High Demand for Optimism

Written by Armando Castelar.

Yesterday, the Brazilian Institute of Economics (IBRE) held a seminar on Brazil’s Economic Outlook. What most impressed me in the presentations was the latent conflict between high hopes that the worst in the economy is behind us, with numbers that continue to show a daunting economic situation.[1] The surveys of business and consumer confidence illustrate this conflict: all improvements chronicled in recent months were due entirely to an upgrade in expectations about the future, with no significant progress in how firms and consumers assess the current situation.

The presentations revealed an external scenario with mixed impacts on the Brazilian economy. They stressed the importance of low growth in both global GDP and world trade, a factor that will weigh on the demand for Brazilian exports. On the other hand, they discarded major shocks coming from either higher interest rates in the US or a hard landing in China. Downside risks are apparently more concentrated in China, where expansionary fiscal and monetary policies produce ever less bang for the buck. In addition, risks are mounting around the vote on BREXIT (June 23) and the US presidential elections (November).

IBRE presented a favorable outlook for the external accounts, with a current account surplus in 2016 and a deficit next year, both of 0.1% of GDP. With net FDI inflows projected at 3% of GDP, and a Central Bank less willing to pile up foreign reserves, this should pressure the currency up. However, IBRE foresees the exchange rate at R$ 3.70/ US$ at the end of 2016 and R$ 3.85 / US$ a year later, on account of rising sovereign risk.

Whether the real strengthens or not will have direct implications for inflation and the degrees of freedom of Brazilian monetary policy. Here we see both good and bad news. Inflation will come down significantly in 2016, to an expected 7.1%, from 10.7% last year. However, in the base case scenario, it will reach 6.2% in 2017 and 5.7% in 2018, far from the target of 4.5%. Indeed, the seminar sent a clear message in this regard: if the Central Bank is serious about pursuing the inflation target, it will have limited room to lower the policy interest rate.

The most critical challenge the Central Bank will have to face is an adamant inflation in services, projected to come down to 7.4% this year, from 8.1% in 2015. This is surprisingly little disinflation considering that the unemployment rate should hit 12.3% by the end of this year and real labor earnings will likely drop 2.0%. IBRE expects unemployment to rise further in 2017. However, how much longer can unemployment remain at these record levels before the authorities are forced to provide some relief? In my view, this is will raise the temptation to let the real strengthen.

Much of the conflict between bulls and bears focus on how much GDP will grow next year. IBRE believes the economy is still going down and foresees a rather gradual recovery in GDP, which it expects will drop 0.1% in 2017. As I discussed in a previous post, bulls believe the economy has already hit bottom and predict an expansion between 2% and 3% next year.

A slow and lackluster recovery will make the fiscal problem Brazil currently faces even more worrisome. In IBRE’s scenario, the public sector debt will rise to 75.4% of GDP by the end of this year and 80.9% a year later. Higher growth would mitigate the problem, but it will not be sufficient to solve it.

The seminar revealed a great demand for optimism and widespread hope that the new administration will be able to put the economy back on track. The positive expectations about the future lay on sound foundations: a better economic team, a sounder diagnosis about the economy’s problems, and a more favorable attitude towards the private sector and international integration. It will be a great help if actual numbers reinforce these positive expectations.

Unfortunately, I myself believe that in a confrontation between optimism and hard numbers, it’s usually the high hopes that leave the arena bloodied. The positive initiatives the new administration has ventilated in the press are insufficient, on their own, to power an economic upturn. A sustained turnaround would require the government to secure congressional approval to measures that put stringent and sustained limits to the expansion of government expenditures. Otherwise, the honeymoon the new government currently enjoys may be short lived.

[1] In what follows I sum up key points of the presentations done by Regis Bonelli, Jose Julio Senna, Livio Ribeiro, Aloisio Campelo, Salomao Quadros, Silvia Matos, Samuel Pessoa, Braulio Borges and myself. Julio Mereb, Bruno Ottoni and Vilma Pinto also contributed to build the outlook discussed herein.

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