Brazil’s economic crisis is not a surprise, although neither the intensity nor the pace of economic deterioration had been anticipated. In 2015-16 GDP will fall by 5% or more, and domestic demand and real labor earnings will both contract almost 10%. By the end of next year, a tenth of the Brazil’s labor force will be out of a job, with a rising share of those who remain occupied working in the informal sector. And there is a sizable risk that, despite all of this, inflation will stay near the current yearly rate of 10%.
To be fair, not all news is bad news. Economic policy has improved vis-à-vis what it was in 2009-14 and should bear fruit in the medium term. The external accounts are on the mend: despite the predictable fall in export prices, the current account deficit will drop to US$ 50 bn or less in 2016, down from US$ 104 bn in 2014, a gap that will be fully financed by FDI inflows. And relative prices are changing substantially and in the right direction: electricity prices are up; real labor earnings are on their way down, soon to be followed by that of nontradables in general; and the real has weakened considerably over the last four years: in real terms, 40% against the USD and 34% against a wide basket of currencies.
Yet, these developments have done little to lift the spirits of economic agents (Figure 1). Consumer and business confidence was further depressed by the S&P´s surprise decision, on September 9th, to downgrade Brazilian debt to junk. Although the timing of the announcement came as surprise, the same cannot be said of the decision itself: Brazil’s economic fundamentals deteriorated significantly over the last four years and the market had already been pricing the country’s debt as a higher risk than Russia’s and Turkey’s, neither of which is rated as investment grade (Figure 2).
Figure 1: Confidence at a record low (avg Jul/07-Jul15 = 100)
Figure 2: Five-Year CDS for Brazil, Russia and Turkey (basis points, monthly avg)
The main reason for the rating downgrade was the explosive outlook for the public sector debt: according to IBRE/FGV, barring significant reforms in public sector accounts, the public debt will climb to 81% of GDP by the end of 2018, up from 53% of GDP in late 2013 (65% as of July 2015). At this level, and taking into account the high cost of financing in Brazil, public sector solvency will become once again a critical issue.
Three factors are pushing up the public debt to GDP ratio. First, low output growth: GDP is expected to fall 3% this year and 2% in 2016, and expand between 0% and 1% in 2017 and 2018. Second, large interest payments on the debt (Figure 3): these have risen from 4.8% of GDP in 2013 to 7.9% of GDP in the 12 months up to July 2015, on account of rising interest rates, losses incurred by the Central Bank on swap operations, and credit subsidies the Treasury provides to the National Development Bank (BNDES). As the debt grows, so will those expenditures. Third, a dismal primary fiscal balance (i.e., the budget balance before interest payments): this has dropped from a positive 1.8% of GDP in 2013 to a negative 0.6% of GDP in 2014 and is projected to fall further in 2016. To stabilize the debt to GDP ratio, the primary fiscal surplus should be around 2.5% of GDP.
Figure 3: Budget deficit broken down in primary and interest payments (% GDP)*
Source: Central Bank.
It was, though, the government’s reaction to those fiscal challenges that spurred S&P into action: rather than face the difficult choices that the situation demands, the government opted to ignore the problem, as illustrated by the downward revisions of the primary fiscal target. The risk that other credit rating agencies will soon follow on S&P’s tracks led the government to announce a fiscal package that (mainly) raises taxes and (secondarily) cuts expenditures. But it is too little, too late, and of too poor quality. Even if Congress approves the measures proposed by the government in full, an unlikely scenario, the medium-term solvency of the public sector debt will continue to be under question.
This state of affairs has led economic agents to shorten their planning horizons: as they look at the numbers, they fail to see how Brazil will get out of its current economic predicament. As I see it, though, anxiety has been amplified by the tendency of most analysts to focus on searching for an economic way out, when the crux of the current crisis lies on party politics. That is, in my view, there will be no solution for Brazil’s economic malaise until the current political impasse is solved. This is what I have in mind when I refer to “political dominance”.
