Brazil: Rethinking the 2008 Outlook

Latin America’s economic outlook for 2008 is increasingly uncertain, caught somewhere in a no-man’s land between last year’s quiet complacency about decoupling and last week’s panicky market sell-off and fears of a return to the 1990s-style crises.

Concern about the economic outlook for Latin America is natural because a good part of the region’s recent prosperity (experts disagree on exactly how much, but it was considerable) was due to commodity prices, growth in world trade, and the liquid conditions in global financial systems. For the most part, and with some exceptions, Latin America’s “quiet rise” in recent years has not been attributable to the more durable Asian formula of improvements in efficiency and global competitiveness.

The favorable world scenario, upon which the market’s expectations for Latin American growth are still based, is fast disappearing. We see US and European growth forecasts being yanked downward with each passing week. The outlook for China and the rest of emerging Asia is bound to be affected and, in terms of their export sectors, it already has been. Then we have the alarming breakdown in the global credit system, unknown toll it will exact on once-mighty global financial institutions, and the near-certainty of rising risk aversion.

In these circumstances, Latin America is going to be affected seriously and growth expectations are bound to be damped down in the coming months, especially in places such as Brazil, Argentina, and Colombia, which have done the least to prepare structurally for the leaner times ahead.

Brazil is my case in point. Despite Brazil’s much stronger fiscal balance sheet and high level of international reserves, it is difficult to see what fiscal or monetary tools the government can avail itself of to stimulate the domestic economy without harming long-term growth.

Some stimulus may be needed. The market consensus for Brazil in 2008 has growth heading down to 4.5% and to 4% in 2009. These forecasts, in my view, are still too optimistic and are likely to be revised downward, perhaps significantly, in the weeks ahead as will similarly optimistic assessments for Latin America.

Export growth in Brazil has been slowing for the better part of a year and that is without taking into account yet a likely decline in 2008 of 20% (or more) in global commodity prices. Import growth is soaring so quick erosion in the trade balance and a return to a current account deficit in 2008 look likely as well. In the meantime, estimates of foreign direct investment inflows in the range of $25-30 billion for 2008 seem to me optimistic in view of the global crisis.

The financial sector is probably the most important channels for the transmission of global woes into Brazil. An important counterpart of the huge buildup of international reserves in the Central Bank was the influx of foreign funds into Brazil’s equity and bond markets. (Colombia saw a similar phenomenon and also has grounds for concern.) Already, we are seeing strains develop in these markets as these funds are repatriated. Credit spreads are widening, the currency is showing greater volatility, and the Bovespa is down almost 12% in the last month. While not alarming, these are all signs of impending problems as the global scenario worsens. Brazilian companies dependent on global financing will find increasingly adverse credit headwinds.

If Brazil had really succeeded in bullet-proofing its economy, monetary and fiscal instruments would be available to pump up domestic demand in 2008 and prevent a serious fall in economic growth.

But, when we think about it, what can Brazil really do? Wedded as it is to an inflation-targeting framework and faced with rising inflation, the Central Bank is unlikely to countenance a decrease in interest rates under any circumstances. Even if it were to occur, a loosening of monetary conditions in the face of a global crisis could accelerate capital flight. Similarly, selling of international reserves by the Central Bank to do anything more than maintain orderly trading conditions might be like putting gasoline on the fire by spreading fears of a weaker currency and rapid reserve erosion, an all too familiar storyline in Brazil.

The Brazilian government has come out of this remarkable period of bonanza with a relatively weak fiscal position. Granted the stock debt numbers look much better, yet the flows are still a concern, including the uncomfortable public sector deficit which has been running at about 2-3% of GDP in most years.

The mix of fiscal spending in Brazil adds to the sense of vulnerability. Primary social expenditures have been skyrocketing in the last five years, mostly driven by middle-class entitlements (rather than income transfer programs directed at the poor which are just a small part of the story.) Investment spending has lagged badly as the government has struggled to get its mammoth infrastructure plans off the drawing boards.

The upshot is that, once again, Brazil in early 2008 is in a much more difficult position than Chile which has accumulated rainy day fiscal funds with which to cushion the expected decline in government revenues. Brazil with its public deficit likely to expand in 2008, is not in any comparable position. Worse, much of the Lula government’s soaring political popularity has been due precisely to the expansion of social spending, so is it ready to consider serious reform? All of this about Brazil’s fiscal position is without even mentioning the unexpected loss of tax revenues in 2008 due to the non-renovation of the CPMF tax which the government is hoping will be made up by growth in general revenues. That assumption looks more and more questionable.

A nasty downturn in the global economy, in other words, is going to catch Brazil in need of policy adjustments which may be politically difficult for the government to make. What needs to happen in Brazil is a shift in public spending priorities toward public and private investment in 2008, and away from current spending. In part, this requires determination on the part of the government to prepare for a new global reality of slower economic growth. In part, as well, it requires a renewed emphasis on privatization and on tax and regulatory reform, all of which have disappeared from the political agenda during the recent euphoria in Brazil.

Last week’s market turmoil was for Brazil was an unwelcome reminder of crises past. Hopefully, it could also be a wake-up call to prepare for crises yet to come.

4 Responses to "Brazil: Rethinking the 2008 Outlook"

  1. Vitoria Saddi   January 28, 2008 at 6:16 pm

    Tom, Fully agree with the problems you raised about Brazil. Despite the better fundamentals in Brazil, don’t you think that the open capital account may trigger sell-off in the Brazilian equities in a matter of days? Different from the previous crisis, Brazil has an open capital account, which introduces more volatility in the system. Do you agree?Great piece!

  2. Lorna Brown   January 29, 2008 at 9:49 am

    Do you think that Chile will be able to internalize its fiscal surplus to offset the decline in revenues? It seems that the surplus is kept abroad in a stabilization fund and to internalize it may lead to exchange rate and inflation pressures.Am I right?

  3. Tom Trebat   January 29, 2008 at 11:29 am

    Thanks for the comments.Yes, the open capital account in Brazil does create an open valve for the transmission of global volatility. A good part of the buildup of international reserves in Brazil has had its counterpart in equity inflows of all types. The openness is a good thing. Not much Brazil can do about this directly. The issue is whether other public policies (especially fiscal policies) can act to reinsure investors during volatile market selloffs.With respect to Chile, the question of repatriating the fiscal surplus funds (which are held abroad) certainly does raise questions of exchange rate and inflation. With respect to the exchange rate, any repatriation of public sector funds would tend to strengthen the currency at a time when the falling price of copper threatens to weaken it. In this sense, bringing public sector funds back onshore leans against the trend toward currency weakness which should dampen currency pressures. Whether the additional fiscal spending adds to inflation, that is possible as well. The net impact? Hard to say, but Chile would still be running a structural budget surplus of 0.5% of GDP.

  4. Anonymous   January 31, 2008 at 1:36 pm

    Great article!I´m not sure if I agree with the forecast of a sharp decline in commodities prices. But, if that happens, than Brazil will be in a big trouble and this crisis will start to look pretty much like all the one we had in the recent past (only worse).As a Brazilian I have mixed feelings about this. I know that this will bring a lot of pain to the Brazilian people. On the other hand, my anti-Lula side would LOVE to see his lame economic team dealing with a serious crisis…