jamestown latin america: trends+views: brazil's central bank and the issue of independence

EXECUTIVE SUMMARY

The benchmark interest rate in Brazil recently hit a record low, and

the current real rate of approximately 3% is well below the historical

average.

As the Banco Central do Brasil is not an independent central bank,

there are bound to be concerns about political interference in its

decision making.

Policy makers appear to be accommodating a rate of inflation above the target, albeit still

low relative to Brazil’s prior experience and many other large Emerging Markets countries.

Longer-term interest rates are higher than regional peers, due to doubts about the inflation-

targeting regime.

Independence is not a necessary precondition for meeting inflation targets, and the recent

history shows a mixed performance for independent central banks.

Nonetheless, home buyers have access to mortgage rates, that on an inflation-adjusted

basis, are lower than most other countries in Latin America.

Brazil’s central bank and the issue of independence – October 2013

TRENDS + VIEWS

JAMESTOWN LATIN AMERICA

Real Estate Private Equitywww.jamestown-latam.com

Contact:

Bret Rosen – Managing Director, Research+1 [email protected]

Rio de Janeiro • Bogotá • Atlanta • New York

Brazil’s central bank and the issue of independence – October 2013TRENDS + VIEWS

TRENDS + VIEWS OCTOBER 2013

Interest rates in Brazil have fallen substantially over

the last decade, and indeed this has been a major

contributor to price appreciation of real estate in recent

years. Mortgage rates, in inflation-adjusted terms, are

comparable to those in other major economies of the

region, if not lower, which has pushed up the stock

of mortgages as a share of GDP to a record high of

7.8%, according to the most recent data. The stock

of mortgages is growing at more than 30% year over

year, thanks in part to more reasonable financing rates,

while banks are also increasingly prioritizing housing

products. The ability of policy makers in recent years to

create a lower and more stable inflation environment

allowed for the issuance of longer duration mortgages,

which naturally reduced monthly payments and

improved affordability. Controlled inflation has also

been supportive of increasing real wages, which in

turn encouraged housing demand. More predictable

inflation rates in Brazil also allowed the sovereign

government and corporations to finance themselves

in local currency, for longer durations. This healthy

combination of factors contributed to Brazil’s sovereign

debt reaching investment grade status in 2008.

However, despite the decline in borrowing rates, the

benchmark interest rate in Brazil is still, by far, the

highest among

Latin America’s

major economies.

Explaining the

elevated level of

interest rates in Brazil

has been a central

topic for observers of

the country’s economy for years. While the benchmark

SELIC rate, currently at 9.5%, is well below the historical

average (as recently as 2003, the SELIC was 26.5%),

and indeed earlier this year, the SELIC hit 7.25%, an all-

time low, Brazil’s borrowing rates are still higher than in

its Latin American peers – even though the sovereign

rating on Brazilian debt is similar to a country such as

Colombia, whose benchmark rate stands at 3.25%, 625

basis points below the SELIC.

There are a number of explanations for the elevated

level of Brazilian rates. Economists cite reasons such as:

• The relatively lax fiscal policy in Brazil, with the most

recent headline number showing a 3.1% of GDP

deficit over the last twelve months.

• Brazil’s relatively recent history of hyperinflation, as

inflation was several thousand percent, on a year

over year basis, as recently as 1994.

• The large role of state-held banks in the financial

system, which can distort monetary policy and

financial conditions.

• Inflation inertia caused by still-significant amounts

of indexation in the economy, which is a legacy of

Brazil’s hyperinflation past. One example of this is the

setting of the minimum wage, which is based on a

prior year’s inflation rate.

• The relatively high 4.5% inflation target in Brazil,

which is above those in Latin American peers such as

Colombia, Mexico, and Peru, where the targets range

from 2%-3%.

Another oft mentioned reason for elevated rates in

Brazil is the lack of independence of Brazil’s central

bank. Central bank independence is a feature in many

of Brazil’s peers, such as Chile, Colombia, Mexico, and

Peru. However, establishing true legal/constitutionally

mandated independence of the Banco Central do Brasil

(BCB) has never gained political traction and is not on

the current political agenda. Whether or not this lack

of independence influences the level of interest rates

in Brazil, and to what degree, is a complex and heated

topic.

PAGE 2

With a benchmark rate in single digits, the SELIC is very low by historical standards.



To start, in theory, independent central banks can

make monetary policy decisions based on their actual

mandate, whether that is an inflation target or some

other metric or goal. Decisions can be taken, presumably,

without worry that politicians will interfere in the policy

making process or feel apt to remove a central bank

governor that makes a decision that could compromise

short-term economic outcomes.

