Brazil: No smooth ride

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Brazil: No smooth ride

Brazil: No smooth ride

Global Economic Outlook, Q2 2014

In the absence of reform, Brazil’s economic outlook is poor. High consumer indebtedness, excessive regulation of the labor market, tight monetary policy, and mixed signals from the government are limiting growth.

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Brazil’s economy continues to face multiple challenges from all quarters of the economy. The binge in private consumer spending has ended as households face rising indebtedness and high inflation. At 18 percent of GDP, fixed investment is still below that of key emerging economies and much lower than the 25 percent deemed critical for productivity enhancement and sustainable growth. The structural deficiencies and lack of reforms have resulted in weak economic fundamentals. In addition, global uncertainties and risks are adding to the domestic woes. The country faces slowing external demand for its commodities as economic growth slows in China.

A return to growth in Q4 2013

Brazil’s economy grew 0.7 percent quarter over quarter in Q4 2013, up from a 0.5 percent contraction in Q3. This pushed up annual GDP growth to 2.3 percent in 2013 from 1 percent in 2012. Both investments and exports posted a recovery in 2013; while the former grew 6.3 percent, the latter expanded 2.5 percent. The modest recovery in exports was expected, given an uptick in global growth, although a slowing Chinese economy dented the rise in commodity exports. After a contraction in 2012, fixed investment growth in 2013 was encouraging, especially given that a key factor behind this was higher private sector participation in infrastructure (roads and airports).

Brazil’s economic growth continues to remain low relative to the previous decade and to key emerging-economy peers.

Despite these two encouraging trends, Brazil’s economic growth continues to remain low relative to the previous decade and to key emerging-economy peers. This year, the economy is likely to face numerous headwinds, the most important one being slowing private consumption growth. Exports are also not likely to accelerate much (despite a weaker currency), given slowing commodity demand from China and lack of competitiveness in manufacturing. Meanwhile, investments will have to cope with tight monetary policy, lack of reforms, and slow domestic demand growth.

Brazil Figure 1

Private consumption will no longer be the key growth driver

Consumers currently face two major problems—rising indebtedness and high inflation. Household debt as a share of disposable personal income rose to 43 percent in 2013 from 10 percent in 2010. Most of this debt is concentrated in the middle class, a key driver of spending. The composition of household loan portfolios is also a worry. Only 20 percent of the portfolio is mortgages, a segment with higher tenures and lower interest rates.1 For the rest, interest rates range from 30 percent for some consumer loans to as high as 175 percent for overdrafts.2 As a result, debt servicing costs in Brazil (23 percent of disposable income) are much higher than Latin American peers and the United States.3

Brazilian consumers have also been facing high inflation, which currently is still above the mid-point of the central bank’s wide target range. Price pressures are not likely to ease soon, thereby weighing on real wage gains and consumer confidence; the latter, in February 2014, fell to its lowest level since May 2009. Other indicators do not look rosy either. In 2013 retail sales growth was lower than that in the past two years, while car sales declined for the first time in a decade. All in all, private consumption growth is expected to edge lower this year to 1.5–2.0 percent from 2.3 percent in 2013, with any sharp upturn not likely in the next couple of years.

Brazil Figure 2

Investments will also face problems this year

Investments also face headwinds in 2014 as monetary policy is expected to remain tight, and critical reforms (especially in labor markets) are not expected in an election year. The latter, in particular, will continue to weigh on investments in manufacturing, which reported another disappointing quarter in Q4 2013, with production declining 0.9 percent quarter on quarter. Lack of reforms is also likely to hit foreign direct investment (FDI). Despite steady inflows, FDI growth has eased in recent years (1 percent in 2012 and -1 percent in 2013) and is not expected to pick up much in 2014. Meanwhile, slowing growth in China will dampen investments in mining.

