THE EFFECTS OF EXCHANGE RATE DEVALUATION ON THE WORKERS
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The process of devaluation of the Brazilian real which began on January 13 revealed the inconsistency and fragility of the economic policy practised and defended by the government to date. Ever since the Mexican crisis at the end of 1994, there have been warnings that the policy of supporting the real would lead to the external strangulation of the Brazilian economy and to public debt, and this has now become explicit in the form of economic and social instability.
After the success of a stabilization plan based on a mechanism of total indexation of prices and wages (the URV - Unidade Real de Valor, or Real Unit of Value) and its conversion into a unit of currency, the real, the Brazilian government opted for a policy of overvaluing the exchange rate in order to stimulate the entry of imported products, so as to thereby increase domestic competition and accelerate the fall in inflation. This option led to an imbalance in the Brazilian balance of trade, which was transformed from a surplus to a deficit (TABLE 1).
Source: Brazilian central bank
The principal objective of the high interest rates which accompanied the support for the real during this period was to attract foreign capital interested in higher returns than those offered on the international market. This capital was intended to cover the deficits which had been created and to increase Brazilian dollar reserves, thereby allowing the country to sustain the policy that had been adopted. The high interest rates were also intended to check the economic growth of the country as a means of controlling the foreign trade imbalance caused by the exchange rate policy, and avoiding pressure on prices due to excess demand.
One consequence of this combination of policies (an overvalued exchange rate and high interest rates) was an increase in unemployment during the period of the real, from 14.2% in 1994 to 18.3% in 1998 in the Metropolitan Area of São Paulo according to the Surveys of Employment and Unemployment PED (Pesquisa de Emprego e Desemprego) carried out by DIEESE/Seade. This has been the most serious consequence of this economic policy (others include the difficulty of obtaining salary adjustments in line with inflation, and the loss of workers' benefits, etc.). This policy also created a stumbling block to its own success, in contributing to internal and external debt.
External debt increased due to the fact that the private sector was encourage to cover its financial needs with money borrowed on the international market at interest rates lower than those available domestically. The increase in internal public sector debt was the direct consequence of the increase in interest rates (TABLE 2). Consequently, despite the funds generated by intensive privatization of state-owned companies, there was a reappearance of a public sector deficit, which led the government to take severe fiscal measures (increasing taxes and spending cuts) in order to cover the shortfall caused by the high interest rates, with a consequent profound recessive effect.
TABLE 2 - External debt, internal debt and public sector deficit,Brazil 1994 and 1998
Item
Dec/1994
Sep/1998
External debt (US$ billion)
148.3
228.3
Internal debt (R$ billion)
151.6
310.6
Public sector primary surplus or deficit (% GDP) (1)
5.2%
-1.2%
Public sector operating surplus or deficit (% GDP) (2)
1.3%
-7.7%
Source: Brazilian central bank
Notes(1) Public sector primary surplus or deficit = net fiscal outcome (tax income - spending), excluding debt service;
(2) Public sector operating surplus or deficit = net fiscal outcome including payment of public sector debt
In short, the administration of the Real Plan, backed by a vicious circle of indebtedness and dependence on external funding, has led the country to a extremely vulnerable position. Crises in Mexico (1995), Asia (1997) and more recently in Russia (1998) have decreased the degree of confidence of foreign investors in the so-called emerging countries, making it more difficult, more expensive and more hazardous to maintain an economic policy which is anchored to an overvalued exchange rate and high interest rates. Faced with the risk of devaluation of the real and the impact thereof on increasing public sector debt, there has recently been a growing movement among Brazilian and foreign investors to withdraw capital from Brazil. This was the situation that prompted the resignation of the then president of the Brazilian central bank, Gustavo Franco, and the change in the exchange rate policy.
Initially the government sought a devaluation of only 8.5%, by extending the upper limit of the exchange rate band to R$ 1.32/US$ 1.00. Speculation, fortified by the timid nature of this measure, led to a more intense withdrawal of capital and forced the exchange rate against the dollar beyond the limit established by central bank. To have maintained the new exchange rate sTABLE would have meant increasing the availability of dollars at the cost of international reserves, which is what was done initially. However, as the reserves continued to fall without the desired results, the government opted for a freely floating exchange rate.
