What's Next for Brazil's Economy?

In case you did not notice, the Eurozone recently slipped into a near recession and so did Japan. Together with an already limping and essentially recessionary US economy this has prompted some analysts to ponder the probability of a global recession or more aptly; a significant and serious widespread global slowdown. Nouriel Roubini, who recently got some fine words in the NYT by Stephen Mihm (hat tip: Stefan Karlsson), massages the probability of a global recession in a recent piece. This is a topic also taken up, in a US context, by Joachim Fels in his recent installment over at Morgan Stanley's Global Economic Forum.

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more.

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

• One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.

• The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?

I clearly have my bias and some have theirs; now let us wait and see what happens. It will be an important test for many hypotheses and views.

Notes

[1] - Although not so booming as of late.

Comments

[User 247325:]

I agree with the points above, but the biggest issue that Brazil has today is corruption at all levels. The executive is so corrupt and it is not just at the federal level, but at the state and local goverment as well. The legislator, which are supporsed to monitor the executive, are member of the corruption cartel. Money is sent from the Federal government down to states and cities, but by the time it gets into its final destination - Health - most of the money is gone or has been diverted into other areas - people pocket or what they call in Brazil - Laranjas.

2008 Aug 21 11:48 AM

[Brahm:]

This article is well argued, but it is too long and touches on too many important points. One can disagree on the degree or extent of the effects on the global economy. My strong feeling is for a painful slowdown of the overall global economy with different levels of effects in different regions. But no deep global slowdown. It will be somewhat painful for Western Europe, Japan and the US. Perhaps outright recession in Europe nd Japan. The US is already in mild recession (desoite the official GDP numbers!), but will perhaps be not be in as serious recession as in the foregoing two regions. Because the US tolerates a higher level of inflation, than Europe or Japan. The US's banking and housing sectors are in more bad shape than elsewhere, and will need the Fed's "moderation" which will be forthcoming at least in this political year.

India is actually trying to moderate or slow its economy to get a handle on its inflation problem. So there will be a lowering of the growth rate for the GDP.However, a reduction of its GDP, to say 5-6%, would be painful for India. The Government would want to avoid going lower than this rate.

China has room to crank up its domestic economy as exports to Europe and Japan pullback somewhat. But will it? Inflation is rampant in China as well. The extent of the slowdown in China requires an expert in reading Chinese tea leaves to figure out how China will act or not act!

Brazil is an interesting case. My take here is that commodity prices will have some effect on the export revenues. However, I do not expect severe decrease as commodity prices will moderate probably by only 10-15% overall. Don't expect massive decrease in revenue because a disproportionate fraction of exports of commodities is to emerging economies. These economies will not have much decrease in infrastructure investment, and hence the need for commodity imports will remain significant as most of the economies do not serious balance of payment problems.

Food imports by emerging economies (China, Pakistan and others) will continue without appreciable benefit of decrease in food commodity prices (supply and demand issues here!). Unlike in the past, Brazil has a healthy balance of payment situation. The marginal decrease in export revenues for a year or two can be taken in stride. I do not expect serious slowdown in Brazil's economy.

Unmentioned is Russia. The Russian economy is expected to continue growing, perhaps with marginal rate decrease, as most investment is infra-structiure related, consumer demand and energy/commodity export related production. The Russian balance of paynebt situation is comfortable to make for some slack in exports, if any at all.

Overall, my take is still for marginal growth of 2% at least for the global economy. But that will be painful in some regions.

2008 Aug 21 01:48 PM

[whidbey:]

Easily the most long winded review I have seen, but the facts mustered are interesting if not totally persuading.

I did not see much on internal consumption in the economy in your analysis: why? True, Brazil must export and it will, but it must also develop its own internal markets and consumers. The structure of the demand side of the economy is weak and seriously underdeveloped for want of educational and training policies that foster the middle classes and a stable lower class and lack of economic opportunity and mobility. Secondly Brazil must become more involved in SA economics in general. Brazil is the logical leader of SA and should be encouraged to seek that role by more overt leadership on hemispheric issues.

You have promise as an analyst,but your focus to too narrow. Keep it up. I like your work and you have a future W

2008 Aug 21 04:30 PM

[Urbane Gori...:]

User 247325 is concerned with corruption in Brazil..... Unlike the corruption in Russia, China, India, Mexico ...etc. etc ... I figure if you invest in foreign equities you had better believe that the companies you invest in are capable of dealing with corruption on that countries scale.

Course, we don't have any such issues... Like Enron, financials, government dirty tricks, baiting of Russia, lying to involve our country in expensive un-winnable wars........ Because we are righteous Americans! Ta-Dah!

jegan ;-)

2008 Aug 21 06:10 PM

[Claus Vistesen:]

Hi Guys,

Thanks for your comments.

@ User247325

"I agree with the points above, but the biggest issue that Brazil has today is corruption at

all levels."

Point taken! I certainly do not want to come off as someone who seems complacent towards

this issue. Honestly, I also have to admit that it is a topic of which my knowledge is very

limited. However, if I take your points at face value they would obviously constitute an

important obstacle for whatever Brazil sets out to "become".

Ultimately though beauty, as always, is in the eye of the beholder and I would be surprised

to see if Brazil's development endeavors shored up at the sluggishness by which the state

apparatus conformed to modern "western standards". This does not mean of course that

something should not be done and that the issues should not be treated.

I guess that I am seconding Egan's points here since what is "corruption" really in this

context. Clearly, if you are placed with operations in Venezuela et al. the threat of

trigger happy govvy soldiers marching in and taking your property is a BIG issue, but I

would argue that Brazil is another level up from these kinds of adverse business

environments.

