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Get Real

Get Real

Less than four months from now, billions of people around the world will focus on Brazil as the World Cup kicks off in São Paulo. But some Brazilians are looking forward with as much trepidation as pride, and not just because of their soccer team’s form in recent tournaments. Under the spotlight, their economy may be revealed as much less than meets the eye.

It’s easy to beat up on Brazil these days. Its currency, the real, has lost more than 15 percent of its value in the past year, as has São Paulo’s stock market, and preparations for the World Cup are not exactly on schedule. But just a few years ago, as the world reeled from economic downturns in Europe and the United States, Brazil was the darling of the financial markets. What happened?

In the years leading up to the financial crisis, Brazil had become an attractive option for investors seeking to balance their portfolios. Stock markets in Europe, the United States, and other established economies track each other so closely as to be almost identical. For example, the DAX index of the Frankfurt Stock Exchange had a correlation of 0.95 with the Standard and Poor’s 500 index on a month-to-month basis between January 2005 and August 2008. By contrast, the correlation between Brazil’s Bovespa stock market index and the S&P 500 was only 0.73. For investors who wanted to insure themselves against dips in the big markets, some of Brazil’s stocks were a reasonable option.

Moreover, Brazil’s economic growth had been accelerating, from 3.2 percent in 2005 to 4.0 percent in 2006 and 6.1 percent in 2007. Its export markets were geographically diverse, and its interest rates were relatively high. Together with Brazil’s sheer size, these factors were more than enough to get the attention of harried investors looking for a safe haven other than the United States. Not that the global downturn had left Brazil unscathed — the Bovespa lost almost half its value between June and November of 2008. But then the money started pouring in.

Rising demand pushed up Brazilian asset prices, and by December 2009 the self-fulfilling prophecy in the stock market was in full swing. The Bovespa rocketed to all-time highs, while the S&P 500 still had much ground left to recover. So much money was coming into Brazil in 2009 that the government decided to institute a 2 percent tax on short-term investments by foreigners. Within a year the government increased the rate twice, to 6 percent for some securities. But by then Brazil’s growth was already slackening, and it would not recover as quickly as the stock market.

The economy’s expansion had been driven by forces that were not necessarily sustainable. One was the global boom in commodity prices, which was among the first casualties of the global downturn. The other was ballooning consumer demand from rapid urbanization, higher incomes, and increased borrowing. For long-term growth, Brazil would need saving and investment as well as borrowing and spending. Its urbanization wave was also petering out, with 84 percent of people living in cities by 2009. Raising incomes simply by putting more labor next to capital would not be possible for much longer.

In retrospect, what happened next was inevitable. Brazil’s economic growth peaked at 7.5 percent in 2010 and has failed to reach 3 percent in any year since. The tax on capital inflows stopped the stock market in its tracks; the Bovespa peaked just before the rate increases in October 2010 and then lost a third of its value. In June, following a year of stagnation in average incomes, the tax rate on capital inflows was finally cut back to zero.

It was too little, too late. Brazil’s economic party ended well before the soccer party was set to begin. As Brazilians pick up the discarded beer glasses and silly hats, it’s worth asking how the country used the gains from its brief heyday and how it will grow in the future.

The answer to the first question is far from flattering. Although Brazil’s monetary authorities built up a mountain of foreign currency reserves thanks to booming exports, the depreciation of the real and a sell-off of assets held by foreigners could soon turn it into a molehill. Brazil also did little to fortify its infrastructure, moving from 78th place in the World Economic Forum’s Global Competitiveness Report in 2008-2009 to 71st place in 2013-2014 — hardly a significant change.

Corruption undoubtedly sapped some resources that could have strengthened the economy, too. Between 2008 and 2013, Brazil only managed to improve from 80th place to 72nd on Transparency International’s Corruption Perceptions Index. This week yet another protest over graft in spending for the World Cup turned violent. And the Brazilian tax system’s nightmarish complexity creates even more opportunities for malfeasance. Since 2006, there has been no change in the World Bank’s estimate of the work needed to ensure a company’s compliance: a mind-boggling 2,600 hours.

The money Brazil has invested in its next generation of workers offers some grounds for optimism about the long term. Brazil is building human capital, which is just as important as physical capital. But without improvements to its business climate and the rule of law, all that human capital could go to waste. The story of tomorrow’s Brazilians may mirror that of their soccer team in the last two World Cups: a sad tale of unfulfilled potential.