Tiradentes, Brazil’s national hero, was executed and had his dead body cut into pieces by the Portuguese crown for opposing a hike in taxes. The year was 1792. Fast forward 223 years and Brazil is again divided over a government’s attempt to further raise the tax burden. The government wants to implement a new tax, the CPMF, of 0.2%, on top of all financial transactions. The government estimates the CPMF can generate R$ 32 billion in revenues per year.

Congress is discussing whether to approve the constitutional amendment creating the CPMF. The issue has generated a heated debate in the press and among economists. Some see it as the least bad option to fix the chaotic situation of the public sector accounts (see here). That is also the government’s view (see here). Yet, three questions about the CPMF linger without answer:

     ·  The government argues that it is near its limit on what it can discretionarily cut in primary expenditures (all but financial expenses), citing the earmarking of revenues to specific areas or programs as the key restraint. But if the constitution can be changed to raise taxes, why not change it to undo the earmarking and cut inefficient government expenditures?

      ·  Why not fix the budget by cutting financial expenses the government controls? So far the government has spent R$ 102 billion to benefit firms unhedged against the exchange rate devaluation. The 2016 budget foresees expenditures of R$ 38 billion on interest subsidies to firms borrowing on one of the credit programs extended by the national development bank. Other credit subsidies to agriculture, industry and construction will consume even more. Considering that Brazil already has a very large state, the size of which has expanded dramatically over the last three decades, why not seize the opportunity to cut back on some of these financial subsidy programs?

   · How can one be sure that even with the CPMF there will not be another fiscal crisis in a couple years? The government talks about the rise in taxes as providing a bridge, but it doesn’t say what is on the other side of the bridge. Public sector expenditures have risen continuously over the years, lately on account of rising subsidies and social security expenditures, but nothing is being proposed to stop that process. Moreover, former president Lula, who carries enormous influence over the government and will be a presidential candidate in 2018, has repeatedly spoken against the fiscal adjustment and in favor of expanding public sector expenditures. What certainty can there be that the CPMF collections will not be squandered in another binge of inefficient spending?

As the death of Tiradentes, a dentist and army officer, illustrates, the debate over taxes is seldom a technical matter, but one that hinges on the nature of the society and economic model we want. Yet, so much taxpayer money is wasted on inefficient and regressive government programs, that the case for further raising taxes is weak also on technical grounds. Brazil already has one of the largest tax burdens in the world, higher than the OECD average. It has not served Brazil well, either in generating growth, offering appropriate public services or improving income distribution (see here). Something has to be done to cut the budget deficit, but creating yet another tax is not the best option.

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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 9^th, 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)

Source: IBRE/FGV

Figure 2: Five-Year CDS for Brazil, Russia and Turkey (basis points, monthly avg)

Source: Bloomberg.

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. 

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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. 

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A friend once remarked that financial markets tend to be optimistic, because most investors are generally long on the economy: they hope for higher profits, more IPOs, more bond issuances … and higher bonuses. Brazilian financial market analysts, however, have not been as optimistic, at least judging by their GDP growth forecasts. Figure 1 shows how much they predicted Brazil would grow from 2000 to 2014, considering their median forecast on the last day of the previous year.[i] This is compared to how much GDP actually expanded. Taken together, they predicted an average growth of 3.4%, only slightly more optimistic than the 3.1% average annual GDP growth that Brazil delivered.

Figure 1: Predicted vs Actual GDP Growth Rates

   Sources: Central Bank of Brazil and IBGE.

Forecast errors were not random, though: they showed a pattern that is also telling by itself. Between 2000 and the global financial crisis, analysts generally short-changed Brazil, often to the tune of 2 percentage points (p.p.) of GDP growth, as seen in 2004, 2007, and 2010. In 2004-08, in particular, analysts clearly underestimated the effect of the commodity and credit booms on growth, as they did in 2010.

Just the opposite has happened since the financial crisis and, more to the point, after Dilma Rousseff became president of Brazil. Since then, market analysts have indeed been quite optimistic, failing to factor in how much Rousseff’s “new economic matrix” policies have become a drag on the economy. The average growth in 2011-14 (1.6%) was only half what financial market analysts had predicted (3.3%).

For some time now I have believed that analysts are also behind the curve regarding 2015 GDP growth. Figure 2 shows that, as late as October 2014, they still foresaw an expansion this year of 1%. Indeed, they currently still predict GDP to grow more in 2015 (0.4%) than in 2014 (0.1%).

