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Brazil’s Stress Test of
Inflation Targeting
Afonso Bevilaqua
December 2003
1
I. Overview
2
Overview
 January 1999: Floating exchange rate regime;
 Since then, 3 major waves of currency depreciation:
• 1999
• 2001
• 2nd Half of 2002;
 No generalized financial distress or credit crunch due to low
exposure of companies, households or financial institutions to
currency risk  provision of FX hedge by the public sector;
 Main impact of devaluation on public sector’s debt.
3
Debt/GDP Ratio – 1994/2003
Sep 02
62.5%
65
60
57.7%
50
45
1999-02: FX realignment
40
35
30
Sep 03
Nov 02
Jan 02
Mar 01
May 00
Sep 98
Nov 97
Jan 97
Mar 96
May 95
25
Jul 99
1994-98: lax fiscal stance
+ high interest rates
Jul 94
% of GDP
55
4
Net Public Sector Debt and
Real Exchange Rate (1994/03)
63
4.0
45
Net Public Debt / GDP
2.5
36
2.0
Real Exchange Rate
Sep 03
Nov 02
Jan 02
Mar 01
May 00
Jul 99
Sep 98
Nov 97
Jan 97
Mar 96
1.5
May 95
27
Jul 94
% of GDP
3.0
R$/US$
3.5
54
5
Sep 03
Nov 02
Jan 02
Mar 01
May 00
Jul 99
Sep 98
Nov 97
Jan 97
Mar 96
May 95
Jul 94
% of GDP
Public Sector Primary Surplus – 1994/2003
7
6
5
4
3
2
1
0
-1
-2
6
Net Public Sector Debt Increase
Decomposition - % of GDP (1995/98)
1995
1996
1997
1998
95-98
Net debt increase
1.4%
1.9%
1.1%
7.4%
11.7%
1. Primary surplus
-0.3%
0.1%
0.8%
0.0%
0.7%
2. Pure interest on the debt
6.1%
5.4%
4.8%
7.4%
21.2%
3. Depreciation on domestic debt
0.1%
0.1%
0.2%
0.5%
0.8%
4. Depreciation on foreign debt
0.9%
0.1%
0.3%
0.3%
1.2%
5. Skeletons
1.5%
2.0%
0.1%
1.6%
4.5%
6. Privatization proceeds
0.0%
-0.2%
-1.8%
-1.4%
-3.3%
7. Effect of GDP growth
-7.0%
-5.6%
-3.3%
-1.0%
-13.5%
Debt dynamics (1+2+7)
-1.2%
-0.1%
2.4%
6.4%
8.4%
Currency (3+4)
1.0%
0.2%
0.5%
0.7%
2.1%
Net "skeletons" (5+6)
1.5%
1.8%
-1.8%
0.3%
1.2%
7
Net Public Sector Debt Increase
Decomposition - % of GDP (1999/03)
1999
2000
2001 2002
2003* 99-03*
Net debt increase
7.0%
0.1%
3.8%
4.0%
1.2%
16.0%
1. Primary surplus
-2.9%
-3.3%
-3.5%
-3.4%
-3.7%
-14.4%
2. Pure interest on the debt
8.2%
6.8%
6.9%
7.3%
7.4%
31.1%
3. Depreciation on domestic debt
3.8%
0.8%
1.5%
4.9%
-1.4%
8.0%
4. Depreciation on foreign debt
2.8%
0.8%
1.5%
4.5%
-2.6%
5.7%
5. Skeletons
1.3%
0.8%
1.5%
0.9%
0.1%
3.7%
6. Privatization proceeds
-0.9%
-1.8%
-0.1%
-0.2%
0.0%
-2.2%
7. Effect of GDP growth
-5.4%
-3.9%
-4.0%
-10.2%
0.6%
-16.7%
Debt dynamics (1+2+7)
0.0%
-0.5%
-0.6%
-6.2%
4.2%
0.0%
Currency (3+4)
6.5%
1.6%
3.0%
9.4%
-4.0%
13.7%
Net "skeletons" (5+6)
0.5%
-1.0%
1.4%
0.7%
0.1%
1.5%
* Data for September/2003
8
II. 1999: Exit Strategy
9
1999: Exit Strategy
 Inflation Targeting regime adopted in June 1999.
 Initial targets established when regime was implemented
encompassed strategy of fast disinflation:
• 1999: 8% +/- 2%
• 2000: 6% +/- 2%
• 2001: 4% +/- 2%
 Exchange rate depreciated 48% during the year.
