How to Bring Brazil’s Economy Back to Life
The policies that helped Brazil to healthy growth over the past decade have lost momentum. The next president will need bold new ideas that look beyond the short term. Third in our series of Lab Reports on Brazil.
As Brazilians went to the polls on Oct. 5 to choose their new president, Aécio Neves, the Brazilian Social Democratic Party (PSDB) presidential candidate, surged dramatically into the run-off election against the incumbent, Dilma Rousseff — taking almost all observers and polling companies by surprise. The twisting campaign remains unpredictable, but two things are certain. The first is that the Brazilian electorate faces a very distinct choice between two candidates with completely different economic philosophies and policies. The second is that the Brazilian economy is desperately weak. Brazil, which suffers from serious macroeconomic imbalances, fell into recession in the first half of this year. Whoever wins in the final stage of the election on Oct. 26 will face the daunting task of restoring dynamism to a slow-moving economy.
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At the end of September, the central bank lowered its prediction for Brazil’s annual growth from 1.6 percent to just 0.7 percent. Such low growth is behind most other Latin American countries, with the exception of Argentina and Venezuela. For example, Mexico expects to grow at 2.7 percent and Colombia by 4.7 percent. Yet 0.7 percent is actually an optimistic estimate for Brazil: A survey of 100 private economists by Brazil’s central bank revealed an average growth rate projection of just 0.29 percent. The level of public sector debt (at 60 percent of GDP), government taxation, spending rates, and the economy’s investment and savings levels are closer to those of developed market economies than emerging market nations. Unfortunately for Brazil, this means that its growth outlook is more in line with Portugal’s than Peru’s.
Essentially, Brazil is suffering from “short-termism.” In the 2000s, the economy maintained robust growth thanks to the 1994 implementation of a tough anti-inflation regimen during the presidency of Henrique Cardoso — but subsequent Brazilian governments (especially during the 2000s) were content to enjoy economic prosperity without introducing the macro and micro reforms that would have sustained it. Growth depended entirely on the commodity super-cycle — Brazil’s mineral exports (particularly iron ore) and agricultural commodities (particularly soy) — as well as on domestic consumption. After the 2008 financial crisis, global liquidity entered emerging markets and extended Brazil’s benign financial backdrop. Since the Workers’ Party (PT) assumed power in 2002 under President Luiz Inácio Lula da Silva, Brazil’s leaders have taken measures against income inequality (such as the Bolsa Familia, a social security program that provides financial support to low-income families) and achieved social advances that produced significant positive results. This combination of factors contributed to the rise of a new, consuming middle class that helped to sustain growth through a consumer boom.
Since these tailwinds have eased, however, the government’s response has been to tinker, intervening in industries through price controls and tax adjustments, extending credit in public banks as part of a quasi-fiscal expansion policy, and pulling on monetary and fiscal policy levers in attempts to re-start spluttering growth. In the future, Brazil’s government will simply have to prioritize policies that affect long-term growth.
The next president’s first problem will be to address high and stubborn inflation, which is very close to the top of the central bank’s target band of 4.5 percent, plus or minus 2 percentage points. Inflation hasn’t hit the center of the target since December 2009, and the IPCA consumer price index has been running at above 6 percent since July 2011. The central bank has adjusted by raising interest rates, but this has only slowed GDP growth even further. The Selic, the country’s base interest rate, now stands at 11 percent. In all likelihood, the central bank will have to raise it even higher after the election if it truly means to get a grip on inflation.
Meanwhile, service-sector inflation is running at about 9 percent, and recent currency devaluations will create additional pressures. Economists say that, on average, every 10 percent of currency devaluation adds 10 base points to inflation due to the increased cost of imports in local currency. With inflation already high this is hitting the spending power of ordinary people. The traumatic hyperinflation that plagued Brazil in the 1980s and 1990s remains vivid in the minds of many Brazilians, and politicians are all too aware of the sensitivity of the issue.
At some point, the government will also have to dismantle the current price controls on gasoline and electricity subsidies, a move that will inevitably also increase inflation — and that will be incredibly unpopular with the public.
