Brazil: Into the storm Global Economic Outlook, Q2 2015
As the Brazilian president starts her second term in office, it is clear that the economic picture is not pretty. Private consumption, a key driver of growth, has slowed, and the labor market has worsened.
A long time has passed since the heyday of Brazil’s economy. In 2014, the economy barely grew and is poised for a recession this year. Commodity exports, a key growth driver of the previous decade, are weak. Another sizable contributor to the economy, private consumption, is weighed down by high household debt, lower access to credit, rising inflation, and poor near-term economic prospects. A worsening labor market has helped neither economic growth nor social stability. In January 2015, unemployment jumped to 5.3 percent from 4.3 percent the month before. This comes at a time when the government has embarked on austerity to sort out the fiscal mess of 2014. Support from monetary policy would have come in handy at this stage. But belated monetary tightening is underway to tackle inflation and restore central bank credibility.
Four consequences of the Petrobras scandal are worrisome for the wider economy.
When Dilma Rousseff won a reelection last year, she promised strong economic growth and no changes in social policy. As she starts her second term in office, it is clear that the economic picture is not pretty. Adding to pressure on her is growing discontent over austerity measures and the widening scandal at oil giant Petrobras. Her sudden change in track to cut social spending due to fiscal necessity has raised the ire of some of her key supporters, including trade unions. Only 13 percent of voters think she is doing a good job, according to the latest Datafolha survey.1 On March 15, nearly 1 million people across Brazilian cities protested against current policies, and this will certainly not be the last protest.
Poor Q4 sums up forgettable 2014
In 2014, real GDP grew a mere 0.1 percent, the worst performance since the global financial crisis. Although the country managed to fend off a recession in 2014, economic fundamentals were undoubtedly weak. High inflation, slowing commodity export revenues, and downbeat business sentiment contributed to weak economic activity in Q4 2014, thereby dragging down annual GDP growth and raising the specter of recession in 2015. GDP (seasonally adjusted) expanded 0.3 percent quarter over quarter in Q4 2014, with exports and investment contracting sharply—12.25 percent and 0.4 percent, respectively (figure 1). Relative to the same period a year before, GDP contracted by 0.2 percent in Q4 2014.
Commodity exports from Brazil have suffered recently due to slowing growth in China, a key export market. A dip in global commodity prices has not helped either. These, in turn, have impacted investment in the sector. Investments outside the commodity space also have not fared well due to slowing domestic demand, rising interest rates, and the Petrobras scandal. No wonder then that the National Industry Confederation’s business confidence index fell to a record low in March 2015.2 The scenario is not likely to change much in the near term. Consequently, fixed asset investments are set for another contraction in 2015.
Petrobras scandal poses risks for the economy
Petrobras is now under intense scrutiny from prosecutors who allege that engineering and construction firms paid at least $800 million in bribes to executives in the firm in exchange for lucrative contracts. “Operation Car Wash,” as it has been dubbed, has already led to investigations against executives from Petrobras and some of its key contractors as well as politicians from the governing coalition. In February, Moody’s downgraded Petrobras two notches below investment grade.
The immediate impact on Petrobras has been a hammering of its stock price, which has lost about 54 percent since the middle of October 2014 (figure 2). It has also led to the resignation of the CEO and five board members. Worryingly, these developments along with prospects of a recession have hit wider debt and equity markets (figures 2 and 6).
Four consequences of the Petrobras scandal are worrisome for the wider economy. First, the scandal has hit construction and engineering firms dependent on Petrobras’s operations. For now, oil production by Petrobras has not been affected, but future exploration and subcontracting will be until investigations are over. The scandal also has vitiated the business environment and will likely lead to lower public sector investment, especially where a lot of subcontracting is involved. This does not bode well for construction and infrastructure projects.
Second, if Petrobras fails to get audited financial statements out by July, it might suffer another rating downgrade. Creditors might also accelerate claims to outstanding obligations. Such a move might force the government to intervene by injecting capital directly or through public sector banks. That will not help the government’s fiscal position, which in turn could pose a threat to sovereign ratings.
Third, the government will face increasing opposition from its own ranks. Some politicians who are being investigated have responded by raising opposition to the finance minister’s fiscal consolidation measures. For example, this year the senate president rejected a presidential decree to end some payroll tax breaks. The president’s decision to overturn two populist bills related to income tax brackets and social security charges for domestic workers have also run into opposition. Such actions will hamper strong reforms and fiscal austerity.
Finally, the scandal has put a question mark on Rousseff herself: She was head of Petrobras between 2003 and 2010. Ongoing austerity measures have not helped her popularity. In her reelection campaign, Rousseff had promised not to reduce social spending. Her sudden change in track due to fiscal necessity has raised the ire of some of her key supporters, including trade unions. This is not likely to subside any time soon.