If I am correct, then, the best way to think about the medium-term economic outlook is to work backwards, starting from the solution to the political impasse. I see four main components to this impasse:
- President Rousseff has neither the willingness nor capacity to carry out the policy changes the economy requires. I covered the first issue in another post (click here), so let me focus on the second point. Rousseff’s approval rating is down to single digits, what limits her ability to pass her proposals through Congress. But equally important is that the necessary measures face opposition from within her own party, the Workers’ Party (PT, Partido dos Trabalhadores). Remarkably, former president Lula da Silva vehemently opposes a fiscal adjustment program.
· With more than three years to go until the next presidential election, and the economy deteriorating so fast, this is not a sustainable arrangement. Yet, notwithstanding the wish of most Brazilians, an impeachment of President Rousseff is an unlikely scenario right now and, in my view, also an undesirable one. In particular, as I see it, there is no alternative political coalition that could govern Brazil with enough political support to implement the necessary policy changes and to guarantee political stability. There is still too much pain in stock for a new government to face the opposition of the PT and the charismatic Lula da Silva. Moreover, any new government coalition would have a difficult dilemma: how to choose participants without knowing whom the growing Petrobras corruption scandal might engulf next.
· In turn, a political coalition that includes the PT is unlikely, given the party’s history and culture as a political free-rider. The PT opposed the political arrangement that ended the military regime in 1985, the 1988 Constitution, the political coalition that fought hyperinflation and sought to stabilize the country after the impeachment of Collor de Mello, the Real Plan, and the Fiscal Responsibility Law, to name but a few of the instances in which the PT preferred to stay as an outsider. Although from the PT’s viewpoint this strategy has been rather successful, and my intention here is not to pass judgement on it, it does pose important constraints regarding the establishment of a broader political concensus. Lula, particularly, has always been more confortable painting himself in the role of fiery outsider than in building coalitions to implement unpopular but necessary reforms.
· The PT -- and the Rousseff’s government, in particular -- is well aware of these facts. The party knows that it cannot at the same time fix the economy and save Lula da Silva’s competitiveness in the 2018 elections. Therefore, it has opted for an in-between strategy: President Rousseff has labelled it a Confucian (or confusion, according to some) stance. This is the logic behind the kick-the-can-down-the-road fiscal adjustment package announced on September 14, 2015. And why it excluded urgently-needed initiatives to change the social security system (minimum retirement age, for instance), reform labor laws, strengthen the rule of law, lower subsidies to government banks and open up the economy.
I have serious doubts that the PT’s long shot will pay off. As I noted above, the crisis is unfolding too fast and too strongly for the current arrangement to survive until the October 2018 elections. So, this is how I see the situation unfolding:
- Rousseff will continue to follow her Confucian strategy, favoring some fiscal discipline, but with care not to seriously sacrifice the PT’s political support base, nor to totally reverse the main programs she initiated in her first term. Meanwhile, Lula da Silva will strengthen his opposition to those policies, blaming them for rising unemployment and declining real earnings. Soon, however, this stance will be put to check by the explosive path of the fiscal accounts. At this time, there will be a change in the economic team, with the Central Bank going back to accommodating high inflation, to lighten the burden on government finance.
- As a consequence the yield curve will steepen and the Treasury will have to significantly shorten the public debt’s duration. As the value of Brazilian assets decline, so will the currency, leading to higher inflation. Investment will contract further, while the rises in unemployment and informality accelerate.
- By then, Lula da Silva’s competitiveness in the 2018 elections, as well as the PT’s popularity, will be seriously compromised. In turn, the chance of a new sustainable political coalition, with those untainted by the corruption scandal, will rise. It will be this coalition that will start the reform process, to be continued by the administration elected in 2018.
Fortune tellers and astrologers are very popular in Brazil. But as I highlighted in a recent post, no honest economist or political scientist can tell the future with the certainty suggested above. Thus, I recommend that the above be seen as one of many possible scenarios, although one that I find compelling. For those who are skeptical about this scenario, I suggest trying to use the basic assumptions as elements to build alternative scenarios. The political constraints around President Dilma are real. Prediciting how quickly the cards fall, and in which order, is quickly becoming the new Brazilian pastime.