How Can Brazil Restore Its Growth Trajectory?

How Can Brazil Restore Its Growth Trajectory?
Chart via S&P CapitalIQ

How Can Brazil Restore Its Growth Trajectory? by Dan Steinbock, Difference Group

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.

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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?

Brazil’s Lula Boom

In 2003 President Luis Inacio 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 favorable 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 modernize, Brazil needed demand for its commodities; to industrialize, 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.

“In the early 1990s, Brazil still had a reputation as the world’s champion in “unfulfilled agreements with the IMF.”

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 realization 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.

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