Otaviano Canuto, IMF: China’s Spill-Overs on Latin America and the Caribbean

[caption id="attachment_11281" align="alignright" width="300"] China: Hong Kong[/caption]

The Chinese economy is rebalancing while softening its growth pace. China’s spillovers on the global economy have operated through trade, commodity prices, and financial channels. The global reach of the effects from China’s transition have recently been illustrated in risk scenarios simulated for Latin American and the Caribbean economies.

The Chinese economy is rebalancing while softening its growth pace…

The weight of the Chinese economy in the global economy rose on its way to become the world’s second largest economy at market exchange rates and first in terms of purchasing power parity. As noted by the IMF (2016a, p.47),  approximately one third of global growth during 2000-15 took place in China, while its exports increased from 3 percent to 9 percent as a share of world exports (Chart 1)

More recently, China’s economic growth has been morphing from one led by public investment and exports of manufactures, towards one where consumption and services are the main drivers (Canuto, 2013a) (IMF, 2016a). The new growth pattern entails lowering the GDP growth rates to levels that are more balanced and sustainable, based on rising purchasing power of its population and less dependent on huge trade deficits elsewhere in the global economy.

“China’s transition may, however, face bumps. First of all, some complex and time-consuming structural reforms will need to be implemented.”

China’s transition, on the other hand, may face bumps. First of all, some complex, time-consuming structural reforms will need to be implemented. The provision of public services must be widened, in order to convince households to raise their propensity to consume. The business environment will have to be reconfigured as a necessary step to make possible moving up the sophistication ladder in value chains and overcoming so-called “middle income traps”  (Agenor, Canuto and Jelenic, 2012) (Agenor, Canuto and Jelenic, 2014). The existing universe of state-owned enterprise will also need to be reformed.

[caption id="attachment_11276" align="aligncenter" width="887"] Chart 1: China’s Role in the Global Economy. Source: IMF, Regional Economic Outlook – Asia and Pacific, April 2016, p.48.[/caption]

Furthermore, there is the legacy of corporate debt and excess capacity in former lead sectors that resulted as a consequence of policies implemented to avoid a hard landing in the aftermath of the global financial crisis. This legacy has been at the origin of occasional financial market jitters more recently. Fears of disorderly financial unraveling and abrupt exchange-rate depreciations have been behind episodes of capital outflows and loss of foreign reserves - Canuto and Gevorkyan (2016) - even if a more benign scenario has prevailed in recent months.

… leading to spillovers on the rest of the world…

 In hindsight one now understands the core role played by China’s growth-cum-structural-change in the upswing and – in the last five years – downswing phases of the cycle during which developing and emerging market countries went from “switching over as global locomotives” - Canuto (2011) - to “getting lost in the transition” (Canuto, 2013b). Notwithstanding idiosyncratic, country-specific factors and policies underpinning the growth performance in those economies, they have all been impacted by the evolution of China’s economy – including the growth resilience exhibited by the latter after the global financial crisis, despite the cost of rising financial and capacity imbalances. The recent rebalancing of the Chinese economy has naturally also brought spillovers.

There are three channels through which those spillovers from China to the rest of the world have operated (IMF, 2016a, ch.2). First, there is trade as a direct channel. A faster-than-expected slowdown in imports and exports has reflected not only a deceleration in investment and manufacturing activities, but also a movement of densification of domestic value chains to the detriment of imports of intermediates or export-related inputs. China’s foreign trade was a key factor behind the world trade slowdown last year (Canuto, 2016).

Second, there are spillovers through commodity prices. The growth slowdown and rebalancing in the Chinese economy has been a major factor affecting the demand and prices of commodities. This is matched by developments on the supply side, following technological innovations and new capacities that emerged during the upswing phase of the super-cycle.

Third, there are the direct and indirect spillovers through financial channels. As bouts of uncertainty about the smoothness of China’s growth slowdown and policy changes often spark global risk aversion episodes, financial spillovers extend way beyond those economies that have developed deeper financial links with China. Interestingly, while the “taper tantrum” derived from U.S. monetary policy signals in the summer of 2013 - (Canuto, 2013c) – the turbulences in emerging markets’ exchange rates and capital flows in January 2014 could be traced to financial events in China (Canuto, 2014). This has also been the case in August 2015 and January this year.

… including Latin America and the Caribbean

Spillovers from China, as it undergoes its growth-slowdown-cum-rebalancing are illustrated in recent simulations of the impact on Latin America and the Caribbean as reported last month by the International Monetary Fund - IMF (2016b) – and the Inter-American Development Bank - IDB (2016).

The IMF’s Regional Economic Outlook for the Western Hemisphere developed a risk scenario for Latin American and the Caribbean economies associated with a sudden bout of financial market turmoil in China. The simulation is based hypothetically on a  wide set of the latter’s financial and real estate assets losing value, corporate risk premiums increasing, a new wave of capital outflows being triggered, the Renmimbi depreciating by about 15 percent, and falling investment and output. The supposed impact on the Chinese economy is a move of China’s growth 2 percentage points down relative to the IMF’s baseline in 2016 and 2017.

Such shock would affect the region not only through direct trade linkages, but also as a result of commodity prices being pulled downwards, with substantial declines in the case of minerals and fuels and smaller corrections in world food prices. As one would expect from the diversity of exposure to commodity prices in the region - Canuto (2015) - effects would tend to be highly heterogeneous notwithstanding their overall significance.

The IMF’s risk scenario also includes the effects of a rise in global risk aversion following the simulated financial turmoil in China, leading to a re-pricing of sovereign debt in the region. The overall results of both simulated stress factors are depicted on the right side of Chart 2 (IMF, 2016b, p.42):

“Based on model simulations, the cyclical slowdown in China could reduce growth in Latin America and the Caribbean by about ¼ percentage point in 2016 relative to the [IMF’s]World Economic Outlook baseline. In addition, an increase in sovereign risk premiums triggered by higher global risk aversion would cut growth by another ¼ percentage point. The overall impact declines in 2017 but is still negative (total of about 0.2 percentage point).”

The latest annual macroeconomic report of the Inter-American Development Bank also features risk scenarios for the region, that include the impact of a shock to China’s economic growth (of approximately 3 percent of GDP) and a global asset price shock (measured as a 10 percent fall in equity prices) - IDB (2016, p.9-10). The combined effect of both shocks would be something close to 1.4 percent per annum for 2015-2017 (Chart 2, left side). As illustrated in the IMF simulation, the impacts would be heterogeneous among countries but broadly significant.

[caption id="attachment_11277" align="aligncenter" width="819"] Chart 2: China Slowdown and Global Risk Aversion Shocks - Impacts on Latin America and the Caribbean. Sources: (left) IADB, 2016 Latin American and Caribbean Macroeconomic Report, 2016, p.11; (right) IMF, Regional Economic Outlook: Western Hemisphere, April 2016, Box 2.2.[/caption]

China’s economic rise has also entailed increasing repercussions of its development in the rest of the world, including Latin America and the Caribbean. No wonder there is so much attention and hope for smoothness in China’s current economic rebalancing. After all, what happens in China does not stay in China…

About the Author

Otaviano Canuto is the executive director at the board of the International Monetary Fund (IMF) for Brazil, Cabo Verde, Dominican Republic, Ecuador, Guyana, Haiti, Nicaragua, Panama, Suriname, Timor Leste, and Trinidad and Tobago. The views expressed here are his own and do not necessarily reflect those of the IMF or any of the governments he represents.

Follow Otaviano Canuto on Twitter: @ocanuto


UNCTAD: A Policy Compact to Get Investment Flowing Again

[caption id="attachment_11336" align="alignright" width="300"] Geneva: United Nations[/caption]

James Zhan suggests world leaders make a joint effort to formulate effective investment policies to help build investment firepower to face 21st Century development challenges.

