The chances of a recession in Brazil in 2015 are rising: the country is experiencing a water shortage and the government – which faces an increasingly tight election in October – is in denial. Some leading private-sector consultancies say the chance that the government will be forced to ration power is close to 50%.
And the longer the wait for rationing, the more severe the action will need to be should it be required. Investment banks’ models – based on the last time rationing was implemented, in 2001 – point to a possible energy-deficit blow to 2015 GDP that would push the country into a recession and a stagflationary spiral. Foreign direct investment would collapse, leading the exchange rate to plunge – by as much as 33%, according to an HSBC projection – creating financial losses for companies, investors and speculators alike.
Already, the drought in the southeastern and centre-western regions of Brazil is beginning to have an impact on the country’s current weak GDP growth. The modest expectations for 1.7% GDP growth in 2014 of the 100 economists surveyed by the Brazilian central bank look likely to be missed as some large industrial users begin to take profits from selling back energy allocations to the grid and scaling back production.
Failure to bring in rationing until the beginning of the rainy season (in November, which is not entirely coincidentally after the presidential elections in October) will lead to more severe rationing measures being introduced should mandatory reductions in energy usage be needed. Private-sector consultancies predict that the likelihood of rationing is growing rapidly, and in mid-May hit 46% according to PSR, one of the most respected consultancies in the energy sector. Rio de Janeiro Federal University’s Engineering Research Institute has already recommended reduction in energy consumption of between 5% and 10%.
Brazil relies on hydroelectric power. Water is the basis for about 68% of the current energy matrix. The southeast and centre-west produce 75% of this hydroelectric power; they are the regions suffering worst from the drought. The country’s reservoirs entered 2014 at levels (40%) within the normal range of recent history, but a very hot and dry summer has led to a fall in the levels of almost 10 percentage points at the start of the year.
As Brazil entered its dry season at the beginning of May, the levels in the southeastern and centre-western reservoirs were uncomfortably low, at 38% and close to the levels of 2001, the last time water rationing was implemented in Brazil. Some reservoirs are already at critical levels: for example Furnas, a hydroelectric dam in Minas Gerais, was at 29% at the beginning of the dry season, compared with 72% last year and 18% in 2001.
No one really knows what will happen to the hydro turbines if reservoir levels drop below 15%; sand and mud will likely have an impact on their effectiveness. As Morgan Stanley summarizes the situation: “The minimum levels of reservoirs that the government would accept is unknown. In fact, there is no consensus from sector specialists on what is the minimum level at which the system could keep operating. At 15% levels, the operational efficiency of plants would drop materially and there could be operational issues, exposing the system to the risk of collapse.”
An HSBC report already sees worrying signs of systemic weakness: “Blackouts have already occurred in several cities in the country, including major cities like São Paulo, Rio and Brasilia during February, due to the automatic disconnection of transmission substations – a sign, in our view, that the system is overloaded and stretched.”
Models from respected consultancies such as Thymos Energia point to the 15% threshold being breached in October if the country receives 80% of its long-term average (LTA) rainfall in its dry season. If rainfall is just 70%, the threshold will be breached in September. These are distinct possibilities: according to PSR, rainfall in the first half of the month was 79% of normal levels and ONS (the operator of Brazil’s national grid) predicts 70% for the month as a whole.
Rainfall is notoriously difficult to predict outside the short-term forecast, which is for more dry weather. The critical factor is the level of water in the reservoirs as Brazil reaches the rainy season. “Many experts have said the water could be as low as 15% by the end of November – that is critical,” says Jose Soares, vice-president at Moody’s in São Paulo.
Another expert’s assessment is starker: “Even with a normal dry season we will have reservoir levels at between 15% and 25% at the start of the rainy season, which is very close for comfort. Rain by year-end is the most important thing. We need to pray.”
The government also has little room for manoeuvre on the energy-supply side. The country’s thermo plants have been at full operation since January, causing the spot price of electricity to jump to its ceiling cost of R$822/MWh (the 10-year average is about R$130/MWh) and the marginal cost of production is about R$1,400. With no room for supply-side expansion the obvious answer is a reduction of demand: Morgan Stanley research indicates that if between May and the end of November the rainfall is at 70% of LTA, reservoir levels would dip to 6.7% in November. If the government implemented a 5% rationing of energy, that would sustain levels to 13.1%, equivalent to rainfall of 80% of LTA – clearly better, but still very low.
“From a technical point of view, initiatives to reduce consumption are strongly recommended,” says Miguel Rodrigues, analyst at Morgan Stanley, in a research note dated May 2. “Our base case [for the official GDP prediction] remains no rationing [taking place], but the pace of deterioration is a concern.”
WHY IS THE GOVERNMENT RUNNING the risk? The deterioration in reservoir levels is taking place in the run-up to the football World Cup – with the world’s eyes on Brazil – and the presidential election at the end of October. President Dilma Rousseff will remember the boost that her party, the PT, got the last time energy rationing was introduced, in 2001: the rate of approval of president Fernando Henrique Cardoso fell seven percentage points in the first three months of rationing (from an already low 26% to 19%).
Rousseff was energy minister from 2002 to 2005 in the Lula administration. She is already taking hits in the polls from scandals relating to Petrobras and there is little expectation in Brazil that she will have the appetite to open herself to criticism of her handling of the energy sector – specifically regarding delays in bringing new power plants onto the grid. New generation capacity has been delayed for several reasons, including environmental issues, litigation and planning problems.
Another political vulnerability stems from the government’s decision in 2013 to implement a controversial early renegotiation of existing electricity concessions to bring electricity prices down by 16%. These lower tariffs have done nothing to dampen demand from consumers, and the government is not planning to pass on the recent big cost increases in energy generation from its thermo plants, which would constrain demand, until 2015 or beyond.
