Articles:
Can Brazil emulate China?

01.10.07 Publication:

Economic growth in Brazil in recent years has been disappointing, especially to the country’s many well-wishers abroad. During a commodity-price boom, and record rates of global economic growth, Brazil should have done better than 3% a year. But the surge this year to GDP growth at annual rates of more than 5% has made us excited as well as rather dreamy: could this be the beginning of a period of sustained, rapid development? In other words, could Brazil now do what China has been doing?

            Actually, this is the wrong question. It is always tempting to take the growth champion and compare ourselves to it. Everyone did that with Japan in mind during the 1960s, 70s and 80s too. But countries are very different, and few are more different than China and Brazil, in their heritage, their economic history, in their political structures. The starting points are completely different, whether you compare Brazil with China at the beginning of its high-growth period in 1978 or if you compare them today. For a start, Brazil is already richer than China, with an income per head more than twice as high at market exchange rates and 50% higher if you adjust for differences in purchasing power. Mind you, China is closing both gaps quite rapidly.

            There are, however, two good questions to ask, to help illuminate our dreams. They are, first, what should Brazil do if it wants to achieve faster economic growth? And, second, is there anything Brazil can learn from the success in China and, perhaps, from India too, if it wishes to achieve faster growth? India is even poorer than China, with incomes per head less than a fifth of Brazil’s, measured at market exchange rates. But in the past four years, it has achieved a surge in growth of the sort that may now be beginning in Brazil. In India’s case, though, the surge has been from 6% per year to 9.4%, rather than from 3% to 5%.

            Moreover, if you just look to China for lessons, there is a danger that the lessons may be dismissed on political grounds. Brazil is a democracy, in which people, states and interest groups have well-established rights as well as the means to defend them. China is an authoritarian system with no democracy, no independent judiciary and with individual rights that do exist but which are vulnerable to changes of policy by the Communist Party. So Chinese success in building infrastructure or forcing changes in industrial development might be thought to depend on that governmental power, which Brazil will rightly not wish to emulate.

            The truth about China, though, is that its success should not be dismissed as being a result of its dictatorship, even if some of its specific characteristics may arise from that political system. If that were the full explanation, it would require an implausibly brilliant set of people running the dictatorship during the past 30 years, since most dictatorships fail to achieve or sustain such growth. But also, China’s economic model is far from unique to its dictatorship: it is simply following the pattern pioneered by Japan, South Korea, Taiwan and other Asian “tigers”, many of which are now democracies. India—the world’s biggest democracy—is beginning to follow that pattern too. A Communist Party dictatorship is not a necessary condition for capitalist success.

 

Investment is the key

The fundamental difference between Brazil and those East Asian success stories can be summed up in just one statistic: the ratio between fixed investment and GDP. In Brazil, fixed investment in 2006 accounted for 16.8% of GDP. That is quite similar to the figure for the United States. But in China, the figure was almost 45%. In India, the figure was 34%. In Japan during its period of most rapid growth, the 1960s, the figure reached 40% at its peak.

            Investment is an important indicator because it is the source of future growth in output and hence GDP. If you build a factory today, it shows that you expect to be producing more in the future. Of course, not all investment turns out to be productive, in fact. Some of China’s investment may be wasted, if it consists of office buildings that are not needed, or airports that few people use. And China’s investment in recent years seems to have become less efficient, since such a level of 45% might have been expected to generate annual GDP growth even faster than the 11% that has recently been seen.

            Most economists in China, if they are honest, also believe that the official statistics are unreliable. Investment is probably being overstated, while GDP may be being understated. Even so, the gap between Brazil’s 16.8% and China’s 45% is so vast that even if China’s true ratio were as much as ten percentage points lower, it would still be double the level in Brazil.

            If Brazil is to achieve faster economic growth, it must encourage both private and public investment to increase. But how? Governments cannot simply raise the investment rate as a matter of policy; their only means of doing so directly is by spending more public money on it, but that leads to widening budget deficits, huge increases in public borrowing, and the sort of debt crises that Latin America endured in the 1980s.

            Here is where the Chinese lessons become relevant. The reasons why investment has grown so high are that the cost of capital in China has been low, that it has been made steadily easier to open or expand a business, and that low import tariffs mean that competition is intense and the cost of inputs for manufacturers is low.

Those factors have, in turn, encouraged a huge boom in Chinese exports and have lured in foreign multinationals to build factories in China for the export market. Foreign direct investment, of up to $70 billion a year, has caught the headlines and has been helpful for GDP growth, but it has not been the decisive influence: most of the investment has been by domestic companies and the government, not foreign firms.

            There is another factor that lies behind those reasons. It is that the exchange rate of China’s currency, the renminbi, has been fixed by the government at a rate well below the level that would be set in a free market. Combined with controls on capital inflows and outflows, that has both boosted exports and kept the cost of capital low.

            If you look at other successful Asian countries, such as South Korea, Taiwan or now India, many of these factors also apply—though not all of them. The cost of capital has been low in all three places. In India, that has chiefly occurred because inflation was brought under control, interest rates dropped, and domestic savings increased. It is not, however, easy to open or expand a business in India. And the currencies of Korea, Taiwan and India have floated more freely, and at more realistic values, than has been the case in China.

