A Legal and Economic update on Brazil and Mercosul

Notes for the presentation to the Investigation and Judgement Commitee of Industry Injury State Economic and Trade Comission of the People’s Republic of China in São Paulo, SP, Brazil, on November 28, 2001.


1.1.- High volatility makes life difficult for business as well as for speakers at events such as this. I had my paper ready for presentation to the organisers in early October, when Brazil’s Supreme Court ruled1, in a unanimous decision, that legislation covering the reduction of social security sinecures for public sector workers, and payment of contributions by those already retired, were unconstitutional.

In view of the rejection of US$1.2 billion from the federal budget for the new fiscal year, the government enacted, on the 7th of October, a new set of measures with a view to increasing revenue to cover the shortfall caused by the judicial discomfit. The respective provisional measure (MP)2 derogated no fewer than eight different federal tax laws3, with some aberrations that will undoubtedly be challenged in the courts. In addition, the government promised to release, on the 18th of October, the particulars of a new bill, modifying the constitution to permit the reintroduction of those measures outlawed by the Supreme Court.

1.2.- It would be no exaggeration to say that the most frequent question I am asked by business people interested in Brazil, is this: “If Brazilians are so liberal and adept at innovation, why is it so, that in your country, institutional change is so hard to come by?”.

The answer is not an easy one. Try to imagine a country of continental dimensions, with vast ethnic and geographic differences; with a very limited government experience within the rule of law; and with an enormous educational deficit, and you have a picture of Brazil. Institutional change, therefore, does not come about easily. The lack of change ensures the continuance of the problems.

1.3.- Today, I have been asked, and will endeavour, to give you a panoramic view of the very intricate reform of Brazil’s anachronistic and, on occasion, surrealistic legal structure4. I shall also address general macroeconomic conditions; the particulars of working with Brazilian trade unions; the state of current trade relations within MERCOSUL and negotiations for the Free Trade Area of the Americas. I have divided my presentation as such:



2.1- In terms of purchasing power, Brazil has the 9th largest economy in the world, estimated at US$ 1,039 billion and Argentina has the 20th largest, worth about US$ 360 billion. Fifty per cent (50%) of Brazil’s GDP comes from the service sector, with 39.3% coming from industry, and the remaining 10.7% from agriculture. The components of GDP are 69.2% private consumption, 10.8% public consumption; 20.3% investments;

13.6% exports; and (13.9) imports.5 On a regional basis, the south-eastern part of the country accounts for 59.4% of Brazil’s GDP; the south for 17.1%; the north-east 13.8; the north 4.4%; and the centre-west 5.3%.6

2.2- Unlike Mexico, which depends on the USA for 80% of its external commerce, Argentina and Brazil have a more diversified foreign trade profile. Both countries have the European Union as their main trading partner. In 1997, 27.4% of Brazil’s exports (US$ 53 billion) went to the European Union; 24.7% to Latin American Integration Association (LAIA); 17% to the USA; 5.7% to the OPEC countries; and 20.8% to others. In the same year, 26.7% of Brazil’s imports (US$ 61.4 billion) came from the EU; 23.3% from the USA; 21.8% from the LAIA countries; 5.9% from Japan; 3.3% from OPEC countries; and 19.1% from others.7 Brazil is the least trade dependent of the world’s 10 largest economies, with just 7.3% of its GDP dependent on foreign commerce. Similarly, Argentina derives just 8.6% of its GDP from external trade, putting it ahead of the USA.8

2.3- With respect to financial numbers, Brazil has the largest foreign debt of all the developing countries in the world, at approximately US$ 200 billion. Argentina has the 7th largest, at approximately US$ 125 billion. As a result, Brazil and Argentina have the second and third highest debt service of all developing countries, after Mexico, at US$ 36 billion and US$ 18 billion, respectively. Argentina has the highest debt service ratio – the percentage of debt service in relation to the country’s export of goods and services – at 58.7%, while Brazil is a close second with 57.4%. Brazil has the second largest current account deficit in the world, after the USA, at approximately US$ 34 billion, and Argentina the 4th largest, at about US$ 10 billion.9

2.4- Given this, both Argentina and Brazil are very dependent on external lending and foreign direct investment. Brazil’s privatisation programme has brought in unprecedented amounts of foreign investment, from US$ 1 billion in 1993; US$ 2,2 billion in 1994; US$ 5.1 billion in 1995; US$ 10 billion in 1996; US$ 17.5 billion in 1997; and US$ 20.3 billion in 1998.10 Projections for 1999 again indicate investments in the order of US$ 20

billion. From 1991 to 1999, 88 federal and 29 state companies were privatised in Brazil, the majority of which were in the petrochemical (27 companies); telecommunications (25 companies) and steel (8 companies) sectors.