Figure 2: Median forecast by financial market analysts for 2015 GDP growth (%)

Source: Central Bank of Brazil.

I find this forecast too sanguine, considering all the headwinds facing the Brazilian economy in 2015. Overall, I see eight main factors pressuring GDP down in 2015:

• The federal government is tightening economic policy quite substantially. Interest rates have been on the rise since right after the elections. The policy Selic rate is expected to average 12.5% in 2015, compared to 10.9% in 2014. The Ministry of Finance set a target for the public sector primary surplus of 1.2% of GDP in 2015, against a recurrent primary deficit of 0.5% of GDP last year. Interest rates charged on subsidized credit by state-owned banks are also on the rise and the amount of new loans will also be curtailed.
• Local state governments have also embarked on significant fiscal tightening, reversing the excesses of last year. Oil rich states will also have to accommodate the drop in revenues resulting from the decline in oil prices.
• Private consumption is bound to drop, as unemployment rises, real incomes decline and consumer credit becomes more expensive and scarce. Consumer price inflation will go up, on account of significant rises in electricity prices and bus fares, a weaker currency, and the end of tax exemptions on a number of durable consumer goods. And cheaper oil will not help: gasoline prices will remain flat so that Petrobras can recover its previous losses and as taxes on fuels are raised.
• The oil and gas sector will have a terrible year as a result of the Petrobras corruption scandal. The company is cash starved and will have a hard time rolling over its mammoth debt without an audited balance sheet. It has already suspended a number of contracts with suppliers implicated into the scandal.
• Investment will contract substantially. Public sector investment will fall, as part of the adjustment in the public sector accounts. Investment in infrastructure projects will not pick up the slack: for one, because many projects belong to Petrobras’s suppliers, the finances of which are in shambles, as previously mentioned; for another, because they need to adjust for the rise in financing cost resulting from the higher rates charged by state-owned banks. Housing construction will also suffer from declining incomes and higher interest rates on housing loans. Investment in mining and agriculture will be negatively affected by the fall in commodity prices. Last but not least, investment in manufacturing and commerce is unlikely to go up with real incomes declining and credit more expensive.
• Brazil will almost certainly experience a severe shortage of water for power generation and household and business use. This will harm production and be another drag on private investment. Obviously, if the situation gets as bad as to force a rationing of electricity the economy will be severely hit.
• Many hope that the weaker currency will boost exports. I see very limited scope for that to happen. With declining prices and slow Chinese and European growth, commodity exports are unlikely to expand. The outlook for manufactured exports is not bright either. With important markets, such as Argentina and Venezuela, in recession and the loss of competitiveness in the US market, it is not clear which markets would absorb a rise in Brazilian manufactured exports. Moreover, manufactures currently account for a smaller share of total exports than ten years ago: 36% in 2014, as opposed to 55% in 2004. Thus, they would need to grow more to produce the same rise in total exports.
• On a more technical note, the statistical carryover effect going into 2015 will be around 0.3 percentage point, half that of 2014, and will likely disappear when GDP falls in the first quarter of this year.

All in all, I see only two arguments favoring a less bad performance of the Brazilian economy in 2015. Firstly, it is possible that part of the drop in consumption and investment will fall on imports, rather than on domestically produced goods and services. Secondly, it could be that a substantial part of the adjustment in investment and private consumption was anticipated in 2014.

Although I am sympathetic to these arguments, I believe they are insufficient to preclude a drop in Brazil’s GDP in 2015. In the four quarters leading up to the third quarter of 2014, GDP expanded 0.7%. During this period, consumption added 1.5 p.p. to growth. On the other hand, investment--including changes in inventories--subtracted 0.7 p.p. from GDP growth, and net exports took away another 0.1 p.p. In 2015, I expect for consumption to stagnate or even contract slightly, the contribution of investment to be nearly as negative as it was in 2014, and for net exports to have a neutral impact on growth. Those of us who are not professionally disposed towards optimism would be wise to head the warning signs of a GDP contraction.

January 12, 2015

In Brazil, the government has 39 ministries headed by 39 ministers from all types of parties. Thus, it is no surprise to see ministers antagonizing one another, as happened last week between the Ministers of Agriculture and Agrarian Development. Nor is it unusual to see the Minister of Planning take a complete U-turn on his statement about the minimum wage policy, after being publicly rebuked by the president, who in turn was reacting to condemnation by labor unions.