Brazil’s deteriorating labor market is also suppressing growth prospects. Until recently, the economy’s lack of job creation (now running at rates last seen in the 2008 crisis) wasn’t leading to increased unemployment because the labor market participation rate was also falling — largely driven by greater numbers of young people entering full-time education. Now, however, unemployment has increased over the last two months, and expectations are that it will continue to rise throughout 2015. This will be yet another blow to consumer confidence. Consumption rates were already low following a decade long credit-boom that left the new “middle classes” indebted. Some estimate that 30 percent of this segment’s disposable income is now spent paying off debt. In response to weakening credit quality, private banks have been hesitant to expand lending — and now even the public banks (which the government has been using as a counter-cyclical credit tool) are showing wariness about extending credit further down the risk spectrum.
The new president will also have to raise short-term tax revenue to counter the country’s weakening fiscal position. Brazil’s tax revenue is currently at 36 percent of GDP — above the OECD average and twice the average for Latin America — while its expenditures, at 41 percent, are even higher. Non-discretionary expenditures account for about 85 percent of that spending, so fiscal cuts will require significant structural reforms. Nor will the next government be able to count on the large, one-off revenue streams that shored up its balance sheet under previous administrations (such as the $6.2 billion the government earned by selling rights to the Libra oil field in October 2013).
The implication is clear: The next government will have to raise taxes. It will also have to abandon Brazil’s recent experiment with supply-side economics, such as the auto-industry tax breaks that were meant to stimulate demand. Just as in the United States in the 1980s, the only material effect of this policy has been the lowering of tax revenues (by an estimated $36.5 billion in 2014, or 1.72 percent of GDP) and widened deficits.
Meanwhile, the country’s southeast and center-west regions have been suffering from a severe drought. These areas are responsible for about 70 percent of all hydroelectric power generation. The government has ignored calls from hydrology experts to conserve dwindling reservoir levels, and if rainfall doesn’t return to historical norms by November, it will have to consider energy rationing. Economists estimate that this will knock off between 100 basis points and 150 basis points of 2015 GDP growth, almost certainly plunging the country into recession. Environmental consultancies say that energy rationing is still a material risk for Brazil in 2015 — and offers a perfect example of the lack of strategic, long-term thinking among the country’s policymakers.
But these are just the domestic issues. The next government will also find itself operating in an external economic environment that is considerably less favorable than in the recent past. The expectation that interest rates will rise in the United States is already leading to greater risk aversion among investors, and the bountiful, quantitative-easing-created tide of liquidity that swept into emerging markets will recede. International investors are also beginning to differentiate between emerging markets to a greater extent, and Brazil isn’t coming out on top. Mexico is now Latin America’s favored economy — followed by the other more dynamic economies that make up the Pacific Alliance. In many respects Brazil’s closed economy, high level of government intervention, and persistent fondness for red tape and regulation — the famous “custo Brasil” — have made the country unattractive to investors, making its economy similar to Venezuela and Argentina in the eyes of some.
For longer-term growth to rise above trend growth projections, the government needs to address the country’s low investment rate. Brazil invests less than 18 percent of GDP compared to the regional average of about 23 percent. Low investment has always been a drag on productivity-led growth, and now the demographic driver of growth is subsiding, making investment-led growth even more important. Brazil’s working-age population is now growing at just 1.2 percent a year and will stop growing altogether by 2030.
The government is the best-positioned agent in the economy to facilitate this leap in investment. However, given Brazil’s already high tax burden and large fiscal spending, any attempt to boost savings and investment would have to incorporate social security reform, reduced government expenditure, and cuts to tax and onerous and expensive business regulations. (Brazil’s current account has deteriorated sharply in recent years — recording a deficit of 3.6 percent last year — and international financing of investment would widen the current account deficit to an unsustainable level.)
