A very interesting debate is occurring in Brazil, one unimaginable a few short years ago, about policies to pursue in the light of the US recession. Should Brazil hew to the painful lessons of crises past and tighten policies? Or are internal and external conditions so different nowadays that Brazil should do the opposite: stimulate domestic demand to prevent an unnecessary and wasteful slowdown?
Both sides of the debate agree that domestic demand remains extremely strong, with special emphasis on the growth of household consumption and more liberal credit policies in Brazil. (See graph below.) At the same time, and related to this growth in demand, the external accounts are experiencing a dramatic change. Led by the declining trade balance, the current account has plunged into deficit in recent months. (See graph.) Forecasters anticipate a deficit of $12 billion for 2008 as a whole, and that could wind up being a significant underestimate of the eventual deficit given the stunning growth in imports we are witnessing in recent months.
Brazil appears to face little risk of a precipitous collapse in growth. Commodity prices, which are central to the Brazilian story, are holding up reasonably well, though correcting. The government fiscal accounts remained quite strong, despite the loss of the CPMF revenues. International reserve levels remain very high, of course, though no longer increasing. While the current account deficit is mounting, still the resulting external financing needs seem manageable. Inflation expectations (though edging up) are well anchored.
This all being the case in Brazil, why worry? As a confessed worrier, it seems to me that the external storm clouds are more threatening than most Brazilians perceive and, as a consequence, the best way to assure steady growth in the long-run is to diminish the pace of growth of domestic demand in the short-run. In other words, things are different in Brazil, but not that different so that vulnerabilities can be ignored and the external threats lightly dismissed.
First, the pace of domestic demand growth in Brazil (about 7% per year) is running well in excess of the growth of potential GDP which is closer to 4%-5% at most. (This gap is partially explained by Brazil’s still low rate of investment which caps future output growth.) Demand growth will have to slow considerably to prevent the continued emergence of strong pressures on domestic prices in Brazil.
Second, it is risky to depend on imports to fill the gap created by strong demand growth. Even though export growth has held up, the rate of import growth is extraordinary and the current account deficit could easily balloon beyond forecasts. The risk here is that Brazil could be demanding larger amounts of credit from a global financial system increasingly reluctant to provide it.
Third, much uncertainty has to exist about the future of capital inflows to Brazil and the likelihood that a worsening of the global crisis could convert these fairly quickly into outflows which, combined with the current account deficit, could lead to a rapid depreciation of the currency, inflationary pressures, and the need for a hike in interest rates. I am worried about capital outflows because much of Brazil’s recent growth in international reserves came in the form of easily-reversible short-term investments from abroad, especially in the fixed-income markets.
The best approach now for Brazil would be some sort of fiscal package to take pressure off of domestic interest rates, hopefully avoiding the need for Central Bank rate hikes. At the same time, a credible fiscal package does not seem likely in Brazil today. It could be incredibly difficult for the Lula government to be acting preemptively when the economy appears to be growing so smoothly and the poor, at long last, seem to be benefiting from strong income growth.
My fear is that if the government does not act on the fiscal side, and it probably will not, the Central Bank will move to raise interest rates even more aggressively than many in the market already fear and this would be occurring in a scenario of a rapidly depreciating currency, foreign exchange outflows, and plunging confidence.
Yes, it is difficult to imagine even a worse case scenario for Brazil that would lead to a replay of the tiresome 1990s-style financial crises. At the same time, it would be wrong to assume that this crisis is so different from all the others. Now, as then, the enemy is false sense of security in the face of the external threats.