Why would a newly reelected president choose such a heterogeneous cabinet? A popular explanation is the need to secure Congressional support to weather the difficult year ahead. Economic stagnation, high inflation, rising unemployment, and the unfolding of the Petrobras corruption scandal will bite on Ms. Rousseff’s popularity. Support from a broad party coalition will protect her from a reinvigorated opposition, so the argument goes.

 This is a logical argument. In my view, though, it is too narrow. As I see it, ideological antagonism among ministers is a purposeful feature, not an inconvenient side effect, of this amorphous government. By purposefully lacking a clear character or direction, the new government can claim to be all things at once. It wants to be in charge of policy and oppose it at the same time, a trick played with great skill by Lula da Silva in his first government. How better to weaken and disorient the opposition?

In no area is this more evident than regarding economic policy. In her first term, Rousseff antagonized banks, electricity companies and most of the private sector, presenting herself as a modern-day Robin Hood. But her “new economic matrix” policy of fiscal, credit and monetary expansion led to high inflation and low growth.  Holding the course secured her reelection, but generated a pressing need for policy change.

Pragmatically, she now presents herself as a fiscally responsible, business friendly president. Her new Finance minister, Joaquim Levy, is a Chicago trained, former IMF staffer who previously occupied a top position at one of Brazil’s largest banks. It is expected that, by almost completely reversing the economic policies of the previous economic team, the government will regain business confidence, fostering a rise in private investment and sustained growth. This effort to befriend the private sector also explains the appointment of business leaders to lead the ministries of agriculture and industry.

While attracting praise from the business sector, the government risks alienating supporters who secured Rousseff’s narrow win in October. As I will explain in future posts, for the new policies to work, they will have to lead to a lot pain in the short term: real wages will fall, credit will become scarce and easy subsidized credit to favored companies will have to be severely cut down. This will harm the new middle class, civil servants and the companies that received lavish government financing in 2012-14.

The Workers’ Party (PT) does not want to lose these constituencies. How better, then, to keep them than vocally criticizing the policies its appointed ministers are implementing, and simultaneously pursuing some other conflicting policies? Thus, it should not come as a surprise to see the government sending conflicting messages, but also to have organizations traditionally linked to the PT leading street protests against economic policy.

The plan is likely to go along with economic orthodoxy for a year or two, and replace it with renewed fiscal and monetary expansionism when the economy’s health improves sufficiently, in time for the 2018 elections. It helps that the austerity “villains” of the story are associated with the party most capable of mounting a spirited opposition in 2014 and 2018. Meanwhile, the government and the PT will have to manage these policy inconsistencies, cornering the opposition to support unpopular but fiscally responsible initiatives.

Will this strategy work? The optimistic draw a parallel with what happened in Lula’s first government to bet on it. The pessimistic stress Rousseff’s lack of political skills and the much more difficult economic landscape of 2015, compared to that of 2003.  Thus, many analysts sum up the discussion in the doubt of whether Rousseff will support her Finance minister for long enough for his policies to work, or whether she will give in to her interventionist, heterodox personal views on the economy when the pain starts to bite into her popularity.

As I see it, though, this discussion misses the point. An ideologically divided government is the PT’s best strategy to prepare for the next presidential election. So to speak, it makes the party “antifragile”, in Nassim Taleb’s sense of benefiting from opacity and obfuscation, as both business and the traditional PT voters continue to see Lula as the key for a return to good old times, without alienating support from either group.

What impresses me is that the opposition fails to see this. The most likely scenario is that it will continue to bet on Congressional speeches, press interviews, and the hope that a weak economy and the Petrobras scandal will cause the Presidency to fall into its lap. The opposition is playing tennis, lobbing back the balls served up to them, while the PT under Lula is playing chess. 

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Brazil ended 2014 with a trade deficit of USD$ 3.9 billion. A year earlier, market analysts had forecast a trade surplus of US$ 8.4 billion. As I explained then, this forecast failed to account for the drop in export prices, due to lower growth in emerging Asia and a stronger dollar, among other factors. And it has been export prices, not volumes, which have determined the dynamics of export values in the last ten years; in constant prices, exports have remained essentially flat throughout (Figure 1).

Figure 1: Export price and quantity indices (average 2006=100)

Source: FUNCEX/IPEADATA. Note: Export prices in current US$.