2.5- Brazil’s public deficit, from January to July 1999, was R$ 80 billion, up from R$ 73 billion in 1998; R$ 54 billion in 1997; R$ 47 billion in 1996; and 49 billion in 1995. As a result, public debt in Brazil is in excess of R$ 500 billion, approximately 50% of GDP, even after a substantial part of revenue generated by the privatisation programme was utilised to offset loans. Part of the public deficit is generated by the social security system, estimated at R$ 46 billion for 1999. The public sector has 918,000 pensioners, raising R$ 2.9 billion per year but spending R$ 21.5 billion per year, generating a deficit of R$ 18.6 billion. The private sector has 18.5 million pensioners, raising R$ 51 billion per year and spending R$ 63 billion, generating a deficit of R$ 12 billion per year.11 The value of the average public pension is nine times higher than the private one. Approximately 80% of federal spending is allocated to wages and pensions.

2.6- In an attempt to balance the public accounts, the government has resorted to ever-increasing raises in taxation and reductions in investment. Federal tax revenue rose 58.9% between 1995 and 1998, whilst the real growth of the GDP was less than 10%. In 1998, the overall burden of the 70 taxes that exist in Brazil was 30% of corporate income. This year, it will reach 35%. Next year, it will exceed 37.5%. All eight of the different tax laws derogated by the provisional measure on the 7th October were enacted after 1995. The nightmarish Brazilian tax structure allows for the taxation of every financial movement; gross revenues and two value-added imposts, managed by the federal union and states, a service tax managed by municipalities and numerous other aberrations singular to the country. This appalling situation, in its insane harshness, is obviously not conducive to business and drives economic activity to the informal sector. Of the 4 million companies registered in Brazil, 3.6 million are presently in default with the Internal Revenue service.12

2.7. – With the restoration of democracy in Brazil in 1986, a new constitution was enacted in 1988, dividing the judiciary into ordinary and specialised courts. As Brazil is a federation, the ordinary courts comprise civil and criminal benches while the specialised courts attend to labour, military and electoral cases. Appeals may be filed to second and

third instances. At the top of the pyramid is the constitutional court – the Federal Supreme Tribunal (STF) – with 11 justices. The Superior Tribunal of Justice (STJ), with 33 ministers, is the court of last resort for non-constitutional matters. All last resort tribunals are based in Brazil’s capital, Brasilia.

2.7 Since the adoption of the 1988 Constitution, Brazil has become an increasing litigious country. In 1998, the specialised labour courts alone tried 2.3 million suits. It is estimated that more than 4 million cases were filed in the Brazilian courts in 1997. In 1998, 52,000 cases were decided by the STF with published opinions. In the same year, the STJ decided 101,000 cases with published opinions. For each MP enacted by the government, there are approximately 30,000 suits.

2.8.- In spite of such numbers, the Brazilian judiciary has only approximately 10,000 first-instance judges and 200,000 active lawyers for a population of 150 million people. Those judges are all civil servants subject to a public examination for qualification. In the higher courts, 20% of members come from the legal profession as well as from the public prosecution service, another category of civil servants. More sophisticated judges and courts tend to be found in more economically developed federal states. At present, cases normally take from 3 to 5 years before conclusion. Discovery is extensive. Litigation is expensive and the discomfited party will pay full court fees and reimburse legal costs of between 10 and 20% of the value of the case. The judiciary system does not adopt the “stare decisis” doctrine and thus every case has to be tried individually, even if higher courts have already decided the matter of law. The states and the federal government are the most frequent litigants, more often than not in the passive pole, as a result of the numerous attempts against the legal order, commonly in the economic area. Municipal, state and federal governments have a stated policy of litigating matters for as long as possible in order to defer payments for indemnification.


3.1.- The first term of the Cardoso administration, which began in 1995, was marked by some important successes in reforming areas of the 1988 Constitution. |These included giving equal treatment, under the law, to all Brazilian companies, regardless of the origin

of their capital13; and liberalisation of the telecommunications14, oil and gas15, and reinsurance sector16. Other measures were taken with a view towards liberalisation that did not require constitutional amendments, such as in banking and transportation, and privatisation of sectors not protected by the constitution.17 The monetary reform had already been effected in July of 1994. The Real plan, as it became known, was a series of temporary measures with a view to stabilising the currency until structural reforms were implemented. The plan over-valued the local currency by approximately 35%, in order to make imports cheap and thus check inflation. It also involved very high interest rates to attract foreign financing and substantial tariff liberalisation.

