Global Management Practice – Reflection Paper

Tackling the “Custo Brasil”: a policy approach

REBECCA RYAN – TOMMASO STORARI

FGV-EAESP, CEMS MIM

17/03/2015

1. Custo Brasil: facts and components The Custo Brasil refers to the additional cost of doing business in Brazil that companies have to bear due to inefficiencies and peculiar factors of the country. The many drivers can be grouped in four main categories, namely a) taxes and corruption b) labor market issues c) management practices d) weak infrastructure. These issues contribute to increased costs and consequently prices in the country; a study from Gerência de Estudos Econômicos da Firjan (Gerência de Economia e Estatística, 2013) showed that unitary costs increased by 40% in the period 2008-2012, while prices of industrial products show a markup of 20% to 30% relative to Developed Economies and China respectively. Another study from the Boston Consulting Group shows that production is now 23% more expensive in Brazil than in the United States, despite the fact that in 2004 it was 3% cheaper(The Boston Consulting Group, 2013). These issues have remarkable social, economic and political implications. On one side, Brazil became an ever more expensive place to live in, exacerbating the social tension among population groups and between the citizens and the government. On the other hand, rising production costs reduced Brazil’s attractiveness as far as FDI and manufacturing are concerned, weakening the country’s position in the international industrial forum.

This paper will focus on two drivers of Custo Brasil, corruption and labor market issues. In the following pages, their size and economic impact will be evaluated, and subsequently policy implications will be drawn and a scope for action will be proposed. A tentative comparative approach will be used to understand which intervention will lead to the most significant short-term gains and improvements. The main aim of the paper is to demonstrate how severely these two topical areas affect Brazil’s economy and business environment. Subsequently, it will be argued that effective and targeted policies to improve the labor market can yield immediate and tangible gains that can boost output in a short-run horizon, while tackling the corruption problem will require a different, more extensive approach that will display results in a more long-term horizon.

2. Corruption Corruption is captivating the headlines in Brazil and the world over with the recent Petrobras scandal that has emerged, deemed “the most daring and outrageous corruption scheme and embezzlement of public funds ever seen in Brazil.” (Antunes, 2013) This controversy has shed light on an embedded and integral part of Brazilian culture and how business is done in Brazil. The state owned Oil Company, Petrobras was illegally diverting 3% of its value to slush accounts for political parties (The Economist, 2015). The outrage across the country was heard with people expressing their disappointment with a failed and corrupt government when pots were banged throughout at least five major cities in the country during President Dilma Rousseff’s speech, proposing belt-tightening, fiscal austerity policies to get the country back on its feet (Merco Press, 2015). What the Brazilians may find even more disheartening about this case however, is the involvement of President Rousseff. A President that promised change for her country, one that fought aggressively against such dishonesty, one that defended her role to bring about change – all conditions upon which she was elected (Antunes, 2013). Her failure therefore is not only to the nation she fought so courageously for, it is also a failure of the fight against corruption in the country. This unfortunately, is just another corruption scandal in Brazil, a country with a long history of bribery. The Mensalão Scandal that emerged in 2005 was another such case. Political figures organized a vote-buying scheme whereby quick congressional approval was ensured in a diverse coalition government where consensus was difficult. In 2012, allegations were made against thirty-nine politicians of which twenty-five were sentenced for criminal charges. (De Salles Brasil, 2013)

These corruption cases are more detrimental to the economy than the image of Ms Rousseff and fellow politicians alone. To put into perspective, if the money in the Petrobras case had been invested in Brazil’s education system, the number of Brazilian students enrolled in elementary school could be improved from its current 34.5 million to 51 million (Antunes, 2013). Such an investment would allocate precious resources

that would contribute to lifting people out of poverty by improving their qualification and chances of finding a source of remuneration. Instead, the impact of corruption and lost funds is counter-productive to the whole economy. Following the controversy surrounding the Petrobras case, the real tumbled by 5% against the dollar amid the political uncertainty surrounding the “Janot list” (where politicians where named for investigation). Inflation reached 7.7% in February, the highest in a decade (pushed up in part by long overdue hikes in regulated prices for fuel and electricity). The central bank raised interest rates last week at 12.75%, meaning that they are now back to where they were just after Ms Rousseff first took office in 2011, and up from 7.25% in 2012-13 (The Economist, 2015). These are all indicators of an economy that is struggling to emerge, and with Brazil being the poorest performing BRIC country in terms of GDP growth in recent years, people are now starting to question its merit as an emerging BRIC economy (Pereira, 2013). Austerity measures following such scandals seems too little too late in terms of recovering a prosperous GDP growth for 2015.

