How Can Brazil Restore Its Growth Trajectory?

How Can Brazil Restore Its Growth Trajectory?

photo: PortoBay Hotels & Resorts

Only a few years ago, Brazil exemplified the BRIC dream of rapid growth. Now it is coping with its longest recession, loss of confidence,possibly a lost decade. Dan Steinbock explains what happened, and how and when Brazil could restore to its growth.

In summer 2016, Rio de Janeiro shall host South America’s first-ever Olympic games, which were supposed to be a great coming out carnival. But dark clouds hover over Brazil’s growth miracle.

When President Lula’s former chief of staff Dilma Rousseff took the office in 2011, she wanted Brazil to overcome the “middle-income trap” by shifting the nation’s growth model from finite commodities to enduring human capital – an educated population.

And yet, today middle-class Brazilians fear the return of poverty and headlines report about a massive corruption scandal around the state-controlled oil giant Petrobras. Moreover, Rousseff is coping with a threat of impeachment for increasing state bank’s debt to hide expenditures.

Even nature seems to conspire against Brazil. During the Rio Carnaval, it was the mosquito-borne Zika virus rather than the annual samba carnival that dominated headlines. With almost 4,000 cases of suspected microcephaly, the world’s most populous Catholic country is amidst a divisive debate about the near-ban on abortion.

As more than 200,000 soldiers participate in a “Zika Zero” campaign to contain the spread of the virus before the Rio Olympics in August, Brazil’s economic, political, corruption and health risks continue to climb and growth is spluttering.

The exchange rate tells the story. Before President Rousseff’s reign, the value of US dollar almost halved relative to the Brazilian currency real to about 1.70. But under Rousseff, real has plunged almost 140 percent. Today, one US dollar is worth 4.05 real; by the year-end, perhaps 4.40 real.

How did it all happen? What undermined Brazil’s growth success? How and when will rebound follow?

The Lula Boom                   

In 2003 President Luis Inácio Lula da Silva inherited a poor, resigned nation on the verge of an economic implosion. During those boom days, Brazil overtook Italy to rank as the world’s seventh-largest economy, while living standards soared by almost 60 percent. In Brazil, they were the days of wine and roses – or caipirinha and orchids.

In the early 1990s, Brazil still had a reputation as the world’s champion in “unfulfilled agreements with the IMF.” When Lula won the presidency heading the left-wing Workers’ Party (PT), his primary objective was to stabilise the economy to lay foundation for the struggle against poverty. However, he was able to achieve stability with conservative fiscal policies that calmed the markets.

Lula’s economic policies were born under favourable stars. In 2001, China joined the World Trade Organization (WTO). Only a year later, Lula initiated Brazil’s economic reforms. The main exports were commodities whose prices depended on the demand from China and the US. To modernise, Brazil needed demand for its commodities; to industrialise, China needed commodities. When Lula won the presidency in 2002, Brazil’s main trading partner was the US, whereas China had a lesser role. In the subsequent eight years, the US share plunged, while China’s soared.

It was more than a marriage of timing and convenience. Brazil led Latin America. China spearheaded Asia. Both shunned President Bush’s unipolar foreign policy; each supported a more multipolar view of the world.

In the 2010s, Lula’s success shifted the policy momentum to the expanding middle class. The goal became to provide new opportunities for the upwardly mobile, while ensuring income transfers to the poorest.

When Rousseff took office half a decade ago, the realisation of Brazil’s BRIC potential required the government – as I argued at the time – to reduce the importance of the informal sector and correct macroeconomic deficiencies, including high interest rate, and a relatively high government debt to GDP ratio. Moreover, Rousseff would have to reduce the notorious red tape and streamline the labor laws, which originated from Mussolini’s Italy. Finally, the new administration would have to contain political corruption and improve the quality of public services (education, justice, and security), and to develop new infrastructure.

Few of those changes took place, however. Instead of intensifying Lula’s reforms in her first term, Rousseff rewarded her constituencies with higher pensions, ensured tax breaks to strategic industries and spent unwisely.