The government has been refocusing its policies on infrastructure investment. Rousseff recently committed herself to a market-driven program of private-sector concessions, such as building and operating ports, airports, and toll roads. At one stage Rousseff seemed ideologically against this form of private-sector development, but people who have spoken to her directly about this issue now say she “gets it,” and expect a new Rousseff government would continue with more rounds of concessions.
Such projects would generate investment that will not only boost growth but also address the negative side effects that poor infrastructure has on investment levels in other industries. For example, agriculture in Brazil is blessed with huge natural competitive advantages, but high costs for transporting crops from the interior to ports hit margins hard: It currently costs less to ship soy from a Brazilian port to China than it does to get the soy to the port from the farm.
There is also a growing risk to the country’s investment grade status. The decline in the primary surplus (total spending before debt payments) this year will probably amount to around 1 percent — well below the 1.9 percent target and also well below the level required to stabilize its debt. Standard & Poor’s cited the country’s fiscal deterioration when it downgraded Brazil to the lowest investment grade rating in March 2013. And the position is worsening: In July, the government’s revenues fell 2.4 percent when compared with the same period in 2013, and expenditures (adjusted for inflation) rose by 3.7 percent. This is well below projections. Without significant increases in taxes, cuts in spending, or short-term growth, Brazil will face a material threat to its investment grade status — not immediately after the election perhaps — but quite possibly in 2016.
The problems then, are many and deep-rooted. The markets clearly think Neves is the better option for re-starting Brazil’s growth. The day after Neves shocked everyone by winning 34 percent of the popular vote in last Sunday’s election, the stock market rose 5 percent. In the short term, a win for Neves would inspire a substantial recovery in business confidence, which has plummeted in recent months. That, in turn, would lead to a similarly short-term boost in investment and GDP growth.
Neves’ commitment to return of Brazil to the economic “trinity” of inflation targeting, a free-floating exchange rate, and fiscal restraint (established by PSDB President Henrique Cardoso) would also likely reap immediate benefits. Neves has been so far light on specific policies, and instead has been focusing on criticizing Rousseff’s interventionist approach. However, his announcement that Armínio Fraga — president of the central bank under Cardoso — will be his finance minister has created the impression that his would be a presidency that would return orthodoxy to macro-economic policy.
This could have a powerful effect: A study into the components of inflation by one economist found that almost 70 percent of the higher inflation in the period between 2011 and 2013 (compared to 2004 and 2010) came from the expectation of higher inflation. Re-anchoring inflation targets would bring significant benefits, and the next administration would be wise to signal its desire to hold inflation to under 5 percent in the next couple of years. It could do this by planning to dismantle current price distortions in the economy and committing to exchange rate liberalization.
In the longer term, Neves is the only of the two candidates to talk about the need for fiscal discipline and market-friendly reform. He supports opening up the notoriously closed economy to competition from the outside and reducing state intervention in the economy. But the challenge of putting these policies into effect shouldn’t be underestimated, and any reform agenda is likely to encounter major political roadblocks — on the streets as well as in congress. The newly emerged middle classes, who typically vote for Rousseff’s Workers’ Party, regard Neves’s Social Democrats as a self-serving and elitist group. If they believe that the richer classes are the only ones who will benefit from Neves’s reforms, the result could be a return of last year’s protests. But if Neves harnesses the momentum from his surprising first-round election win, and if he cites the success of modernizing policies in other Latin American economies like Mexico’s, it could be possible for him to push through reforms significant enough to make Brazil more competitive and attractive to investment.
The alternative, a second Rousseff administration, is more problematic. During her campaign, Rousseff warned against making the central bank independent — which certainly doesn’t suggest a swift return to credible inflation targeting. Over the longer term, Rousseff may broaden her infrastructure concessions, but that alone is unlikely to power growth. She would also need to implement wider, structural change, yet she has shown little inclination to do so during her first administration. Optimists suggest that Rousseff’s current plan is likely to trigger sudden ratings downgrades — and the resulting increases in cost of capital and the damage to Brazil’s pride might just convince her to reconsider her economic policy. It’s conceivable that a second Rousseff administration may discover a new will to reform. One thing, though, is for sure: Brazil cannot afford to wait.