Report No. 16793-BR Brazil From Stability to Growth through Public Employment Reform (In Two Volumes) Volume I: Main Report February 17, 1998 Brazil Country Management Unit Poverty Reduction and Economic Management Unit Latin America and the Caribbean Regional Office Document of the.World Bank CURRENCY AND EQUIVALENTS Currency Unit: The Real R$1.005 = US$1 1996 R$1.078 = US$1 1997 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS BANDEPE = Banco do Estado de Pernambuco BANRISUL = Banco do Estado do Rio Grande do Sul BNDES Banco Nacional do Desenvolvimento Economico e Social CLT = Consolida,cao das Leis Trabalhistas FGTS Fundo de Garantia por Tempo de Servi,o GFS = Government Finance Statistics IBGE Instituto Brasileiro de Geografia e Estatistica IFS = International Financial Statistics INSS = Instituto Nacional de Seguridade Social IPEA = Instituto de Pesquisa Econ6mica Aplicada PDV Programas de Demissao Voluntaria PROER = Programa de Estimulo a Restructura,ao e ao Fortalecimento do Sistema Financeiro SECEX = Secretaria da Receita Federal - Banco do Brasil VAT = Value Added Tax Vice President: Shahid Javed Burki Director: Gobind T. Nankani Lead Economist: Suman K. Bery This Report was prepared by a team consisting of Gautam Datta (Task Manager, LCSPR), Indermit Gill (LCC5C) and Craig Burnside (DECRG). Indermit Gill is the author of Chapters 3 and 4 of the main report and the Annex. Homi Kharas (PRMEP) helped formulate the framework and provided guidance throughout. A background paper for the World Bank authored by Nissan Liviatan (Bank of Israel and Hebrew University) was extensively drawn on for the macroeconomic sections. The public employment sections of the report are the result of a collaborative effort with IPEA, Rio de Janeiro. Contributions were also made by Francisco Carneiro (University of Brasilia) and Edward Amadeo (PUC, Rio). Michael Walton (PRMPO) was the peer reviewer. BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM Table of Contents Page No. EXECUTIVE SUMMARY ..................................................................i CHAPTER 1: FROM STABILIZATION TO FISCAL ADJUSTMENT AND EMPLOYMENT REFORM ....1 Introduction ................................................................1 Stabilization is taking hold .................................................................3 Efficiency and confidence are increasing ................................................................4 Poverty and income distribution improved with the fall in inflation ...........................................5 CHAPTER 2: MACROECONOMIC DEVELOPMENTS SINCE STABILIZATION ...................................7 Introduction ................................................................7 External Balance: Current account deficit grows as capital inflows increase .............................7 But financing of current account deficits is improving .............................................................. 12 Internal Balance: Fiscal adjustment is needed ............................................................... 13 But debt appears to be sustainable ................................................................ 16 Nevertheless, risks remain ................................................................ 21 Fiscal Adjustment Possibilities ................................................................ 24 CHAPTER 3: PUBLIC-PRIVATE DIFFERENTIALS IN EMPLOYMENT AND COMPENSATION ......... 30 The Approach ............................................................... 30 The Background ............................................................... 32 Public-Private Differences in Earnings ............................................................... 36 Public-Private Differences in Job Security ............................................................... 39 Public-Private Differences In Pensions ............................................................... 39 CHAPTER 4: PUBLIC EMPLOYMENT REFORM: WHAT IS BEING DONE, AND WHAT IS NEEDED ................................................................. 41 Recommended Measures for Reducing Payroll Costs ............................................................... 41 Employment Reduction Through Voluntary Severance Programs ............................................ 42 Reducing Public Employment under Current Conditions ......................................................... 48 Selective Pension Reform Can Eliminate Public Sector Pension Premium .............................. 49 Labor Market Reforms Can Reduce Informality and Turnover in Private Employment .......... 50 Administrative Reforms Can Reduce Public-Private Job Stability Differentials ........... ........... 51 REFERENCES ................................................................. 53 -1- BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM EXECUTIVE SUMMARY 1. THE MACROECONOMIC SETTING Brazil has made impressive progress since 1994. Brazil's progress since implementing the ongoing Plano Real in mid-1994 deserves praise. Annual inflation has been reduced to below 5%. With the consequent rise in real wages, income distribution improved markedly and poverty levels have gone down. In spite of a large decline in inflation-related revenues, there has been no systemic crisis in the banking system because of the Central Bank's restructuring initiative. The exchange rate was made flexible in early 1995 and Brazil tided over the Mexico crisis without any need for external assistance. Direct capital inflows jumped in 1996, reflecting increasing foreign investor confidence and new opportunities. Unlike many other stabilizing economies, unemployment has not emerged as a major problem. But tight money and a loose fiscal stance have led to growing pressures. However, the Real Plan still faces