 To make matters worse, regulated prices (backward-looking
prices that represent about 30% of consumption basket) rose
20.9%.
 Despite level of depreciation and pressure of regulated prices,
inflation rate (IPCA) stood at 8.9%, within target range.
• Nominal Exchange Rate • Consumer Inflation Rate • Inflation vs Regulated Prices
• Brazil Risk
• Selic Rate
10
1999: Exit Strategy
 Causes for low pass-through and initial success of IT regime:
• Widespread anticipation of devaluation;
• No currencies mismatch for households, companies or
financial institutions, due to provision of hedge by
Government;
• Currency clearly overvalued before floating;
• Low initial Inflation level.
11
III. 2001: Target Miss
12
2001: Target Miss
 2001 marked by external shocks (Argentina crises, September
11th, increase in risk aversion) and domestic adverse supply
shocks (energy rationing) ;
 Depreciation of the exchange rate by nearly 44% in the peak of
the year and 19% for the calendar year;
 Like in previous years, inflation pressured by regulated prices
changes, especially electricity rates;
 Inflation at 7.6% missed the 4% + 2% target.
• Nominal Exchange Rate • Consumer Inflation Rate • Inflation vs Regulated Prices
• Brazil Risk
• Selic Rate
• Market Inflation Expectations
13
2001: Target Miss
 Policy responses:
 Increase in primary surplus target for 2001 (from 3% to 3.35% of
GDP) and 2002 (from 2.7% to 3% and later to 3.5% of GDP);
 New IMF agreement;
 Increase in Selic rate to 19% from 15.25% p.a. in March;
 Increase in reserve requirements on time deposits to 10% from
0%;
 Sales of US 8.8 billion, including a strategy of non-discretionary
intervention (US$ 50 million per day) during the 2nd half of the
year;
 Sales of US$ 11,1 billion in FX indexed securities to alleviate
pressure on the exchange rate.
14
IV. 2002: Sudden Stop
15
Sudden Stop
Capital Inflows(*)
(US$ billion)
61.7
52.8
US$ 8.9 billion
GAP
US$ 28.0 billion
GAP
24.8
2000
2001
2002
16
2002: Sudden Stop
 Confidence crisis caused by uncertainty about future
macroeconomic policies;
 Depreciation of the exchange rate by 53% over the year,
concentrated in 2nd half;
 Inflation peaked in last quarter of the year and contaminated
long-term inflation expectations. Consumer inflation ended year
at 12.5%, missing the 3.5% + 2% target;
 Continued depreciation since 1999 allowed a significant gain for
real exchange rate, and led to a reduction in current account
deficit of 5% of GDP for the 2001-2003 period.
• Nominal Exchange Rate • Consumer Inflation Rate • Inflation vs Regulated Prices
• Brazil Risk
• Selic Rate
• Market Inflation Expectations
17
V. 2003: Disinflation
18
2003: Disinflation
 New Government earlier initiative was to reaffirm the fiscal stance
(4.25% of GDP target for primary surplus);
 IT reinforced, with use of adjusted inflation target methodology
(accommodation of first round effects of supply shocks and fight of
1/3 of second round effects);
 Adjusted target for 2003 set at 8.5%; for 2004, at 5.5%;
 Monetary tightening up to first quarter (750 bps) + increase in reserve
requirements on demand deposits to 60% from 45% in February;
 Exchange rate appreciation after February Copom meeting;
 Calendar year inflation to nearly 9%, compared to market inflation
expectations around 12.5%.
