Brazil: A troubling dive into the known Global Economic Outlook, Q4 2015

Brazil’s economy is struggling, with inflation running high, rating agencies weighing downgrades, and low business confidence. Will lawmakers move beyond recent scandals to make necessary reforms and lay the groundwork for long-term competitiveness?

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On September 9, Standard & Poor’s (S&P) downgraded Brazil’s long-term sovereign debt rating to junk.1 Other rating majors, such as Moody’s, still have Brazil at investment grade, although Moody’s rating is just one notch above junk. Observers expected this rating downgrade due to faltering fiscal management during an economic recession, and political uncertainty has actually risen sharply in recent months, preventing critical budgetary reforms. It is perhaps ironic that Brazil’s downgrade came at the hands of the same rating agency that promoted the country to investment grade in April 2008.2 At that time, it was a recognition of Brazil’s rise in the global economic order. Now, for policymakers to regain that level will be a steep climb.

Deteriorating public finances in a recession were the last nail in the coffin, especially with political conflict sabotaging efforts to shore up fiscal health.

The moves that rocked the rating

In July, S&P put Brazil on negative outlook, citing concerns about fiscal consolidation efforts and the economy; then came September’s downgrade. A number of factors led to this. First, economic activity has deteriorated since July’s cut in outlook (the economy slipped into recession in Q2) with key indicators pointing to a GDP contraction this year and the next. Second, with inflation running high, support from monetary policy is not expected. In fact, the Banco Central do Brasil (BCB) had left it too late to raise rates last year.3 Third, low commodity prices (Brazil’s main exports) and a weakening currency (figure 1) are putting more pressure on the economy. Finally, deteriorating public finances in a recession were the last nail in the coffin, especially with political conflict sabotaging efforts to shore up fiscal health.

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In fact, rising debt and the inability to curtail spending (figure 2) have been a concern since President Dilma Rousseff’s reelection. Even more perturbing is the unraveling of planned spending cuts and tax increases to spruce up public finances. Although many applauded Finance Minister Joaquim Levy’s initiative to reform public finances, the scandal at Petrobras proved to be a deal breaker, with investigations ensnaring top business and political leaders. With about 90 percent of government spending ring-fenced by a belligerent Congress, cutting down spending has proved to be a difficult task, as did the government’s failed attempts to introduce a financial transactions tax. Rousseff’s sliding popularity, now in single digits, has not helped matters.4

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Interestingly, markets appear to have priced in a rating downgrade, especially after the Rousseff administration sent its 2016 budget to Congress on August 31. In the budget, the government set a primary deficit target (-0.5 percent of GDP) for 2016, the first time since 2000 that a budget failed to include a primary surplus. This was also the fifth time that the government had lowered its target. Markets reacted immediately: On September 1, the main Ibovespa index fell 2.5 percent, the real lost 2.1 percent against the dollar, and bond yields rose (figures 3 and 4). In fact, domestic and global turmoil have been feeding into financial markets since the beginning of the year. And now, the downgrade has added to the gloom.

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Most worrying is a rise in the cost of borrowing, which generally follows a downgrade to junk. Along with businesses and households, the government is likely to feel the pressure, especially when it is running a primary deficit. The government is expected to raise debt to meet prior obligations as well as for current expenditures—the latter at higher costs. With the economy expected to be in decline over 2015–16, the debt burden will likely rise during that time without sharp cuts to spending.

Because of internal rules, institutional investors such as pension funds cannot hold securities rated junk, although often at least two rating agencies have to rate the debt as junk. For now, Moody’s has Brazil at its lowest investment grade, with a stable outlook. But as the S&P downgrade shows, a downgrade by Moody’s could come sooner than thought; S&P’s came just six weeks after it had lowered Brazil’s outlook to negative. If that happens, capital will flow out sharply, putting even greater pressure on the real and borrowing costs.

Economic activity on a downward slide

In Q2, GDP contracted 1.9 percent quarter over quarter, the sharpest decline since Q1 2009. The decline in Q1 (-0.7 percent) turned out to be higher than initially estimated (-0.2 percent). With two straight quarters of economic contraction (figure 5), Brazil is now in a technical recession. For policymakers, weak domestic demand is the biggest headache: Private consumption fell 2.1 percent in Q2, down from a 1.5 percent decline in Q1. The contraction in Q2 was the sharpest since Q4 2001.

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Interestingly, markets appear to have priced in a rating downgrade, especially after the Rousseff administration sent its 2016 budget to Congress on August 31.

Investments are reeling from declining domestic demand, high borrowing costs, and weak business confidence. Gross fixed-capital formation fell 8.1 percent, worsening sharply from a 2.4 percent decline in Q1. The ongoing investigation into the Petrobras scandal is weighing heavily on private businesses’ investment decisions and the awarding of contracts by the government; the latter’s dip has also hit construction, which fell 8.4 percent in Q2.5 Exports were the only saving grace in Q2, rising 3.4 percent. However, the figure was much lower than the previous quarter’s rise (16.2 percent).

Private consumption is in deep trouble

Households are facing both a deteriorating labor market and cuts to fuel and electricity subsidies. The subsidy cuts earlier this year have pushed up consumer inflation, which is now close to double digits (9.5 percent in August) and has dented real wages, at a time when wages are already under pressure due to rising unemployment (7.5 percent in July). For example, real average earnings for those in the private sector fell 3.0 percent year over year in Q2, following a 1.3 percent decline in Q1.

The one bit of good news is that a falling currency has made Brazilian exports more competitive. Indeed, the real effective exchange rate fell 10.7 percent between January and June.

The BCB’s efforts to tackle rising prices have not yet borne fruit, though, in all fairness, it takes time for monetary policy to have an impact. For the BCB, the task has become even more difficult due to a weak real (which has pushed up import prices) and a rise in administered prices (due to cuts in subsidies). With the BCB raising rates and banks tightening credit, household credit growth has fallen sharply even as the debt service ratio remains high (figure 6). All these are putting pressure on private spending: Retail sales fell 3.5 percent year over year in July, the fourth straight month of contraction.

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A difficult time for businesses

Business confidence has been in negative territory since April 2014, with the value in September at its lowest level since the series started.6 And the Getulio Vargas Foundation manufacturing confidence index also fell to its lowest level since the series was started.7 Car sales growth has been in negative territory since March 2014, with the trend similar for overall manufacturing and industrial production (figure 7).

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While a contracting economy and high cost of capital (figure 8) are weighing on confidence, businesses are equally troubled by rising uncertainty after the Petrobras scandal. The one bit of good news is that a falling currency has made Brazilian exports more competitive. Indeed, the real effective exchange rate fell 10.7 percent between January and June.8 However, for manufacturing companies, this may not be enough. The country does not rank high in global competitiveness, and policymakers failed to pass necessary reforms in the boom years to address the problems.9

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Time for political conciliation

Economists surveyed by the central bank forecast a 2.7 percent annual contraction in 2015, followed by a 0.8 percent decline in 2016.10 These numbers do not make for pleasant reading. One thing is certain: Without political conciliation, measures to improve government balances and tackle weak economic competitiveness will not see the light of day. It is possible that the downgrade may work in Rousseff’s favor, forcing Congress to approve key measures and quelling dissent within the ruling coalition. But if it does not work out that way, Brazil’s troubles may have just begun.