30 September 2018

Brazil will go to the polls next weekend in perhaps the most wide-open, consequential election in its history. I will leave it to more clever pundits to predict the outcome (especially after Brexit and the US election results!).  Rather, following recent volatility in emerging markets,  I will outline the challenges the next Brazilian government will face after polling day. Specifically, can Brazil get back on the path of sustainable, inclusive growth? Given the economy’s recent sub par performance, it is easy to  forget the successes of the decade prior to the Global Financial Crisis (GFC). Indeed, between 2000-08 GDP advanced 4% per year, Brazil became the world’s 8th largest economy, inflation declined from 3,000% in 1995 (and 20% in 2003), and 25 million people were lifted out of poverty. And, Brazil’s growth was inclusive:  the Chart illustrates that Brazil was one of the very few countries that reduced inequality during this period.

However, Brazil is  only now limping out of the severe 2014-16 recession, which followed in the wake of the GFC. And, the nation remains amongst the most inequitable in the world (Chart above). The World Economic Forum (WEF) annually compares the competitiveness of nations. In 2018, Brazil ranked 80th (out of 137 countries), down from 48th as recently as 2013. Brazilian voters are sceptical that their political leaders have the answers.  Indeed,  in the 2018 WEF report Brazil ranks dead last for trust in politicians, diverting public funds, and efficiency of public spending. Last, think about that!  With the help of an outstanding Survey by the OECD (which I strongly recommend reading), I will highlight a few key, post-election priority areas, and I will assess the chances of Brazil’s successful return to inclusive economic growth.  Emerging market investors are expecting immediate action. The next few months may prove decisive, so buckle up!

Fiscal Reform: Urgent Action Needed Now!

Despite its numerous past successes in stabilising its macro-economy, fiscal policy remains Brazil’s Achilles Heel. However, in assessing whether Brazil can deliver the urgently needed post-election belt-tightening, it is again worth noting that the budget position was not always as perilous as it is today. Indeed, the Chart illustrates that prior to the GFC, Brazil consistently ran large primary surpluses (excluding interest payments), and government debt was only about 50% of GDP, and declining.

In response to  the GFC and the deepening domestic recession in 2014, however,  fiscal policies understandably turned expansive. The sharp rise in the budget deficit — peaking at 9% of GDP  in 2016 — can be attributed to a 5% of GDP rise in public spending.

Following the election, policymakers must address two budgetary objectives.  Most urgently, the overall deficit must be reduced to prevent an uncontrolled rise in the government debt/GDP ratio. The OECD’s chart above illustrates that in the absence of radical reforms, the debt ratio — now 84% of GDP — will race well above 100% of GDP during the next decade. To be fair, the previous government outlined measures to freeze future spending in real terms and reform the pension system, which would stabilise the debt ratio by 2023 (at over 90%). However, in the run-up to polling day the pension measures have been shelved, and this year’s pre-election fiscal stimulus casts doubts on the credibility of the pledge to curb future spending.  In order to stabilise the debt ratio, I estimate an overall fiscal adjustment approaching 5% of GDP will be required in coming years. Needless to say such a painful adjustment will be unpopular.

Therefore, for such a prolonged, painful adjustment to be sustained, post-election spending priorities must be altered to ensure that the burden of the fiscal adjustment does not fall heavily upon the poor.  Deep-seated pension reforms are inevitable, as the  current system is both unaffordable and tends to benefit the affluent beneficiaries most (as it is based on final salaries).

The Chart above illustrates that Brazil’s pension expenditures are amongst the highest in the world, despite its young population which is set to age sharply in coming decades.  Already pension spending accounts for nearly 50% of Brazil’s total primary Federal government outlays, and on current trends will gobble up all tax revenues within a generation.

Unpopular, but fundamental changes are inevitable.  The above Chart shows that Brazil’s retirement age is the world’s lowest. And, the pension system is considerably more generous than the OECD average.

In the Table above, the OECD identifies additional sources of budget savings. I highlight a few of the most important.  For instance, the next Chart highlights that  Brazil rightly spends generously on education: roughly 15% of public sector spending.  However, educational achievements are distinctly sub par. Greater efficiency could improve results and/or save money. The WEF ranks the quality of Brazil’s education system at 128th out of 137 nations.

