Brazil and the IMF Press Release: IMF Approves 15-Month Extension, and US$6.6 Billion Augmentation of Brazil's Stand-By Credit December 15, 2003 Country's Policy Intentions Documents Free Email Notification Receive emails when we post new items of interest to you. Subscribe or Modify your profile

Brazil—Letter of Intent Brasília, November 21, 2003 The following item is a Letter of Intent of the government of Brazil, which describes the policies that Brazil intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Brazil, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.   Mr. Horst Köhler Managing Director International Monetary Fund Washington, D.C. 20431 Dear Mr. Köhler: 1. As we come to the end of the first year in office of this administration it is clear that much progress has been made. The government's reform agenda has proceeded expeditiously through Congress: the tax and pension reforms and the bankruptcy law have completed their approval in the Chamber of Deputies and are currently being considered by the Senate. In addition, social assistance programs have been improved, including through the introduction of the Fome Zero and Bolsa Familia programs, to increase the support provided to Brazil's most disadvantaged families. And, importantly, macroeconomic policy has remained firm, as evidenced by the adherence to primary surplus targets and the rapid convergence of inflation and inflation expectations to official targets. All performance criteria and structural benchmarks for the fifth review were observed, and we request completion of the review. 2. The benefits of this strong policy approach have been realized in a number of ways. After a slowdown in the first half of the year, there are signs that a recovery of output growth is underway. Employment has grown, albeit at slower-than-desirable rates. In addition, the balance of payments has strengthened: the current account is likely to register a small surplus this year, and the quality of capital inflows has steadily improved throughout the year. The impact of the government's policy efforts has also been reflected in the behavior of financial market variables, with the strengthening of the real and bond spreads falling to their lowest levels in five years. Moreover, the cost of servicing the public debt has fallen, maturities have increased, and the structure of public debt has improved.

3. While much has been accomplished, an important agenda of reforms remains before us. In particular, to consolidate the government's achievements and further improve the welfare of Brazil's poorest citizens, it is critical that Brazil converge to a path of sustainable and equitable growth. In this context, we believe that it would be in the best interests of the country to continue our close and cooperative working relationship with the Fund. We therefore request that the Stand-By Arrangement be extended by 15 months, to cover the four quarters of 2004, with an augmentation in access in the credit tranches of an amount equivalent to SDR 4,554 million (150 percent of quota). Together with the amount available on completion of this review, this would increase the total amount available to Brazil during the remainder of the arrangement to 335 percent of quota. We should emphasize, however, that we do not intend to make any further purchases under the arrangement, and that the present request for extension is part of our strategy to exit from Fund support. The proposed extension would provide insurance against the impact of any deterioration in the external environment. In addition, to smooth the path of repayments to the Fund, we request an extension of some repurchase expectations to the Fund—shifting the first SDR 4 billion in credit tranche repurchases from an expectations to an obligations basis in each of 2005 and 2006. This, too, will help insulate the country from potential external shocks. Quantitative program targets and structural benchmarks under the proposed extension are summarized in Boxes A and B.

4. Last year's market crisis cast a shadow over economic activity for much of this year. As a result, real output growth for the year is likely to reach only around ½ percent. Recent reductions in real interest rates, structural improvements in the balance of payments, and better private sector access to capital markets have now set the stage for a robust economic recovery in 2004. As a result, we anticipate that growth will reach 3.5 percent next year, driven by strong domestic demand. As the economy recovers, some slight weakening of the current account position is to be expected, although the structural improvement that has taken place during the past 18 months will result in a current account deficit that is low by historical standards. The capital account is expected to further normalize, in part due to a recovery of foreign direct investment flows. Net international reserves are expected to rise, with the Treasury meeting a share of its external debt service obligations through open market purchases of foreign exchange. Inflation should converge toward the midpoint of the official target range throughout the year. Table 1 summarizes the key macroeconomic parameters underlying the program.

Maintaining Macroeconomic Discipline

5. The maintenance of sound fiscal and monetary policies lies at the core of our program for 2004. Continued low inflation and further declines in the debt ratio are essential to further restore confidence and to ensure an environment in which economic agents can make long- term investment decisions. Thus, strong macroeconomic policies remain an essential component of our growth strategy.

