1.  The main features of the current economic policy framework of the Brazilian government were outlined in the Memorandum of Economic Policies attached to the March 8, 1999 letter of the Minister of Finance and the President of the Central Bank of Brazil, requesting the completion of the first and second reviews under the stand-by arrangement with the Fund approved by the Executive Board on December 2, 1998. The government remains fully committed to the thrust of that policy framework. This memorandum outlines the main developments in the Brazilian economy since then, and details some steps that are being taken to implement those policies in the evolving domestic and external economic environment.

2.  Developments in the Brazilian economy in the first half of 1999 have been, on the whole, significantly better than projected in the revised Fund-supported program of the Brazilian government (henceforth the program). Following the pronounced decline in the second half of 1998, GDP is estimated to have begun to recover already in the first quarter of 1999, reflecting in particular a strong increase in agricultural output. Barring renewed external shocks, GDP is likely to decline on average by 1 percent or less in 1999, compared to the decline of 3.5-4 percent projected in the program. Although data are not yet available on developments in the components of aggregate demand, the better than expected performance of GDP is likely to reflect, in particular, the strengthening of confidence, both domestically and abroad, which resulted in an easing of financing constraints. The improved output performance has been reflected in a broad stabilization of the open unemployment rate around 8 percent in the first four months of 1999, only marginally higher than in 1998. This rate is expected to decline gradually in the second half of 1999, and further in 2000, when GDP growth is projected to accelerate to around 4 percent.

3.  The inflation performance to date has also been remarkably better than projected. The accumulated increase in the general price index (IGP-DI) in the first five months of 1999 was 7.4 percent, compared with 11 percent projected in the program. Consumer prices rose even less, by 3.8 percent, over the same period. These favorable developments allowed a more rapid than projected decline in interest rates from 45 percent on March 4 to 21 percent on June 23, 1999. Although the price level in the next couple of months will reflect the impact of adjustments in energy and other administered prices, the increase in the IGP-DI through the year (in the absence of significant external shocks) is now expected to be contained to around 12 percent, compared with the nearly 17 percent projected in the program, and that in consumer prices (as measured by the INPC and IPCA price indices) to under 8 percent. The 12-month rate of inflation, as measured by the IGP-DI, is projected to decline further, to around 5 percent, by the end of 2000. The low passthrough of the exchange rate depreciation to prices reflects the firm stance of macroeconomic policies, the continued absence of indexation mechanisms, the sizable output gap, and the favorable impact of low commodity prices and a very good harvest.

4.  In contrast, developments so far in external trade have been less favorable than projected. The trade balance has continued to show a small deficit in the first five months of 1999, reflecting a slower than projected response of export volumes, a less steep decline in import volumes (in line with the stronger than anticipated domestic demand), and a significant deterioration of the terms of trade, as international oil prices recovered, while those of other important Brazilian commodity exports remained depressed. The trade balance is expected to improve from mid-year on, as the response of exports to the real exchange rate depreciation strengthens, export financing constraints continue to ease, and the terms of trade stabilize. This improvement is, however, expected to be contained by the relatively depressed demand conditions in some of Brazil's major trading partners, and by the foreseeable gradual recovery of imports, as domestic economic activity picks up in the second half of the year. Thus, the trade surplus is now projected to remain under US$4 billion for the year as a whole, well below the level (US$10.8 billion) projected in the program. The balance on services, however, is likely to continue to improve faster than forecasted in the program, facilitating a reduction of the current account deficit of the balance of payments to around US$21 billion, from the US$33.6 billion recorded in 1998. A further, significant improvement in the external accounts can be expected in 2000, when, in the absence of new shocks, the trade surplus should strengthen to over US$9 billion, and the current account deficit in the balance of payments decline to under US$19 billion.