            What they do share, however, is that in all of those countries trade has become more open, cutting input costs, that the opportunities available to private entrepreneurs have increased, and that domestic savings have been abundant enough to finance most or all of the investment.

            Some of China’s investment-boosting factors may well be about to diminish. Inflation is on the rise, reaching more than 6% in the year to August. Wage pressures are increasing, as the vast pool of young rural migrant workers has begun to diminish. Exports could well be hit quite hard if America enters a recession during the next 12 months. And the pressure to revalue the Chinese currency is going to get stronger, both from domestic policymakers keen to use it as an anti-inflationary tool and from American politicians keen to show that they are doing something to cut US imports and increase US exports.

            In that sense, China today may well prove to be in a similar situation to that of Japan in 1970, when that country’s investment rate peaked, and it was forced to revalue the yen and take severe measures to control inflation. In Japan during the 1970s, the investment ratio fell. But by 1980 it was still well over 30%, and Japanese GDP growth continued to be healthy. The same could happen to China over the next decade. But while that will narrow the gap between Chinese investment levels and Brazilian ones, it will not eliminate it. China and its Asian neighbours will still hold lessons for Brazil.

 

Taxes, costs and rules

Apart from the investment ratio, the other big difference between China and Brazil lies in the role and size of the state. In China, although capitalism has been unleashed and state ownership of industry has been reduced considerably, the state still plays a very important role. That role is not, however, expressed in taxes and public spending.

            In the past 10 years, the ratio of tax revenues to GDP in China has doubled, from about 10% to nearly 20% in 2006. Thanks to this, the government’s fiscal deficit has been eliminated. But that still makes the impact of the Chinese state through taxes and public spending a lot smaller than that of the Brazilian state, whose taxes account for more than 35% of GDP.

            That makes the Brazilian state roughly equal to those of America and Japan, and much smaller than the states of Western European countries, whose taxes vary between 40% and 55% of GDP. But Brazil’s state is a lot bigger than those of most other developing or even middle-income countries, where tax takes vary between 15% and 30%.

            We are all prejudiced against taxes, unless we are among those who receive the money that is spent by the government. The important economic effects of high taxes are two, however: they reduce the incentives to work and to start new businesses; and they increase the incentive to avoid taxes by operating illegally, on the black market. Black markets still contribute to economic growth. But the businesses that operate illegally must by necessity remain quite small and cannot invest very much, for fear of being detected by the authorities.

            As well as through tax, the Brazilian state also deters investment by its rules and procedures. The World Bank produces an annual survey of the ease of doing business in 175 countries around the world, looking at laws, the judicial system, bureaucratic procedures and rules for exports and imports, as well as at taxes themselves. The Bank gives Brazil a poor score: it comes in 121st place. That was better than India, which came 134th, but a lot worse than China, in 93rd place. Compared with China, in Brazil it takes much longer to open a business, to enforce a contract, to export or import goods, and far, far longer to process and pay corporate taxes.

 

A decade of reform

So, let us return to the questions posed at the start of this article. We have examined the lessons that might be learned from China’s success: investment needs to grow, the state needs to shrink. But what about the other question: what can Brazil do to adopt those lessons.

            Two things are obvious. One is that Brazil cannot adopt such lessons overnight. The other is that fast economic growth does not arise by supporting one or two super-sectors, such as ethanol or aircraft manufacturing, as some enthusiasts suggest. A large economy such as Brazil needs to fly on many engines not just a few. Private enterprise needs to be allowed and encouraged to find a million sources of expansion and places to invest.

            The experience of Asian countries also, however, suggests a third conclusion. It is that to achieve fast growth, you do not have to get everything right. The minimum requirement is macroeconomic stability, which means low inflation and predictable fiscal policy, both of which usually also help to reduce currency volatility. That is what Brazil has already succeeded in doing, under Fernando Enrique Cardoso and now Lula. The final step should be to grant independence to the central bank, in order to convince everyone that this progress really will be permanent.

            Beyond that, a country needs to create a feeling among private businesses that their opportunities are increasing and that the costs imposed on them by government are likely to be reasonable. This does not mean that all regulations, taxes and limitations have to be abolished overnight. But clear plan for the elimination or reduction of barriers, taxes and bureaucratic requirements will allow investors to think ahead and to seek ways to exploit the freedoms that are going to arrive.

            That, really, is the story of India’s growth acceleration in the past four years. A steady process of incremental reform, combined with increasing evidence of macroeconomic stability, convinced businesses that it was worth their while to invest. The public sector has been investing too, especially in infrastructure, but most of the extra investment has come from private businesses.

            The custo Brasil will not be easily or quickly removed. But the announcement of a ten-year programme to make it easier and cheaper to do business by reforming procedures, removing regulations and gradually lowering taxes would encourage the private sector to plan for the time when costs in Brazil really are competitive.

            It is much harder for government policy to reduce the cost of capital, beyond simply reducing the risk of inflation. It can and should make it easier to use capital, however, by streamlining planning regulations and reforming the judiciary to make the court system less of a blockage to investment.

            Brazil cannot become like China. It does not have the same demography or political heritage; it is not a raw, greenfield site waiting to be built on, as China has been for the past few decades. But if it wishes to achieve faster economic growth, Brazil can learn lessons from China and the other Asian successes. Those lessons are really quite simple: that private investment needs to be encouraged rather than discouraged. Simple lessons, however, are often the hardest to implement.