• Nominal Exchange Rate • Consumer Inflation Rate • Inflation vs Regulated Prices
• Brazil Risk
• Selic Rate
• Market Inflation Expectations
19
VI. Annex
20
Nominal Exchange Rate - 1999
4.0
3.5
R$/US$
3.0
2.5
2.0
1.5
1.0
Nov 03
Sep 02
May 00
Mar 99
Jan 98
Nov 96
Sep 95
Jul 94
Jul 01
Depreciation 1999: 48%
0.5
• Voltar
21
Nominal Exchange Rate - 2001
4.0
Peak of depreciation: 44%
3.5
R$/US$
3.0
2.5
2.0
1.5
1.0
Nov 03
Sep 02
Jul 01
Mar 99
Jan 98
Nov 96
May 00
• Voltar
Sep 95
Jul 94
0.5
22
Nominal Exchange Rate – 2002
4.0
3.5
R$/US$
3.0
2.5
2.0
1.5
1.0
Nov 03
Sep 02
May 00
Mar 99
Jan 98
Nov 96
Sep 95
Jul 94
• Voltar
Jul 01
Depreciation: 53%
0.5
23
Nominal Exchange Rate – 2003
4.0
3.5
R$/US$
3.0
2.5
2.0
1.5
1.0
0.5
Nov 03
Sep 02
Jul 01
Mar 99
Jan 98
Nov 96
May 00
• Voltar
Sep 95
Jul 94
Appreciation to November: 16%
24
Apr 98
Mar 97
Nov 03
Aug 02
Jul 01
Jun 00
May 99
• Voltar
Feb 96
Jan 95
Basic Points
Brazil Risk - 1999
3,000
2,500
2,000
1,500
1,000
500
25
Apr 98
Mar 97
Nov 03
Aug 02
Jul 01
Jun 00
May 99
• Voltar
Feb 96
Jan 95
Basic Points
Brazil Risk 2001
3,000
2,500
2,000
1,500
1,000
500
26
Apr 98
Mar 97
Nov 03
Aug 02
Jul 01
Jun 00
May 99
• Voltar
Feb 96
Jan 95
Basic Points
Brazil Risk – 2002
3,000
2,500
2,000
1,500
1,000
500
27
Apr 98
Mar 97
Nov 03
Aug 02
Jul 01
Jun 00
May 99
• Voltar
Feb 96
Jan 95
Basic Points
Brazil Risk – 2003
3,000
2,500
2,000
1,500
1,000
500
28
0
Jun 95
Oct 03
Oct 02
Nov 01
Dec 00
Jan 00
Feb 99
Mar 98
Apr 97
May 96
• Voltar
Jul 94
% p.a.
Consumer Inflation Rate - 1999
30
27
24
21
18
15
12
9
6
3
29
0
Jun 95
Oct 03
Oct 02
Nov 01
Dec 00
Jan 00
Feb 99
Mar 98
Apr 97
May 96
• Voltar
Jul 94
% p.a.
Consumer Inflation Rate - 2001
30
27
24
21
18
15
12
9
6
3
30
0
Jun 95
Oct 03
Oct 02
Nov 01
Dec 00
Jan 00
Feb 99
Mar 98
Apr 97
May 96
• Voltar
Jul 94
% p.a.
Consumer Inflation Rate - 2002
30
27
24
21
18
15
12
9
6
3
31
0
Jun 95
Oct 03
Oct 02
Nov 01
Dec 00
Jan 00
Feb 99
Mar 98
Apr 97
May 96
• Voltar
Jul 94
% p.a.
Consumer Inflation Rate - 2003
30
27
24
21
18
15
12
9
6
3
32
Inflation Rate and Regulated Prices
25
Consumer inflation rate
20.9
Regulated prices change
20
18.9
15.3
15
14.0
12.9
%
12.5
10.8
10
8.9
7.7
6.0
5
0
1999
2000
2001
2002
2003*
* 12 months change up to October
33
• Voltar
Nov 03
Sep 02
Jul 01
May 00
Mar 99
Jan 98
Nov 96
Sep 95
Jul 94
% p.a.
Selic Rate – 1999
100
90
80
70
60
50
40
30
20
10
0
34
• Voltar
Nov 03
Sep 02
Jul 01
May 00
Mar 99
Jan 98
Nov 96
Sep 95
Jul 94
% p.a.
Selic Rate – 2001
100
90
80
70
60
50
40
30
20
10
0
35
Selic Rate – 2002
Increase in Selic rate
to 25% from 19%;
100
90
80
70
% p.a.
60
50
40
30
20
10
Nov 03
Sep 02
Jul 01
May 00
Mar 99
Jan 98
Nov 96
Sep 95
• Voltar
Jul 94
0
36
Selic Rate – 2003
100
Cut in Selic rate to 17.5% in Nov
from 26.5% in Feb/Jun period
90
80
70
% p.a.
60
50
40
30
20
10
Nov 03
Sep 02
Jul 01
May 00
Mar 99
Jan 98
Nov 96
Sep 95
Jul 94
0
• Voltar
37
Nov 03
Sep 03
Jul 03
May 03
Mar 03
Jan 03
Nov 02
Sep 02
Jul 02
May 02
Mar 02
Jan 02
Nov 01
Sep 01
Jul 01
May 01
Mar 01
6
Jan 01
Nov 00
Sep 00
Jul 00
May 00
Mar 00
Jan 00
%
Market Inflation Forecasts (Median)
for Calendar Years (2000-2004)
14
2002
12
10
2003
8
2001
2000
2004
4
2
38