Good News on the Way for Brazil

Dando continuidade à parceria com Ricardo Amorim, o EIC mais uma vez se encarrega de verter para o inglês a opnião do economista mais influente do Brasil.

Yes, you read that right. First the good news: we’re nearing the end of 2015. After the toxic mud spill in the state of Minas Gerais, flooding in Brazil’s South and North, an epidemic of microcephaly, endless corruption scandals, a political crisis, and the Corinthians soccer team holding title as the countrywide champions, most Brazilians are more than happy to bid a grateful good riddance to 2015.

Now the great news: 2016 may not be as bad for the economy as people fear, and it is nearly certain that subsequent years will be even better, maybe drastically so.

To understand why this is, we need to step back in time. President Rousseff came to power in 2011. In the years since, two notable economic patterns have been patently clear: future growth forecasts, calculated as average growth projected by a number of bank economists, have consistently deteriorated with each passing year; and, worse still, actual growth each year has also fallen short of expectations. In other words, Brazil’s economic performance has steadily deteriorated since 2011.

In fact, since 2011, Brazil has posted the second slowest growth rate in all of Latin America. The country has only fared better than problematic Venezuela, whose GDP is expected to shrink by about 10% this year.

This was not always the case; trends were just the opposite during the five years prior to 2011. With the exception of 2009, when we were somewhat impacted by the global financial crisis, forecasts presented a steady upward trend year on year, and actual GDP growth always outstripped projections.

So, what changed in Brazilian economic policy beginning in 2011?  A lot. Perhaps the two most significant changes were a marked increase in government intervention and the administration’s cowardice to tackle inflation.

A common feature of the economic policies adopted by Finance Minister Guido Mantega’s team during President Rousseff’s first term in office involved solutions premised on the belief that lowering corporate taxes would offer a viable solution to economic woes. Perhaps the most striking example of this can be seen in the energy sector.

About four years ago, the government diagnosed – correctly, by the way – that electricity costs in Brazil were among the highest of the 30 largest world economies and concluded that something had to be done to reverse the situation. Prices were high for a number of reasons, the biggest being that total taxes paid by both consumers and utility companies were, hands down, the highest of all 30 countries. Instead of drastically reducing taxes, which would require cuts in government spending, the government marginally reduced taxes and demanded, as a condition to renew concessions, that utility companies reduce the rates charged to end users. At first, prices dropped slightly and, since power consumption remained constant, utility companies’ revenues consequently decreased. Unfortunately, utility companies have little room for flexibility given their high fixed costs, namely building infrastructure for power generation, transmission and distribution.  So, what then was the impact of these price cuts on the utility companies? Lower revenue coupled with invariable fixed costs led to reduced profitability, subsequent investment cuts and ultimately decreased expansion of the power supply in the years that followed. To make matters worse, the rain gods did not seem too pleased with the changes, and rainfall dropped abruptly in part of the country. So here we are, four years on, and the lack of investment has translated concretely to a shortage of power vis-à-vis demand and to a two- and even three-fold price hike.

In short, economic policies that encouraged consumption but discouraged production led to an steady drop in the business community’s confidence levels. This, in turn, led to lower investment in production and to two major economic imbalances.

The first imbalance concerned Brazil’s balance of payments. Rising domestic production costs forced a growing number of companies and consumers to import goods from abroad rather than make or buy them domestically.  When former Finance Minister Guido Mantega took office nine years ago, Brazil boasted a $10 billion annual trade surplus for manufactured goods: we exported $10 billion more than we imported. At the end of Mantega’s term, 11 months ago, Brazil reported a $110 billion deficit. This is why industry has shrunk over 20% since the launch of the Programa Brasil Maior (Greater Brazil Program), which was created four and a half years ago supposedly to foster the competitiveness of Brazilian manufacturing.

The second imbalance led to inflation. Increases in leases, labor and raw materials drove inflation up and were left unchecked by the Central Bank until just shy of the presidential election last October.

Worse still, the government waited until just after the election to increase prices under its control. After the election and with the public accounts in shambles, price hikes for electricity, gas, bus fares, subway fares and other services hit the country all at once, climbing an average of 18% over the last 12 months and further exacerbating inflation.

As if that were not enough, the Rousseff administration created yet another major macroeconomic mess of the public accounts. Increased spending coupled with a stagnant economy, which translated to lower tax revenue for the government, led to a fiscal imbalance that undermined confidence in the country, reduced investment and stymied economic growth.

In short, the economic legacy bequeathed by the first Rousseff administration to the second Rousseff administration was a seriously ailing economy. In an attempt to treat the cancerous economy, out went Guido Mantega and in came Joaquin Levy with his plans for hardnosed economic chemotherapy.

Economic policy has now changed radically and is working to cure our diseased economy, albeit in fits and starts. The problem lies in the fact that the patient – our poor Brazilian economy – must initially suffer the pains of a yet uncured disease as well as the side effects of harsh treatment. In other words, before Brazil’s economic imbalances are corrected, high interest rates, dollar exchange rates and taxes continue to further sap the economy.

In order to adjust the balance of payments, the real (BRL) experienced substantial devaluation, which jacked up the price of foreign goods, made imports less attractive and stimulated domestic production. As a consequence, Brazil’s trade balance has started to improve.

However, there has been one notable side effect to the appreciation of the dollar against the real: the increased price of imported goods has fueled inflation. To curb inflation, the Central Bank doubled the basic interest rate to 14.25% p.a., making consumer loans more expensive. As a result of the remarkably high interest rates, consumers have cut back on purchases. And now faced with less demand for their goods, businesses have been unable to increase their prices, which will ultimately reduce inflation.

