“Opportunity is missed by most people because it is dressed in overalls and looks like work”
-Thomas A. Edison
Brazil has been a story of extremes over the last 12 months—a story of economic and political collapse transformed, by a presidential impeachment, into a story of stability, hope, and even exuberance. Will it last?
Maybe some history can help answer this question. After all, this story should sound familiar to Brazil.
The Problem That Has Plagued Brazil
Economically, Brazil has been plagued by one root issue for a long time. It’s not a political issue (e.g., the Dilma or Lula presidencies) but rather a fiscal one that dates back to more than three decades ago: the country’s inability to implement austerity and reign in the growth of spending when necessary.
In the past, Brazil tried to resolve this issue in different ways. Initially (hyper) inflation brought relief to government debt; then an overreaching tax burden was imposed to finance spending but choked off economic growth; and over the last few years it was direct debt financing that fueled the spending. What Brazil has now done in a much-awaited, first-floor vote in Congress this Monday was to cut its spending growth to zero in real terms.
Direct efforts to curtail expenditure growth were previously met by immediate political obstruction, as Joaquim Levy, a well-respected Brazilian finance minister, experienced last year. Increasing the tax burden is no longer tolerated either. The opportunity that presents itself now is a new fiscal proposal—a function of the goodwill and unity created by the transitional government, as well as the way the proposal is packaged.
Instead of directly identifying specific areas for cuts, which would trigger immediate opposition, the proposal is one of an overall spending cap that will be enforced over time. It is designed to trigger an actual debate over a budget largely dominated by constitutionally mandated spending, something that has rarely happened in Brazil. Brazilians will be forced to discuss this proposal and make tradeoffs. So the winners and losers of this proposal are not immediately known, and will likely change from one budget decision to the next.
The fear that the finance minister will not adhere to the new limits has also diminished significantly as impeachment and jail time for government officials has become a reality. This is a good start for Brazil from a political standpoint—but also from an economic point of view.
Brazil’s economy—which was hurt by the commodity bust, a domestic policy of overspending, and a breakdown in confidence—contracted roughly 7%, and inflation peaked at 11% over the last two years (Exhibits 1 and 2).
Add in the political malaise Brazil has experienced, and you have yourself a perfect storm, but not by coincidence. The interplay between policy, politics and economic metrics was strong.
Prospects for a Turnaround
Yet the political element in the equation has stabilized: There is more clarity on policy, and as long as President Temer sticks to his pledge not to run for office in 2018, this goodwill accord for reform—whose purpose is to promote confidence and unleash growth—could continue for six to nine months. The economy seems to have stabilized as well judging by recent economic indicators.
With a pick-up in confidence (Exhibit 3), investments should return and expectations of a slow recovery are solidified. In our view, the probability of an upside scenario (a rebound of 2-3% in GDP growth for next year versus a base case of 1.5%) is greater than the possibility of no recovery, as we see Brazil’s policymakers using the political momentum to get economic measures passed that could stabilize the debt dynamic.
A Path Forward, Fraught with Risk
A reform agenda to stabilize the debt-to-GDP ratio and bring growth back is now being discussed and goes beyond a recently proposed bill for a cap on spending. Markets are rightfully skeptical, and Brazil has faced a period of unusual uncertainty. The misallocation of capital and risks in the economy was staggering and occurring everywhere, most visibly in the oil sector and the public banks.
Now there is political uncertainty surrounding discussions over the merits of concrete reform proposals. Brazil has realized that it needs to change the severe misallocation of capital through fiscal reforms. We have already seen some examples of this realization since the new government took office: A new wave of legislation has passed, including the removal of earmarks from government revenues, a new budget, and a “pre-salt” bill1 allowing for more foreign participation in the oil sector. Once the spending-cap bill is fully approved, the next topic in line for discussion is social security reform, whose outlays have tended to grow automatically and unsustainably over time.
Overall, we believe Brazil is on the right track. But the large unknown in our opinion concerns Brazilians themselves. Will they be patient enough? The days of recovery led by a boom in consumer credit are long gone. So far, so good: In this month’s local elections throughout more than 5,600 cities, Brazilians rejected the government’s previous ways in what appears to be a realization that public money is no longer available—only difficult choices.
Ultimately, Brazil’s political tumult over the past year has been cathartic for Brazilian society and for the country’s political and economic realities. For the first time since the country’s period of hyperinflation, Brazilians are discussing the viable policy options we mentioned here. Had Brazil not changed its course, we believe it would have suffered further downgrades—and perhaps even defaulted on its debt. But now, with reform in sight, we think that positive changes in Brazil’s debt dynamics have a momentum of their own—and any improvement may trigger a virtuous cycle of further improvement.
What does Brazil’s central bank have to do? Its policy rate (SELIC) is now at 14.25%, and inflation is hovering around 8%. The mission of the monetary policy committee is to reach an inflation target of 4.5% by year-end 2017 and 2018. Expectations are now at 5.1% for 2017 and 4.5% for 2018 (Exhibit 4).
Policymakers will need to get confirmation of benign inflation trends in order to validate these expectations as realistic, and they’ve been looking at several indicators. Some have behaved as expected (e.g., the inflation of food prices, which has been coming down); some are not moving in the right direction (including the inflationary inertia in Brazil overall); and some have been moving up and down (such as the cost of services). But to us, from an economic perspective, the most important parameter to control is fiscal spending.
As economic confidence in Brazil returns, the pipeline of merger-and-acquisition (M&A) deals grows and the repatriation of flows picks up, we question how much Brazil’s currency could further appreciate under the current benign economic environment worldwide. We also wonder whether Brazil’s central bank will build reserves or institute a tax on financial operations (known as IOF, which is a federal tax levied on credit, foreign exchange, insurance and securities transactions).
Either way, Brazil has been a very profitable trade for us, as we had recognized early on the political catalysts that would unleash the current opportunity set in that country. We remain constructive on both the local rates side (despite hundreds of basis points of cuts being priced into government bonds) and the currency side.
Overall, to borrow from the Thomas Edison quote with which we began this piece, we hope Brazil uses its tailwinds and the opportunity granted by the current macro environment to “put on its overalls and get to work.”
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1 1. The “pre-salt” bill allows companies other than state-led Petrobras to run new oil and gas projects in certain regions in Brazil, with the aim of reviving stalled investments in petroleum exploration and production.↩
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