Brazil's Selic Rate Cut To New Low: Is It Enough To Spark Economic Growth?

Includes: EWZ, PBR, VALE
by: Caiman Valores

The Brazilian government has just announced that it has cut the official interest rate, the Selic rate to an historic low of 8%. This is the eighth time the rate has been cut since hitting a peak of 12.5% in July 2011. It is also the first time that the rate has been under double digits since October 2009. Brazil's consistently high official interest rate has acted as a magnet attracting significant inflows of foreign investment or 'hot money' seeking high secure rates of return. This hot money has disrupted the government's already heavy handed monetary measures which were aimed at containing inflation and dampening a growing consumer credit bubble.

This rate cut is in line with expectations and comes on the back of weaker than expected economic growth, with a first quarter GDP growth rate of 1.89% and second quarter GDP growth estimated to be at around 2%. With weak economic growth and a domestic economy that is more and more looking like it has hit 'stall speed' the Brazilian government is pulling out all stops to kick-start economic growth.

Other policy measures put in place

Already the Brazilian government has introduced a wide range of measures from across the economic policy spectrum in order to catalyze growth but with little or no result. This has included implementing a range of measures aimed at protecting Brazilian industry from imports and introducing regulations that give local Brazilian companies preference in government procurements.

The government has also been keeping an artificial cap on gasoline prices as means of managing inflation and domestic transport costs in order to promote domestic growth. It has also introduced local content rules for the oil and gas industry, forcing energy companies to ensure that 65% of all materials used in operations are sourced from within Brazil. But the primary impact from these measures to date has been to harm the future expansion prospects of the government controlled oil giant Petrobras (PBR).

The government has also moved to cut the presence of foreign mining and energy companies by declaring assets such as farmland, oil, metals and minerals as strategic assets. These measures have also given Petrobras preferential access to the pre-salt oil fields and forced foreign oil and gas companies to operate in partnership with Petrobras.

Yet this hasn't been enough to restart an economy that is dangerously approaching economic stall speed and where the government's previous heavy handed monetary policy initiatives have crushed one of the key engines of Brazil's economic growth, domestic consumption. These measures so far have done little other than to increase the degree of political risk present when investing in Brazil, making investors more wary and less likely to invest.

Factors inhibiting Brazil's economic growth

Despite all of these indicators many market pundits and investors are still selling the virtues of investing in Brazil, its growth miracle and growing domestic consumption. But even with an additional fall in the Selic rate I doubt that domestic consumption rise will to the levels optimistically predicted.

While there is an obvious link between the cost of money and domestics consumption, dramatically reducing the cost of money in order to increase the money supply in an emerging like Brazil's does not have the same effect on consumption as it does in a developed economy such as the U.S.

There are a number of reasons for this, and some of the key reasons are Brazil's significant income inequality, high poverty and low average income. It is estimated that more than 26% of Brazil's population lives in poverty and even those households classified as middle-class in Brazil are living on a modest income in a country that has one of the highest levels of income inequality in Latin America.

The Gini coefficient which measures income inequality between 0 and 1, with 0 being the most equal and 1 being the least, indicates that Brazil has one of the highest levels of inequality in Latin America as the chart illustrates.

Click to enlargesource data: World Bank

This indicates that a significant portion of Brazil's population has a moderate to low level of income and very little disposable income available for discretionary spending. As a result many consumers unable to access consumer credit or engage in significant levels discretionary spending, with most if not all of their disposable income spent on necessities.

The chart below illustrates that Brazil's average monthly wage adjusted for purchasing power parity is among the lowest in Latin America and is far lower than the United States, Chile or Argentina.

Click to enlargesource data: International Labor Organization

Another indicator of Brazil's inability to sustain strong domestic consumption and rapidly grow consumption through increasing the money supply by reducing the price of credit is the country's low credit to GDP ratio. Currently, Brazil's credit to GDP ratio is around 50% and this is significantly lower than the average for emerging European and Asian economies.