Forecasts of deeper global economic gloom are tumbling one over the other. The global economy has been treading water for almost a decade now, and no manner of intervention since the start of the financial crisis seems to get us closer to turning the tide. The path to balanced, stable growth remains elusive, and while advanced economies have borne most of the brunt, more recently the woes have started spilling into emerging economies.

UNCTAD data show foreign investment zigzagging its way through the last nine years, with the best of the peaks still well below the height scaled in 2007. Unlike post-crisis trends in GDP growth and trade, international investment flows are still below pre-crisis levels. While preliminary data for 2015 show an upswing in foreign direct investment (FDI) flows, this was largely attributable to merger & acquisition activity, with greenfield investment in productive assets only contributing modestly to the growth. Some of the flows were also related to corporate reconfigurations involving large values in the financial account of the balance of payments but little movement in actual resources. In other words, the positive figures are a veneer which masks deep investor skepticism and lack of confidence in economic prospects. What is more, plummeting commodity prices are now biting deep into the investment flows to commodity-dependent countries, with the investment flows to Africa and Latin America faltering. And 2016 is marked for another decline by forecasters.

The Appetite Has Gone

A multitude of adverse factors has converged to unhitch the carriage from the growth locomotive. Steeped in debt, demand has slumped to chronically weak levels in high-income countries. At the same time a sharp deceleration is now evident in several large emerging markets, which has ushered the end of the commodity super-cycle. On the political front, pernicious inequality, regional conflict, security concerns and the migrant crisis have provoked further instability and uncertainty. The result: global economic and political gloom that has choked off FDI.

“UNCTAD data show foreign investment zigzagging its way through the last nine years, with the best of the peaks still well below the height scaled in 2007. Unlike post-crisis trends in GDP growth and trade, international investment flows are still below pre-crisis levels.”

This matters because investors operating across borders have become a significant force in the global economy. Just over 90,000 multinational enterprises (MNEs) have some $27 trillion of FDI stock invested in over 1 million foreign affiliates worldwide, UNCTAD statistics show. Together, these MNEs account for more than a quarter of global GDP and are behind one-third of private sector value-added. Their investments in productive assets overseas account for up to a third of capital formation in the productive sector in developing regions. Their global production networks drive as much as 80% of global trade, and they generate a sizeable share of formal employment in developing countries: foreign affiliates alone employ more than 80 million people, and that is without accounting for their impact on suppliers, contractors, service providers and other so-called non-equity forms of international production. And these affiliates contribute some $730 billion annually to government coffers in developing countries.

Bashful When They’re Needed Most

Investors’ reluctance to invest should deeply trouble policy makers. What is more, the international community last year announced the Sustainable Development Goals (SDGs) to advance global development objectives. The goals seek to arrest poverty, flatten out inequality, universalize basic services, preserve environmental integrity and ultimately create a safer, more prosperous world.

By UNCTAD’s count an average $3.9 trillion needs to be invested in SDG-related infrastructure development in developing countries if these highly ambitious development objectives are to be met. But current levels of investment in these sectors are at only a third of the required level, leaving an annual investment shortfall of some $2.5 trillion, outstripping the combined mettle of public investment, international aid and remittances. The crux is that private sector investment will be indispensable if the international community hopes to make a dent in poverty and the other global development challenges.

The incongruous present circumstances, however, set up a veritable conundrum: if delivery proves meaningful, the SDGs can be a tool to soften political tension and ease economic anemia; but economic and political conditions need to be more conducive to unlock more investment in the first place if the goals are to be achieved.

Clear and coherent policies will therefore be absolutely pivotal to overcome the blockage, unlock investment and funnel these flows to meet development objectives. In reality, however, investment policy suites around the world are not tailored for this purpose. Developments in investment policies in recent years have exposed an accelerating, clashing dichotomy: while the bulk of national investment policy measures implemented tends towards investment liberalization, facilitation and promotion, the overall share of restrictive measures has been on the rise (from an average of 5% in the early 2000s to an average of 27% in the past five years). What is more, a significant number of investment protection measures are hidden in the administrative processes applied at and behind borders.

Measures Do Not Match Investors’ Needs

On the investment promotion and facilitation side, UNCTAD analysis has also exposed structural weaknesses in the strategies governments most commonly choose to try lure investment to their shores. That is, instead of easing out and culling administrative and regulatory requirements in the operating environment to help investors get on with their business more easily, most governments opt to try coax them through incentives — and leave the obstacles unhindered for investors to muddle through.

A recent UNCTAD survey of FDI policies shows more than 1,100 new investment policies were set up over the past decade. Yet, for the 323 investment promotion and facilitation measures, the overwhelming majority was related to investment incentives or special economic zones-type benefits. Only 24% were measures that are truly facilitatory in nature.

This means a range of inexpensive, yet potentially valuable, policy fixes go unheeded: opaque legal or administrative requirements faced by investors, cumbersome operating environments, and costly business requirements. Rather than handing out incentives, fixing these constraints would be a far more compelling key to unlock investment flows in the first place, and create a business environment that would keep investors invested.

Interestingly, the same deficiency marks investment policies at the international level. In most of the existing 3,300 international investment agreements (IIAs) concrete investment promotion and facilitation actions are either absent or weak. UNCTAD analyzed 1,200 IIAs and found that only 22% of these treaties contain some sort of investment facilitation provisions. And even in those agreements that deal expressly with investment facilitation issues, many of the adopted measures are poorly designed and doomed to be ineffective. Far more work would need to be done to win over cautious investors.

Beyond the inability to effectively promote investment, the broader international investment policy regime also needs fixing. It is widely acknowledged that IIAs contain flaws that hold risks and uncertainty for signatory countries and benefiting investors alike. The IIA regime — with its almost 3,300 bilateral or regional treaties — as a whole is incoherent and fragmented, making it difficult and burdensome to implement and navigate. Another priority area for redress is the IIA regime’s compatibility with the development agenda. To an extent, investment treaties lock-in a country’s legislative environment for foreign investors. This puts the treaties at odds with evolving sustainable development objectives. Also under scrutiny is the regime’s dispute settlement mechanism, which exposes governments to costly legal action by aggrieved investors when they adjust their laws. What is more, the inefficacy of the investment mechanism has plunged it into a legitimacy crisis: arbitral findings, for instance, are sometimes inconsistent, which means divergent legal interpretations of similar provisions exit, undermining the predictability of the system. And no well-functioning appeals option is available. The investment policy diagnostic is unpropitious: the regime does not effectively serve the purposes for which it is intended and needs fixing.

A Policy Compact to Direct Them to Development

UNCTAD has long been advocating for more suitable and harmonized investment policies precisely to improve policy firepower to oil investment flows, particularly towards sustainable development objectives. The best way to achieve this would be for countries to formally join efforts and build a coherent set of national and international investment policies: something like a Global Investment Policy Compact, containing a set of guiding principles for investment policy making in the 21st century.

International coordination to global investment relations would be a stellar approach to stimulate investment for growth and jobs, to make investment contribute to sustainable development, to avoid protectionism, and to get investment policies to work in tandem with other policies such as those for competition, tax, trade, social and environmental policies, which can mean even more firepower to bolster the global economy.

Unfortunately, this is unlikely to happen because — unlike for international trade and finance respectively governed by the World Trade Organization and the International Monetary Fund — there is no global governance equivalent for international investment. This means the systemic problems that exist are addressed in a piecemeal way, mostly by individual country action in a kind of a trial-and-error approach, which is really the last thing one would want to see as a governance system for one of the central pillars holding up the global economy.

The governance vacuum has prompted UNCTAD to explore alternative ways to facilitate collective action. The organization has developed a diverse set of policy frameworks, with guiding principles and policy recommendations to address various aspects of investment issues. These policy instruments are intended to help prop up countries’ policy-making capacity and function like a toolbox, giving countries the policy options to address their particular national concerns and development prerogatives. The main components of UNCTAD’s comprehensive investment policy frameworks and capacity-building package are:

The Roadmap for Reforming International Investment Treaty Regime was developed to guide the reform of the highly fragmented investment treaty regime and remedy commonly perceived problems and concerns. Elements include safeguarding the right to regulate, improving investment dispute settlement, promoting and facilitating investment, ensuring responsible investment, and enhancing systemic consistency.

