Brazil risks becoming latest emerging-market victim of stagflation as economy falters
Brazil’s recovery is being cut off at the knees by a set of economic challenges that have all come home to roost – from a depreciating currency and rising current-account deficit to structural problems, including an overdependence on credit-fuelled consumption.
Brazil has failed to capitalize on the era of abundant global liquidity to boost its investment climate and embark on supply-side structural reforms while nurturing domestic business confidence, say analysts.
The global emerging market (EM) rout appears to have awoken the government from its reformist slumber and has highlighted the need to rebalance the economy away from debt-fuelled consumption in favour of investment.
However, the violent cyclical sell-off is colliding with these reform efforts in the short-term as fears grow the economy is marching towards stagflation.
Growth has rebounded from 0.9% in 2012 to around 2.5% in the second quarter of this year as government monetary and fiscal stimulus came to fruition, but those gains are being eroded by deteriorating conditions domestically and externally, and growth might flat-line in the second half.
Analysts have trimmed their full-year growth forecasts to around 2% and slightly higher for 2014 on fears higher interest rates and persistent inflation, which is eroding purchasing power, are dragging on consumption.
The central bank has raised rates four times this year to 9%, initially to curb above-target inflation, and then to try to arrest the fall in the real as well. The real is the second worst-performing EM currency this year after the rupee, losing almost 16% of its value against the dollar since May.
Copom, the bank’s monetary policy committee, is expected to implement two more hikes this year – one of 50 basis points and one of 25bp – but these are seen as too little too late and will do nothing to restore its credibility as an inflation-targeting central bank.
The bank has also launched a $60 billion currency intervention programme that will see it inject liquidity to the tune of $3 billion a week by selling dollar currency swaps, derivative contracts and repurchase contracts in the hope of preventing nervousness turning to panic.
The instruments help companies and investors with dollar obligations to hedge against further weakening of the real, with the aim of preventing them rushing to buy dollars now, for fear that delaying will make those dollars more costly.
EM currencies around the world have been hit by capital outflows sparked by the anticipated scaling back by the Fed of its massive quantitative-easing programme, but most have avoided raising rates to stem the flight for fear of hurting growth.
Outflows have nearly doubled Brazil’s current-account deficit in the first seven months of the year to $55.5 billion from $29 billion in the same period in 2012.
Rises in public transport fares pushed inflation to 6.7% in June, sparking riots in São Paulo and protests in other cities before the government caved in and rescinded the increases, helping pushing July inflation back down to 6.3%, just inside the central bank’s 6.5% upper-band limit.
Despite the climb down, the unrest unleashed popular discontent over corruption and poor public services, and rioting spread to the capital Brasilia, Rio de Janeiro and other cities, exposing fault lines.
This rift, together with the tough response of the authorities, has damaged the popularity of president Dilma Rousseff’s ruling Workers’ Party (PT) ahead of elections next year.
Brazil has enjoyed a decade-long expansion under PT, with more stable and better-paid jobs and a strengthening currency, but the main growth driver has been rising private consumption, much of it fuelled by pricey consumer credit. Household credit now accounts for 16% of GDP and while interest rates have plummeted from 80% a decade ago, they are still around 30%.
Private consumption accounted for 2.6 percentage points of the 3.6% average GDP growth between 2003 and 2012, according to Oxford Economics, with consumer spending surging 4.3% a year throughout the period. With an economy that is two-thirds services, Brazil is now hooked on that spending.
“Consumption growth is decelerating and has been for two years or so,” says Marcos Casarin, Brazil economist at Oxford Economics. “The government needs to rebalance the economy away from consumption toward investment.
“In the government’s dreams there is a drive to rebalance but in reality we can’t see any evidence of this rebalancing. It will probably start when consumption proves to be slowing down, but it will be conditional on the government’s ability to complete a successful round of infrastructure concessions, which could have the potential to unlock investment.
“Only then will we see more investment-led growth and less consumption-led growth, but I wouldn’t bet on it.”
The government’s first effort at using the private sector to build and operate badly-needed key infrastructure – including ports, oil fields, airports and roads – earlier this year ended in failure, attracting no bidders. Rules capping investors’ returns at 6% doomed the initiative.
A fiscal deficit of 2.9% of GDP in the year to April appears to have sealed the government’s commitment to transferring responsibility to the private sector. A second concessions round is scheduled for the fourth quarter of the year for which the government is expected to have relaxed its conditions.
“We are sceptical because investors don’t like regulatory changes, especially multiple changes in the same year going first one way and then in the opposite direction,” says Casarin.
“The danger of rule changes midway through, say a 20-year concession, pushes the already substantial risk of long-term infrastructure projects too high.
“It’s not in our baseline that round two will be this great success and then investment will drive growth from the second half onwards. Consumption will remain the main engine of the economy, but it’s a dwindling engine.”
Policy continuity and reforms to boost domestic saving, phase out subsidies and streamline taxation are seen as essential to near-term growth.
Vital segments of the economy are dominated by huge state-owned utilities such as oil producer Petrobras and power utility Eletrobras, whose prices are set by the government. Both have been hit hard by price cuts and rising costs – due the weaker real – that they have been unable to pass onto consumers, savaging their share prices.
A 6% tax on foreign capital introduced in 2010 was lifted at the beginning of June, providing a welcome boost to inflows. Government bonds, into which flows had dried up completely in the first half of the year, have been the beneficiary, with net inflows of $6.5 billion and $4 billion in June and July respectively.
“The importance of the state is way too high in Brazil, probably the highest of all the emerging markets we look at,” says Nicolas Jaquier, EM economist in the fixed-income team at Standard Life. “There’s too much red tape and they need a lot more investment in developing infrastructure but instead we’ve had a contraction in investment this year.”
Investment detracted 1% to GDP growth last year whereas consumption, while it did slow, added 2% to GDP growth, but the weak investment pulled down the actual GDP figure to 0.9%, says Jaquier.
“The weakening of the currency was initially quite welcomed by the authorities as they felt the real was too strong for a long time, but we’re now reaching a level where they’re starting to worry about the inflationary implications,” he says.
“Brazil has been one of our main underweights on the sovereign debt side. But we’ve just turned a bit more positive on the local rates because the curve is pricing a lot of hikes we don’t believe the central bank is going to deliver, as we think inflation has probably reached a peak.
“This, together with the intervention programme which is quite big for the scale of the problem, makes us much more comfortable being long the currency. They do have firepower to really keep the currency from depreciating further.”
After a decade of rising wages, Brazil's new middle class might have hit a ceiling.
The country might even struggle to hang on to what they have gained in recent years as inflation erodes their increasing wages.