3.2.- The time bought by these measures was ultimately lost by the failure of government and Congress to act decisively to reform the institutional infrastructure. As a result, the currency was under a massive pressure at the beginning of 1999 and was devalued in January.

As far back as 1996, the federal government knew it needed to balance the public accounts, reform the state and improve the overall business climate, and it had an agenda of strategic objectives to do this.18 In order to achieve such aims, the Cardoso administration proposed administrative, social security and tax reform. It is tragic for Brazil and MERCOSUL that none of these have yet been passed, and are either floundering in Congress or foundering in the judiciary. However, two other reforms were added to the agenda, one pertaining to the judiciary and the other, to the political structure of the country.

3.3.- The social security reform attempts to balance benefits with contributions, as well as correct numerous loop-holes in the system which allow for early retirement, accumulation of pensions or exceptionally high annuities for a few privileged people. The government also wants to alter the criteria for the calculation of pensions, with a view to gradually tying them more closely to the amount contributors have paid in, over the years. As I mentioned at the beginning of this presentation, Congress passed a

government bill to increase the contributions by higher wage earners within the public-sector, and deduct contributions from those already retired. This bill was ruled unconstitutional by the STF.

A new legislative initiative modifying the constitution to allow for such measures is expected in the near future. As, however, a special majority quorum of two-thirds will be required, its chance of success is by no means clear. It must be said that some important modifications to the social security system have already been passed, such as the increase in the minimum retirement age to 55 years for women and 60 for men and new rules for proportional retirement.

3.4.- The administrative reform seeks to rationalise the public service in Brazil, making it more efficient, less costly and more manageable. It attempts to eliminate, in most cases, the stability or tenure system in place today which does not allow for dismissals or redundancies. The government also intends to require legislation for salary increases to employees in the three branches of government. Part of the reform has already been approved in connection with redundancies, motivated by excess personnel. However, opposition parties, who want to retain the tenure system for the civil service, are suing in the STF. |Meanwhile, the STF is resisting the proposal to require legislation for salary increases.

3.5.- Tax reform is a constant demand of the business sector in Brazil. The taxation-derived costs of doing business in Brazil today are so high that they have adversely compromised the competitiveness of Brazil-based companies on a global scale and even internally, in an open economy. The sheer madness of Brazil’s tax structure, with approximately 70 different imposts, has driven important, aggregated sectors into the informal economy, which has the dreadful corollary of the corruption of tax agents. This is when it has not encouraged capital flight and diverted investments to other countries. The tax system’s gross imperfections have also encouraged a major fiscal war between federal states, with a view to attracting investments.

3.5.1.- There is currently a bill before Congress which intends substituting 9 taxes, including the tax on financial transactions (CPMF), with three: one value-added tax to be shared between the states and the federal government (ICMS); one import duty to be levied by the federal government (II); and one sales tax to be levied by municipalities (IVV).

The government supports the bill in part only, as it wishes to maintain the CPMF and the ability to create new taxes by provisional measures and presidential decrees. States and municipalities do not wish to share tax revenue with the federal government. The opposition wants to create new taxes, including a 10% solidarity tax on assets over R$ 100 million.19 It must be pointed out, however, that commodity exports are no longer taxed by the states to the chagrin of the governors who miss the lost revenue.

3.6.- Of the numerous reforms necessary in the country, the one lowest priority is undoubtedly the restructuring of the judiciary. This is not to say that the Brazilian judiciary is perfect. Despite its shortcomings, the judiciary is the one power with the most credibility in Brazil. Against the 4 million suits filed in 1997, there were less than 100 arbitration cases. Reforms are, of course needed to establish: a better framework; the enlargement of the structure; more training; better facilities; and external control.

Considering the government is the most common defendant in the courts, and, keeping in mind the years of repression the rule of Brazilian law has faced under past dictatorships, the Brazilian Bar is firmly against the adoption of the “stare decisis” doctrine, as it may be abused. Legitimate rights could be thrown in the common grave with matters already decided.

In the current bill for judicial reform, the extinction of the military justice, and its prosecution service, is contemplated, along with major restructuring of the labour justice.


4.1.- Brazilian unions were first introduced by the fascist regime of Getulio Vargas in 1930 and have retained many of the vices from this period, to the present day. Unionism in Brazil was initially rural, controlled by the state, with benefits granted by the state and financed by the state. Many important modifications were introduced in 1978, during the military dictatorship, and later with the reinstatement of democracy in 1986 and the Constitution two years later.

