Brazil From Stability to Growth through Public Employment Reform

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Report No BR Brazil From Stability to Growth through Public Employment Reform (In Two Volumes) February 17, 1998 Volume I: Main Report Brazil Country Management Unit Poverty Reduction and Economic Management Unit Latin America and the Caribbean Regional Office Document of the.world Bank

2 CURRENCY AND EQUIVALENTS Currency Unit: The Real R$1.005 = US$ R$1.078 = US$ WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS BANDEPE = Banco do Estado de Pernambuco BANRISUL = Banco do Estado do Rio Grande do Sul BNDES Banco Nacional do Desenvolvimento Economico e Social CLT = Consolida,cao das Leis Trabalhistas FGTS Fundo de Garantia por Tempo de Servi,o GFS = Government Finance Statistics IBGE Instituto Brasileiro de Geografia e Estatistica IFS = International Financial Statistics INSS = Instituto Nacional de Seguridade Social IPEA = Instituto de Pesquisa Econ6mica Aplicada PDV Programas de Demissao Voluntaria PROER = Programa de Estimulo a Restructura,ao e ao Fortalecimento do Sistema Financeiro SECEX = Secretaria da Receita Federal - Banco do Brasil VAT = Value Added Tax Vice President: Shahid Javed Burki Director: Gobind T. Nankani Lead Economist: Suman K. Bery This Report was prepared by a team consisting of Gautam Datta (Task Manager, LCSPR), Indermit Gill (LCC5C) and Craig Burnside (DECRG). Indermit Gill is the author of Chapters 3 and 4 of the main report and the Annex. Homi Kharas (PRMEP) helped formulate the framework and provided guidance throughout. A background paper for the World Bank authored by Nissan Liviatan (Bank of Israel and Hebrew University) was extensively drawn on for the macroeconomic sections. The public employment sections of the report are the result of a collaborative effort with IPEA, Rio de Janeiro. Contributions were also made by Francisco Carneiro (University of Brasilia) and Edward Amadeo (PUC, Rio). Michael Walton (PRMPO) was the peer reviewer.

3 BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM Table of Contents Page No. EXECUTIVE SUMMARY... i CHAPTER 1: FROM STABILIZATION TO FISCAL ADJUSTMENT AND EMPLOYMENT REFORM... 1 Introduction... 1 Stabilization is taking hold... 3 Efficiency and confidence are increasing... 4 Poverty and income distribution improved with the fall in inflation... 5 CHAPTER 2: MACROECONOMIC DEVELOPMENTS SINCE STABILIZATION... 7 Introduction... 7 External Balance: Current account deficit grows as capital inflows increase...7 But financing of current account deficits is improving Internal Balance: Fiscal adjustment is needed But debt appears to be sustainable Nevertheless, risks remain Fiscal Adjustment Possibilities CHAPTER 3: PUBLIC-PRIVATE DIFFERENTIALS IN EMPLOYMENT AND COMPENSATION The Approach The Background Public-Private Differences in Earnings Public-Private Differences in Job Security Public-Private Differences In Pensions CHAPTER 4: PUBLIC EMPLOYMENT REFORM: WHAT IS BEING DONE, AND WHAT IS NEEDED Recommended Measures for Reducing Payroll Costs Employment Reduction Through Voluntary Severance Programs Reducing Public Employment under Current Conditions Selective Pension Reform Can Eliminate Public Sector Pension Premium Labor Market Reforms Can Reduce Informality and Turnover in Private Employment Administrative Reforms Can Reduce Public-Private Job Stability Differentials REFERENCES... 53

4

5 -1- BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM EXECUTIVE SUMMARY 1. THE MACROECONOMIC SETTING Brazil has made impressive progress since Brazil's progress since implementing the ongoing Plano Real in mid-1994 deserves praise. Annual inflation has been reduced to below 5%. With the consequent rise in real wages, income distribution improved markedly and poverty levels have gone down. In spite of a large decline in inflation-related revenues, there has been no systemic crisis in the banking system because of the Central Bank's restructuring initiative. The exchange rate was made flexible in early 1995 and Brazil tided over the Mexico crisis without any need for external assistance. Direct capital inflows jumped in 1996, reflecting increasing foreign investor confidence and new opportunities. Unlike many other stabilizing economies, unemployment has not emerged as a major problem. But tight money and a loose fiscal stance have led to growing pressures. However, the Real Plan still faces major challenges. Brazil has relied on tight monetary policy and a strong exchange rate as the primary instruments of stabilization. Unlike other stabilization programs in high inflation countries, Brazil saw an initial worsening of its fiscal stance, with measurable but slow progress since then. The result has been extremely high real interest rates with several consequences for Brazilian indebtedness. The fiscal deficit itself has been affected negatively since the government is a large debtor. The high interest rates accompanied by a predictable exchange rate regime have also led to capital inflows from abroad. R$ 23 billion of these inflows had to be sterilized between July 1994 and February 1997, adding to domestic debt and inducing Central Bank losses because of the differential between domestic and foreign interest rates. Furthermore, under the prevalent policy regime, private sector external indebtedness has grown rapidly, since it is cheaper to borrow abroad rather than finance activity domestically. The current account deficit worsened from virtual balance in 1994 to 4.2% of GDP in This factor, the lack of fiscal adjustment, and the policy mix in general, contributed to the attack on the Real at the end of October 1997, although contagion from the Asian crisis was the precipitating factor. This attack was successfully resisted by a rapid fiscal response, as well as an acceleration of reform passage in Congress. However, there was a substantial loss in reserves in late 1997, and the policies adopted will lead to much slower growth through 1998, at least. The risks are manageable. There are few signs that the leading and contemporaneous indicators most related to macroeconomic crises in other countries -- the level of reserves, the real exchange rate, domestic credit, credit to the public sector and domestic inflation -- are outside prudent limits in Brazil. Nor are there any signs of lack of credibility in the behavior of

6 inflation vis-a-vis growth in money supply and debt. Brazil has also carried out significant restructuring of its financial sector after the Real Plan. However, the widening current account deficit requires adjustment to be stretched out. This increases vulnerability since a prerequisite is a stable flow of international capital to Brazil, and international shocks have to be ruled out for this to be assured. Brazil's substantial foreign exchange reserves, a credible privatization program and record of policy management so far, make the risks associated with the Real Plan manageable in the short to medium term, although these risks could be further reduced with a change in the policy mix. Long run prospects appear favorable, given that new sectors are being opened up to foreign capital and that Brazil is only at the start of its privatization program. But the momentum for privatization has to be sustained, and long-run public sector solvency requires that a definitive fiscal turnaround take place sooner rather than later. The recent progress in the (first round) passage of Constitutional reforms relating to public employment and social security provides comfort that this process has indeed accelerated. But the policy mix is proving costly in terms of foregone growth. The policy mix of high real interest rates, a strong exchange rate and a weak fiscal stance, however, has undesirable consequences, beyond the growth of indebtedness. The paucity of policy instruments that can be effectively used has led to the very active use of deflationary interest and credit measures, resulting in unusually severe intra- year output cycles in 1995 and The Authorities resorted to interest rate increases and credit restrictions when output growth picked up, because the high responsiveness of imports to output changes in Brazil meant that output increases led to pressures on the current account- a symptom of overheating. In the short and medium run a lowering of absorption through fiscal adjustment is the indicated course of action. Moreover, progress in fiscal adjustment would be an important positive signal to foreign investors. A significant nominal devaluation is not recommended at this time as it may trigger inflation when the fiscal deficit is high in an economy with a history of indexation. In the interim, measures to enhance productivity growth through privatization and regulatory reform have a crucial role to play. The most damaging consequences of the current policy mix and resulting high interest rates will be felt over the longer term. The growth record of lend support to this view. The growth rate fell from 5.8% in 1994 to 4.1% in 1995 and to 2.9% in Preliminary estimates for 1997 show a small recovery to 3.0%. Although better than the record of the 1980s and early 1990s, this is far below Brazil's potential. Investment has not increased significantly since 1990, even though foreign savings have risen from zero to more than 3% of GDP since the Real Plan. Sustainable fiscal adjustment is the main policy change required, and this should take the form of reduced government spending. Fiscal adjustment requires adjustment in taxes or expenditures or both. The ratio of tax revenue to GDP in Brazil is one of the highest in Latin America, with high nominal rates of the main tax, a state VAT (ICMS). Moreover, this ratio has risen significantly after the Real Plan as inflationary erosion has come to a halt. While measures to improve the tax system in Brazil will help, in the long run, to improve efficiency, their impact on revenue could be offset by a move towards a more neutral tax regime with a lower dead weight burden. It is also difficult for the federal government to raise budgetary savings through revenue increases, since many taxes are earmarked for specific expenditures or sub-national levels of government which do not give stabilization the same priority. Increases in federal revenues will come only from a comprehensive tax reform, which has to address sensitive areas

7 in federal-state relations. The federal executive has suggested such a reform, but this is still a technical proposal in its early stages. Therefore, the immediate thrust has to be on government spending, especially at the state and municipal levels where deficits have grown disproportionately. Government expenditures are dominated by payroll expenses. Capital expenditures in Brazil are much smaller than in the eighties and there is an aggressive divestiture program in place at both the federal and state levels. Non-wage recurrent expenditures have also been squeezed, since salaries and wages are not easy to reduce in an increasingly low inflation environment where institutional constraints make layoffs in the public service virtually impossible. There is scope for further reduction in capital expenditure since privatization will remove the need for the federal treasury to contribute to investment in public enterprises. With overall federal capital expenditure at only 0.8% of GDP, however, this will not be enough and other measures need to be taken. Since public sector salaries and pensions consume 60% of net revenues at the federal level, 70-80% in several major states and over 100% of net revenues in other states, the major avenue for expenditure reduction has to be through reduction in the public sector wage bill. The need to unify the labor market provides another major rationale for public sector employment reform. The approach adopted in this report is to explore measures which equalize earnings, pensions and job stability across the private and public sectors. The issues of fimctional distribution of public employment and efficiency in the delivery of public services are not touched here. Even if the problem was approached from this angle, however, public sector wages and pension related questions could not be avoided, since these constitute the bulk of government expenditure. The adjustment can be partly through wage adjustments, especially where public sector workers are better paid than their private sector counterparts. Since not all public servants are higher paid and selective wage adjustment is not always possible, some of the adjustment will have to come through cuts in public sector employment. Moreover, the pension system for civil servants is more generous than private social security. Even the latter needs reform, since it is actuarially unbalanced and has increasingly strained the budget with deficits since Reforms along the lines suggested in this report should have, thus, both a fiscal impact and an efficiency one through unification of the labor market. 2. THE PUBLIC EMPLOYMENTSCENARIO: WHAT TO DO. Brazil does not have exceptionally high public employment levels, but the public wage and pension bill has risen to unsustainable levels. Although there is scope for savings through employment reduction, Brazil's problem is not one of gross over-employment in the public sector. At the national level, employment in government was about 9% of total employment in September 1995, close to the level that would be predicted for Brazil by a World Bank crosscountry study. Including employment in public enterprises, this ratio increases to about 12%, still below the international levels for countries similar to Brazil. As against this, public payrollrelated expenses are about 12% of GDP in Brazil, which is high relative to comparable countries (though such international comparisons can be misleading given differences in coverage of public accounts). These findings point to misalignment of compensation levels compared to salary, pensions and job security in the private sector. Salaries and pensions in the federal government and enterprises and state enterprises are especially high relative to the private sector.

8 -iv - Since 1994, public employment has been largely unresponsive to economic changes, while the private sector has been adjusting. Public employment grew between 1992 and 1995 at all levels except state administrations. Real earnings grew at all levels until 1995, and have fallen only slowly since then in federal administration. Pension payments - that are linked to these earnings - also have grown. Public employees retain rights to lifelong employment. In general, public employment levels and salaries have not systematically adjusted to a more stable and open economy. In contrast, adjustment in the private sector has been shared by wages and employment, reflected in the growing degree of informality of employment and increases in unemployment in the formal sector. But while many private formal sector firms have downsized successfully, but unemployment rates have risen only to 6-7%. Efforts shouldfocus on reducing public-private differences in earnings, pensions, and job stability. The fundamental principle proposed by this report to underpin a sustainable reduction of the fiscal burden of public employment - also enunciated clearly in a 1995 address by the Minister of Federal Administration and State Reform, Luiz Carlos Bresser Pereira - is to reduce the differences in public and private earnings, pensions, and job stability. Since 1994, these have diverged instead of converging. Salaries and pensions of public sector employees are generally higher than those of similarly qualified private workers. While there is "too much" stability in the public sector, one could argue that there is "too little" job security in the private sector": artificially high informal employment is more than 50% of urban private employment in some states. Accordingly, the aim of administrative, social security and labor market reforms should be to reduce differences in compensation between the public and private sectors, and not to reduce levels of public employment and/or pay per se. In the judicial and legislative sectors and in the federal administration, sustainable reduction of payroll spending principally implies lowering salary and pension levels. The main problem in these sectors appears to be overcompensation rather than over-employment. Federal government workers earn about 30% more than private sector workers with similar attributes. For judicial and legislative workers this premium is more than 50%. Reducing salaries and altering pension rules (principally requiring pension contributions at the same rate and duration as for private employees, and imposing the same ceiling of 10 minimum salaries) is the most effective way to reduce payroll expenses in these sectors. In federal and state enterprises, sustainable payroll reduction implies lowering salaries, pensions, and employment. On average, workers in state government enterprises enjoy an earnings premium of about 20%, while those in federal public enterprises enjoy a premium that is about 35%. In enterprises that are overstaffed relative to comparable private firms, employment reduction may also be required. In this sector, reduction of payroll costs thus requires a mix of reduction of compensation and employment. In state civil service and municipal administrations and enterprises, sustainable payroll reduction requires reduction of employment and delinking pensions from salary adjustments. In these government sectors, where salary levels of workers are the same or lower than equally qualified private workers (e.g., in municipal administration and enterprises, and for education

9 - v - and health workers in many states) substantial reduction of employment will be necessary in order to control growth of payroll-related spending even if salary and pension adjustments are feasible. 3. REDUCING PUBLIC EMPLOYMENT UNDER CURRENT CONSTITUTIONAL CONDITIONS: HOW TO DO IT. Analysis of employment and earnings from PNAD (annual national household) surveys, and costs and effectiveness of ten downsizing programs in the federal government and in the states of Pernambuco, Rio Grande do Sul, and Sao Paulo provides guidance on rules for financially efficient and sustainable reduction of public employment. Enforcing working hour regulations, reducing salaries, and keeping salary increases small will reduce the incentive to stay in government. Efforts to reduce employment under the current legal and political constraints can be assisted by keeping public sector salary increases to a minimum, and enforcing - and, in some cases, even increasing - minimum working hours. Declining real earnings of public employees would encourage their voluntary departures as private sector employment and earnings increase, keep payroll expenses for current employees from rising, and - since pension payments to inativos (retirees) are linked to salary levels of ativos - keep pension-related expenses from rising. Separation programs for public administration should be redesigned and expanded. State downsizing efforts contain substantial hidden expenses for the federal government because of an implicit transfer of pension obligations from state treasuries to the INSS system. Despite these costs, downsizing is a profitable strategy for consolidated government: the benefits - in termns of reduced salary and pension bill - of credible downsizing programs can be 7-10 times the financial costs. Many state governments have resorted to relatively expensive early retirement schemes to spread costs over time because severance schemes involve large one-time expenses. Tlhe findings of this report suggest three main lessons. First, separation programs can be made more effective by introducing an element of involuntariness; the experience in some states such as Rio Grande do Sul shows that pressure can be legally brought to bear. Second, to lower costs, packages for nontenured government employees should be smaller than for those with tenure; currently estatutarios often get lower severance benefits than CLTistas. Third, these schemes entail large implicit transfers of pension obligations from state governments to the INSS's time of service program; mechanisms to make these transfers explicit (e.g., recognition bonds) would solve this problem, though the preferred solution would be to unify the pension systems for public and private employees. Separation programs for public enterprises can be made less generous. Downsizing efforts in public enterprises, despite often paying more than what is legally required - are financially profitable: the benefit-to-cost ratios can be as high as seven. Since these employees are CLTistas who can technically be dismissed, special indemnity payments to induce them to quit can be viewed as unnecessary. Nevertheless, if indemnities are paid, then these workers should not have access to their FGTS balances. In fact, workers are generally allowed to withdraw these funds (i.e., the separation is treated as involuntary), and state enterprises often

10 - vi - pay an additional 40% of the accumulated balance as a penalty for "unjustified dismissal". Cash-strapped enterprises have also relied on expensive early retirement schemes to spread the costs of downsizing over time. The report suggests three main lessons. First, costs can be reduced by introducing an element of involuntariness; Bandepe's (State Bank of Pemambuco) experience suggests that this is possible with little or no labor unrest and litigation. Second, given growing actuarial deficits in closed company funds, public enterprises should be encouraged to rely more on severance than early retirement. Third, if special indemnity payments are made, departures should be treated as voluntary quits, and workers not be given access to FGTS accounts. 4. CONSTITUTIONAL REFORMS TO INCREASE LABOR MARKETEFFICIENCY While the above measures can in principle be activated immediately, longer-term fiscal sustainability requires constitutional reform in the areas of social security, administration, and private labor regulations. Social Security Reforms Measures to reduce disparities between public sector and private sector pensions are the most beneficial actions over the longer term, from fiscal, efficiency, and equity viewpoints. To increase labor market efficiency and increase equality, the most important guidelines are: * Public pension levels should not be more generous than private pensions. The ceiling for benefits (10 times monthly minimum salary) that applies for INSS pensioners should apply for public employees as well, and the same rate of replacement - below the current 100% rate - should apply. Besides reducing government expenditures, equalizing pension benefits will also reduce distortions such as the practice of switching to public service late in the career to obtain higher pension benefits. * Entire work histories should be used to calculate the base for pensions. Estimates indicate that in 1996, this change alone would have reduced the annual pension bill by about 20-25% for medium- and high-salaried civil servants, and about 30% for low-salaried civil servants. For INS S recipients, the savings would be smaller (about 10-15%) but still significant. * Public employees should contribute at the same rate as private employees. While these contributions are between 8% and 10% for wage and salaried workers in the private sector, civil servants in many states do not contribute at all. Requiring estatutarios (public employees with tenure) to contribute at the same rate as CLTistas (those covered under the consolidated labor code) will reduce the pension burden by about 10%, make public employment less attractive and aid downsizing programs, and remove distortions in these programs due to the transfer of pension obligations from states to the federal government. * Eligibility rules should be made stricter and uniform for private and public employees. Making the minimum years of contribution for workers the same regardless of their occupation and sector of employment, basing eligibility in both the public and private