6. Fiscal performance this year has exceeded program targets, with the primary surplus reaching 5.1 percent of period GDP at end-September. The strong fiscal outturn so far this year has contributed to a stabilization of the debt ratio at 57.7 percent of valorized GDP at end-September. The 2004 budget, based on a primary surplus of 4.25 percent of GDP, has been sent to Congress, reaffirming the government's commitment to prudent fiscal policy and continued reductions in the public debt. The fiscal performance criteria for the program are described in Box A. As is commonly the case in most budget systems, the nominal target for end-year creates incentives for inefficient spending late in the fiscal year. To reduce these perverse incentives, we propose that any fiscal over performance should be carried forward to 2004, to be used to meet additional priority social spending (see paragraph 17).

7. Monetary policy will continue to be oriented towards achieving the government's inflation objectives. Over the past year, the central bank has responded forcefully to counter the inflationary impulse that resulted from last year's sizeable depreciation of the real. As a result, both inflation and inflation expectations have fallen, allowing the central bank to begin a process of prudently easing monetary policy. The BCB will continue to determine monetary policy in a forward-looking manner to achieve the inflation targets set by the National Monetary Council. Given the convergence of inflation to government targets, we expect there to be scope to continue to ease monetary policy in the future. Box A describes the consultation bands for inflation proposed for the program period, which are consistent with the official end-year inflation target of 5.5 percent, plus or minus 2.5 percentage points.

Creating an Environment for Sustained Growth

8. Strong and socially equitable growth stands at the top of the government's economic agenda. Returning the country to growth rates that are consistent with Brazil's considerable potential will require action on a number of fronts: improving the quality of expenditure in the budget, to enhance and make more flexible the allocation of public resources and allow for a recovery of public investment; increasing financial intermediation and reducing the cost of credit, to stimulate the financing of private investment; and enhancing the business and regulatory environment, to remove bureaucratic impediments to growth. At the same time, to provide additional support to the poorest Brazilians the government will continue efforts to redirect resources to projects with the greatest social returns. In addition, the government will work to ensure the implementation of the tax and pension reforms, to reduce vulnerabilities associated with the structure of the public debt, and to enhance the delivery of critical social services.

9. Budget flexibility and investment. As a legacy of years of inflation and insufficient fiscal discipline, less than 15 percent of primary spending is allocated at the discretion of the government, creating budget rigidities that are a significant constraint to a more just and efficient allocation of public resources. These rigidities force a relatively small share of the budget to bear the brunt of any fiscal adjustment, often implying cuts in some of the most productive and growth-enhancing public expenditures. In addition, revenue earmarking tends to make fiscal policy procyclical and to reduce scrutiny over the quality of earmarked expenditures. Also, there is still too little evaluation of the effectiveness of public outlays, with programs´ performance indicators too often failing to focus sufficiently on outcomes. The government is committed to tackling these problems and intends to prepare a study of the implications of sectoral earmarking, especially for the aims of moving towards a cyclically-adjusted fiscal stance and improving the quality of public spending.

10. The Multi-Year Plan (PPA) presented last August proposed that a significant share of future infrastructure investment be conducted by the private sector. This will allow government resources to be leveraged to increase investment in growth-enhancing infrastructure while maintaining budget discipline. For this purpose, the government is setting up a fiscally responsible program of private-public partnerships; all commitments entered into under this program will be publicly disclosed in a timely manner and will be consistent with medium-term fiscal sustainability. All financial outlays will be included as part of the budget. The legal framework to support this approach has been presented for public consultation and should be voted on in time to be operational in 2004. The recently-regulated program to support the implementation of social investment schemes (Programa de Incentivo à Implementação de Programas de Interesse Social-PIPS) will help launch these partnerships in both housing and infrastructure.

11. Financial intermediation and the cost of credit. A strong and efficient system of financial intermediation is essential to channel private savings to productive private sector use. The easing of monetary conditions has already resulted in lower banking spreads, but deepening intermediation and reducing its costs will require further reforms. High bank reserve requirements contribute, in part, to the structurally high banking spreads. However, their role is complex and any change in this area will require careful study. To clarify the issue, the central bank will prepare by mid year a position paper to evaluate the preconditions to reduce reserve requirements over the medium-term. Approval of the government's draft bankruptcy law will also be an important step forward in deepening credit markets; the law's approval will be followed by a concerted education and training campaign to facilitate its implementation.