major challenges. Brazil has relied on tight monetary policy and a strong exchange rate as the primary instruments of stabilization. Unlike other stabilization programs in high inflation countries, Brazil saw an initial worsening of its fiscal stance, with measurable but slow progress since then. The result has been extremely high real interest rates with several consequences for Brazilian indebtedness. The fiscal deficit itself has been affected negatively since the government is a large debtor. The high interest rates accompanied by a predictable exchange rate regime have also led to capital inflows from abroad. R$ 23 billion of these inflows had to be sterilized between July 1994 and February 1997, adding to domestic debt and inducing Central Bank losses because of the differential between domestic and foreign interest rates. Furthermore, under the prevalent policy regime, private sector external indebtedness has grown rapidly, since it is cheaper to borrow abroad rather than finance activity domestically. The current account deficit worsened from virtual balance in 1994 to 4.2% of GDP in 1997. This factor, the lack of fiscal adjustment, and the policy mix in general, contributed to the attack on the Real at the end of October 1997, although contagion from the Asian crisis was the precipitating factor. This attack was successfully resisted by a rapid fiscal response, as well as an acceleration of reform passage in Congress. However, there was a substantial loss in reserves in late 1997, and the policies adopted will lead to much slower growth through 1998, at least. The risks are manageable. There are few signs that the leading and contemporaneous indicators most related to macroeconomic crises in other countries -- the level of reserves, the real exchange rate, domestic credit, credit to the public sector and domestic inflation -- are outside prudent limits in Brazil. Nor are there any signs of lack of credibility in the behavior of - 11 - inflation vis-A-vis growth in money supply and debt. Brazil has also carried out significant restructuring of its financial sector after the Real Plan. However, the widening current account deficit requires adjustment to be stretched out. This increases vulnerability since a prerequisite is a stable flow of international capital to Brazil, and international shocks have to be ruled out for this to be assured. Brazil's substantial foreign exchange reserves, a credible privatization program and record of policy management so far, make the risks associated with the Real Plan manageable in the short to medium term, although these risks could be further reduced with a change in the policy mix. Long run prospects appear favorable, given that new sectors are being opened up to foreign capital and that Brazil is only at the start of its privatization program. But the momentum for privatization has to be sustained, and long-run public sector solvency requires that a definitive fiscal turnaround take place sooner rather than later. The recent progress in the (first round) passage of Constitutional reforms relating to public employment and social security provides comfort that this process has indeed accelerated. But the policy mix is proving costly in terms of foregone growth. The policy mix of high real interest rates, a strong exchange rate and a weak fiscal stance, however, has undesirable consequences, beyond the growth of indebtedness. The paucity of policy instruments that can be effectively used has led to the very active use of deflationary interest and credit measures, resulting in unusually severe intra- year output cycles in 1995 and 1996. The Authorities resorted to interest rate increases and credit restrictions when output growth picked up, because the high responsiveness of imports to output changes in Brazil meant that output increases led to pressures on the current account- a symptom of overheating. In the short and medium run a lowering of absorption through fiscal adjustment is the indicated course of action. Moreover, progress in fiscal adjustment would be an important positive signal to foreign investors. A significant nominal devaluation is not recommended at this time as it may trigger inflation when the fiscal deficit is high in an economy with a history of indexation. In the interim, measures to enhance productivity growth through privatization and regulatory reform have a crucial role to play. The most damaging consequences of the current policy mix and resulting high interest rates will be felt over the longer term. The growth record of 1994-1995 lend support to this view. The growth rate fell from 5.8% in 1994 to 4.1% in 1995 and to 2.9% in 1996. Preliminary estimates for 1997 show a small recovery to 3.0%. Although better than the record of the 1980s and early 1990s, this is far below Brazil's potential. Investment has not increased significantly since 1990, even though foreign savings have risen from zero to more than 3% of GDP since the Real Plan. Sustainable fiscal adjustment is the main policy change required, and this should take the form of reduced government spending. Fiscal adjustment requires adjustment in taxes or expenditures or both. The ratio of tax revenue to GDP in Brazil is one of the highest in Latin America, with high nominal rates of the main tax, a state VAT (ICMS). Moreover, this ratio has risen significantly after the Real Plan as inflationary erosion has come to a halt. While measures to improve the tax system in Brazil will help, in the long run, to improve efficiency, their impact on revenue could be offset by a move towards a more neutral tax regime with a lower dead weight burden. It is also difficult for the federal government to raise budgetary savings through revenue increases, since many taxes are earmarked for specific