@ Brahm

Thanks for this elaborate comment. I do have to concur that this piece was not one of my

most succinct.

It is of course interesting to note that those four economies you mention constitute that

almost infamous BRIC economy group coined by Goldman Sachs almost a decade ago (I think).

My main argument here is consequently first and foremost that Brazil together with other

rapidly developing emerging markets WILL see their share of world GDP grow. I think that

this is the big global development story of the 21st century and it really should not be

lamented. I would also expect that their increasing clout of their economies as a share of

world GDP be especially pronounced in DOLLAR terms. In this way, the world already HAS de-

coupled from the US economy so to speak, but it is a much longer term process than what we

are immediately seeing.

Within this frame of reference I am fundamentally bullish on Brazil (and India btw)

especially compared to China and Russia where I think we will NEVER see a them becoming a

net absorbers of global capacity (i.e. sustainable external deficit economies). Of course,

Russia may experience an external balance at some point but Gazprohm inc will fight long and

hard before that happens.

You see, what Brazil has is a relatively favorable demographic structure and one which at

this very point in time is almost at its "optimal" level if we look at age structure. This

is really the gist of my argument (I guess that I should have been clearer here).

So, I would simply put up the simple hypothesis that Brazil CANNOT be expected to crash

completely due to internal momentum. Obviously, as you say yourself; both India and Brazil

are hard at work to try to halt the spike in inflation and to prevent the money from coming

in too fast. So, they WILL definitely slow, but 1997 style crises should not occur in these

two countries I think.

"Brazil is an interesting case. My take here is that commodity prices will have some effect

on the export revenues. However, I do not expect severe decrease as commodity prices will

moderate probably by only 10-15% overall. Don't expect massive decrease in revenue because a

disproportionate fraction of exports of commodities is to emerging economies. These

economies will not have much decrease in infrastructure investment, and hence the need for

commodity imports will remain significant as most of the economies do not serious balance of

payment problems."

I could not agree more really. I think this is an excellent point. Sure, commodity prices

are falling and can fall further if the investor community starts to worry about deflation

and recessionary risks in OECD, but once countries as Brazil, India, Turkey etc start

accelerating again (my guess is end 2009), then commodities will once again begin their

structurally bound upward march.

@ Whidley

Thanks for your points and also those of educative nature. SA readers and commenters are a

demanding bunch, but I do appreciate that you (they) take their time to massage the more

argumentative side of my pieces.

"I did not see much on internal consumption in the economy in your analysis: why?"

A fair point, and while the Brazilian consumer is sure to wind down in the coming slow down my main argument is that she will not fold completely. Moreover, I am arguing that the relative "gusto" of Brazilian domestic demand is high compared to other (especially OECD) economies which should flatter the the economy in terms of inflows for investments and portfolio purposes.

"The structure of the demand side of the economy is weak and seriously underdeveloped for want of educational and training policies that foster the middle classes and a stable lower class and lack of economic opportunity and mobility."

Definitely, and nothing comes for free. More specifically, I would say that Brazil now has a golden opportunity to lock in a growth and optimal growth path for the next 20 something years. One of the challenges/pre-requisi... here will certainly be investment in human capital (i.e. on the quality side that is).

best wishes everybody

Claus

2008 Aug 22 03:32 AM

[gato:]

Ahaaa!...Yawn!..Excuse me!,... I almost almost nodded off!..your article made me think of President Harry Trueman (USA) he was always looking for "A one handed economist, 'cause, the ones who advised him, were always telling him.."Such and such could happen to the economy,....BUT..then, on the other hand...this could happen"...I guess he figured, if he could find that "one handed guy" his decisions would be easier....Now!..where was I?... Oh!....yea!..Your take on the Brazilian economy...well, after checking your bio. ('an seeing that you're 23 years old....Hmmm!..it clicks!...you're still wet behind the ears)..so, I'll go light.
I not an economist so take what I say with 2 grains of salt, (At the very least) you article was long, full of data essential to understanding where a country's economy is going....Here comes the ...BUT,.. the piece lacks an understanding for the social/cultural/ethics of a country, which in my opinion reduces it to a "dry" mathematical equation.
For example you said in reference to the first comment on corruption:

"Honestly, I also have to admit that it is a topic of which my knowledge is very limited. However, if I take your points at face value they would obviously constitute an important obstacle for whatever Brazil sets out to "become".

That's a good honest response, but, why don't you know this?...data on crime in every country is widely available on the Internet..did you think that info. is not important?...If you would pull up the web sites of Brazilian news papers (Folio do Sao Paulo,..or..uol.com.br ) you would find that there is a (undeclared) Civil War raging in the big cities of brazil.....What?..Are you talking about?...Hmmm!..(Only this) I talking about the "narco-terrorist" drug gangs who dominate the cities of Rio, Sao Paulo and most of the other cities. They often attack police stations, with heavy military weapons..grenades, machine guns etc. more people are get killed there, than in Iraq....of course, Iraq is a small country compared with Brazil ..(expecially population wise). The people (honest ones..Diogenes are you there?) who live in those cities have to live behind steel bars..they have to imprison themselves in their homes to protect themselves and families.as the streets run red with blood.

Bottom line,...Claus?... If you don't know any of this (and most non-Brazilians don't, 'cause the gov. tries to hid it)..in my opinion, your
assessment of the Brazilian economy is not complete, but, is excusable, because of your tender age. I guess my main point is: there's a lot more to an economy than the import and the export numbers...What say you?

2008 Aug 22 02:35 PM

[Directoy:]

I hope you are rigth on that!
It time to Brazil become A great Nation!!

2008 Aug 23 11:47 PM