Brazil: Yearning for the good times Global Economic Outlook, Q2 2016
Last year was perhaps one of the toughest for Brazil. The economy contracted sharply, even as political challenges hindered economic policy, amid concerns about fiscal dominance. Exports proved to be a bright spot, though.
Last year was perhaps one of the toughest for Brazil’s economy since the early 1990s. The economy contracted sharply, even as political challenges prevented much-needed pragmatism in economic policy. Investigations into a widening bribery scandal have ensnared some of the country’s highest political leaders. The resulting political conflict thwarted attempts to deal with a high fiscal deficit as well as rising debt and debt-servicing costs. Inflation showed no sign of retreating despite tight monetary policy. All these led to concerns about fiscal dominance: a phenomenon where inflation no longer responds to monetary policy but depends more on fiscal policy. The economy, however, still had something to cheer about. Exports recovered strongly in Q4 2015, providing much-needed succor at a time when high inflation and rising unemployment weighed down one of the key growth drivers, household spending.
A contraction yet again in Q4
Real GDP contracted 5.9 percent year over year in Q4 2015, worsening from the 4.5 percent decline in Q3 (figure 1). This was the sharpest contraction in a quarter since the early 1990s, when Brazil was still finding its way out of hyperinflation. Real GDP has now fallen by 7.2 percent since Q1 2014. Both private consumption and investments suffered in Q4 2015. While private consumption contracted 6.8 percent in the quarter, gross fixed capital formation fell 18.5 percent. With government finances in poor shape, it was no surprise that government consumption also fell 2.9 percent in Q4. Overall, final domestic demand fell 8.3 percent, perhaps highlighting how hard it will be for policymakers to revive the economy. Amid all this gloom, there was one bit of positive news though: Exports expanded 12.6 percent, the fastest pace of expansion since Q4 2010.
It won’t be easy for exports to lead the recovery
Brazil’s exports have changed greatly in the last 15 years. Faced with high demand from fast-growing Asia (primarily China) amid a commodity boom, Brazil turned its attention to commodities in early 2000. As a result, manufacturing exports have suffered over the years. In 2000, for example, manufacturing accounted for 59.1 percent of Brazil’s merchandise exports (in US dollars); by 2015, that share had declined to 38.1 percent. Commodities were, of course, the big beneficiary (figure 2). With Asia eager for Brazil’s commodities, the region’s share in Brazil’s exports shot up between 2000 and 2015 (figure 3).
Turning toward Asia is a step in the right direction for Brazil, given the former’s ascendancy in the global economy.1 But with commodities a key export to Asia, Brazil is vulnerable to the fluctuations in the global commodities market—as it is painfully finding out.
Is the current commodities downturn a good opportunity for Brazil to revive manufacturing competitiveness? And will a weak Brazilian real aid this process? The answer is likely yes. In recent months, the weak real has indeed come to the aid of Brazil’s exports. The currency has lost 41.1 percent against the US dollar since December 2013 (figure 4). Depreciation isn’t restricted to the nominal value of the real. According to the International Monetary Fund, Brazil’s real effective exchange rate also declined (by 18.7 percent) during this period.2 It is no wonder, then, that export volumes from Brazil have been growing (year over year) since December 2014.3
Turning toward Asia is a step in the right direction for Brazil, given the former’s ascendancy in the global economy. But with commodities a key export to Asia, Brazil is vulnerable to the fluctuations in the global commodities market—as it is painfully finding out.
A weak currency, however, won’t be enough to restore Brazil’s manufacturing advantage. The shares of two key exports, airplanes and vehicles, in manufacturing exports have declined (figure 5). Brazil also faces formidable competition in manufacturing. For example, Mexico fares much better in the World Bank’s ease of doing business rankings: 38 against Brazil’s 116.4 It is hard to start a business in Brazil, and the country’s tax system continues to be its Achilles’ heel.5 Moreover, while Brazil fell in overall rankings in 2016, Mexico went up. So even though the recent growth in exports is a welcome relief for Brazil, it does not indicate a structural shift in overall competitiveness. For such a shift, Brazil likely needs deep-seated reforms and to drastically improve infrastructure. Such measures will also make Brazilian industry competitive again, which in turn will aid capacity utilization and subsequent investment (figure 6). With competitors in Asia and Latin America benefitting from numerous free-trade agreements and large-scale foreign direct investment, Brazil likely needs to also raise its game by liberalizing trade further and tying up with key markets, especially those in Asia.