Where does this corruption stem from and why does it seem to be archetypal of emerging economies? The nature of social practices in a country can be seen as a reflection of the long-term development and organization of its social and political system. These countries’ particularistic and personalized social structures remained in place as financially poor and administratively inefficient central states in the past were forced to rely on ‘regional brokers’ at local level and were seen as an important social mechanism. The existence of these strong clientelistic networks may contribute to the development of a path dependency, in which it becomes almost impossible to escape from what Donatella Della Porta has described as the ‘vicious circles’ of clientelism-corruption-clientelism and poor administration-corruption-poor administration. Another view is that corruption is the product of growing state intervention, where an increasing amount of decisions is left in the hands of a few with greater financial resources (Heywood, 1997). The jeitinho in Brazil is a case in point. It rests on the use of personalistic ties to temporarily bypass formal rules, for example, moving to the front of the line because of personal connections. People are aware that the formal systems often produce inefficient results and are prepared to make exceptions, leading to a cordial and informal social style (Holanda, 1996).Thus, the administrative order is temporarily inverted in order to consolidate the interpersonal order (Islam, 2010). The transitions toward democracy and market economies have not yet overcome this culture of corruption. Furthermore, setting up institutions that monitor corruption often appears more a publicity and marketing ploy to boost a government’s public image, a way to create a pretense that action is being taken whereby people no longer protest. It seems unrealistic to believe that those who benefit from corruption will be the ones who will eradicate it (Salas, 2014). National power is simply not enough to tackle such an issue that is so embedded in the culture. International Organizations that provide transparency to the people of their government needs to happen for even a hope that corruption will cease to exist in Brazil’s future.

Corruption - comprising all kinds of is the improper use of resources, such as bribery, nepotism, extortion, use of privileged information, fraud, and others for non-official purposes (Houaiss and Villar, 2001) – appears to be a dominant feature of an emerging economy, and yet it is also a severe hindrance to its chances of development to an advanced stage. Brazilian stockholders have become aware of the risks involved in unethical procedures and are adopting the Best Practices of Corporate Governance initiative. International agencies have intensively supported organizations and governments in an effort to define policies that inhibit illegal or corrupt cultural habits throughout the world, but despite this, Brazilian practitioners show insufficient response (Halter, et al., 2009).

Globalization and democratization are two important transparency promoters. Transparency is no longer a choice. The society is demanding and pressuring governments and organizations to implement it (Halter, et al., 2009). Such an organization has to be international in order to ensure a non-biased source. Transparency International, together with Social Accountability International (SAI) developed the Business Principles for Countering Bribery (BPCP) and together are one such organization that seeks to empower anti-corrupt

movements in countries. Its 2009 edition brings recommendations of greater emphasis on public reporting of anti-bribery systems and enterprises commission external verification or assurance of their anti-bribery program (Halter, et al., 2009).

These initiatives are gaining momentum and result surely positive, as they stimulate thinking and awareness on the problem and promote honest and fair practices throughout companies. However, their direct effect on the Custo Brasil issue is uncertain. In her article, Rita Ramalho challenges the effectiveness of anti-corruption campaigns (Ramalho, 2004). Furthermore, given the informal and voluntary nature of such measures, the impact on Custo Brasil will be related to the speed and capillarity with which such practices are adopted and implemented, and on their accurate enforcement. Finally, as argued by Athanasouli & Giroud (Athanasouli & Goujard, 2012), high corruption levels are associated with poor management practices, and this can lead to a vicious circle whereby conflicted managers avoid adopting such business practices, perpetrating unfair and dishonest behavior.

