Brazil: No escape from a contraction Global Economic Outlook, Q3 2015

This year was never going to be easy. It started with a fiscal austerity overdrive, and, with the labor market deteriorating and pessimism rife among consumers and businesses, the stage is set for a potential recession.

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This year was never going to be easy for Brazil. It started with a fiscal austerity overdrive, and rightly so, given the profligacy of the last four years. In addition to aiming to raise revenue, the government cut spending, including subsidies on fuel and electricity. Consequently, administered prices have shot up, forcing inflation higher. But it was not as if price pressures were low to start with. Inflation has been above the midpoint of the Banco Central do Brasil’s (BCB’s) target range of 2.5–6.5 percent since September 2010. A bout of rate cuts in 2011–12 was ill timed and dented the BCB’s credibility. Thankfully, the BCB appears intent on regaining lost ground and getting inflation under control. It has raised the key SELIC rate a total of 275 basis points (bps) since October 2014, setting a hawkish tone for its policy outlook. As expected, the mix of tough fiscal austerity and monetary tightening is taking a heavy toll on domestic demand. With the labor market deteriorating, and pessimism rife among consumers and businesses, the stage is set for a recession this year.

As expected, the mix of tough fiscal austerity and monetary tightening is taking a heavy toll on domestic demand.

Falling domestic demand drags down economy in Q1

Brazil’s GDP contracted 0.2 percent quarter over quarter in Q1 2015, reversing from a 0.3 percent rise in Q4 2014. Domestic demand was hit hard in Q1, falling 1.4 percent due to contractions in three key components: private consumption, investment, and government expenditure (figure 1). Private consumption, which has been the mainstay of GDP growth in recent years, fell 1.5 percent in Q1 2015. This was a sharp deterioration from a 1.1 percent rise in Q4 2014 (figure 2). Households, which were already reeling from high debt, are now having to cope with rising unemployment, high inflation, subsidy cuts, and rising interest rates.

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Weakening private consumption is one in a series of bad news for investment activity in Brazil; business confidence is already low, and the cost of capital is rising. It is not surprising then that gross fixed capital formation fell 1.3 percent in Q1 2015, down from a 0.6 percent decline in Q4 2014. A scandal at oil giant Petrobras has not helped either; the company has already shelved its investment targets for this year. The scandal is also likely to affect government projects, especially those in infrastructure and where subcontracting is involved.1 Fiscal support for the economy will only get worse as the government tightens finances and tries to prevent a sovereign rating downgrade. For example, in Q1, government consumption fell 1.3 percent compared with the 0.9 percent contraction in Q4 2014.

Economic growth in Q1 would have been worse had it not been for a jump in net exports. Exports rebounded in Q1, rising 5.7 percent. And although imports grew 1.2 percent during the quarter, net exports still contributed strongly to GDP growth. Exports are likely to have benefited from primary sector shipments and an increase in coffee prices in Q1. Part of this is reflected in a 4.7 percent expansion in agriculture in Q1; mining and petroleum also fared well (3.3 percent). In contrast, both industry (-0.3 percent) and services (-0.7 percent) declined, reflecting the strong contraction in domestic demand during the quarter.

It’s not getting any better in Q2

Brazil’s woes will not go away any time soon. Latest data indicate a likely contraction in GDP in Q2 as well, thereby ushering in a recession. In April, industrial production fell 7.6 percent year over year, the 14th straight month of contraction. Similarly, data for the purchasing managers’ index (PMI) show that manufacturing activity in May fell to its lowest level since September 2011 (figure 3).2 Within manufacturing, the auto industry has been hit hard. An end to fiscal sops for car purchases and rising interest rates are weighing on car sales. Seasonally adjusted domestic automotive sales fell a little less than 7.0 percent month over month in May, while production dropped 7.6 percent.3 The National Association of Automobile Manufacturers (ANFAVEA) expects sales to drop a staggering 20.6 percent this year, and production by 17.8 percent.4

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The industry slowdown is denting the labor market. Data for the manufacturing PMI reveal that in May firms cut jobs at the fastest pace since July 2009.5 In the auto industry, ANFAVEA says that payrolls have shrunk 9 percent in the past year; about one in six workers appear to be in furlough.6 The story is similar in construction, where about 293,000 workers have lost jobs between October 2014 and April 2015.7 All these factors have impacted unemployment (figure 4). In April, the unemployment rate went up to 6.4 percent from 6.2 percent in March. April’s unemployment figure is the highest since May 2011.

