01 Jul 2014 12:30

Back to reality in Brazil after the World Cup

The World Cup is shining the spotlight on Brazil for one month. Although there have been protests against the high costs of the arenas, the football tournament and popular support for the national team are still at least temporarily deflecting attention from the weak Brazilian economy. When the festivities are over, however, the economy will still face numerous challenges.

Growth has decelerated sharply and inflation is taking off as the October presidential election approaches. Capital spending will need to take the lead after a long period when private consumption has served as the main growth engine. Yet bringing about this shift will require extensive reforms, of which there are no major signs at present.

Structural slowdown in growth

In recent months, the economy has weakened further. The purchasing managers’ index for the manufacturing sector has fallen below the neutral 50 level, and consumer confidence has plummeted. First quarter 2014 growth reached only 1.9 per cent year-on-year: the third such quarterly slowdown in a row.

Even in a slightly longer-term perspective, growth has clearly decelerated compared to prior years. During the period 2000-2010, annual GDP increases averaged 3.7 per cent. Last year, GDP rose only 2.5 per cent.  Growth forecasts have also recently been revised downward, and full-year 2014 growth is expected to be even lower. SEB’s forecast is that GDP will increase by 1.7 per cent in 2014 and 1.8 per cent in 2015.

Like the other BRIC economies (Russia, India and China), most of Brazil’s deceleration is due to structural factors. As in Russia, growth in Brazil has, for the past decade, been driven by private consumption, while capital spending has been too low. Consumption has benefited from a strong labour market, further fuelled by rapid credit expansion, with state-owned banks helping to swell lending while the private sector has been more restrained.

The biggest obstacle to capital spending is a low national savings rate. In 2012, domestic saving in Brazil was equivalent to some 16 per cent of GDP, one of the lowest levels among emerging economies. Another economic obstacle is a high tax burden for an emerging economy and cumbersome bureaucracy.

In addition, Brazil cannot expect any support from external demand in the next couple of years. On the contrary, exports are being hurt by China’s growth slowdown, among other things manifested by lower Chinese commodity imports. Brazil is a key supplier of commodities to China, which buys about 17 per cent of its total exports. The recent downturn in the commodity cycle has been unfavourable to Brazil, and terms of trade have deteriorated in recent years.

Rising inflation puts BCB under pressure

Another challenge is high inflation, which accelerated during the second quarter of 2014 − driven by rising food prices. In May, the consumer price index was 6.4 per cent higher than a year earlier. CPI is soon expected to surpass the central bank target of 4.5±2 per cent and then remain above target during 2014 and 2015, thus undermining household purchasing power. Rising inflation is putting the central bank − Banco Central do Brasil (BCB) − in an awkward position. At the same time as growth is approaching stagnation, the BCB is being forced to maintain a high key interest rate to support the currency and curb inflation. The BCB has managed to do this largely because there is a political opening for inflation-fighting. The demonstrations that occurred one year ago were an expression of widespread discontent with a variety of shortcomings in public services, including education and health care. One of the few common denominators among the demonstrators was anger at high inflation. However, we do not expect this opening to remain if unemployment rebounds as a result of weak economic growth.

In addition to higher food prices, a weakening of Brazil’s currency has also helped drive inflation. The real appreciated after 2009 as a result of capital flows from mature markets in search of returns, but since August 2011 it has fallen sharply in value. Although the currency has climbed 10 per cent since January of this year, it is nearly 30 per cent lower against the US dollar than it was in August 2011. The financial market turmoil during 2013 caused by the US Federal Reserve’s announcement that it planned to reduce monetary stimulus programmes showed how vulnerable the real is to global conditions. Since inflation is expected to stabilise soon after surpassing BCB’s target range as growth slows, the outlook for the currency remains weak. Another factor that will push down the real is Brazil’s widening current account deficit, which is expected to total 4 per cent of GDP during 2014.

Rousseff leading in presidential election

On October 5, Brazilians will elect a president. According to public opinion surveys the incumbent, Dilma Rousseff, will win with a relatively clear margin, but weak economic growth is eroding confidence in Rousseff and her support has decreased from more than 40 per cent in late 2013 to around 37 per cent at present. Although her main opponents, Aécio Neves and Eduardo Campos, enjoy substantially lower public support in the surveys, they probably have enough to force a run-off vote on October 26. Yet Rousseff can rely on a number of factors. The labour market remains strong, and real wages are still rising. Another important factor is that incumbent Brazilian presidents tend to be re-elected. One uncertainty factor in the run-up to the election, however, is that Brazil’s fate in the football World Cup risks impacting the election results. If Brazil meets expectations and manages to win the football championship, much of the discontent about the expensive arenas will probably be forgotten. All else being equal, this will benefit Rousseff. The effects of a failure by the national team are hard to assess but they may reduce support for the incumbent.

Great need for reforms

Reforms need to focus on increasing capital spending and saving. One way to boost saving, for example, is a reform of the pension system. Public expenditures need to be re-balanced from social welfare projects and expansion of the “Bolsa Familia” conditional cash transfer programme to infrastructure investments. The tax system needs to be reformed. Privatisation of government-owned companies and liberalisation of markets would also benefit growth; not least a deregulation of petrol prices.

Yet at present there are few signs that economic reforms that could sustainably boost capital spending will be implemented. Elections can usually serve as catalysts for reforms, but this is not our assessment of this October’s presidential election. Neither Rousseff nor her opponents Neves and Campos are advocating large-scale reforms towards a market economy. The clear slowdown in growth compared to prior years can thus not be fully reversed.

This inability to push through reforms is largely due to a fragmented political situation, where the largest party − the Workers’ Party (PT) − has only 86 of 513 representatives in the lower house of the National Congress. Together with a low investment level, this leads to potential annual growth of around 2.8 per cent.