11 - Vllsystems on the years of contribution rather than years of service, and introducing a minimum age at which retirement benefits commence would reduce labor market distortions and result in significant savings even at current replacement rates and eligibility periods. Administrative Reforms Constitutional changes proposed in the administrative reform bill are being monitored as a signal of the government's commitment to fiscal adjustment. The most contentious clause in this bill is the revocation of job stability for civil servants. * Immediate fiscal benefits of tenure revocation depend on political will. The review of downsizing efforts undertaken for this report raises doubts about immediate fiscal benefits of this clause. Even public employees without tenure (CLTistas) are being "bought out" with indemnity payments, though many can legally be fired. The main constraint to successful downsizing of public employment appears to be political will. Thus the passage of this bill is unlikely to benefit state governments that lack the political will to adjust, though it will help reform-minded state governments obtain higher savings from voluntary severance programs. - There may be some efficiency gains. Revocation of tenure for civil servants would allow governments to put pressure on negligent workers, and hence result in greater efficiency in provision of government services. Here again, our review of state reforrm efforts indicates that governments with adequate political will have done so even under current laws, using measures such as time monitoring systems and performance evaluations to encourage grossly negligent workers to take relatively modest packages and quit. For such governnents, the efficiency gains resulting from passage of the administrative reform will be modest. * The cost of waiting for constitutional reform is high. While the fiscal and efficiency gains from the administrative reform bill are uncertain or modest - even if passed in its current form and applied to all workers immediately - the cost of waiting is certain and high. The two main factors are the high rate of interest paid on debt and - because of the rising share of pensions in payroll expenses - a later public sector reform will be less fiscally rewarding than one today. Labor Market Reforms Realistically, most government employees are likely to view formal sector jobs as the alternative to their current jobs, since the salary, pension, job stability and locational differences between such jobs and government employment are smaller. Labor market measures to improve the likelihood and attractiveness of private formal employment are an important but underrated instrument for reducing the burden of public payroll expenses: * Reduction of payroll taxes will reduce informality of employment. There is mounting evidence that high payroll taxes and current design of the systems financed by these levies increase informality of employment. Given that differentials in earnings, pensions, and job stability are smaller for public and formal private employment than those observed for public and total private employment, reforms of these programs combined with a reduction of

12 - viii - payroll taxes will encourage formality and narrow the public-private gap in compensation. The passage of a constitutional amendment that allows workers to be hired under temporary contracts that have an extended probationary periods and lower payroll taxes is not a substitute for more general labor reforms, but appears to be a step in the right direction. Reform of FGTS scheme will reduce turnover in theformal sector. While there are distinct similarities between the US and Brazilian labor markets, one of the differences is that Brazil's turnover rate is about 33% higher. Severance fund (FGTS) laws are believed to increase turnover levels to artificially high levels in the formal sector and increase informality of employment. Reforming the FGTS system (e.g., by reducing the penalty for unfair dismissal to the pre-1988 level of 10%) to reduce the perverse incentives to workers to "get fired" will reduce turnover rates and increase investments in worker skills by firms. * Reform of selected laws will increase employment and earnings. Reform of relatively strict hiring and firing laws will lower the cost of labor and increase employment, and lower the duration of unemployment in the formal sector. Both will encourage government employees to seek private sector jobs. Delinking pension benefits from minimum wages will reduce the increases in fiscal burden that accompany even small increases in the minimum monthly salary.

13 BRAZIL: FROM STABILITY TO GROWTH THROUGH PUBLIC EMPLOYMENT REFORM CHAPTER 1: FROM STABILIZATION TO FISCAL ADJUSTMENT AND EMPLOYMENT REFORM Introduction 1. Brazil underwent a fundamental regime change in terms of macroeconomic policy in mid-1994 with the full fledged launching of the Real Plan with a new, anchored currency. With this ended more than a decade of price instability, indexation and stagnation in per capita output. The background and steps leading to this stabilization episode have been described in the World Bank Economic Report titled Brazil: An Agenda for Stabilization, October 7, 1994 (Report. No BR), and the Plan has been analyzed in various Government documents.' Stabilization has now persisted for three years; since 1996 the annual inflation rate has come down to single digits. 2. At the beginning of the decade the realization had set in that the model of development that had served Brazil in the past, with a prominent role for the state in resource allocation decisions, was unsustainable. High levels of protection had made Brazilian industry inefficient and inward looking. Accordingly, trade liberalization, liberalization of the capital account and limited privatization had started even before the Real Plan was introduced in mid However, the pace and impact of reform were limited by the overwhelming problem of managing an economy where the specter of hyperinflation was ever-present. Finally, the political crisis that led to the impeachment and resignation of President Collor had its additional impact. With the election of President Cardoso and the success of the Real Plan, internal and external confidence in economic management has been restored. A change in inflationary expectations can have a very significant impact on the inflation rate if monetary accommodation moves in parallel. This is what appears to have happened in Brazil after the Real Plan, where inflation has come down without a significant reduction in the fiscal deficit in the face of social consensus that the days of state supported indexation are over. 3. This chapter looks at three sets of issues in the post-stabilization phase. First, it examines the sustainability of the Real Plan. Sustainability in this context refers to the continuation of a low inflation regime with some growth and with trends in the fiscal deficit and the current account which ensure that the economy is not excessively vulnerable to shocks. Clearly, a stabilization episode that has lasted three years and continues to show a declining trend in prices is not a transitory phenomenon. It must reflect some change in economic fundamentals and confidence in the future course of the economy. The questions are: Can we infer from the behavior of relative prices and other evidence that inflation will continue to be on a converging path to international rates? Second, what can be done to improve the policy mix such that the adjustment is efficient, i.e. the economy does not have to go through accentuated cycles or fall See The Brazilian Economy in the Wake of the Real Plan, Central Bank, July 1996 for a comprehensive review.

14 -2 - back on protective measures. Consolidation of stabilization is a lengthy process and, as the cases of Chile and Mexico have shown, progress is not linear and may be interrupted by significant recessionary and crisis episodes. To the extent that Brazil can learn from such experiences, it can take advantage of being a latecomer to stabilization. In addressing this issue, we focus on the post-real Plan behavior of the balance of payments and fiscal deficit. Finally, we examine the longer run question of whether the economic regime is conducive to a recovery of investment and growth. 4. The findings are that inflation in the prices of non-tradables are converging to tradable prices (see Figure 1). This strengthens our conviction that inflation will fall, presuming there is no movement towards closing the economy once again. This presupposes that the current account deficit can be contained and in this context the report identifies the lack of sufficient fiscal adjustment as the major shortcoming of the Real Plan. Rapidly growing public debt is a symptom, although the growth of debt is not driven only by fiscal deficits but by the adopted macro regime in general :00:.500\.0 :1;:: Figure 1: Brazil - Monthly Rate of Inflation for Tradable and Non-Tradable Goods' 600 X *- = 'I.v 0 LO LO U1 LO) LO co co 0 ( (0 rl T ) X X 0 0e 0 0) t t 0) 0) 0) m < I D LL<-n C m i6 n <a0 U- Tradables goods prices as reflected by Brazilian wholesale price indexfor industrial products (IPAIP I). Non-tradable goods prices are measured by Brazil cost of living index (IPC-BR- housing, public services and clothing only). 5. Accordingly the issue of sustainability of public debt is examined by the report. Debt is, ultimately, related to the level of public expenditures, and within expenditures, to the high level of wages and public pensions. Thus, the report goes on to deal with public sector employment reform. This is a complex subject which covers private-public earnings differentials, incentives for workers to leave the public sector, pension rules and labor market regulations; accordingly, a major Annex of the report is devoted to the detailed analysis of public-private employment, earnings, pension, and tenure differentials, and the reforms required to develop a sustainable and efficient civil service, and ensure a competitive private sector. 6. In order to restore balance in the current account the report suggests that instead of relying on tight monetary policy combined with a weak fiscal stance - which characterizes the

15 present set of policies - a changed mix with lower domestic demand through a significant fiscal adjustment and cost reducing measures to promote exports is the answer. 7. In order for stabilization to be sustainable in the long run, credibility has to be gained by appropriate macro policies and structural reforms. This is an urgent task in the light of the worsening external situation through late 1997, triggered by the Asian crisis. Various policy options at this juncture are spelt out in the next chapter, with their benefits and shortcomings. In our assessment, the Authorities' choice to not waver from the policy of accelerated fiscal adjustment with a gradual real depreciation of the exchange rate after the October 1997 attack on the Real, is the correct one. 8. The long run prospects for growth are dependent on a change in domestic savings behavior. This theme is not fully explored here, being beyond the scope of this Report. However, fiscal adjustment is clearly a pre-condition for addressing this issue through an improvement in public savings. Stabilization is taking hold 9. Table 1.1 presents selected macroeconomic indicators for the period. Table 1.1: Selected Macroeconomic Indicators, Internal Debt to Investment to Investment to Inflation Real Interest GDP GDPe GDP Ratio Year Rate' Rate1 Ratio Ratio (I) (II)4' N.A. N.A. Source: Central Bank Boletim, various issues. " Annual inflation rate according to the INPC (consumer price) Index. 2 SELIC (overnight rate equivalent to interbank) Annual Average. 31 Gross fixed capital formation at 1980 prices. 4/ Gross fixed capital formation at current prices. 10. Several features are worth noticing. The annual rate of inflation has come down rapidly from over 2000% in 1993 to single digit levels in In most other hyper-inflationary economies the decline to below 10% rates took longer. The real rate of interest in the economy has declined since September 1995, even though it is high by international standards. This should be read along with the column one on the level of internal debt to GDP, which has been rising. The public is willing to hold larger volumes of debt at lower real yields. The proportion of indexed public bonds in the economy (post-fixed in Brazilian terminology) also fell between 1994 and mid The investment to GDP ratio (at constant prices), has been rising since 1992, albeit very gradually, after having declined continuously since 1980.

16 -4 - Efficiency and confidence are increasing 11. These indicators show greater credibility in the economy on the part of economic agents. While stabilization itself has increased confidence, the efficiency of the economy has also increased in the 1990s. Some of this improvement stems from policy measures that preceded the Real Plan and from other concomitant measures. Evidence of this efficiency increase and the related policy measures are presented in Table 1.2 and 1.3. Table 1.2: Efficiency Indicators, Weig bed Averag Money Supply (M 1 j omalrtectio "'Labor Prod uct"ivi to GDP Ratio Year Growth Rate Rate Index (end of period) N.A N.A (Aug.) N.A. N.A. 5.3 Source: 1. National Accounts, IBGE 2. A Politica de lmportaqao no Plano Real e a Estrutura de Protegao Efetiva by H. Kume, IPEA, Mercado de Trabalho, [PEA - Ministerio de Trabalho. 12. Labor productivity has been increasing since the late 1980s. The economy has become more open with a rise in the ratio of trade to GDP. The effective tariff rate had declined to 12.9% by 1995 and the weighted nominal protection rate to 11.5% (Table 1.2). 13. Capital flows have increased as a consequence of the Brady deal rescheduling Brazil's extemal debt with the commercial banks in 1994 and the removal of restrictions on capital flows since 1991 (Table 1.3). These measures include removing punitive withholding taxes on excess profit remittances, authorizing subsidiaries to pay royalty to parent companies, reducing delays in registering re-invested capital, authorizing multinationals to increase their capital base, allowing access to official sources of export finance for foreign firms, and removing restrictions on foreign investment in important sectors of the economy. Since 1991 the stock market has been open to foreign institutional investors, and the range of investors allowed to operate has been widened. New instruments such as derivatives are now permitted. Even before the Real Plan, in 1993, portfolio investment was 11 times its 1991 level. Post-Real Plan increases have been concentrated in direct investment, which currently finance 50% of the current account deficit. Privatization has gained momentum (Table 1.3). The share of the financial sector in GDP has been falling. The share of money supply (M,) in GDP has risen since stabilization (Table 1.2) and in May 1997 stood at 4.4% of GDP. The improvements following the Real Plan have, therefore, a structural component. While some of the changes in the structural area were initiated prior to 1994, recent policies have reinforced them. A more open economy was a crucial policy instrument in bringing down inflation, and unless the low inflation regime is maintained, many of the efficiency gains will not persist.

17 - 5 - Table 1.3: Further Indicators of Efficiency, M- -#on*i--; - Year ---:-l-iqns) (-i (In-U!,,,, lhlons):- - atlzedd , , , , , , Source: 1. BNDES 2. Central Bank V Balance of payments concept. y Refers to Federal Enterprises only. Values include debt transferred. An additional three state-level enterprises have been sold for a total of US$ million. Poverty and income distribution have improved with the fall in inflation 14. Finally, Table 1.4 shows that poverty indicators and income distribution have improved with the Real Plan. The proportion of poor, where they are defined as households with incomes less than half the minimum wage, fell from over a third in 1994 to a quarter in The minimum wage is currently R$120 per month. The share of income of the bottom 50% of households rose from 11.3% in 1994 to 12.3% in The Gini coefficient, which is slow to change, fell from 0.60 in 1993 to 0.57 in The channels through which these changes occurred are: There was a strong rise in real wages after the Real Plan and wages rose more in the informal segment of the labor market where the poor are concentrated. The minimum wage was also raised. Average real income for formal sector workers was 12% higher in 1995 relative to For informal sector workers the difference was 28%. This effect was part of the relative rise in the price of non-tradeables that accompanies an exchange rate anchor based stabilization plan. At the same time the consumption basket of the poor, which is intensive in food, rose much less than the general consumer price index. Indeed, the cumulative rise in the cost of the basket of essential rations between December 1994 and February 1997 has been only 5.2%.2 The poor also benefited from the end of income erosion due to high and rising inflation combined with imperfect indexation of labor earnings. Less than a quarter of Brazilians have bank accounts (there are 33 million bank accounts in a country with a population of more than 150 million). It is also worth noticing that, unlike many other countries, stabilization and opening up of the economy have not resulted in a significant rise in the rate of unemployment in Brazil, enabling the gains in real wages to be preserved as gains in real income. 2 In view of the difficulty in measuring prices in Reais in the transition month of July 1994, we have chosen to use the December 1994 date as the starting point. The source of data is Boletim Dieese, various issues.

18 -6 - Table 1.4: Poverty, Income Distribution and Unemployment N.A. N.A Source: 1. Carta de Conjuntura, IPEA, No. 71, March Mercado de Trabalho, IPEA, various issues.!/ Average of six metropolitan regions according to monthly survey (PME) data. 16. It should be kept in mind, however, that the distribution of income in Brazil continues to be highly unequal. Structural problems such as disparities in educational attainment, income differences by education, regional inequalities and skewed distribution of assets continue to persist. Furthermore, while the trend in the deterioration of income inequality indicators was reversed in mid-1994, many of these indicators are worse than their levels in the 1980's or even the early 1990's. Finally, the impact of the stabilization plan was of a one-shot nature and cannot be expected to continually improve the distribution of income. 17. In spite of the success sketched above, the Real Plan suffers from weaknesses. These can largely be traced to the policy mix, and have exacted costs. The twin deficits, fiscal and the current account, are at levels above comfortable. Moreover, this experience has been accompanied by increased policy induced fluctuations in growth within the year. This underscores the problems with the policy mix followed, with very tight monetary and credit policies interspersed with periods of loosening as output fell. The growth rate of the economy in the post-real phase has been unimpressive and has declined over time. In 1994 the annual growth rate was 5.8%, in 1995 it fell to 4.1%, and to about 3.0% in 1996 and 1997, although Brazil's growth rate is still higher than in the early nineties which were marked by high inflation. Some of this is a shared experience with other stabilizing economies that have used an exchange rate anchor. In the next chapter, the external and internal balance of the economy in the post- Real Plan period is examined.

