Brazil: A glimmer of hope Global Economic Outlook, Q3 2016

Brazil’s new government, though temporary, has its work cut out. GDP contracted for the fifth straight quarter, fiscal deficit is in double digits, and inflation is way above target. However, the president has started on the right note by putting in place a credible economic team.

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Brazil will soon host the Summer Olympics. When Brazil won the race to host two major events—the 2014 Soccer World Cup and the 2016 Olympics—it was a proud moment for a country that was emerging as a strong contender on the global stage. However, much water has flowed down the Amazon since then. The economy is in bad shape. Political acrimony is high. Indeed, doubts have also emerged about Olympic host city Rio de Janeiro’s ability to complete facilities on time.1

The new government appears determined to restore fiscal health and reform the economy.

Things seem to be improving though. The new government appears determined to restore fiscal health and reform the economy. Markets have responded positively. There is good news for the Olympics, too. The World Health Organization has given its consent to the games despite the Zika virus threat.2 And the federal government has stepped in with financial support for Rio de Janeiro.3 As in the Olympics, however, victory—in this case for the economy—hinges on continuing the momentum of economic reforms, if not increasing it.   

The economy contracted yet again in Q1

There was not much respite for the economy in Q1 as real GDP contracted 0.3 percent quarter over quarter. This was, however, an improvement from the 1.3 percent decline in Q4 2015. Domestic demand faltered yet again, with gross fixed capital formation (-2.7 percent) and private consumption (-1.7 percent) contracting in Q1. Even though government consumption expanded 1.1 percent, any support to the economy from the fiscal side will be temporary, given the dire need to get government finances back on track.

The big standout for the quarter was exports, which expanded 6.5 percent (figure 1). Exports are benefitting from a rise in competitiveness due to a weak real—both nominal and trade weighted.4 With imports declining in Q1, net exports contributed positively to GDP growth, thereby providing much-needed relief to the economy.

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The new government means businesses

The new government has its work cut out. GDP contracted for the fifth straight quarter and for the seventh time in eight quarters. The fiscal deficit is in double digits. Inflation is way above Banco Central do Brasil’s (BCB’s) 2.5–6.5 percent target. Worse, confidence in politicians is at an all-time low.5

Thankfully, President Michel Temer appears to have started on the right note by putting in place a credible economic team. The finance minister, Henrique Meirelles, headed BCB during 2003–11 and was at the forefront of the fight against inflation in the last decade. Ilan Goldfajn, the new BCB governor, has reiterated his commitment to tackle inflation. Most importantly, both of them agree on the need to improve the government’s finances.

The government’s first step has been to improve transparency in fiscal management. In May, lawmakers approved a primary deficit of 170.5 billion Brazilian reals (2.8 percent of GDP) instead of a surplus as projected in the initial budget. Without this approval, the government would have ground to a halt. Clarity on budget figures is also likely to boost credibility among rating agencies and investors.

In its efforts to cap spending, the government intends to amend the constitution to index budget spending to inflation for the next 20 years.6 If revenues go up due to any economic recovery, the excess amount will be used solely to narrow the deficit. Interestingly, curbs on spending will extend to two key sectors—education and health—that have often remained outside the ambit of budget cuts. The government has also asked the public sector development bank BNDES to repay its treasury debt.7

Falling bond yields and a return of confidence have mitigated the threat of fiscal dominance to a large extent.

The new administration has also talked about pension reforms, a key component of government spending. According to the Wall Street Journal, about 41 percent of Brazil’s federal budget spending is directed toward pensions; the comparative figure for the United States is 24 percent.8 Temer’s team has started consultations with labor unions in a bid to prepare a proposal for pension reforms soon.9

The government is also mulling other reforms such as scrapping the sovereign wealth fund, greater participation of private companies in the oil and gas sector, increased privatization, more infrastructure concessions to the private sector, and tax reforms.10  If carried out, these measures will likely help Brazil gain competitiveness in the medium to long term.

The markets are loving it—for the moment

Markets seem to approve of the changes. Equities, for example, have bounced back this year, although much of the change was priced in earlier. The Ibovespa stock index is up 17.3 percent this year, while the financial index—a key forward indicator of macroeconomic movements—is up 24.4 percent. Given Brazil’s relatively open capital markets, rebounding equities will help stem capital flows. Confidence will be further strengthened if the government passes key reforms. The real has already benefitted (figure 2) and is one of the strongest emerging-market currencies this year. This, in turn, has helped curb imported inflation; import prices of both consumer goods have been contracting (year over year) since last year.11

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Arguably, the best news is the decline in long-term interest rates. Yields for 10-year government bonds have fallen about 3.7 percentage points so far in 2016 (figure 3). This will bring down the cost of servicing government debt. If this trend of falling yields persists, the BCB will find it easier to cut rates when inflationary pressures retreat.

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The threat of fiscal dominance abates further

Falling bond yields and a return of confidence have mitigated the threat of fiscal dominance to a large extent. The government’s borrowing requirement is now at about 10.1 percent of GDP, while interest payments amount to 7.8 percent, lower than at the beginning of the year (figure 4).12 Inflation has eased partially to 9.3 percent in May from 10.7 percent in January. It is likely that the lagged impact of monetary policy and the base effect have come into play.

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Despite these improvements, restoring confidence in monetary policy will not be easy—at least, not until inflation falls back to the target range of 2.5–6.5 percent (figure 5). Without that, BCB will not be able to cut the policy rate, which, at 14.25 percent, is the highest among prominent emerging economies. In June, BCB kept its policy rate unchanged yet again, waiting for more improvements on the fiscal front. In a sign that market participants are still unsure about price pressures, inflation expectations for the next 12 months have gone down by just one percentage point this year.13

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The way forward won’t be easy

GEO_Q316_Brazil_Image2The key hurdle for Brazil’s economy is political uncertainty. Trouble has already started for the new government—although it is a temporary one, at least until former president Dilma Rousseff’s impeachment process is completed. Three ministers have resigned so far.14 Also, while the proposed reforms are encouraging, the passage of these reforms faces different hurdles. Pension reforms, for example, will face opposition from labor unions, especially those aligned with the previous government. Unions resent the proposal to raise the retirement age and want to make any changes to pensions applicable to just new job market entrants.15 Other reforms, such as the one on inflation-indexed budget spending, will have to be passed in the legislature with a two-thirds majority. For now though, the government appears to have the numbers.16

External problems also abound. Brexit will weigh on global markets, and emerging economies such as Brazil will be no exception to this volatility. That could, in turn, put pressure on Brazil’s currency and push bond yields up. A global shock could also dent exports, a key source of sustenance for Brazil’s economy of late. And while markets have given the benefit of doubt to the new administration, they can be unforgiving if the administration fails to deliver on reforms. Latin American economies, including Brazil, have learnt this the hard way. The government will do well to keep that in mind.