In 1997, foreign investors fled Asian markets and these once unstoppable countries came to be called “Paper Tigers” as the region was swept up in a financial flu. Could it be that within the next two years Brazil will be identified as a “Paper Jaguar” as it falls ill with a financial dengue fever? There are certainly a number of striking differences between Asia in the 1990s and Brazil over the last five years. However, there were also great differences between 1950s communist Soviet Union and 1990s East Asia, yet this did not deter economist Paul Krugman from identifying factors which were shared by both. These same factors may also exist in the Brazilian economy, resulting in the fate that befell the once revered Asian countries.
In his 1994 essay titled “The Myth of Asia’s Miracle," Krugman posited that sustained economic growth cannot be achieved only with increases in inputs such as growth in employment and increases in capital. He concluded that long term prosperity required a rise in output per unit of input and not merely additional capital investment. The rapid growth of the Asian Tigers was largely attributed to growth in available labor and capital rather than growth in total factor productivity. Net private capital flows to South Korea, Indonesia, Thailand, Malaysia and the Philippines had risen from $37.9 billion in 1994 to $97.1 billion in 1996 and unemployment rates were remarkably low in most of Asian countries. According to Krugman, all of the growth experienced in the region can be explained by increases in measurable inputs and not increases in efficiency.
Foreign capital flows to Brazil in 2010 grew 16.3% to $30.2 billion and unemployment dropped to 6.1%, representing a significant increase in capital inputs. Meanwhile, productivity has remained notably low from 2000-2008 at a rate of less than 1% annually (as compared to the United States, which averaged 4.6% per year over the same period). This would indicate that Brazilian growth is more closely correlated with increases in overall inputs than increases in output per unit of inputs. According to Krugman’s assessment this would place Brazil on the same unsustainable path as the economies of East Asia. Brazil in 2011 likely has more room to increase inputs than the Asian countries did in 1997, but unless the South American giant addresses efficiency issues, the current boom may be short-lived. A number of factors could increase Brazilian productivity including improved infrastructure, education and technology and reduced regulation and taxes.
The Asian crisis resulted in a massive exodus of foreign capital which economist Joseph Stiglitz compared to a bank run. The second half of 2008 already witnessed a rapid pullout of foreign capital from Brazil and it is entirely possible that a similar event could reoccur.
One trigger for a reversal of capital flows could be interest rate hikes by the U.S. Fed, or even a termination of QE2. A recent IMF study indicated that “the Fed's ultra-easy monetary policy - particularly its current $600 billion bond-buying spree - have sent even more hot money flooding into the (emerging market) economies, driving up inflation.” In the study, Brazil was in seventh place in terms of its vulnerability to U.S. policy. Although interest rate increases are not expected this year, there is a growing belief that QE2 will end shortly and not be followed by QE3 due to a number of factors, including signs of strength in the U.S. economy and employment, an increase in hawkish views in the Fed, rate hikes by the European Central Bank and political sentiment against further money printing.
The capital inputs in Asian markets did not come to an end until three years after Krugman’s premonition. Brazil may not have that much time to improve its productivity outlook and allow for a sustainable Brazilian miracle.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.