19 - 7- CHAPTER 2: MACROECONOMIC DEVELOPMENTSINCE STABILIZATION Introduction 18. Post-stabilization episodes in high inflation economies with exchange anchors are vulnerable to exchange rate overvaluation and large deficits in the current account financed by short term, speculative capital inflows. These situations tend to end in an attack on the currency and a painful period of readjustment. If a return to high inflation is to be prevented, the economy may have to undergo a bout with severe recession. In the case of Brazil, the duration of the Real Plan and the change to a moving band exchange rate regime in 1995 rules out the simplistic notion of consumers importing to beat the collapse of the Plan and the depreciation of a nominally fixed exchange rate. However, trends in the profile of the external account are a cause of concern and need to be examined in detail. Export growth has been generally low and import growth much higher. External Balance: Current account deficit grows as capital inflows increase (i) Current and capital account 19. The current account in Brazil was roughly in balance in 1991 (a deficit of 0.3% of GDP), showed a surplus of 1.6% of GDP in 1992 and was again, virtually, in balance in 1993 and Since then the deficit has widened, reaching 2.5% of GDP in 1995, 3.2% in 1996 and 4.2% in It is projected to go down to 3.7% of GDP in 1998 (World Bank projections). 20. As a developing country, it is natural for Brazil to have a deficit in its current account to allow for absorption of foreign savings. The profile of the balance of payments in the lateeighties and early nineties when the country was suffering from the consequences of the debt crisis cannot be considered normal in the long run. And a current account deficit that is increasingly financed by foreign direct investment should not be a cause for alarm. Many economies have experienced deficits of this magnitude in recent years. Major speculative attacks such as the Mexico crisis of 1995 and the more recent attacks on the Thai baht and the Czech crown have occurred with deficits in the 7 to 10% range. However, a detailed look at the external accounts suggests that a shift in policies is warranted even if there is no imminent danger of a crisis. 21. In 1997, the current account deficit in absolute terms was US$33.4 billion, about 37% more than the level in The trade account was in surplus until Since then it has become negative and for twelve consecutive months prior to December 1997, the trade account has been in deficit. The services portion of the current account has also been worsening since Among the major economies of Latin America, only Colombia and Peru currently have larger current account deficits as a percentage of GDP and in terms of the ratio of interest payments to exports, Brazil is second only to Peru in the continent.

20 - 8 - Table 2.1: Balance of Payments, (US$ Thousands) A c t u a*l. C~.... +,.. a Sv i i t CV; X T.... ': Indicator Balance of Payments Exports (GNFS)a 32,947 36,919 39,874 44,948 47,960 49,558 54,968 Merchandise 31,620 35,793 38,563 43,545 46,508 47,746 52,986 Imports (GNFS)a 23,229 22,494 28,299 36,133 54,306 59,355 65,990 Merchandise FOB 21,031 20,562 25,256 33,133 49,858 53,286 61,358 Trade balance 10,589 15,230 13,307 10,412-3,428-5,540-8,372 Resource balance 9,718 14,424 11,575 8,815-6,346-9,797-11,022 Net current transfersb 1,556 2,243 1,686 2,588 3,973 2,899 2,220 (including official current transfers) Current account balance -1,266 6, ,689-17,784-24,300-33,439 (after official capital grants) Net private foreign direct investment 972 2,061 1,292 3,072 4,859 9,195 16,330 Long-term loans (net) 74 4,297 8, ,750 14,294 n.a. Official -1, ,014-2,076-1,380-2,251 n.a. Private 1,132 5,215 9,586 2,071 6,130 16,544 n.a. Other capital (net) , ,409 21,162 9,446 9,172 Change in reservesc ,348-8,443-6,787-12,987-8, Memorandum items Current account balance (% of GDP) -0.3% 1.6% -0.1% -0.3% -2.5% -3.2% -4.2% Reserves/months of imports of GNFS Source: Data provided by the Central Bank numbers are estimated. a. "GNFS" denotes "goods and nonfactor services." b. Includes net unrequited transfers excluding official capital grants. c. Includes use of IMF resources. 22. The worsening of the current account in 1995 was essentially driven by the trade account. The trade account worsening immediately after the Real Plan can be attributed to a sharp rise in imports. This was, in part, a consequence of a post-stabilization boom in consumption. The annualized rate of GDP growth rose to 10% in early The nominal exchange rate also appreciated by over 15% against the dollar due to a Central Bank commitment to not let the Real-dollar rate depreciate beyond its level on July 1, Finally, trade liberalization took hold and was encouraged as a device to keep the price of tradeable goods from rising. (ii) Policy Response, 1995 and Policies were changed in early 1995 following the Mexico crisis. The exchange rate was allowed to depreciate within a broad band and this led to a 10% devaluation against the US dollar in February-March Subsequently, the exchange rate has not been allowed to appreciate

21 - 9 - against the dollar in real terms, with an accumulation of US$8.6 billion in reserves in According to our calculations, the exchange rate against the dollar appreciated by 7.5% between and and a further 1.6% the following year. The real effective exchange rate appreciated by 20% over the same period, driven by the appreciation of the dollar against other major currencies (Table 2.2)3. The overall growth rate of the economy was slowed down through a policy of credit restraint, which translated into very high interest rates. The real interest rate (overnight/inter-bank) averaged 26% in In the second half of 1995, the growth rate turned negative. Output (deseasonalized) fell by 3% in the second quarter of 1995 and by 1% in the third quarter. Fresh trade restrictions were imposed, the most notable being on cars, which now carry a tariff rate of 35% plus a quota. Table 2.2: Real Exchange Rate Variations (1/86 = 100) Year Exchange Rate Versus the US$ Real Effective Exchange Rate' n.a. Against 15 major trading partners. Source: World Bank data files. Monthly average official exchange rate, IFS WPI deflator and IPA/PI index for Brazil used. 24. The policy response of keeping the exchange rate fixed in real terms against the dollar, slowing down the economy through credit restrictions and the imposition of some trade measures did not provide a permanent solution as the experience of 1995 and 1996 would demonstrate. Policies had to be altered as the growth rate turned negative while the high interest rates led to an increase in banking spreads and increasing defaults, especially on consumer loans. However, as growth rates picked up in 1996 with lower interest rates, the trade account worsened and the current account deficit has been steadily rising, casting doubt on how much growth is allowable by the current policy framework in which fiscal adjustment has not yet played a major role. In the first four months of 1997, the trade deficit was US$4 billion, in contrast to a trade deficit of US$0.3 billion in an equivalent period a year previously. In March 1997, the Government announced restrictions on foreign financing of less than a year's duration to cut down on imports and stopped letting the interest rate decline. A number of export promotion measures have also been announced. The impact, till now, has not been significant. Moreover, the high domestic interest rates have attracted capital inflows. These have had to be sterilized in order to support the policy of tight money, adding to the upward pressure on interest rates and worsening the fiscal deficit. 3 Note that this cannot be taken as evidence that the Real is currently overvalued, since in Brazil had a large surplus in its trade account and its current account was almost balanced. It can also be seen from Table 2.1 that 1991 was a year of large reserve accumulation and in 1992 the current account showed a surplus.

22 -10- (iii) Developments in In 1997, a further complication arose following contagion effects from the Thai crisis and, later, the speculative attack on the Hong Kong Monetary Authority. The Real came under full-fledged attack in late October. In response, the Authorities showed determination in not changing track on their exchange rate policy and in mounting a classic high interest rate defense, losing reserves in the process. Their strategy can be favorably contrasted to that of many other Central banks which vacillated on the exchange rate or did not raise interest rates quick enough or sufficiently. Possible policy combinations beyond the immediate short run could have involved the following: * Tight money or a contraction of domestic credit. This was necessary during the crisis to mop up liquidity and foil the speculative attack. However, by itself, such a policy would have had a recessionary effect and would have been viewed as temporary, with limited effectiveness in restoring confidence to the asset market. It would exacerbate the problem of the fiscal deficit through a higher interest burden and impact negatively on the financial institutions. * A maxi-devaluation. Such a policy could restore equilibrium if the source of the current account imbalance lay in setting the nominal exchange rate at an artificially appreciated level. However, in Brazil, the growing current account deficit was correlated with a growing fiscal deficit. In such a situation, a devaluation by itself would have delivered a price shock and cut away the main pillar of the Real Plan. * Fiscal Adjustment and maxi-devaluation. The combination of a fiscal adjustment and a maxi-devaluation can, in principle, redress the balance of payments deficit and eliminate the overvaluation, and at the same time, enable the reduction of the real interest rates to normal levels through an expansion of domestic credit. However, a problem with this solution is that, in practice, the seriousness of the fiscal adjustment cannot be evaluated instantly and the move may be perceived as solely a maxi-devaluation and a price shock. Overall, in a context where disinflation has been the paramount policy goal, a recurrence of surprise inflation by changing the exchange rate anchor could have very serious consequences. * Fiscal adjustment without a maxi-devaluation but with a continuing rate of crawl. This is left as the most desirable policy alternative. This policy would have to be supported by tight money in the near future. It is not an easy option, because it carries a recessionary cost. Moreover, its success depends on the seriousness and transparency of the fiscal adjustment and on the ability to convince the public of its persistence. Progress on the structural reforms will play a crucial role because of the latter consideration. 26. The last option is the policy course that has been chosen by the Authorities. In addition to raising interest rates, a fiscal package was announced on November 10, 1997, involving 51 measures. The size of the package is R$20 billion, or about $18 billion. It is expected to raise the primary surplus in 1998 to about 1.5% of GDP from the close to zero level expected in 1997 and reduce the PSBR by over 1 percentage point of GDP to below 4%. Structural reforms have been speeded up. As of February 1998, both the Administrative Reform Bill permitting civil

23 -11 - service layoffs is in the Senate and the Social Security Bill have cleared committee and have been approved in the first round of voting in both houses of Congress. Privatization has also proceeded rapidly, an estimated US$19.7 billion of assets being privatized in 1997 alone. 27. However, in our view, the above strategy still leaves room for movement on exchange rate policy in the future. Even though the exchange regime in Brazil was changed from a fixed, nominal peg in March 1995, the wider horizontal band within which it is supposed to move is not operational. Rather the exchange rate has been following a tight, predetermined crawl. Fixing the exchange rate in the initial stage is common to most stabilizations from high inflation. However, the stress related to maintaining such a regime increases over time. In addition, the global liberalization of capital flows has increased the vulnerability of such regimes to speculative attacks, as is increasingly evident from the experience of the nineties in Europe, and, more recently, Asia. After a period, it is advisable to switch to a less rigid regime. A wide, crawling band can be a solution. Inside the band, the exchange rate can vary, subject to varying degrees of intervention. The rate of crawl of the band retains the signal with respect to the inflation target, while the width of the band allows flexibility, and, hence, reduces vulnerability. The experience of Chile, Israel, Poland, etc., show that disinflation can proceed successfully with increasing flexibility of the exchange rate band. 28. However, the Brazilian Authorities were correct in not changing the exchange rate regime when the Real was under pressure in The condition for a soft landing in this context is that a change of regime should take place from a position of strength. (iv) Price and output elasticities of imports and exports 29. A log-linear regression exercise on total merchandise imports, using quarterly data from 1990:2 to 1996:4, with the real exchange rate and output lagged one quarter as the independent variables, suggests that Brazilian imports are more sensitive to domestic activity than the exchange rate. There is no significant change in the relationship between the pre-and post-real periods, although the goodness-of-fit of the equation improves significantly. This structure indicates that a "stop-go" policy of output contraction is almost mandatory in the current environment. The alternatives are more import restrictions, which reduce the efficiency of the economy or a devaluation large enough to influence imports in spite of the low elasticity. The latter, however, is likely to trigger inflation and have repercussions on the capital account and on the domestic financial institutions with assets in Real and growing liabilities in foreign exchange. The way out is through a fiscal adjustment which reduces domestic demand and imports and the promotion of exports through cost reducing measures. 30. The behavior of exports and imports in detail gives further clues as to the forces driving the trade deficit. As Table 2.3 shows, exports grew by 2.7% in There was a large variation by category. Exports of raw materials grew by 11.1%, while industrial exports (including exports of semi-manufactured products) grew only 0.1%. In the case of manufactured products, there was an increase in quantum in specific categories such as shoes, orange juice, cars and agricultural machinery but overall exports grew by a modest 3.3%. 31. Turning to imports, we observe growth of 6.9% in There was a strong increase in the imports of raw materials, intermediate products, petroleum imports and capital goods. This suggests the contrary of a consumer boom driving imports. However, too much cannot be read

24 - 12- into this data. In the second half of 1996 and the first quarter of 1997 there has been a strong recovery in the import of durable consumer goods, including automobiles. 32. In 1995, the worsening of the trade balance explained close to 90% of the worsening of the current account. In 1996, the picture is somewhat different, with the trade account worsening accounting for only a third of the deterioration. Interest payments were 21% higher, relative to However, 1996 is probably an atypical year. In the first quarter of 1997, the influence of the trade account is again predominant. In the longer run however, as Brazil runs current account deficits, the importance of the non-trade portion of the current account in determining the overall balance will grow. Table 2.3: Change in the Trade Balance, (% ages) Exports Total 2.7 Raw Materials 11.1 Industrial Products 0.1 of which, semi-manufactured -8.7 manufactured 3.3 Imports Total 6.9 Raw Materials and Intermediate products 10.0 Oil and derivatives 19.3 Capital goods 12.1 Consumer goods of which, Non-durable 6.7 Durable (includes cars) Source: 1. SECEX 2. Central Bank But financing of current account deficits is improving 33. The financing of the current account in 1996 led to a flow of US$9.2 billion of foreign direct investment, almost 90% higher than in Net long-term loans amounted to US$14.3 billion and other capital flows (net) were US$9.5 billion (Table 2.1). Further, reserves grew by US$8.6 billion. It can be noted that loans to the private sector were more than US$10 billion higher in 1996 relative to In contrast other capital (net) flows declined by over US$11.7 billion. The shift in the financing of the current account deficit to direct investment is a generally recognized sign of strength in the balance of payments. The increase in private indebtedness should, however, be monitored. The cost of this source of financing is still high and maturities comparatively short, although improving progressively over time. In the fourth quarter of 1996, the private financial sector was facing an average spread of 400 basis points above U.S. Treasuries and an average term of 6-7 years. 34. The current account following stabilization has displayed normal behavior. The pattern of a deteriorating current account after stabilization, followed by subsequent improvement is normal. In the case of Chile, for example, the average current account deficit between 1982 and 1984 was 8.4% of GDP. Till 1987, this deficit continued to exceed 4% of GDP. By the period, however, the deficit had come down to an annual average of 1.4% of GDP. In Argentina the deficit rose through 1994 to 3.5% of GDP and declined in to

25 % of GDP. The tolerance for high current account deficits and financing available for them, however, may be coming down after the East Asian crisis of Internal Balance: Fiscal adjustment is needed 35. In examining the fiscal accounts of the consolidated government over the period, we find a clear break in In 1991,1993 and 1994 the nonfinancial public sector as a whole ran operational surpluses. The primary balance increased from 2.6% of GDP to 4.3% (Table 2.4). However, there was a growth of contingent claims on the consolidated Government, not accounted in the fiscal budget. These range from debt that is not being serviced and claims against Federally guaranteed funds (FCVS and FGTS), losses of Government banks (Banco do Brasil, BANESPA, BANERJ) to arrears of the Government and public enterprises to closed pension funds and the social security institutions. Currently contingent claims are in the neighborhood of US$100 billion. Since the Real Plan, debt to the extent of 1.6% of GDP has been securitized, giving explicit recognition to some of these claims. 36. Finally, the Govemrnment was able to raise an inflation tax that amounted, on the average, to 2.5% of GDP during the period. Even though the money base of the economy was very small and shrinking, rising rates of inflation compensated for this fall and kept the inflation tax at a sizable level. Moreover, the state govemments had access to the inflationary gains of the financial institutions through the ownership of state owned banks. Table 2.4: Summary Results of the Nonfinancial Public Sector, (Percent of GDP) -Actual Nominal public sector borrowing requirements Federal Government and BCB State and local governments State enterprises Primary deficit Federal Government and BCB State and local governments State enterprises Real net interest payments Federal Government and BCB State and local governments State enterprises Operational deficit Federal Government and BCB State and local governments State enterprises Memwrandsum Inflation Tax NA. Source: 1. Central Bank 2. Boletim Conjuntural, IPEA

26 The above picture suggests that public finances were far from being in equilibrium in the period preceding the Real Plan, in spite of the apparent budgetary balance in the early and mid- 1990s. 38. At the initiation of the Real Plan in 1994, certain steps were taken to bring about a fiscal adjustment. At this stage, two concerns were predominant. One was increasing the flexibility of action of the federal government in managing its finances in the face of a budget that is heavily dependent on earmarked revenues. This was achieved by the implementation of the Social Emergency Fund (subsequently renamed the Fiscal Stabilization Fund and extended to mid- 1998). This fund delinked 20% of taxes in the federal budget from automatic transfers to the social security system and other levels of Government for earmarked expenditure. The other was instituting a mechanism such that wages in the economy in general and public sector wages did not rise unduly during the transition from inflation at monthly double digit levels to a more normal profile. 4 Table 2.5: Economic Classification of Expenditures by Level of Government (Percent of GDP) 4W Federal Gross Wages Pension Benefits Transfers to other levels Other Current Expenditures Capital Expenditures Float and Discrepancy Real Interest Payments States and Municipalities Gross Wages Other Current Expenditures Capital Expenditures Float and Discrepancy Real Interest Payments Enterprises 1. Federal Gross Wages N.A. 2. Others N.A.. N.A.. N.A. N.A.. Source: IMF and Ministry of Finance. 39. Structural changes in the system of taxation or management of expenditures, including federal finance issues did not form a part of the Real Plan, even though a need was recognized in this area. These reforms were designed to come later. 40. In the event, the fiscal adjustment was incomplete, even in the areas where it was primarily focused. The public sector wage bill could not be controlled satisfactorily in 1995 (Table 2.3). For the consolidated government it rose by 0.7% of GDP. In 1996, no nominal wage increases were conceded to civil servants and the wage bill has declined marginally. The overall operational deficit was 4.8% of GDP in 1995, which fell to 3.8% in 1996, but rose again to 4.1% in The primary balance worsened to less than half a percentage point of GDP in 4 This was the URV or Unidade Real de Valor, a unit of account to which all prices had to be indexed prior to the introduction of the Real as a currency.

