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Economic Insights

While the government finally is promoting reform efforts, the nation’s economic and political troubles are likely to stick around.

Brazil has deep troubles: economic, financial, and political. Its economy, after years of disappointing growth, has fallen into recession. Its central bank now expects the country's real gross domestic product (GDP) to fall 3.0% this year and slide further next year. Unemployment is high and rising, most recently reported at 7.5% of the country's workforce. Brazil's currency, the real, has hit 10-year lows against the U.S. dollar, adding force to an already accelerating domestic inflation problem that has carried consumer prices up at annual rates approaching double digits. Public finances continue to deteriorate, despite recent efforts to cut government spending.1 Nor is there any sign that these pressures will let up anytime soon, even with an encouraging recent turn toward policy reform.

How Brazil came to this turn sheds considerable light on why problems likely will persist. Aside from the corruption, which has overshadowed Brazilian politics and business for decades, the country's mess fundamentally has two sources: 1) China's economic slowdown as well as Beijing's efforts to reorient its economy toward a domestic engine of growth have curtailed that economy's imports of raw materials, hitting Brazilian exports hard, not the least because Brazil in the good years had oriented its economy around Chinese buying, and 2) Brazil suffers from its own unsustainable redistribution and subsidy policies—a major cause of the country's recent credit downgrade to junk status—and which the government must now unwind at the worst possible time, in the teeth of a prolonged recession.

A Mistake to Count on China          
For a long while, China's boom was Brazil's. The Middle Kingdom's great hunger for raw materials pushed the Brazilian economy up in three ways: 1) through direct exports; 2) by raising the global prices of raw materials, especially those that Brazil sells; and 3) by giving the Brazilian government resources to pursue generous domestic redistribution policies that gave the economy a boost by putting money in people's pockets. Brazil's exports surged during those boom times, rising from the equivalent of $70 billion in 2003 to some $200 billion in 2008, a 23.3% yearly rate of gain. Brazil's overall economy grew at about a 5.0% annual rate during that time, and the country's aggressive income-redistribution policies got credit for bringing literally millions out of poverty.2   

Matters, however, deteriorated after 2010, as the Chinese economy slowed and brought down Brazilian exports. In U.S. dollar-equivalent terms, Brazilian sales abroad have dropped from $250 billion in 2011 to $225 billion in 2014 (the most recent period for which complete data are available). This is an almost 4.5% annual rate of decline in nominal terms. Adjusting for the inflation that prevailed during this time puts real Brazilian exports down about 20% over the three-year span. Little wonder, then, that the country's trade balance has deteriorated from a dollar-equivalent surplus of $29.8 billion in 2011 to a deficit of $4.0 billion in 2014, or that the current account balance, which includes some capital flows, has deteriorated from a deficit of 2.0% of GDP in 2011 to a deficit, in 2014, equivalent to 4.4% of the economy.3  

Alone, this kind of a shortfall would put any economy back on its heels, but Brazil compounded its problems by misusing its surplus during the earlier period of booming exports. For one, it made no effort to diversify its economy while China was buying big, a move that would have enabled Brazil to cope better when Chinese demand slowed. Instead, most of Brazil's investment during the fat years went into the very industries serving China, in particular iron ore, soy beans, and oil. The economic orientation in the direction of the raw materials sought by China was so thorough that manufacturing fell from 62% of all exports in 2000 to less than 40% by 2014.4       

Brazil not only made itself increasingly vulnerable to China but also made more trouble for itself by misusing the tax boon from Chinese sales to fund income-redistribution programs that were otherwise unsustainable. A more prudent approach would have been to use the surplus to fund investments that would have strengthened the economy and increased productivity. Such an effort would have justified real wage hikes and supported a sustainable increase in general living standards. But instead, Brazil kept investment spending below 20% of GDP, low by both global and Latin American standards.5 It used the additional revenues to subsidize industries aimed at exports to China, to enlarge social welfare programs aggressively, and to increase the minimum wage far faster than labor productivity grew. Social spending generally expanded from some 13% of GDP in 2003 to 16% in 2011.6 Without the industrial development and productivity growth that might have provided real economic support for this largesse, all these efforts fell on the public purse or otherwise burdened the economy as the revenues from Chinese trade slowed.