On the fiscal side, the government is more likely to focus on subsidies and related spending before elections than on investments. For example, drought-related energy subsidies are expected to rise in 2014 by BRL 18 billion (up from BRL 10 billion in 2013) as the government compensates power producers for not raising tariffs amid rising production costs due to a drought. Given all the above factors, fixed capital investment is expected to grow by only 1.0–1.5 percent this year, with the figure not likely to rise by more than 3.5 percent in 2015.

Monetary policy to remain tight

To counter high inflation and a declining real, the Banco Central do Brasil (BCB) has hiked its policy rate by 350 basis points (bps) since April 2013 with the latest rate hike of 25 bps coming in February 2014. Despite this bout of monetary tightening, inflation (5.7 percent in January 2014) is still above the mid-point of the central bank’s 2.5–6.5 percent range. Price pressures will not ease sharply in the near term, although government subsidies to keep power tariffs in check will likely help. However, tariffs are likely to rise after the elections this year, thereby exerting upward pressure on consumer prices in 2015.

A key driver behind rising inflation has been the weakness in the domestic currency; the real fell by a little more than 13 percent in 2013 without making solid gains this year. While the US Federal Reserve’s tapering decision is one big reason behind the real’s weakness, structural weaknesses in the economy have not helped either. These issues are discussed at length later in the article.

The central bank’s credibility in targeting inflation has also come under scrutiny. Post the hyperinflation of the early 1990s, BCB had done a credible job of getting inflation back on track. That appears to have been partially undone in 2011–12 when BCB loosened policy despite inflation staying above the mid-point of its target range. Moreover, the inflation target itself has been subject to criticism, with experts deeming the upper band (6.5 percent) as too high. Amid these challenges, BCB will be eager to bring down inflation and restore confidence. So, it is not likely to loosen policy any time soon; if required, it is likely to raise rates by 50–75 bps this year.

Brazil Figure 3

Brazil Figure 4

The economy’s structural inadequacies

The weak macroeconomic fundamentals, aggravated by poor macroeconomic policy implementations and their management, and ineffective government interventions have contributed the most to the steady economic deterioration. The economy repeatedly lost opportunities to revamp its growth by implementing structural reforms when the external environment was favorable. Instead, the government focused more on short-term fixes to boost demand, kicking the can of reforms further into the future.

Brazil has a highly inflexible labor market. The labor laws are rigid, labor productivity is low, and generous public policies and high minimum wages contribute to high production costs. While the unemployment rate in the economy has remained low despite slow growth, it is more likely an outcome of rigid labor markets and burdensome tax laws at the expense of costly business operations and poor private investments.

The other problem is that of infrastructure bottlenecks. According to the World Economic Forum’s Global Competitiveness report, Brazil ranks 114 among 144 countries assessed for the quality of infrastructure.4 Not only does that put Brazil below every other BRIC nation, its ranking is lower than almost every other emerging economy (figure 5). A partial energy blackout across many states in February 2014 is one of the many instances that point to the inability of the country’s infrastructure to cope with the rising demand. The other factor is the inadequate schooling and lack of vocational trainings for the labor force, making it hard for businesses to move up the value chain and unfavorable for innovative economic growth.

Lately, the government has taken several initiatives to improve the infrastructure. The president announced her decision to upgrade Brazil’s infrastructure through private sector concessions and involvements in the energy sector. There have been some successes as well, like auctions in several major airports; however, achievements have been modest in road, railroads, and ports. The corrective measures have, so far, fallen short of what is needed to build quality infrastructure in the economy.

Brazil Figure 5

Lack of fiscal consolidation

The Brazilian government has failed to address the structural bottlenecks for years. Instead, it has embarked on ambiguous policies, which have resulted in high and persistent inflation, lowered the potential for growth, and led to the deterioration of public finances. The government’s expansionary fiscal policy since the global financial crisis has widened the fiscal deficit and has increased the government’s debt burden with limited impact on growth. The government missed its fiscal target in 2013 as government spending outpaced revenue by the widest amount on record. The government reported a primary fiscal surplus of 1.9 percent of GDP in 2013, failing to reach its target of 2.3 percent.