Failure to foresee the fall in export prices forced market analysts to repeatedly lower their projections for total exports throughout the year, not only for 2014 but also for 2015 and 2016. For this year, in particular, the financial market’s forecast is now at US$234 bn, down US$86 bn from what it had projected two years ago (Figure 2). As I see it, these are still optimistic forecasts which fail to account for the additional drop in export prices likely to occur in 2015.

Figure 2: Exports: Evolution of Median Forecast by Market Analysts (US$ bn)

Source: Brazilian Central Bank.

In 2015, two key factors will weigh on Brazilian export prices: a new round of dollar strengthening and the further slowdown in China’s GDP growth. Both have been at play in the last three years, with the latter playing a dominant role. For 2015, though, I expect the stronger dollar to play a more prominent role. It is obviously difficult to say how much the dollar will gain in 2015, but even if it stays flat at its average level in December 2014, it would be up by 7.4% from its average value last year.

To observe the close historical relationship between the US dollar trade weighted index and Brazilian export prices, I’ve plotted them together on a graph. (Figure 3).

Figure 3: US Trade Weighted Index (DXY, 1973=100) and Brazilian Export Price Index (2006 = 100)

Sources: Fed St. Louis and FUNCEX/IPEADATA.

In Table 1 I do some sensitivity analysis for a projected fall in Brazilian export prices in 2015, given different assumptions regarding growth in China and the appreciation of the US dollar (based on the trade weighted index). The exercise relies on a simple econometric model relating quarterly YoY changes in export prices, the US dollar trade weighted index (DXY) and China’s GDP. Keep in mind that since Brazilian export prices fell during 2014, so even if there are no further declines at the margin average 2015 prices will be down compared to last year.

Table 1: Sensitivity Analysis for Drop in Export Prices Given Different Rates of Chinese Growth and US Dollar Appreciation

In the best-case scenario considered in the sensitivity analysis, export prices will drop by 10%. In this scenario, export volumes would have to rise by 13% for the median forecast by market analysts for 2015 exports to come through. In other, more realistic scenarios, the expansion in export volumes required would approximate 20%, which is unlikely in the absence of a further sharp weakening of the real.

Obviously, these are projections based on past co-movements among certain variables, which need not hold true with exactness in the future. Still, the close relationship between the US dollar trade weighted index and Brazilian export prices should work as an alert to the challenges that Brazilian exporters may have to face in 2015. 

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As I feared, GDP underperformed financial market forecasts in Q2 2014, dropping 0.9% YoY and 0.6% QoQ. Moreover, growth in Q1 2014 was revised down to -0.2%. Technically, Brazil experienced a recession in the first half of 2014 and will likely close the year with low or even marginally negative growth.

This poor performance resulted from two main factors:

$1·      The sharp drop in consumer and business confidence (Figures 1 and 2);

$1·      The government’s failure to keep the economy growing through credit expansion.

These two forces led to a sharp drop in investment and a slowdown in consumption growth (Table 1). The YoY rise in private consumption was by far the lowest in over ten years! Moreover, the contraction in investment reached levels last seen at critical moments of the financial crisis of 2009. Indeed, the retrenchment in domestic demand caused GDP to fall 1.6% YoY; it was the 0.7% contribution to growth coming from external demand—lower imports and higher exports—that prevented an even sharper drop in output.

Table 1: Growth rates in Q2 2014 GDP and its demand-side components

Source: IBGE

The decline in consumer and business confidence can be reversed relatively fast, if policy mistakes are reverted and sound macroeconomic policy adopted. Obviously, the government must first correct its mistaken diagnosis—it is still blaming weak growth on the international crisis and the unwillingness of banks to expand consumer credit. I believe this phase of denial will eventually come to an end, as reality imposes itself, through a change in government in the October elections or further downgrades in Brazil’s credit risk assessment.

Overcoming the negative impact of the exhaustion of the credit-led growth model will be more complicated. To see what an important role credit played in fostering output growth in recent years, let’s divide the last decade and half in three periods: 1998-2004; 2005-11 and the two and a half years that go from 2012 to the first semester of 2014.

In the first seven-year cycle, credit expanded basically on par with GDP: it dropped from 27.7% of GDP in December 1997 to 25.7% seven years later, but this fall was largely due to the “clearing” of bad debts from the balance sheet of Caixa Econômica Federal, a state owned bank, in June 2001, when this total came down from 28.5% to 25.6% of GDP.

