 40 billion reais, which was well above the 28.9 billion reais figure registered for the same period last year. The strong first half performance enabled authorities to over comply with the accumulated primary surplus target for the first six months of the year agreed to with the International Monetary Fund (IMF) under the terms of the US$ 30.7 billion stand-by agreement signed on 6 September last year. As a result, the government remains well on target to complying with the 4.25% primary surplus target set for the year as a whole. Participants remain confident that the government will stay the course of fiscal discipline throughout this year, expecting the fiscal deficit to narrow to 3.9% of GDP by year-end. Nevertheless, the pension reform bill that was approved by the lower house of the legislature on 7 August will prove key to any further improvement in fiscal management. The approval of the bill in the lower house is considered major success for the Lula administration, as measures to tax civil servant pension benefits and cap the judiciary pensions were included. Even though final approval requires two additional Senate votes and one more Assembly vote, confidence in the government’s ability to persuade legislature is high. If approved, the pension reform should pave the way for significant savings in public accounts and more sustainable fiscal balances over the medium-term.



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Note:  The above text is an abridged version of the LatinFocus Consensus Forecast country briefing.  For more details please click here.


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