Any exports revival will not make up for beleaguered private consumption
Private consumption, a key growth driver in recent years, has lost steam. In 2010 and 2011, private consumption grew 6.2 percent and 4.7 percent, respectively. In contrast, it contracted 4.0 percent last year. Multiple factors are weighing on private consumption. First, the labor market has suffered due to the recession. For example, the unemployment rate (non-seasonally adjusted) went up to 7.6 percent in January 2016 from 4.8 percent two years ago (figure 7). During this period, total employment fell 3.2 percent, while employment in the mining, manufacturing, and utilities sector dropped a staggering 14.1 percent.
Second, a weak labor market has dented nominal income gains. According to estimates by Oxford Economics, nominal disposable income in Brazil went up 7.3 percent in 2015, slowing down from the heyday of 2010–12 (figure 8).6 Real income gains fared worse because of high inflation, which has not slowed down. For example, in January 2016, consumer prices went up 10.7 percent, the highest since November 2003 (figure 9).
Third, consumers have suffered due to banks’ higher interest rates and tighter lending conditions. Rising interest rates have pushed up debt-servicing costs for households, although household debt has stabilized (figure 10).
Political challenges and the threat of fiscal dominance
Last year, as the Banco Central do Brasil (BCB) struggled to contain inflation, economists started worrying about fiscal dominance.7 When fiscal dominance occurs, any hike in interest rates raises the government’s interest payments, thereby denting its fiscal health. This, in turn, stokes currency weakness, which then pushes up inflation.
Key trends support the fiscal dominance theory. First, repeated hikes in interest rates have failed to curtail inflation. Second, both nominal deficit and interest payments have shot up. For example, while the nominal deficit as a share of GDP nearly doubled between January 2015 and January 2016 (5.8 percent to 10.8 percent), interest payments went up from 5.2 percent of GDP to 9.1 percent of GDP (figure 11). Third, Brazil’s credit rating was cut to junk by two rating majors last year; a third downgrade followed in early February.8 Finally, the currency plummeted last year, falling 34.2 percent between January 2015 and January 2016. In fact, worries about fiscal dominance may have been one of the factors prompting the BCB to keep rates on hold since July 2015—despite official denials to the contrary.9
When fiscal dominance occurs, any hike in interest rates raises the government’s interest payments, thereby denting its fiscal health. This, in turn, stokes currency weakness, which then pushes up inflation.
This year, however, the threat of fiscal dominance is likely to recede. First, as the economy enters the second straight year of high inflation, the base effect will come into play. The downward pressure from aggregate demand on inflation will also rise, especially with GDP contracting 3.9 percent in 2015. Second, the worst for the currency is over. Since the end of January, the real has gained against the US dollar (1.6 percent in a month), making it one of the better-performing emerging-market currencies this year. Third, by the end of 2015, capital markets had priced in all major changes, including declining growth, political uncertainty, and any further rating downgrade. Brazil’s benchmark index is up 14 percent so far this year.
Nevertheless, things could easily spiral out of hand. A deterioration in fiscal health cannot be ruled out in the current environment of political uncertainty. President Dilma Rousseff is facing impeachment proceedings over allegations of violating budget rules.10 The sudden investigation into Rousseff’s predecessor Lula over the ongoing bribery investigation involving both public officials and the private sector has added fuel to an already-raging political fire.11 That has hardened positions across the political aisle and also led to protests on the streets.12 Clearly, such an environment is not conducive to economic legislation, let alone structural and fiscal reforms. Economists are hoping for a quick resolution. For now, however, the dark clouds of political uncertainty still loom over the economy.