The UNCTAD’s Investment Policy Framework for Sustainable Development (IPFSD) is mainstay in UNCTAD’s advocacy to evolve a 21st century generation of investment policies. The framework accompanies the guiding principles and proposes concrete national and international policy options, aligned with sustainable development objectives. The framework has the potential to guide policy coherence and has already proven a strong impulse for international cooperation in the area of investment with the potential to prompt incremental multinational economic coordination in the long run. More than 105 countries are currently using it to reorient their policy suites.

The Global Investment Facilitation Action Menu complements the IPFSD and comprises a set of policy options and actions to boost cross-border investment in productive assets, in parallel with and reinforcing analogous actions on trade facilitation, and remedying the systemic gap in international investment treaties, which insufficiently addresses actual investment promotion and facilitation measures.

The Action Plan for Investing in SDGs is a comprehensive plan containing six sets of transformative policy actions aimed at governments, but also suggested measures for private sector action to promote and facilitate investment in low-income countries in line with the Post-2015 Development Agenda and its set of Sustainable Development Goals.

The Entrepreneurship Policy Framework and implementation guidance supplements UNCTAD’s investment policy tools in support of the development of a strong, vibrant entrepreneurial sector to boost job creation and incomes. The framework consists of six policy components and forms the basis for a comprehensive, coordinated and inclusive approach to promoting entrepreneurship and the formulation and implementation of national entrepreneurship strategies and policies.

UNCTAD is also uniquely placed to facilitate consensus-building among countries through its intergovernmental convening power. This means while no formal multilateral negotiating mandate exists, an UNCTAD-facilitated investment policy conversation can give further impetus to comprehensively deal with the systemic policy concerns of the FDI regime in a manner approaching multilateral collaboration. Such an approach will reach much further than the fragmentary national and regional efforts that currently characterize investment policy making and reform.

UNCTAD’s World Investment Forum, which takes place in Nairobi, Kenya from 18-21 July 2016 will provide the next opportunity for exactly this kind of debate and key government leaders and investment stakeholders have already confirmed their participation in this dialogue. For the SDGs to gain traction, investment will be key. And for the right kind of investment to materialize, a common response to today’s shared ambition to promote investment in sustainable development is needed. The international community cannot afford to ignore the policy vacuum that characterizes the investment domain.

About the Author

[caption id="attachment_11338" align="aligncenter" width="300"] James Zhan[/caption]

James Zhan is Director of the Investment and Enterprise Division at the United Nations Conference on Trade and Development (UNCTAD). He leads the team that produces the World Investment Report.


Venezuela: As the Economy Sinks, Bond Markets Take Heart

The country may be unable to buy food or medicine; Venezuela continues to meet with clockwork precision all its obligations to bondholders. Struggling with triple-digit inflation and deploying the army to supress food riots, the monumentally inept government of President Nicolás Maduro has so far refused to take a shortcut (or negotiate a haircut) and default on its debt. The president’s shenanigans have, however, spooked early investors holding Venezuelan sovereign debt. Bonds issued by the government or by state-owned oil company PDVSA trade on average at forty cents on the dollar.

Data from credit default swaps indicate that the market estimates the likelihood of one-year contracts not being honoured at 61% - down from 78% in February 2016. Slowly, savvy and risk-tolerant investors are waking up to the fact the Venezuelan sovereigns are a veritable mint. The benchmark 2027 bond – a $4bn debt tranche raised in 1997 and the country’s most traded bond – pays a 9.25% semi-annual coupon and is currently trading at a 50% discount, pushing the yield up to just shy of 20%.

"Enjoying an average yield of 14.1%, investors holding Venezuelan bonds have earned around $7bn so far this year."

Whilst the country’s economy is in such a mess that a default seems a given at some point in the none too distant future, most investors have already factored in this possibility and remain confident that any haircut will still keep them solidly in the money. More interestingly, a significant part of Venezuelan bonds – some $40bn worth by one estimate (out of a $61bn total) – lack collective action clauses (CACs) which force all creditors to sign on to whatever post-default restructuring deal is brokered. CACs are the bane of hedge funds – aka vultures – that insist on full repayment or hold out for improved terms.

Investors price non-CAC New York Law bonds – such as the issue maturing in 2027 – much higher. Though the yield of that bond is already impressive, the notes maturing in 2028 – carrying an identical coupon but, crucially, with a CAC clause – trade at a significantly higher discount, pushing their yield close to stratospheric height (with the attendant risk now close to certainty). Paying attention to the notoriously dull and extensive legalese that accompanies bond issues can be a profitable pursuit.

In any case, Venezuela will want to avoid a long (court) battle with the holders of non-CAC bonds who could, conceivably, seize both inbound and outbound oil shipments and PDVSA’s sizeable overseas assets. Whilst the country sits atop the world’s largest proven oil reserves (300+ billion barrels), Venezuela imports vast amounts of light crude oil which is mixed with its own extra-heavy crude to produce a marketable commodity.

The fate suffered by Argentina also discourages the Maduro Administration from applying its socialist rhetoric to bondholders. After 13 years of litigation, Argentina – all the while deprived from accessing international capital markets – lost its fight against the investors holding out for better terms than the ones offered after the 2002 default and was ultimately forced to pay up almost in full.

Finally, with Venezuela’s near-total dependency on oil exports, the country can ill afford to scare off investors as it will need untold billions to keep degraded oilfields from falling dry. This is why President Maduro repeatedly assures the markets that his administration will not renege on its commitments to bondholders. The administration has already made provisions for the repayment of short-term debt by liquidating $3.6bn of the gold reserves. In order to free up hard currency, the government has also cracked down on imports, reducing inbound trade by 42% in the first months of 2016.

Portfolio manager John Baur of Eaton Vance who oversees the firm’s Absolute Return Fund, in 2015 cut back his exposure to Venezuelan sovereign debt but has since reversed his stance. “The view is that the bonds are trading below their recovery value. The situation in the country is disastrous and they’re very likely to default at some point, but with the world's largest oil reserves, you’re likely to see a recovery that is well above the current bond prices,” says Mr Baur.

Paradoxically, as Venezuela sinks deeper into a depression largely of its own making, the country’s bonds have already started to rally. While the country’s GDP is expected to shrink by 8% this year, market sentiment remains cautiously optimistic with one analyst – Francisco Rodríguez, chief economist at Torino Capital in New York – concluding that Venezuela is only temporarily being poorly run: “The way in which it’s run will shortly change. That change is now closer than most of the maturities of the outstanding bonds. What this means is that, considering current discount levels and yields, those bonds are a sound investment.” Not, though, for the faint-of-heart or those without the wherewithal to ride out any short to medium-term complications.


World Bank Group: Development Finance Frontline - Strategic Investment Funds

[caption id="attachment_11356" align="alignright" width="300"] CEO of the Senegalese Fund for Strategic Investments: Amadou Hott[/caption]

This is the first of a series of occasional interviews with senior strategic investment fund (SIF) professionals. Tasked with attracting private investors to priority economic sectors and projects, SIFs combine developmental aims with commercial financial return objectives.

"The only way to achieve the sustainable development goals is to use more public capital strategically for unlocking private investment, particularly to infrastructure,” says Amadou Hott, CEO of the Senegalese Fund for Strategic Investments.

The Senegalese Strategic Investments Fund (FONSIS, for its acronym in French) is part of a rapidly expanding network of state-sponsored strategic investment funds now emerging in countries at all income levels. The World Bank Group and its partner, the Public Private Infrastructure Advisory Facility, work with FONSIS in an advisory role, and FONSIS provides input to the bank’s research on SIFs. In the World Bank Group’s recently issued Climate Change Action Plan, SIFs feature as one of the tools to crowd in private capital to climate mitigation and adaptation projects.

