What's Behind Brazil's Slow Growth?

By MARY ANASTASIA O'GRADY, WSJ

Along with Russia, India and China, Brazil is supposed to be a 21st century economic tiger. So how come it grew a measly 2.7% last year?

President Dilma Rousseff would have you believe that it is because the Federal Reserve's low interest rate policy is making her country uncompetitive and thus "impairing growth." She said so on a visit to Washington last week and again over the weekend at the Summit of the Americas in Cartagena.

It is not a new charge. Brazil has been complaining about Fed Chairman Ben Bernanke's easy money policy for some time. Brazilian finance minister Guido Mantega is credited with coining the term "currency wars" to describe the export advantage a country gains by debasing its national money.

To be sure the Fed's "quantitative easing" and near-zero interest rate policies have meant that there are many dollars seeking better returns in energy markets. This has fueled a rush into Brazil, where plentiful offshore reserves have been discovered and, in contrast to reserves in the U.S., have been targeted for exploitation. Unlike Mexico, Brazil is allowing foreign companies to be part of the process. In agriculture too, Brazil has tapped the highest technology available and used it to become a world-class producer during a time of rising food prices.

When investors pile into these profitable Brazilian assets, the value of the real goes up. So Mrs. Rousseff is right that "helicopter Ben" is playing a key role in the Brazilian economy. Investors are also right to be wary of a commodity play that is heavily dependent on the Fed's free credit policy.

A bubble could be in the making. If production would not be profitable at lower prices, a bust could follow.

Yet a strong currency makes Brazilians richer, something the president ought to celebrate. So why is she mourning it? The answer lies in the political power of domestic manufacturers.

Think of what would happen if policy makers allowed the real to appreciate. As dollars flowed into the country and were used to purchase reais, the exchange rate would appreciate. The stronger real would give Brazilians more purchasing power around the world to modernize production facilities, increasing productivity and thus competitiveness.

This would be a wealth-building process. But Brazilian central planners have other ideas. They have always envisioned the country as a manufacturing giant, and the government has long subsidized domestic producers—think of the theory of infant industries—and provided protection from foreign competition. That was easier when the local currency was weak. Brazilians could not afford imports and the country's exports looked more attractive to foreigners.

Today the strong real is exposing the weakness of Brazilian manufacturing, which even before the Bernanke boom was shrinking in economic importance. According to Brazilian economist Raúl Velloso, manufacturing as a percent of Brazilian gross domestic product is now half of what it was in the late 1980s. Fully 65% of the economy is now services and the service sector employs four times as many Brazilians as manufacturing does.

Even so, domestic producers remain politically powerful and they are putting pressure on Brasilia to stop the appreciation of the real. To do that the central bank has to buy up the dollar inflows, issue new reais and then issue bonds to remove those reais from circulation so they do not generate inflation. The bank now has over $400 billion in dollar reserves and bond issuance has pushed up interest rates.

Higher interest rates attract more buyers of reais looking for higher yields. So rather than weakening the currency, the bank's intervention makes it stronger. Higher rates also make holding reserves expensive. Another problem is that investors may be more likely to put their money in government bonds rather than investments needed to boost productive capacity.

The government is also devouring savings needed for investment by pushing up consumption in a variety of ways. The consumption push, including the expansion of subsidized credit from BNDES, the national development bank, is perilous.

As demand heats up Brazil's low investment-rate-to-GDP of 18% (versus China's at 50%) means imports are needed. Protectionism blocks imports, so prices of tradable goods rise. Prices of services, which are not imported, also rise.

The higher consumption without the corresponding production capacity provokes inflation, raising wage costs for those domestic manufacturers the government is supposed to be helping. The central bank has to rely on high interest rates to control the situation. Growth suffers.

The way out of this trap is to embrace the strong real and the nation's comparative advantages in services and commodities. Allowing the centrally planned manufacturing industry to restructure won't be painless. But better to do it now, alongside pro-growth reforms in tax and regulation, than to wait for the inevitable crisis.