The Brazilian Miracles and a Certain Dose of Pessimism

In 2010, Brazilian real GDP should grow by more than 7%, maybe reaching 8%, or even more than that. Between 1987 and 2009, that is, for more than 20 years, Brazil grew at very low rates, quite inferior to 7%, having sometimes negative growth—at least four times: 1988 (minus 0.5%), 1990 (minus 4.3%), 1992 (minus 0.5%) and 2009 (minus 0.2%). Therefore, at the moment, we have a “Brazilian miracle” of one year only—a “samba of one single note” as the famous song says. It should be noticed that, in those 20 years, we went from President Jose Sarney to President Lula, passing through Fernando Collor, Itamar Franco and Fernando Henrique Cardoso.

Let us go back for a while to the second half of the last century. There were two periods that we can really call as “Brazilian Miracles,” as far as economic growth is concerned. For more than 10 years, between 1952 and 1962, Brazil grew practically every year above 7% (with the exceptions of 1953 with 4.8% and 1956 with 4.1%—still satisfactory growth rates). Even more impressive, for nine years, between 1968 and 1976, Brazil grew practically every year above 10% (yes, two digits just like China!)—with the single exceptions of 1974 (8.2%) and 1975 (5.2%)—still excellent growth rates.

Therefore, there were at least two Brazilian “miracles” in the 20th century, which lasted one decade each. Normally, analysts tend to associate such “miracles” to President Juscelino Kubitschek and to Minister Delfim Netto (the latter under several Presidents), but we must include also President Getulio Vargas in this economic history, not only because he was president in the beginning of the fifties, but, more importantly, because he also ruled Brazil for a long period (1930-1945) which must also be classified as a period of rapid economic growth, that is, a third Brazilian miracle—even though data are not as good for the thirties and forties in Brazil.

What differentiates after all 2010 from the Brazilian miracles of the previous century? Clearly, one tends to mention the low level of inflation in 2010. But, to be very precise, inflation really became out of control and reached three digits per year only in 1980/81, that is, after those three “miracles” of 1930-45, 1952-62 and 1968-76.

In other words, Brazil really began to travel through stagflation during the eighties, when inflation effectively exploded, and the country had—in addition to those four recessions mentioned in the first paragraph—a strong recession period in 1981-83, with highly negative rates of growth for Brazilian standards.

It is true that inflation was practically stopped in 1994-95, with the “Plano Real,” but one cannot deny that GDP growth in Brazil was maintained at very mediocre levels even after the end of high inflation, during a period of around 15 years (1994-2009), mixing Fernando Henrique Cardoso and Lula.

Consequently, the hyperinflation or super inflation of 1981-1994 was replaced by the mediocre real GDP growth of 1994-2009. This is the reality of the inflation-growth equation in Brazil.

Finally, we reached the miraculous year of 2010, when Brazil is going to have at the same time both low inflation (5%) and high growth (8%). But something very similar had already happened in 1961, 1972, 1973 and 1976 —to mention at least four previous examples. Even if inflation in those years was at two-digit annual levels, economic growth was very high, reaching 8.6% in 1961, 10% in 1972, 13% in 1973 and again 10% in 1976—comparable to the China growth rates of today.

What is going to happen next year? How will 2011 be? One tends to give high grades, with great intensity, for the triple economic policy approach of inflation targeting, floating exchange rates and primary Government surplus, but it cannot be denied that, since 1999—when the triple approach was adopted as the official economic policy—the Brazilian economy grew very little, even though inflation remained well contained at low levels.

Apparently, both FHC and Lula Governments have perceived that low inflation is politically more important than high unemployment (after all, inflation affects all Brazilians, while unemployment affects “only” the unemployed and their families).

The fact is that, after more than 20 years of mediocre growth, Brazil began to build a huge “output gap” (the percentage difference between potential real GDP and actual real GDP), something which clearly helped to produce the spectacular recovery of 2010 without major inflationary pressures.