Central banks that lack independence are more at risk

of political pressure, which undermine their ability

to implement policy decisions based on mandates

and objectives, such as inflation targeting. Politicians

presumably prefer monetary policy to be less restrictive

as a means of encouraging lending, consumption, and

economic growth. Most standing governments prefer,

all things equal, a lower interest rate to a higher one.

There are essentially three models of arrangements

for central banks. The first is one where the central

bank is legally and constitutionally independent, where

decisions can be taken without fear of major political

repercussions. Within Latin America, Chile stands out

in this regard, for example. The second model is one

where the central bank is de facto independent, but

subject to risk of government intervention; Brazil fits

this category. Finally the third category is one where

the central bank is essentially an arm of the executive

branch, and carries out monetary policy in accordance

with the political goals of an administration. Argentina

would be an example, where the Central Bank finances

the Treasury, and its fiscal deficit at the behest of the

Kirchner government, even when this policy mix leads

to major inflationary consequences.

The mission of the Banco Central do Brasil is “to ensure

the stability of the currency’s purchasing power and a

solid and efficient

financial system,”

through an inflation

targeting system,

which began in 1999.1

In Brazil’s case, the

current inflation

target is 4.5%, with

a tolerance band

of 2% to each side

of this central target. Under a true inflation targeting

regime, the central bank would adjust the policy rate

in accordance with its expectations for future inflation,

and lower or raise the benchmark rate to enhance its

chances of achieving the target. However, in recent years

the track record of Brazil’s Central Bank in delivering

its inflation target has been less than stellar. The most

recent September reading on the benchmark IPCA index

showed an inflation rate of 5.9% for example, which was

the first report in 2013 where year over year inflation

was below 6%.

Under the government of President Lula (2003-11), the

Central Bank appeared to enjoy functional independence,

despite fears that Lula would intervene in its policy

making. Indeed, after assuming office, then Central

Bank President Henrique Meirelles raised interest rates

substantially in 2003 and kept the benchmark rate at or

PAGE 3

1 Banco Central do Brasil website: www.bcb.gov.br

During the Lula government, the central bank operated a very disciplined approach to monetary policy.

2000 20042002 2006 2008 2010 2012 2013

0%

3%

6%

9%

12%

15%

CHART 1: REAL INTEREST RATES IN BRAZIL (SELIC – ACTUAL INFLATION)

Source: Bloomberg



above 26% for the first six months of the government.

While this policy approach led to contracting economic

activity, it showed that the administration was serious

about fighting inflation, resulting in a stabilized exchange

rate, which had weakened markedly in the months

leading up to the election. Inflation, which reached

17.2% in May 2003, fell to 5.2% by May 2004, helping

create the necessary conditions for an improvement in

business confidence in the years that followed. Long-

term interest rates fell substantially, as the Central

Bank was viewed as being a strong inflation fighter,

and Meirelles was seen as holding a “hawkish” attitude

toward inflation, even with a left-of-center government

in office. In May 2007, inflation fell below 3%, and even

as late as 2009, inflation ended the year at 4.3%, below

the official target.

When Dilma Rousseff took office in 2011, she appointed

Alexandre Tombini, an experienced technocrat, as

Central Bank Governor. However, under the present

administration, some investors have questioned

whether the Central Bank enjoys the same de facto

independence that it enjoyed under Lula. Rousseff, who

holds an economics degree from the Federal University

of Rio Grande do Sul, is perceived by many observers to

be more intrusive than Lula. These observers question

whether or not Rousseff might have pressured the BCB

Board, pointing to BCB policy decisions that might

confirm their suspicions. For example, in October 2011,

even though the most recent report had showed IPCA

inflation above 7.3%, the monetary authority lowered

the SELIC rate by 50 basis points. This decision alarmed

some investors now concerned that the Central Bank

might not be a true inflation targeter. Easing policy could

have led to elevated inflation expectations moving well

above the upper limit of the target band’s range, and

maybe even providing a sign of political intervention

in the Bank’s processes. However, others have also

argued that the BCB was particularly prescient in this

case, as Europe’s sovereign debt crisis represented a

major economic headwind for Brazil and that Tombini,

by easing when he did, proved to be well ahead of his

peers.

Indeed, the current Board of the Central Bank has

faced a challenging

backdrop over the

last 1-2 years, with a

challenging external

environment, slower

than normal domestic

economic growth, but

an elevated inflation

rate. When growth

and inflation are both

low, the typical policy prescription is to ease. However,

when growth is low and inflation is high, a central bank

cannot usually attack both problems simultaneously.

