Brazil: headwinds intensify
The Brazilian government is trying to reverse the strong increase of the fiscal deficit and inflation of the past years against an unfavourable external environment. That is taking a toll on confidence and the economy. Political headwinds due to a major corruption scandal complicate the situation.
Strengths (+) and weaknesses (-)
(+) Relatively diversified economy and a large domestic market
Brazil’s exports are relatively diversified, both in terms of export products and markets. Together with the large domestic market, this reduces the vulnerability to external shocks.
(+) Large stock of foreign reserves
Brazil’s foreign exchange reserves stood at USD 365bn, or around 15 months of import cover, at the end of August 2015 and thereby provide a cushion against liquidity risks.
(-) Structural issues constrain growth potential and hurt competitiveness
A complicated and high rate tax system, a large infrastructural deficit and an inadequate supply of human capital constrain the competitiveness of Brazilian producers and economic growth potential.
(-) Sizeable current account deficit
Large and increasing current account deficits, no longer covered by FDI since 2013, render Brazil vulnerable to a sudden stop or reversal of capital inflows.
1. Brazil slides into one of the deepest contractions in history and perspectives are bleak
The Brazilian economy fell into recession in 2015 on the back of a deteriorating labour market, very negative sentiment, a credit slowdown and monetary and fiscal tightening. The outlook for 2016 is also dim. The Brazilian economy contracted by roughly 2% yoy in 15H1 and the only bright spot was net external demand. More importantly, private consumption contracted for the first time since 2003 on the back of high inflation, a deteriorating labour market, a credit slowdown and prevailing negative sentiment. The labour market deterioration does not come as a surprise after many years of weak growth. The continued fall of the unemployment rate that took place until recently was driven by a fall in the participation rate. That was particularly the case among the young as educating enhancing measures of the government delayed entrance to the labour market. A marked pickup in labour participation, partially due to the delayed entrance to the labour market of the first groups affected by the measures, and contracting employment pushed the unemployment rate up by 2ppts since December 2014 to 7.3% in July. Inflation soared from 6.4% at the end of 2014 to 9.5% in July 2015, as administered prices were increased and the real has depreciated by 43% since January 2015, partially as FX interventions were reduced.
Another drag on growth was the Lava Jato corruption scandal (see key development 3), which has severely damaged economic activity in the energy and construction sector (infrastructure). Lastly, a fiscal and quasi fiscal consolidation also took its toll on economic activity, particularly the sharp fall in cheap financing by public banks, which account for more than half of total bank assets. The recession is likely to continue in 2016, but the contraction of GDP is likely to be much smaller than in 2015, as most of the correction of past macroeconomic imbalances will have taken place, the government is shifting its focus towards growth-enhancing measures and the impact of Lava Jato on economic activity and sentiment is likely to moderate, despite an expected further weakening of the labour market and credit supply. We expect growth to be in the -0.5%-0% range next year.
2. Fiscal consolidation runs into execution difficulties
Ambitious fiscal consolidation plans announced at the beginning of this year are running into political headwinds and cost Brazil its investment grade rating with S&P. Following elections in October last year, a new economic team embarked on the difficult task of bringing Brazil’s primary balance back into positive territory from a 0.6% of GDP deficit in 2014. However, Brazil’s constitution makes it almost impossible to implement expenditure cuts to large part of the budget and high political tensions and fragmentation in congress have made the necessary approval for reining in such spending very difficult. Besides, the economic contraction is hurting revenues. Consequently, the primary deficit increased to 0.9% of GDP in 15H1 and the government reduced the fiscal targets for 2015-2017 significantly and postponed the stabilisation of public debt to 2018. A second downward revision of the 2016 primary balance target by 1ppt to -0.3% of GDP within six- week time is damaging the government’s credibility. It is the first time since the adoption of the fiscal responsibility law in 2000 that the government is not targeting a primary surplus. This backtracking on fiscal consolidation also resulted in Brazil losing its investment grade sovereign rating with S&P on 9 September. Moreover, there is a high chance that authorities will even miss the revised targets, as congress support for planned measures remains volatile and discretionary spending accounts for a small part of total spending. Lava Jato could complicate things in coming months, as ongoing investigations move to formal accusations of politicians and increase tensions in congress. Furthermore, restoring fiscal sustainability and policy credibility is currently highly reliant on the leadership of Finance Minister Levy. Tensions around the 2016 budget raised speculation about his departure, which would darken the economic and political outlook. The probability of a departure still seems low, though the downgrade to junk might reduce his political support.
3. Lava Jato, a corruption case with impact?
The Lava Jato corruption scandal is having a high political and economic short term cost. It remains to be seen whether the scandal will lead to institutional gains in the longer term. Lava Jato is a corruption scandal involving bribery at state owned oil company Petrobras that has so far led to the investigation and arrests of high ranking politicians and some of the richest executives in Brazil. The scandal has spread out to the majority of the companies in the construction sector and, thus, has severely damaged economic activity in the energy and construction (particularly infrastructure) sectors. The involvement of high ranking politicians has increased tensions in congress and hindered ongoing fiscal adjustment. As official investigations in the political arena are likely to intensify in coming months, the situation could deteriorate further and threaten governability. However, the impact on institutions remains to be seen. It has revealed some positive developments: an increasingly autonomous and qualified justice system in Brazil and stronger use of existing and new legislation. It has also increased attention to the corporate governance of state owned companies within congress. But high ranking politicians have managed to reduce serious indictments to a light punishment in the past. Time will tell whether this case will make a difference.
Brazil has a turbulent macroeconomic and political history. After a long period of military rule, democracy was (re)established in the 1980s. Brazil had to reschedule its public debt in the late 1980s and experienced hyperinflation in the late 1980s and early 1990s. Since the launch of the Plano Real in 1994, Brazil has been able to make its macro economy much more stable, in spite of a number of crises in the first decade after the launch of the Plano. Rising commodity demand and booming domestic demand on the back of vigorous wage and credit growth and government support programmes resulted in strong economic growth in the 2000s. Due to progress on reducing poverty and inequality Brazil is no longer one of the most unequal countries in the world, but income disparity remains high, even by Latin American standards. Several structural issues limit the growth potential of the economy. First, the savings and investments ratios are extremely low. Second, tax rates are high and the tax system is extremely complicated. Third, the quality of infrastructure, education and health is quite low. However, Brazil’s banking sector is well capitalised and supervised and is expected to remain so during the current difficult economic environment, despite some deterioration. Brazil’s exports are relatively diversified, both in terms of markets and products, even as the reliance on commodity exports has increased in the past decade. Brazil is a global player in the agriculture sector and is well positioned to benefit from the likely continued rise of global demand for food and agricultural products. Brazil also has the potential to become a major oil producer, but deepwater, pre-salt fields make it a high cost producer and low oil prices could delay the development of the sector. Brazil also has an important manufacturing sector.