27 and became negative in In 1997 it worsened further (Table 2.4). At the same time, contingent liabilities of the federal government not included in the fiscal deficit), have increased, partly due to the policy mix inherent in the stabilization plan. The latter has led to greater exposure of the Central Bank to the commercial banks. Over US$20 billion has been lent to the private banking sector under the PROER scheme. The Caixa Economica Federal, acting as the agent of the Treasury, had to extend lines of credit worth R$2.2 billion in 1995 and 1996 in order to refinance the debts of the states and finance redundancy programs. The Government also lost command over resources via the loss of the inflation tax since tight monetary policy and low inflation resulted in the elimination of this source through much of 1995 and 1996 (Table 2.4). 41. Another aspect of internal balance that is worth noticing is the Box.-i. :Public Sector W.age Shares fiscal adjustment required at the sub-national level. A large part of Igternational comparisons of publit wage expenditures are difficult the deterioration of the fiscal to"make be e of data limitations. However, Brazi'sratiosseem very high. In The.Composition of Fiscal Adjustment and Growth, accout h eim Ocasional Paper 149,1997, MacKenzie, Orsmond and Gerson worsening of the position of the find thatthe share-of wages and saide in Chile declined fom state governments. From a position 8.7% to 3.6% /ogdp beiween19-7if3 and In Mexico it of primary surplus before the Real fell from 4.1% to 2.1% of GDP between and Int Plan, they have moved to a the sample, of eigt countries in this study, the highest pre- - '.. ~~~~~~~~a'duustinent rat i6a im 0. 7.%/ of GMP.---;--; position of deficit (Annex Table 3). a r w l7 o- This led to a restructuring of the Incontrast, in Brazil this ratio 12% of GDP in 1995 and bad debts of the state governments with increased between 1994-and But alternativestimates using the federal government and banks QFS data and Brazili-anGDP estimatesuggest a som.ewhat.lowerin This restructuring ratio for Brazil. and ways out of the present situation are discussed below, together with the federal government's response to the problems of internal and external balance. 42. A new development was a fiscal package of 51 measures announced on November 10, 1997 in response to the speculative attack on the currency in late October. This package is impressive and adds up to about 2.25% of GDP. The expected increase in revenues is R$6.7 billion and covers the personal income tax, excise taxes and reductions in tax exemptions. Public enterprises are expected to save R$5.7 billion through increased tariffs, reduced operating costs and reduced investments. Federal expenditure reductions amount to R$5.3 billion, while the Government also expects to save R$2 billion in lending costs to sub-national units. 43. The implementation of this package may be affected to some extent by administrative resistance, while the slowing down of the economy in 1998 will have an impact on revenue gains. However, its passage through Congress in record time reveals the consensus is Brazil on preserving the disinflation gains from the Real Plan. It has to be kept in mind, though, that the measures in this package do not touch on the long run, structural problems that affect the fiscal balance. For that, the agenda of social security reform, administrative reform and comprehensive fiscal reform has to be carried out. Since October 1997, the progress on social security and administrative reforms has also been considerably speeded up. 44. Further setbacks in administrative reform, social security reform and tax reform could give negative signals. Currently the Brazilian constitution prohibits the dismissal of any civil

28 - 16- servant with more than two years of service except on the grounds of non-performance, which is extremely difficult to prove since a proper evaluation system does not exist. Constitutional amendment to change this provision requires a three-fifths majority in each House of Congress with two rounds of voting. A number of benefits enjoyed by civil servants which do not require legislative approval to remove were taken away in late A reform bill, which has gone through the entire legislative process except for the second round of voting in the Senate has imposed a salary ceiling of R$12,720 per month for all compensation (including non-salary benefits). It also makes it more difficult for legislators and the judiciary to award themselves raises. Most importantly, it establishes a procedure of performance evaluation for public employees, which makes dismissals feasible in the case of non performance or disciplinary causes and, further, allows layoffs of entire categories when personnel related expenses exceed 60% of revenues (the Lei Camata limit). Savings from this measure may amount to 1% of GDP but may not be available till the end of 1999 due to the cost of severance packages. 45. Social security reform is even more important. The total cost of pensions, public and private, is about 12% of GDP and the general system (INSS) is running a cash deficit amounting to about R$4.2 billion in The public system is especially generous. About 3 million retired civil servants get half of the total benefits while there are more than three times as many beneficiaries in the general (INSS) system. Moreover, about one third of the benefits go to early retirees below the age of 55 and these are almost all ex-public employees. Contribution rates are also lower for civil servants and their pensions are not capped as in the INSS system. There are, in addition, special categories of workers who can retire early. A female school teacher, for example, can retire after 25 years of work with her full pay as pension. 46. The current reform bill tightens eligibility. It introduces a minimum age for early retirement and fixes a ceiling of R$1,200 on public employee pensions. Some special categories lose their differentiated treatment. These reforms will have a significant effect after a time but the current impact is small because of grandfathering. The Government's intention is to move in the longer run to a defined contribution system from a defined benefit system. 47. The outline of a fiscal reform proposal has been discussed with the Congress by the Executive. This is much more comprehensive than any bill in Congress so far and would overhaul and integrate the entire tax system across levels of government. However, it is not expected that this proposal will be fashioned into a formal bill during the term of the current Administration. The improvement in the pace of movement of these fundamental, structural reform bills through Congress after the October 1997 crisis has been important in improving expectations about the sustainability of the Real Plan. Conversely, if they are delayed again - the probability of which is now remote - or the perception starts growing that even at this late stage they may again be modified, this could serve as a destabilizing trigger. But debt appears to be sustainable 48. It can be concluded, therefore, that the failure to obtain a better fiscal stance presents the greatest challenge to stabilization. It results in a reliance on tight monetary policy, the consequent high interest rates and capital inflows that have to be sterilized through higher supply of public debt. In the section below, we explore the implication of this growing debt burden on stability. There is concern that the rapidly rising debt is an indicator of an impending financing crisis since a growing debt without a reversal in the fiscal stance will eventually cause debt holders to lose confidence, precipitating monetization.

29 A consequence of the policy stance adopted since the inception of the Real Plan has been growing internal debt. From an intertemporal perspective, growing debt or even a growing debt to GDP ratio is not an indicator of disequilibrium per se. On the other hand, there has to be an expectation of a change in fiscal policy on the part of economic agents which should assure them that debt is not on an explosive path and that the government will not follow a policy of monetization of the debt and high inflation in the future. Can we be sure that this is how economic agents are behaving at present? A related question that we investigate is the relation of the stock of debt and growth of domestic debt to crises episodes, where a crisis is identified as a situation involving a sharp depreciation of currency and a large decline in international reserves. The available evidence reassures us that Brazil is not on a disequilibrium path. 50. At a first glance, the current situation in Brazil seems far from critical in terms of public debt. At the end of 1997 the level of net debt stood at 34.3% of GDP, relatively low by international standards. Moreover, the level of public debt had been higher in the past, reaching a peak of 53% in 1984 and showing fluctuations since then (Table 2.6). However, the overall level of debt has been growing since 1994, when it was at a low of about 25% of GDP. There has been a 14 percentage point of GDP increase in the level of domestic debt between 1994 and 1996, accompanied by a decline in the level of external debt. Thus, there has been a substitution of lower cost external debt by more expensive domestic debt. Finally, it may be remembered that debt reductions from previous peaks were often due to monetization, confiscation and subindexation and not necessarily to improvements in the fiscal stance. Thus the upper limit for the past debt to GDP ratio may not indicate a sustainable debt level. Table 2.6: Net Debt of the Public Sector (percentage of GDP) 1 -Year Internal Exteral Total Source: 1. Evolucao da Divida Liquida do Setor Publico, , Fabio Giambagi, BNDES, Boletim, Central Bank. 51. In analyzing the behavior of debt in Brazil, we try to answer several questions. The first is, is the growing level of debt and the level currently reached an indicator of crisis? The second

30 - 18- is what does the current behavior of the debt and debt holders tell us about the likelihood of a policy shift in the future. Finally, what are the potential macroeconomic costs associated with the current policy. (i) Historic Evolution 52. Obtaining historically consistent debt series is not easy. For Brazil, perhaps the best measure of domestic debt available over a long time span is federal debt in bonds and bills outside the central bank. A monthly time series for this debt concept is presented in Figure 2.5 The figure shows that there have been substantial fluctuations in the level of Brazilian federal domestic debt over the past decade and a half. Furthermore, the level of securities debt at the end of 1996 was unprecedented. A synthetic net debt series over the period constructed by Giambiagi (1996) for the consolidated government also shows considerable fluctuations (Table 2.8) IL Figure 2: Effective Federal Securities Debt (D. (J (V) U) (D 1-. co 0) 0 C C') U) co co co co co co co co co co CD0)0 0) 0) ) CD T'he evolution of domestic debt and the factors driving it may be summarized as follows: The period from 1983 through 1990 was one of turmoil. Brazil lost much of its access to long term external capital. The governmnent ran sizable operational deficits largely due to the substantial real interest burden on its accumulated and growing debt. Fiscal policy was never tightened sufficiently and repeated attempts at stabilization failed. Growing domestic debt levels were followed by bouts of monetization. The periods during which federal domestic debt fell relative to GDP generally corresponded to periods of unusually high seignorage revenue at the beginning of the stabilization plans when the monetary base grew at an accelerated rate. This series is different from the consolidated series in Table 2.7 but is more comparable over time.

31 - 19- * From 1991 until the inception of the Real Plan there was a return to a relatively low seignorage regime and there were no stabilization plans of the old type. There was a decline in extemal indebtedness. There was a build up of domestic debt, but the public sector ran substantial primary surpluses which enabled it to achieve approximate operational balance. Sterilization operations were responsible for much of the domestic debt accumulation. * Under the Real Plan, after the early stages, seignorage has become unimportant. External public indebtedness has continued to decline. However, there has been a return to operational deficits. Moreover, there has been a recognition of certain past liabilities and debts, involving securitization. The exchange rate and interest rate regimes followed have also led to an inflow of capital and sterilization to prevent expansion of the money base with possible inflationary effects. Consequently the level of domestic debt has grown quite dramatically. (b) Crisis Likelihood Low 53. What might be the consequence of a level of debt as high as Brazil's? Does it portend a crisis and are there signs of declining credibility on the part of holders of the debt? The answer is in the negative. 54. A crisis is defined here as a sharp depreciation of the currency and a significant loss of reserves. Five such crises can be identified for Brazil for the period 1980 to mid These include a 23% devaluation in February 1983, the abandonment of the Cruzado Plan in November 1986, a 11% devaluation in July 1989, a 35% devaluation in November 1990 and a 38% devaluation in October Each crisis occurred when the level of international reserves was low. The level of domestic debt was not associated with the crisis, although the first three of the crises were preceded by periods of domestic debt accumulation. 55. Furthermore, the evidence presented in the recent international literature on the relation between debt and crises show clearly that the level of debt is not a good predictor of the onset of a currency crisis (see Box 2). However, the evidence has to be interpreted cautiously. First, there is the standard problem of associating causation with correlation. In this context it may be worth reflecting on recent Brazilian experience. During the large devaluations of late 1990 and 1991, the level of domestic debt was declining. However, this is because confiscation and suspension of indexation during Collor Plan 1 in early 1990 had reduced domestic debt. This does not mean that the fundamentals that led to the crises were necessarily unrelated to the growth of debt. Instead, debt was reduced before the onset of crisis through deliberate policy action. We have to keep in mind that we are examining debt as a leading indicator and not a causal factor. Second, there are differences among countries. For instance, the indebtedness of the private sector will affect the amount of government debt a country is willing -to absorb. The volume of financial assets outstanding in a country relative to its GDP is also relevant. In many of the highly indebted countries of Western Europe, for instance, this ratio is higher than in Brazil. Third, crises are relatively rare, low probability events. It is fundamentally difficult to estimate with confidence the association between the level of different time series and the probability of such unlikely events. In the end, we must be guided by the theoretical prior that the level of debt plays a role, even if this cannot be identified statistically with any precision. From this viewpoint, the current debt level is not necessarily relevant for the onset of a crisis.

32 -20 - Investors are likely to consider the future path of government policy rather than past behavior, although a large accumulated debt stock would increase vulnerability. 56. From this perspective, the Real Plan can be evaluated both in a pessimistic as well as an optimistic way. In the pessimistic scenario, in spite of the success on the inflation front, the operational fiscal deficit is higher in the Real Plan and the primary surplus lower than in the years immediately preceding the Plan. There was a big increase in real wages and there have been no drastic structural refo%rs compared with some other countries in a similar situation. There has also been an increase in the current account deficit, probably driven by the decline in public savings. However, it is possible to provide an optimistic scenario which is not any less plausible than the pessimistic one. Further reduction in the fiscal deficit, in a sustainable manner, is contingent on the working of the agreement of debt rescheduling with the states and on the implementation of the reforms in the social security system and in the public administration. The chances for these developments are good, and they have improved recently as shown by the progress in legislation and Congressional activity since November The fact that one may present two opposing interpretations of the situation suggests the possibility of "multiple equilibria" as discussed in the literature. Currently Brazil is in the "good" equilibrium and, in spite of the shock suffered in late 1997, continues in this state. 57. The overall conclusion is that the level of intes al debt is continuing to rise in Brazil. However, this has not led to an impact on the contemporaneous level of inflation, suggesting that economic agents expect a fiscal adjustment in the future. Given the relevant parameters, such an

33 expectation is reasonable, even though the strategy of fiscal adjustment is not as well articulated as it could be. Nevertheless, risks remain 58. However, notwithstanding the above analysis, setbacks in fiscal adjustment can reverse the stabilization process. The triggers could be the following: (i) Delay orfailure of reform bills 59. First, any setbacks in administrative reform, social security reform and tax reform would give negative signals. Currently the Brazilian Constitution prohibits the dismissal of any civil servant with more than two years of service. Civil servants enjoy a pension with a 100% replacement rate. There are a number of special categories: female teachers, for example, can retire after 25 years of service with full pay as pension. Other examples of generosity of the public pension system are given in Chapter 4. Constitutional amendments to change these provisions require a three-fifths majority in each House of Congress with two rounds of voting. Even though the reforms have been on the government's agenda since its inception, it has not yet secured full passage through both Houses for either the administrative or social security reform. But a number of benefits enjoyed by civil servants which do not require legislative approval to remove were taken away in late 1996, and the pace of congressional passage has been perceptibly quickened. There is awareness, both within and outside the country, that these reforms are difficult but also that their fiscal impact is largely in the medium and long run. Thus day-to-day shifts in prospects of their passage do not have much of an effect on financial variables. However, this is different from a scenario - very unlikely at the time this report is being issued - where perception grows that these reforms will never be carried out. (ii) Recognizing previously unacknowledged liabilities. 60. Second, the extent to which previously generated liabilities, of which the public is not aware, are acknowledged by the government. Currently, less than 2% of GDP of the internal debt is due to the securitization of previously unrecognized debts. This figure could grow to 10-15% of GDP. Whether this phenomenon has been internalized by the market is unknown. If it has not been, there is a chance that credibility will be eroded as the process continues. Given that some liabilities are unknown, (for example, shortfalls in the pension funds of some public enterprises), there could be damaging consequences. (iii) Treatment of state debt. 61. Third, although a new and comprehensive state debt rescheduling process is ongoing with an enforcement mechanism that is superior to that embodied in previous reschedulings, an unraveling that leads states to pile up debt in the future could cause a breakdown of confidence. The full adjustment of the states to a creditworthy status, where their debt to revenue ratio falls to 1:1 will take 8 to 10 years. However, within this period, the enforcement of the debt agreement with the federal government is expected to restore fiscal discipline. This agreement covers privatization of state assets, restrictions on the issue of debt by the states and controls on wage increases permitted by them. The states can be penalized through withholding of their tax share in revenue sharing and through direct deductions from their own tax revenues deposited in banks

34 in the case of non-compliance. These enforcement measures are stronger than those adopted in similar debt reschedulings in the past. However, an agreement between entities at different levels of government is, in the final instance, a political agreement, and we have to assume that the commitment to fiscal stability is maintained over time. (iv) Financial sector restructuring 62. Fourth, developments in the financial sector. Financial sector restructuring has been encouraging so far. Weak and ill- supervised financial systems have proven to be the Achilles' heel in other countries which have opened up their capital account and where financial flows have increased in response to high returns (see box 3). Progress in Brazil since 1994 has been salutary. Continued progress in this area in Brazil will be essential for maintaining credibility. 63. The banking sector in Brazil received a severe jolt with the decline in inflation and change in the macroeconomic regime under the Real Plan. Inflationary profits from float fell off, with the smaller banks being the most affected. State owned banks, which could mask their inefficiency with these profits were also in trouble. At the same time, the mix of tight monetary and loose fiscal policy has resulted in high domestic interest rates. This has led to a worsening of the portfolio quality of banks and also to increased borrowing from abroad. Banks with unhedged exposure in foreign currency and those which have onlent to non- exporting sectors of the domestic economy are facing increased devaluation risk. 64. While many of these risks remain while the fiscal deficit remains high, holding up the interest rate, significant action has been taken by the Authorities to lower the vulnerability of the financial sector. Of the 271 banks at the time of introduction of the Real Plan, 76 have gone through some kind of adjustment. These include the following. A program of restructuring with Central Bank support (PROER) has led to the merger and takeover of several major private banks, while others have been liquidated. Foreign banks have been allowed to participate in the acquisitions. Over R$20 billion has been extended by the Central Bank under this program. The facility is no longer open as the Authorities believe that the bulk of restructuring needed in the private sector is over. In the case of state-owned banks, the Central Bank and federal and state governments have shared in taking over bad assets and non-deposit liabilities of several banks in order for them to become privatizable. The state bank of Rio de Janeiro, BANERJ, and Credireal in Minas Gerais fall in this category. The federal government has also refinanced the debts of state governments, including their debt to state owned banks, the most notable instance being BANESPA in Sao Paulo. Finally, a new program, PROES, has been launched, under which the federal government will provide up to 50% of the cost of restructuring the remaining state owned banks which still remain non-viable. For states unable to provide counterpart financing, the alternatives are extra-judicial liquidation by the Central Bank or transfonnation into a nondeposit taking institution. 65. In addition to instituting measures such as PROER and PROES, which allow transfer of shareholder control of financial institutions to take place more easily, the Govermment has issued a new set of banking laws and supervision rules which are in accordance with those recommended by the Basle Committee on Banking Supervision. The minimum capital requirement of lending institutions, for instance, is 10% of risk-weighted assets. A World Bank technical assistance loan, negotiated in 1997, is expected to help in improving the quality of bank