Doubling Down on Past Errors
If this were all, Brazil would have found itself in a difficult enough place as exports to China slowed. But Brazil made matters worse with a decision to offset the loss of that business by doubling down on its already unsustainable policies. Despite the economic and revenues shortfall, social spending continued to rise into 2014, at the same amazing yearly rate of 7.0% that prevailed between 1995 and 2010. The minimum wage kept rising, too, at close to the 8.0% annual pace it had averaged between 2005 and 2012. The Bolsa Familia, a cash-transfer program for poorer families, also maintained its formerly rapid growth rate, rising from 0.2% of the economy, covering 9.0% of the population when it was initiated in 2003, to 0.5% of the economy, covering almost 30% of the population at last count. The program now provides 60% of the income of the poorest families.7 It is a kindness in these difficult times, but realistically it is more than the government can afford now that the export-based revenues have disappeared.

Brazil took other financially straining steps as well during this time in an effort to fight the economically retarding effect of the fall-off in trade. It cut taxes on selected industries and pushed the country's development bank to greatly increase its subsidized lending. Those efforts went to such extremes that Brazil's domestic development bank now has a portfolio larger than the World Bank, and some 55% of lending in Brazil occurs under some subsidy. Along with this effort, the federal bureaucracy has exploded by 30% in the last 10 years, while pension promises have led most Brazilians to expect retirement in their early 1950s. In an effort to induce consumer as well as business spending, the governments also pressured the central bank to cut interest rates after 2011, as the China trade tapered, and keep them down even as the declining foreign exchange value of the real added to inflationary pressures. Brazil vainly tried to stop the real's decline with capital controls and vainly tried to blunt the inflationary effects on consumers with price controls on everything from gasoline and diesel fuel, to electricity, to bus fares.8 The public companies involved suffered losses accordingly. To support the low fuel prices, Petrobras, the government-owned oil company, has gone through the equivalent of $17 billion in just the last three years.9

Amid these circumstances, it is hardly a surprise that public and business finances have deteriorated, visiting still other ill effects on Brazil's economy. Because of price controls, Petrobras and the country’s utilities have no surplus with which to invest, raising doubts about the economy's longer-term growth potential. Federal budgets have gone deeply into the red, both because they have lost the revenues from sales to China and because the government has made these additional efforts to boost the economy. Deficits, which ran at a mere 2.5% of GDP in 2010, have climbed to an uncomfortable 7.0% of GDP more recently.10 The real has continued to lose value against the U.S. dollar, dropping by half in the last three years. It is hardly a surprise, then, that questions have risen about Brazil's ability to service the $230 billion in dollar-denominated debt of all kinds it has outstanding.11 Not surprisingly, direct foreign investing into Brazil, of critical importance for development, has fallen off, dropping in excess of 7.0% since 2011.12 And as if to underscore the whole mess, Standard & Poor’s earlier this year downgraded Brazilian debt to junk status.13

Reform and Prospects
Now after all these policy mistakes, the newly re-elected president, Dilma Rousseff, has at last decided that the old approaches need to change. She has reopened trade negotiations with the European Union and Mexico, neglected when China was buying so much. After persuading the central bank to cut interest rates during her first term in office, she has released it to deal with inflation and currency declines in the way most central banks do, by raising interest rates. In just a brief time since the move to reform, the bank has pushed up the benchmark interest rate to 14.25%, more than 125 basis points above its level before her earlier push for cuts.14 The bank promises more rate hikes in coming months. Rousseff also has turned toward more prudent fiscal policies, replacing her former finance minister, Guido Mantego, with the Chicago-educated Joaquim Levy. He has removed many of the subsidies, raised taxes on fuel and electricity, cut government spending where he can, and set up a program to reduce the federal deficit, promising to bring it back to a sustainable level before even considering any new fiscal stimulus.15

The reform should encourage Brazilian investors, but after almost two full decades of ill-conceived policies, it will take a long time to bear fruit. Even with political support—and that is by no means sure—reform can at best only go slow. With the economy already in recession, neither the central bank nor the finance ministry can go too far too fast in the move toward economic and financial prudence. Too much austerity all of a sudden, either of the budgetary or the monetary variety, runs the risk of setting off a vicious cycle in which cutbacks to satisfy reform objectives depress the economy so much that they compound budgetary, currency, and monetary problems. It would overstate on the pessimistic side to say the recent reform efforts are too little too late. On the contrary, they are welcome and encouraging. But the lingering effects of all these past errors will not only weigh directly on the economy but also constrain the pace of reform. It will, for a while, seem as though matters will go from bad to worse and take a long time before there are adequate signs of relief.

 

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