12. A number of additional measures are underway or are planned to enhance intermediation or reduce credit costs. First, the process of privatizing the federalized banks has resumed, with a new round of evaluations to determine the minimum price for sale for one of the banks. Second, by June 2004 the government will fully implement the central bank's credit reporting system (Cadastro Positivo) to allow for better credit-rating decisions by lenders and enhance competition among financial intermediaries by making it easier for borrowers to move from one lender to another. Third, to improve the working of consumer credit markets, workers will now be allowed to pledge a fraction of their future wages to the repayment of consumer loans; by March 2004, this arrangement will also be expanded to include retirees in the public pension system. By reducing collection risks on personal loans, this measure should significantly increase flows and reduce spreads on these types of loans. Fourth, in line with the amendment of Article 192 of the Constitution approved in 2003, the government remains committed to work toward the approval of the draft law for increased accountability and operational autonomy of the BCB, as soon as the Congressional agenda permits. By further enhancing the credibility of the inflation targeting regime, approval of the new central bank law should also contribute to a reduction in lending rates. Finally, the government is committed to improving the workings of private capital markets by establishing clear rules for the issuance of private equity and simplifying the requirements for medium-size firms to issue corporate debt. By opening new financing sources for medium-size firms, this measure will also stimulate credit flows and reduce financing costs.

13. The business environment. Improving the regulatory framework is a government priority. In this area, as well, progress is already being made, and significant future steps have been announced. First, a position paper and draft legislation on the role of regulatory agencies has recently been circulated for public comment. Second, the new regulatory framework for the electricity sector is expected to be completed by the end of the year. The framework is aimed at increasing private investment in this key sector of the economy while minimizing the costs to consumers. Third, reforms in land transportation—notably for new road concessions and to stimulate investment in railroads—are already underway. Such reforms will help address the high transportation costs that are widely cited as a major factor inhibiting investment in Brazil.

14. In addition to these regulatory initiatives, the government has worked to reduce tax-induced distortions while maintaining budget discipline. The broader tax reform now being debated by congress will help reduce distortions arising from the tax system. The government is moving to transform the COFINS contribution into a value added-type tax. In addition, the government will reduce the impact of the bank debit tax (CPMF) on portfolio reallocations by widening the set of portfolio adjustments that are free from the tax. The government will also reduce the burden of the IPI tax on industrial goods, especially capital goods. Finally, reducing the red tape associated with business start-up and termination, as well as with customs procedures, will generate sizeable efficiency gains. To that end, the government will identify measures to reduce bureaucratic barriers that slow business startups and distort incentives to export and import. We will begin implementing these measures over the course of 2004, with an eye toward reducing the time and requirements involved in opening new firms and facilitating international trade, including by smaller firms.

15. Public debt structure. The more stable economic environment and aggressive efforts to reduce the rollover rate on dollar-linked public debt have contributed to a significant improvement in the composition of the public debt this year. The share of debt that is linked to the exchange rate has fallen, while that of fixed rate debt has increased. Nevertheless, the structure of the debt remains an important vulnerability, and important measures are planned in this area, as well. To improve the workings of capital markets, the government intends to continue broadening the investor base for long-term debt, including by using competitive repurchase mechanisms for inflation-linked instruments. The treasury will also continue, as market conditions allow, to increase market liquidity by consolidating the maturity dates of public debt instruments, to reduce the share of public debt indexed to the exchange rate, and to increase the share of debt that is at fixed rates or indexed to the consumer price index.

16. Social Policies. The government continues to focus its efforts on reducing poverty and reducing Brazil's deep income disparity. This administration has created the Bolsa Familia program, which consolidates existing social programs and provides a unified institutional structure for those receiving social assistance. The new program aims primarily at supporting families with school-age children, fostering school attendance and compliance with nutrition and family-health programs. The Bolsa Familia initiative will help better target social outlays, lessen the administrative burden, and extend coverage of the social safety net to an initial target of more than 3.5 million households.

17. The government is undertaking several measures to help upgrade and extend the country's water and sanitation systems. Improvements in this area will have a widespread, positive impact on the welfare of the population—particularly for low-income groups—and on the environment. We will work on a Water and Sanitation Act and clear regulations to create an institutional environment that will encourage stable contractual relationships and long-term cost recovery. These improvements will be supported at the subnational level by increasing, on an exceptional basis, borrowing limits for state and local governments that propose qualifying revenue-yielding projects of a self-sustaining nature in water and sanitation. The criteria for these projects will be announced by December 2003 (Box B).

18. As usual, we will maintain a close policy dialogue with the Fund and stand ready to take additional measures, as necessary, to achieve the objectives of the program.