35 supervision. There is deposit insurance for deposits up to R$20,000 since 1995, and a Credit Risk Center was set up in Box- 3 - Brazil and Southeast Asia: MoreDifferences than Similarities The current account deficitin.brazil had:been worsening since the lreal Plan was introduced,:particularly in ihe period , and stood at around 4.4% of.gdp on a cumulative, 12 month basis through August T.he fiscal deficit also was high, although declining every year, with the PSBR at 5% of GDP. Furthermore, there had been an appreciation of the Real: against a trade weighted.basket, principally due to ihe appreciation of the dollar against other major world currencies. In the third quarter of 1997, since the Asian economies which recently experience-dspeculative pressures on their exchange rate:had growing-current account deficits and appreciating real effectivo exchange rates, there were fears that a speculative attack against-the Real may occur and result in an unplanned devaluation along the lines of what happened in Thailand, Indonesia, Malaysia and the Philippines. While Brazil experienced an attack on the Real much as East Asian currencies were attacked- by speculators, the results have been quite different. The main differences are -the pre-attack conditions (especially in the financial sector), the timing and strength of countermeasures, and political stability (especially in relation to Indonesia and Korea). This box briefly contirasts the current account and financial sector conditions in Brazil with thosein. East Asian countries, particularly Thailand. Current account deficit andforeign reserves. In -Thailand, the current account deficit had been over 5% of GDP since 1990 and over 7% of GDP since The level of reserves had-been constant since February Otherwarning signals were an appreciation of 17% ofthe currencybetween 1995 andjune 1997 and a-sharp. deterioration in export performance. Exports were flat in dollar -terms through 1996 and: Direct investment had been financing only about -10% of the current account; In the case of Brazil, the change in the indicators since the. beginning of the Real Plan is much less stark. The current account balance went over 3% of GDP only in 1996 and is still below 5% of GDP on a cumulative -12 month basis through December Over- 50% of the deficit' is financed by direct capital inflows and this proportion is increasing. The level of reserves rose to cover more than 10 months of imports, compared to less than 4 months for Thailand in recent years. -The nomninal exchange rate against the US dollar has been allowed to depreciate since 1995 and, more recently, the real exchange rate against the dollar has also been falling. While export performnance could have been better, exports rose from:r$47.7 billion in l996 to R$53.0 billion in TMe only indicator-where the Asian economies-have had a consistently better performance since 1995 is the fiscal deficit. Real GDP growth has also been higher in the case of Thailand, Indonesia -and Malaysia, although not necessarily due to higher efficiency of investment. In the nineties, Brazil has witnessed a strong rise--in labor productivity in manufacturing at an annual rate of -about 7%. Together with privatization and concessioning in the: infrastructuresectors of eriergy, telecommunications and ports, this points to continued productivity gains for some years to come, promising better export performance. Many Brazilian exports are natural resource based, even if they are classified as manufactures or semi-manufactured items, and have no readily available substitutes from-other sources. The situation is different in some East Asian countries,.particularly Thailand, where there is the fear that export shares in labor intensive manufacturing will be - lost to fierce competition from other countries in the- region' with lower labor costs while significant productivity gains are not-expected in the medium run. Financial sector. The triggering factor in the case-of the Thai crisis was the weakness of the financial sector, partly resulting from a credit boom in financing real estate. Total liquidity support from the Bank of Thailand to the financial sector amounted to 10% of GDP by August. In the case of Brazil, a significant restructuring of the financial sector had already occurred after the Real Plan. The liquidity support needed was much less. The private banking sector has gone through a process of mergers and liquidations, including several significant purchases of domestic banks by international ones. Two. major public banks have been privatized and a third, the much larger BANESPA,- is likely to follow. suit. While there- has been an expansion in consumer credit following the Real Plan, outstanding credit-to GDP in Brazil is only 60% compared to 143% in Thailand. (v) Public sector wage behavior. 66. Fifth, developments on the public sector wage front. A change in trend in the wage bill adjustment was observed in 1996 and early Between March 1996 and February 1997 the

36 -24 - federal payroll fell by 2.6% relative to a year earlier. It will be argued in this Report that this is a key variable of adjustment. While the sources for the drop in 1996 have not been identified, this may be traced to measures of control and cuts in certain benefits carried out in In future, this role may be taken over by the shedding of personnel and selective wage reductions. This has been the major adjustment in the primary accounts of the government between 1996 and 1997 and may have done more to bolster credibility in the ability of the current administration to control expenditures without recourse to Constitutional changes or legislative approval than any measure in Congress. (vi) Pace ofprivatization 67. Finally the pace of privatization would have an impact. There is considerable scope for debt reduction in Brazil via this mechanism. It is currently estimated that the stock of privatizable assets is $74 billion, while the stock of gross public debt is $321 billion. In Argentina and Chile, privatization accounted for over 10% of reduction in debt. However, since privatization is a swap between two types of capital, its benefits will partly accrue through the removal of public enterprises as an ongoing budgetary concern of the government. In this regard, the scope for improvement in Brazil is small. In recent years, public sector enterprises have represented a declining share of the operational deficit of the public sector. In 1995 they represented one-sixth of the deficit, while in 1996, they represented less than one-tenth of it. 68. The biggest factors driving credibility may be a perception that the shrinking of the public sector will permit efficiency gains and attract new, foreign investment to the privatized enterprises, which will drive the economy onto a higher growth path. Currently, high interest rates that follow from a lack of fiscal adjustment have a crowding out effect. To some extent this effect has been mitigated by access to foreign capital. However, this affects external balance or the current account surplus and influences vulnerability. Net private external debt currently represents 10% of GDP, up from 7% in This is not out of line with Brazil's own history, but this history has not always been happy. Thus, a substitution of foreign debt by foreign direct investment would bolster credibility. Another worrisome feature is the extent to which the current account deficit does not seem to be leading to a corresponding increase in investment although a turn around appears to be taking place in The concerns outlined here can be termed the ongoing macroeconomic costs associated with the current policy. In terms of measurable, financial costs, the impact of the policy of keeping a wide spread between external and domestic interest rates can be seen in the profits of the Central Bank, which went from approximate balance to a deficit of more than US$4 billion in 1994 and US$2.9 billion in Fiscal Adjustment Possibilities 69. Table 2.4 refers to Government Finances from 1991 (pre-real Plan) onwards. It can be seen that the position of the state and the federal governnents worsened sharply in the first full year after the Plan. In 1996 there was a further worsening in the primary account, this time concentrated at the level of the states. In economic terms, the share of wages and the interest bill in total expenditures has been rising. 70. Why has fiscal adjustment been so difficult to achieve? The answer lies on both the tax and expenditure side, but more on the side of expenditure. There are significant distortions in Brazil's tax structure and failures in tax administration which need to be addressed on efficiency

37 grounds. The present system is marked by an accretion of distortionary taxes that have grown without any logic, purely to deal with revenue retention concerns of the federal government within the constraints of a system that is forced by the Constitution to earmark the bulk of its proceeds to sub-national levels of government and the social security system. In spite of this, however, the tax to GDP ratio is one of the highest in Latin America. The Real Plan also resulted in a significant jump in the tax to GDP ratio as a consequence of the reversal of the Tanzi effect associated with the erosion of tax revenues by inflation. Consequently, fiscal adjustment via an increase in the tax burden is not a very promising possibility at present. Attempts at raising nominal rates in the present system in which the VAT is prominent and which has one of the highest nominal rates of VAT taxes in the world are not likely to yield fruitful results. Payroll taxes are also prominent and distort factor use. More fundamental changes such as integrating the Federal, state and municipal VAT's and rationalizing them run into fiscal federalism issues and are likely to be time consuming to implement. Discussion of these measures takes us beyond the scope of this report. This is not to say that tax structure reform should not be undertaken or tax administration improved. It is, however, probably correct to say that the most promising fiscal reform possibilities in the short run lie on the expenditure side of the budget. 71. If we look at the fiscal position of governments across levels and by Box 4: Fiscal Adjustment in Latin America economic categories of expenditures, we n Brazil's experience with fiscal:adjustment is different from that of other post-stabilizion economies with a history and the role of expenditure on personnel. ofhigh inflation, even though fiscal adjustment has been 72. The position of State typically difficult to obtain. n cases such as Mexico,. Argentinand Chile,:stabilization wa.sfollowed by an Governments deteriorated significantly improvement in the- fiscal stance and, often, a budgetarybetween 1993 and subsequent years. One surplus. In Chile the went,pwr an average.of 3.7% of of the responsible of e the f factors res s is is tgdp thle hilghl -Mexico to1.hi the:p of GDPbetween19824and (operational) improved fom % of In GDP proportion of wages and salaries in states i 1987 to 0.71%-in 1988.and was at the-leve! of 1.5% of GDP in their expenditures and their inability to in contain wage levels. Even though comprehensive data is not available prior In some cases, the improvement-could not be sustained over time- but Brazil seems unique in having a successful stabilization with a deteriorating fiscal position. that this ratio was manageable (Table Currently Brazil has the largest fiscal deficit among the major 2.5). This was partly due to wage countries of Latin America. Part of the paradox can be traced repression. The period of the early to data problems. In Brazil, as discussed in the text, some nineties saw a significant deterioration in elements of a deteriorating fiscal position prior to stabilization civil service wages and a low levelrof were not coveredby- the fiscal deficit as presented in consolidated Government data. The electoral cycle in Brazil minimum wages. Moreover, state -also coincided with stabilization. Inthe-recent case of Mexico governments were able to control real during the 1995 crisis, it was oft6enmentioned that a saving wage levels in a period when inflation grace - as contrasted with earlier cases of crisis in Latin was at monthly double digit levels by the America. - was that the tiscal situation was under control. simple device of denying full nominal DBrazil still has the bulk of fiscal adjustment lying ahead. adjustments. 6 6 Table 2.7 presents a much worse picture of state finances than Table 2.5 based on aggregate data. What is most relevant is the worsening trend through time in both sets of data.

38 L Table 2.7: Personnel Costs as a Share of Current Net Revenues (Percentages) ==~~~~~~~~~~~~~~~~~_, n.a. n.a. n.a. n.a Source: 1. Execu o Orgamentario dos Estados e Municipios das Capitais, Data provided by the state authorities. 73. In 1994 and early 1995, the minimum wage rose sharply and most states also granted generous increases to their civil servants. As a consequence, several states currently have wage bills in excess of 100% of their revenues, net of transfers, and the median is over 70%. In 1996, even though no general increase was give to civil servants at the state level, there was significant wage creep, as reflected in the data. The states also started to institute redundancy programs, both in state administrations and in enterprises, requiring expenditures under this rubric. These payments, however, have been quite small. 74. The wage payments in Table 2.7 also include payments to retirees. Again, while comprehensive data are not available, we know in selected cases that these payments have increased disproportionately because of early retirement. In some instances, as much as 40% of the payroll of a state is payment to retirees. Civil servants in the judicial and legislative branches of the government, who largely determine their own salaries, also account for a disproportionate share of salary costs. 75. While the decision to give large nominal increases in civil service wages in 1995 is immediately responsible for the current impasse, the problem is a structural one and stems from overstaffing in many of the states. The ratio of civil servants to population varies considerably among the states. It is particularly high in some of the north-eastern states. Considering only civil servants employed in the executive branch of the Direct Administration, for which country wide data are available, the three states of Alagoas, Rio Grande do Norte and Sergipe, contain 4.4% of the population but employ 6.6% of the civil servants, a number 50% higher than the average. However, it is not easy to generalize. Sao Paulo's per capita public employment is not appreciably lower than that of the north-east as a whole, while Ceara, also in the north-east, has a much better ratio than many southern or south-eastern states. Comparability is affected by the fact that the largest fraction of state employees are teachers and the extent to which states share the responsibility for primary teaching with the municipalities differ and affect state payrolls significantly. The growing proportion of retirees is due to several factors. Of late, expansions in the civil service have been modest, while extremely generous early retirement rules prompt many to retire early to pursue second careers. It can be noted that since the replacement rate is 100% and the contribution rates are zero, with rising life expectancy, there is no immediate fiscal relief from normal attrition. 76. Finally, state finances have been adversely affected by the growth of debt service payments. This is especially true of the four largest states -- Sao Paulo, Rio de Janeiro, Rio Grande do Sul and Minas Gerais -- which have bonds outstanding in the domestic market. These bonds carry market rates of interest equal to that on federal bonds plus a premium. With

39 the rise in interest rates following the Real Plan, these states were unable to service their debt and had to have a swap arrangement with the Central Bank in order to avoid default. At end-1993, the Central Bank held virtually no state bonds. However, in 1994 the stock of bonds outstanding rose by 21% in real terms and by end-year, 72% were in the Central Bank custody account. In 1995, the debt stock grew by 38% in real terms and by a further 20% in In February 1997, there were R$51 billion of state bonds outstanding, of which only 26% were in the market. The four larger states account for 80% of this debt. Subsequently this debt has been rescheduled by the federal government in 1997 on a provisional basis. 77. While the debt situation of the other states is better, the majority of them have also had to reschedule their debts, beyond previous debts that already had been rescheduled in 1992 and These debts were usually wage arrears to employees or floating debt of less than one years duration undertaken with private banks during the upswing of the electoral cycle in The refinancing was undertaken by the Caixa Economica Federal, the federal savings and housing bank. 78. The above analysis suggests that a structural reduction in state financed payroll and pensions is essential for long run equilibrium in public finances. 79. At the federal level wages and pensions as a proportion of revenues is contained at slightly below 60%. The payment to retirees is, however, 42% of this total. At this level of government it is interest expenses that have been driving expenditure. Real interest expenditure as a proportion of GDP increased from 1.4% in 1993 to 2.2% in 1995, coming down to 2.1% in Real interest rates in 1995 were on average about 26%, declining to only 17% in This is a consequence of the policy mix. The inability to bring about a fiscal adjustment and growing debt results in high interest rates which, in turn, leads to a higher operational deficit. 80. The social security system has begun running cash deficits (difference between contributions and payment of benefits) since June 1995, with the exception of only four months. The deficit (nominal) was R$4.2 billion in Demographic changes have been important in making the system unbalanced. However, the growth of the informal sector (in a large part due to high payroll taxes) and increased evasion are also very relevant. 81. The imbalances will continue to grow unless steps are taken to economize benefits, reduce incentives towards informalization and ensure compliance: the annual deficit is projected by the Ministry of Social Security to grow to more than R$5 billion in 1998 if no reforms are undertaken immediately. The main system design issues are a high replacement ratio, endloaded replacement formula, weak benefit contribution links and absence of a minimum age at which retirees begin receiving benefits.' 82. Public enterprise accounts, contrary to the picture presented above for the federal, state and municipal governments, have improved significantly since the Real Plan. This is largely due to the recovery of public sector tariffs from inflationary erosion after Parts of the public sector have also undergone downsizing and restructuring with a view to subsequent privatization. 7 For details refer to Indermit Gill "Reforming Social Security: Lessons from International Experience and Priorities for Brazil," May 1997, Economic Note No. 18, Country Department 1, LAC Region, The World Bank. The main findings are summarized in the Annex to this report.

40 Savings - Investment Balance and Long Run Growth Prospects 83. Brazil started the decade of the 1980s with an investment ratio (Gross capital formation to GDP) of 23.6%. Measured at constant, 1980 prices, this ratio had declined to 13.6% by After this there has been a gradual recovery, with the ratio reaching 16% in The use of this indicator, is however, affected by a significant shift in the composition of investment during the period. While in 1980, buildings (civil construction) accounted for 62% of investment and machinery and equipment for 34%, by 1994 the composition had changed to 70% buildings and 28.6% in machinery and equipment. 8 Turning to the investment ratio at current prices, we see greater stability over a longer period. As late as the late 1980's and 1990, the investment ratio was well over 20% (this is partially attributable to a relative price effect). It then fell to 18.8% in 1991 (Table 2.6) and has remained practically unchanged since then. In terms of the division between public and private investment, the ratio between public investment outside the public enterprises and private investment (which includes all enterprises, private or public) has also been stable. Investment in federal public enterprises was 4.9% of GDP in Between 1983 and the end of the decade there was a decline until the level fell below 2% of GDP 9. It has since oscillated around this level. There has, thus, been no crowding out of private investment by public investment. If there is any crowding out effect, it has operated via public consumption. 84. In terms of financing, Table 2.8 shows that domestic savings financed almost all of it between 1991 and 1994 when the current account was close to zero or in surplus. This is in marked contrast to Brazil's earlier experience in the seventies and early eighties when foreign savings provided the fuel for investment and growth during the miracle years. Foreign savings peaked at 6.5% of GDP in 1974 and was an average of 4.5% in Between 1984 and 1994 foreign savings were below 2% of GDP and often negative. After the Real Plan the picture changes with domestic savings declining from an average of 19% to 15.7% in 1996 with a corresponding growth in foreign savings. However, foreign savings is still much less important than in the pre-1983 period.'" 85. Coming to the composition of savings into components, public and private, although there are severe problems with data reconciliation between the national accounts and public accounts as maintained by the Central Bank, it is clear that public savings played a much larger role in the seventies and early eighties. Public saving levels were in the 7 to 8% of GDP level in the seventies but were close to zero or even negative in the late eighties, a 10% point of GDP turnaround. In the period, public savings were at an average level of 2.8% of GDP. Since public finances worsened after the Real Plan, public savings fell to negative 1.4% of GDP in Domestic private savings were much more stable but were clearly unable to substitute public savings, leading to a decline in total savings and investment starting in the early eighties. In the period following the Real Plan private savings rose in 1995 but fell in 1996 by over 1.5%age points of GDP. s The decline in the share of machinery and equipment could itself exert a negative influence on growth. 9 Pinheiro and Giambiagi (1997). 10 For pre-1991 data refer to "Obstacles to Investment Resumption in Brazil" by Carneiro and Werneck in Edmar Bacha (1993).