Also, public sector employees tend to earn considerably more than private sector workers.  As a result, the burden of public sector pay on Brazil’s budget is amongst the world’s largest. Government sector redundancies and public sector pay cuts may be inevitable.

In addition, even though Brazil’s government debt burden (while high) is not amongst the highest in the world, interest expenses top all other countries (see Chart below).  This sets up a potential virtuous cycle: if budget problems are addressed, bond yield spreads may narrow and reduce the interest expense.

The OECD also estimates that savings amounting 2% of GDP could be achieved by eliminating ineffective industrial subsides and reform of individual and corporate taxation.  Indeed, the WEF ranks Brazil 137th — again, dead last! — on the tax code’s adverse impact on providing  incentives to both invest and work.

Business Climate: Reinvigorating the Growth Potential

For all Brazil’s achievements in stabilising its macro-economy in recent decades, micro-level reforms have lagged well behind. The WEF highlights the most problematic issues within Brazil’s business climate, which helps identify the priorities in the next phase of economic reform.  In addition to the fiscal issues discussed, The WEF ranks Brazil 136th of 137 nations for business regulation (at least not last!), 132nd for crime, 126th for the ethical behaviour of firms, 127th for the quality of education, and 121st for the flexibility  of wage setting.

As a result, Brazil’s long-term GDP potential growth rate appears to have slowed sharply towards 1.5% following the GFC.  Not strong enough to lower unemployment and poverty, nor enough to impress EM investors.

What lies behind the lacklustre growth potential?  First of all, Brazil’s investment (and savings) rate has always been low (Chart below). But, capital spending  contracted sharply after the GFC, and there is evidence that Brazil’s budget deficit crowds out private investment.

Likewise, during periods of fiscal austerity, cuts in public sector capital spending programs have taken their toll on the quality of Brazil’s infrastructure.

Ultimately, the pathway to higher living standards, especially amongst the poor, is through higher productivity.  Unfortunately, Brazil also lags on this key metric.

Brazil’s integration in the global economy also lags behind other EM countries (Chart below). Moreover, Brazilian exports need to move up the value chain: currently 70% of Brazil’s sales abroad consist of raw materials and intermediate goods.  Moreover, Brazilian exports will be challenged by slowing growth in China and Argentina, which account for over 30% of foreign sales.

Strategic Implications

• I am optimistic that any new Brazilian government will recognise the need for change. Pre-election proposals for pension reform, financial market liberalisation, labor market flexibility, educational reform, privatisation, and deregulation to boost competition and competitiveness will be revisited soon after polling day.
• However, history suggests that actions may fail to meet market expectations.  I am a huge admirer of Brazil; indeed, an image of Corcovado adorns my website’s homepage! However,  I am sceptical that Brazil will sustain the type of fiscal adjustment required to stabilise the debt/GDP ratio, which I expect to rise to 90-100% of GDP during the next decade.
• Like other nations, Brazil borrowed heavily following the GFC. In addition to higher government debt, private sector liabilities (both corporate and households) have risen sharply.  In addition, external debt rose from $500 to $800 billion since 2012. However, Brazil’s external position is much stronger than many EM counterparts, especially Turkey and Argentina (Chart below).  Brazil’s current account deficit is small and is easily covered by large inflows of FDI ($25 billion and $75 billion respectively).

• I calculate the Brazilian Real is about 5% undervalued (Chart).  Nevertheless, unless  post-election reforms exceed expectations, the FX is likely to weaken further.  Moreover, even if tough fiscal actions do occur, I would expect the central bank (BCB) would offset the impact with easy money and FX policies.

• As economic growth remains below potential and inflation is low, the BCB would like to maintain low interest rates (or even lower them).  However, recent Real weakness will push up inflation next year; therefore, the BCB will remain cautious until the post-election policy framework emerges.
• While a relief bond market rally after polling day is quite possible, higher US interest rates would limit this bounce.  Ultimately, progress on reform will determine the medium-term outlook.  Success could lead to a rally of up to 200bp, but inaction would be far worse. I await news on reform and the Fed, and remain cautious for now.