Yours sincerely,

/s/ Antônio Palocci Filho Minister of Finance

/s/ Henrique de Campos Meirelles Governor of the Central Bank of Brazil

Box A. Quantitative Targets All definitions, adjustors, and reporting requirements not amended herein remain identical to those set out in the Technical Memorandum of Understanding attached to the Letter of Intent of August 29, 2002, as modified in subsequent reviews under the Stand-By Arrangement.
	PC, IT, CB or PA 1/	2003				2004
		end-Sept		end-Dec		end-Mar	End-June	End-Sept	End-Dec
		Program	Actual	Program		Program	Program	Program	Program
Fiscal Targets (R$ billions)
Floor on cumulative primary surplus of the consolidated public sector 2/	PC	54.2	57.1	65.0		14.5	32.6	56.9	71.5
Ceiling on stock of net debt of the consolidated public sector	IT	985.6	891.1	955.4		995.8	1,017.0	1,034.3	1,052.6
External sector targets (US$ billions)
Ceiling on stock of external debt on nonfinancial public sector	PC	94.9	89.4	95.6		95.9	93.1	94.7	94.7
Ceiling on stock of publicly guaranteed external debt outstanding	PC	1.6	0.2	1.6		1.6	1.6	1.6	1.6
Ceiling on stock of total short-term external debt of the nonfinancial public sector	PC	3.5	0.0	3.5		3.5	3.5	3.5	3.5
Floor on net international reserves 3/	PC	5.0	16.2	5.0		5.0	5.0	5.0	5.0
Increase in BCB's exposure in FX futures markets 3/	PC	0.0	0.0	0.0		0.0	0.0	0.0	0.0
Increase in BCB's exposure in FX forward markets 3/	PC	0.0	0.0	0.0		0.0	0.0	0.0	0.0
Monetary sector targets (in percent)
12-month rate of change of the IPCA
Upper Outer Band	CB	17.5		12.0		10.3	9.5	8.8	8.0
Upper Inner Band	CB	16.0		10.5		8.8	8.0	7.3	6.5
Mid-point	CB	15.0	15.1	9.5		7.8	7.0	6.3	5.5
Lower Inner Band	CB	14.0		8.5		6.8	6.0	5.3	4.5
Lower Outer Band	CB	12.5		7.0		5.3	4.5	3.8	3.0
Memorandum items (R$ billions)
Privatization receipts (cumulative)	PA	0.0	0.0	0.0		0.0	0.0	0.0	0.0
Recognition of liabilities (cumulative)	PA	8.6	2.0	10.0		2.9	5.7	8.6	11.5
Programmed investment of Petrobrás	PA	9.6	...	11.9		3.3	6.7	10.5	13.5
1/ Performance criteria (PC), indicative target (IT), consultation band (CB) or program assumption (PA).
2/The floor will be decreased by the amount of capital investment of state oil company Petrobrás that exceeds the programmed level of investment and by the amount of disbursements for water and sanitation projects in 2004, as discussed in paragraph 17. The latter provision is subject to a ceiling of R$2.9 billion and is linked to the fiscal overperformance as of September 2003. Eligible disbursements will be defined by the criteria established under the December 2003 benchmark, and will be reported to the Fund staff on a quarterly basis.
3/ Continuous performance criteria.

Box B. Structural Benchmarks

End-December 2003

Announce criteria to increase borrowing limits for state and local governments that propose qualifying revenue-yielding projects of a self sustaining nature in water and sanitation, with a view to modernizing the sector.

End-March 2004

Implement the Provisional Measure to allow workers to pledge a fraction of their future wages to the repayment of consumer loans and expand the arrangement to include retirees in the public pension system via a National Social Security Institute (INSS) ruling. Introduce legislation to Congress to expand the scope of portfolio adjustments that are free from the bank debit tax (CPMF).

End-June 2004

Enable loan applicants and banks to have access to the central bank's centralized credit rating system (SCR, Cadastro Positivo), with a view to make available to competing banks information on borrowers credit profiles. Implement the bankruptcy law (after congressional approval) by providing training as outlined in paragraph 11. Complete a study on the implications of budget rigidities for maintaining a cyclically-adjusted fiscal stance.

End-September 2004

Conduct a study to identify measures to simplify, integrate, and reduce registration requirements for business and address overlaps and redundancies between different agencies and levels of government.