Brazil: The World Cup is not enough

Brazil: The World Cup is not enough

Brazil: The World Cup is not enough

Global Economic Outlook, Q3 2014

Brazilian protests against hosting the World Cup highlight what is currently wrong with the country’s economy: lack of transparency, labor market rigidity, and an overarching presence of the state.

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No one perhaps plays football as skillfully as Brazilians. The fact that the country has qualified for every football World Cup bears testimony to that. So, while it is not a surprise to see Brazil host the 2014 World Cup, what is surprising are the frequent outbursts of popular anger over the event. Since mid-2013, a number of Brazilian cities have witnessed protests against the hosting of the event, arguably because of the high cost involved. Estimates put the total splurge for the World Cup at $11.5 billion. Many Brazilians believe that that the money would have been better spent on public services, education, and social housing.

There have also been a host of labor strikes, especially by public sector workers, prior to the start of the World Cup. These and other incidents related to the hosting of football’s most prestigious event highlight what is currently wrong with Brazil’s economy: lack of transparency, labor market rigidity, and an overarching presence of the state. While the government has repeatedly touted the benefits of hosting the World Cup—better infrastructure, more tourism, and global prestige—ordinary Brazilians don’t seem to agree. They want the government to do more to improve their standard of living and help them move up the economic ladder. For them, policymakers’ efforts in the previous decade to reduce poverty and inequality are not enough.

Growth slows down in Q1 2014

GDP growth in Brazil slipped to 0.2 percent quarter over quarter in Q1 2014 from 0.4 percent the year before (figure 1). Consumer expenditure, a key driver of economic activity in recent years, contracted 0.1 percent. Investment fared even worse, dipping 2.1 percent. In such a scenario, government consumption, which grew 0.7 percent, provided much-needed support to the economy.

Brazil Figure 1

Both industry and services fared poorly in Q1 2014. While growth in services dipped to 0.4 percent from 0.7 percent in Q4 2013, the contraction in industrial production deepened during this period. Agriculture was the only silver lining, with growth shooting up to 3.6 percent from –0.5 percent in the previous quarter.

The scenario is not likely to change much in the near term, with both consumer and business sentiment remaining subdued. This is despite a 0.1 percent month-over-month rise in the index of economic activity (a proxy for GDP) in April; the index itself was down 2.3 percent year over year.

Estimates put the total splurge for the World Cup at $11.5 billion. Many Brazilians believe that that the money would have been better spent on public services, education, and social housing.

Industrial activity remains weak

Manufacturing continues to be Brazil’s weak link, stifled by a poor regulatory environment, high taxes, and stiff labor laws. The manufacturing purchasing managers’ index for May indicated a contraction for the second straight month; for Q1, the figures were barely positive. Meanwhile, industrial production grew just 1.3 percent in 2013 and has been poor so far this year (figure 2). In April, production fell 5.8 percent year over year, continuing from a 0.9 percent decline in the previous month. Both capital goods (–14.4 percent) and consumer goods (–6.0 percent) posted sharp declines; the former in particular bodes ill for investment activity in the coming months.

Brazil Figure 2

Weak growth prospects and expectations of continued tight monetary policy have dented business confidence. This does not augur well for fixed investment. Businesses are also likely to keep some big-ticket spending on hold until the presidential elections in October. Moreover, with the World Cup already underway, infrastructure investments will slow this year relative to 2013. Consequently, after a healthy 6.2 percent rise in 2013, gross fixed investment growth is likely to move down to 0.5–1.5 percent in 2014. This could change a bit next year, with infrastructure in particular likely to benefit from the Summer Olympics in Rio de Janeiro in 2016.

Commodities also subdued

Commodity exports, led by iron ore, soybean, sugar, and oil, have played a key role in Brazil’s strong economic ascendancy in the previous decade. However, in the last few years, conditions for the sector have turned unfavorable (figure 3). Global commodity prices have been subdued, while slowing growth in China and the European Union—Brazil’s key export markets—kept external demand in check. As a result, trade has suffered. Exports (in US dollar values) fell about 3.5 percent year over year in the first five months of 2014, with May recording the third straight month of decline. Interestingly, although export volumes have gone up for some items, subdued prices have ensured a decline in revenues. For example, the US dollar value of iron ore exports fell 12 percent in May despite a 13 percent rise in volumes.

Brazil Figure 3

Weak commodity prices are also likely to impact investments in the mining sector. In some instances, though, weak prices could aid Brazilian miners as mining activity in some countries turn unviable. For example, the closure of unviable iron ore mines in China could benefit Brazilian miners such as Vale despite the high cost of transportation from Brazil to China. Nevertheless, Brazilian firms will have to compete with rivals in key commodity-producing nations such as Australia. The other concern for mining in Brazil is growing conflict with the local population as mining activity expands into environmentally sensitive areas such as the Amazon forests. It will take a lot of finesse and empathy—on the part of both the government and mining companies—to keep mining activity strong without raising tensions with local communities.