expenditures or sub-national levels of government which do not give stabilization the same priority. Increases in federal revenues will come only from a comprehensive tax reform, which has to address sensitive areas - 111 - in federal-state relations. The federal executive has suggested such a reform, but this is still a technical proposal in its early stages. Therefore, the immediate thrust has to be on government spending, especially at the state and municipal levels where deficits have grown disproportionately. Government expenditures are dominated by payroll expenses. Capital expenditures in Brazil are much smaller than in the eighties and there is an aggressive divestiture program in place at both the federal and state levels. Non-wage recurrent expenditures have also been squeezed, since salaries and wages are not easy to reduce in an increasingly low inflation environment where institutional constraints make layoffs in the public service virtually impossible. There is scope for further reduction in capital expenditure since privatization will remove the need for the federal treasury to contribute to investment in public enterprises. With overall federal capital expenditure at only 0.8% of GDP, however, this will not be enough and other measures need to be taken. Since public sector salaries and pensions consume 60% of net revenues at the federal level, 70- 80% in several major states and over 100% of net revenues in other states, the major avenue for expenditure reduction has to be through reduction in the public sector wage bill. The need to unify the labor market provides another major rationale for public sector employment reform. The approach adopted in this report is to explore measures which equalize earnings, pensions and job stability across the private and public sectors. The issues of fimctional distribution of public employment and efficiency in the delivery of public services are not touched here. Even if the problem was approached from this angle, however, public sector wages and pension related questions could not be avoided, since these constitute the bulk of government expenditure. The adjustment can be partly through wage adjustments, especially where public sector workers are better paid than their private sector counterparts. Since not all public servants are higher paid and selective wage adjustment is not always possible, some of the adjustment will have to come through cuts in public sector employment. Moreover, the pension system for civil servants is more generous than private social security. Even the latter needs reform, since it is actuarially unbalanced and has increasingly strained the budget with deficits since 1995. Reforms along the lines suggested in this report should have, thus, both a fiscal impact and an efficiency one through unification of the labor market. 2. THE PUBLIC EMPLOYMENTSCENARIO: WHAT TO DO. Brazil does not have exceptionally high public employment levels, but the public wage and pension bill has risen to unsustainable levels. Although there is scope for savings through employment reduction, Brazil's problem is not one of gross over-employment in the public sector. At the national level, employment in government was about 9% of total employment in September 1995, close to the level that would be predicted for Brazil by a World Bank cross- country study. Including employment in public enterprises, this ratio increases to about 12%, still below the international levels for countries similar to Brazil. As against this, public payroll- related expenses are about 12% of GDP in Brazil, which is high relative to comparable countries (though such international comparisons can be misleading given differences in coverage of public accounts). These findings point to misalignment of compensation levels compared to salary, pensions and job security in the private sector. Salaries and pensions in the federal government and enterprises and state enterprises are especially high relative to the private sector. -iv - Since 1994, public employment has been largely unresponsive to economic changes, while the private sector has been adjusting. Public employment grew between 1992 and 1995 at all levels except state administrations. Real earnings grew at all levels until 1995, and have fallen only slowly since then in federal administration. Pension payments - that are linked to these earnings - also have grown. Public employees retain rights to lifelong employment. In general, public employment levels and salaries have not systematically adjusted to a more stable and open economy. In contrast, adjustment in the private sector has been shared by wages and employment, reflected in the growing degree of informality of employment and increases in unemployment in the formal sector. But while many private formal sector firms have downsized successfully, but unemployment rates have risen only to 6-7%. Efforts shouldfocus on reducing public-private differences in earnings, pensions, and job stability. The fundamental principle proposed by this report to underpin a sustainable reduction of the fiscal burden of public employment - also enunciated clearly in a 1995 address by the Minister of Federal Administration and State Reform, Luiz Carlos Bresser Pereira - is to reduce the differences in public and private earnings, pensions, and job stability. Since 1994, these have diverged instead of converging. Salaries and pensions of public sector employees are generally higher than those of similarly qualified private workers. While there is "too much" stability in the public sector, one could argue that there is "too little" job security in the private sector": artificially high informal employment is more than 50% of urban private employment in some states. Accordingly, the aim of administrative, social