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Brazil raises rates after painting itself into a corner

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Brazil is boxing itself into a corner on growth. The central bank on Wednesday raised its benchmark Selic interest rate to 7.5 per cent to fight inflation. Real GDP expansion, meanwhile, is already stalling. High public spending and rapid private credit growth, the fuels for Brazil's boom, are both reaching their limits.

The rate hike was prompted mainly by consumer prices, which in March were 6.6 per cent higher than a year earlier, above the 6.5 per cent upper limit of the central bank's official tolerance band. Individual items such as a 120-per-cent leap in the price of tomatoes have prompted media alarm, reawakening memories of episodes of triple-digit inflation in recent decades. The central bank believes that interest rate rises can be limited, provided their signalling effect against inflation is clear.

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Unfortunately, the growth that earned Brazil its place as an up-and-coming BRIC economy has already tailed off. Heavy public-sector spending and rapid credit expansion fuelled growth of an average 3.6 per cent a year in the 2000s. Last year, though, the economy grew at less than a 1-per-cent pace.

President Dilma Rousseff is running out of room on the spending front. Brazil's surplus before interest payments was only 2.4 per cent in 2012, short of the targeted 3.1 per cent. Rising interest rates will only worsen the situation.

And on the credit front, growth can only slow, too. Official figures showed a 16.8-per-cent increase in outstanding financial system credit in the year to March, almost 10 percentage points above nominal GDP growth. That follows an eight-year period during which domestic credit to Brazil's private sector increased from about 30 per cent of GDP to more than 60 per cent.

The two state-controlled banks, Banco do Brasil and Caixa Economica Federal, have pushed their share of outstanding loans to 48 per cent. They have avoided significant additional credit losses so far, but their losses may increase if interest rates rise significantly.

That means two big engines of growth are slowing just as inflation starts pushing interest rates higher, which also tends to weigh on activity. Ms. Rousseff may be running out of options.

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