The Real Plan

The Real Plan

On July 1, 1994, Brazil implemented the last, and to date, most successful of its economic stabilization programs to end inflation. Nearly three years later, the Real Plan was intact, far outliving its ill-fated predecessors. By late 1996, inflation by some measures approached an annual rate of less than 20 percent, a remarkable achievement in an economy that a few years earlier would have regarded even a monthly rate at this level a triumph. The new monetary unit created by the plan, the real (pl., reais ; for value of the real , see Glossary), actually appre-ciated against the dollar in the months after its creation.

The design and implementation of the Real Plan also distinguished it from the earlier plans, and may help explain some of its success in its first years. Unlike the earlier plans, it did not depend on a general price and wage freeze to stop inflation. At the heart of the new plan was the de-indexation of the Brazilian economy, which was accomplished in part by converting salaries and a number of other prices in the months preceding the implementation of the Real Plan into Real Value Units (URVs), which were then linked to the United States dollar. After July 1, 1994, prices in URVs were converted into reais , which began officially at par with the dollar, but traded at a premium in the open market. Although the new plan made no guarantees of automatic price and wage adjustments to compensate for inflation, few restrictions were placed on employers and employees in private wage negotiations.

Although some observers characterized the Real Plan as a form of "dollarization" of the Brazilian economy, in which prices and wages that previously had been indexed to inflation were now linked to a foreign currency, there was a significant difference between Brazil's approach and that of countries like Argentina, which attempted to stabilize the value of their currencies through a formal and legal link to the dollar. Brazil did not make such a commitment, and despite the stability of the real against the dollar throughout the first year and a half of the Real Plan, there was a widespread expectation that the real eventually would depreciate.

This exchange-rate policy and the expectations that accompanied it had significant consequences for the domestic Brazilian economy. Expectations of an eventual depreciation of the currency, coupled with the short-term stability of the exchange rate and much greater mobility of financial capital between Brazil and world financial markets led to a strong appreciation of the real and painfully high domestic real interest rates. Lenders required interest rates that would protect them against a possible depreciation. With prices stable or even falling for some products, borrowers could not repay in currency that had lost its value through inflation, as they were accustomed to do in earlier years.

International enthusiasm for the Real Plan, reinforced by its apparent success in its first year, led to the resumption of large-scale flows to Brazil, permitting the government to maintain its policy of approximate exchange-rate stability. Despite the worries about a depreciation, and several speculative attacks against the real in its first year, the high level of capital flows to Brazil more than financed the high level of imports stimulated by the resumption of economic growth, leading to a sharp increase in Brazil's reserves of foreign currency. By late 1995, they totaled more than US$50 billion.

The fall in inflation, supported in part by the strong real , led to important changes in income flows within the Brazilian economy. Decades of inflation had produced a large financial sector, which flourished in part through the spread between borrowing and lending rated in a high-inflation environment. With the fall in this revenue, a number of financial intermediaries came under severe pressure, despite the high real interest rates. During 1995 there were bank insolvencies, with failures avoided by Central Bank intervention to merge these intermediaries with stronger ones.

The fall in inflation also had consequences for Brazil's income distribution. Lower-income groups, which had borne a disproportionately large share of the inflationary burden because of their relatively limited access to fully indexed savings opportunities and to the tendency of minimum salaries and other nominal wages to lag behind inflation, benefited significantly from the Real Plan. In the months following its implementation, sales of consumer durables, especially those purchased by lower-income groups, increased significantly, leading the government in 1995 to attempt to restrict consumption and reward saving. The rise in the real incomes of lower- income groups produced a level and depth of political support for the Real Plan that made it difficult for unions and other groups opposing many of the policies of the new Cardoso government to confront the Real Plan head on. It also may have helped the government in its efforts to secure the support of the Congress for a number of its proposed reforms.

The Real Plan's success in its first year strengthened the political support that the government needed to attack the underlying fiscal disequilibrium. By 1995 the operational budget of the federal government was significantly smaller than it had been in earlier years, and the attempts by some organized sectors, among them the employees of state enterprises, to overturn many of the policies of the Real Plan had been resisted. Further progress in reducing the pressures on the finances of Brazil's public sector rested on the rates of the first year of the Real Plan, as well as on the support of Congress for the fiscal reforms proposed by the Cardoso government.

By the end of 1996, the Real Plan appeared to have succeeded in its objective of ending decades of inflation and macroeconomic uncertainty. It had also bought valuable time for the government to attack the underlying fiscal imbalance that generated the inflationary pressures. There was little time to be lost, however, and the rise in public-sector expenditures, especially at the state and municipal levels, cast a cloud over the prospect for the long-run success of the Real Plan. This rise was the consequence of a number of factors, among them the surge in costs for public-sector employees created in part by the requirements of the 1988 constitution. In the short run, the rise in interest costs in the first year of the Real Plan was a heavy burden for many states and municipalities, some of which were unable in 1995 to pay employees their full salaries. Other pressures on the public sector included rising pension and social security costs, caused in part by demographic trends and by the generous promises of earlier governments to future retirees.

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