3. The labor market issues The other determinant of Custo Brasil analyzed here is the inefficient Labor market. The unemployment

level of Brazil has been low and declining in recent years. Yet this result may convey unjustified optimism

and conceal thorny issues. Particularly when put into the context of the last years’ sluggish GDP growth,

such low unemployment level may be connected to rigid labor laws and low labor productivity, and

eventually lead to unjustified high cost for firms and inefficiencies in the market. Truly, part of the fall in

unemployment is attributable to a decrease in the labor force. Although this could bring about the issue of

discouraged workers (which do not figure out as unemployed but still represent a social issue), there is

evidence that part of such decline is due to an increase in schooling, and this is good news.

As mentioned before, Brazil is not a low-cost country when it comes to manufacturing. As shown in Figures

1 to 3, Brazil regulation is pretty generous in terms of minimum wage compared to other countries,

especially in relation to the value added produced by a worker. This affected its relative cost

competitiveness vis-à-vis other countries up to -15%, as depicted in Figure 4. The contrast is even more

striking in Figure 5, where Brazil displays a manufacturing cost index in line or even higher than most

developed economies. The index score for Brazil was 123, compared to 100 for the U.S.A., 96 for China, 91

for Mexico. Not surprisingly, the biggest share of this score is labor-related. High labor cost per se is not a

problem. However, it becomes critical when coupled with disappointing productivity levels. As displayed in

Figures 6 to 8, Brazil performed poorly on this dimension. Data of the Total Economic Database show GDP

per hour worked remain flat in a decade; total factor productivity, as calculated by The Economist (The

Economist , 2013) , declined significantly.

This mismatch between wages and productivity is in part regulatory-originated. It is argued that labor

market laws are excessively protective of employees (for example in terms of benefits, pension funds and

minimum wages), rigid in terms of workers deployment and onerous in terms of taxes

(Knowledge@Wharton, 2007). This increases the cost for firms, but this high cost does not find justification

in productivity gains. Furthermore, the low productivity of labor may even reinforce the problem, as firms

need to hire more workers, ceteris paribus. Not surprisingly, The Boston Consulting Group (BCG) estimated

that “approximately 74% of GDP growth over the past decade was due to increase in the number of people

working and only about 26% can be attributed to productivity gains” (The Boston Consulting Group, 2013).

Add to this the decline in supply for labor, driven by increased schooling and demographic changes, and the

room of maneuver for companies to further narrow down, exacerbating the issue. This may imply additional

increases in costs, time lost for bureaucracy or in tribunal to deal with labor law issues and the infamous

yet frequent recourse to “informal” employment.

A final mention is due to skills and competency level. The above-mentioned report by BCG also uncovered

issues related to a shortage of skilled and high-qualified labor among companies. This “scarcity” negatively

affects companies not only because it raises labor costs further (due to high bargaining power of skilled

workers), but also because it somehow limits the extent to which firms can find talented and trained

personnel to grow and compete. The issues appears to be connected to the quality of education and training

rather than its quantity. Indeed, government spending on education is among the highest among OECD and

most developing countries (OECD, 2012). The issue is rather in the allocation. As The Economist illustrates,

most funding is concentrated to higher education, and less to primary and secondary school education (The

Economist, 2013). This creates a bias, in the sense that those who have access to high-quality university

education are children of rich people who could attend private school. This not only has implications in

terms of fairness and equality, but it is also economically inefficient, as investing more resources in primary

and secondary school would benefit a larger fraction of the youth population and increase chances of

university attendance and development of qualified labor force. Besides this, spending also lacks in training

and educational programs targeted at people who would like to pursue off-university preparation and

workers willing to update and learn new skills.

4. Policy implications As mentioned in the beginning, our analysis of these two key drivers of Custo Brazil has a pragmatic aim in

terms of policies and possible medidas. We already stated our argument that tackling the Labor Market

problem would be a more viable option, conducting to possible short-term “quick wins” which could

contribute to a boost of the current economic situation. A more detailed and data-driven analysis of the

relative impact of the two issues could be insightful to understand which measures would yield the greatest

results. Unfortunately, this calls for extensive analysis that is beyond the scope of this work. Still, a

qualitative approach can be embraced that support our claim.

