A Lesson From Brazil's Backwards Development

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Includes: BRZU, BZQ, DBBR, EWZ, FBZ, UBR
by: Dartmouth Business Journal

At the start of the twenty-first century, Brazil's economy was floundering. Record levels of unemployment, high inflation and the woes of its trading partner, Argentina, were just a few of the factors contributing to a Brazilian economic rut. But global expectations were optimistic. British economist Jim O'Neill had just published his seminal paper forecasting the rise of the BRIC (Brazil, Russia, India and China) nations and their future influence on the global stage. A new President had been elected, riding his campaign on promises of cutting government spending and bringing stability back to the economy. Brazil was still resource rich and had underdeveloped manufacturing and industrial sectors. There was no reason to think Latin America's biggest economy wouldn't right its ship and capitalize on its sizable economic potential.

Over the next 10 years, Brazil emerged as a powerhouse economy, cementing its place as a BRIC nation and as the economic driver of South America. According to the World Bank, GDP growth year over year from 2002 to 2012 averaged four percent. GDP per capita grew nearly 450 percent. An estimated 35 million people were lifted out of poverty. Foreign investment increased, and Brazilian business magnates made fortunes in the mining and oil industries. Even as the 2008 financial crisis harmed many of the world's economies, Brazil's stayed steady and, according to the Wall Street Journal, posted a growth rate of 7.6 percent in 2010. The country was selected as the site of the 2014 FIFA World Cup and as the host of the 2016 Summer Olympics. Unemployment fell from a high of 14 percent in 2003 to just 5.4 percent in 2012. President Dilma Rousseff's approval ratings were nearly 60 percent that year, an enviable number for any chief of staff.

Her ratings now hover at an abysmal 12 percent, with the country in the grips of its worst economic crisis since the Great Depression. World Bank statistics indicate unemployment has climbed back up and is currently at almost nine percent, a six-year high. Inflation year after year has topped 10 percent for the first time in a decade. In response to sizable trade reductions, the country's currency, the real, has had a 30 percent annual depreciation against the dollar. Protests regularly occur in the streets and calls for the President's impeachment are growing louder. A formal attempt to remove Rousseff has already occurred and failed in December 2015.

While a lot of factors contributed, and are contributing, to Brazil's economic regression, two loom tall: politics and dependence on commodity exports.

The latter of these problems seems counterintuitive, as economists worldwide touted Brazil's plentiful resources. Economists believed that exporting would bring in much needed revenue to fix Brazil's infrastructure and poverty problems. Indeed, according to the Wall Street Journal, companies like Vale (NYSE:VALE) (iron ore) and Petrobras (NYSE:PBR) (oil) deployed fleets of new ships and developed deep-water rigs in the Atlantic, respectively, to extract these resources and export them across the globe. One country in particular became a heavy importer of Brazilian commodities: China.

If Brazil's economic rise was one of the stories of the twenty-first century, then China was the story. Its enormous growth meant it needed resources to drive its economy and satisfy its increasingly wealthy population. Brazil, as a top producer of iron ore, oil, soybeans and beef, was a prime candidate. So began a fruitful relationship. Trade with China, totaling $2 billion in 2000, reached $83 billion in 2013, according to the World Bank. China replaced the United States as Brazil's largest trading partner. Backed by Chinese imports, iron ore grew from $19 a ton in 2001 to over $126 a ton by 2011.

Buoyed by its relationship with China, Brazil believed that the United States' traditional dominance in Latin American trade was at an end. It worked with its anti-American neighbors such as Venezuela and Argentina to prevent American free trade agreements from taking hold in the region. It formed a security coalition with other Latin American countries to supplant the one already in place. Brazil had always been prominent in Latin America, but it now sought to expand its influence into the rest of the Western hemisphere.

Politicians spent and invested accordingly. Budgets were planned in advance, based on anticipated commodity sales. Extravagant spending on World Cup and Olympic stadiums became the norm. The Wall Street Journal report that consumer credit was extended heavily, and the Brazilian Development Bank's loan portfolio became bigger than that of the World Bank, causing many loans to be made at below-market rates.

This expenditure rested on the assumption that demand and prices for Brazilian commodities would remain at high levels. But as China's economy began to slow, coupled with plummeting global oil prices, Brazil's economy began to unravel. Loans could not be repaid. Mines fell into disuse and laid off thousands of workers. Petrobras' investment in deep-water oil rigs didn't pay off, and it is now the most indebted oil firm in the world with over $125 billion of debt. Moody's charts show that government debt as a whole has risen almost 10 percent over the last two years and is currently at about 65 percent of GDP.

In addition, accusations of corruption have plagued the administration in recent years as the economy has taken a turn for the worse. The New York Times states that much of Petrobras' senior management has resigned over the past few months due to accusations of taking bribes and colluding with competitors to charge high prices. The administration has also been gridlocked by opposing parties and has been unable to pass any substantial regulation to mitigate the recession.

Brazil's economy, once one of the fastest growing in the world, contracted four percent in 2015 and, according to Bloomberg, is forecasted to contract another three percent in 2016, with no end in sight. Historically speaking, the situation is not surprising. Brazil's current economic woes are typical of commodity driven economies and indicative of the "resource curse" observed by economists in the latter half of the twentieth century.

The Council on Foreign Relations describes the resource curse as the phenomenon in which countries with an abundance of natural resources tend to fare worse economically than countries that have less. This puzzling situation has normally occurred due to poor governance and/or a lack of competitiveness in other industries.

Both of these traits appear in Brazil's case. The former manifested itself in accusations of corruption and the inability of the administration to pass any policies to stop further contraction of the economy. Goldman Sachs' 2011 report described the latter occurring due to the overvaluation of the Brazilian real from the influx of revenue from commodity sales. For example, a taxi in Sao Paulo was at one time more expensive than a taxi in Manhattan. As a result of the currency's appreciation, manufacturers were unable to price their exports competitively and additional employees had to be laid off.

Brazil's situation thus offers a warning to other countries currently facing the resource curse. Today, many of those countries are located in the African subcontinent. Countries such as Nigeria, Sudan and the Democratic Republic of the Congo all have resource extraction and exports constituting a sizable proportion of their GDPs (well over 30 percent). The individual resources vary by country but the underlying issue is the same - resource extraction cannot maintain an economy indefinitely. While recession has generally not plagued the African subcontinent in recent years, violent conflict and government corruption have, with Africa's eight top oil producers all having negative scores on the World Bank's control of corruption index.

Economic growth cannot properly occur under these conditions. Even fixing corruption with more transparent industries and preventing job loss by diversifying the economy cannot guarantee progress. Care must be taken to prevent relapse of these circumstances, as was the case in Brazil. Though the country's politicians promised that the booms and busts of the last 50 years would not occur in the new and modern Brazil, the current economic situation indicates the contrary, with Brazil's boom period of the last 12 years quickly turning into a recession with no end currently in sight. Similar situations must be prevented from taking hold in other countries with substantial natural resources if they wish to continue to develop economically.