Interest rates had to be kept at high levels to control aggregate demand in view of the lack of further fiscal adjustment. The impossibility of a more drastic reduction of the rate differential between domestic and foreign assets, which would naturally discourage the inflow of foreign financial savings, resulted in measures that would make it possible to attenuate the monetary impact of the foreign sector, without interrupting the process of integration with international financial markets. As the Central Bank of Brazil noted in its 1994 Annual Report, The controls were intended to maintain a suitable interest rate differential, while minimizing currency appreciation pressures and sterilization costs. Starting in mid-1993, the authorities began to introduce numerous control measures to reduce short-term capital inflows, with an emphasis on fixed income securities. These inflows were further facilitated by regulatory changes implemented in 1987–92, which amounted to a further liberalization of capital inflows (in particular, by giving foreign investors an exemption from domestic income tax on capital gains). Inflationary expectations fueled by persistent government financing needs gave rise to a large interest rate differential, which, in turn, led to accelerating capital inflows in the context of a tightly managed exchange rate regime. Attempts to contain it, involving combinations of price and wage controls, efforts to tighten monetary policy, tax increases, freezes of bank deposits, and sequestering of financial assets, were generally unsuccessful. The macroeconomic situation in Brazil at the beginning of the 1990s was characterized by persistent inflation.
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