Brazil: caught up in a political storm
Brazil is struggling with policy paralysis and a deep recession as a colossal corruption case has brought politics to a gridlock. Little improvement is expected in 2016.
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 356bn, or around 17 months of import cover, at the end of 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 twin deficit
Large current account deficits and soaring budget deficits render Brazil vulnerable to swings in market sentiment, which could affect access to domestic and external financing.
1. Lava Jato increases tensions and leads to political gridlock
Political tensions edged up higher on the back of Lava Jato and related corruption investigations, leading to political gridlock and undermining governability. Lava Jato is a colossal corruption case regarding kickbacks at state owned oil company Petrobras involving the business and political elite. Many arrests of executives in energy, construction and engineering in 15H1 hurt economic activity markedly. The pace of arrests slowed down in 15H2, even as a member of parliament was detained (the first MP detention ever) then for obstruction of justice, despite his immunity. The arrest of the director of BTG Pactual, the largest investment bank in Latin America, thereby also raised concerns about contagion to the financial sector. On top of that, leaked testimonies and rumours suggested involvement of the whole political spectrum and the highest political ranks, such as former president Lula, opposition candidate Neves or chief of staff Wagner. This stoked tensions and pushed policy making to the backseat.
Tensions also increased political instability, as the decision of lower house president Cunha to start an impeachment proceeding against President Rousseff seems to have been precipitated by the decision of the ethics committee to proceed with a motion to strip him of his seat due to corruption allegations. Given the fact that the impeachment motion needs the votes of a two-thirds majority to pass the lower house, the president looks likely to stay in office. But that will not improve stability, given that the threat of impeachment will persist on the back of low approval rates and high political polarization as Lava Jato continues to unfold. Besides, we cannot rule out an impeachment of the president. Impeachment will not restore governability. First, it is poised to be a protracted procedure. Second, vice president Temer, who is first in line to succeed Rousseff, could also come under fire as many of his fellow PMDB members have been linked to the Lava Jato.
2. Macroeconomic policy becomes increasingly erratic or absent
The political polarization described above has led to a marked deterioration of macroeconomic policies. The main victim of increasing political tensions has been the fiscal position. 75% of public spending is constitutionally mandated and can only be altered with congressional approval. This allowed an increasingly rebellious congress to constrain the implementation of fiscal austerity measures. Consequently, between 2014 and 2015 the budget deficit soared by 4 percentage points (ppts) to 10.5% of GDP (figure 1). Falling revenues as the economy contracted, higher debt service as monetary policy was tightened and payment of past arrears also pushed the shortfall higher. Public debt skyrocketed by 15 ppts to 72% of GDP in 2015.
Policy also became increasingly erratic as President Rousseff tried to balance restoring confidence of markets and appeasing to her leftist PT base. The primary deficit target was revised three times within two months’ time. Backtracking on fiscal policy and the deterioration of the public finances cost Brazil its investment grade with two rating agencies in 15H2 and precipitated the departure of Minister of Finance Levy on 18 December 2015 . His successor, Nelson Barbosa, is less hawkish on fiscal consolidation. Little improvement is expected in coming years and that places public finances on an unsustainable path. Moreover, we are concerned about the direction of macroeconomic policy in general. Recently, the Brazilian Central Bank (BCB) has not followed suit on hawkish rhetoric, raising doubts about its independence. Between the political gridlock and Rousseff trying to appease to different support groups while on the defensive, policy is poised to be absent or erratic moving forward. This will keep the economy muddling through and damage the country’s long term economic potential. More importantly, it tilts the risks to the economic outlook further to the downside.
3. The economy slides into one of the deepest and longest recessions in history
The economy is estimated to have contracted by 3.7% in 2015, the largest contraction since 1990, as the labour market deteriorated, credit conditions tightened and double digit inflation eroded purchasing power. Only exports contributed positively to growth, despite a less benign external environment. The political backdrop and policy inaction pushed private sector confidence to historic lows and exacerbated existing economic woes. This is reflected in the fact that over the course of 2015 economists’ economic growth expectations fell by roughly 4ppts for both 2015 and 2016 (figure 2). Economic activity is likely to stabilise in 16H2, but is forecast to contract by around 3% over the whole year nevertheless, as the political and policy backdrop remain unfavourable.
4. Depreciation lowers CA deficit, while FDI remains strong
Brazil’s current account deficit is estimated to have shrank by 1ppt to 3.3% of GDP in 2015, as a 32% depreciation of the BRL and weak domestic demand contained imports, despite lower export receipts due to softening commodity prices. Moreover, net FDI inflows were 3.4% of GDP and once again covered the current account deficit. As a result, Brazil’s external balances have become less susceptible to the fall of more volatile capital flows and, thus, to a deterioration of market sentiment. This is good news in light of Brazil's downgrade to junk by 2 rating agencies in 15H2 and, together with large holdings of FX reserves, underpins the country’s external position.
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. 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 current low oil prices make the further development of the sector less certain, given the high costs of its deep water, pre-salt fields. Brazil also has an important manufacturing sector.