Click to enlargesource: Banco Bradesco Q1 2012 Presentation

This I believe is symptomatic of Brazil being caught in the "middle income trap" where it has already experienced the rapid growth associated with being a catch-up economy and is now plateauing because it lacks the right catalysts to become a high income economy. This has created a ceiling on the level of domestic credit and consumption.

Of even more concern is that the ratio is only forecast to grow moderately over the next 2 years to reach 55% by 2014. This indicates there is little if any opportunity for ongoing growth in consumer credit and a repeat of the consumer credit funded explosion in consumption witnessed over the past two years. It is also representative of how little effect the dropping the official interest rate has on stimulating domestic consumption.

Economic growth is dependent on China and Europe

An important piece of the Brazilian economic puzzle lies in the global economic headwinds being generated by slowing growth in China and the ongoing European financial crisis. Brazil has developed a dangerous economic dependency on China, which is now Brazil's dominant export partner and the destination for 18% of its exports. China is also now the dominant consumer of Brazil's iron ore and soybeans.

Brazil's other key trading partners are the member countries of the European Union ('EU') which as a collective region are the destination of 20% of Brazil's exports. All told, China and the EU are the combined destination for 38% of Brazil's total exports as the chart shows.

Click to enlargesource data: Banco Central do Brasil

However, with the European financial crisis in full swing many of the EU's member states have fallen into deep recessions resulting from economic mismanagement and the now severe fiscal austerity measures being imposed upon them. In conjunction with this the Chinese economy has been slowing as part of a controlled economic slowdown initiated by the Chinese government to control inflation and prevent the growth of an emerging property bubble. As a result, Chinese industrial production, construction and domestic consumption have fallen curtailing the Chinese appetite for commodities.

Both of these have had a significant impact on the demand for Brazil's commodities and effectively brought to an end the tremendous commodity boom that was driving Brazil's economic growth. It is unlikely that monetary policy alone will be sufficient to trigger economic growth in Brazil, particularly because domestic consumption has stalled and will require a catalyst like a sustained surge in the demand for commodities to trigger renewed consumption.

The future outlook

While a lower Selic rate is beneficial for Brazilian exporters and for industrial activity as a whole, it is bad for Brazilian companies with share prices denominated in U.S dollars. Already the Brazilian real has depreciated against the U.S dollar by 8% this year and it is now likely that it will depreciate further.

This will have the effect of increasing interest costs for Brazilian companies with dollar denominated debt such as Petrobras and Vale (VALE) and for those Brazilian companies with significant dollar denominated debt placing further pressure on lending covenants. It is also likely that any further significant depreciation in the real will see those companies examining means of limiting capital expenditure so as to contain expenses in a difficult operating environment. Obviously this would see less domestic investment in Brazil by some of the country's largest corporations.

It is unlikely that reducing the official rate alone will reinvigorate Brazilian economic growth nor stimulate domestic consumption. The key catalyst that will trigger renewed economic growth in Brazil will be a resumption in China's rapid growth and demand for commodities. A further catalyst will be renewed economic growth in Europe, which will only occur when European financial crisis is resolved.

While there is certainly cyclical element to the current fall in Brazilian economic growth related primarily to global demand for commodities, I believe there are structural economic and developmental issues that will prevent the overly optimistic view of Brazil's economic miracle becoming reality. These include the dangerous over-dependence on China, the excessive economic protectionism and high levels of poverty and income inequality. Until these structural issues are dealt with, it will not be possible for Brazilian domestic consumption to become a driver of economic growth.

For these reasons even if there is a strong recovery in China and Europe it is unlikely that Brazil will experience the rapid pace of economic growth that it has seen over the last decade. I would expect future economic growth to be moderate and this will obviously effect the valuation of Brazilian companies. For these reasons it is unlikely that investors will see the high returns expected from what has been touted as one of the world's hottest emerging markets. This doesn't bode well for the performance of broad based Brazilian ETFs such as the iShares MSCI Brazil Index (EWZ), which leads me to speculate that Brazilian investments have been overbought on optimistic sentiment.

Disclosure: I am long PBR, VALE.