September 06, 2016
Economics Group Special Commentary Eugenio J. Alemán, Senior Economist
[email protected] ● (704) 410-3273
Brazilian Economic Prospects Improve a Bit Executive Summary
Brazil is not new to serious political and economic crisis over the course of its history. However, the current economic malaise is almost of historic proportions as we could not find a period in Brazilian history where the economy posted two consecutive declines in economic activity, as it did in 2015 and is expected to do in 2016. This underscores the seriousness of the current Brazilian environment, both economic and political. Furthermore, the Temer administration will remain a transitional administration in the sense that it will govern the current crisis but will not have enough support to produce the necessary structural reforms that will allow the country to post strong economic growth results during the next two years. At the same time, the administration will have to deal with the serious fiscal crisis, which will further limit its ability to help the economy. At the same time, it will be trying to limit the effects of higher inflation on society as a whole. Fundamentally, those that suffer inflation the most were the ones who most benefited from the PT or Workers’ Party over the past 13 years, that is, the poor. Furthermore, high inflation and high unemployment are threatening to send approximately 40 million recent arrivals into the middle class back to the lower echelons of Brazilian life.
Brazil is not new to serious political and economic crisis over the course of its history.
Deep Brazilian Recession Continued in Q2
The Brazilian economic contraction continued during Q2, as the political crisis also continued to redraw the boundaries of what is and what is not possible in Brazil. With the number for Q2 in, it is clear that the economy seemed to have touched bottom even though the data are probably extremely noisy because of the impeachment process and the closeness to the Olympic Games. According to the IBGE, the Brazilian statistical institute, the economy dropped 3.8 percent on a non-seasonally adjusted year-over-year basis during Q2. This drop was much better than the 5.4 percent decline registered during Q1. However, the economy actually contracted more in Q2, by 0.6 percent, than in Q1, by a downwardly revised 0.4 percent, and on a seasonally-adjusted basis. This means that even though we believe that the economy may have touched bottom during Q2 the news during Q3 will not be even in the neighborhood of being “better” than the second quarter, especially since the Rio Olympics as well as the impeachment of President Dilma Rousseff served as a national distraction. This means that it will be difficult to expect the economy to do better in Q3, especially on a seasonally-adjusted basis, as the Olympic event is a unique event in the history of the country and it is unlikely that numbers are able to capture that disruption.
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The Brazilian economic contraction continued during Q2.
Brazilian Economic Prospects Improve a Bit September 06, 2016
WELLS FARGO SECURITIES ECONOMICS GROUP Figure 2
Figure 1 Brazilian Real GDP
Bars = Compound Annual Rate, SA
Brazilian Exports of Goods and Services
Line = Yr/Yr % Change, NSA
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-20%
-15% Real GDP: Q2 @ -2.3% Year-over-Year Percent Change: Q2 @ -3.8% 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
-20%
30%
Year-over-Year Percent Change, Not Seasonally Adjusted
30%
Exports of Goods and Services: Q2 @ 4.3%
25%
4-Q Moving Average: Q2 @ 7.7%
25%
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-15%
-20% 2000
2002
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2006
2008
2010
2012
2014
2016
-20%
Source: IHS Global Insight and Wells Fargo Securities
Perhaps the best news of the Q2 GDP report was that output in the manufacturing sector remained flat.
High inflation and high unemployment threaten to send 40 million newly arrived into the middle-class back to being poor.
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Perhaps the best news of the Q2 GDP report was that output in the manufacturing sector remained flat compared to the previous quarter even as it plunged 5.4 percent on a year-earlier basis. However, there is still a steep climb ahead for manufacturing activity in the country. The second relatively positive sign, this time from the demand side of GDP, was a 0.4 percent increase in gross fixed capital formation. Still, gross fixed capital formation fell 8.8 percent during the quarter compared to Q2 2015, but it performed much better than during Q1 when it collapsed 17.5 percent versus a year earlier. The only other sector that was positive for the economy in Q2 was real exports of goods and services, which increased 0.4 percent during the quarter, while increasing 4.3 percent versus a year earlier. Interestingly enough another “positive” sign that things may be improving a bit was a 4.5 percent increase in real imports of goods and services compared to the previous quarter. On a year-earlier basis, however, real imports of goods and services were still down 10.6 percent compared to a collapse of 21.7 percent during Q1. However, recall that a drop in imports helps the economy grow. What Q2 GDP numbers clearly show is that the domestic economy remains in tatters, with personal consumption expenditures dropping 0.7 percent from Q1 on a seasonally-adjusted basis and 5.0 percent on a non-seasonally adjusted year-over-year basis. The strongest sector during the quarter from the production side was utilities production, whose output increased 1.1 percent on a seasonally adjusted basis followed by the mining sector whose output rose 0.7 percent. The increase in utilities output was a consequence of a relatively severe winter season especially in southern Brazil and thus, will probably not help GDP that much during Q3. The other two supply sectors that posted positive rates of growth compared to the previous quarter were public administration, health and education services, up 0.5 percent, and real estate activities, up 0.1 percent. On a year-earlier basis, the only two supply sectors that posted positive rates of growth were the utilities sector, up 7.9 percent, and real estate activities, up 0.1 percent. Again, the performance of the utilities sector was due to a winter season that was colder than the year earlier.