Soares points out that with the residential and commercial sectors growing their energy demand by about 8% a year since 2011, the sluggish industrial sector – demand has been broadly flat – is something of a blessing for the current energy situation, if not for Brazilian economic growth. Also, even if earlier rationing would be milder than delayed rationing, there would be knock-on to the economy that would further weaken the president’s election chances. Even without energy rationing, the presidential race is tightening: polls in early May predict – for the first time – that a second round of elections is likely. Rousseff still leads, with 35%, but in April last year she had ratings in the mid-60s.
The government justifies its wait-and-see approach through official figures and projections that say the country will be able to completely avoid energy rationing. In a report dated April 28, Lilyanna Yang, analyst at UBS in São Paulo, said that the ONS had been revising upwards its projections for rainfall and reservoir levels and it believed that reservoirs in the southeast and centre-west will be at 39.2% in May – within the comfort zone to avoid rationing.
Yang’s report says, though: “We highlight that even when using the ONS rainfall assumptions, independent experts continue to view the government’s reservoir forecasts as optimistic, mainly because water consumption/GWh production in the dams would be underestimated… under our energy deficit scenario investors would have supply issues sooner rather than later, ie, possibly before the October 2014 elections.”
The head of the ONS, Hermes Chipp, has expressed confidence in the security of reservoir levels, but this is beginning to be challenged by his technical staff. According to a report in the local business newspaper Valor, employees of the organization called for demand reduction of 3GWh to 4GWh to save up to 10 percentage points of water capacity by the end of November. UBS’s Yang notes that “the ONS has been widely criticized by sector experts for underestimating the risk of energy deficit”.
WHAT MIGHT THE IMPACT BE FOR Brazil’s economy and markets in 2015? UBS’s Brazil economist, Guilherme Loureiro, ran three simulations to gauge the potential impact of energy rationing on real GDP growth, inflation and unemployment. His models used different approaches (a value-at-risk model, a modified version of a central bank study from 2001 and a structural model to simulate a supply-side shock using 75% of the 2001 shock). The outcomes were consistent.
The base assumption was for 10% energy rationing for 12 months, compared with rationing of 20% for eight months in the 2001 case study. The bank’s analysis points to a fall in GDP of between 0.7 and 1.5 percentage points, and an increase in inflation of 120 basis points and unemployment of 0.5 percentage points. Morgan Stanley and HSBC haven’t published this type of analysis, but their rationing projection predicts 20% rationing for one year.
Loureiro says that in these projections it would be reasonable to expect the impact on GDP to be doubled: therefore a hit to growth of between 1.5 and three percentage points. He says the impact on inflation and unemployment isn’t as linear, but it is safe to assume both would be at much higher levels than in the UBS model. In this 20% rationing projection, it is likely the country would be pushed into recession, with stagflationary pressures.
Morgan Stanley predicts that industry would be most severely harmed given its electricity-intensive nature. “During the 2001 rationing, industrial output slowed from a 10% pace of growth in December 2000 to a 6.4% contraction by December 2001. More importantly, business confidence fell materially, also creating a sharp slowdown in investments. Although the energy rationing in 2001 did not affect consumers’ income directly, it hurt confidence, and slower growth affected the labour market.”
The financial fallout from any crisis is harder to model: Brazil is far more integrated into the world’s financial system today than it was in 2001. “It is possible there would be much greater financial volatility,” says Marcelo Kfoury, head of the economic department at Citi Brazil. “We’d expect harder times for investment – foreign and domestic – in a context of higher volatility. You could see in the medium term the Brazilian real getting weaker because of the lower FDI capital flows, which is a concern.” HSBC predicts rationing would lead the real to $3 (currently $2.21), bringing additional pass-through inflationary pressures.
The growing concern of energy consultants and economists isn’t being mirrored widely. The risk to energy production hasn’t yet become an election issue – media interest is elsewhere, such as on the very low levels of reservoirs for drinking water: “Everyone is preoccupied with the World Cup,” one banker offers as a reason why the issue isn’t getting more attention “but by the end of the year, if the reservoirs are lower, you will see this becoming more visible in the media.”
Investors seem unconcerned too: the Bovespa is rising – rallying 20% between mid-March and early May, while the real is one of the world’s leading performers in 2014.
“The chance of the opposition winning was getting higher without this energy issue,” says one economist. “I think this explains the dichotomy between the seriousness of the issue and asset prices still going up. But there is a danger in that [Rousseff] might start doing crazy things to get approval.”
The same economist warns of a backlash should Rousseff win the election and then immediately implement rationing. Should Rousseff lose both the election and her water gamble, the new government would be starting from a very bleak position.
With so much uncertainty regarding the functioning levels of reservoirs, possible alternative sources and – crucially – rainfall levels until November and beyond, only two certainties warrant attention. First, the impact of a persistent drought would be very serious for the economy and the population. The second is that if rationing is needed, then the sooner it begins the less severe it will need to be. And perhaps a third: politics is, as always, the wild card, making the decision about whether or not to ration – and when – hugely complicated and sensitive.
João Carlos Mello, president of energy consultancy Thymos Energia, summarizes the dilemma: “If we have a small reduction in energy usage, it has a small impact on GDP – it is almost zero. But it has political implications because it is a sign that Brazil has rationing again. It’s complicated – reductions in load can save you water and make energy more secure and limit the impact on GDP. And if you postpone you reach a time when you must reduce load by a very large volume, which will have a large impact on GDP and other variables. This is a very difficult decision for the government today – I realize it is difficult – but they prefer to wait and see.”