But there is no doubt that it will be very difficult to repeat the miracle in 2011, that is, inflation tends to accelerate and real GDP growth tends to decelerate. The so-called output gap is much smaller now and—worse than that—the famous triple economic policy approach seems to begin to show signs of exhaustion.

The external scenario is clearly unfavorable for 2011. The U.S. economy will continue to grow at low rates, while maintaining high unemployment rates. Many analysts are beginning to fear seriously a Chinese real estate bubble. Europe will face serious fiscal problems. All that tends to promote more and more what used to be called in the thirties the “beggar-thy-neighbor policies,” that is, competitive exchange devaluations, an authentic race to discover which country will devalue more, in order to export its internal recession.

Under such international scenario, the Brazilian system of floating exchange rates is clearly provoking an enormous distortion in the balance of payments. The huge differential between internal and external nominal interest rates is maintaining a strong surplus in the capital accounts, but there is an unbearable and unsustainable growth of imports and profit and dividend remittances, in addition to the loss of dynamism in the exports of manufactured goods. Brazil is back to becoming an exporter of commodities, just like it happened in the first half of the last century. And oil is coming now strong with new discoveries, maybe reinforcing this trend, which some analysts tend to call the “Dutch disease”—look at Venezuela. An overvalued exchange rate, perhaps super-overvalued.

The very concept of a primary government surplus has lost meaning after the end of inflation. In all other countries without inflation, such concept (which does not consider interest payments as expenses) does not even exist. What must be closely followed are the nominal public deficit and the gross debt of the public sector. It is true that Brazil is far—in a positive sense—from other countries (particularly Europe) as far as the public deficit and the public debt in relation to GDP are concerned. But, on the other hand, what is behind all this is clearly unsustainable and it hurts long-term economic growth of any country: an amazing tax burden and an enormous growth of current expenditures of the public sector. In dynamic terms, consequently, Brazil is doomed to face worrisome growth in the public deficit and public debt in 2011.

With the existing level of the exchange rate and a very loose fiscal policy, the inflation targeting system is left only with interest rates to try to keep inflation under control. A high real interest rate keeps inflation low of course, but it certainly tends to influence GDP negatively (this is not happening for the time being due to an erroneous perception from the general public that after all real interest rates are not so high—this is because Brazil still survives under an inflationary memory, which tends to misinterpret a situation of nominal interest rates below 1% per month).   

On the other hand, a high nominal interest rate (in comparison to other countries) attracts short-term foreign capital and is financing “dangerously” the current account deficit of the balance of payments which is growing rapidly every month now, with an explosion of imports of goods and services. It is as if international investors simply did not take into account expectations of currency devaluation (and—worse—they even continue to bet in the appreciation of the Brazilian real), even with the futures exchange market establishing, by pure arbitrage, that the interest differential (for example, between reais and dollars) is always equal to the percentage difference between the exchange rate in the futures market and the spot exchange rate for a certain period of time (in the sense of devaluation, naturally).

The challenge, therefore, whoever is the next president, will be to have the courage to change or modify something in the famous Brazilian triple economic policy approach. The exchange rate needs to be devalued, interest rates need to decline both in nominal and real terms, and fiscal policy must be tightened through the expenditure side. Big dilemmas. How to solve this equation? And one must remember that anyway—even with the adequate adjustments in economic policy—inflation will get worse and economic growth will diminish.

Therefore, the needed economic policy changes will only serve to mitigate the end of the 2010 miracle, a one-year miracle. But at least such changes will be able to avoid a balance-of-payments crisis.

It seems to be ridiculous to talk about an external crisis with the existing amount of international reserves, but the Brazilian FX market—in contrast to what is normally said—is very thin. The exit door may become very small when and if one begins to face a strong exit of international funds. And, in such case, an interest differential of the order of 10% per year represents less than 1% per month, but this is practically nothing, in comparison to potential monthly devaluations of 10% or more. Great emotions for 2011 in Brazil—and the rest of the world.