5.  The outlook for the capital account of the balance of payments for the rest of this year continues to be affected by significant uncertainties related to the external environment. Like most other emerging markets, Brazil remains somewhat vulnerable to shocks in international financial markets, although the strengthening of economic policies and the shift to a floating exchange rate regime have significantly reduced this vulnerability. In the absence of a major shock, but assuming the continuation of a relatively cautious attitude of foreign financial markets toward emerging market countries, net capital inflows to Brazil are projected to exceed current account financing needs by a modest margin in the second half of 1999, leading to an overall balance of payments surplus of around US$3 billion during that period. The moderate recovery of capital inflows so far has been accompanied by a lengthening of their maturity, which should help reduce their volatility. Foreign direct investment (FDI), in particular, has continued at a strong pace. It amounted to US$31.3 billion in the 12 months ending in May 1999 and to US$10.7 billion during January-May 1999. For 1999 as a whole, FDI is projected to reach at least US$18 billion, equivalent to 85 percent of the current account deficit, despite a possible delay to early 2000 of some privatization operations originally planned for the last quarter of 1999.

6.  The Republic and a number of public and private companies (including banks) have returned to international capital markets in recent months. Following the successful US$3 billion global bond issue (of which US$2 billion involved new money) in late April 1999, further sovereign bond issues are planned for the second half of the year. These issues—the timing, amounts and maturities of which will be determined in light of prevailing market conditions—will be primarily aimed at refinancing maturing external public debt and establishing benchmarks along the yield curve for private sector borrowers. The government intends to gradually reduce over time the share of external and foreign exchange-linked debt in the total public debt, pari passu with the further development and deepening of domestic capital markets.

7.  The stock of interbank credit lines is now some 4.5 percent higher than in February 1999 (the reference date in the agreement with private banks for the maintenance of such lines), despite a fall in import financing reflecting the decline in imports. In cooperation with the domestic banks, the central bank (BCB) has substantially improved its monitoring of developments in these lines. It is expected that bank credit lines will continue to be rebuilt in the months ahead, as confidence continues to strengthen and demand for trade-related credits increases. Given the uncertainties currently affecting the capital account, and with a view to providing adequate scope for the central bank to intervene in the foreign exchange market to counter temporary disorderly conditions, the floor on net international reserves (NIR) in the program has been set US$3 billion below the projected path of NIR during the second half of this year. The adequacy of this margin will be reassessed during the fourth review of the program later in the year.

8.  Fiscal developments to date have been, on balance, better than projected in the program. The R$6 billion floor for the first quarter 1999 primary surplus of the consolidated public sector—comprehensively defined in Brazil to include the federal government, the BCB, the states, municipalities, and the nonfinancial public enterprises of all levels of government—was met with a wide margin, as the surplus exceeded R$9.3 billion (4.1 percent of period GDP). About R$2.2 billion of the overperformance was accounted for by unprogrammed collections of tax arrears at the federal government level. The consolidated primary surplus of states and municipalities and that of public enterprises were also somewhat higher than projected. On the basis of the information available to date, it is expected that the R$12.9 billion target for the primary surplus of the consolidated public sector in the first half of 1999 will also be met. As a result of the better performance of the primary balance, the rapid strengthening of the exchange rate from early March through mid-May, and the steeper than projected decline in interest rates, the indicative program ceiling on the net public debt for March 1999 was met with an ample margin, as the net debt declined to R$470 billion (48.3 percent of GDP) at the end of March, compared with the R$506 billion (52.2 percent of GDP) projected in the program. The indicative target for end-June 1999, equivalent to 51.7 percent of GDP, is also expected to be met with a significant margin.

9.  Faced with the recent emergence of risks to the achievement of the targeted 3.1 percent of GDP primary public sector surplus for 1999 as a whole, the government has taken prompt corrective action. These risks reflected, in particular, the recovery of international oil prices, which, in the absence of corresponding adjustments of the domestic prices of petroleum products, would have led to a substantial revenue shortfall. To prevent such an occurrence, the government has already increased these prices by 18 percent on average (with varying rates, depending on the product), and intends to adjust them regularly in the light of changes in international oil prices and the exchange rate. Over the longer term, in view of the ongoing progressive liberalization of the oil sector, and in the context of the overall tax reform, the government intends to propose a comprehensive reform of the taxation of oil products. Further risks to the fiscal outlook for 1999 are entailed by recent court challenges to some of the revenue measures enacted earlier this year (notably the increases in the social security contribution of civil servants and the COFINS). The government is confident that the primary balance target can be achieved even in the event of unfavorable decisions on some of these cases. Moreover, it is fully committed to taking additional measures, as needed, to ensure strict adherence to the primary fiscal target for the year as a whole. The government has also continued to firmly enforce the payment by the states of the service of their restructured debt. This fact, together with the strict limits enacted by the Senate on the states' access to new financing, is promoting a progressive improvement in their primary balance, which is expected to move into a small surplus in 1999. The proposed restructuring of the debt of some municipalities, which is in the process of being approved by the Senate, will also help increase over time the consolidated primary surplus of the municipal sector. On the working assumptions of a broad stabilization of the exchange rate around its current level (R$1.75 per U.S. dollar) and of a further gradual decline of the overnight interest rate, the PSBR in 1999 should be contained to around 9 percent of GDP, and the net public debt is projected at the equivalent of 51 percent of GDP by year-end.