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BCB continues hawkish stance

On June 3, the BCB raised its benchmark SELIC rate by 50 bps to 13.75 percent, the highest rate since January 2009. This hawkish stance, no doubt, aims to both restore credibility and dent price pressures. The BCB aims to bring inflation down to 4.5 percent by December 2016.8 Despite the rate hikes, price pressures remain elevated (figure 5) due to a hike in administered prices (fuel and electricity). In May, inflation went up to 8.5 percent from 8.2 percent in April. May’s inflation figure was the highest since December 2003. As a result, and also due to financial markets’ continued wariness about the BCB’s credibility, inflation expectations for 2016–19 remain high.

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Nevertheless, the BCB has gained some ground in its efforts to force inflation expectations down. For example, inflation expectations for 2016 have fallen to 5.5 percent.9 They could decline further if the BCB sticks to its tight monetary policy; to force down expectations, the BCB could hike the SELIC rate another 25–50 bps this year. Like many of its global peers, the BCB could do better in communicating its policy stance. For example, contrary to the BCB’s hawkish message, markets currently expect the SELIC rate to come down in early 2016. This is not helpful in getting inflation expectations down, and the BCB needs to find ways to make its policy decision more transparent, and hence credible.10

Weakening private consumption is one in a series of bad news for investment activity in Brazil; business confidence is already low, and the cost of capital is rising.

Overall, inflation is likely to slow down in 2016 as the base effect of the hike in administered prices sets in; slowing aggregate demand will also weigh on inflation next year. This year, though, there will be little respite from surging prices. Economists surveyed by the BCB expect inflation to end this year at 8.5 percent; it will be the first year since 2004 when inflation will likely end above the BCB’s ceiling (6.5 percent). In 2016, inflation is expected to fall to 5.5 percent.11

The currency could, however, play spoilsport for the BCB if the US Federal Reserve (Fed) hikes rates ahead of market expectations. This year, for example, the Brazilian real has gone down 14 percent against the US dollar (figures 6 and 7). However, fears of a Fed rate hike are not the only factor contributing to the real’s weakness; the currency is also suffering from negative external balances. For example, in Q4 2014, the current account deficit (not seasonally adjusted) deteriorated to 5.3 percent of GDP, a level not witnessed since Q4 2001; the deficit has not got any better this year.

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Despite the real’s strong decline, it is likely that the currency has almost run its downward course for the near term. As the economy slowly starts to recover next year, and fiscal health improves, the real is likely to find some support.

Contraction in 2015

A tight monetary policy, subsidy cuts, and a worsening labor market will keep the pressure on consumers in 2015. In May, consumer confidence, as measured by the Getulio Vargas Foundation, fell to 85.1 from 85.6 in April; the index inched back to a record low set in March.12 Consumer pessimism is weighing on private spending in Q2 and will continue to for the rest of the year. As a result, private consumption growth for the whole of 2015 is likely to slip into negative territory from 0.9 percent in 2014.

Overall, inflation is likely to slow down in 2016 as the base effect of the hike in administered prices sets in; slowing aggregate demand will also weigh on inflation next year.

The economy will also have to bear with weak investments and falling government spending. Private investment is already low, and declining business confidence—which, in May, fell to its lowest level in nearly five years—will not help. External demand is not likely to come to the economy’s rescue given slowing growth in China, a key export market for Brazil’s commodities. And although a weak real will make Brazilian exports competitive, the country’s declining fortunes in manufacturing have left it too weak to take much market share from others.

In this scenario, GDP is set to shrink in 2015. Results from the latest BCB survey of economists show that GDP is likely to contract 1.3 percent this year before returning to moderate growth of 1 percent in 2016.13 If this happens, 2015 will witness Brazil’s worst economic performance in the last quarter century.