Brazil: rays of light at the end of the tunnel
Political risks have decreased and the economic downturn seems to be bottoming out, but the outlook of the currently dire fiscal position is still uncertain.
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.
(-) Unsustainable fiscal position
Large budget deficits have pushed public debt close to 80% of GDP. Moreover, public debt will only increase further without a sustained fiscal consolidation effort.
1. Political milestone behind us, but risks persist
On 31 August 2016, the Brazilian senate voted in favor of impeaching president Dilma Rousseff, thereby putting an end to a period of high political uncertainty. The end of the interim period is likely to boost president Temer’s political capital, which is needed as he has to deliver on envisaged fiscal reforms sooner rather than later. He is expected to be fairly successful in implementing microeconomic reforms, such as the opening of the energy sector. Progress on more contentious fiscal measures, such as the pension reform, is more uncertain. Temer’s strong political negotiation skills bode well, but the high fragmentation of congress and the volatile nature of Brazilian politics pose a challenge. Besides, time is not on Temer’s side. He needs to get most of the work done before 17H2 when the electoral campaign for the 2018 elections starts, and the slow nature of Brazilian congressional processes does not augur well in that regard. Besides, contagion from the Lava Jato or offshoot corruption investigations remain a threat. The recent expansion of investigations to state pension funds reinforces the persistent character of this threat. For contagion to become a real threat to the cabinet, direct involvement of the president or a key member of the economic team would have to be proved though. All in all, political risks have diminished significantly but have not been eliminated fully.
2. The economic downturn seems to be bottoming out
Confidence and market sentiment have benefited from the government change and there are signs the economic activity might be reaching the trough and move towards a mild economic recovery in 2017. The ouster of Dilma Rousseff and the return to more sensible policies was embraced by markets even during the interim phase (figure 1). The resulting confidence boost seems to be translating to economic activity, as 16Q3 was the first quarter to record a q-o-q growth in investments since 13Q3. Also inflation has been decreasing, partly due to base effects, which should support purchasing power and eventually monetary easing in the coming year (figure 3). Nevertheless, on a y-o-y basis, the economy contracted in the first two quarters of 2016 (figure 2), with net external demand remaining the only positive contributor to the economy. Other economic indicators such as industrial production (IP) and the economic activity indicator, also remain in negative territory. Overall, the economy is estimated to contract by 3.2% y-o-y in 2016. Positive developments will help activity to stabilize in 16H2 and a GDP growth recovery of 0.5% in 2017. The recovery will be mild due to constraints such as tighter credit conditions for especially corporates, high and increasing unemployment, high leverage levels in the private sector and low capacity utilization in the industry.
3. Public finances still on an unsustainable path
The outlook for the dire public financial situation is less certain, as it depends on the capacity of the current government to pass contentious fiscal reforms through congress. Even if all reforms are approved, public debt is only expected to start decreasing in the beginning of the 2020s, so there is little room for complacency. Brazil’s budget deficit reached 10.3% of GDP in 2015 and is expected to remain a high around 8% of GDP in 2016 on the back of low revenues (due to the economic recession), rigid expenses and high debt servicing costs. The 2.1% of GDP primary balance target recently proposed for 2017 is also not very ambitious – only half a year ago the government was talking about achieving primary surpluses. The current target will cut the budget deficit to 8% of GDP, as debt service costs are expected to fall in 2017. Nevertheless public debt is expected to continue to make large leaps upwards – from 67% of GDP in 2015 to 80% of GDP in 2017, which is extremely high for an emerging market. Should the government fail to get envisaged fiscal reforms or get them adopted in a very diluted form, the risk of a fiscal crisis would become imminent in the longer term. The strong domestic appetite for government debt provides some mitigation against a sovereign default, but it also creates a dangerous symbiosis between local institutional investors and the government. Hence, a crisis is more likely to entail a shift to very short term financing and very high interest rates.
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 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. Brazil also has the potential to become a major oil producer, though the high costs of its deep water pre-salt fields makes it less attractive for investment while oil prices remain low. Brazil also has an important manufacturing sector. Decades of reforms and track record have led to the formation of an apolitical and independent judicial system which culminated with the Lava Jato, a gigantic corruption case involving the business elite and high ranking politicians. On the other hand, Brazil scores very poorly on press freedom and that has only deteriorated in recent years.