Federal Reserve Chairman Paul Volcker faced facing

a similar low growth, high inflation quandary in

the late 1970s and early 1980s, and opted to tighten

policy dramatically, which sent the US economy into

a recession, but ultimately led to lowering inflation

and longer-term interest rates, setting the stage for

a subsequent impressive economic recovery in the

United States. In Brazil, the Central Bank, until recently,

kept the policy rate at an all-time low, even with inflation

well above its target. The BCB’s current policy mix of

low interest rates in spite of high inflation in a slow

growth environment is compromising the Central

Bank’s credibility as an inflation targeter and may result

in longer-term interest rates, if markets perceive that the

BCB might not be targeting 4.5% inflation, but perhaps a

higher rate, if not another metric (such as GDP growth).

Recently, with inflation becoming a more politically

charged topic in Brazil, especially in the wake of the June

protests, which were ignited over the increase of bus

PAGE 4

Market participants believe that the central bank is not necessarily targeting the official goal of 4.5% inflation.


TRENDS + VIEWS OCTOBER 2013 PAGE 5

fares, the BCB has tightened policy in an effort to ward

off any potential inflation spikes. Since April, the SELIC

rate has been lifted from 7.25% to 9.5%, with the market

looking for several more hikes in the near term. Indeed,

interest rate markets price in another 50 basis points hike

at the November meeting, with several more 25 basis

points hikes to follow in early 2014. The recent moves

have especially important implications as Brazil heads

into an election year. Recent comments from Central

Bank Directors, for

example stating that

there is much work

for monetary policy

to do to curb inflation,

seemed to temporarily

lessen concerns that

government pressure

might be a factor behind the recent policy decisions in

Brazil. However, such doubts, due to the BCB’s penchant

for easing policy over the last couple years even as

inflation surged well above the target rate have already

been cast.

The net result of these worries about central bank

independence is that longer-term interest rates in Brazil

are presumably higher than in other countries in part

because the market has some doubt about the inflation

fighting resolve of the BCB. Indeed, longer-term rates

in Brazil are in the double digits, and the yield curve is

steep, relative to many other large emerging markets.

The supposed “neutral” interest rate, i.e. the real

interest rate that neither stimulates nor restrains activity,

is also estimated to be higher in Brazil, at perhaps 4%,

compared to around 2% in a country such as Colombia.

The inflation-growth tradeoff is a tricky one for policy

makers. Orthodox economists argue that allowing

more inflation does not necessarily result in more

growth, while more heterodox ones, such as Brazil’s

Finance Minister, seem to think that allowing a bit more

inflation (via lax fiscal and monetary policy) contributes

to stronger growth. The Taylor Rule indicates that the

policy rate should be increased in a rising inflation

environment, but the Central Bank in Brazil has not

necessarily followed this model, and one can argue that

Brazil’s economy is now paying the cost, as inflation

expectations, even according to its own forecasts, are

expected to remain well above the 4.5% target for the

foreseeable future.2

However, in spite of the arguments favoring more

central bank independence, such independence is not

always a necessary condition to bring down longer-

term interest rates, even though legally mandating

independence does enhance credibility. Where the

central bank does have legal independence, the track

record for achieving inflation goals has generally

been better, as countries such as Colombia and Chile

demonstrate, where inflation in each is currently below

their respective 3% targets. However, independence

is no guarantee of achieving an inflation target, as

the Mexico case shows, where inflation has remained

stubbornly above its 3% target. Indeed the track record

for the major Latin American central banks of meeting

their inflation targets is mixed. In the below chart, we

take the five major Latin American central banks, and

display the year over year inflation for each country at

the end of each calendar year, since 2003. We note that

Brazil, whose central bank is not officially independent,

met its inflation target in three of the last ten years, for a

success rate of 30%. Chile in contrast met its goal 60%

of the period, while Mexico – even with its independent

central bank – has not satisfied its inflation target once

during this time frame.

If we extend the analysis however, we see that in years

2 The Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. The rule is named after renowned economist John Taylor, currently a professor at Stanford University.

Track record of independent Latin America central banks in fighting inflation is mixed.



where the Brazilian central bank missed its target,

the average ‘miss’ has been by 2.18%. Chile actually

displayed the largest ‘misses,’ due to the commodity

price shock that impacted that small, open economy

in 2007-08. Since Chile imports nearly all of its oil, its

inflation rate proved very susceptible to the move to

$150/barrel in oil during that time frame. Meanwhile,

Mexico which never actually hit its 3% inflation target,

showed the smallest average inflation ‘miss’ during the

time frame examined.

