Despite a rebound in growth in the second quarter, the outlook remains troubling because of slow growth in the third quarter, excessive inflation, and a deteriorating external balance.
In Q2 2013, the Brazilian economy experienced its fastest growth in eight quarters, but the outlook for the year continues to deteriorate. Amid internal and external challenges, the government and the International Monetary Fund (IMF) have repeatedly cut growth forecasts for 2013 . However, despite slowing growth, the central bank had to employ monetary tightening to counter inflation and a sharp depreciation in the currency (see figure 1). While the government also plans spending cuts to improve fiscal balance, the country is looking to spur growth by boosting trade. Brazil is looking to enter a free-trade agreement (FTA) with the European Union (EU), and although both parties appear favorable, major roadblocks remain.
Amid internal and external challenges, the government and the International Monetary Fund (IMF) have repeatedly cut growth forecasts for 2013.
Q2 glimmer quickly fades
Brazil’s GDP expanded at 3.3 percent year over year in Q2 2013, compared to 1.9 percent in Q1 2013. Double-digit growth in agriculture and capital goods production, along with a rise in exports of manufactured products, drove the performance. Subsidized loans and tax cuts by the government in the first half of the year appear to have aided the economy, but their impact was limited by rising unemployment and inflation. Unemployment averaged 5.9 percent in Q2 2013, up from 5.6 percent in the previous quarter, while inflation went up to 6.6 percent from 6.4 percent in the same period. These were the highest rates of unemployment and inflation in nearly 12–18 months. Consequently, private consumption recorded the second-slowest growth in 17 quarters in Q2, rising a mere 2.0 percent year over year. Another low point for the Brazilian economy in the second quarter was persisting weakness in the mining sector. Extraction fell an average 6.7 percent in Q2 2013 due to tepid demand as well as production challenges.
The overall economic scenario for the rest of the year appears even less promising, with the government and the IMF recently cutting full-year growth forecast by 50 basis points to 2.5 percent. Industrial production data for July backs the lack of optimism, registering just 1.1 percent year over year growth compared to the 3.3 percent average for Q2 2013. A decline in intermediate goods and significant slowdown in consumer goods has weighed on industrial activity. Exports have also been hit by soft demand from European markets, and for the full year, they are expected to grow a modest 1.5 percent, compared to 0.5 percent in 2012. In addition, private consumption growth for 2013 is forecast at the lowest level in a decade, due in part to cooling real wages. These weak internal and external factors are reflected in deteriorating business sentiments, with the purchasing managers’ index for July as well as August dipping below 50 after nine consecutive months in expansionary territory.
Tightening purse strings despite slowing growth
From March to June 2013, Brazil’s inflation rate hovered at or exceeded the Banco do Brasil’s (BCB’s) upper limit of 6.5 percent, driven in part by a double-digit increase in food prices. In addition, in the past four months, the Brazilian real has depreciated nearly 19 percent against the dollar. This was triggered by the US Federal Reserve’s hinting on May 22 at a winding down of its quantitative easing program (Fed tapering) and could stoke imported inflation.
To counter these challenges, the BCB has hiked its key interest rate four times since April 2013 by a total of 175 basis points, to bring it to 9.0 percent in August. On August 22, the BCB also launched a $60 billion currency intervention program including swaps and repurchase agreements with businesses that need dollars. The host of steps seems to have stemmed both price rise and currency depreciation to some extent. Inflation declined to 6.1 percent in August, while the real strengthened by 6.1 percent against the US dollar since August 22.
After significant stimulus spending earlier in the year, the government is now looking to curb spending to cool inflation and bolster the country’s fiscal balance. To this end, in July, the government announced plans to cut its expenses by 10 billion reals. This follows an announcement in May to cut spending by 28 billion reals. With these cuts, the government seeks to achieve its 2013 primary budget surplus target of 2.3 percent of GDP. However, a primary surplus of only 1.5 percent of GDP appears within reach for the year, given spending for economic stimulus and improving public services. Nevertheless, the expenditure incurred on public services has boosted President Dilma Rousseff’s public approval ratings, which took a beating during the widespread street protests in June. As a result, President Rousseff is likely to remain ahead of rivals before campaigning for the October 2014 election begins.
Paving trade routes for growth
The EU accounts for a fifth of Brazil’s exports, and forging an FTA with the EU has acquired an immediate urgency for Brazil. The urgency arises from Brazil’s recent classification by the World Bank as an upper-middle income country, which makes the country lose the EU’s preferential trade status in 2014. Brazil paid lower duties on its exports under the EU’s preferential status, which covers several less developed and developing economies. Given a deteriorating current account balance, it becomes even more important to boost trade with the EU, with whom net exports have favored Brazil for nearly a decade.
The only remaining hurdle for Brazil is its trade alliance with Argentina, Paraguay, Uruguay, and Venezuela—the Mercosur trade bloc. The trade bloc has been unsuccessfully trying to negotiate an FTA with the EU since 1999, and Brazil will now need a waiver from other Mercosur members to negotiate its separate deal. While Argentina and Venezuela’s positions remain doubtful, Brazil may receive support from Uruguay. Uruguay has also been seeking flexibility from the Mercosur to pursue individual FTAs.
The situation calls for Brazil to tread carefully. While waiting for a Mercosur-EU deal may be in vain given Argentina’s protectionist stance, alienating a sizeable market such as the Mercosur, which accounted for 10 percent of Brazil’s exports in 2012, would also be unwise.
Given a deteriorating current account balance, it becomes even more important to boost trade with the EU, with whom net exports have favored Brazil for nearly a decade.