“Essentially, we invest in good opportunities that can meet our minimum projected rate of return”

Mr Hott was in Washington for meetings, and we caught up with him during a break in his schedule. Mr Hott represents a new generation of African financial sector professionals and leaders, who have returned to opportunities at home after earning degrees at leading global universities and gaining extensive experience on Wall Street, in the City of London, and in other global financial centres. He was also nominated a Young Global Leader by the World Economic Forum.

FONSIS has been doing some very interesting projects. Could you tell us about some of your signature investments?
One project that I think is innovative is our building and commercial operation of the POLIMED (Pôles d’Infrastructures Médicales) diagnostic centre within the public hospital of M’Bour, a coastal city seventy kilometres from Dakar. The hospital itself couldn’t afford to buy the required advanced technological equipment, and we were asked to build and run the diagnostic centre as a commercial operation, with the public doctors and technicians of the hospital providing the medical services to keep down patient fees. Since operations started at the end of December 2015, more than 4,000 patients have been diagnosed, and the financial results are looking good so far. We intend to replicate this model all over the country to upgrade our medical infrastructure.

Another interesting project is the 30 megawatt, €41 million, solar energy power plant Santhiou Mékhé, and a nine kilometre transmission line to the grid. We closed that deal this past February. We were approached by the project’s initial developer, and our role was to structure the financial side of the project, help finalize the power purchase agreement with the off-taker, reach out to potential investors, and negotiate the debt and equity contributions. We also put down about one million euros of our own capital as a cornerstone investor, to give the project credibility at the initial stage. We expect the plant to be producing electricity in late 2016. I think we’ve achieved a good result: about €40 of external equity and debt co-investment for every euro that we ourselves invested. In general, we aim to achieve a multiplier of around 10 on our own invested capital, but we achieved an exceptionally high multiplier in this case, as we managed to secure a debt/equity ratio of 80/20.

Essentially, we invest in good opportunities that can meet our minimum projected rate of return, or hurdle rate, but focus on projects that generate jobs and have a developmental impact in the framework of the Plan Sénégal Emergent (PSE). For example, within the energy sector we can provide early-stage money if we know that afterwards there is a good chance of private interest. Furthermore, we serve as a local champion of entrepreneurship, and have invested €1.5 million in a venture capital fund of €6.1 million for small and medium-sized enterprises (SMEs). As we see it, Senegal is heavily dependent on its export potential, and innovative SMEs have been instrumental in developing the export sector in many other countries.

FONSIS combines developmental objectives with those of a commercial investor. Isn’t this a contradiction?
Look, we are an investment holding company focused on creating value for investors in our projects, and we operate as a private equity investor on behalf of the Senegalese government. We are rigorous in our investment decisions, and our hurdle rate is 12%. I think we bring good value, both in terms of the social and economic contribution of the projects that we are able to deliver, and in terms of the financial returns that we are able to generate for the state.

Our staff’s background – as investment professionals in global financial centres, and from multinationals in our core sectors – means that we have access to a network of international private investors, we have transaction experience, we have negotiation experience, and our co-investment on behalf of the state brings credibility to our projects. We may, exceptionally, participate in projects that have returns below the hurdle rate, but only if the government, or a donor, provides an equivalent subsidy to the project, which, of course, has to be approved in the government budget.

Not all state-sponsored investment funds have been successful, and some have ended up losing significant amounts of their capital on politically motivated projects that were not profitable or even had a developmental impact. How do you solve this?
In my view, independence and transparency are key. FONSIS is established by dedicated legislation, not simply by decree, and the terms of our board and management transfer across election cycles. Our investment strategy, ticket size per investment, and project selection criteria have all been extensively published in the national press and elsewhere to reduce external pressure. And transparency helps provide a sense of public ownership of the fund. In any case, I don’t expect that the public decision makers, who have strongly stressed the need to invest only in viable projects, would try to impose any transaction on FONSIS. Our investment committee and our board are very independent, with healthy debates taking place before we approve any project. Furthermore, the requirement to secure equity co-investment from professional investors and non-recourse debt from tough commercial and development banks, provides further assurances that financial return criteria will be met by our projects.

You also need a very strong team of investment professionals, people that have a future after FONSIS in other financial institutions, and therefore a reputation to protect. Having a highly qualified team of experts that can find other attractive jobs relatively easily makes it easier to resist external pressure. The FONSIS legislation sets specific requirements for staff financial sector experience and education. We used a professional recruitment firm to help select our staff, and now have thirteen investment professionals with backgrounds in international private equity firms, the global top-five consultancies, various industries and sectors, and investment banking. We felt it was critical for the Fund’s success to be able to hire on relatively competitive terms—albeit lower than those of international private equities or investment banks. So, benefits and performance-based remuneration are similar to the private sector, and FONSIS is by legislation exempt from the public sector’s salary structure. This is standard practice for well-functioning SIFs and sovereign wealth funds.

Strategic investment funds seem to be emerging everywhere now in Europe, Asia, Africa and elsewhere. How replicable is the FONSIS model in other countries?
I cannot emphasise enough that capacity is key. In Africa, the bigger and more dynamic economies have this capacity available at home or in their diaspora. For example, Kenya, Nigeria, Côte d’Ivoire, several of the North African countries and, of course, South Africa. Smaller countries may need to get external help to build this capacity over time, and political authorities need to allow SIFs to operate as fully independent professional investment managers, within a stable government-defined mandate.

SIFs represent a relatively new model of blending public and private capital. What, in your view, are the implications for development finance overall?
When it comes to development aid, you can just do the math. The annual global development aid budget is about $140 billion, whereas the investment needed to address development and climate change runs into the trillions. Only institutional investors and the private sector have that kind of investment capital available. Development finance institutions have a critical role to play, because low and middle-income countries are capital scarce. So, they don’t have much public capital to deploy for attracting private investment.

In my view, developing countries that have the required capacity and conditions could set up FONSIS-like structures, receive some development aid or even commercial loans - so long as the projects generate financial returns as well - to fund those structures, and use that capital to crowd in private investment. While in Washington, I have attended the seminars of the Sustainable Development Investment Partnership, which seeks to increase the impact of public capital by finding new ways of leveraging it with private investment, and where both IFC and MIGA are members.

What attracted you to return back home to Dakar after an itinerant career as a global investment professional?
President Sall and I first met at the World Economic Forum in Cape Town, a year before he was elected, while I was running a financial advisory firm in Dubai. I felt this initiative was important to Senegal, so it was an easy choice to get involved by starting as his special adviser with a focus on investment issues and setting up FONSIS.

About the Authors

Håvard Halland is a senior economist at the World Bank’s Finance & Markets Global Practice, Investment Funds Group. His research and advisory work focus on sovereign wealth funds and strategic investment funds. In particular, his work has focused on fund mandates, governance frameworks, as well as economic and policy implications of SWFs’ domestic investment. He is an author or joint author of academic and policy research papers, book chapters, magazine articles and blogs, and regularly presents at international conferences and seminars. He earned a PhD in economics from the University of Cambridge.

Michel Noel is currently Head of Investment Funds in the Finance and Markets Global Practice, Equitable Finance and Institutions Vice-Presidency of the World Bank. Previously, Michel was Practice Manager for Non-Bank Financial Institutions in the Finance and Markets Global Practice and Lead Financial Sector Specialist in the Africa Region and in the Europe and Central Asia Region of the Bank. He was on secondment from the Bank to Dexia Asset Management in Geneva and London from 2000 to 2003 working on local infrastructure private equity funds. Previously, Michel held a number of positions in the Africa and Europe and Central Asia Regions of the Bank. He also consulted for the OECD Development Research Center in Paris. Michel holds a MA in Economics and Social Sciences from the University of Namur, Belgium.