4.2.- Labour relations are regulated by the Consolidation of Labour Laws (CLT), and numerous complementary laws and administrative rulings. The laws cover employees for up to two years after termination of the labour contract. The statute of limitations for labour claims is five years. There is a specialised labour justice, which accounts for approximately 50% of the budget of the judiciary power.

Labour relations in Brazil are very litigious. An employee is not allowed to waive any rights or benefits, stated by law, in an employment contract. Workers are required to hold workers’ booklets in which the terms of the professional relationship are recognised. Mergers and acquisitions do not affect the labour rights of an employee. Labour credits are privileged. Employers and unions negotiate salary increases on a annual basis. Social costs to be born by the employer represent up to 80% of the value of the salary.20 In view of such extraordinary costs, most workers in Brazil now operate in the informal market, where the law of demand rules, and very few rights recognised.

4.3.- Employers make contributions of 8% of the employee’s monthly remuneration to the Severance Pay Fund (FGTS. If an employee is dismissed without just cause, the employer pays an additional 40% of the previous deposits, plus respective earnings during the time of employment. Contracts can be terminated without just cause with 30 days notice. Pregnant workers may not be dismissed. Employers may not terminate the labour contract of a candidate for a union post or a former union leader until one year has elapsed after their final term of office.

4.4.- Unions in Brazil are conservative and support the paternalistic structure inherited from the past. They have been politically stronger since the reinstatement of democracy, even if the percentage of workers, who are members, remains low by European standards. The main unions are CUT, which claims to represent 23 million workers and 2 000 entities, and is very closely related to PT, the Labour Party, the main opposition party; CGT, which claims to represent 15 million workers and 1 200 entities; and FS, which claims to represent 8.5 million workers and 800 entities. The unions are organised nationally and have chapters in all states. The national boards are very small, in proportion to national membership. CUT, for instance, has only 25 members in the national executive board.

4.5.- Labour unions have been difficult to work with, as they are often eminently ideological and closely associated with political parties in opposition, who have very limited experience in regional government. Unions have traditionally failed to appreciate that an improvement in the general business climate will result in better and more numerous employment opportunities.

However, one can detect a slow improvement, as the harsh lessons of massive informal employment options and formal unemployment settle in the leadership. Potentially, business and labour are the greatest natural allies, as economic growth benefits both. Thus, dialogue with the labour unions has become essential for business expansion in the country. The fact that labour unions are closely associated with political parties should be interpreted more as an opportunity than an obstacle.


5.1.- The Treaty of Asuncion signed on March 16, 1991, which created MERCOSUL among Argentina, Brazil, Paraguay and Uruguay, had as its objectives:

i) the free circulation of capital; goods; services and people;
ii) the creation of a common external tariff and the establishment of a common external trade policy; and
iii) the co-ordination of macro-economic policies.

5.2.- Brazil negotiated MERCOSUL with an agenda of regional political leadership, rather than concrete economic benefits, unlike the Argentines, who negotiated in close contact with its business sector. For Argentina, the major benefit of a trade bloc with Brazil was preferential access to Brazil’s enormous internal market, which would leverage economies of scale non-existent in Argentina, and which would make the country more attractive to foreign direct investment. On Brazil’s part, this policy made the country open its internal markets to the Argentine wheat and automotive industries, whilst allowing Argentina to retain barriers to sugar, Brazil’s most competitive commodity for 400 years, and a sector which employs 1.2 million rural workers. Such a situation enabled Argentina to attract large investments for its automotive sector, as it had assured access to the large Brazilian market and a better institutional environment.

5.3.- This adversely competitive scenario for Brazil, vis-à-vis Argentina, was further exacerbated by Brazil’s fiscal incompetence, which prompted it to launch a short-term economic project, the Real plan, implanted in 1994, which saw the currency over-valued to make imports cheaper and thus combat inflation. With the same purpose, interest rates were raised to unprecedented levels while import duties were lowered to record levels. As a result of the Real plan, the Brazilian currency was overvalued by 35% with respect to the Argentine peso, only increasing the competitiveness of Argentine products in the Brazilian market. In the five years of the Real plan, Argentina accumulated a trade surplus with Brazil of more than US$ 6 billion21.

5.4.- Since the beginning of the Menem administration, Argentina has passed legislation adopting the currency board, which pegs the Argentine peso to the US dollar at rate of one to one. Although radical, this measure was nevertheless very well received by the Argentine people tired of institutionalised monetary instability. However, the Argentine Central Bank waived control of monetary policy as a result of the currency board system, subjecting the country to the risks of currency flotation against the US dollar with respect to the currencies of other trade partners, such as Brazil22.