As a result of the impact on speculation of the recent decision by the economic team, the dollar has appreciated by more than 50% since the beginning of the process of devaluation of the real. The consequences of this process for workers are discussed below.
1 - The impact of exchange rate devaluation rate on prices
The exchange rate is a fundamental economic indicator. In the case of Brazil, liberalization of trade in the 1990's and an overvalued exchange rate in the period following the introduction of the Real Plan forced a reduction and stabilization in prices, especially of the so-called "tradeable goods" which have foreign equivalents which can be negotiated on the international market. However, as mentioned earlier, one consequence of this policy for controlling inflation was the destabilization of the balance of trade of the country. Moreover, the replacement of national products by similar goods imported from abroad disrupted various production chains and put many companies out of business.
1.1 - The effects of exchange rate devaluation
Exchange rate devaluation means a potential increase in income for exporting sectors. In the case of sectors which depend on foreign resources and imported goods, machinery and starting materials, exchange rate devaluation implies increased costs. The new exchange rate will define the magnitude of this increase in costs in these sectors. However, the impact of this increase on consumer prices will depend on the following factors.
a.The level of economic activity.
b.The domestic contribution to production.
c.The result of commercial and diplomatic negotiations with Brazil's trading partners, and especially with the other countries forming the Mercosur.
d.The capacity and time necessary for companies installed here to adapt to the new conditions and bring their production into line with the new demands for quality and price in order to replace imports and increase exports.
e.The results of negotiations on price between suppliers and producers at each stage of the various production and demand chains.
f.The characteristics of competition within each sector - the numbers and sizes of companies, the essential nature or otherwise of their products and the response of their prices to variations in production;
g.The political capabilities of the Federal Government and the effectiveness of their institutional mechanisms for establishing and policing prices. One important factor here is the possible effect of oil imports on prices. However, the effect of this factor could be cushioned by the significant scope that exists for controlling the price of oil, given the fact that recent falls in the international price have not been passed on to domestic consumers.
There is still uncertainty in relation to what new exchange rate policy will be adopted by the Government - whether it will continue with a floating exchange rate, or establish some mechanism for manipulating the rate, such as "informal bands". Recently the National Monetary Council CMN (Conselho Monetario Nacional) began the unification of the free and commercial dollar markets, which will have a single official value; leading to the possibility of there being more dollars in one market than those needed in the other. In the face of enduring doubts as to the solvency of the Brazilian economy (public and private sector) one can reasonably expect that exchange rates will continue somewhat volatile during the coming weeks.
1.2 - Impacts on inflation
1998 saw the smallest ever annual change in the DIEESE Cost of Living Index (0,49%) culminating a tendency towards a lowering of price increases since the introduction of the Real Plan - from 27.44% in 1995, to 9.94% in 1996 and 6.11% in 1997.
Although it would be premature to make any estimates of what might happen to inflation in 1999, the current exchange rate devaluation will affect prices over the coming months. The instability of the currency market makes it impossible to predict what will be the new parity between the real and the dollar, and this makes it difficult to analyse possible effects on inflation.
The absence of indexation of the economy acts to inhibit the spread of rising trends in prices. The impact on costs provoked by exchange rate devaluation will tend to be passed on in a dispersed form over several months, causing a knock-on effect on some prices which will have a temporary effect on inflation. However, in the absence of formal or informal indexation mechanisms, the effect of these increases should not spread to the economy as a whole.
Thus, it is possible to envisage that in the absence of new economic disturbances the rate of inflation could retract to levels lower than those generated during the exchange rate crisis. This would result in a transfer of income within the economy - especially in the case of workers - to those sectors which manage to index their income to the exchange rate and the rate of inflation.
Before the turbulence of this start of year, it was being predicted that there would be a retraction of economic activity in 1999. The government itself was predicting a decrease of 1% in the Gross Domestic Product - GDP. More than the absence of indexation, the stagnation of the economy makes it highly improbable that all companies will be capable of passing on any increases in costs in full to their customers in the form of prices.
Among the items in the basic "hamper" of subsistence products and essential consumer products, wheat derivatives can be expected to suffer an increase in price, given that 73% of such derivatives consumed in Brazil are imported. The same is also true of rice, 1/4 of which is imported. Medicaments and pharmaceutical products already tend to be prone to price increases - in the last two years the average price increase has been 25.36% - and this will inevitably continue to be the case. Export crops such as coffee, sugar, poultry, fruits and cocoa could also be subject to price rises, despite recent decreases in the prices quoted on the international market. Increased exportation of these products tends to result in prices on the domestic market which are equal in reals to those practised on the international market.