Labor market issues have been identified in three main categories: productivity, costs (connected to

regulation) and skills. Although such problems cannot be solved overnight, there is scope for government

to implement measures that have significant and relatively fast effects. For example, reallocating the

investment in schooling to primary and secondary education would have sizable effects in terms of number

of students impacted and their chances to pursue a higher degree, with positive spillovers on productivity

as well. Investment in technology can further boost specialized labor and development of valuable skills

sought by companies. The development of training and updating programs for workers can promote

updating of skills and fulfillment of qualified job requirements from companies, thus expanding the supply

of qualified labor.

For what concerns labor market flexibility, measures can be embraced to simplify tax laws, address the

issue of pension spending and rethink the benefits systems. Although these are sensitive topics, the

government shall find clever solutions to relax and simplify the regulations without necessarily reducing or

affecting the well-being of workers. According to Mrs. Fabiola Marques, professor of labor law at the

Pontifical Catholic University in Sấo Paulo, crucial labor reforms are needed. Suggested ones include the

reform of the taxation system, the change of Trade Union law to prevent that workers “are obligated to

make payments to Trade Unions that do not fight on their behalf” and changes in the norms that regulate

the relationship between companies and employees conductive to a more flexible and company-tailored

approach (Knowledge@Wharton, 2007). Such measures shall be aimed not at reducing the well-being or

wages of workers, but rather increase the room of maneuver of firms in terms of hiring policies, tax

spending and benefits spending. One suggestion by Mrs. Marques in this sense would be to allow company

to classify bonuses paid to works differently than “salary”, so to have a lower tax payable on those amounts.

Many OECD countries underwent significant reforms in both the education system and the labor market,

which in turn affected productivity, efficiency and costs. One famous and praised case is Germany in 2005

(Krebs & Scheffel, 2013). The ambitious reform plan encompassed most of the aforementioned elements,

and led to significant reduction in labor costs and unemployment in less than 2 years, originating a true

“labor market miracle”. Clearly, such measures are not easy to replicate and promulgate, the context is

different and often they bear the risk of being unpopular and controversial. Yet, we are convinced that to

improve the wage-cost-productivity issue underpinning the Custo Brasil, such reforms are of paramount

importance. Moreover, by working at the same time on both “components” of the problem (the numerator:

wages/costs, and denominator: productivity), the overall net benefit will be amplified. If properly designed

and implemented in a timely manner, such measures could yield significant changes within a moderate

period of 12-24 months, generating visible effects in terms of reduction of the Custo Brasil, positive impact

on companies and attractiveness for FDIs.

On the other hand, it was discussed above how corruption-related issues appear to be deeply connected

with Brazil’s historical and cultural development. This is due in part to a past characterized by inefficient

institutions and congested regulation, whereby people relied on networks to get things done and

circumvent the suffocating state intervention in the country. The corruption cases that have emerged in

the country are becoming more and more scandalous as political figures take advantage of their role in

society. In order for this to change, non-biased institutions need to intervene to change the mentality of

the system and provide transparency to the institutions. MNCs located in Brazil have a crucial role to play

here by enacting OECD Guidelines for Multinational Enterprises which ‘provide recommendations for

responsible corporate behavior, in particular in such areas as transparency and anticorruption’ (OECD,

2003). MNCs have the power to implement these guidelines and influence the government to improve

public relations whilst improving the economic environment in the country that they intend to operate in.

This concerted action is needed to tackle corruption, but such process will be inevitably is a more complex

and lengthy one.

5. Counter-Argument An alternative approach is also foreseeable. The Labor Market is undoubtedly one of the most complex

policy topics, and some could well argue that it would be too complex to design and pass the necessary

measures to adequately tackle these problems. Instead, it could be argued that policymakers attention shall

be directed more towards fighting corruption with more stringent laws on bribery, closer monitoring and

checks, tighter expenses and budgets to encourage appropriate spending, investments in transparency for

the public administration and publicly available information.

