When I took over as Central Bank governor, Brazil had annualized inflation of 30%, high interest rates, minimal reserves and a weak currency. There was no fixed-income issuance and there have been times when we felt under siege for being too conservative. Now its all euphoria.
The role of Henrique Meirelles has indeed changed, and fast. He has overseen the Central Bank of Brazil in a period when the country has achieved stability thats unprecedented in living memory for most of its population. He is applauded for holding a steady course on interest rates and facing down powerful critics. But he faces a new test. He has to maintain his record when expectations are high and in an environment with which Brazil is entirely unfamiliar: normality.
When talking about Meirelles, unflattering adjectives like steely, and guarded are often used. A different personality to his more flamboyant economist predecessor Arminio Fraga, Meirelles came up through the ranks of commercial banking. He overcome his lack of experience as an economist on the job at the central bank and has grown increasingly economically savvy during his tenure, say market watchers. His experience of financial and capital markets and the private sector have worked to his advantage in communicating a clear message too.
This steady eddy character has proved invaluable in maintaining a consistent policy in the face of criticism from politicians, particularly Guido Mantega, Minister of Finance, who often pushed for faster rate cutting from the bank with the argument that rates were unnecessarily choking growth. Meirelles stood firm and is reaping the rewards now with high public confidence. The result is that today there are far fewer brickbats from politicians and he has the unqualified support of President Luiz Inácio Lula da Silva. Esteem in an institution that has still not been made officially independent from the government is about the best legacy he could hope to pass on.
Interest rates and inflation
The last years have seen Brazil quell fears that it was perennially unstable and the Central Bank has played an important role in achieving that. The benchmark Selic short-term rates stood at 25% when Meirelles became bank president. He has not shied away from raising rates when needed, but has fought to bring them down consistently and when the market allowed.The track record of the central bank has been very good. You dont need to look any further than falls in inflation and interest rates, says Ilan Goldfajn, Economics Professor at the Pontifical Catholic University of Rio de Janeiro and himself an ex-deputy central bank governor. The Selic is now 11.5% and inflation estimated at 3.7% for 2007.
The global and domestic economy have helped as has the last three years appreciation of the real which has aided in containing inflation, giving scope for continued rate cutting. Even so, Meirelles must take a lot of the credit. Each year, inflation has trended down Meirelles notes proudly, from 9.3% in 2003 to 3.1% last year. We are getting used to being a regular central bank and taking a longer-term view, he says.
Stability is a phenomenon that exposes the bank to a host of unfamiliar situations. It doesnt have the historical data for this new economy.
Recent history has all been about change and shocks so although the bank has sophisticated econometric models, it has no history of how the economy reacts to stability, says Lisa Schineller, director of the Sovereign Ratings Group at Standard & Poors. The paucity of historical data makes it hard to predict what data inputs may do to the economy, she reasons. And she was disappointed by the June decision of the National Monetary Council, the CMN, to set a mid-point inflation target in 2009 of 4.5%. It would have sent a signal of growing maturity and ever-deeper targets and helped to consolidate downward trends in inflation if the bank had pushed the target down, perhaps to 4%, believes Schineller.
Inflation: down, not out
Ironically, the central bank may have little time to enjoy the praise it is currently basking in. The huge improvement in the economy and the high currency are changing the engines of growth by turbo-boosting domestic demand. The impact of domestic demand together with global food price increases is leading inflation to trend back up. In 2007, inflation is slated to be a subdued 3.7% versus a mid-point target of 4.5%. Thats still very positive, but higher than last year.
While commodities continue to be strong exporters, some industrial sectors are struggling against Chinese exports and the highly valued currency. Some economists argue thats creating a two-tier Brazil, split between a competitive commodities sector and a dying manufacturing base while politicians regularly call for the Central Bank to contain the appreciation of the real.
China is a tough competitor in some sectors, but Brazil is still increasing manufactured exports, counters Meirelles. He points out that commodities represent just 30% of exports and high tech areas including aviation are growing fast. The export drive is progressing well and our job is to keep exchange markets working effectively without creating distortion through protecting specific areas of the economy, he says. Specific competitive problems need to be dealt with through anti-dumping procedures, he says.