In the second seven-year period, credit boomed, rising to 49.1% of GDP in December 2011. That is, it almost doubled as a proportion of GDP.

Finally, in the last two and a half years credit continued to grow ahead of GDP, but at a decreasing rate: it increased to 53.9% of GDP at the end of 2012, to 56.0% of GDP in December 2013 and to 56.3% of GDP in June 2014.

Table 2 shows how output growth differed in these three periods in the aggregate and at the sector level.  Note how growth accelerated in 2005-11, compared to 1998-2004, but also that in the last two and a half years growth slowed down in all GDP sectors, in some cases dramatically.

I believe that the most noteworthy result in Table 2 is the extraordinary drop in growth in the three sectors that most clearly characterized the boom years of 2005-11: construction, commerce and financial intermediation. These industries boomed when credit flourished and they are now feeling the pain, as households can no longer expand their debts.

Table 2: Average annual growth rates of sector GDP (% p.a.)

Source: IBGE

I expect these sectors to go back performing as they did prior to the credit boom. In the absence of reforms, this will contribute to weigh down GDP growth, but will also have a substantial impact on the labor market, reflecting the fact that these are labor-intensive sectors. We will have to see how this feeds back on default rates and the health of financial institutions.

Does this sound worrying to anyone else? 

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This Friday, August 29, IBGE will publish its first estimates for Brazil’s GDP in the second quarter of 2014 (Q2 2014). Market analysts are waiting for the number with great expectation, as it may reveal whether Brazil has entered, or not, into technical recession (two quarters of negative growth). The results for GDP in Q2 2014 are important also because they will influence the overall result for the year. With consumer and business confidence at five-year lows, and credit and investment subdued while firms and workers wait for the October presidential elections, the economy is expected to expand only moderately in the second half of the year.

Most people believe that GDP contracted QoQ and YoY in Q2 2014, but there is substantial uncertainty regarding how bad this drop was. This is what show the results of weekly polls carried out by the Central Bank with market analysts to check on their forecasts for a number of economic indicators. Graph 1 reveals that market forecasts for YoY growth in Q2 2014 GDP have deteriorated continuously since mid-2013, with a more accelerated downturn starting in late May 2014. In the most recent poll conducted by the Central Bank among market analysts (August 22, 2014), forecasts for YoY change in Q2 2014 GDP ranged from -0.9% to 1.0%, with a median of -0.2% -- thus, quite a wide interval.

A key reason why market analysts lowered their predictions for GDP growth over the last three months was the release of statistics showing a poor performance of manufacturing, retail and construction in Q2 2014. YoY, manufacturing output contracted 6.5% in Q2 2014, with potentially large impacts on wholesale trade, transportation and services provided to firms. Retail sales declined by 1.8%. The results were no better for construction: the output of manufacturing products used in construction dropped 9.1% YoY in Q2 2014, while retail sales of these products contracted 2.8%.

In light of these sharp contractions in manufacturing output, retail sales and construction, the median forecasts in the Central Bank’s poll seem somewhat optimistic. Indeed, the Central Bank itself recently published a much more bearish estimate of output growth in Q2 2014. This comes from an indicator of the level of activity calculated monthly by the Central Bank, known as IBC-BR, which has dropped 1.5% YoY in Q2 2014. As shown in Graph 2, the IBC-BR is a good coincident indicator of GDP: in the 10 years represented in the Graph (41 observations), the mean error was zero, with a standard deviation of 0.6 percentage point. That is, the IBC-BR suggests there is a two to one chance that the YoY variation in Q2 2014 GDP will be between -2.1% and -0.9%.

It is important to take into account, however, that, as Graph 2 suggests, the IBC-BR tends to overestimate extreme GDP variations. In particular, in the four cases in which the IBC-BR signaled a contraction in GDP, it overestimated the fall in output by an average 1.0 percentage point. If this happens again, the YoY decline in Q2 2014 GDP would be closer to 0.5% than to 1.5%; thus, still below what market analysts anticipate.

A 1.5% YoY decline in GDP would translate into a 1.0% QoQ decline in Q2 2014 GDP, plus a downward revision in the QoQ change in Q1 2014 GDP, from 0.2% to -0.3%. This is a more bearish scenario than market analysts have in mind, but which is consistent with high frequency output indicators. Thus, QoQ, manufacturing output contracted 2.3% in Q2 2014, while retail sales fell by 3.1%. Moreover, retail sales of products used in construction dropped 5.2%.[i] In turn, a 0.5% YoY decline in GDP would translate into a 0.4% QoQ decline in Q2 2014 GDP, with a much less significant downward revision in QoQ growth in Q1 2014.