Furthermore, one could well claim that the Custo Brasil shall be addressed primarily by solving the

infrastructural problem, and hence concentrate the spending on this area. There is plenty of available

evidence on the obsolete and precarious condition of roads and ports, as well as on the weak investment

stock in infrastructure if compared with other developed countries. (Loman, 2014)

With respect to the first one, we believe that tighter restrictions and regulation on corruption may prove

useful, but could as well exacerbate the “formal-informal” conflict mentioned above, with the undesired

result of further nurturing the “jeitinho” practice. We stress again our perspective of effectively addressing

the corruption issue, the country shall embrace a broader mindset challenge to fight the problem out of

the regulatory scope. Government measures and initiatives can help, but they work insofar as they support

a more substantial and comprehensive practice review conducted by companies, managers, workers and

citizens in general. Hence, in this sense policy attention would be more fruitful if addressed to labor market

reforms that, if properly drafted, can improve the playground upon which business is conducted.

Regarding the second argument, it is undeniable that infrastructures deficiencies cannot be left unsolved,

especially in a country that aspires to restore to fast and sustained economic growth. Here as well, however,

we believe that the government action shall be mostly supportive. Experiences in developed economies

showed how often government-backed projects often present inefficiencies and delays, while more and

more often large infrastructural projects are carried out mostly or entirely thanks to private investors under

the supervision of public bodies. As an investment priority, we are convinced that the government shall

maintain a key focus on improving the spending and allocation on the education system and on the training

programs to promote a positive productivity shock, and at the same time, work to decrease the costs

associated with the ineffective labor market. If this plan succeeds, significant progresses in terms of Custo

Brasil reduction can be realized quickly, and this would stimulate FDIs in the country possibly conductive to

new infrastructural development.

6. Conclusion The paper uncovered the facets of two important components of the Custo Brasil, labor market

inefficiencies and corruption. An historical perspective was followed in order to trace back the corruption

problem to the country’s institutional development. The current state of government action was found to

be remarkable misaligned with the urgency and delicacy that the issue demands. Indeed, the recent

corruption scandals revealed how institutions lay right at the heart of the matter, uncovering a rooted and

idiosyncratic inclination towards such practices. Such behavior is a result of the turbulent and irregular

pattern of democratization and institutional development of Brazil, which was characterized by a “formal-

informal” dichotomy and the reliance on clientelistic stratagems to cope with the overly rigid institutional

framework. This led to a gradual blending of the borderline between the licit and the illicit practice which

distinguishes the jeitinho approach. While policymakers’ actions to curb bribery, corruption and illegal

practices are desired and important, the real key to wrestle this issue is, in our view, a mindset change. In

order to tackle the most controversial aspect of the jeitinho, it is necessary to bring about a common

reflection on the jeitinho itself and on its grounds, to discern the good practices from the bad and borderline

ones. This long process shall be fostered by a plethora of actors including companies, international

organizations, administrations and the people calling for leading figures, inspirational examples,

widespread practices, public opinion sensibility and social awareness.

On the labor market side, the problems examined encompass productivity of labor and rigidities in labor

market laws, which in turn lead to high labor costs and low flexibility for companies. A comparison with

other countries was helpful to highlight such critical areas. It was argued that government action could

prove effective in addressing this issue, mostly through targeted and well-designed reforms. Relaxing the

labor market and reducing unjustifiably high labor costs on one side, while working to improve labor

productivity through education and trainings on the other side, may represent the appropriate recipe to

combat the disappointing cost-to-productivity ratio in companies. In our view, policymakers’ efforts –

notoriously subject to time and scope constraints- would be best deployed when addressing this

component of the Custo Brasil.

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8. Appendix

Figure 1. Source: The World Bank database

Figure 2. Source: the World Bank database

Figure 3. Source: The Economist

Figure 4. Source: The Boston Consulting Group

Figure 6. Source: The Economist

Figure 5. Source: The Boston Consulting Group Figure 5. Source: The Boston Consulting Group

Figure 7. Source: Total Economic Database

Figure 8. Source: The Boston Consulting Group

Figure 9. Source: The Boston Consulting Group

Figure 10. Source: Education at a Glance: OECD Indicators 2012, OECD