In addition, the government’s continuous interventions with unclear policy signals have dampened business confidence and constrained the attractiveness of the business environment. The rising fiscal indiscipline has lately concerned global investors, and a few credit-rating agencies have factored this as one of the primary reasons to lower their outlook for Brazil. Due to external pressure, the government announced a few spending cuts in 2014. Nevertheless, with the election around the corner, the likelihood of the government tightening fiscal discipline substantially is low. This suggests that fiscal corrections will likely follow after the elections in October 2014, if at all it happens.

The economy faces external risks

In addition to domestic factors, the Brazilian economy has been severely affected by global uncertainties. The economy has failed to contain its current account deficit over the past few years. Fall in global demand for semi-manufactured and manufactured goods have impacted export growth, while growth in imports have outpaced the growth in exports due to high imports of consumer goods and fuel products. The current account balance rapidly deteriorated to record levels of $11.6 billion in January 2014, up from $8.7 billion in December 2013 and $11.4 billion a year ago.

Brazil has also been highly vulnerable to volatile capital flows due to its overdependence on such funds to finance growth in the past few years. Data suggests a high net outflow of portfolio investment in Q4 2013. This has been further aggravated by investors’ concerns over deteriorating economic fundamentals and the government’s continuous and ineffective interventions. Brazil recorded a $23.4 billion outflow in its financial account in 2013, which includes foreign direct and portfolio investment. This led to a net foreign exchange outflow of $12.3 billion, the first decline since the global financial crisis of 2008.

Consequently, currency has steadily depreciated in the last one year (figure 6). Downward risks to currency are likely to remain high this year, if global uncertainties persist, and especially if the banking crisis in China intensifies. China is Brazil’s largest trading partner and also one of its biggest sources of investment. Besides, a fall in commodities demand from China will likely impact prices and may deteriorate Brazil’s terms of trade.

However, foreign direct investment (FDI) remains strong in Brazil, financing a large part of the current account gap. Brazil is expected to remain attractive to FDI due to its large natural resources and growing domestic demand due to a rising middle income class. The country is a net external creditor and has enough foreign reserves to cover its external debt.

The impact of sudden capital outflow and current account imbalance has also been evident on the equity index and sovereign bond rates. The equity index fell during most of 2013, except for a few months. Since October 2013, there has been a steady fall in the index. The 10-year government bond rates have increased by more than 50 percent in one year; most of this increase was after global uncertainties intensified the past summer (figure 7).

Brazil Figure 6

Brazil Figure 7

Growth will stay low in the absence of reforms

Domestic and external risks to the economy are high and will likely impact growth in 2014. Given slowing investments and consumer spending growth, overall GDP growth is expected to decline this year to 1.5–2.0 percent, despite increased spending by football fans and massive investments as the country hosts the football World Cup 2014. Sadly, things are not likely to improve much, given no policy commitment to tackle long-term structural deficiencies in the economy.

To escape from this gloomy scenario, what Brazil needs is long-term strategies to address the economy, not quick fixes. What would help is a strong dose of economic liberalization coupled with fiscal discipline. This is not unattainable—it just requires the government to embrace some tough economic reforms. It is a path that the government has not treaded on for some time.

Endnotes

View all endnotes
  1. “Brazil: Technical note on consumer credit growth and household financial stress,” IMF, June 2013.
  2. Ibid.
  3. Ibid.
  4. Klaus Schwab, “The global competitiveness report, 2013-14,” full data edition, country economic profile: Brazil, World Economic Forum, IMF, p. 135.

About The Authors

Dr. Rumki Majumdar

Dr. Rumki Majumdar is a macroeconomist and a manager at Deloitte Research, Deloitte Services LP.

Akrur Barua

Akrur Barua is an economist and a manager at Deloitte Research, Deloitte Services LP.

Brazil: No smooth ride
Cover Image by Jessica McCourt (Cover), Maria Corte Maidagan (Brazil)