If we go another step further, and look at the 2010-13 time

frame, which encapsulates the period of Dilma’s election

followed by her appointment of the current economic

policy leadership, we see that Brazil has missed on its

target in all four of these years (assuming that 2013

inflation is in line with the Bloomberg consensus

forecast of 6.2%). The average deviation from the 4.5%

target over this time frame has been 1.61%. Mexico and

Peru have been within 1% of their target on average,

while Chile and Colombia have on average remained

below their 3% targets over this time frame.

Is Brazil’s inability to meet its inflation target in recent

years due to any change in the de facto independence of

the Central Bank? Indeed in recent years one can point

to a number of factors exogenous to monetary policy

that also contribute toward higher rate of inflation in

Brazil, including the 1) weakness of the real over the

last 18 months; 2) lax fiscal policy; and 3) expansion of

credit from state owned banks. When one adds other

factors that contribute to structural inflation such as the

high degree of indexation that still exists in the Brazilian

economy, as well as infrastructure and issues related

to red tape, one might conclude that the BCB’s job of

achieving its inflation target is especially difficult

Would an independent central bank have been able to

satisfy the 4.5% target under such conditions? The answer

to this question is uncertain. Brazil’s 6% inflation rate

actually compares favorably to other large EM countries

such as South Africa, Indonesia and Turkey, all of which

have legislated central bank independence and are

struggling with similar internal and external conditions.

Some researchers have argued that the independence

of the U.S. Federal Reserve has been eroded in recent

years, through its policy of quantitative easing, which is

a form of “cooperating with the Treasury and engaging

in fiscal policy.”3 These outcomes could lead one to

suggest that maybe central bank independence just

doesn’t matter as much as some economists perceive.

In Brazil, while the BCB is not legally independent, it

is important that the institution make strides toward

fulfilling its inflation-targeting mandate. Achieving

more credibility is a necessary condition toward

reducing longer-term interest rates, which can unleash

even further demand for mortgages and other longer

duration financial products. Should mortgage rates

fall to the mid-single digits as a result, as has occurred

in the developed world, the real estate market would

obviously feel the benefit.

We would further the notion that what matters more

than independence is political will. Central bankers,

whether they have true independence or not, need

to have the political will to offset pressures that may

come within government, the private sector or society

at large, to manage monetary policy according to their

mandate – whether that mandate be price stability or

some other goal.

PAGE 6

3 John Taylor, “The Effectiveness of Central Bank Independence Versus Policy Rules.” Stanford Institute for Economic Policy Research. January 2013.



SUCCESS RATE

IN YEARS MISSED AVG. DEVIATION

2010-2013 AVG. DEVIATION

BRAZIL 30% 2.18% 1.61%

CHILE 60% 2.76% -0.33%

COLOMBIA 20% 2.49% -0.06%

MEXICO 0% 1.22% 0.87%

PERU 50% 1.61% 0.82%

TABLE 2: ABILITY OF LATIN AMERICAN COUNTRIES TO MEET INFLATION TARGETS IS MIXED (2003-2012)

Source: Jamestown Latin America calculations

PAGE 7

TARGET (%)

TARGET SINCE INDEPENDENT 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E

BRAZIL 4.5 4.5 since 2005* No 9.3 7.6 5.7 3.1 4.5 5.9 4.3 5.9 6.5 5.8 6.2

CHILE 3 2000 Yes 1.1 2.4 3.7 2.6 7.8 7.1 -1.4 3.0 4.4 1.5 1.8

COLOMBIA 3 2002 Yes 6.5 5.5 4.9 4.5 5.7 7.7 2.0 3.2 3.7 2.4 2.4

MEXICO 3 2002 Yes 4.0 5.2 3.3 4.1 3.8 6.5 3.6 4.4 3.8 3.6 3.7

PERU 2 2002** Yes 2.3 3.7 1.3 2.0 1.8 5.8 3.0 1.5 3.4 3.7 2.7

TABLE 1: TRACK RECORD OF INFLATION IN MAJOR LATIN AMERICAN COUNTRIES

*Target was 5.5% + or - 2.5% in 2003-04.Chile independent in 1989.**Was 2.5%, lowered to 2% in 2007

INFLATION (%)

Source: Bloomberg

jamestown latin america: trends+views: brazil's central bank and the issue of independence

Economy & Finance