In the light of the considerations above, it is possible to estimate that the impact of the current devaluation on the cost of living will remain well under two figures in 1999 (4% to 6%). This estimate is based on an appreciation in the dollar relative to the real of 30% and applies to the group of products used to calculate the DIEESE Cost of Living Index ICV. It takes into account the probable effects of the alterations in the exchange rate on costs and also considers different possibilities with regard to their impact on prices. However, it should be remembered that not all of the prices monitored in surveys which measure inflation are determined by the exchange rate. Thus, increases (or decreases) may occur during the course of the year due to factors which are unrelated to the devaluation of the real, such as seasonal or climatic factors (harvests, flooding, drought, change of season, etc.), but which have an impact in increasing or decreasing the cost of living index.
Obviously if the appreciation in the dollar remains greater than 30%, as has been the case during the past few days, the impact on inflation will be significantly greater than estimated above. In this case forecasts become more complicated because the reactions of those who guide political policy, society and the market could prompt the return of formal or informal mechanisms of indexation, which in turn could trigger off a new leap in the level of inflation.
2 - Impacts on the Labour Market
The 1990's have seen a decrease in the stability of the labour market. Some two million jobs in the formal economy have disappeared and the level of unemployment has almost doubled. The unemployment rate measured by PED Surveys of Employment and Unemployment carried out by DIEESE/Seade in the Metropolitan Area of São Paulo has jumped from 10.3% in 1990 to almost 18.3% in 1998. Despite an accumulated growth in GDP of the order of 16.6% there was no let up in unemployment after the Real Plan. On the contrary, it has undergone two major increases and has tended to oscillate around ever higher levels (TABLE 3).
The policy proposed at the end of 1998 to confront the crisis in Russia envisaged a fiscal reform based on cuts in public spending and increases in taxation. Interest rates were to be maintained high until the effects of this fiscal reform began to be felt. This policy already pointed clearly towards deepening recession and the likelihood of a new jump in unemployment. The current instability (the exchange rate fluctuation and high interest rates) does nothing to alter this forecast; it only makes it all the more likely
TABLE 3 - Unemployment, GDP and GDP per capita (1). Brazil and the Metropolitan Area of São Paulo 1990-1998 (%)
Measure/Year
1990
1991
1992
1993
1994
1995
1996
1997
1998 (2)
Unemployment (Greater São Paulo)
10.3
11.7
15.2
14.6
14.2
13.2
15.1
16.0
18.3
GDP (Brazil)
-4.3
1.0
0.5
4.9
5.9
4.2
2.8
3.0
0.7
GDP per capita (Brazil)
-5.5
-0.6
-2.1
3.4
4.3
2.8
1.4
1.5
-0.7
Source: DIEESE/SEADE. PED-SP Survey of Employment and Unemployment, and the Brazilian central bank 1997 report
Notes(1) Unemployment: mean annual levels. GDP and GDP per capita: percentage difference over the year
(2) Values for GDP and GDP per capita in 1998 are estimates
3 - Wages and Collective Bargaining
In the first six months of 1998, 68% of the 220 collective negotiations monitored by the DIEESE database achieved a wage adjustment equal to or greater than the increase in the National Retail Price Index of the Brazilian Institute for Geography and Statistics (IBGE). This result was better than in the same periods of 1996 and 1997. However, the picture for 1999 is not so positive.
The greatest difficulties in recuperating the buying power of salaries are in manufacturing industry and the public sector. The decrease in jobs in the industrial sector means that negotiations are slanted towards protecting jobs. In the public sector, on the other hand, successive fiscal measures and administrative reforms have complicated the negotiating process, which often fails to even get as far as signing a collective employment contract.
Sectors less hard hit by the current destabilization of the economy seek to lay emphasis on negotiation of more flexible forms of remuneration, such as bonuses and profit sharing, because even though they may be in a position to make up the loss in the value of salaries they are under intense pressure not to do so, since there is no prospect of a sustained increase in sales.