security and labor market reforms should be to reduce differences in compensation between the public and private sectors, and not to reduce levels of public employment and/or pay per se. In the judicial and legislative sectors and in the federal administration, sustainable reduction of payroll spending principally implies lowering salary and pension levels. The main problem in these sectors appears to be overcompensation rather than over-employment. Federal government workers earn about 30% more than private sector workers with similar attributes. For judicial and legislative workers this premium is more than 50%. Reducing salaries and altering pension rules (principally requiring pension contributions at the same rate and duration as for private employees, and imposing the same ceiling of 10 minimum salaries) is the most effective way to reduce payroll expenses in these sectors. In federal and state enterprises, sustainable payroll reduction implies lowering salaries, pensions, and employment. On average, workers in state government enterprises enjoy an earnings premium of about 20%, while those in federal public enterprises enjoy a premium that is about 35%. In enterprises that are overstaffed relative to comparable private firms, employment reduction may also be required. In this sector, reduction of payroll costs thus requires a mix of reduction of compensation and employment. In state civil service and municipal administrations and enterprises, sustainable payroll reduction requires reduction of employment and delinking pensions from salary adjustments. In these government sectors, where salary levels of workers are the same or lower than equally qualified private workers (e.g., in municipal administration and enterprises, and for education - v - and health workers in many states) substantial reduction of employment will be necessary in order to control growth of payroll-related spending even if salary and pension adjustments are feasible. 3. REDUCING PUBLIC EMPLOYMENT UNDER CURRENT CONSTITUTIONAL CONDITIONS: HOW TO DO IT. Analysis of employment and earnings from PNAD (annual national household) surveys, and costs and effectiveness of ten downsizing programs in the federal government and in the states of Pernambuco, Rio Grande do Sul, and Sao Paulo provides guidance on rules for financially efficient and sustainable reduction of public employment. Enforcing working hour regulations, reducing salaries, and keeping salary increases small will reduce the incentive to stay in government. Efforts to reduce employment under the current legal and political constraints can be assisted by keeping public sector salary increases to a minimum, and enforcing - and, in some cases, even increasing - minimum working hours. Declining real earnings of public employees would encourage their voluntary departures as private sector employment and earnings increase, keep payroll expenses for current employees from rising, and - since pension payments to inativos (retirees) are linked to salary levels of ativos - keep pension-related expenses from rising. Separation programs for public administration should be redesigned and expanded. State downsizing efforts contain substantial hidden expenses for the federal government because of an implicit transfer of pension obligations from state treasuries to the INSS system. Despite these costs, downsizing is a profitable strategy for consolidated government: the benefits - in termns of reduced salary and pension bill - of credible downsizing programs can be 7-10 times the financial costs. Many state governments have resorted to relatively expensive early retirement schemes to spread costs over time because severance schemes involve large one-time expenses. Tlhe findings of this report suggest three main lessons. First, separation programs can be made more effective by introducing an element of involuntariness; the experience in some states such as Rio Grande do Sul shows that pressure can be legally brought to bear. Second, to lower costs, packages for nontenured government employees should be smaller than for those with tenure; currently estatutarios often get lower severance benefits than CLTistas. Third, these schemes entail large implicit transfers of pension obligations from state governments to the INSS's time of service program; mechanisms to make these transfers explicit (e.g., recognition bonds) would solve this problem, though the preferred solution would be to unify the pension systems for public and private employees. Separation programs for public enterprises can be made less generous. Downsizing efforts in public enterprises, despite often paying more than what is legally required - are financially profitable: the benefit-to-cost ratios can be as high as seven. Since these employees are CLTistas who can technically be dismissed, special indemnity payments to induce them to quit can be viewed as unnecessary. Nevertheless, if indemnities are paid, then these workers should not have access to their FGTS balances. In fact, workers are generally allowed to withdraw these funds (i.e., the separation is treated as involuntary), and state enterprises often - vi - pay an additional 40% of the accumulated balance as a penalty for "unjustified dismissal". Cash-strapped enterprises have also relied on expensive early retirement schemes to spread the costs of downsizing over time. The report suggests three main lessons. First, costs can be reduced by introducing an element of involuntariness; Bandepe's (State Bank of Pemambuco) experience suggests that this is possible with little or no labor unrest and litigation. Second, given growing actuarial deficits in closed company funds, public enterprises should be encouraged to rely more on severance than early retirement. Third, if special indemnity payments are made, departures should be treated as voluntary quits, and workers not be given access to FGTS accounts. 