41 -29 - Table 2.8: Savings and Investment, (Percentage of GDP) Investment Public Private Savings (Domestic) Public (excluding enterprises) Private Savings (External) Memorandum: (i) Surplus Savings of the Private Sector (ii) Investment of Federal Public n.a. n.a. Enterprises Source: 1. Boletim Conjuntural, IPEA. 2. Pinheiro and Giambiagi in Revista Brasileira de Economia, Vol 51, No. 1, Jan/March, pp From an accounting analysis of the type carried out above, it is not possible to determine whether constraints on investment or savings are holding back growth in Brazil. What is evident is that there has not been a recovery of investment on any significant scale in the aggregate after the Real Plan and both public and private investment continue to be low relative to the high growth period of the past. Public saving has fallen after the Real Plan while private domestic savings are at the same level as in the early nineties. External savings have gone up, compensating for the fall in domestic savings, implying that investment has not declined. However, neither has it increased, as we observed above. This picture is not very promising for future growth. In particular, it is unlikely that external savings can rise above present levels without increasing the vulnerability of the Brazilian economy to unacceptable levels. In that case, higher investment will have to be accompanied by higher domestic savings. The combination of declining public savings, stagnant private domestic savings, high interest rates and a low investment rate suggests strongly that the macroeconomic framework is not quite right, and cannot provide the basis for growth above current levels.

42 CHAPTER 3: PUBLIC-PRIVATE DIFFERENTIALS IN EMPLOYMENT AND COMPENSATION The Approach 87. The problem of reducing the fiscal burden of public employment is viewed as central to a sustainable reduction of the high public deficit, which in turn is required to sustain the successful stabilization. Government efforts to reduce the wage bill attributable to civil servants through reduction in real salary levels is increasingly difficult with the decline in inflation to single digit levels since Reductions in employment are constrained by the presence of tenure or near - tenure rights of most public sector workers, guaranteed under the Constitution. The payment of generous pensions to civil servants results in their becoming a financial burden for the life (or even longer because of survivor benefit schemes) but reduction of pensions or increases in time of contribution are difficult because these rights are unassailable under the Constitution. 88. In order to deal with this impasse, the strategy of the Government in the fiscal readjustment process in Brazil has manifested itself in two sets of actions. The first is constitutional reform to reduce pension expenditures and allow dismissals of tenured civil servants in case of fiscal necessity, through, respectively, the Social Security and Administrative Reform Bills currently being debated in Congress. The other is the increasing number of redundancy programs or PDVs (programas de demissdo voluntaria) in both federal and state administrations and enterprises. 89. This chapter identifies sectors where public employment is relatively hiigh and those where, alternatively, the problem of high public sector payroll costs is the result of private-public sector differentials in compensation. The following chapter discusses the experience of the PDV programs and what further needs to be done in terms of public employment reform. 90. In general, employment in consolidated government (excluding public enterprises) in Brazil is neither extraordinarily high nor low by international standards. The most up-to-date study of public sector employment in 90 countries (Rama, 1997), finds that the predicted level of government employment for Brazil is about 9.6% for the 1990s. This is close to the actual figure from nationwide PNAD (annual national household) surveys, which ranges between 9.0% and 9.4% during There is no clear trend in this ratio, indicating that government employment has not risen faster or slower than private employment. Including employment in Brazil's public enterprises, the share of government goes up to about 12%, which is also not usually high by international standards. Private-Public Differentials in Employment Levels 91. At the most aggregate level, therefore, the problem of high payroll expenses in Brazil is not due to excessive government employment. However, this does not rule out the possibility of public sector redundancies in particular regions (e.g., in some northeastern states), at particular levels of government (e.g., at the municipal level) or for particular classes of workers (e.g., for

43 judicial and legislative workers). In this report, we focus on public-private differentials in employment at a more disaggregate level: * Using PNAD surveys, we examine public-private employment differences in selected states and the federal district; the states are Pernambuco, Minas Gerais, Sao Paulo, Rio de Janeiro, and Rio Grande do Sul. * For the country as a whole, and for each of these states (and the federal district), we examine the share of public employment at different levels of government - federal, state, and municipal, and public enterprises. * For the country as a whole, and for these selected states, we examine public and private employment by type of contract (e.g., com carteira, or sem carteira or with or without a signed social security card). Emphasizing Private-Public Differentials in Compensation 92. Given the constraints imposed by the 1988 Constitution, state and federal governments have relied largely on incentives to induce tenured public employees to leave government employment. In most cases, the size of severance packages required to induce employees to leave depends not simply on the level of public earnings, but upon public-private differences in earmings, pensions, job stability, and other benefits. Much of the discussion surrounding fiscal adjustment, however, has focused on the former. In this report, we explicitly focus on the latter: * Based on nationwide household surveys, we compute public-private differences in monthly earnings, adjusting for worker characteristics such as education, age, tenure, sex, and race. * Using experience-earnings profiles, and rules for determining pensions, we compute publicprivate differentials in pensions. * Using data on tenure in the current job, we estimate public private differentials in job stability. 93. This approach lends itself directly to the design of policy. Labor market reforms that reduce the cost of labor and raise the demand for labor (e.g., by lowering payroll tax rates), or social security reforms that make INSS pension benefits conform more closely with contributions, or reforms that lower artificially high turnover rates and increase private sector job stability (e.g., social security reforms that lower the informality of employment or a redesign of the fundo garantia por tempo de servico - FGTS) would reduce private-public differentials in earnings, pensions, and job stability respectively, and make it easier to reduce civil service employment. Similarly, an administrative reform bill for the public sector that enforces longer working hours, requires civil servants to make contributions for pensions at the same rate as for INSS benefits, or eliminates tenure, would also reduce public-private differentials in earnings, pensions, and job stability and make it easier to reduce public employment. 94. Focusing on public-private differentials also helps to illustrate that there is more than one way to achieve the same objective. Thus, the incentives for public sector employees to give up

44 government jobs can be made stronger by reducing public sector earnings, pensions, and job stability; or by increasing private earnings, formality of employment, or job stability. 95. Finally, the analysis can also be used to distinguish the effects of policy measures that require constitutional reforms, and those that are feasible under current conditions. Thus, the severance packages that are required to compensate workers for possible losses in earnings and pensions can be estimated. The fiscal effects of specific constitutional reforms can be identified as the reduction in severance packages due to these changes. The efficiency effects of constitutional reforms are harder to estimate, and are not discussed in detail in this report. The Background Employment, PNAD surveys indicate that total employment in Brazil was 62.5 million in September Of this, public sector employment - other than public enterprises - was approximately 5.6 million (2.2 million in public administration, more than half at the municipal level, 0.6 million in the judiciary, legislature and military, and 2.9 million in the education and health sectors). The enterprise sector had 56.9 million workers (16.1 million in agriculture, 8.4 million in industry, and 28.4 million in services). Table 3.1: Sectoral Shares in Employment, All Brazil Public Employment Direct Administration Federal State Municipal Education & Health Judiciary & Legislative Military Private Employment* Total (%) Total (millions) n.a.** n.a.** n.a.** * Enterprise employment includes employment in public enterprises. ** Total employment figures before 1991 are not accurately estimated. Source: Pesquisa Nacional por Amostra de Domicilios (selected years). 97. The share of the "public sector" - civil servants and the military - as defined above rose from about 7% to 9% of the total between 1981 and 1990, and has stayed above 9% since then. Between 1992 and 1995, the number in public administration increased from about 2.07 million to 2.16 million - almost all of this increase was accounted for by an increase in municipal employment. State employment fell by 1%, and federal employment rose about 7% over these two years. The size of the military stayed roughly constant at about 0.27 million. Both judicial/legislative and education/health sectors registered increases in employment between

45 and Judicial/legislative staff increased from 0.26 to 0.32 million, and employment in education and health increased from 2.66 to 2.85 million. 98. Using the class of worker distinction, the share of the public sector was about 12% during the period This definition thus includes workers in public enterprises and autonomous agencies (fundacoes). Almost all government employees are either public servants (estatutarios) or have a signed work card (CLTistas, com carteira). Workers in the public sector who do not fall into this category - i.e., are not estatutarios and do not have a signed work card (sem carteira) form about 1.5% of total employment in the country. Table 3.2: Share of workers, by contract type (%), All Brazil * ; SSA 43 *;-- - * -t--- g -, l--~~~, Public Sector Workers 11.5 Federal State Municipal Military Private Sector Workers 88.5 Salaried Selfemployed Employers Unpaid Total Source: Pesquisa Nacionalpor Amostra de Domicilios, As far as differences in the spatial distribution of the labor force are concerned, public employment tends to be only marginally over-represented in the northeastern states. In fact, public employment is over-represented in the Federal District and in Rio de Janeiro, which are among the states with the highest average wage. The argument that poorer states use public employment as a safety net is not supported by evidence. Employment in the public sector is only slightly over-represented in the poorest areas: 49% of public employment and 46% of private employment are in states with the average wage below the overall average There is also considerable variation across states in the degree of formality of private employment across states. Northeastern states have largest proportions of private workers who fall into this category. While the share of workers with a signed card in private employment is 35-50% for southern states and the federal district, it is 15-20% for the northeastern states. Minas Gerais, with a ratio of about 30%, falls in the middle. Earnings, Average real monthly earnings by sector were computed using PNAD surveys and the INPC deflator. Between 1981 and 1995, real monthly earnings for increased about 29% for federal employees and 8% for state employees, and fell by 12% for municipal employees. Earnings for judicial and legislative employees rose by more than 40% during these years, by about 7% for the military, and stayed roughly constant for education and health workers in the

46 public sector. In the private sector, earnings in agriculture fell by about 10%, in industry by 6%, but rose in distributive and productive services by 6%, and in personal services and construction about 16%. The largest increase in real earnings was therefore for judicial and legislative employees, and the largest fall was for municipal employees In absolute terms, and unadjusted for worker characteristics, average earnings were highest for judicial and legislative workers in 1995, who earned almost R$1500 per month. Earnings were 25% lower than this for federal workers, 50% lower for state and military personnel, 62% lower for education and health workers, and 75% lower for municipal workers. In the private sector, earnings were highest in productive services at about R$950 per month. Earnings in distributive services and manufacturing were about 45% lower than this, those in personal services and construction about 60% lower, and those of agricultural workers about 75% lower. Given nominal salary restraint in the public sector in 1996 and especially in the federal administration and enterprises - it is possible that these earnings differences are smaller today (see MARE, 1998). But the magnitudes of earnings differences reported here and the relatively low inflation rates in these years make it very likely that large differentials persist, especially for judicial and legislative salaries that are outside of executive control. Table 3.3: Average Monthly Earnings, All Brazil, in constant September 1995 reais* Direct Administration Federal State Municipal Education & Health Judiciary & Legislative Military * The deflator used is INPC (Brazil) * Private employment includes employment in public enterprises. Source: Pesquisa Nacionalpor Amostra de Domicilios (selected years) Considerable differences existed in average earnings in different parts of the country. In 1995, average earnings in almost all sectors were highest in the federal district and Sao Paulo than in other states, and earnings in Pernambuco and Bahia were generally the lowest. Earnings in Minas Gerais were somewhat higher than for the two northeastern states, and earnings in Rio Grande do Sul and Rio de Janeiro higher still. Relative to salaries in the manufacturing sector, state employees received roughly 67-80% more in Bahia and Pernambuco, and 40-45% more in the other states. Municipal workers' earnings relative to private manufacturing earnings, in contrast, were highest in Rio Grande do Sul and Rio de Janeiro, somewhat lower in Minas Gerais and Bahia, and lowest in Pernambuco and Sao Paulo. In absolute terms, however, earnings of Sao Paulo's municipal workers were more than double those in Pernambuco In the private sector, relative earnings by sector are uniform across regions. The only exception is that in Rio Grande do Sul, where earnings of agricultural workers is comparatively high. But this is hardly surprising; what is more striking is that sectoral earnings relative to those in manufacturing are similar for all states.

47 The Wage Bill, Using employment and average earnings for each sector, we computed the sectoral wage bill in Figure 3 graphs the relative importance of each of the subsectors in public employment. Education and health workers, who are about 50% of all government workers, absorb about 45% of the wage bill. Municipal employees are about 20% of total public employment, but absorb only 12.5% of total wages; state employees, who are about 15% of employment, absorb about 17% of total wage. Federal and military workers are relatively small fractions of both total employment and wage bill. The most dramatic difference between these two shares is for judicial and legislative workers, who are about 5% of total employment, but almost 14% of the total wage bill. Thus, while employment of judicial/legislative workers may be relatively small, they are potentially critical for fiscal reasons. Figure 3: Education and Health Workers Take Home Almost Half of the Public Sector Wage Bill ! o40.00i _ Share of Employment * Share of Wage Bill _ 1 1i To examine the trends in wage-related expenditures in the public sector, we computed the growth of the wage bill in the public and private sectors. Because of inaccurate weighting before 1991, wage bill figures are reliable only for the three PNAD surveys for 1992, 1993, and Figure 2 graphs the annual growth rate for employment, average earnings, and the wage bill during the period Average earnings grew in every part of the private sector, especially in personal and distributive services and construction. In contrast, industry and agriculture registered modest earnings growth, and employment actually fell in agriculture. In general, only employment growth in services exceeded the national average of about 2% during this period. In the public sector, on the other hand, employment of federal, municipal, judicial and legislative, and education and health workers rose faster than this average rate. Only state and military employment grew slower than the national average In the public sector, the 20% annual growth of the wage bill for judicial and legislative workers dwarfs that of other workers. This growth in personnel expenditures was due to both an increase in their number (about 7.5% annually) and increased average earnings (about 12% annually). The growth of the state wage bill exceeded 9%, despite a small decrease in state

48 employment. The wage bill for education and health workers increased by 7.5% annually, due to increases in both average real earnings and employment. The federal wage bill also increased by 4.5% because of both new hires and higher wages. Military employment stayed roughly constant, but earnings increased moderately. Figure 4: Judicial and Legislative Workems had the Highest Annual Growth of Eamings and Employment Dunng illi_- _ Wage Bill 0 Earnings g X ~~~~~~Employment o X ' IL Public-Private Differences in Earnings 109. Without knowing what the wage gap between the public and the private sector is, however, it is difficult to determine whether earnings growth of government employees has been excessive. Thus, for example, the relatively high average earnings of judicial and legislative employees may be because of their higher skill levels relative to other public employees and workers in the private sector. And the relatively rapid growth in their earnings may be because they have been historically underpaid relative to their private sector counterparts. To examine whether or not public sector employees are under- or overpaid relative to those in the private sector, we compute the earnings gap in this next section. This would help in determining whether the solution to the problem of a high public sector wage bill lies in reducing public sector employment, or average earnings and pensions, or both. Public-Private Earnings Differentials 110. Table 3.4 presents estimates for the wage gap between the public and private sectors for Brazil. Average earnings tend to be much higher in the public than in the private sector. This table also shows that the wage gap between the sectors is much greater when labor income is not standardized for the number of hours worked, indicating that workers in the public sector work fewer hours per week than workers in the private sector. The gap in non- adjusted wages tends to be between 15% and 20% smaller than the corresponding gap in adjusted wages. The results using the standardized wages indicate that the relative wage gap between the sectors is equivalent to 33% of the average wage in the public sector or 48% of the average wage in the private sector.

49 Table 3.4: Measures of the Public Sector Wage Premium Unadjusted for Sector, Region and Worker Attributes,% Meas.~~~ PuNie-To~~ta Prvt ulic-formal Private. d' sted* Not gajusted Adjusted- Not adu ted Relative Wage Gap Baseline: Public Sector Wage Baseline: Private Sector Wage Log Measure of Gap** Log average-wages Average log-wage * Adjusted refers to earnings adjusted for differences in hours worked. ** These measures refer to the wage gap relative to a weighted average of the levels of wages in the two sectors, and have the advantage of not being dependent on whether the comparator is the public or private sector wage level Table 3.4 also reports estimates of the gap between the wage of employees in the public sector and employees in the privateformal sector, which may be the part of the private sector that those leaving government employment are more likely to seek employment in." This table reveals that this wage gap is smaller than the overall standardized gap between the public and private sectors. At this stage of the analysis, it is very difficult to interpret these large wage gaps. Three factors complicate such a comparison: first, there are large differences in average earnings within the public (e.g., between municipal and legislative workers) and private sectors (e.g., between agricultural and service sector workers); second, there are regional differences in average earnings (e.g., between state employees in Pernambuco and Sao Paulo); and third, there are large differences across workers by individual attributes (e.g., workers in the public sector tend to be better educated and older). Controlled wage gaps by sector and class of worker 112. Differences in the skill composition of the labor force explain a large part of the wage gap between the public and private sectors. Therefore, overall measures for the wage gap that do not control for differences in the characteristics of the labor force are misleading indicators of the actual wage advantage of workers in the public sector. The basic set of observed characteristics includes gender, race, schooling, and age. We also work with a version of this set that includes tenure at the current job. In this section we estimate the wage gap between each segment of the public sector and overall private sector controlling for differences in worker-specific attributes. This is perhaps the best estimate of the "pure" premium enjoyed by public sector employees over what they would have earned had they held private sector jobs. Table 3.5 presents estimates for the controlled wage between each segment of the public sector and the private sector for the country as a whole The table reveals large differences among segments of the public sector with respect to their wage advantage. The wage advantage, measured by the controlled log-wage gap, is largest at the federal level for both among public servants and among employees in public enterprises. It can also be reasonably argued that a revealing comparison would be between pay and employment conditions in government agencies and large firms in the private sector. This would be a useful extension to the estimations presented in this report.

