Six Myths About Brazil and the Market Implications

Summary

• We dispel six myths about Brazil, covering COVID-19, the vaccine rollout, economic recovery, inflation and fiscal dynamics.
• While Brazil’s outlook has risks, by some metrics, the country has achieved more than most this year, better than headlines often suggest.

Market Implications

• The rally in Brazilian assets has further to run.

Local and international press paint Brazil in the throes of never-ending crises, between COVID-19, spiralling fiscal deficits and debt, and a struggling recovery. Although the situation is suboptimal, it is far better than the pervasive narrative in the media. Here is a summary before I take each issue in turn.

First, Brazil’s infection and mortality trajectories are on the decline. Second, Brazil has vaccinated over 40% of its population with at least one dose, higher than world, Asian, and South America averages and just below North America and Europe.

Third, growth is recovering quickly, like most parts of the world. Fourth, inflation has accelerated, but the all-important nontradable goods and service inflation rates remain well below 3% YoY. The Banco Central do Brasil (BCB) has started tightening. They have achieved unprecedented of a weak real exchange rate and relatively low inflation.

Fifth, fiscal accounts have improved significantly, with Brazil achieving net-of-interest surpluses for the first six months of 2021. Sixth, net debt and gross debt to GDP ratios have consequently declined recently and remain firmly under 100% of GDP.

Myth 1: Covid-19 and Variants Are Running Rampant in Brazil

Many think Brazil’s daily new cases and deaths are continuously rising. This is untrue (Charts 1 and 2). Both new cases and deaths are still relatively high, but clearly trending down. The situation could be better, but COVID-19 is not out of control in Brazil.

Myth 2: Brazil Is Far Behind All Countries on Vaccinations

Certainly, vaccination in Brazil started disappointingly, especially since its vaccination system advanced due to the country’s experience fighting mosquito-borne viruses. But Brazilian authorities are catching up, with over 40% of the population vaccinated with at least one dose (Worldometers). Also, Brazil’s vaccinations per capita are better than many regions worldwide; including the world, Asia, and South America averages and just under those of Europe and North America.

Moreover, the vaccination pace has accelerated in recent weeks that should reduce infection and mortality rates and the deleterious economic effects of the pandemic.

Myth 3: Economic Activity Is Not Recovering

In 2020, most expected 2021 growth at under 4%. But as we have seen in prior, purely external shocks, growth forms a V-shape. Put another way, when you stop walking, velocity goes to zero, but when you start again, acceleration is infinite.

The COVID-19 pandemic is a purely external shock, and the US, European, and Brazilian banking systems were all in good shape, especially leverage. Once the shock was over, there was no reason to think economic activity would not snap back. All sectors of the Brazilian economy are showing fast and significant V-shapes; now services too, which is important for monetary policy.

Myth 4: Inflation Is Accelerating Without Resistance

Headline inflation has risen dramatically in recent months to 8.4% YoY in May, but core inflation rates are less alarming (Chart 3). These stem from a huge rise in the USD/BRL exchange rate and global commodity prices, leading to a 12.6% YoY rise in tradable goods inflation.

But in my view, the most relevant inflation rate is nontradable goods, currently standing at 2.71% (Chart 4; see here for a good analysis). The most important component, services, stands at 2.25%, well below the inflation target of 3.75% and next year’s target of 3.25%.

Some who argued the BCB was behind the curve on lowering rates are now saying it should raise rates faster. Anticipating the services recovery, the BCB has already raised the SELIC from an all-time low of 2.0% to 4.25% and should raise it again in July to 5.0%, peaking at 6.0% in October. This is tight enough to counter any nontradable inflation and accommodate a USD/BRL decline.

Myth 5: Fiscal Accounts Are Continuously Deteriorating

Despite press reports, fiscal accounts have improved significantly (Chart 5), with Brazil achieving a net-of-interest (primary) surplus year through May 2021 of BRL60bn. Few countries have achieved this, especially in the G7. With ongoing recovery, we expect a return to annual primary surpluses in 2022.

Myth 6: Debt-GDP Is Rising Exponentially

Media headlines say Brazil’s government debt is out of control. It is not. Gross general public sector debt stood at 84.5% of GDP at the end of May 2021, down from 90% in February. Once we net out foreign exchange reserves that are an asset of the BCB, the debt-GDP ratio falls to 63.7%, down from a peak of 66.8% in December 2020.

The fact is that Brazil’s total foreign debt (USD299bn in May 2021) is lower than foreign exchange reserves (USD353bn in May). Government foreign debt currently stands at USD131bn. A 10% rise in USD/BRL reduces the government’s debt-GDP ratio by 0.7 ppt of GDP. The recent rise in USD/BRL has helped the performance of the ratio.

Market Implications Beyond the Myths

In addition to this extraordinarily good external, Brazil’s terms-of-trade has risen by over 12% YoY. Correspondingly, Brazil’s current account has turned into a surplus in the last 12 months. These developments mitigate a USD/BRL below 5.0. We expect downward pressure to resume and would sell USD/BRL on any uptick. Moreover, Brazil’s five-year CDS implies a high probability of default given Brazil’s external position. In a world of QE, this type of spread on a sovereign bond calls for selling Brazilian CDS or buying USD sovereign bonds.

In my view, Brazilian assets are overcompensating investors for the risks. Despite continued risks, the market is over-discounting difficulties.

John Welch is a former Chief/Senior Economist at HSBC, Lehman Brothers and Barclays, and holds a PhD in International Economics from the University of Illinois.

(The analysis and opinions expressed in this article are my own and do not necessarily represent those of the Brazilian American Chamber or any other of my employers, past or present.)

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