Economists believe that the inflation problem is controlled for now, but a risk of acceleration exists. Paulo Leme, managing director at Goldman Sachs, says that domestic demand is being pushed by highly expansionary fiscal policies, which are in part going to higher wages for public sector employees and support for poorer families. That has helped further pump up consumer demand. Demand is running very hot and were beginning to see indices, including core and sub-components, going up. And although its not a huge concern yet, it is changing the interest rate environment, he believes. The prolonged cycle of easing is coming to an end. For now, he sees the Selic at 10.75% by the end of the year and three more cuts to bring it to 10% by April. After that, he believes the central bank will be forced to pause and there is a reasonable chance that this may happen sooner.
The increased spending by central government, particularly on the current account, is temporary, reasons Meirelles, who underlines that Brazil is still set to post a primary surplus target of 3.8% of GDP this year. The government so far is beating the target by a reasonable margin and our expectation is that the target will be met, he says. He notes that there has been a very healthy increase in tax collection as a result of GDP growth. He admits that spending is increasing but says it is an aberration because of commitments for this year and says it will slow next year and in 2009 because of measures including a cap on wage increases control growth of current expenditures including limits on increases.
Longer-term, Meirelles sees progress on fiscal reform, but notes that it is subject to very tough discussions between Federal, state and municipal governments. He is less confident about labour and pension reform, which would be subject to a larger negotiation and discussions regarding social security. We have to see how the fiscal reform moves on before tackling the next areas. Economists, however, are less optimistic that the central government will be able to rein in the beast of spending. If Meirelles is wrong about the governments ability, that could lead to the wrong bases for calculating economic data.
Communication and Reserves
The Central Bank has built a good reputation for communicating with the market. Its much better than it was a couple of years ago and a couple of years from now it will be better still, says Meirelles, who adds that in Augusts turbulence, he put out additional statements and gave interviews, re-assuring the market of Brazils strong position.
Economists agree that the banks releases are timely and accurate. However, they add, recent deeper splits in Copom will test the banks skills at putting forward a coherent message. At the July meeting, four members were in favour of a 25 basis point cut and three wanted 50, points out Goldfajn. Its hardly surprising given the changes in the economy that interest rate setting has become more controversial. The changing economy has put the hawk among the doves. Some economists are even predicting a reversal back to the interest rate hikes last seen in 2004, says Leme. Send a muddled message to markets and you add to interest rate volatility, he warns.
Communication may have helped minimize the effect of recent market turbulence in which there was a relatively weak pass-through to Brazil. But in larger part thats because the Republic has slashed its exposure to dollar debt and built up sizeable international reserves. In 2004, the central bank announced a policy to build up international reserves and decrease exposure to FX risk, says Meirelles. The programme has been an unqualified success and Brazil now has some $160 billion. That compares to a low of $40 million. The build-up has proved instrumental in reducing the impact of market turbulence, he says. He adds that the banks Interventions in FX markets are not aimed at specific rates, but used to build reserves when advantageous. Most economists agree that the bank has not been pressured into protecting the real.
For now, the bank is unlikely to diversify much of those reserves away from dollars and Treasuries, a tactic China and some Middle Eastern funds are pursuing. Leme points out that Brazils reserves arent in the same league and Meirelles adds that most of Brazils liabilities are dollar denominated so it makes sense to have dollar assets. Still, Meirelles adds: We do have some diversification and criteria to diversify a portion of our reserves that are not used for hedges. If reserves grow, further diversification would be a subject for consideration.
The Central Bank of Brazil has done a superb job in predicting the direction of the Brazilian economy, fine-tuning interest rates to maintain falling inflation, and building reserves to help in crisis times while ignoring howls of protest from senior politicians and the public. Its now revered as an institution with the Midas touch, encouraging consumers to stack up credit in the belief that inflation has been vanquished. And thats surely when the dangers start.