5.5.- Although Brazil maintained monetary stability, the combination of advantages gained under the Treaty of Asuncion and the overvaluation of the Brazilian currency meant Argentina’s battered business sector achieved a high degree of competitiveness in Brazil. It became Argentina’s largest trade partner, absorbing approximately one third of Argentine exports and half of its exports of manufactured goods. Furthermore, Brazil became the only country with which Argentina had a trade surplus, which is very indicative of the distortions in place.

5.6.- In the middle of January 1999, Brazil devalued its currency, neutralising a good number of the advantages that favoured its MERCOSUL partners. Consequently, Argentina, Brazil, Paraguay and Uruguay fell into grave social and economic crisis threatening not only MERCOSUL as an institution, but political stability in the region. Such crisis triggered very serious trade conflicts between Brazil and Argentina in several sectors of economic activity. Argentina desperate attempts to preserve the status quo and thus avoid the collapse of its monetary policy. In order to offset the newly-achieved

competitiveness of Brazilian products in its internal market, Argentina used several expedients, legal and illegal, to restrict the access of Brazilian exports in sectors of reciprocal importance, such as steel, textiles, paper, electronic goods, poultry and shoes.

5.7.- Accordingly, Argentina managed to maintain, in the first 6 months of 1999, a slight surplus in the trade balance with Brazil, even though diplomatic trade talks practically collapsed affecting many economic sectors in both countries, none-the-least the automotive sector which requires a new common regime by the end of this year in view of multilateral commitments assumed by both countries before the World Trade Organisation (WTO). Some automotive companies, probably sensing the difficulties in the formulation of a new automotive regime in the current scenario have already moved their assembly lines from Argentina to Brazil.

5.8.- The inability of Brazil and Argentina to deal efficiently with their institutional problems led to the failure of most of the Treaty of Asuncion’s objectives. Accordingly, the free circulation of capital does not exist because Brazil continues to administer exchange controls. The free circulation of goods does not exist at the moment due to; the numerous exceptions to the common external tariff; to treaties signed by Brazil and Argentina outside MERCOSUL; and to the recent idiosyncratic treatment of regional trade with numerous non-tariff barriers. For example, voluntary restraint agreements became a common way to avoid bilateral conflicts. Lastly, the co-ordination of macro-economic policies has become a joke, after the way in which Brazil handled the devaluation of its currency.

5.9.- Whilst MERCOSUL is in deep crisis, negotiations continue for a FREE TRADE AREA OF THE AMERICAS (FTAA). These negotiations are hindered by the lack of fast-track authority by the US Congress under the current American administration. The proximity of US elections constitutes an obstacle to the granting of such authority in the near future. The upcoming round of negotiations of the WTO is also going to affect the rapid progress of the FTAA initiative. The negotiations are also being deeply affected by the present economic turmoil in South America. However, the FTAA’s next ministerial meeting in Toronto, Canada, on November 3 and 4, is expected to approve business facilitation measures in the area of customs. Such measures would include codes of conduct for customs officials, procedures for express and low value shipments, and temporary admission procedures for business travellers23.


6.1.- Both Argentina and Brazil have established, as priorities, the institutional reforms of the tax system; social security; labour relations; public administration; and of the judiciary. Both countries have advocated the institutional policy of achieving a fiscal balance within a climate conducive to private economic relations. It is the tragedy of MERCOSUL that both Brazil and Argentina have failed miserably to do so.

6.2.- Even if achieved, fiscal balance obtained without radical improvement to the overall economic and business climate would cause the failure of the model of open economies applicable to both Brazil and Argentina. This would result in the foundering of MERCOSUL. The alternative of a closed economy, much to the taste of populists, will bring about economic stagnation, misery, unrest and probably violations to the rule of law.

6.3.- Regional and national governments have to learn to spend less money, more efficiently. A radical tax reform should be implemented in order to establish a system compatible with those of our main trade partners, in order to allow for the global competitiveness of MERCOSUL industries and businesses. Labour laws should be equally modernised in both Argentina and Brazil, and the objective of legal harmonisation within MERCOSUL offers such an opportunity. Brazil cannot desire to be a competitive global trader and major recipient of foreign capital investment with exchange controls in place. Argentina cannot expect MERCOSUL to survive if it continues to peg its currency to the US dollar. A common currency could be a viable alternative, if the adequate conditions were in place. Lastly, MERCOSUL could do with a credible Regional Trade Tribunal or Court of Justice.

6.4.- In any event, MERCOSUL can no longer exist if adequate institutional economic conditions are not in place in Brazil and Argentina.