The Rousseff plunge                    

Recently, the official fiscal deficit almost doubled to -9.5 percent of GDP (as opposed to 2 percent in Lula’s era), while credit deterioration continued. Having cut spending by a historical $18 billion and restricted eligibility for unemployment insurance, Finance Minister Joaquim Levy resigned, even though he had been appointed to stabilise public finances. Minister “Scissorhands,” as he had become known in Brazil, had had enough of months of fiscal inaction, thanks to political gridlock.

Before last Christmas, the police raided the offices of both the leading the ruling party PT and Rousseff’s main coalition partner, the huge but fractious Brazilian Democratic Movement Party (PMDB), led by Vice President Michel Terner. Meanwhile, all three big credit-rating agencies – S&P, Moody’s and Fitch – downgraded Brazil’s debt to junk. In 2015, Brazil’s economy contracted 3.7 percent. Inflation is still at 9 percent, although interest rate exceeds 14 percent. Living standards are actually falling in the world’s 9th largest economy.

Finance Minister Levy’s successor Nelson Barbosa is a former senior treasury official but enjoys greater support within the ruling PT. Barbosa can neither raise revenues nor raise taxes, which already account for 36 percent of GDP. He is more likely to offer “gradual” and “realistic” fiscal adjustment. As a result, his appointment caused the real to plunge and the São Paulo stock market to tumble.

Barbosa faces insurmountable obstacles because most public spending is shielded from cuts. In part, this is due to the 1988 constitution, which ended the military rule with generous job protection and state benefits. In Brazil, women and men tend to retire a decade earlier than the average in advanced economies. Nor are austerity policies favoured at the PT; in December, pro-government rallies attracted more people than those against the government, for the first time in a year.

Some expect Brazil to inflate its debt. Unlike Greece, it does not necessarily face default. It is more like Japan in that most borrowing is in domestic currency. Nevertheless, conservatives fear of “fiscal dominance.” As the treasury spends more servicing public debt, rising rates can boost inflation rather than reduce it, which could result in runaway inflation.

The Fed, China and diminished global prospects                 

Recently, the Economist opened the year 2016 with a cover story about “Brazil’s fall.” Nevertheless, two terms were missing from the report: “China” and the “Fed” explain much of Brazil’s international challenges. While Brazil’s internal dynamics explains much of its recent fall, it is also coping with a far more challenging international environment.

Barely a year after Rousseff replaced Lula, Xi Jinping and Li Keqiang began a massive rebalancing of the Chinese economy. Their urbanization and infrastructure initiatives and particularly the “One Road, One Belt” initiative continue to provide opportunities to Latin America’s growth engine. But with growth of 6.5 percent, they come with limitations.

Furthermore, the international environment has changed dramatically. The aftermath of the global financial crisis still came with years of recovery, stabilisation and stimulus injections in the advanced West. Even toward the end of Lula’s reign, world trade still seemed to rebound, demand prevailed, and commodity prices were reasonable. That’s no longer the case in the Rousseff era. World trade has plunged; demand is lingering, commodity prices – including those of Brazilian oil, iron ore and soya – have collapsed.

In addition to China’s deceleration and the plunge of oil prices, Brazil must cope with the Fed’s rate hikes. In the early 1980s, the Fed’s chief Paul Volcker resorted to harsh tightening that led to a ‘lost decade’ in much of Latin America where growth plunged from 7 to -3 percent causing a 5-year long depression. In 2011, it was the then-Finance Minister Guido Mantega who coined the term “currency war.” As Brazil’s interest rate climbed to 11 percent and the Fed launched another round of quantitative easing, he criticized the loose policy for driving hot money (short-term portfolio flows) to emerging markets, boosting asset bubbles, causing inflation and appreciation.

Now Barbosa faces a reverse challenge as Brazil is struggling with hot money outflows from emerging markets, which leave behind asset shrinkages, causing deflation and currency depreciation.

What Brazil needs is greater political unity than ever before. What it has is precisely the reverse. The corruption scandals will remain in the headlines and the impeachment debacle is not over.

Impeachment efforts and corruption scandal           

In Brazil’s Congress, the Speaker of the Lower House Eduardo Cunha seeks to remove President Rousseff, apparently to defuse allegations that he took $5 million in bribes from the state oil company Petrobras. Ironically, Cunha represents Rousseff’s main partner, the PMDB.

