COMPETITIVENESS AND GROWTH IN BRAZIL Juan Blyde, Armando Castelar Pinheiro, Christian Daude, Eduardo Fernández-Arias, Peter Montiel, Mauricio Moreira Mesquita Second Draft Washington, September 20, 2007

Real GDP growth (in per cent)

Decomposition of growth in GDP per worker (average annual change in variables) Variables GDP/worker4.5%4.0%-0.2%0.5% Capital/worker7.4%5.0%0.7%-0.7% TFP1.0%1.7%-0.5%0.9%

Potential constraints tested Low return to economic activity Inadequate infrastructure Low human capital Gov failures –Inadequate business environment –Taxes –Informality –High price of investment Market failures –Innovation shortfalls –Low self discovery and structural transformation High cost of finance Low domestic savings and lack of access to international finance Poor financial intermediation

Testing hypotheses Is Brazil different? –Cross-country comparisons controlling for income level. Has the constraint changed in a way consistent with growth deceleration? What do firms say? –Investment climate survey Do prices or other variables signal excess demand? Is constraint consistent with growth patterns?

Rank of constraints (tentative) Severe Potentially Strong Moderate Small - Taxes - Human Capital - Infrastructure - Bad Intermediation / low savings - Bad International Finance - Price of Investment - Inadequate Business Environment - Informality - Lack of Innovation - Low Structural Transformation

Low Human Capital  Brazil has historically invested little in human capital  Poor education indicators compared to other middle- income countries  High return to education indicates human capital is a binding constraint  Municipalities with less educated population showed lower subsequent GDP growth  Things improved when growth decelerated  But not in relative terms, so that the gap remains wide

Poor education indicators Secondary Level Completed, 2000 (% of pop)

Poor education indicators II Secondary Education and Development

High returns indicate binding constraint Returns to Education and Development

Firms rank it middle of the way Obstacles to Firm Growth Skills and education of workers Source: ICS, World Bank.

Municipal GDP growth

Things are improving I Average Years of Schooling Total Population Aged 25 and Over Source: IPEADATA and Barro and Lee dataset. Barro&Lee IPEA

Things are improving II Returns and Years of Schooling

The gap remains large … Educational Attainment of the Total Population Aged 25 and Over Source: Barro and Lee dataset.

And is widening in certain dimensions Differences b/w Brazil and benchmark in secondary level completed

Bad Infrastructure  Investment in infrastructure has declined substantially  Significant slowdown in capacity expansion  Brazil still has indicators comparable to LAC and consistent with its income level  Firms do not see infrastructure as a major constraint to their growth

Substantial decline in investment Investment breakdown (as percent of GDP, in constant 1980 prices)

Capacity has expanded slowly in recent decades Average annual rates of expansion (%)

And to countries with similar income Differences from trend line

Firms don’t see poor infrastructure as a major constraint Obstacles to Firm Growth Source: ICS, World Bank. Telecom Transportation Electricity

Selected indicators of savings constrained growth

In sum GDM offers a structured means to make a comprehensive analysis of growth constraints. It is difficult to obtain “smoking gun” evidence on whether a constraint is binding or not. Constraints can change significantly over short periods of time. So far, our findings suggest that a number of constraints influence growth, some more intensely than others. Expand methodology to consider direct effect on growth of TFP, public investment and human capital.

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

High Real Lending Rates Ex-Post Real Lending Rates in LAC 2005

…declining but still very high Real Ex Ante Interest Rates (annual %)

Co-movement in interest rates and investment Real Lending Rates and Gross Fixed Investment

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

Spreads are significantly lower… Comparison of Sovereign Spreads

… also for the private sector Comparison of Sovereign Spreads

Brazil is a low-savings country Savings/GDP Average 1995 – 2005 vs. GDP per capita

Returns on savings are high… Ex-Post Real Deposit Rates in LAC 2005

…but in recent years savings increased significantly,

…driven by an increase in private savings Domestic savings Public savings Private savings Foreign savings

…substituting foreign financing Domestic savings Public savings Private savings Foreign savings

Brazil is currently a net exporter of savings

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

High Intermediation spreads Ex-Post Real Intermediation Spread (annual %)

… are correlated with funding rate Monthly Real Ex-Ante Rates November 2001 – May 2007

but high funding rate is only a small fraction of the story Real_spread = Real_SELIC (0.46) (0.03) R-squared = 0.14 Micro factors matter

Net Interest Margins are high despite low concentration

Operating costs are also high, pointing towards low efficiency

Decomposition of Spreads Source: Costa and Nakane (2004)

Effective Creditor Rights are low

… and so are recovery rates

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation ?