Travails of the Brazilian consumer

For policymakers, slowing consumer spending is another worry. Poor economic growth prospects and high inflation have taken a toll on consumer sentiment. In May, consumer confidence, as measured by the Getulio Vargas Foundation, fell to its lowest level since April 2009. This is despite a tight labor market; unemployment was 4.9 percent in April. Subdued consumer sentiment is also evident from retail sales data. Seasonally adjusted retail sales fell 0.4 percent in April, continuing from a 0.5 percent dip in March (figure 4). For the poor and the middle classes, rising house prices is another burden. Construction for the football World Cup and the summer Olympics scheduled for 2016 (in Rio) have kept up the pressure on house prices, making them unaffordable to many Brazilians.

Brazil Figure 4

In such a scenario, any sharp uptick in consumer sentiment in the near term is not likely. With elections around the corner, Brazilians will probably adopt a wait-and-watch approach before deciding on their spending plans. Meanwhile, high interest rates for consumer lending will continue to keep people away from credit-driven consumption. Consequently, private consumption growth is likely to slow down to 1.5–2.0 percent this year from 2.3 percent in 2013.

Markets shrug off an S&P downgrade

In March, Standard & Poor’s (S&P) downgraded Brazil’s long-term debt rating by one notch to BBB minus, the lowest investment grade and only one notch above “junk” status. The rating agency was critical of Brazil’s fiscal management and cited weak economic growth prospects, indicating that things are not likely to improve before October’s presidential elections. Surprisingly, equity markets seem to have factored this in. Since mid-March, the Ibovespa Brasil Sao Paolo Stock Exchange Index has risen by a little more than 20 percent.

The rating downgrade did not dent the Brazilian real either, which has gained about 5 percent against the US dollar since mid-March (figure 5). The real’s gains have been due to declining uncertainty over tapering of quantitative easing by the US Federal Reserve (Fed). Concerns over Fed tapering had hit the real hard last year and had forced it down by 3 percent against the US dollar in January 2014. That seems to have changed as markets factor in a steady reduction in asset purchases by the Fed.

Brazil Figure 5

Rising foreign investments, again due to lower global uncertainty over US monetary policy, have also helped the real. Net portfolio investments went up more than 50 percent year over year in the first four months of 2014, driven primarily by inflows into debt securities seeking gains from Brazil’s relatively higher interest rates. Direct investments have also increased during this period, although the pace was much slower at 2.3 percent.

A tight labor market and minimum wage adjustment will continue to exert upward pressure on inflation.

Central bank to keep monetary policy tight

A relatively stable (and stronger real) gives the central bank, Banco Central do Brasil (BCB), the opportunity to wind down some of its foreign exchange intervention programs, including its daily auction of currency swaps since August 2013. Real appreciation is also likely to help stem the rise in consumer prices, although that impact is not evident right now. Inflation was 6.4 percent in May, rising for the fourth straight month and reaching an 11-month high (figure 6). Although the figure is marginally below the central bank’s upper target of 6.5 percent (the lower target is 2.5 percent), it is still above the desired midpoint (4.5 percent) of BCB’s target range. Interestingly, inflation has been above 4.5 percent since August 2010. This has led to questions regarding the central bank’s credibility.

Brazil Figure 6

In the near term, inflation is not likely to go down sharply. A tight labor market and minimum wage adjustment will continue to exert upward pressure on inflation. Also, administered prices are likely to go up after the elections; the government had kept those in check since 2013. And although the negative impact of food prices (due to weather-related problems) is likely to weaken by the end of the year, this weakening will not be enough to push inflation below 5.5 percent.

In such a scenario, BCB is likely to keep monetary policy tight, perhaps hiking rates by another 25–50 basis points this year. BCB has raised its key policy rate by 375 basis points since April 2013. In May, the central bank kept rates unchanged, preferring to analyze the lagged impact of its tightening cycle before taking any decision.

A call for reforms

The new government that comes to power post October’s presidential elections will have its task cut out. First, it needs to get its fiscal house in order. Rationalizing subsidies and directing savings into public services could be a start. Second, the government needs to interfere less in the economy, especially if it wants to develop vibrant manufacturing and services sectors that generate jobs and income. Third, Brazil will have to think anew about its labor market: Removing rigidities is the need of the hour—without doing so, private businesses are not likely to flourish. Fourth, the regulatory machinery needs to be overhauled and made more transparent. It will help in addressing concerns related to corruption as well. Finally, new ideas are needed for improving economic and social welfare. President Dilma Rousseff’s efforts to tie up with the private sector to develop infrastructure is a start; the new government needs to extend such efforts to education, health, and affordable housing.

Failure to enact critical reforms would mean that economic growth will continue to remain below par in the medium term. Already this year, all economic indicators point to GDP growth of only 1.5–2.0 percent; this is even lower than the 2.3 percent rise recorded in 2013. This is not a healthy growth trend, especially for an emerging economy. Brazil needs to get out of this malaise, and urgently so. What the country needs is some grit from its policymakers and maybe some imaginativeness in governance. Perhaps the boys in yellow can show the way.

Credits

Akrur Barua

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

Brazil: The World Cup is not enough
Cover Image by Jessica McCourt (Cover), Maria Corte Maidagan (Brazil)