50 For these groups the average salaries are 35% to 65% higher than for comparable workers in the private sector. At the state level, the wage advantage is close to zero for public servants; for employees in public enterprises the wage advantage is positive and between 10% and 22%. At the municipal level, public servants and employees in public enterprises get lower wages than workers with similar observed characteristics. Overall, the evidence corroborates the existence of significant wage premium of some segments of the public sector relative to the private sector. Table 3.5: Measures of the Public Sector Earnings Premium, September 1995 Adjusted for Worker Characteristics*, by Sector/Class,%.=easure. MMtl Ir*.. Hou-I By Sector of Activity: Federal Administration State Administrations Municipal Administrations Judicial & Legislative Military Education and Health By Class of Worker: Federal Public Servants Federal other, with signed card State Public Servants State other, with signed card Municipal Public Servants Municipal other, with signed card All workers without signed card Military * Worker characteristics adjusted for are age, sex, race, tenure, and education. ** Monthly earnings premia are not adjusted for differences in hours worked. Hourly earnings comparisons are adjusted for differences in hours worked About 70% of the gross wage gap is explained by the higher educational level of the labor force in the public sector. The remaining 30% is explained by the fact that public employees tend to be older and have longer tenure, with each of these two factors being responsible for 10% to 20% of the differential. The impact of the differences in the composition by gender and race is small. Differences in race composition between the private and public sectors are very small and, as a consequence, they have a negligible impact on the wage gap. The impact of gender differences is also small because though women have lower wages than men in either sector, they tend to be over-represented in the public sector which pays higher wages. Regional differences in the public-private wage-gap 115. To examine regional differences in the public wage premium, we consider the labor market of the six major Brazilian metropolitan areas and Brasilia. In sum, differences in the sectoral composition of the labor force are a significant, but partial explanation for the wage gap between the public and private sector. Once the differences in worker attributes have been eliminated, the high wage gap between the two sectors becomes smaller but remains considerable for most states:

51 * In Brasilia, the wage gap declines to a still very large public-private wage gap of 63% among workers with identical observed characteristics. * In Recife and Salvador, workers in the public sector receive salaries that are 32% and 21% higher respectively. * The public-private wage gap is 17% in Belo Horizonte, 14% in Porto Alegre, and 12% in Rio de Janeiro. * Only in Sao Paulo is the pattern reversed: among equally qualified workers, workers in the public sector receive salaries that are 13% lower than private sector salaries. Public-Private Differences in Job Security 116. Table 3.6 presents the average tenure on the current job in months, for the seven metropolitan areas. The table presents the average tenure in the public and private sectors, the "raw" gap in average tenure, and then the gap controlling for differences in worker-specific attributes. Not surprisingly, it appears that public sector workers have more job security, as measured by the tenure at the current job, adjusting for characteristics such as age, education, and gender. This is only a crude measure of job security, because it does not measure expected tenure. Nevertheless, it does suggest that public sector workers, besides earning higher wages in all states except Sao Paulo, also have jobs that are more secure. Estimates of the public-private gap in job security range are 50% for the federal district, and between 20-35% in the six states. Table 3.6: Measures of the Public-Private Tenure Gap, By State In September 1995 MetrpoliauiRegio' P. Priva-' Co2... Average Tenure (Months) Distrito Federal Pernambuco Bahia Minas Gerais Rio de Janeiro Sao Paulo Rio Grande do Sul * Estimates are for differences for workers with identical characteristics This advantage of public sector workers appears to be strengthened by the lower unemployment rate of workers, classified by their sector of previous employment. But this pattern is reversed when worker-specific attributes are controlled for. Combined with the finding for average tenure differences, this may indicate that while public sector workers are less likely to lose their jobs, they are more likely to stay unemployed if in fact they do. Public-Private Differences In Pensions 118. The calculation of public-private differentials in pensions is somewhat complicated, and we present the technique only in outline here, focusing the discussion on results instead. To estimate differences in pensions for public servants and those receiving social security benefits from the INSS Time of Service and the Old Age schemes, we use the following technique:

52 -40 - * First, using 1995 PNAD survey data for the seven metropolitan areas used in this report, we estimate the profile of monthly earnings for male and females, divided further into four worker categories and three education groups. * Second, using these estimated earnings profiles, and assuming that all males retire after 35 years of service, and all women after 30 years, we estimate the average pension levels for each group. For public servants, we use the 36th year's salary in the 36th year as the estimated monthly pension (because pensions for public servants are based on the last month's salary). For com carteira salaried workers and the self-employed, we use the 34th year's salary as the estimated pension level (because INSS benefits are based on salary levels in the last 36 months of service). We assume that self-employed workers actually contribute to and receive social security. For sem carteira workers, we assume that these workers will receive minimum pensions from other INSS programs: their pensions are assumed to be equal to one minimum wage in 1995, which we assume to be R$ 100 per month. * Third, we make adjustments for the fact that INSS pensions are capped at 10 minimum wages. This results in pensions for two groups - com carteira men and women with 12+ years of education - being restricted to equal R$1000 per month. * Fourth, using weights obtained from nationwide PNAD data for 1995 on the shares of com carteira and sem carteira employees, and self-employed workers, we compute the average expected pensions for private sector men and women. We do not take into account pensions from the supplementary social security system (i.e., closed or company funds). * Finally, these numbers are compared with expected monthly pensions for public servants with the same education level Table 3.7 reports the results of these estimations. The results show that due to the nature of the estimated profiles and differences in rules (basically the pension ceiling of 10 minimum salaries), public-private pension differences are greater for men than for women, and greatest for the most educated male workers. Thus, the average CLTista male worker with 0-8, 9-11, and 12+ years of schooling will receive, respectively, 75%, 72% and 50% of the monthly pension level of his estatutario counterpart. The corresponding numbers for women are 73%, 73%, and 71%. The findings on private pay and pension differences, combined with the fact that pension contribution rates are 0-2% for public servants but range between 8-11% for CLTistas, have important implications for the structure of optimal severance packages, and the likely success and full costs of current voluntary severance programs. Table 3.7: Estimated Monthly Pensions, September 1995 Reais Males 0-8 years schooling years schooling years schooling ** Females 0-8 years schooling years schooling years schooling Source: PNAD Surveys, World Bank calculations. Men are assumed to retire after 35 years of service, and women after 30 years. * Using weights derived from nationwide PNAD employment distribution data. ** Capped at 10 times the minimum monthly salary level, assumed to be R$100 in September 1995.

53 CHAPTER 4: PUBLIC EMPLOYMENT REFORM: WHAT IS BEING DONE, AND WHAT IS NEEDED 120. This chapter discusses what is being done to address the problem of high personnelrelated expenses at the federal, state, and municipal levels. Principally, this has involved voluntary severance programs in public administrations and enterprises, and the use of attrition to reduce employment levels. We analyze ten voluntary severance programs in public administrations and enterprises launched since 1995, and the concurrent measures taken by these agencies/enterprises. Then, using the framework and the findings discussed in chapter 3, we detennine the steps that are needed to address the problem of high and rising personnel costs, both those that do not require constitutional amendments, and those that require the passage of reform bills by Congress. Among the measures that need not await the passage of these bills, we suggest the course of action that is most appropriate given the current state of private and public employment and pay, and previous experience in tackling public employment reform. Recommended Measures for Reducing Payroll Costs 121. Based on the analysis in Chapter 3, the recommended steps for reducing public sector payroll expenditures differ across the various branches and levels of government. Table 4.1 presents the set of measures that are appropriate. Several points should be kept in mind in using this table. First, the analysis is based on the principle that compensation should be the same for equally qualified workers in the public and private sectors. While such comparisons are difficult, they are necessary to ensure efficiency in the public sector. Second, the analysis presents strategies for reducing payroll expenses at all levels of government. Clearly, federal, state and municipal priorities will dictate whether in fact downsizing efforts should be broad, or instead target some workers (e.g., lower level administrative staff) while sparing others (e.g., education and health workers). Finally, this analysis should be viewed as general guidance. Specific steps should be determined after more detailed analysis of private-public earnings differences at the state or municipal level The recommended measures are: * Judicial and legislative payroll expenses should be controlled by lowering salary and benefits (e.g., by limiting overtime payments to legislative staff) and pensions (e.g., by eliminating special retirement rules for such workers) and by reducing employment levels. * Reducing personnel expenses in federal administration and federal and state enterprises mainly requires lowering salary and pension levels, though employment reduction in selected occupations and enterprises may also be necessary. * Reducing personnel expenses in state administrations is best done by employment reduction preceded by tenure revocation and reforms to make state pension programs less generous. * Reduction of personnel expenses for education and health workers and municipal administrations and enterprises should be done mainly by reducing employment, preferably after revoking tenure for public employees; for some groups of workers (e.g., teachers) special retirement rules should also be eliminated.

54 Table 4.1: Measures to Reduce Public Payroll Expenses While Maintaining or Improving Labor Market Efficiency Seto. Compensation..,:Wor Conit ions Empomn -~ ~~~~aaybnft Pension Work Hours Staiity, Job Employmen7tl\ Reie Judicial & Legislative / ' ' Federal Administration ' V / State Administration / '/ Municipal Administration V ' Education & Health / V/ VI" Military Federal Enterprises v? State Enterprises / 'V? Municipal Enterprises V? Notes: 'V signifies that this is a priority countrywide measure, though the measure may not be appropriate for some states, municipalities or occupations; V signifies that this is a recommended countrywide measure;? indicates that our analysis does not allow generalizations. Employment Reduction Through Voluntary Severance Programs A. Overview 123. We examine the costs and effectiveness of voluntary severance programs (called programas de demissao voluntaria or PDVs) in tackling the problems of a growing public salary and pension bill. The programs selected are from the states of Sao Paulo, Rio Grande do Sul, and Pernambuco, thus representing a broad economic spectrum; also included is the Federal Government and Banco do Brasil. Not by coincidence, public private earnings and employment differentials were also examined for these three states and the federal district in Chapter 3. The programs were chosen so that the sample was representative: four of the programs are for public administration, and six are for state-owned enterprises (three banks and three public utilities). The three public enterprises are FEPASA - Sao Paulo railways company, CEEE - Rio Grande do Sul electricity company, and CESP - Sao Paulo electricity company. The public sector banks are included in the study: Banco do Brasil; Bandepe - Bank of the State of Pernambuco; and Banrisul - Bank of the State of Rio Grande do Sul Take-up rates The federal government's program had the lowest take-up rate (1.7%), followed by Sao Paulo administration (2.2%). Pernambuco and Rio Grande do Sul administrations obtained more than double these rates: the ratio of total job separations to baseline employment was about 5% and 6.5%, respectively. Amongst public enterprises, FEPASA managed to reduce employment by almost 27% while CEEE's ratio was only about 6%. Official banks, with substantially greater financial incentives, averaged higher take-up rates. Bandepe had the highest take up rate of about 34% of pre-program employment among the PDVs analyzed. Banco do Brasil averaged about 12% and Banrisul 10.5%. Overall, governments

55 aimed to lay off low-skilled and negligent workers while the main target of official banks were workers with above average tenure (i.e., older workers). Public enterprises simply aimed at reducing baseline employment without specifying any particular target group Main design features Financial incentives varied from case to case but were usually based on the number of years of service. Bandepe was the exception to this rule, paying only the equivalent of four gross monthly salaries to those who joined the voluntary separation program, regardless of years of service. Enrollment for the programs in the federal and state administrations was treated as a voluntary quit or a justified dismissal. As a consequence CLTista workers leaving public employment through the PDVs were not paid the 40% penalty over the balance of their FGTS accounts. On the other hand, public enterprises and official banks have treated voluntary separations as unjust dismissals and paid substantially higher financial incentives relatively to the ones offered by public administrations. Due to a collective bargaining agreement, FEPASA paid 180% of FGTS account balances for PDV takers Average benefits Among public enterprises and official banks, Banrisul paid the highest package per person (R$58,700) followed by Banco do Brasil (R$50,000) and CEEE (R$41,885). Among public sector enterprises, average benefits were lowest for Bandepe (R$21,930). The federal government offered the highest package amongst public administrations paying roughly R$23,500 per person; Rio Grande do Sul paid an average of R$17,055 while Pernambuco and Sao Paulo paid R$10,665 and R$5,500, respectively. Nonfinancial assistance for PDV takers was offered in all cases except FEPASA. The most common form of assistance was extended medical benefits (usually for one year after leaving employment), training programs, and help with business start-ups. Banco do Brasil contracted a firm specializing in job search assistance to help PDV takers to find other jobs while Bandepe only offered special loans for PDV takers interested in starting small businesses Total financial costs, savings, and reported recovery periods The biggest outlay was for Banco do Brasil program which had a total cost of R$350 million, and the smallest was that of Bandepe at R$30 million. Following Banco do Brasil, other large programs were those of Rio Grande do Sul (R$216 million), the federal government (R$183 million) and FEPASA (R$135 million). The highest saving in monthly wage bill was obtained by Banco do Brasil which managed to reduce its monthly payroll by some R$35 million. The lowest saving was achieved by Pernambuco State government (R$3.3 million). The federal government's PDV program has had limited success in reducing payroll expenditures with the monthly wage bill for PDV takers amounting to R$9 million (out of a total monthly payroll of about R$800 million). In the case of Pernambuco, considerable delays in releasing the financial benefits due to PDV takers undermined the credibility of the program and limited the number of volunteers With regard to the period necessary to recover PDV expenses - as reported by the enterprise/agency - public sector banks presented the best performance relative to both public enterprises and administrations. Bandepe, for example, estimates that it would recover PDV spending in 5 months; for Banco do Brasil, the recovery period was estimated at 10 months and for Banrisul at 19 months. In the case of public enterprises, the average recovery period was estimated by its administrators at 24 months for FEPASA and 14 months for CEEE. Amongst state governments, Sao Paulo had the shortest recovery period of about 5 months. Pernambuco and Rio Grande do Sul report that they would recover their expenses within 12 and 16 months,

56 respectively, and the federal government's program had an estimated recovery period of 20 months. Figure 5: Voluntary Separation Programs of Public Enterprises Have Higher Take-up Rates Than Those of Administrations ; i0 00 g;;0 ;.00 0,: l o z _ l 0._0-1b Average - Benefd ($,'000) Average Benefts (x monthly wage) Take-up Ratio (%) v oa e) m '@ E ~~~~~'a cc CU CD ~~~0 C 0.~~~~ B. Critical Features of Public Administration PD Vs 129. There is little or no pressure on employees to take the program In general, state governments do not apply pressure on redundant employees to accept severance packages. It cannot be fully determined whether this was due to legal reasons (i.e., it was unlawful for these programs to have even a semblance of coercion for estatutarios) or because of a lack of political will on the part of program administrators ("cultura"). But the relative success of the Rio Grande do Sul program indicates that political will is the more important factor. This program is exceptional among the public administration PDVs in that negligent or redundant workers were explicitly targeted by the program and pressured into leaving (e.g., by instituting a new system for monitoring attendance for all workers, informing workers whose performance was less than satisfactory that they were being monitored and by re-assigning them to other jobs. The program had the highest take-up rate (about 7% of baseline employment), both because of this pressure and because the payments were somewhat higher than those of other administrations Nontenured employees obtain better severance packages than those with tenure In most cases, CLTista employees of public administrations - who technically do not have tenure or "estabilidade" - obtained higher severance benefits than tenured estatutarios. This is because while special incentives (indemnity payments) under the schemes were the same for CLTistas and estatutarios, CLTistas also obtained at least 100% of their accumulated FGTS balance (i.e., the separation was treated as a justified dismissal). For example, in the Sao Paulo state program, any worker with a monthly salary of $500 and ten years of service got R$6,250 if s/he volunteered during the first two weeks (one month's pay for each year of service, plus the 25% early volunteer bonus). But if the worker was a CLTista, s/he would also receive more than R$5,000 in FGTS benefits, with the exact figure depending upon the profile of earnings over the