BCB continues tightening spree
In March, the Banco Central do Brasil (BCB) raised its key Selic rate by 50 basis points to 12.75 percent, the highest in the last six years. BCB has raised rates by a total of 150 basis points since December 2014 to counter rising inflation, which for 54 months has been above the midpoint of BCB’s target range of 2.5–6.5 percent. Worse, inflation has been steadily breaching the upper ceiling since June 2014. In February 2015, inflation was 7.7 percent, the highest since May 2005 (figure 3).
High inflation can be attributed to the large fiscal deficit and BCB’s falling behind the rate curve. In recent months, what has added to the pressure on consumer prices are cuts in fuel and utility subsidies as the government attempts to prevent a rating downgrade. For example, transportation prices rose 8.1 percent year over year in February 2015, up from 3.8 percent in December 2014. Food inflation also has gone up due to a severe drought in 2014.
The other key contributor to inflation is a weak Brazilian real. The currency has fallen by about 25 percent against the US dollar since January 2014 (figure 4) and by about 16 percent this year; it touched an 11-year low in March. Part of this decline is due to dollar strength on expectations of a hike in interest rates by the US Federal Reserve this year. But another contributor to real weakness is poor economic fundamentals, including stalling growth, weak governance, a high fiscal deficit (6.75 percent in 2014), and a loss in monetary policy credibility last year.
The pressure on the real will continue in the near term as the government struggles to improve economic fundamentals amid fears of a ratings downgrade. This, in turn, will keep imported inflation high. Analysts surveyed by the BCB on March 20 forecasted that inflation this year will touch 8.12 percent.3 However, some easing in inflation is likely in 2016–17 as aggregate demand softens due to higher interest rates and slowing economic growth. Also, starting next year, the base effect of one-off increases in administered prices will have a positive impact on inflation.
A good start to getting fiscal house in order
In 2014, Brazil posted its first primary deficit (0.6 percent of GDP) since the current data series started in 2001. The wider fiscal deficit deteriorated sharply to 6.75 percent of GDP from 3.30 percent over 2013–14 (figure 5). In an effort to restore investor confidence and keep rating agencies from dropping Brazil’s debt to junk status, Finance Minister Joaquim Levy has proposed a mix of tax increases and budget cuts: hiking the payroll tax for certain companies and reducing tax credits for exporters, likely to save the government more than $5 billion in 2015–16; reducing federal spending until April 2015; curbing subsidized lending by public banks to favored sectors and firms; raising personal loan tax and social security tax on imports; and curbing home equity loan programs.
Encouragingly, the primary balance turned into a surplus in January 2015, much before some of the above measures came into effect. The government will be hoping that it has turned a corner. However, fiscal consolidation is not going to be easy. Already, political opposition to Rousseff is rising among politicians implicated in the Petrobras scandal, thereby making Levy’s task more difficult. Moreover, Levy and his team will encounter rising public discontent due to austerity, along with having to contend with a weak economy. If GDP declines by more than currently expected, tax revenues will be hit, forcing Levy to fall short of his 2015 primary deficit target (1.2 percent of GDP).
Keep the faith with Levy
For Brazil, the road ahead is not easy. According to the latest survey of analysts by the central bank, real GDP is expected to contract by about 0.83 percent in 2015.4 This was the 12th straight weekly survey in which economists had lowered their forecasts. Added to this are worries related to achievements of fiscal targets. These sentiments are reflected in equity and bond markets. Despite a recovery in March, the benchmark equity index is down by about 15 percent since last year’s peak in early September (figure 2). Sovereign bond yields have also gone up during this period (figure 6).
And it doesn’t look as if key growth drivers are likely to strengthen this year. Consumer spending, for example, will slow further in 2015 due to slowing real income gains, high household debt, rising debt servicing costs, restricted credit access, and poor economic prospects. In March, consumer confidence in Brazil as measured by the Getulio Vargas Foundation fell to its lowest level since the foundation began computing the index nearly a decade ago.5
The pressure on the real will continue in the near term as the government struggles to improve economic fundamentals amid fears of a ratings downgrade.
A deeper recession will make Levy’s task even more difficult, especially at a time when the Petrobras scandal has dented his president’s popularity and raised opportunistic political opposition. Levy and his team will do well to hold their ground. In fact, they should add long-term structural reforms to their agenda, including an overhaul of the tax regime, removal of labor market rigidities, and more private sector participation. Some of these measures will run counter to what Rousseff followed in her first term. She would be wise to change course. She has made a good start by putting in place a credible economic team and backing them for now. She needs to keep doing that. At stake is not only Brazil’s sovereign rating but also a prosperous future that currently seems like a distant dream.