Brazil Is on Its Own
For a country that bet its future on the ability of the external sector to deliver economic growth as well as enough revenues to conduct generous fiscal policies that included a massive redistribution of income scheme that moved approximately 40 million people from the low income class into the middle class the future does not look particularly promising. Many of those that recently arrived into this new, and larger, middle class have either fallen back again into the lower income echelons of Brazilian society or are expected to do so in the next several years, as inflation and unemployment have both increased.
Brazilian Economic Prospects Improve a Bit September 06, 2016
Figure 3
WELLS FARGO SECURITIES ECONOMICS GROUP
Figure 4 Brazilian Consumer Price Index
Brazilian Unemployment Rate
Year-over-Year Percent Change
Six Major Metropolitan Areas, NSA
18%
18%
14%
14%
12%
12%
10%
10%
CPI: Jul @ 8.7% 15%
15%
12%
12%
9%
9%
6%
6%
3%
3%
8%
8%
6%
6%
Unemployment Rate: Feb @ 8.2% 0% 1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
0%
4%
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
4%
Source: IHS Global Insight and Wells Fargo Securities
Furthermore, now that the Brazilian Senate has ousted President Dilma Rousseff from her presidency during a contentious impeachment process, those who benefited the most from the Brazilian Workers’ Party policies and political success, during the past 13 years, will lose their most important, and only, voice and ally. Meanwhile, the fiscal measures that need to be implemented by the no-longer temporary Temer administration need to be close to draconian in the sense that most of those affected by those measures will be constituents of the PT, or Workers’ Party—that is, the Brazilian poor and marginalized. Some analysts have been comparing the current crisis, and the path forward, to what happened in early 1999 when the country was forced to abandon the currency exchange rate system at that time, the crawling peg. However, the political environment back then was much more certain than it is today. Today’s lack of leadership is, perhaps, one of the most concerning aspects of the current environment. According to Transparency International, the global coalition against corruption, “more than half of the 594 men and women that make up Brazil’s Congress face some kind of legal challenge, including corruption charges.” 1 Even the new president, Michel Temer, is being investigated for soliciting illegal campaign contributions from the country’s petroleum giant Petrobras, or Petróleo Brasilerio. If found guilty, he will not be able to run for office during the next presidential elections in 2018, even if he does a good job during the next couple of years. This means that it will be difficult for the current government to set a reform agenda that could be followed by a majority within the Brazilian political system. Up until now, the Brazilian political system had only one objective, to oust Dilma Rousseff. Now that this objective has been achieved, we wonder if there is such certainty in the path forward and even if there is certainty, if there is commitment to do what is needed, especially in an environment of recession and/or slow economic growth. The first task must be to improve the country’s fiscal malaise, which, presumably, was the original reason for impeaching Dilma Rousseff. The fiscal deficit stands at close to 10 percent of GDP today, composed by the primary deficit (the deficit that does not include payment of interest on its debt). The primary deficit is about 2.5 percent of GDP and the payment of interest on the country’s debt, which is close to 7.5 percent of GDP. In 1999, then President Cardoso was able to set forth a path of structural reforms and decrease federal government expenditures that allowed the country to turn around fast and to decrease the fiscal deficit by committing to a primary fiscal surplus of about 3 to 4 percent of GDP. At the same time, starting in 2001, strong growth in China and the commodity boom cycle helped spur strong economic growth that put the country back on a sustainable fiscal path. President Lula da Silva, starting in 2003, took full advantage of this boom, while former President Rousseff benefited during her first years as successor of the da Silva administration. 1
It will be difficult for the current government to set a successful structural reform process.
“Brazil’s corruption clean-up”. Transparency International. May 31, 2016.
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Brazilian Economic Prospects Improve a Bit September 06, 2016
WELLS FARGO SECURITIES ECONOMICS GROUP
However, today, the world is different from what it was during the first decade and a half of this century. China’s growth is faltering, the commodity boom cycle has given way to a commodity bust, emerging market growth is weak and growth in the developed world is weak and not enough to help the Brazilian economy in any meaningful way. Thus, Brazil is on its own.