Travis Kalanick: Uber or Bust

Whether you’re the old-fashioned type that likes to hail a cab by the roadside or rich enough to have your own driver, it’s likely you’re aware of Uber. The company has entered the global consciousness and become a popular culture reference – in some conversations it even acts as a verb.

Uber has disrupted the traditional business model of minicab and taxi cab, relying as it does upon regular people using their own vehicles to basically offer lifts for payment, operating in more than 60 countries and 404 cities worldwide.

Set up by web entrepreneurs Travis Kalanick and Garrett Camp, Uber was originally pushed by Mr Camp, with Mr Kalanick less keen. Once on board, though, Mr Kalanick was ready to fight for Uber’s right to exist. He has been quite aggressive in insisting the business model is legal. Thailand’s Department of Land Transport begs to disagree and declared Uber illegal in 2014. Uber remains the subject of protests and legal action around the world.

Unsurprisingly, Barry Kornegold, president of the San Francisco Cab Drivers Association, is not a fan. “I think of them as robber barons,” he said. “They started off by operating illegally, without following any of the regulations and unfairly competing. And that’s how they became big – they had enough money to ignore all the rules.”

Unlike many regular cab companies, Uber uses a surge-pricing model so customers pay more at times when demand goes up – in bad weather for example – or during public transportation strikes. Uber has even sent its own people out to get rides with rival services Lyft and Gett, then either cancelled or used the opportunity to persuade drivers to work for them instead.

Yet by many, Uber is seen as good for its employees. Mr Kalanick certainly believes – or says he believes – so: “There is a core independence and dignity you get when you control your own time,” he said.

But business models such as Uber’s rely heavily on those whose services they offer, yet are accused of giving little in return. Uber drivers have none of the benefits many traditional cab drivers enjoy such as pensions, sick pay, health-insurance (particularly important in countries without a national health service), or union rights. Drivers provide their own vehicles, licences, and have no guaranteed hours or pay per week.

This may work for owners and customers, but for workers it feels like a race to the bottom. And with price-slashing a common tactic for Uber – Hailo, a similar London-based app, withdrew from North America unable to compete) – the company may end up as an unrestrained monopoly after it is done crushing the opposition.

Time Magazine called Uber “probably the fastest-growing start-up in history.” Mr Kalanick meanwhile claims he has no intention of slowing down, or at least not until every city on earth has an Uber presence.
Of course, as a disruptor, Mr Kalanick has also made sure Uber does not stop expanding its offering: in France, Uber is even available for helicopter rides while in San Francisco, slightly less excitingly, an UberEATS driver promises to deliver takeaway food within ten minutes. The 39-year-old Mr Kalanick does not himself seem to envisage a limit to what Uber can deliver, or how: “If something is moving from one place to another in a city, it’s our jam.”


Ann Low, National Defense University: Excellence in Government through User-Centric Design

Around the world a revolution is occurring, not one of violent upheaval, but one of excellence. Estonia and New Zealand are the oft-cited exemplars of user-friendly eGovernment, but they are not alone. On every continent, government employees are waking up to the imperative of user-centric, online, good governance. Individual reformers are improving lives by improving users’ experiences interacting with their governments. From investing in Vietnam, to opening a business in Oman, to applying for a permit in Washington, DC, pockets of government are changing for the better. These reformers are united by their quest for efficiency and their commitment to making every interaction with their part of government a positive experience from the user’s perspective. Their stories can inspire better governance everywhere, and they combine to provide seeds for global peace and prosperity.

Documenting procedures is the first step to simplifying them. Before the implementation of Project 30 on simplifying administrative procedures in Vietnam, seven different provinces implemented the same national laws in seven different ways. However, this wasn’t apparent until each province detailed its processes online.

“The application of information technology in administrative reform strongly contributes to the reform process by enhancing transparency in procedures for citizens and businesses.”

- Dr Ngo Hai Phan, Vice-chairman, ACAPR,Vietnam

The seven provincial portals combined show 121 procedures, encompassing 1,438 steps and 2,085 forms and requirements. The processes are clearly described on vietnam.eregulations.org, so the provinces can harmonize and simplify them. That clarity reduces corruption and facilitates investment by showing investors what to do, when and where to do it, how much it will cost, how long it will take, and the legal justifications for the required steps.

[caption id="attachment_11381" align="aligncenter" width="669"] 10 principles to simplify administrative procedures. Source: businessfacilitation.org[/caption]

Dr Ngo Hai Phan, Vice-chairman cum Secretary General of the Advisory Council for Administrative Procedures Reform (ACAPR), explained, “the application of information technology in administrative reform strongly contributes to the reform process by enhancing transparency in procedures for citizens and businesses.” [1]

Political Will

With political will, a country can transform itself rapidly, creating and implementing world-class eGovernment in just a few years. Oman launched its eTrasformation program in 2013, and in 2016 launched InvestEasy, one of the five most user-friendly business registration websites in the world. [2]

It’s all the same story: make each interaction with government clear and simple from the user’s standpoint. In 2010 Guatemala created its online information portal (asisehace.gt) to document procedures on how to set up a business, but then realized the portal could be much more. Ministries collaborated to add processes for trade, tax payments, permits, police checks and other services [3] . As of August 2016, 315 procedures were documented online, encompassing 2,509 steps and 871 forms and requirements.

In 2015, 309,000 users visited the site, while in the first eight months of 2016 alone, over 230,000 users visited the site. Seven countries in Africa (Benin, Kenya, Mali, Nigeria, Rwanda, Tanzania and Uganda) will be among the first in the world to create online trade portals describing how to import and export goods, in accordance with the recommendations of the 2013 World Trade Organization (WTO) Trade Facilitation Agreement negotiated in Bali. The Director-General of the WTO estimated that the Trade Facilitation Agreement would boost global trade by $1 trillion per year by streamlining, standardizing and simplifying border processes around the world — with the majority of the benefits going to developing and least-developed countries. [4]

Communicate

A great website also needs a great communication campaign to attract users. Argentina has faced challenges in creating more efficient and responsive government services. Mayor Martin Insaurralde and his team in Lomas de Zamora (population @600,000), responded by putting processes online, simplifying them and supporting users with an online call center open 24 hours a day, seven days a week.

“We can improve infrastructure and services, generating a virtuous circle of economic growth, based on easier compliance with legal obligations.”

- Minister of Economy Tharsis Salomon Lopez, El Salvador

“Providing 24/7 service sounds like it would increase costs, but putting processes online and simplifying decreased costs, so we could provide better services while generating increased municipal revenues through better compliance and economic growth. This is a giant leap for the municipal administration, after decades of bureaucracy,” said Mayor Insaurralde.

Some 396,000 users visited the lomasdezamora.eregulation.org website in 2015, and the site is on track to receive over half a million unique visitors in 2016. “It is essential that citizens and businesses know what the rules are and how they can comply with them. We have invested in a massive communication campaign and assigned a team of 25 municipal employees to publishing and simplifying procedures, and attending inquiries.”

An elegant website isn’t enough, governments must consider the full life cycle of a process from the user’s perspective. El Salvador built a single window, MiEmpresa.gob.sv, to allow simple online business registration, but informality remained a major problem, with over 60 percent of businesses noncompliant with relevant regulations.

[caption id="attachment_11384" align="aligncenter" width="900"] Stakeholders across El Salvador are collaborating to implement user-centric design on MiEmpresa.gob.sv[/caption]

While it was much easier to register a business, compliance with the law after registration, including tax payment, remained complex and cumbersome. El Salvador is piloting a project in Santa Ana, a municipality of 250,000, to simplify tax payments, put them online and educate users about the benefits and obligations of registering a business.

