Capital flows to Brazil in the nineties: macroeconomic aspects and the effectiveness of capital controls. (includes appendix)

I. INTRODUCTION

The history of the resumption of capital flows to the Brazilian economy since the early nineties is intertwined with the success of the current stabilization plan, the Real Plan of July 1994. The very large volume of reserves worked and still works as the (short term) insurance policy of the exchange rate, which anchored the new currency. Nevertheless, the large volume of capital flows has prompted the government to try to fine-tune its size and composition.

Here we characterize those flows and analyze their main determinants. A simple econometric model finds that the interest rate differential has been, since 1991, the main determinant of the capital inflows. We then carefully review the empirical evidence on the interest rate differential between the Brazilian bond markets and abroad.

The restrictions on capital flows are reviewed and their effectiveness is analyzed. Finally, we sum up with a discussion of the macroeconomic causes and consequences of the capital flows, and the prospects for the future. The continued success of the current stabilization plan will in great portion depend on what will happen to the capital flows.

I. EMPIRICAL DESCRIPTION OF CAPITAL FLOWS TO BRAZIL IN THE NINETIES

This section describes the capital movements to and from Brazil in the nineties. In order to provide a short historical perspective, the late eighties were also included in the data. This provides a very sharp contrast between those years - when the foreign debt problem was a huge constraint on the Brazilian economy - and the nineties, when the resumption of capital flows, together with the foreign debt renegotiation significantly relieved the external constraint, vis-a-vis the earlier period.

A. Size

Brazil, like many developing countries, witnessed a revival of capital inflows in the nineties. Chart I shows the capital account balance since 1987 (both in USS millions and as a percent of GDP), displaying the remarkable reversal since 1992. Chart 2 shows the aggregate net transfers to Brazil, defined as the sum of the capital account balance, the interest payments (negative, because Brazil is a net debtor), and the change in short-term liabilities flows (basically arrears). One can detect the same patterns as in the capital account (reversal since 1992), but with a much more marked increase in 1995. This is because in 1992, US$16.6 billion of the inflows took the form of refinancing,(1) which were used to pay back the arrears (US$14,253 million of arrears were repaid in 1992). In 1995, only US$0.5 billion of arrears were repaid, and there was a net inflow of US$19,667 million in short-term capital. One can detect the new pattern of the aggregate net transfers in 1995 and 1996, when around 3 percent of GDP was transferred to Brazil.

Therefore, the global picture is that Brazil has overcome the shortage of capital inflows since 1992. Moreover, since 1995 those flows, mainly short term, have become excessive, creating many problems for monetary and exchange rate policy, as analyzed below.

B. Composition

Chart 3 displays the behavior of medium and long-term capital movements.(2) The net figures are presented for the three main components: investments, financing, and currency loans (explained below). Those net figures, together with the net total of medium and long-term capital movements, are presented in bars referring to the first axis scale. The gross movements are presented in lines, referring to the second axis scale.

The reversal of the total net figure in 1992 is due both to foreign investments and currency loans, while the burden of the foreign debt shows up in a steadily negative figure for the item financing. Both the inflows and outflows grew substantially during the nineties, with the latter almost reaching the US$65 billion figure in 1996.

Investments

Chart 4 displays the behavior of net foreign investment (direct and portfolio) and reinvestment in Brazil. For the net figures, once again, 1992 is a turning point. The decrease in the 1995 figure may be attributed to the effects of the Mexican crisis. In the first quarter of 1995, US$3,352 million of foreign investment (mainly portfolio investment) flowed out of the country (the year-end figure was positive, US$4,670 million). In 1996, the growth trend that started in 1992 resumed.

The most striking feature of Chart 4, however, is the enormous growth in both inflows and outflows. As Charts 5 and 6 make clear, the main source of such growth was the portfolio investment which was multiplied by a factor greater than 30 between 1991 and 1994/5 (see Chart 5). Portfolio investment will be further analyzed later.