Moreover, there are voices which argue that salary adjustment could provoke a return of inflation and the consequent reindexation of the economy. Sectors which are under the greatest cost pressure will inevitably broaden discussion relating to flexibility both in working hours (credits of working hours, temporary lay-offs and decreases in salaries and working hours) and in social privileges and conditions of work. In the public sector, restrictions on personnel spending could well mean further cuts in numbers of jobs and in social privileges.
In as much as the effects of this new situation differ between different companies and economic sectors, it can be predicted that the trend away from centralized bargaining will continue.
4 - Prospects for the future
Any attempt to anticipate outcomes during this time of high instability should be regarded with caution. The procedure adopted here is to analyse different scenarios which might emerge from the current crisis in the real.
The trends in the labour market (employment, unemployment and wages) for the first few months of 1999 indicated by DIEESE at the end of last year will be reinforced by the devaluation of the real. The results expected from a fiscal reform and a brutal increase in interest rates already indicated a retraction in economic activity with a consequent deepening of unemployment and a fall in the real value of wages.
We propose two possible scenarios for consideration.
Scenario 1
Presuppositions
1A significant fall in interest rates during the next three months.
2Stabilization of the exchange rate at a level close to a 30% appreciation in the dollar (US$ 1.00 = R$ 1.55 to R$ 1.60).
3The principal elements of the fiscal reform passed by the Brazilian Congress.
4Continued non-indexation of the economy.
Probable repercussions
Within this scenario the effect of the devaluation of the real on the rate of inflation will tend to be cushioned. Inflation can be expected to be greater than during the last year, due to local pressures within certain sectors of the economy. Recession and the difficulties in collective bargaining make it unlikely that earnings in general, and salaries in particular, will keep pace with inflation; and there could be an overall reduction in the total wage bill due to a decrease in the level of employment. Unemployment will tend to increase, especially during the first half of the year, with the possibility of a recovery in the second half of the year. However, the average unemployment rate over the year is certain to be higher than that in 1998, which was 18.3% in the Metropolitan Area of São Paulo. There is bound to be an increase in negotiations directed towards maintaining jobs (credits of working hours, decreases in working hours, overtime, etc.) and profit sharing.
Scenario 2
Presuppositions
1 High interest rates maintained over a long period.
2Exchange rate instability with pressure for greater devaluation, equivalent to an appreciation of more than 50% in the dollar. (US$ 1.00 = R$ 1.80 to R$ 1.90).
3Difficulties in achieving rapid approval of important elements of fiscal reform.
Probable repercussions
In this scenario, the inflationary pressure will be sufficient to lead the government to adopt an more restrictive monetary policy in order to restrain price speculation. There is not a great deal of room to manoeuvre, since there is a rapidly forming consensus within society, among economic experts and within the market that the high interest rate policy has outlived its usefulness. There will be an attempt to reintroduce indexation of the economy (the financial system, taxation, salaries and the exchange rate). Recession will inevitably deepen to confront the imbalance in the external account; and this will have an impact on the levels of employment (fall) and unemployment (rise), and on wages (fall). Negotiation will become immensely difficult.
These scenarios are not the only ones possible as a consequence of the current crisis facing the Brazilian economy. The expectations of society of the politicians, as well as the market will have a strong influence on the direction of economic policy, but the room for manoeuvre has decreased dramatically in recent days. In our analysis of the scenarios above we have not consider the merits of the elements under consideration. For example, we have not considered whether the proposed fiscal reform is the only one possible. At this point in time it appears difficult to ignore the effect on market expectation of the result of the vote on this reform in the Brazilian Congress.
There is also still a real possibility that the current crisis will spin out of control, with an even more serious loss of currency reserves and devaluation of the real, leading to a serious undermining of the already sparse credibility of government economic policy. The consequences of this scenario are unpredicTABLE and will have repercussions for society as a whole and for the economy, politics and social structure of the country If this happens, the prospects for the future will be affected by new factors, which could lead Brazil in a totally different direction.
The crisis of the past few days has revealed the unsustainability of the exchange rate policy adopted by the Brazilian government during the past four years. DIEESE will be monitoring the situation carefully during the coming days and attempt to update the present analysis as rapidly as possible to reflect developments as they occur.
**This text is based on information available up to January 27, 1999
English version sponsored by AFL-CIO / Solidarity CENTER-Brazil
DIEESE - Departamento Intersindical de Estatística e Estudos Sócio-Económicos
1 - The impact of exchange rate devaluation rate on prices