4. CONSTITUTIONAL REFORMS TO INCREASE LABOR MARKETEFFICIENCY While the above measures can in principle be activated immediately, longer-term fiscal sustainability requires constitutional reform in the areas of social security, administration, and private labor regulations. Social Security Reforms Measures to reduce disparities between public sector and private sector pensions are the most beneficial actions over the longer term, from fiscal, efficiency, and equity viewpoints. To increase labor market efficiency and increase equality, the most important guidelines are: * Public pension levels should not be more generous than private pensions. The ceiling for benefits (10 times monthly minimum salary) that applies for INSS pensioners should apply for public employees as well, and the same rate of replacement - below the current 100% rate - should apply. Besides reducing government expenditures, equalizing pension benefits will also reduce distortions such as the practice of switching to public service late in the career to obtain higher pension benefits. * Entire work histories should be used to calculate the base for pensions. Estimates indicate that in 1996, this change alone would have reduced the annual pension bill by about 20-25% for medium- and high-salaried civil servants, and about 30% for low-salaried civil servants. For INS S recipients, the savings would be smaller (about 10-15%) but still significant. * Public employees should contribute at the same rate as private employees. While these contributions are between 8% and 10% for wage and salaried workers in the private sector, civil servants in many states do not contribute at all. Requiring estatutarios (public employees with tenure) to contribute at the same rate as CLTistas (those covered under the consolidated labor code) will reduce the pension burden by about 10%, make public employment less attractive and aid downsizing programs, and remove distortions in these programs due to the transfer of pension obligations from states to the federal government. * Eligibility rules should be made stricter and uniform for private and public employees. Making the minimum years of contribution for workers the same regardless of their occupation and sector of employment, basing eligibility in both the public and private - Vll- systems on the years of contribution rather than years of service, and introducing a minimum age at which retirement benefits commence would reduce labor market distortions and result in significant savings even at current replacement rates and eligibility periods. Administrative Reforms Constitutional changes proposed in the administrative reform bill are being monitored as a signal of the government's commitment to fiscal adjustment. The most contentious clause in this bill is the revocation of job stability for civil servants. * Immediate fiscal benefits of tenure revocation depend on political will. The review of downsizing efforts undertaken for this report raises doubts about immediate fiscal benefits of this clause. Even public employees without tenure (CLTistas) are being "bought out" with indemnity payments, though many can legally be fired. The main constraint to successful downsizing of public employment appears to be political will. Thus the passage of this bill is unlikely to benefit state governments that lack the political will to adjust, though it will help reform-minded state governments obtain higher savings from voluntary severance programs. - There may be some efficiency gains. Revocation of tenure for civil servants would allow governments to put pressure on negligent workers, and hence result in greater efficiency in provision of government services. Here again, our review of state reforrm efforts indicates that governments with adequate political will have done so even under current laws, using measures such as time monitoring systems and performance evaluations to encourage grossly negligent workers to take relatively modest packages and quit. For such governnents, the efficiency gains resulting from passage of the administrative reform will be modest. * The cost of waiting for constitutional reform is high. While the fiscal and efficiency gains from the administrative reform bill are uncertain or modest - even if passed in its current form and applied to all workers immediately - the cost of waiting is certain and high. The two main factors are the high rate of interest paid on debt and - because of the rising share of pensions in payroll expenses - a later public sector reform will be less fiscally rewarding than one today. Labor Market Reforms Realistically, most government employees are likely to view formal sector jobs as the alternative to their current jobs, since the salary, pension, job stability and locational differences between such jobs and government employment are smaller. Labor market measures to improve the likelihood and attractiveness of private formal employment are an important but underrated instrument for reducing the burden of public payroll expenses: * Reduction of payroll taxes will reduce informality of employment. There is mounting evidence that high payroll taxes and current design of the systems financed by these levies increase informality of employment. Given that differentials in earnings, pensions, and job stability are smaller for public and formal private employment than those observed for public and total private employment, reforms of these programs combined with a reduction of - viii - payroll taxes will encourage formality and narrow the public-private gap in compensation. The passage of a constitutional amendment that allows workers to be hired