57 last ten years. The Rio Grande do Sul state program was exceptional in that it did not allow participants to withdraw funds from their FGTS accounts, i.e., treated the separation as a voluntary quit When potential pension payments are considered, benefits of state PD V programs are greater than if only saving in salaries is considered Government saves more when an estatutario takes a PDV package than when a CLTista leaves, because public pensions are more generous than INSS pensions. Using a simple methodology, we estimated the saving in salaries and pensions for groups of workers according to their sex, education, and tenure. Table 4.2 lists results of this exercise for men and women with, respectively, 0-8, 9-11, and 12+ years of education. In the case of men, it is assumed that the PDV taker has 17.5 years of service. In the case of women, this is assumed to be 15 years. These numbers are similar to actual tenure levels of participants in these programs. When pensions are considered, the savings due to an estatutario leaving government employment are about 12%, 10% and 23% higher for men with 0-8, 9-11 and 12+ years of education. For women, the corresponding numbers are 25%, 21%, and 21%. Pension-related savings are greater for highest wage males because private sector pensions are capped at 10 times the minimum salary, and the cap is binding only for this group. Other than this group, savings are greater for women because the expected length of retirement is greater for women. The numbers would be greater if we account for the fact that while pension contributions are zero in the public sector, they can be as much as 20% of earnings for private employees. Table 4.2: Implications of Reducing Public Employment (Average earnings, transfer of obligations, and DPV* of savings, in thousand Reais) Education Consolidated Government Transfer of State Government Level Saving Obligafions Saving t :MSS** Salari es e T e Total Males, with 17.5 years of service*** 0-8 years years years Females, with 15 years of service*** 0-8 years years years These estimates are based on estimated earnings profiles of private and public sector workers in a nationwide sample drawn from the 1995 PNAD survey. * A 6% discount rate was used to calculate present values. ** These transfers do not take into account the expected contributions of these workers (and their employers in the case of salaried employees) to the INSS system. *** Men are assumed to retire from public employment after 35 years of service, and receive pensions for 20 years; women are assumed to retire after 30 years of service and receive pensions for 25 years The severance amounts paid are small relative to saving in payroll expenses The most striking finding is that the potential benefits of PDV programs - in terms of reduced salary and pension bills - dwarf the costs of existing prograrns. While the potential saving for these groups ranges between R$34,000 (for least educated women) and R$265,000 (for educated men), the average benefits being paid range from $5,000 and $25,000. One of the main reasons is that

58 -46 - governments are cash-strapped, and cannot afford to pay much more. As a consequence, though, take-up rates are low, and a promising source for reducing the long-term fiscal burden on state and federal governments remains largely untapped Voluntary separation programs for estatutarios involve large state-to-federal government transfers of pension obligations For estatutarios who leave under these programs but do not qualify for early retirement, there is an uncompensated transfer of pension obligations from the state administration to the national INSS scheme. This is because these employees carry over their years of service into the private system and, after a relatively short period of contributions, become eligible for private pensions. Thus a male PDV participant with 17.5 years of service would be eligible for reduced INSS pensions after only 12.5 more years of work in the private sector, and for full pensions after only 17.5 years. The present value of these obligations for men and women leaving public employment mid-career are about RI 5,000 to R$17,500 for low wage workers, R$25,000 to R$30,000 for medium wage workers, and R$42,500 to R$55,000 for high wage workers. Thus, for example, a state PDV for 10,000 estatutarios drawn from all education/salary categories could imply a transfer of obligations of more than R$300 million in current terms from the state to the federal pension system Expected social security contributions of PDV participants do not make up for the transfer of pension obligations To some extent, this transfer of pension obligations would be offset by payroll contributions. But under the current rules, the INSS system never recovers the "lost contribution" of these estatutarios, viz., what they and their employers would have contributed had they belonged to the INSS system during their years of service with the government. If one assumes that the INSS system is actuarially fair for workers who make full contributions for 30/35 years, this means that the INSS is "owed" employee and employer contributions (which add up to about 30% of earnings) for their years of tenure. The estimated present values of "lost" contributions are R$16,000, R$42,000, and R$78,000 for men with 0-8, 9-11 and 12+ years of schooling who take PDV packages after 17.5 years of service; and R$13,000, R$25,000 and R$54,000 for the corresponding groups of women with 15 years of service. Naturally, these numbers would be smaller for PDV takers with lower tenure levels, and greater for those more senior civil servants Administrators are aware of the problem of adverse selection, and have taken some measures to address it Despite being legally or constitutionally constrained, program administrators have taken some measures to counter the problem of "good" workers leaving and "bad" workers staying on. The main instruments were encouraging some workers to volunteer for the program, and by discouraging "good" workers who had volunteered from leaving, and even refusing them the package. The latter appears to have been the more effective way to address this problem. C. Critical Features of PD Vs of Public Enterprises 136. Matters are both simpler and more complicated for calculating the saving from PDVs in public enterprises. They are simpler because these workers are all CLTistas, so the issue of transfer of pension obligations from states to the federal government does not arise. They are more complicated because many public enterprises have "closed" or company pension funds (called the "complementary" social security system), which give generous benefits that imply increasing company contributions. Severance schemes that entail shedding company

59 responsibility to pay pensions thus imply a saving for the government. But because these closed pension schemes vary from company to company, we do not address this problem here Generally, there is little or no pressure on employees to leave As with PDVs of public administrations, state enterprises generally do not apply pressure on redundant employees to accept severance packages. In this case, however, it is clear that this is not due to legal reasons: the law permits firing of public employees because they are CLTistas. So the voluntary nature of downsizing programs is obviously because of political reasons. Bandepe's program is exceptional among the public administration PDVs in that negligent or redundant workers were explicitly targeted by the program and pressured into leaving (mainly by instituting an evaluation system to identify unmotivated or mismatched workers, who were advised to take severance packages). Despite having the lowest average indemnity payment, this pressure helped Bandepe's program achieve the highest take-up of all PDVs (about 33% of baseline employment) Severance programs always provide more than what is legally required For employees of public enterprises, the FGTS scheme provides mandated minimum benefits to be paid to workers upon dismissal. Collective bargaining agreements - e.g., in the case of FEPASA - specify additional payments. But in all of the schemes studied, workers were paid indemnity payments in addition to FGTS-related benefits. These payments were usually a multiple of monthly wages: thus higher wage workers got considerably more than workers with low salaries. The payments also generally increased with years of service, implying added compensation to what they already received under the FGTS scheme. The only case where workers received indemnity payments that were not related to their tenure was Bandepe's program: not coincidentally, this program also was the only one where participation was not entirely voluntary Voluntary separations are treated as unjustified dismissals Despite there being little or no pressure on employees to participate in PDVs, those volunteering to leave were treated as though they had been dismissed sem justa causa. As a result, they were allowed to withdraw their FGTS balances, and get 40% more as a penalty from the firm. In FEPASA's case, where participation in the program was somewhat involuntary, a collective bargaining agreement resulted in the penalty being doubled, so that participants got 180% of their FGTS balances, plus special indemnity payments Severance payments are considerably greater than in PDVs of public administrations As Figure 5 shows, the average benefits as a multiple of monthly wage was considerably higher for public enterprises than for administrations. The exceptions are the federal administration - where benefits were 24 times the average monthly salary and hence greater than PDVs of public enterprises - and Bandepe, where benefits were only five times average monthly salaries and hence smaller than any other PDV (these benefits do not include the FGTS account, and the 40% penalty). Participants in PDVs of public enterprises also had higher average salaries than those of administrations. This is consistent with the greater disincentives facing estatutarios who expect to earn very high pensions to leave voluntarily, due to the ceiling (eight times the minimum salary) on private sector pensions being binding Severance amounts paid are smaul relative to saving in payroll expenses As with the PDVs of state administrations, the potential benefits of PDV programs - in terms of reduced

60 -48 - salary bills - appear to be significantly greater than the costs of existing programs. While the potential saving ranges between R$27,000 (for least educated women) and R$215,000 (for better educated men), the average benefits being paid range from $22,000 and $52,000, a large part of which are from FGTS balances and not government or company funds. Reducing Public Employment under Current Conditions 142. The range of experience with voluntary severance programs in Brazil is broad. No two programs were alike, so it is difficult to generalize and draw implications for future programs. Nonetheless, some findings appear to be quite general and, if interpreted carefully, will help in guiding future efforts at downsizing. The main implications of these findings for future PDVs are: 143. Downsizing is a financially profitable strategy. Under reasonable assumptions, financial benefit-to-cost ratios exceed ten for many worker categories. Current benefit levels imply that the costs of severance packages are recovered within three years. When both the saving in salaries and pensions are considered, few investments are as rewarding as downsizing programs, even under fairly constrained legal circumstances. Comparing the reduction in payroll expenses of lowering employment by one person, with the alternative of lowering the same worker's salary by 10%, we find that downsizing has about 7.5 times the financial return, when severance payments are not considered. Even when severance payments twice as large (e.g., with payments averaging 48 months' salaries) as those found in the programs studied are used, downsizing is between 5.5 and 6.5 times more rewarding than a 10% cut in the worker's salary Some involuntariness is necessary for increasing take-up and containing costs. The programs surveyed show that some pressure has to be used to ensure that the take-up rates are reasonably high, and that those leaving are largely those who should leave. For PDVs of both public administrations and enterprises, those that used pressure (Rio Grande do Sul administration and Bandepe) were most successful in reducing employment and payroll expenses Even under the existing laws, it is possible to use pressure on negligent public employees to leave with modest severance benefits The cases of Rio Grande do Sul and Bandepe again show that constitutional reform is not strictly necessary to carry out a successful public sector downsizing operation. With careful planning and execution, both programs have reduced the number of workers and avoided litigation. The experience of state PDVs implies that administrative reforms that are being debated in Congress - while lowering the cost of downsizing somewhat - may not be strictly necessary for successfully reducing the public sector wage bill Severance payments for CLTista employees are more than what is legally necessary, and those for estatutarios less than what is sufficient under current tenure and pension laws On equity and efficiency grounds, estatutarios should get at least as much as similarly qualified CLTistas. But because under current laws they cannot easily be fired, estatutarios have to be bought out. Other things being equal, therefore, estatutarios should be getting higher severance benefits than CLTistas. In fact, the opposite holds. States could reallocate some of what is now being spent on CLTistas to get estatutarios to volunteer for the program. While on equity considerations these payments should at least be equal, on efficiency grounds it makes sense to

61 spend more to induce an estatutario to leave than a CLTista with similar attributes (salary, age, sex, education, tenure, etc.) Keeping salary increases small will reduce the incentive to stay in government. With constitutional and other restrictions on firing public employees or reducing their salaries or pensions, the use of voluntary separation programs initiated by state administrations and enterprises has been the major - perhaps overemphasized - avenue for reducing the fiscal burden of public employment. Efforts to reduce employment under the current legal and political constraints should be assisted by keeping public sector salary increases to a minimum. Declining real earnings of public employees would encourage their voluntary departures as private sector employment and earnings increase, keep payroll expenses for current employees from rising, and - since pension payments to inativos are linked to salary levels of ativos - keep pension-related expenses from rising. Selective Pension Reform Can Eliminate Public Sector Pension Premium 148. While these measures can provide some short-term relief, longer-term sustainability requires constitutional reform in the areas of social security, private sector labor regulations, and public administration. Of these, perhaps the most important are measures to reduce the high and growing bill for both public and private sector retirees. Immediate measures to reduce the inequality between public and private pensions are most beneficial from fiscal, efficiency, and equity viewpoints Reform of private pensions will have a fiscal impact, in that contributions will rise and eliminate the growing INSS deficit. But these reforms are likely to be effective only if the system is individualized and capitalized. Reform of public pensions is perhaps the most critical measure for immediate and long-term fiscal reasons. Pensions of public servants are between 33% and 100% higher than pensions of similarly qualified private sector employees. The generosity of public pensions relative to those in the INSS time of service program has three harmful effects: (a) it prevents successful retrenchment of all types of public employees at all levels of government, but especially those with salaries that will exceed ten minimum wages during their lifetime; (b) it adds to the growing fiscal deficit because average public pensions are greater than average wages, and (c) it reduces the fiscal benefits of employment reduction in the future Lower replacement ratios to international levels. The most effective way to prevent the pension burden from growing is to lower the replacement ratio from 100% to more modest levels. For equity reasons, replacement ratios can be higher for low wage workers, e.g., about 50% for workers eaming up to 4 minimum monthly salaries, 45% for workers earning between 4 and 8 minimum salaries, and 40% for those earning more Public pension levels should be no more generous than private pensions. We find that salaries of public employees in state and municipal governments are approximately the same as private sector workers with similar attributes (education, age, gender, race, tenure and location), and the former enjoy considerably greater job stability. Thus, there is no justification for public servants not having the same basic pension benefits as private employees. Thus, the ceiling for benefits (ten times the monthly minimum salary) that applies for INSS pensioners should apply for public employees as well, and same rate of replacement - preferably below the current 100%

62 rate - should apply. Equalizing pension benefits will also reduce some labor market distortions, e.g., the practice of switching to public service in late career to avail of higher pension benefits Public employees should contribute at the same rate as private employees. An effective way to begin equalizing public-private pay and benefits is to require public sector employees to make pension contributions at the same rates as private sector employees, viz., between 8% and 10% depending on their salary levels. Given small public-private differences in salary levels, there is little justification for not requiring public employees to contribute at the same fraction of their salaries as private workers. Requiring estatutarios to contribute at the same rate as CLTistas will reduce the fiscal burden for government by about 5-10% annually if not accompanied by any other change), make public servants view pensions as deferred compensation and not an entitlement, reduce the attractiveness of public employment and aid downsizing programs. Equalizing the contribution rates would also mitigate the problem of transfer of pension obligations from state governments to the INSS system when workers leave public employment but are allowed to carry over their years of service into the private pension system Make the formula for calculating public pensions less end-loaded. There are both efficiency and equity reasons to make the formula for calculating pensions less end-loaded. The period used to calculate the salary base for pensions should be the same for public and private employees; the best solution would be to use entire salary histories to calculate pensions, rather than the last month's salary (as for civil servants) or the last 36 months' salary (as for INSS pensions). Even without a change in the replacement ratios, given the slope of experienceearnings profiles of public and private sector workers, this would reduce the pension bill in both the systems by more than 25% for new retirees. Since earnings profiles of less educated workers tend to be flatter, the reduction in pensions would be smaller for those with lower wages Eligibility rules should be the same for private and public employees, and a minimum age at which retirement benefits commence should be instituted. The rules regarding eligibility for pensions should be made uniform for private and public employees. Raising retirement ages for occupations with preferential retirement rules (such as teachers, legislators, and judicial workers) to the same levels as for other workers, basing eligibility in both the public and private systems on the years of contribution rather than years of service, and introducing a minimum age at which retirement benefits commence would result in large savings at current replacement rates and eligibility periods. Labor Market Reforms Can Reduce Informality and Turnover in Private Employment 155. Measures to increase private employment and earnings may be as important as monetary incentives to induce public sector employees to voluntarily leave government jobs. Realistically, most government employees are likely to view formal sector jobs (that offer pension benefits and more job stability than work in the informal sector) as the alternative to their current jobs. Labor market measures to improve the likelihood and attractiveness of private formal employment are an important but underrated instrument for reducing the burden of public payroll expenses Reduction of payroll taxes will reduce informality of employment. There is mounting evidence that the high level of payroll levies of about 45% of gross wages, and the structure of systems that these levies finance, increase informality of employment in Brazil to artificially high levels. Since more than half of these taxes fund the INSS pension system, reform that lead

63 to the perception of these levies as contributions may lower labor costs in the private formal sector, and lead to employment growth. Reforms that encourage workers to view these taxes as contributing to their own pensions also increase the incentives to workers to formalize their labor contracts, leading to a growth in the share of the formal sector in private employment. Given that differentials in earnings, pensions, and job stability are smaller for public and formal private employment than those observed in comparisons of public and informal private employment, these reforms will narrow the public-private gap in compensation Reform of FGTS scheme will reduce turnover in the formal sector. While there are distinct similarities between the US and Brazilian labor markets, one of the striking differences is that while the annual US turnover rate is about 25%, the average rate in Brazil is more than 33%. While no rigorous empirical evidence is available, the structure of severance scheme for private sector workers - a fund financed by employer contributions of 8% of payroll - is widely believed to increase turnover levels to artificially high levels in the formal sector, and even to increase informality of employment. Reforming the FGTS system (e.g., by reducing the penalty for unfair dismissal to the pre-1988 level of 10%) to reduce the perverse incentives to workers to "get fired" will reduce turnover rates and, by increasing investments in worker skills by firms, lower turnover rates to normal levels. By narrowing the gap in job stability between public and private sectors, these reforms will also help to lower the costs of public sector downsizing Reform of selected labor laws will increase employment and earnings. Reform of relatively strict hiring and firing laws will lower the duration of unemployment in the formal sector, and thus reduce the payments required to induce public employees to voluntarily leave the public sector. Delinking minimum wages from pension benefits will reduce the sharp increases in fiscal burden that accompany even small increases in the minimum monthly salary. Additionally, since the ceiling on private sector pensions is fixed at eight times the minimum salary, it can be argued that relatively wealthy workers gain more from this parity relationship than poorer workers. A more efficient labor market will accelerate the growth of earnings of private workers, and narrow the public-private gap in earnings. Administrative Reforms Can Reduce Public-Private Job Stability Differentials 159. Constitutional changes proposed in the administrative reform bill being debated in Congress have received a lot of attention, and are being monitored as a signal of the government's resolve to accelerate the fiscal adjustment process initiated via the privatization program. The most contentious clause in this bill is the revocation of job stability for civil servants, which is regarded as necessary to facilitate cost-efficient downsizing Immediate fiscal benefits of tenure revocation are uncertain. A review of the experience with downsizing casts doubt on the likelihood of immediate fiscal benefits of this clause. Even employees who do not have tenure (CLTistas in public administrations and enterprises) are being "bought out" with indemnity payments, even though many of them can legally be fired. The main constraint to successful and sizable downsizing of public employment appears to be political will, rather than constitutional. Thus the passage of this bill is unlikely to encourage state governments that lack the political will to adjust, though state governments that have displayed the political will to reform will obtain somewhat higher fiscal benefits because they will be able to reduce indemnity payments. For state governments that are reluctant to reform, passage of this bill removes an excuse to delay adjustment. But state governments