According to the Minister of Economy Tharsis Salomon Lopez, “once we implement the new process successfully in Santa Ana, we can replicate it nationally, so we grow our tax base. With those revenues we can improve infrastructure and services, generating a virtuous circle of economic growth, based on easier compliance with legal obligations. We have to consider the entire life cycle of a business, not just creation, but also operation and closure, to get the results we want: greater compliance, tax payments, and dynamic economic growth.”

Washington

Develop a system that includes funds to maintain and improve online procedures. Washington, DC has had a business registrar for over 200 years and, in that time, accumulated a great complexity of legislation and regulations. According to Josef Gasimov, Deputy Corporate Registrar for the District of Columbia, “we had to step back and spend a few years documenting our processes, then working with our municipal government and the U.S. Congress, which approves the District’s budget, to simplify. There was no way to achieve our goals without detailed, hard work and extensive collaboration across District agencies, and with the federal government. We also reached out to business registrars in other states to learn from their experiences. Then we wanted to be sure we kept up with changing technologies, since a good online system today will appear outdated in two or three years. We built into our fee structure funds to maintain and upgrade our services over time. As a result, and with our staff’s assistance and involvement, my agency created the DC Business Center (business.dc.gov), which generates a user-specific checklist of licenses and other requirements to start over 133 types of businesses in the District. It also provides clear step-by-step processes and downloadable forms. In the near future, we aim to make the services provided by all District agencies that issue licenses, permits, or certifications, or perform inspections, transactional online through single windows. Customers will be able to scan and submit documents, receive approvals, and pay for services online. Using the online single windows will save customers’ time, while their digital submissions will simplify our record keeping and improve data accuracy. Our process of continuous improvement has generated over 14,000 new business entities registered in DC during fiscal year 2016 (e.g. October 1, 2015 - September 30, 2016). The average time to register a business has fallen to less than one hour, if the customer decides to expedite her registration, and we continue to improve.”

[caption id="attachment_11386" align="aligncenter" width="926"] As of October, 2016, five countries had put their entire business registration processes online and made them transactional through single windows.[/caption]

Improve from Within

All of these reformers improved their systems from within. They didn’t spend their scarce resources on hiring consultants to write papers about what they should change. Rather, they hired experts to help them improve specific processes, and they sought input from, and listened to, their users. They focused on user-centric design and continually expanded improvements to their systems, one transaction at a time. This is the way forward. It is a path that is open to all governments, at all levels.
Regardless which law or regulation is being implemented, the goal is the same: make each interaction with government simple and positive. The United Nations Conference on Trade and Development (UNCTAD) has codified this approach in its Business Facilitation technical assistance program (businessfacilitation.org) and its 10 principles for administrative simplification (eSimplification).

“Ger.co takes one government procedure, business registration, and compares the user-friendliness of websites worldwide. It enables governments to explore the websites of their higher rated peers and learn best practices from them.”

- Jonathan Ortmans, President, Global Entrepreneurship Network & Ger.co Partner

The Global Enterprise Registration portal (GER.co) rates the user-friendliness of business registration websites worldwide. GER.co lets governments learn to make more user-friendly websites by emulating their higher-rated peers. Reformers’ stories, eSimplification, and GER.co are launching pads to accelerate simple, online governance everywhere and free up the world’s time for more production, peaceful interaction, and joy. By reducing governments’ inefficiencies, we increase productivity and hence economic growth and time for leisure. If you have an idea to improve a government process, tell your government. Together we can create more global prosperity through improved productivity — one process at a time.

About the Author

Ann Low is a Foreign Service Officer with over 20 years of experience representing the United States in multilateral fora. She is studying at the National Defense University’s (NDU) Eisenhower School. NDU is the United States’ premier joint professional military education institution. The Eisenhower School educates U.S. military, civilian staff, and international fellows, to lead strategic institutions and activities associated with the integrated development of national security and national defense strategies.

Disclaimer: The views expressed in this article are those of the author and are not an official policy or position of the National Defense University, the Department of Defense, or the U.S. Government.

Footnotes
[1] Opening speech by the Director General Ngo Hai Phan, Seminar on the Announcement of Vietnam’s Investment Portal, (Hà Nội, June 29, 2015)
[2] www.business.gov.om/wps/portal/ecr and ger.co
[3] www.youtube.com/watch?v=xAio1C5EnR8 minute 2.12
[4] www.wto.org/english/thewto_e/dg_e/dg_e.htm, WTO Director-General: Roberto Azevêdo welcome message


Otaviano Canuto, World Bank: What’s Ailing the Brazilian Economy?

Brazil’s GDP is poised to decline by close to 7% in 2015-2016. Per capita GDP in 2016 is likely to shrink by more than 10% as compared to three years ago. We argue here that a double malaise has been ailing the Brazilian economy: given an anaemia of productivity increases, an appetite for public spending without prioritisation has led to a condition of fiscal obesity. We further approach why market reactions to the Brazilian government’s proposal of crisis response have been positive.

Brazil has been suffering from anaemic productivity growth. This is a major challenge because in the long run, sustained productivity increases are necessary to underpin inclusive economic growth. Without these, increases in real labour earnings tend to conflict with global competitiveness; collecting taxes in order to fund government expenditure on infrastructure and social policies becomes a heavy burden; returns to private investment becomes harder to achieve; and ultimately citizens will have less access to high quality goods and services at affordable prices. The focus on urgent fiscal reforms adopted by the new government – public spending cap, social security reform, etc. – must be accompanied by action on the productivity front.

“It is now widely accepted that a systematic increase in Brazil’s labour productivity and TFP will be needed if the growth-with-social-inclusion that prevailed in the 2000s is to return.”

Brazil’s recent social and economic progress was achieved without major productivity growth. Both minimum and average wages rose a lot faster than labour productivity, and employment moved toward sectors with few opportunities for productivity growth (see chart 1).

According to estimates reported by the World Bank, Brazil’s total factor productivity (TFP) increased at an annual rate of 0.3% from 2002 to 2014 – and only 0.4% p.a. during the roaring years from 2002 to 2010. Two-thirds of Brazil’s GDP increase can be accounted for by higher quantity and quality of labour being incorporated in the economy. Only 10% can be attributed to TFP gains.

[caption id="attachment_11392" align="aligncenter" width="1071"] Chart 1. Source: World Bank (2016a)[/caption]

Demographic trends – a growing working-age population – leading to labour force growth were responsible for 1.1 percentage points of annual GDP growth in 2002-2010, while increases in labour force participation, especially among women contributed about 0.6 percentage points. Better access to education accounted for about 0.7 percentage points of average growth in the same period.

Since the investment-to-GDP ratio remained at or below 20%, it is not surprising that growth in the capital stock contributed only about 0.9 percentage points to growth on average. In labour productivity, Brazil lagged behind most of its peers over the period.

It is now widely accepted that a systematic increase in Brazil’s labour productivity and TFP will be needed if the growth-with-social-inclusion that prevailed in the 2000s is to return. But how can Brazil come up with these productivity improvements?

One obvious source of productivity gains is infrastructure. In addition to being a source of gross fixed capital formation, sustainable investments in infrastructure would alleviate bottlenecks that became increasingly tight as the economy expanded: “For at least the past two decades, investment in infrastructure in Brazil has been below the rate of natural depreciation. The rate of infrastructure investment needed simply to offset depreciation has been estimated to be of the order of 3 percent of GDP. In Brazil, total investment in infrastructure has been less than 2.5 percent of GDP annually at least since 2000.”

[caption id="attachment_11393" align="aligncenter" width="1069"] Chart 2. Source: World Bank (2016a)[/caption]

As illustrated in the World Bank report, substantial negative effects in terms of wasted resources – labour time, misallocation of resources, product loss etc. – are derived from the insufficient investment in infrastructure and the bad state of energy supply and connectivity such as transport, logistics, and ICT (see chart 2). Reducing the waste of resources through more and better investments in those areas would result not only in direct productivity gains, but would also induce private investment in other sectors.