Is the cost of financing really that high? Directed and subsidized creditDirected and subsidized credit Other source of financingOther source of financing

Earmarked funds are still 30% of bank credit

… and at subsidized rates slightly above the TJLP

Non-earmarked funds do not finance much investment

Other ways of financing are quite developed

High Cost of Finance Access to international finance Bad domestic finance Low domestic saving Bad intermediation

Low Investment Low Returns to Investment High Cost of Finance

Low Returns to Investment Low Social Returns Low Appropriability BadInfrastructure Low Human Capital

Low Returns to Investment Low Social Returns Low Appropriability BadInfrastructure Low Human Capital

Low Returns to Investment Low Social Returns Low Appropriability BadInfrastructure Low Human Capital

Low Returns to Investment Low Social Returns Low Appropriability Government Failures Market Failures

Low Appropriability Government Failures Market Failures High Price of Investment Business Environment Informality Taxes Lack of Innovation Low self-discovery and structural transformation

High Price of Investment  Increase in relative price of investment reduced the “purchasing power” of savings  But national accounts revision showed this rise was less substantial than earlier estimated  Indicators for Brazil compare well with those of countries with similar income level

Substantial rise in relative price of investment Ratio of fixed investment to GDP deflators (1980 = 100)

But a similar process took place in other countries Ratio of investment to GDP prices Source: PWT

And investment prices do not seem to be out of line Investment prices Source: PWT

Nor the relative price of investment Ratio of investment to GDP prices in S Source: PWT

Business Environment

Cost of doing business

Quality of Regulation

Rule of Law

Entrepreneurs’ perceptions

Informality Informal firms invest little, have low productivityInformal firms invest little, have low productivity Disrupt incentives in the formal economyDisrupt incentives in the formal economy

Tax Burden

Tax rates are high… Percentage of firms indicating tax rates as a major problem

….paying taxes is cumbersome Time (hours) paying taxes

Evidence from sector’s data Sector performance and tax burden

Evidence from firm’s data Average growth rate of sales

Low Appropriability Government Failures Market Failures High Price of Investment Business Environment Informality Taxes Lack of Innovation Low self-discovery and structural transformation

Lack of Innovation

R&D / GDP

Lack of Innovation R&D / GDP: deviations from the median

Lack of Innovation Obstacles to innovation (% of firms responding)

Lack of Innovation

Structural Transformation There is a positive relationship b/w the level of sophistication of exports and subsequent growth (what you export matters!)There is a positive relationship b/w the level of sophistication of exports and subsequent growth (what you export matters!) Many countries have seen negative per capita growth for a very long timeMany countries have seen negative per capita growth for a very long time There have been growth collapses that have lasted long periods of timeThere have been growth collapses that have lasted long periods of time Most growth collapses coincide with export collapsesMost growth collapses coincide with export collapses

Structural Transformation EXPY vs GDP per capita

Structural Transformation Export sophistication and subsequent growth

What determines the evolution of the sophistication of exports? Every product requires a unique set of capabilities: labor skills, infrastructure, property rights, physical assetsEvery product requires a unique set of capabilities: labor skills, infrastructure, property rights, physical assets Producing new goods require adapting existing capabilities, which are imperfect substitute for the new capabilitiesProducing new goods require adapting existing capabilities, which are imperfect substitute for the new capabilities So future structural transformation depends on what is ‘close’ to your current productionSo future structural transformation depends on what is ‘close’ to your current production

Brazil 1975

Brazil 1980

Brazil 1985

Brazil 1990

Brazil 1995

Brazil 2000

Ecuador 1995

Structural Transformation

Low Appropriability Government Failures Market Failures High Price of Investment Business Environment Informality Taxes Lack of Innovation Low self-discovery and structural transformation