Taken together, these estimates should ring an alert that we may be in for an unpleasant surprise regarding GDP growth in Q2 2014. And for the year as a whole.

For those who read Portuguese or use Google Translate (https://translate.google.com/) well, I recommend Merval Pereira’s column today in the newspaper O Globo (http://glo.bo/1rBSSGr). Merval discusses the government’s reaction to a report written by an analyst at Banco Santander that alerted the bank’s clients to the sensitivity of asset prices to the polls preceding the upcoming election results. In particular, the report warned that the currency would likely weaken and the stock exchange drop if the polls showed signs that President Rousseff would be reelected (http://bit.ly/1tJohrE).

The government protested vehemently against the report. In an interview, President Rousseff called it an intolerable intrusion of a financial institution into politics (http://bit.ly/1mZy2fY). The bank published an apology, considered insufficient by President Rousseff. As a reaction, Santander’s global CEO, Mr Emilio Botin, asked for an audience to apologize personally.

Pereira’s column touches on two issues that I think deserve greater attention.

First, it is my understanding that, when warning clients about the financial risks coming from the pre-election polls, Santander’s analyst was fulfilling his or her professional obligations. A financial institution should expect no less from its employees.[i] Even considering that business in the real world is not fair, the bank’s reaction to this issue has so far been unbalanced.

Second, former President Lula and Mr Rui Falcão, the president of the Workers’ Party, are publicly demanding that all Santander’s employees somehow linked to the report be fired (http://bit.ly/1qIVV3o). More than a punishment, this is a threat to all analysts who may wish to express professional views that are perceived as unfriendly to the government. This should be a matter of concern to all banks, as well as financial sector regulators. And also to voters and bank clients, obviously.

The most remarkable aspect of this case, though, is the ineffectiveness of the reaction to it. If the intention was merely to have people disregard the report, the government had a number of better options: ignore the report, refute its conclusions, or even let the market demonstrate whether the analysis was sound or not. But the government chose the option most likely to spook the market and, thus, to fulfil the poor analyst's prophecies.

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As the October 2014 elections approach, businessmen and market analysts ask themselves whether, how, and how much economic policy may change with the new government. There is a consensus that if the opposition wins, either with Aécio Neves or Eduardo Campos, there will be a shift towards greater fiscal and monetary discipline, with a greater focus on bringing inflation down and adopting more market-friendly policies.

But what if President Dilma Rousseff is reelected?

In a long interview on May 7, Ms. Rousseff stated that, if reelected president, she has no plans to change economic policy in 2015. There is no need to raise interest rates, curb public spending or raise taxes or government-controlled prices (like fuel or electricity prices), she said. She also made clear that bringing inflation down is not a priority, if that entails a rise in unemployment:

“Along comes someone who says that inflation will be 3%--that the inflation target is 3%. Is that it? Just set the inflation target at 3%? Do you know what that entails? Unemployment. At what level? About 8.5%, 9%, 10%, 11%, 12%. In that range.”[1]

Unnamed presidential assistants dismissed this talk as being just empty talk to please voters and win the October elections. The same would be true of the public spending measures announced on April 30, on national TV. If reelected, they say, Ms. Rousseff will pursue much more disciplined policies.

I disagree. I believe Ms. Rousseff is telling the truth about her plans for 2015. Thus, while I do not expect a significant turn for the worse in economic policy, I foresee a government unwilling to pay the necessary cost to prevent a continuous deterioration in macroeconomic fundamentals. Rather, Ms. Rousseff will rely on the remaining slack available in the public and external accounts to prevent inflation from going up too fast. That means that we should see greater use of price controls, from freezing of key prices to the provision of tax exemptions and credit subsidies to firms that refrain from raising prices too much. Moreover, the government will tolerate relatively high inflation. Three main factors lead me to that conclusion.

