Author: Luis A. Vinhas Catão

Source: Valor Econômico, 08/10/2008

In these days of acute financial turmoil, there is a risk that we will lose sight of the important achievements of Brazilian economic policy in recent years and their longer-term benefits. They include not only levels of inflation well below those recorded in the post-war period and lower than most emerging countries, but also inflation that is less volatile. But, not least, the volatility on the real side of the economy (measured by the so-called GDP gap) has fallen a lot, by about a third since 1999. It is notable that this has occurred despite the strong financial shocks arising from domestic political uncertainties (as in 2002) and external adverse factors (as during the Argentine default in 2001, and more recently in the American financial crisis). Important institutional arrangements, such as the inflation targeting regime and the fiscal responsibility law, support such achievements.
A notable benefit has been the reduction in credit risk. On the credit supply side, such risk includes not only the greater probability of default by the borrower when the real economy is adrift, but also the risk of inflationary erosion of the loan value when inflation is high and volatile. Since such risks are minimized by a more stabilizing economic policy that anchors inflation expectations, the lender typically reacts by lowering interest rates and extending the term of the loans. On the demand side, confidence in macroeconomic stability also encourages credit, as it facilitates the predictability of the future and thus the financial management and indebtedness of companies. The combination of these factors explains the strong expansion of domestic financing to the productive sector in Brazil between the end of 2003 and the first quarter of 2008, when bank credit to private companies rose from 15% to 22% of GDP. This happened in parallel to a declining trend in the bank spread. The still high level of this spread and the fact that the cost of credit has increased in recent weeks with the external financial shock should not make us lose sight, however, of recent gains and the declining trend of interest and upward domestic credit. These are expected to continue as adverse external winds hit and economic policy keeps its course, thus making it possible to limit the effects of temporary financial cataclysms on the real economy.

Such beneficial effects of a responsible economic policy on domestic credit have had a very important and neglected effect in the national macroeconomic debate: that of reducing informality and stimulating formal employment. On the one hand, better lending conditions in the regulated credit market increase the so-called opportunity cost of informality, as it prevents or limits access to that market. This induces informal firms to legalize. On the other hand, cheaper and longer-term domestic credit encourages the expansion of firms that are already formal, thus also stimulating aggregate formal employment.

Prima facie, the data suggest a strong correlation between the two phenomena. The strong credit expansion since 2004 coincides with an increase in the formalization rate in the economy: workers with a formal contract rose from 38% of the urban workforce, in early 2004, to about 45% in the current year. Results of a survey conducted at the Inter-American Development Bank (IDB) by the author, co-authored with Carmem Pagés and Maria Fernanda Rosales, indicate that the contribution of domestic credit to job formalization is significant: sectors whose growth depends more on credit from third parties are those where informality has fallen most. This result is robust to alternative definitions of formality (having a formal contract or contributing to Social Security) and also to different econometric specifications that, among other factors, take into account the effects of better inspection. Another important variable captured by the same survey is that greater access to credit apparently induced workers with their own businesses to formalize.

Another interesting aspect of the greater formality of employment in Brazil is that it materializes during a period of strong exchange appreciation. Such an appreciation in principle would have the power to reduce the competitiveness of the domestic manufacturing industry, inhibit employment in the sector and lead to a reallocation of employment to the service sector, where informality is greatest. However, the opposite is observed: formalization has gone up, instead of going down. Greater availability and lower cost of credit may also help to explain such an expansion of formal employment among larger industrial companies, although these are typically less subject to credit restrictions on micro and small companies. This is the theme of a project recently started by economists Márcio Garcia, from PUC-Rio, and Sérgio Mikio, from the Central Bank Research Department and his team, in conjunction with the present author, which aims to examine the various links between the credit, labor and goods market behind formal employment in Brazilian industry. Such a project requires an important effort to cross the database between the Central Bank, IBGE and the Ministry of Labor - something that, although complex, should bring important benefits for the understanding of the phenomenon. The practical implications of such an understanding are obvious: the reduction of informality not only creates better employment conditions, but also leads - according to several studies to other countries - to greater productivity growth and, therefore, to the capacity for sustainable economic growth.

In short, a lot of work remains to be done, but it is certain that the most stabilizing and fiscally responsible macroeconomic policy in recent years - anchored by the Fiscal Responsibility Law and the inflation targeting regime - has had positive effects on formalizing employment in Brazil through the credit channel. This reinforces the importance of maintaining such a policy in order to stabilize and keep inflation under control and limit external financial contagion, and thus avoid the return to past cyclical volatility. This, by increasing credit risk, reduced the supply of credit, fostered informality and conspired against the quality of employment and worker productivity. Although often overlooked in the macroeconomic debate, this is a bonus that we must not lose sight of.

Luis A. Vinhas Catão is a senior economist at the Inter-American Development Bank (IDB) and the International Monetary Fund (IMF) and a PhD in Economics from the University of Cambridge. The opinions expressed in this article are those of the author and do not necessarily represent those of these institutions.