Emerging Markets | Monetary Policy & Inflation | Rates
The Brazilian economy is sliding into a deep recession: it has begun to contract even in nominal terms for the first time in living memory (Chart 1). And the country was barely out of its previous recession in 2014-16, marred by a subdued recovery. The ongoing pandemic has pushed Brazil’s economic activity back down to the levels seen before the global financial crisis. In effect, Brazil might have lost a decade (Chart 2).
The enduring weakness has also changed the country’s risk profile. In stark contrast to past decades, Brazil’s main macro risk now stems from mounting deflationary pressures. CPI has fallen below 2%, the lower end of the central bank’s target range, and could slip to outright deflation in the months ahead. This will make the country’s very high public debt, likely to top 100% of GDP this year, even more unsustainable (Chart 3).
The way out of a public debt trap amid deflationary pressures is to boost nominal GDP. For that, and to tackle the ongoing recession, fiscal taps have been opened. The parliament has allowed one of the largest packages in EM, at 6% of GDP, in direct fiscal stimulus. The central bank (BCB), on its part, has announced a $300 billion financial liquidity package, equivalent to 16% of GDP. In addition, it has cut policy rates down to 2.25%, from twice that level at the beginning of the year. Yet, there are signs that these measures are not yet effective enough.
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
[Bearish Brazil]
The Brazilian economy is sliding into a deep recession: it has begun to contract even in nominal terms for the first time in living memory (Chart 1). And the country was barely out of its previous recession in 2014-16, marred by a subdued recovery. The ongoing pandemic has pushed Brazil’s economic activity back down to the levels seen before the global financial crisis. In effect, Brazil might have lost a decade (Chart 2).
The enduring weakness has also changed the country’s risk profile. In stark contrast to past decades, Brazil’s main macro risk now stems from mounting deflationary pressures. CPI has fallen below 2%, the lower end of the central bank’s target range, and could slip to outright deflation in the months ahead. This will make the country’s very high public debt, likely to top 100% of GDP this year, even more unsustainable (Chart 3).
The way out of a public debt trap amid deflationary pressures is to boost nominal GDP. For that, and to tackle the ongoing recession, fiscal taps have been opened. The parliament has allowed one of the largest packages in EM, at 6% of GDP, in direct fiscal stimulus. The central bank (BCB), on its part, has announced a $300 billion financial liquidity package, equivalent to 16% of GDP. In addition, it has cut policy rates down to 2.25%, from twice that level at the beginning of the year. Yet, there are signs that these measures are not yet effective enough.
Needs Effective Stimulus
Borrowers are still saddled with abnormally high interest rates relative to growth. The 10-year government bond yield, the rate paid by the ‘risk-free’ borrower, is hovering above 7%. Private sector borrowers are paying even more. This is far too high when the economy’s nominal growth rate has fallen to a negative 4% (Chart 1). Such disparity is not only detrimental to public sector debt sustainability, it is also extremely restrictive for the private sector. Indeed, one reason Brazil’s growth has remained lacklustre since 2014 is because lending rates have consistently stayed much higher than the nominal growth rate.
The solution for a revival lies in reducing policy rates further and ensuring that the easing percolates down to the broader economy. In addition, the BCB also needs to engage in large-scale purchasing of government bonds and other modes of quantitative easing (QE) to help drive rates down at the longer end. Fiscal deficit this year is slated to reach 14% of GDP, Fitch Ratings estimates. In absence of meaningful QE, the massive bond issuances would push the interest rates still higher.
Brazil’s central bank chief, however, has been reluctant to pursue QE before exhausting conventional methods. He also said that he saw QE more as a tool to stabilize the markets rather than an alternative way of monetary policy. That said, last week the BCB announced its first QE program, beginning with private sector bond buying in the secondary market. This was a correct step, but much more is needed.
Real Is Vulnerable
One implication of pursuing the solution is a weaker currency. Given that the reducing interest rate is of primary concern now, the BCB will be forced to let currency depreciate. It cannot control both the interest rate and exchange rate in an economy with an open capital account. Besides, a weaker currency is another way to boost nominal growth.
The outlook for the Brazilian real is also muddied by soft commodity prices (Chart 4). The latter show little signs of recovery despite surging equity markets. Muted commodity prices, in turn, are leading to a worsening current account deficit for Brazil as it is a major commodity exporter. This does not augur well for the real.
Note that even though the real now looks cheap versus the US dollar, that is not the case against its other trading partners – as those currencies have also depreciated against the greenback. As much as 85% of Brazil’s trade is conducted with those other partners, and a weak currency would help Brazil rebalance its economy. Going forward, therefore, the path of least resistance for real appears to be down.
What About Reforms?
Brazil’s pension reform last year was a very positive step in its structural reform process. That said, the savings expected from the pension bill were back-loaded and were not supposed to plug the primary deficits in the first few years. In other words, the pension bill alone was insufficient to contain the runaway public debt now.
The ongoing recession has made the matters worse as social security deficit itself has begun to deteriorate again. This is because the revenue, which is obtained from taxes on workers and businesses, has dwindled, while pension payments have not. It is yet another reason for public debt levels to surge this year.
Besides pension, the lawmakers have also been planning other structural reforms, such as privatization of state-owned entities and tax reform. In terms of privatization goals, the government’s originally expected divestment proceeds of $35 billion in 2020 look a distant dream now. In the post-Covid world, most plans have been shelved. Privatization of Electrobas, the state-owned power company, has been postponed until 2021. The state-controlled lender Caixa suspended an IPO of its insurance subsidiary in March. The cancellations and postponements mean a bigger fiscal deficit and correspondingly higher bond issuance this year than originally planned.
Tax reform is another area where Brazil can reap significant value. A higher tax burden and an overly complicated tax system has long plagued the economy. World Bank’s 2020 ‘Ease of Doing Business’ report ranks Brazil 184 out of 190 countries in ‘Paying Taxes’ category. The lawmakers are trying to rectify the situation. The two proposals under consideration for indirect taxes, one at the Senate, and the other at the House of Representatives, are both aiming to simplify the system by combining a plethora of federal, provincial and municipal taxes into one.
A parallel discussion is on for direct taxes as well, although no formal bill has yet been published. Its main objective is to reduce the corporate tax rates from their current 34% to closer to the OECD average of 21%. However, given Brazils’ poor fiscal standing and large debt loads, it’s unclear if there is scope for tax cuts of such magnitude. In any case, the preoccupation of policymakers with the pandemic and a fractured legislature have rendered the timetable for all reform initiatives highly uncertain. Foreign investors should avoid Brazilian assets for now.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)