Last Sunday I watched “Kidnapping Mr. Heineken”, a movie that tells the story of the abduction of Frank Heineken, founder of Heineken beer, in 1982. Although thrilling, the movie kidnapping did not unfold as I read it had in the papers at the time. In real life, Mr. Heineken had significant police protection, but the kidnappers nevertheless had an easy time grabbing him: they simply drove the wrong way down the street. The guards, being Dutch, never imagined danger could arrive from the way they weren’t looking.
I like to use this example when building corporate scenarios, to highlight how easily we can miss dangers that come from futures our minds are framed not to see. I wonder whether all the current pessimism about Brazil is not similarly blinding us to a possible scenario of a mild recovery starting in mid-2016.
This is not to deny that the Brazilian economy is in a big mess. This year GDP will likely contract 3%, inflation will reach 10% and unemployment will rise substantially. The government has acknowledged its inability to meet the modest budget targets it had set for this and the next three years; it has also been unable to pass necessary fiscal measures through Congress, which is keen on expanding rather than limiting public spending. Unsurprisingly, business and consumer confidence levels are at record lows. Investment should drop 10% in 2015, after falling 4% last year.
The current crisis results from different factors. One is the need to correct the many policy mistakes in President Dilma Rousseff’s first mandate. To that end, the government has raised interest rates, taxes, and utility and fuel prices; limited public spending; and curbed credit by government banks. Two other factors are external: the strengthening of the dollar and the decline in China’s demand for commodities, which have caused Brazilian export prices to fall by 22% in the 12 months to July. Last but not least, a corruption scandal involving procurement at state-owned enterprises has increased uncertainty, led to political paralysis, and dampened activity in the oil sector.
Structural flaws reinforce these short-term problems. Productivity growth has been low and the country’s infrastructure is in shambles. Public spending will rise to support a rapidly aging population. Inflation will march higher due to legal mandates like annual real minimum wage increases. None of these dynamics are likely to change without reforms, which are unlikely to be adopted given the ongoing political crisis.
Low growth, high interest rates, and small primary budget surpluses greatly complicate managing the public-debt-to-GDP ratio, raising the sovereign risk. This has pushed Brazil’s country risk premium up and brought the currency down. Credit rating agencies reacted by threatening to strip the country of its investment grade rating.
Thus, the pessimism surrounding Brazil is well warranted. Yet, one should not ignore that there has been progress in key areas. First, the existing problems are now acknowledged, quite differently from what we saw in 2012-14. The Central Bank, for instance, has completely reversed its attitude towards inflation and is regaining its credibility. Inflation will drop considerably in 2016 and should come down to the 4.5% target in 2017. Government accounts have improved and are much more transparent. As the recession comes to a close in late 2015, and interest rates start to come down in the second quarter of 2016, tax revenues will recover from the sharp contraction seen this year.
Second, the real has weakened significantly, increasing the competitiveness of domestic manufacturers, to which falling labor earnings will also contribute. Import substitution, first, and export growth, later, should help industry recover from the deep contraction of 2014-15.
Third, as YoY inflation falls and the Central Bank starts to signal the beginning of the loosening cycle, in the first quarter of next year, confidence will start to recover and so will investment.
The end result will not be a strong recovery, but stabilization at a low growth path, as the country waits for a new government, with higher credibility and political clout, to carry the necessary reforms.
As I remarked earlier, this is one of the possible scenarios for 2016. Other scenarios are more daunting. If Brazil indeed loses its investment grade, output should contract more, the real weaken far further and interest rates take longer to come down. This means that the scenario described above would take longer to set in. It is also possible that the political crisis deepens further, increasing uncertainty, also with negative impact on output and the exchange rate. But the challenge of scenarios is to imagine the unimaginable. With the majority of analysts predicting that Brazil is on a one-way street to ruin, it just may be that someone makes a killing driving the “wrong way” and betting on a mild recovery.