10.  The government is fully committed to sustaining, and indeed strengthening, the fiscal adjustment in the years ahead, in line with the objectives set out in the previous Memorandum of Economic Policies. Specifically, for the year 2000 the primary surplus of the consolidated public sector is targeted at the equivalent of 3¼ percent of GDP. The federal budget proposal for next year, which is to be submitted to congress in August, will be consistent with this objective and the prospects for the finances of the other components of the public sector. Achievement of the primary target in 2000 will be facilitated by the full-year impact of some of the tax and other revenue-raising measures enacted in the course of 1999. On the other hand, the federal government finances will be adversely affected by the disappearance of certain once-off or temporary revenues, and by the elimination of the Fiscal Stabilization Fund, which will boost constitutionally mandated federal transfers to the states. Therefore, continued spending restraint at all levels of government will be needed to secure the achievement of the targeted primary surplus. For this purpose, the federal government will continue its effort to contain its payroll; the recent legislation regulating the implementation of the constitutional administrative reform will require similar, or even greater, efforts by state and local governments. A moderation of the growth of social security benefits will result from the implementation of the constitutional amendment for the pension reform and from ongoing administrative efforts in this area (see paragraph 15 below). The remaining limited subsidy programs will continue to be contained, and other current and capital spending in the federal budget will also be capped to an overall level consistent with resource availability. Within this limit, the government intends to continue to give priority to expenditures on education, health, and other cost-effective social programs, especially those targeted to vulnerable groups. As indicated in paragraph 13 below, priority programs in the 2000 budget will be selected in accordance with the strategy set out in the 4-year Plan, to be presented to congress at the same time as the budget. The outlook for the public finances in 2000 will be analyzed in greater detail in the course of the fourth review of the program later this year.

11.  Progress continues to be made in various areas of structural fiscal reform. Specifically, an important step toward improving fiscal transparency and promoting fiscal sustainability at all levels of government was taken in April 1999, with the submission to congress of a proposed Fiscal Responsibility Law, which is currently expected to be approved before the end of the year. This bill proposes that quantitative limits be set on indebtedness and on personnel for federal, state and municipal governments. It also prohibits the use of borrowed resources to finance current spending (the so-called golden rule). Each quantitative limit will have both a maximum permissible value, and a prudential one. The law sets out adjustment rules in the event of excesses over the maximum values, and forbids new borrowing when the prudential limit on indebtedness is exceeded. The proposed law also prohibits further refinancing of debts of one level of government by another. A short transition period is envisaged, to facilitate adjustment by public entities to the requirements of the law. To promote transparency, the law requires each level of government to provide comprehensive and timely financial reports to the next higher level, with the federal government consolidating these reports into a quarterly report on the state of the nation's finances. Finally, the law sets out the principle of individual responsibility of civil servants for its observance, and envisages a system of individual penalties for noncompliance.

12.  Efforts are being stepped up to move forward in the rest of 1999 the proposed comprehensive reform of the present system of indirect taxation. These efforts involve an intensified dialogue with the legislative branch, state and municipal governments, and the private sector, to secure an adequate base of support for a revised proposal to consolidate and streamline most of the existing indirect federal, state and municipal taxes into a national VAT, to be shared among all levels of government, complemented by a retail sales tax with a low rate and by selected excises at the federal and state levels. The proposed reform aims at eliminating the scope for "fiscal wars" among states, reducing evasion, and minimizing distortions due to tax cascading. In addition, the government intends to present shortly a draft law aimed at, among other things, reducing the scope for tax avoidance, and limiting revenue losses from excessive tax litigation.