But pressure to curb inflation was so harsh that the high interest rates have not yet done the trick. On the contrary, inflation this year is expected to hit a 13-year high. It will probably drop next year, but not enough to reach the mid-range target of 4.5%. And the country may even fall short of meeting the target ceiling of 6.5%, which may force the Central Bank to increase interest rates even more early next year.

However, due to the deepest and longest recession in over 30 years, inflation will likely continue to fall in 2017, clearing the way for interest rates to drop in late 2016 or early 2017. This would once again increase credit and consumption and would encourage investment in production and increased employment.

For this to happen, Brazil must first sort out that final macroeconomic mess created during President Rousseff’s first administration – public accounts. Just like a household or a business, there are only two ways to bring government accounts under control: raise taxes or cut spending. The latter is the ideal solution in a country where total government spending is greater than nearly all emerging countries and where the quality of public services is far from commensurate with money spent.

The government raised a few tax rates in 2015, but this measure alone failed to counterbalance decreased tax revenues caused by a shrinking GDP.  In summary, in order to balance the public accounts and to boost confidence, investment and growth, the government will need to either cut spending further or increase taxes, an impossible task in a time of political crisis.

The president was reelected on her claim that the country was thriving, and that inflation, balance of payments and public accounts were under control. Soon after the election, it was clear that Brazil was strapped by economic imbalances that negatively impacted jobs and wages. There was a pervasive sense that the country had just been duped. To top this off, politicians and executives began accusing congressional leaders and other government officials of corruption. The president’s popularity ratings dropped to the single digits and further frustrated the president’s relations with Congress. Members of Congress summarily began to block bills needed to help balance the budget.

This is where the game will likely change in 2016. As long as political infighting and the country’s massive fiscal deficit persist, investment in production will continue to dwindle and unemployment will continue to rise. The country is close to unemployment in the double digits, twice the rate reported just last year. In theory, the economy could shrink unfettered for another three years, until the 2018 election. But, it is my impression that we will see a turnaround long before that, probably in 2016; the social and economic fabric of Brazil will become so frayed and conflicts so intense that it will become absolutely impossible to sustain our current feeble political balance. But, two other possibilities appear more likely than simply three years of continuous contraction.

The first is the slap-on-the-wrist solution. In this case, the president and Congress agree to fiscal adjustment in exchange for immunity for those currently under investigation in the corruption scandals, including members of government and of the opposition in both branches of government. The price paid by society for squandering the opportunity to end the culture of corruption is exorbitant in the medium to long term, and the very culture of corruption itself becomes even more entrenched. In the short term, however, this solution untethers the economy, ensuring upward-looking growth forecasts for the first time since 2011.

What makes the slap-on-the-wrist solution less plausible is that it could only take place with the highly unlikely approval of the Judicial Branch. And that would only happen if the Judicial Branch, thus far successfully keeping itself at bay from political pressure, were controlled or co-opted by the Executive Branch.

We are left then with the second alternative: the current crisis lingers and is aggravated early next year, unemployment rises and the president’s ratings and support drop even further, making it impossible for her to remain in office. It bears remembering that former President Collor was ousted not only on account of corruption charges but because of his single-digit popularity ratings and allies who gradually jettisoned their support. In this case, the new president – be it current vice-president Michel Temer or the victor of new elections – is most likely bolstered by a more solid political base, enough to push through the much-needed fiscal adjustment and to bolster confidence and economic growth.

Therefore, even though the timing, the pace of recovery and the consequences under the two scenarios are so different in the medium and long term, in either case the Brazilian economy will likely start on the path to recovery sometime in 2016 or, at the latest, 2017. It is even more probable that, once underway, recovery will be more robust than what most economists and businesses have forecast.

Brazilian economic performance over the 2014-2016 triennial, with average GDP forecast at -1.6% p.a, is on schedule to be the country’s worst performance in the last 115 years. All other cases of substantial GDP contraction have been followed by years of accelerated growth.

Almost no-one expects this to happen this time around. Forecasts by most analysts point to a shrinking GDP through the first quarter of 2016 followed by stagnation for nearly two years. Brazilian and international economic history suggests that the decreased GDP over the coming quarters may even be more intense and last longer than analysts are currently forecasting. However, once the fiscal quandary and the political crisis is resolved, and once economic confidence bounces back, recovery will ultimately be much stronger than current forecasts. Just as in the period prior to the Rousseff administration, the economy will once again present us with some positive surprises, and growth will speed up instead of slowing down – at least for a few years.

I am not the only one who sees that long-term economic expectations and, consequently, the price of goods in Brazil are far too pessimistic. To avail themselves of the business opportunities that these positive surprises will usher in, three foreign companies made billion-dollar investments in the country just last week. In cosmetics, the French company Coty purchased Hypermarcas’ entire personal-care and beauty division. In communications, the American company Omnicom acquired the ABC Group. And in aviation, the Chinese company HNA bought Azul.

Are you and your company ready for the positive surprises that await Brazil?

Ricardo Amorim hosts Globonews’ Manhattan Connection, serves as CEO of Ricam Consultoria, is the most influential Brazilian on LinkedIn, figures as the only Brazilian on the list of the best and most important international keynote speakers on Speakers Corner, and was named the most influential economist in Brazil by Forbes Magazine.

For the original article, in Portuguese, please go to: http://ricamconsultoria.com.br/news/artigos/vem-surpresa-boa-por-ai