TCS Daily


Law and Order in Brazil

By Roberto Fendt - March 1, 2004 12:00 AM

RIO DE JANEIRO, Brazil -- In the front page of his major work, Principles of Economics, just below the title, Alfred Marshall wrote: "natura non facit saltum" -- nature makes no leap. Were he a Brazilian professor and author, he could have added that, for a normal business climate and the sound attraction of much needed foreign investment, it would be desirable that "lex autem non facit saltum" -- law makes no leap either.

"The role of institutions in the process of economic development has received increased attention over the last few decades," says Armando Castelar Pinheiro, an economist with the Applied Economic Research Institute of the Ministry of Planning and Budget. This is due to the fact that a stable institutional setting reduces transaction costs, which in turn increases efficiency and promotes investment -- and, ultimately, growth and development. Besides, a modern market economy cannot work without formal contracts -- by definition, the main feature of a modern market economy is the fact that transactions are more often impersonal than not.

Property rights are the raw materials and their exchange the reason for contracts. To protect this exchange of property rights, and enforce what the parties to a contract have voluntarily agreed, arises the need for stable laws and good court procedures. Like it or not, human interaction leads sometimes to conflicts; good laws anticipate and prevent them; good courts solve what had not been anticipated and prevented. The role of good and stable institutions is simply to solve inevitable conflicts as cheaply as possible -- or, as Pinheiro has put it, at the lowest transaction cost possible.

Jacy Mendonça, a professor of Constitutional Law in São Paulo, has carefully analyzed the new trends in the legislation and court decisions in Brazil, and their consequences on contracts. For instance, the debtor may demand at a court the termination of the contract whenever his obligation "becomes excessively onerous, with an extreme advantage to the other party, due to extraordinary or unpredictable events" (Brazilian Civil Code, art. 478); and if only one of the parties is obliged by the contract, that party may request at a court a mandatory reduction of its obligation or a change in the terms of the contract, in order to be able to bear its responsibility and to avoid it to become excessively onerous" (art. 480). As Mendonça rightly puts it, "the [provision in the] new Civil Code may serve the purpose to correct a severe injustice; but, as broadly written as it is, it may well serve the purpose to allow one party to perpetrate a severe injustice on the other," adding injury to offense, if I may add.

One example illustrates the issue. Between 1994 and 1998, Brazil opted for a quasi-fixed exchange rate regime. Based on the expectation of a stable exchange rate, several dollar-indexed leasing contracts were celebrated; when, in January 1999, a freely floating exchange rate substituted the previous regime, the exchange rate almost doubled in a matter of days. Debtors took their contracts to the courts; and, in several decisions, it was stated that such a big leap in the exchange rate could not be anticipated, making the obligation excessively onerous for the debtor. For this reason, the courts mandated changes in the leasing contracts. In other cases, the courts recognized that, although the devaluation made the obligation excessively onerous for the debtor, the creditor would face a similar excessively onerous obligation, since the leasing company had borrowed abroad and its bank debt was equally influenced by the devaluation. In this case, the court decided to split between the parties the unexpected effect of the devaluation.

Examples of institutional instability are well and alive. This week, the Brazilian Senate starts discussing the Provisional Measure 144/03, which introduces drastic changes in the electricity tariff structure in Brazil. By the new rules, electricity prices to consumers will be an average of the price of "old" energy -- generated by depreciated hydro plants, all of which state enterprises -- and the price of "new" energy, generated by high-cost, brand-new thermal plants. The end result is an artificially low energy price and a disincentive for new investment in power generation, part of which could come from abroad.

Such government interventions turned, in first case, the results of contracts completely unpredictable; the risks introduced by the legislation and the different court decisions raised transaction costs and reduced the volume of investment that might have taken place. In the second case, a major price in the economy is determined by government, which replaces the market and introduces the risk of a new blackout in the future. Again, erratic regulation and institutional risks reduce potential investment and the ability of the country to grow faster and solve sooner its many social problems.

Roberto Fendt is an economist based in Rio de Janeiro.

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