During 40 years in the last century, Brazil was the country with the highest average rate of inflation in the world (1954-1994), something like 40% per year, sometimes reaching three- and four-digit annually. Additionally, this was also a period of frequent and severe balance-of-payments crisis generating a huge external debt and at some points even radical decisions such as a moratorium (1983 and 1987, for example).
On the other hand, and somewhat paradoxically, during the same last century, Brazil was also the country in the world with the highest average rate of economic growth, particularly considering the 40-year period from 1940 to 1980 when the average was 7% and sometimes reached a succession of two-digit rates (for example, during the so-called Brazilian Miracle in 1968-1973 when the average was 10%).
Well, in 1995 – due to the brilliant Plano Real – inflation practically stopped and continued to be very low until today. At the same time, external debt negotiations during the nineties and later good economic policies, as well as a favorable world economy, changed entirely the external macro situation of Brazil, which began to accumulate international reserves in the last seven years, reaching an enviable situation where the “net” external debt is now negative, that is, the level of reserves is greater than the external debt.
But there was still a weak point. For the past 24 years (after 1981), the country seemed to have lost its dynamism of the previous 40 years and the rate of economic growth fell to very low levels, with an average of 2/3% per year until 2005, which is practically nothing considering the growth per capita.
However, it was very impressive that last year (2007), the year before (2006) and certainly continuing this year (2008) not only the positive aspects remained – low inflation and good external accounts – but finally economic growth began to accelerate (5% in 2006 and 2007).
For the first time in the last 70 years (or even more), Brazil reached a point where everything seems to be moving in the right direction: low inflation, high economic growth, and an excellent balance-of-payments position. And the numbers for 2008 might certainly better than 2007 and 2006, particularly in terms of economic growth.
The question is: is the process sustainable? First of all, the world economy will not be as dynamic as it was in the last five golden years, but many persons argue that Brazil is showing some ability to react with the right economic policies to the potential negative external shocks and some eventually say that Brazil is even benefiting in many aspects from the lack of good opportunities in countries such as the USA or even Europe, in comparison to Brazil (and other emerging market countries). Supposedly, the “empirical evidences” would be the recent behavior of the Brazilian stock market as well as the appreciation of the exchange rate (real against the dollar).
Moreover, this favorable macroeconomic scenario for Brazil is clearly spilling over to the capital and financial markets. Both the public and private equity markets have never been so active. The growth of debt markets is also impressive – and, more than that, for the first time in at least 50 years, consumers and companies are able to borrow long term in Brazil at reasonably “low” nominal interest rates (although nominal rates are still at the two-digit level today).
Should we then be bullish on Brazil? Many investors even say that other continental countries such as China, India and Russia are also attractive, but these investors emphasize that – in addition to the excellent macro situation – the legal framework to operate in Brazil is much more similar to the Western Hemisphere than the other BRICs.
Without trying to be pessimistic, the question of sustainability is crucial for basically three reasons: the high level of nominal and real interest rates (supposedly, a “strong” currency should not require a two-digit interest rate), the overvaluation of the exchange rate (many estimates indicate that the 2008 present level is equal to the 1995 level, that is, below one-to-one with respect to the dollar) and finally the total size of the Government and the fact that Brazil continues to have a “nominal” public deficit.
Without changes in economic policy related to the interest rate, the exchange rate, and fiscal policy, one might question the sustainability of the good numbers of 2007. For example, it is amazing that – in spite of a major appreciation of the exchange rate in 2006/2008 and a high level for the real interest rate – the rate of inflation is beginning to show negative trends. Also the balance of trade (and more generally the current account of the balance-of-payments) is beginning to respond – negatively – to the overvalued exchange rate.
Our fear is that such “changes” may be the wrong ones. In the long run, a zero nominal public deficit can be reached through higher taxes or lower expenses. The incompatibility between the present interest rate and the present exchange rate must be corrected, but it will certainly affect negatively the present virtuous circle of low inflation and higher growth. What will be the Government’s choice to face this “Phillips curve” type of dilemma or trade-off?