Nevertheless, the PMDB is already losing hope it can impeach the president and replace her with Vice President Temer. Last December, a Supreme Court ruling expanded the authority of the Senate where Rousseff’s backing is more solid, while reducing the clout of Cunha. Although critics continue to accuse Rousseff of manipulating government accounts to support public spending amid her contested 2014 re-election campaign, the evidence is now considered thin.

The corruption debacle is a different story. As the scandal known as Lava Jato (“car wash”) investigation is expanding, the lead prosecutor in Brazil’s largest corruption enquiry has overturned decades of impunity. Starting from money-laundering at a car wash, the enquiry has broadened into the state-owned oil giant Petrobras and across Brazil’s political elite. The young 35-year old Harvard-trained prosecutor Deltan Dallagnol has already charged more than 70 elite politicians, industrialists and lobbyists. The widened investigation covers leading construction companies, Swiss bank accounts, Rolls-Royce and a Dutch offshore drilling platform builder, and raids on senior members of the PMDB. The investigation may extend to Olympic projects.

When Lula left office in 2010, he enjoyed 90 percent approval ratings. In contrast, Rousseff’s current approval ratings are near-record lows. The PT has been challenged for accepting favors from construction companies in exchange for

contracts with Petrobras. During the annual carnival, even Lula was portrayed by one of the floats as a jailbird in a cage clutching bank notes.

While these claims have been scoffed as a smear campaign by lawyers, Lula and his wife Marisa were recently compelled to testify at a public prosecutors’ office in São Paulo in relation to some of the allegations.

Not so long ago, some expected Lula to stage a comeback in the 2018 presidential election, but after the corruption debacle the odds are lower. Moreover, as Brazil’s adjustment will be prolonged, inconsistent political initiatives are likely to result in further downgrades.

Finally, success or failure in the containment of Zika at the eve of the Olympics will contribute to the net effect. As Zika adds to already difficult operating conditions, Brazil’s largest airlines, TAM and Gol Linhas Aereas Inteligentes, may suffer the largest economic impact, while international tourism related to the Olympics could be significantly affected.

What next?             

Here’s the bottom line: President Rousseff did not seize reforms early enough. To opt for a BRIC growth trajectory, she should have seized broader and deeper reforms earlier, including greater trade openness, higher investment and savings, lower public and foreign debt. What’s worse, Brazil’s fragmented political system does not support the kind of unity that’s vital for productivity gains. Rather, its fragmented political system requires coalition governments, which does not facilitate dynamic economic policies.

Brazil’s severe recession is likely to ease only a little in 2016. As real GDP growth is likely to plunge to -3.5 percent or worse, both business and consumer confidence have taken heavy hits. Fiscal deficit is likely to remain more than 5 percent until the end of the 2010s when sovereign debt could exceed 80 percent of the GDP. Thanks to depreciation and stronger exports, current account deficit is expected to narrow in the short term, however.

While the head of Brazil’s Central Bank Alexandre Tombini began his career by cutting the rates from 12.5 percent to 7.5 percent, he had to hike the rates back to 14.25 percent last year, despite failing growth and adverse impact on fiscal consolidation. In early fall, Brazilian equity stages a 10 percent rally, boosted by the government’s austerity package. But in the past months, the demise of the reform momentum and Levy’s resignation has contributed to market deterioration.

In the short-term, sustained success in Brazil would require at least some or most of the following: overcoming political gridlock, reduction of fiscal uncertainty, steady revival of world trade, stabilisation of commodity and oil prices, resilient even if slower Chinese growth and the Fed’s more measured and very gradual tightening. Ideally, progress would also require a more favorable international environment, which is not in the cards, and consensus-supported reforms, which seem absent.

So is Brazil’s BRIC potential gone? No. However, without adequate structural reforms, Brazil’s growth level in the early 2010s will not be restored until the end of the decade. While 2-3 percent growth by then may not sound that much, it will still be two to three times faster than in major advanced economies which are likely to linger in secular stagnation.

The past half a decade showed how much can be lost very fast. Nevertheless, the reverse is true as well – in Brazil much can be achieved very fast, but only with structural reforms.

The original version was published by The World Financial Review on Feb 24, 2016