A true believer

First, Ms. Rousseff believes in the policy mix she has adopted in her first administration. Perhaps her initial enthusiasm has diminished a bit, given that growth remains so low, but changes, if they come, will be more of emphasis than direction. No more than a tweak here and another there. Otherwise, how to explain that policy has remained basically the same in the last three and a half years, although its failure became evident as early as 2012? Moreover, the views embedded in the above remark are not new; they have been expressed earlier, long before the elections came into view. Take, for instance, her offhand reply to a similar question in an interview last year (March 27, 2013):

“I don´t believe in policies that fight inflation by lowering economic growth. This prescription, which kills the patient rather than cures the disease, is complicated. Am I to put an end to growth in this country? This is dated thinking. This, I believe, is an outdated policy.”[2]

Low credibility and elusive political support

Second, it will be very difficult to improve macroeconomic performance without imposing some pain. And there will be more pain if a discredited government implements the necessary adjustments than if this is done by a new government. Moreover, as a continuing government, she will not have the “honeymoon” period a new entrant would enjoy.

Brazil´s main macroeconomic problem is that aggregate demand surpasses output by almost four percent of GDP. Moreover, demand has risen consistently ahead of potential GDP, as reflected on rising inflation pressures and an expanding current account deficit. Aggregate demand needs to slow down and, in the short run, fall below potential output, to bring inflation and the current account deficit down. With the investment rate already at a relatively low 18.4 percent of GDP in 2013, to cool aggregate demand it will be necessary to reduce consumption growth. One way or the other, this will mean lower growth of disposable incomes and tighter credit.

Moreover, the low prices of gasoline, diesel and electricity are hurting the finances of Petrobras, Eletrobras, and ethanol producers; these prices need to be raised. The finances of local governments and bus companies are similarly deteriorating on account of frozen bus fares, which also must go up. The necessary increase in those government-controlled prices will add an estimated two percentage points to consumer price inflation. Although this is a one-time rise, it will impact future inflation through price indexation and its impact on expectations. Managed prices have fallen systematically behind other prices in the economy—an unsustainable dynamic that will eventually have to change.

To bring inflation down, therefore, other prices will have to rise at a more moderate rate. The prime candidate is services’ price inflation, which in the 12 months to April rose nine percent. Inflation in services is mainly a consequence of a tight labor market, which caused nominal average earnings to go up by 9.2 percent, YoY, in March. For the price of services to slow down, the labor market has to cool down, with a rise in unemployment.

Basically the same prescription applies to limiting the rise in the current account deficit. This was supposed to have already started, given the devaluation of the real since mid 2011: in the three years ending in March 2014, the real effective exchange rate fell by 20 percent. Such a devaluation should have brought the external deficit down, by pushing up the relative price of tradables to nontradables, in this way lowering real incomes and shifting resources into exporting and import substitution.

In practice, though, this change in relative prices has not occurred. When it does, it will require tradables’ price inflation to surpass that of nontradables. And for that to take place unemployment will have to rise.

One may argue, correctly, that the opposition, if elected, will also have to follow this prescription. Yet, the political consequences will differ. For one, because policies adopted by the opposition will be more credible: the Rousseff administration has repeatedly failed to keep its promises on meeting economic targets. For another, either Neves or Campos would be given more political latitude to adopt harsh measures in the first year in office should they win. Ms. Rousseff is an abrasive, unpopular figure among most politicians, who will not wait long to pressure her if she becomes unpopular with voters. It is a risk she cannot run.

No pressure to act

Some analysts believe that regardless of what she wants, Ms. Rousseff will have implement changes, for investors will force her to make concessions. I see no channel through which such pressure could come in 2015. Historically, in Brazil this kind of forced reform takes place when the country faces an external financing gap. But there is no reason to expect such a gap to arise in the next two years, although it could materialize towards the end of the next administration.

Brazil is currently a net creditor in foreign exchange. It has had no difficulty in financing its current account deficit. If anything, the perspective that monetary policy in the US and Japan will remain accommodating in 2015-16, and actually loosen up in the Euro Area, will continue to push capital flows into emerging markets with relatively developed capital markets. Interest rates in Brazil may need to go up more, but there is no risk of a foreign exchange crisis on the horizon.

Ms. Rousseff’s main challenge in a second government will be voters´ dissatisfaction with low growth. This will encourage less, and not more, fiscal discipline, as well as a rise in directed credit and subsidies to some critical consumption items.

All in all, I agree with analysts who see in financial markets a widespread “demand for optimism”. This, for me, is the main explanation for the disbelief in Ms. Rousseff’s assurances. They may be in for a big surprise. Or maybe not; the rise in asset prices in recent months, notably of shares of state-owned enterprises, whenever Ms. Rousseff falls in the polls suggests that investors are not putting their money where their mouth is.