Additionally, horizontal productivity gains could be achieved in the private sector by improving Brazil’s business environment. The Doing Business Report, prepared annually by the World Bank for 189 countries, has indicated year after year how a typical Brazilian company is obliged to spend human and material resources on activities that do not generate value because of the difficulties and costs associated with starting a business, registering a property, getting credit, paying taxes, and enforcing contracts. The negative consequences for productivity are three-fold: it subtracts productivity at both enterprise and macroeconomic levels; it stifles competition as it raises barriers to entry and to the contestability of markets, especially for smaller firms that are unable to dilute the costs of doing business through scales; and it stimulates informality.

The Brazilian business environment is especially unfriendly to investments and technological learning obtained through foreign trade (see chart 3 on the right). Transaction costs and difficulties to access technologies, equipment, and supplies from abroad limit innovation, productivity increases, and competitiveness. Investments in logistics infrastructure would help, but an evaluation of the costs of the complex structure of tariff and non-tariff barriers – like local-content requirements – embedded in trade protectionism is also needed. Brazil has become an unusually closed economy as measured by trade penetration and the opportunity cost of failing to open its economy has risen dramatically in the recent past. Not by chance, foreign direct investment is mostly aimed at accessing Brazil’s large domestic market, rather than seeking efficiency in production.

[caption id="attachment_11394" align="aligncenter" width="1077"] Chart 3. Source: World Bank (2016a)[/caption]

Access to finance is another aspect of the Brazilian business environment limiting productivity growth. Finance for long-term projects and for small- and-medium enterprises (SMEs) is limited – except for a small group of preferred enterprises with access to government subsidised credit.

In most of its dimensions, Brazil’s business environment not only takes a toll in terms of waste in the use of resources, but also fails not create incentives towards innovative, technology-adaptive, productivity-enhancing corporate behaviour. Lack of competition is part of the problem:

“Compared to other emerging markets, Brazil has a wider dispersion of productivity levels across firms and a larger number of low-productivity firms. Large gains could be made in aggregate TFP if physical and human capital were reallocated in a way that allowed more-productive firms to grow and the least-productive ones to shrink or exit. High firm dispersion in Brazil suggests market and policy failures that create an uneven playing field for firms, negatively affecting the entry and expansion of more-efficient firms and the exit of less-efficient ones.”

The window of opportunity opened by the on-going corruption scandals will be used to upgrade governance in the interface between public and private sectors, with many gains such as: improved rule of law and corporate governance, resulting in lower risk perceptions; improved competition and market discipline in key sectors, particularly those bidding for public projects; and cutting out wide-spread kickbacks that will reduce both public overspending and the notorious Brazil Cost (Custo Brasil) born by the private sector.

Besides infrastructure investments and addressing the business environment, a third obvious source of systematic productivity gains would come from better and more accessible continuing education and skill acquisition by workers. Despite improvements in quantity and quality of education over the last decade, there remains the legacy of a long history of educational neglect with respect to large swaths of the population that accompanied the non-inclusive nature of Brazil’s economic progress over the previous century.

[caption id="attachment_11395" align="aligncenter" width="925"] Chart 4: Central government primary balance. % of GDP. 12-month sum, adjusted for non-recurring events.
*Includes civil service pensions. The central government balance corresponds to the sum of the Treasury and social security balances.
Source: J.P.Morgan, “Brazil: the unbearable weight of social security”, Global Data Watch, August 19, 2016.[/caption]

Even as Brazil achieved upper middle income status and captured higher positions on some global value chains – such as technology-intensive agriculture, sophisticated deep-sea oil drilling, and the aircraft industry – a substantial share of the population remained mired in poverty. With inadequate education, poor health conditions, and a lack of on-the-job training preventing many workers from increasing their productivity, Brazil’s potential economic growth has been compromised. Provided that the country manages to return to a comprehensive poverty reduction path which includes improved access to healthcare, financial services, and education Brazil’s overall productivity could improve in the coming years.

Lack of Priorities in Public Spending

The anaemic productivity increases in the last decades have taken place while a political desire to finally come to terms with the poverty and inequality has also been exercised. Such a political desire, after the return to democracy, translated into a large role for the public sector, along which primary government expenditures as a proportion of GDP rose from 22% in 1991 to 36% in 2014.

The uptick of public spending took place with increased earmarking of tax revenues and the ability of interest groups to maintain existing privileges. It was matched by a rising tax burden based on levies on consumption and also dependent on rising levels of formalisation in the labour market. When the conditions that allowed for the growth-cum-poverty-reduction experience of 2003-2010 exhausted, the aftereffects of the fiscal pro-activeness on the economy became hard to trim.

Had productivity risen more than it did, the demand on government services in absolute terms would have meant less of a share of GDP and of a tax burden on the private sector. On the other hand, the run-up to a fiscal overweight condition was pushed forward and postponed as the boom of the new millennium unfolded.

[caption id="attachment_11396" align="aligncenter" width="1076"] Chart 5: Spending cap – official forecasts. Note: assuming annual real GDP growth at 2.5% and inflation at 4.5% from 2018 onward.
Source: Brazil’s Ministry of Finance.[/caption]

Indeed, even without substantial productivity gains, the Brazilian economy went through a period of macroeconomic stability and economic growth-cum-poverty-reduction in the first decade of new millennium. The preservation of the economic policy tripod – inflation targeting, floating exchange rates, and significant government primary surpluses – along the transition from President Fernando Henrique Cardoso to President Luiz Inácio Lula da Silva led to substantial stabilisation gains as gauged by rising business confidence and decreasing risk premiums, which culminated with the upgrade of public debt to an investment grade status by the three major international rating agencies.

Such stabilisation gains in a context of very favourable external conditions – the upward phase of the super-cycle of commodities and the abundance of global liquidity – paved the way for a prolonged boom. The creation of formal jobs proceeded at a fast pace, with rising rates of formalisation in the labour market and unemployment rates falling from 11% in the beginning of the decade to 5% in 2010. The differential income growth at the bottom of the social pyramid was particularly remarkable, with a correspondingly impressive emergence of a new middle class. While GDP grew at an average rate of 4.5% per year, income of the bottom 20% rose at rates above 7% p.a.

The favourable external scenario supported growth in several ways. Rising commodity prices provided a fiscal windfall, used to boost social objectives while leaving existing privileges untouched. Improved terms of trade translated into increasing domestic purchasing power of goods and services, besides positive wealth effects for natural-resource owners. Foreign currency indebtedness of the private sector was facilitated. Official external reserves skyrocketed.

[caption id="attachment_11397" align="aligncenter" width="1098"] Chart 6: Spending cap - J.P.Morgan’s forecasts. Source: J.P.Morgan (October 7, 2016)[/caption]

However, the upswing phase from 2004 onwards of the commodity super-cycle brought double-edge effects, while reinforcing the consumption-led, labour income-led underlying growth model. Combined with exchange rate appreciation and rising minimum wage floors – as well as public-sector disbursements indexed to the latter – the commodity boom allowed a virtuous domestic cycle featuring positive feedback loops between consumption – especially services – and formal employment.

On the other hand, profitability levels in the manufacturing industry were crushed and levels of production practically stagnated after 2008 before ultimately declining in 2014. The Brazilian economy ran toward a competitiveness cliff. With the fall of global prices of metals since 2012, followed by food prices in 2014, the cycle began to unfold in the opposite direction.

It is in that context that the government attempted to find a shortcut to a new, investment-led growth cycle in 2012-2014. In response to the global financial shocks in 2008-2009, the Brazilian government had employed counter-cyclical fiscal and monetary policies that helped lift GDP by more than 7% in 2010. As growth returned to lower levels afterwards, the government implemented a second round of stimulus policies, including a sizable package of tax exemptions, local-content policies, credit expansion via transfers of proceeds of public-debt issuance to public-sector banks and, in a failed attempt to slow down inflation without hiking interest rates, curbs on regulated prices. It is worth noticing that the expansion of public spending accelerated after 2008 and tax revenues have collapsed since the beginning of the economic downturn in mid-2014. Given the structural reasons for the private investment retrenchment, the main legacy of what we have called a failed effort to chase animal spirits was mainly fiscal deterioration (as depicted in chart 4).