Containing Inflation Is a Priority, but Structural Reforms Are a Must
One of the most important issues the new administration would have to tackle is the fiscal deficit.
As we discussed above, one of the most important issues that new administration would have to tackle is that of its huge fiscal deficit, which has soared during the past several years. That in it of itself will be a major challenge. The other two important challenges for the new administration would be to tackle the latest bout of inflationary pressures as well as the path for the exchange rate. If the country wants to grow its economy through foreign trade today, the policy prescription is to allow the currency to depreciate nominally but most important, in real terms. Controlling inflation is the first step in this direction. Figure 5
Figure 6 Brazilian Central Bank Policy Rate
Brazilian Exchange Rate
Percent
BRL per USD
4.5
4.5
4.0
4.0
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
21%
21%
18%
18%
15%
15%
12%
12%
9%
9%
BRL per USD: Aug @ 3.27 1.0
99
00
02
04
06
Selic Rate: Aug @ 14.25% 08
10
12
14
1.0
6%
05
06
07
08
09
10
11
12
13
14
15
16
6%
Source: IHS Global Insight and Wells Fargo Securities
The country needs to go further and engage in a major structural reform process.
Brazil was able to grow the economy during the first decade and a half of this century, with a strong currency, both in nominal as well as in real terms, because economic growth in China and the commodity boom cycle allowed them to do it. However, today Brazil needs to compete with other countries in a low global growth environment and the only way it can be successful at using the external sector to contribute to economic growth is by becoming more competitive. There are two ways of becoming more competitive. The first one, and most efficient, is through structural reforms that will make Brazilian producers more productive. The second one is allowing the currency to depreciate, both in nominal but fundamentally, in real terms. However, this is not going to be an easy task as probably every country in the world is considering taking the same approach. In fact, Brazilian central bankers and politicians have been complaining for the past several years that there has been a worldwide push for engineering competitive devaluations to make one country more competitive versus its trading partner or what has been called a “beggarthy-neighbor” policy. 2 However, while keeping inflation contained should be one of the top priorities the country needs to go further and engage in a major structural reform process, a process that was abandoned when the benefits of the commodity boom export cycle started and everybody got complacent with the good times. Brazil is a large economy, the ninth largest in the world, but it is also a highly regulated, overtaxed and inefficient economy. You can get away with these characteristics if the world economy is growing fast, commodity prices and exports are booming and the government has plenty of money to redistribute income, but you cannot get away with it if these conditions reverse, as they have done over the past couple of years. 2
A “beggar-thy-neighbor” policy is an economic policy where a country attempts to fix its own economic problems using strategies that tend to worsen the economic problems of neighboring countries or trading partners.
4
Brazilian Economic Prospects Improve a Bit September 06, 2016
WELLS FARGO SECURITIES ECONOMICS GROUP
Having said this, we do not believe that under the current political environment any major structural reform is possible. Although former President Dilma Rousseff was a major roadblock to economic growth, the less-than-clear impeachment process (where numerous accusers are actually more implicated in fraud than the former president) will continue to cast a shadow on the medium- to long-term reliability of the Brazilian political system. This means that although we are relatively positive about the prospects for the Brazilian economy during the next several years we do not see a clear path to a structural reform process that will allow the country to strengthen its growth prospects. Thus, the Temer administration will probably be able to administer the crisis during the rest of this term, which ends in 2018 and then turn over power to the next president.
Conclusion
Although the recent impeachment of President Dilma Rousseff will give the Brazilian economy some impetus, the prospects for a recovery remain limited as the export growth and commodity boom spearheaded by Chinese economic growth gives way to a more muted global economy. Furthermore, while many argue that the new Temer administration will be able to turn around the economy, our interpretation of these prospects is less positive than what most have been arguing, especially because the Temer administration is still mired in serious fraud investigations, which include an investigation against the new president himself. Furthermore, the Brazilian political system remains as fractured as ever, if not more, after a contentious impeachment process—that for some, lacked legitimacy. This political environment will limit the ability of the Temer administration to produce the fiscal about-face the country was able to produce after the 1999 economic and fiscal crisis. Although we see the economy slowly improving, we do not see much in the sense of a structural reform that could help the Brazilian economy achieve growth rates in the mid-single digits. Particularly, not until a new presidential election chooses a new president at the end of 2018 and the Brazilian presidency regains some legitimacy to conduct structural reforms. This means that the Temer administration will remain a transition administration that will continue to govern the current Brazilian crisis.
The prospects for recovery remain limited, as the export growth and commodity boom spearheaded by Chinese economic growth gives way to a more muted global economy.
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Wells Fargo Securities Economics Group Diane Schumaker-Krieg
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