13.  On the expenditure side, the government is placing increasing emphasis on an improved choice of expenditure priorities, through, in particular, a better articulation of the annual budget process with a multi-year rolling planning framework. This framework, initially covering the period 2000-2003, is to be submitted to congress in August 1999. It will identify priority public expenditure programs, linked to a development strategy centered on specific regional axes. These programs will receive priority in the allocation of budgetary resources during the plan period. The government intends to leverage the budgetary resources allocated to these programs, through partnerships with multilateral development banks and private sector investors in the financing of the programs and of complementary projects. Increasing emphasis will also be placed on evaluation of the results of these programs, and on the accountability of the public managers of the programs for these results.

14.  The approval by congress in 1998 of the constitutional amendment on the administrative reform has laid the necessary basis for a sustained containment of personnel expenditures and streamlining of the civil service at all levels of government. Most of the legislation regulating the implementation of the reform—including a law which sets specific limits on payroll as a share of net revenues at various levels of government, and a law regulating the dismissal of civil servants in cases of excesses over these limits—have been passed recently by congress, and approval of the remaining needed implementing legislation is expected soon. In the meantime, progress has been made by a number of states and municipalities in reducing their personnel spending, within the constraints entailed by existing legislation. The federal government, for its part, has taken steps to reduce its payroll through administrative improvements, including steps to identify and correct payroll irregularities. It is reviewing federal salary scales, to adapt them more closely to appropriate private sector pay relativities. It is also considering additional steps to streamline the civil service, and introduce additional flexibility in the management of human resources in the public administration. Although these measures are unlikely to yield substantial savings in the short run, they will significantly contribute, over time, to improving the quality and efficiency of the public administration.

15.  Through the lengthening of minimum periods of contribution to the pension systems, and the elimination of certain constitutional rigidities in the determination of pension benefits, the constitutional amendment on pension reform, approved in late 1998, represented an important step forward in this area of particular weakness in the public finances. The government recognizes, however, that the reforms enacted to date are not sufficient to either ensure the financial viability of the social security system over the medium term, or adequately improve its equity. Therefore, it intends to continue to work with congress, and garner society's support for further reforms of the public pension system, while promoting, with appropriate safeguards, the development of complementary pension plans designed to supplement this system, foster private saving for retirement, and help deepen domestic capital markets. In this latter respect, three draft bills regulating complementary pension plans for private and public workers were presented to congress in March 1999, and it is hoped that they will be approved in the course of this year. Further reform of the social security system is intended to proceed in steps over the next few months. Specific draft laws will be presented shortly to reform the pension regimes for the self employed, rural workers, and the military. For private sector workers, the system of individual accounts will be extended and improved, to ensure that each contributor's account reflects accurately henceforth the contributions made. This measure will help reduce fraudulent claims for unearned pensions, and allow the eventual shift to a notional-defined contribution system, under which pension benefits will reflect the lifetime contribution histories of recipients—with an appropriate accounting rate of return—as well as life expectancies at retirement. For new public sector workers, the reform is intended to limit basic pension benefits to the ceiling set for private workers, supplementing them through fully funded complementary pension plans. For existing public employees, the government is exploring feasible ways to promote a closer correspondence between benefits and contributions, while maintaining the defined-benefit character of the system. The government is also pressing ahead with administrative improvements to strengthen the enforcement and collection of social security contributions, and reduce abuses, in particular for disability pensions.

16.  Following the shift in mid-January 1999 to a flexible exchange rate regime, the priority objective of monetary policy in recent months has been to avoid that the initial boost to prices of traded goods from the depreciation of the real would lead to a sustained acceleration of inflation and inflationary expectations. This required a sizable jump in early March of interest rates from their already high level, which, in conjunction with the other elements of the policy framework, was instrumental in allowing an early correction of the exchange rate overshoot and a rapid decline in the monthly rate of inflation. Since then, the central bank has reduced interest rates in steps, generally following, rather than leading, market expectations, to a level which, when deflated by current indicators of expected inflation, remains somewhat above what the BCB regards as an appropriate real interest rate in the present macroeconomic conditions. In reflection of this view, the BCB has kept so far a downward bias, allowing the President of the bank to reduce rates between the regular periodic meetings of the Monetary Policy Committee (COPOM), which is responsible for setting the BCB's intervention rate (SELIC) in the overnight interbank market. The announcement of a bias allows the BCB to guide market expectations between COPOM meetings, while preserving a degree of flexibility to adapt short-term interest rate policy to prevailing conditions. In particular, in its conduct of interest rate policy, the BCB will respond to any significant pressures on net international reserves or to exchange rate developments that may threaten the achievement of the inflation target.