In fact, macroeconomic policies implemented in 2015 may be primarily seen as the unwinding of that attempted shortcut. The upward realignment of regulated prices, together with the realignment of foreign versus domestic prices (exchange rate depreciation), both led to an expected inflation shock. The Central Bank then used interest rate hikes to contain expectations of future inflation and avoid the diffusion of the corrective inflation shock. Furthermore, ambitious targets of fiscal adjustments were announced at the beginning of the year, although the barriers to reach such targets – rigid, legally-mandated public expenditure rises with pensions and others – came to be recognised with successive announcements of unwinding of fiscal targets.

Another factor behind the current bust has been the collapse of private investment following the previously mentioned investigations of market rigging and corruption initially associated with Petrobras, the state-controlled oil company, which subsequently spread to much of private-public sector. Large and GDP-relevant domestic private groups involved in those scandals have faced direct impacts – financial drought, operational disarray, and a sudden halt of demand. Furthermore, deteriorating confidence has spread throughout, accompanied by a wait-and-see attitude pervasive with outsiders. The ensuing political crisis not only reinforced the investment paralysis, but also hindered the congressional approval of fiscal adjustment measures.

As remarked, the medium-term silver lining of the investigations is an improved perception of rule-of-law by investors, besides a fiercer private sector competition and lessened cost-effectiveness of public spending in those activities where there is an interface between public and private sectors. However, in the short term, these non-economic factors have been partly responsible for the GDP decline. Furthermore, as tax revenues fell at an even faster rate than GDP, the fiscal adjustment effort has been thwarted and an open fiscal crisis came to the fore.

To summarise, the combination of anaemic productivity increases and a substantial growth in public expenditures oriented towards government transfers (pensions, social programmes) – and real wages rising faster than productivity – during the growth-cum-poverty-reduction cycle was sustainable only while external conditions were highly favourable. Now, a medium-term fiscal adjustment – to be supported by measures to raise the pace of productivity increases – has become essential to return to inclusive growth.

A Straitjacket on Public Spending

Reversing the explosive fiscal trajectory of the last few years has become widely accepted as a government policy top priority. The Brazilian government has proposed to congress a constitutional amendment forbidding central government expenditures for up to twenty years to increase annually in nominal terms by more than the inflation rate of the previous year. Provided that the inflation stabilises at some level, such a cap will eventually mean a decrease of public expenditures as a ratio of GDP as soon as the latter exhibits positive figures – even if public spending keeps rising in real terms in the immediate future ahead while inflation remains on a descending path.

If tax revenues accompany GDP, the fiscal rule will automatically lead to reversal of negative primary balances and of the current rising trend of fiscal imbalance and public debt. The rule may be understood as a trade-off of medium-term enhancement of the fiscal landscape in exchange for some flexibility in the short term, given the prevailing budget hard rigidities (see current simulations from the ministry of Finance in chart 5 and those from JPMorgan in chart 6).

Of course, the main requisite for success will be a review of public spending rigidities and legally-mandated increases. Not by chance, the government has declared that it will also send to congress a proposal of pension reform, a key ingredient of the recent fiscal obesity, as a way to make space for other essential public expenditures not to be dramatically curbed.

Government forecasts point to a deficit of the social security system around 2.7% of GDP next year, larger than the overall government deficit. Although currently still a moderate deficit, pension expenditures are poised to accelerate given demographic trends and prevailing rules. Brazil’s ministry of Finance forecasts social security spending to reach almost 10% of GDP in ten years under existing conditions even with GDP growing by 2.5% p.a. from 2018 onward. Brazil, for instance, is one of the very few countries without a minimum retirement age.

Chart 7 – extracted from a study by Fernandez, Moreira, and Souza, contained in JP Morgan’s Global Data Watch of August 9, 2016 – illustrates how relatively generous Brazil’s social security system is compared to most other countries:

“Brazil paid 6.4% of GDP in pensions in 2011, even though only 7% of the population was above 64 years of age (orange dot marked 2011 in chart 4). By 2016, total expenditure rose to 8.4% of GDP while the proportion of the population over 64 grew to 8.2% (dot marked 2016 in chart 4). Spending is far above the OECD trend, which suggests that Brazil spends as much as countries with higher proportions of people over 64, of about 13% in 2011 and 16% in 2016 (dots around the centre of chart 4). Pensions in Chile, a Latin American peer, amounted to 3.2% of GDP in 2011, with 9.9% of the population older than 64.”

The two previous fiscal adjustments in the last twenty years – at the end of the 1990s and after President Lula’s first election – relied mainly on a combination of tax hikes, discretionary spending cuts, and growth in following years. This time the tax burden is already relatively high, recovery of growth will be gradual, and the share of discretionary spending is only about 25% of the total. Reform of mandatory expenditures as imposed by the straitjacket will have to happen.

More generally, a review of public spending should help abiding to the new constitutional rule. To the extent that one may locate benefits and public subsidies that do not find justification in terms of poverty reduction or needs of the productive system, their elimination would make room for redirection of the corresponding resources.

[caption id="attachment_11398" align="aligncenter" width="889"] Chart 7: Pension public spending and elder’s participation. Spending as % of GDP, orange dots are Brazil’s numbers.
Source: J.P.Morgan, “Brazil: the unbearable weight of social security”, Global Data Watch, August 19, 2016.[/caption]

A review of public spending may also bring a great potential contribution to TFP and economic growth, with effects spanning across two factors behind the productivity anaemia – infrastructure and business environment – as we saw. For an economy with a high tax burden and proportion of public spending in GDP such as Brazil, improvements in the quality of the latter have significant direct and indirect impacts.

More generally, international experience has shown how transparency, evaluation of results, accountability, and competition in public procurement reduce corruption and improve the quality of public spending. There is also evidence that the quality of public services responds positively to the presence of incentives that reward good performance. Improvements in the quality of public spending would provide gains not only as a significant part of GDP, but also as part of the production inputs used by the private sector.

[caption id="attachment_11399" align="aligncenter" width="1054"] Chart 8: Interest rates and risk premium. Source: Bloomberg[/caption]

In addition to the fiscal regime change, the government has also obtained – or is seeking – congress’ approval for other reforms with potential positive effects on investments and productivity. As of the moment this text is written: Petrobras has been freed from the obligation to invest in all pre-salt fields; a reform of the regulatory agencies law has improved their governance and budget independence; prevalence of negotiation over labour legislation; and simplification of two taxes with heavy impact on Brazil’s cost of doing business. The government has also launched a first package of new 34 infrastructure concessions.

The economic agenda proposed by the government and the track record already established with respect to its congress approval have been among the factors explaining the favourable recent evolution of long-term interest rates and risk premiums levels (chart 8). Confidence levels and other early signals point to a private investment-led recovery starting last quarter of this year.

Bottom Line

Brazil’s remarkable achievements in terms of growth-with-poverty-reduction of the last decade can be repeated. As long as due attention is given to the double malaise – productivity anaemia and consequent fiscal obesity – that has been ailing its economy. Although fiscal adjustment comes to the fore as a most immediate focus of measures, success will ultimately depend on how well the productivity anaemia is dealt with, since only with productivity increase the poverty reduction-motivated demand for government services will be exercised without conflicting with fiscal soundness.

About the Author

Otaviano Canuto is the executive director at the board of the World Bank for Brazil, Colombia, Dominican Republic, Ecuador, Haiti, Panama, Philippines, Suriname, and Trinidad & Tobago.

The views expressed here are his own and do not necessarily reflect those of his employer or any of the governments he represents.

Follow Mr Canuto on Twitter: @ocanuto