Foreign direct investment (see Chart 6) also displayed an upward trend since 1994, with a marked increase in 1996. This is explained in part by a change in the tax law that regulated profit remittance abroad. In 1993, the law regarding profit remittance was changed, so that profits paid regular domestic corporate income tax (48%), and dividends remitted abroad were taxed at 15 percent.(3) The resulting joint tax burden (56%) was high by international standards. Capital gains remitted abroad paid a 25 percent tax. Starting 1996, only corporate income tax (30.6%) is charged, which harmonized the Brazilian tax code with its counterparts in the Mercosul. Privatization revenues also account for the increase in foreign direct investment last year.

The continuation of the trend in foreign direct investment will depend on the strength of the privatization process and the public-private partnerships in areas previously restricted to state-owned firms (oil, energy generation, telecommunications, etc.). Forecasts hover around US$16 billion for 1997 and the following years. However, there have been recent claims in the financial press that fixed income investments have been disguised as direct investment, in order to avoid the "entrance" tax (7%, explained below) charged by the Brazilian government. We will further expand on this point below.

B2. Financing and Currency Loans

Chart 7 shows the performance of the Financing item, composed of the multilateral organizations (BIRD, IDB, and IFC), bilateral organizations and suppliers' and buyers' medium and long-term credits.(4)

The better performance of the capital account in the nineties allowed for an increase in the differential between amortizations and disbursements to Brazil, making the item Financing steadily negative in recent years. Nevertheless, in steady state, one would presume that a developing country like Brazil should be a net receiver of official transfers. Therefore, when that happens, this will represent an alternative (better) source of external savings to the short-term capital flows that have entered the Brazilian economy in the first half of the nineties, with positive impact on the stabilization plan.

Currency loans, on the other hand, substantially increased as a result of the resumption of capital flows in the nineties, as shown in Chart 8. The decomposition of those disbursements reveals that the main instrument for this increase was the issuance of notes in the international markets, with large volumes starting in 1992. This stands in sharp contrast with the previous decades, when bank loans accounted for most of the disbursements.

Chart 9 summarizes the main facts regarding the composition of capital movements to and from Brazil since the late eighties. The solid line is total medium and long-term capital movements (see footnote 2 for the difference between this figure and the capital account balance), with the by now familiar pattern of becoming very positive and increasing after 1991. This line is decomposed of its main factors (in columns). On the positive side, the main factors responding for the growth of medium and long-term capital movements in recent years are Foreign Portfolio Investments, Currency Loans - Notes, and Foreign Direct Investments. On the negative side, the main factors are Financing (repayments to official agencies), Currency Loans - Banks (repayments to banks), and Brazilian Investments abroad. The dotted line is the short-term capital movements, which also turned positive in 1992, but reached the very high level of almost US$20 billion in 1995, thereby surpassing the medium and long-term capital movements in that year. Note that the Brazilian Central Bank bulletin classifies portfolio investments as medium and long-term capital movements, not short term ones. If we classify portfolio flows as short-term capital movements, the predominance of short-term capital inflows in 1995 becomes much more striking as seen in Table 1. In 1996, however, short-term capital flows (exclusive of portfolio investment) decreased substantially, while the medium and long-term flows increased to the point of increasing the capital account (see Chart 1).

[TABULAR DATA FOR TABLE 1 OMITTED]

III. MAIN DETERMINANTS

Besides the good prospects for the economy in the medium and long run, which have attracted both portfolio and direct investment, one of the main determinants of capital inflows in the nineties has been the extremely high interest differential between Brazil and the developed economies.(5) Therefore, we start by considering the interest rate differentials between Brazil and the U.S.

A. Interest Rate

On the last day of September 1991, the very low level of foreign reserves prompted the Brazilian Central Bank to adopt a combined strategy of devaluing the currency by 15% and raise interest rates to a steady level above international rates. After the devaluation, the exchange rate policy of daily devaluations (crawling-peg) assured investors that the government aimed at keeping a stable real exchange rate.(6) Given the large interest rate differential between the Brazilian and international rates, short-term …