17.  As indicated in the March 1999 Memorandum of Economic Policies, the government has decided to institute a formal inflation targeting framework for monetary policy, beginning in July 1999. The Minister of Finance announced at the end of June the following targets for inflation in consumer prices, as measured by the increase in the national IPCA price index through the year: 8 percent in 1999, 6 percent in 2000 , and 4 percent in 2001 (in each year with a tolerance interval of +/-2 percentage points). The BCB has been given the responsibility to secure the achievement of these targets through its conduct of monetary policy. It will prepare quarterly inflation reports to explain to the public the considerations that guided its policy in the preceding quarter, and the inflation performance during that period, as well as its forecast of future inflation and its policy response to them. The BCB will base these forecasts on a range of indicators, including its ongoing survey of market expectations, short-term forecasting models and structural econometric models of the transmission mechanisms of monetary policy, as well as its ongoing assessment of prospects for relevant economic variables, including the exchange rate, the fiscal policy stance, and aggregate demand conditions.

18.  Available information on developments in the monetary aggregates in the first half of 1999 suggests that the June performance criterion on the net domestic assets (NDA) in the BCB will be met with a wide margin, reflecting the better than projected level of NIR, and the fact that the growth of base money was largely in line with the projections of the revised monetary program prepared in March 1999. The 12-month rate of growth of base money in June was 10.4 percent, compared with a program projection of 10.2 percent. Broader monetary aggregates have also been growing at a restrained pace, with M2 (as measured under the IMF's definition) expanding by 6.3 percent in the 12 months to May 1999. A performance criterion for end-September 1999, and indicative monthly targets for the rest of 1999 have been set on NDA, in line with the projected paths for base money and NIR. It should be noted that the demand for base money during the second half of 1999 may be affected by the reintroduction of the tax on financial transactions (CPMF) in June and the Y2K problem. The monetary programming framework for the fourth quarter of 1999 and 2000 will be reviewed in the context of the fourth review of the program, and adapted as needed to the new inflation targeting framework.

19.  Available evidence suggests that the banking system has weathered well, on balance, the impact of the economic crisis earlier in the year. Most banks had adequately hedged against a devaluation of the real, and have increased their provisions against nonperforming loans, which have risen from 7 percent of total loans at end-1997 to 8.9 percent by end-April 1999, reflecting high borrowing rates (especially for consumer credit) and the economic downturn. Updated stress tests suggest that the banking system remains robust, with most private banks maintaining a strong capital base (well in excess of the required 11 percent rate on risk-weighted assets) and full provisioning of nonperforming loans.

20.  Progress has continued regarding the privatization of the state-owned banks. When PROES (the program for restructuring of state-owned banks) was launched, there were over 30 such banks. When the program is completed , in about 2 years, only 6 are expected to remain. In the next few months, additional privatizations will be completed. The largest state-owned bank, São Paulo's BANESPA, which is currently under federal administration, is to be privatized before the end of this year. The privatizations of the state banks of Paraná, Goiás, Ceará, and Amazônia, are expected to be completed in the first half of the year 2000. As indicated in the March 1999 Memorandum of Economic Policies, the government has begun comprehensive audits and a review of the role of the major federal banks, expected to be completed before the end of this year.

21.  There has been significant progress in planned improvements in prudential regulation. In May, the BCB issued a regulation to limit open positions in foreign exchange (not to exceed 60 percent of capital), and to require banks to increase capital by 50 percent of the excess of their open positions over 20 percent of capital. This regulation went into effect on July 1, 1999. In addition, with a view to reducing market risk, the BCB is preparing new regulations for interest rate risk; the regulation of other aspects of market risk (particularly equity and commodity risks) will require further work. A draft regulation on a forward-looking loan classification system has been prepared, and is expected to be in force by early January 2000. The BCB is also working, with the technical and financial support of the World Bank, to improve bank supervision, including through increased frequency of on-site inspections and continuous off-site monitoring of financial institutions. Efforts are being made to address as rapidly as possible the existing staff resource constraints, through new recruitment and training of existing personnel.