In late December, Brazil’s central bank trimmed its estimate for 2012 GDP growth: a miserly 1%. The projection set off a debate over the extent to which Brazil’s economy – seen as one of the most dynamic emerging market stories of recent years – is vulnerable to cyclical blips, amid global growth shocks.
More ominously, the poor rate of expansion in 2012 fed fears Brazil is more exposed to structural downturns - triggered by its well-known chronic weaknesses: the infrastructure deficit and poor productivity - than the government would like to admit.
The Brazilian economy has been slow to recover momentum in the past two years and despite the central bank’s prediction of 3.3% growth in 2013, there is widespread confusion as to what economists should now view the country’s long-term trend growth rate.
Brazil’s economy came a long way in a short space of time as its large commodity sector grew rapidly. During the past decade, foreign investors’ appetite for Brazilian investments leapt: FDI and capital flows were attracted to the country by its huge long-term growth potential and very high interest rates, with the allure of the latter compounded by depressed yields in G7 markets.
The newfound stable macro-economic management, its strong financial sector and a model of growth driven by internal demand have all added to Brazil’s appeal. Brazil’s demographic potential is huge: some 31 million people joined the ranks of the socio-economic C and D classes in the decade up to 2010.
The country also easily withstood the 2008 economic crisis, when a small dip in GDP growth in 2009 was followed by a leap of 7.5% in 2010. However, in 2011 growth slackened considerably to 2.7% – much lower than its emerging market peers. That has been compounded by 2012’s sluggish performance, leading many analysts to call for a re-tooling of the Brazilian economic model.
“Brazil is at a crossroads,” says Ramón Aracena, chief economist of the Latin American department at the Institute of International Finance (IIF). “It either has to step up structural policy efforts to achieve higher non-inflationary self-sustaining growth and build upon its strengthened macro-position, or risk endangering the quality of the policy mix and eroding policy reputation by failing to increase capacity in an attempt to sustain high growth.”
Side-tracked by FX
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| Mantega; source: Reuters |
Brazil’s finance minister Guido Mantega was the first to declare an outbreak of “currency wars” in September 2010. Since then, many feel that the Brazilian economic policy has become too focused on the exchange rate.
When the real appreciated strongly against the dollar, reaching a high point of under $1.55 in July 2011, the government saw a threat to its manufacturing sector. Its response was a series of macro-prudential measures to curb capital inflows, and a re-interpretation of the monetary policy mandate, with rate cuts – the Selic has dropped to 7.25% from 12.50% in August 2011 – driven by exchange-rate, rather than inflation, targeting.
These FX-orientated policies worked, insomuch as the real returned – and has remained – in a band between $2.00 and $2.10, at which level the Brazilian government is comfortable. However, the level to which the real’s decline is due to these factors is debateable, with the global fall in cost of commodities and the country’s slower GDP undoubtedly also having an impact.
Neither has the fall in the value worked: in November, Brazil posted a trade deficit of $187 million, compared with a surplus of $577 million one year earlier. In the same month, exports fell 6% from the previous ($20.5 billion), while imports fell 2.5% to $20.7 billion. The central bank predicts that the country’s trade surplus will fall in 2013.
“The exchange rate is not the only variable to assess international competitiveness,” says the IIF’s Aracena. “The government also needs to look at other factors, for example lack of investment, infrastructure bottlenecks and an excessive tax burden in Brazil, which is one of the highest in the world.”
The government is making other efforts to stimulate growth this year. Last year it announced the sale of infrastructure concessions. It has also applied a series of tax cuts for selected industries, such as car manufacturing and consumer goods, along with a reduction in the long-term lending rate, known as the TJLP, used by the state development bank BNDES, to 5.5% from 6%.
Mauro Leos, Moody’s Brazil analyst, says these policies might help growth in the short term but won’t address the country’s fundamental challenge.
“To increase Brazil’s potential growth in the medium term requires policies focused on productivity, which is closely linked to investment and the labour market,” he says. “The government is trying to move in that direction but it will take time.”
Reform drive
Without fundamental reform, any success in promoting growth is likely to lead to inflationary pressures in the short term. Despite the recent slowdown, the country’s inflation is high (CPI is 5.71%) and unemployment is low (4.9%).
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| Brazil's President Dilma Rousseff; source: Reuters |
The government is expected to try to avoid raising interest rates to rising inflation – it will likely fall back on its capital controls before risking raising the Selic and the likely pressure on the real to appreciate.
“The country has had very decent macro-economic policies to date and Brazil has significant international reserves [with which] to face off disturbances from abroad but the next step is to get leaner and meaner,” says Aracena, who also states that any further build-up in its dollar reserves from fighting appreciation would have a substantial impact on the living standards of Brazilians.
“It’s normal for an emerging market currency to appreciate – it has happened all over Latin America but the policy response has been different elsewhere. Other countries, notably Mexico, have allowed their currencies to float and they have done better. Appreciation imposes discipline.”
Many believe the time to address these underlying issues has come. Without fiscal and labour reform, and increased investment in infrastructure and education, economists warn that the country will be poorly placed to deal with the impact of future oil and other commodity booms.
The pre-salt oil fields should be producing substantial dollar-denominated revenues within five years. New farmland is being developed that will add to the concentration of the economy on commodities. If Brazil doesn’t become more flexible and productive in the next few years, the appreciation in the real caused by this anticipated commodity boom could choke off other sectors in the economy, and no level of government FX engineering will compensate.
“Avoiding the disruption to the macro-economy in terms of the impact of the exchange rate will be a very important challenge for the government,” says Moody’s Leos. “The good news is [Brazil] has time to develop a sovereign wealth fund or a stability fund to limit the impact of the oil boom. [The bad news is] that the political reality in Brazil is so complex that it is never easy to do anything, but this could become a very important factor.”