under temporary contracts that have an extended probationary periods and lower payroll taxes is not a substitute for more general labor reforms, but appears to be a step in the right direction. Reform of FGTS scheme will reduce turnover in theformal sector. While there are distinct similarities between the US and Brazilian labor markets, one of the differences is that Brazil's turnover rate is about 33% higher. Severance fund (FGTS) laws are believed to increase turnover levels to artificially high levels in the formal sector and increase informality of employment. Reforming the FGTS system (e.g., by reducing the penalty for unfair dismissal to the pre-1988 level of 10%) to reduce the perverse incentives to workers to "get fired" will reduce turnover rates and increase investments in worker skills by firms. * Reform of selected laws will increase employment and earnings. Reform of relatively strict hiring and firing laws will lower the cost of labor and increase employment, and lower the duration of unemployment in the formal sector. Both will encourage government employees to seek private sector jobs. Delinking pension benefits from minimum wages will reduce the increases in fiscal burden that accompany even small increases in the minimum monthly salary. BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM CHAPTER 1: FROM STABILIZATION TO FISCAL ADJUSTMENT AND EMPLOYMENT REFORM Introduction 1. Brazil underwent a fundamental regime change in terms of macroeconomic policy in mid-1994 with the full fledged launching of the Real Plan with a new, anchored currency. With this ended more than a decade of price instability, indexation and stagnation in per capita output. The background and steps leading to this stabilization episode have been described in the World Bank Economic Report titled Brazil: An Agenda for Stabilization, October 7, 1994 (Report. No. 13168- BR) , and the Plan has been analyzed in various Government documents.' Stabilization has now persisted for three years; since 1996 the annual inflation rate has come down to single digits. 2. At the beginning of the decade the realization had set in that the model of development that had served Brazil in the past, with a prominent role for the state in resource allocation decisions, was unsustainable. High levels of protection had made Brazilian industry inefficient and inward looking. Accordingly, trade liberalization, liberalization of the capital account and limited privatization had started even before the Real Plan was introduced in mid-1994. However, the pace and impact of reform were limited by the overwhelming problem of managing an economy where the specter of hyperinflation was ever-present. Finally, the political crisis that led to the impeachment and resignation of President Collor had its additional impact. With the election of President Cardoso and the success of the Real Plan, internal and external confidence in economic management has been restored. A change in inflationary expectations can have a very significant impact on the inflation rate if monetary accommodation moves in parallel. This is what appears to have happened in Brazil after the Real Plan, where inflation has come down without a significant reduction in the fiscal deficit in the face of social consensus that the days of state supported indexation are over. 3. This chapter looks at three sets of issues in the post-stabilization phase. First, it examines the sustainability of the Real Plan. Sustainability in this context refers to the continuation of a low inflation regime with some growth and with trends in the fiscal deficit and the current account which ensure that the economy is not excessively vulnerable to shocks. Clearly, a stabilization episode that has lasted three years and continues to show a declining trend in prices is not a transitory phenomenon. It must reflect some change in economic fundamentals and confidence in the future course of the economy. The questions are: Can we infer from the behavior of relative prices and other evidence that inflation will continue to be on a converging path to international rates? Second, what can be done to improve the policy mix such that the adjustment is efficient, i.e. the economy does not have to go through accentuated cycles or fall See The Brazilian Economy in the Wake of the Real Plan, Central Bank, July 1996 for a comprehensive review. -2 - back on protective measures. Consolidation of stabilization is a lengthy process and, as the cases of Chile and Mexico have shown, progress is not linear and may be interrupted by significant recessionary and crisis episodes. To the extent that Brazil can learn from such experiences, it can take advantage of being a latecomer to stabilization. In addressing this issue, we focus on the post-Real Plan behavior of the balance of payments and fiscal deficit. Finally, we examine the longer run question of whether the economic regime is conducive to a recovery of investment and growth. 4. The findings are that inflation in the prices of non-tradables are converging to tradable prices (see Figure 1). This strengthens our conviction that inflation will fall, presuming there is no movement towards closing the economy once again. This presupposes that the current account deficit can be contained and in this context the report identifies the lack of sufficient fiscal adjustment as the major shortcoming of the Real Plan. Rapidly growing public debt is a symptom, although the growth of debt is not driven only by fiscal deficits but by the adopted macro regime in general. Figure 1: Brazil - Monthly Rate of Inflation for Tradable and Non-Tradable Goods' 10.00 -8.00 :00:.500\.0 :1;:: 600 X 2.00 -2.00 *- = 'I .v 0 LO LO U1 LO) LO co co 0 ( (0 rl- 0 0 0T ) X X 0 0e 0 0) t t 0) 0) 0) m < D I LL<-n C m i6 n