Brazil at a Crossroads
Need to Know . . .
- Brazil’s economy is in stagflation mode—a mix of recession and inflation. Manufacturing activity decreased 6% over the last six months and business and consumer confidence plummeted
- A confidence shock is needed to address flagging business sentiment and to start building the bridge out of the economic slump
- It will take the right policies to address Brazil's macroeconomic imbalances and that entails some short-term pain in exchange for longer-term gains
Over the past 15 years, Brazil has made significant progress on raising incomes and taking millions of people out of poverty. A more stable economy with relatively sound fiscal and monetary policies was enough to unleash economic growth and fulfill the economy’s output gap. Tailwinds in the form of higher commodity prices—especially iron ore and agriculture-related products—also contributed to the expansion. But over the past four or five years, government-imposed demand-driven growth (mostly via tax incentives on manufactured goods) heated up the economy and dampened the fiscal picture. Overall GDP growth slowed significantly and the industrial sector stopped growing back in 2010. As a result, business sentiment deteriorated. Inflation accelerated and is now above the upper band of the Central Bank’s target. The government response to the sluggish economic performance was to continue fueling the economy via tax breaks and tightening import restrictions in an attempt to boost the local industry. The plan did not work and instead made matters worse by fueling inflation.
Recently re-elected President Dilma Rousseff is at a crossroads. She needs to be loyal to her voters by maintaining some of the populist politics she promised in the campaign, yet she knows that she was elected by the narrowest margin in the country’s history and a change in the policy mix is necessary. Expectations are down to the floor and pessimism among private sector leaders is at levels I have not seen in more than a decade. At a recent event with prominent businessmen in São Paulo, I had the opportunity to listen to their concerns. Clearly, the business community and most of the country’s middle class were expecting Senator Neves to be elected president—more than 48% of Brazilians were hoping for a turn to economic orthodoxy. One important business leader said, “São Paulo looked as depressing in the aftermath of Rousseff’s re-election as it was the night Germany overtook Brazil by 7 to 1 in the World Cup semifinals.” Some of them mentioned plans to leave the country and do business elsewhere. This is an overreaction to what they view as tremendously negative election results. In Brazil, pessimism about the economic outlook reigns.
The Macro Challenges
The latest official statistics portray Brazil’s challenging present and worrisome outlook. Economic growth is stagnant at best, inflation remains high, and public finances are deteriorating. The economy was in a technical recession in the first half of this year and is expected to post virtually no growth in 2014. Manufacturing production plummeted by almost 6% year over year in the last two quarters, with the automotive industry showing a 22% contraction. Layoffs are becoming the norm and the unemployment rate will surely rise in the next few months. At roughly 7%, inflation is above the upper limit of the Central Bank’s target despite government-imposed price controls on electricity, fuel, and public transportation. My concern is that there is pent-up inflation, or in other words, there is plenty of inflation to be passed through to consumers once administered prices are lifted. A deteriorating budget deficit is clearly a result of a combination of weaker revenues—courtesy of generous tax breaks and slower growth—and government overspending for electoral purposes.
Corruption adds to Brazil’s challenges. A few weeks back, the federal police arrested 18 suspects in an ongoing corruption probe into Petrobras, the state-controlled oil giant. Suspects include Petrobras executives appointed by the Rousseff administration and executives from other oil firms and large construction companies. This Petrobras corruption investigation—called “Operation Car Wash”—is attempting to root out nearly $4 billion in illegal financial operations. The case is sensitive, especially in today’s ragged political environment. When the arrests made headlines, the stock market tumbled and the real reached a nine-year low against the U.S. dollar.
A Confidence Shock Is Needed
The government must address flagging business sentiment and start building the bridge out of the economic slump. Appointing people with the right credentials is paramount to stop the decline in confidence levels. When rumors arose that President Rousseff would appoint Joaquim Levy as finance minister, the stock market rose 5% and the real gained 2.3% in just a few hours. Levy was fiscally responsible when he served as treasury secretary under Luiz Inácio Lula da Silva starting in 2003. In 2010, Levy became the head of Bradesco Asset Management, one of the country’s biggest fund management companies. He holds a Ph.D. in economics from the University of Chicago and has worked in various roles at the International Monetary Fund, the Inter-American Development Bank, and the European Central Bank—the right credentials to restore some confidence.
Levy was officially announced as finance minister on November 27. Rousseff also announced that former Treasury Secretary Nelson Barbosa would become the planning minister, overseeing the country’s major infrastructure projects, and Alexandre Tombini would continue in his job as the head of Brazil’s Central Bank. These three are Rousseff’s new economic team and are well-respected economists. It is expected that they will make announcements in early December with the aim of restoring confidence, a necessary condition to take the economy out of the doldrums.
The Tough Choices Ahead for Policymakers
Unfortunately, it will take more than just appointing the right people to run key ministries—the right policies are needed to address the current macroeconomic imbalances and that entails some short-term pain in exchange for longer-term gains. Hiking interest rates to curb inflation will slow growth even further, leading to rising unemployment and discontent. Improving the fiscal situation will involve eradicating some of the tax breaks for consumption and reducing government spending, also denting growth. Although I believe that the new cabinet understands the challenges, all decisions will have to be run by President Rousseff, who is herself a trained economist known to be heavily involved in overseeing economic policy. On that point, politics will prevail over economics and politicians are always skeptical of policies that focus on long-term gains and bring no relief in the short run.
Brazil is at a crossroads and President Rousseff and her new cabinet will have to make difficult choices. Will they be willing to endure short-term pain in order to achieve more sustainable growth in the medium and longer term? In my view, the government is already sending the right signals to correct the imbalances. I suspect Rousseff will push for a gradual correction of imbalances in an attempt to ease the pain of slower short-term growth, though I am not sure that a gradual approach will work this time. Over the next few weeks and months we will have a better sense of the government’s strategy and we will be able to more accurately predict Brazil’s longer-term outlook. In the meantime, the short term will be fairly daunting.
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