Brazil: “the worst is behind us”

In an interview with Euromoney this month Gerrardo Rodriguez, former undersecretary of finance and public credit for the Republic of Mexico, says the markets will force policy change in countries like Brazil. For Rodriguez, now senior investment strategist of BlackRock’s emerging markets team, the markets punish perceived policy weakness, driving corrective responses towards more orthodox marcro-economic management.

“Policy response is going to be the only way to generate a better economic growth environment,” he says.”Hopefully we can see that the policy response function is going to operate in the right direction and these market corrections that we are seeing are actually going to lead governments to adjust policy making in the right way in order to help the economy withstand better the test to which they are being submitted.”

The operative word in that quote is “hopefully”. Unfortunately, for Brazil, the signs are not encouraging. In early September, first finance minister Guido Mantega and then president Dilma Rousseff declared to the national media that “the worst is over” with regards to the country’s struggling economy. Second quarter GDP growth of 1.5% had surprised on the upside and a $60 billion package of support for the Real had ceased its dramatic decline. Seemingly these two combined to give the government the cover to call the bottom of disappointing growth figures.

There are – however – good reasons to think the Rousseff has been dangerously precipitous in predicting a continuing return to strength in the Brazilian economy. True, the second quarter GDP figures took the markets by surprise but a decent performance had – for short term reasons – been anticipated and the consensus was and is for a return to a more anaemic third quarter performance (for example, Goldman Sachs is in line with the market consensus when it predicts zero sequential growth in the third quarter and 0.5% growth in the fourth, taking annual growth to 2.7%).

The stop in the slide in the Real is also a likely short-term – and potentially costly – treatment of the symptoms of FX weakness rather than the disease of underinvestment (at 18.6% of GDP it is one of the lowest ratios in Latin America), fiscal expansionism and an uncompetitive and overly-bureaucratic manufacturing base. Worse, the intervention has probably validated the government’s belief in the effectiveness of its natural inclination to interventionism.

The one bright spot is that the central bank appears to have accepted that the key objective to monetary policy is inflation targeting. It has – belatedly – realised that the government’s commitment to the fiscal side of the inflation commitment isn’t likely to materialise any time soon (the latest budget predicts federal fiscal expansion of 6.7% in 2014). The central bank’s response of raising Selic signals an attempt to regain credibility but that will take time to rebuild and now Brazil faces sharp monetary tightening in the face of stubbornly high inflation at the same time as weak growth. (Perhaps significantly, in the latest Copom minutes the previous meeting minutes’ description of the government’s fiscal policy as being “expansionary” has been removed – not a great sign of its ‘renewed independence’.)

When President Rousseff claimed the worst was past she identified the “oscillation” of the dollar as the principal cause of the country’s recent slowdown. Fed policies had hit all emerging currencies and countries, she claimed, without exception. Well, yes, but not equally, as a report from Barclays called ‘At a policy crossroads’ clearly shows. Since May, Brazil’s five-year swaps have widened by 362bp (between the lowest and highest yield curves) and the Real depreciated by about 15%. In Chile, rates widened by 81% and the CLP depreciated by about 6%. Mexico and Colombia lay somewhere in between but it is clear that Brazil is the outlier among the major Latin American economies.

By identifying the main problems to Brazil’s economy as external, the policy response of internal reform is taken off the table. In contrast, Mexico, which has much stronger financial and economic fundamentals and institutions, is embarking on an ambitious programme of reforms – including labour, fiscal and energy that will – economists and bankers predict – increase investment, competitiveness and boost long-term GDP trend growth.

Rousseff, a former student of economics, must surely recognise the gamble she is taking by predicting resurgent growth in the second half of 2013 and beyond. Facing intense domestic political pressure (the country-wide protests or ‘manifestações’ resurfaced on Brazil’s independence day) and with an election next year it may well be that this is a domestic message, intended to boost confidence in the economy and thereby try to generate some forward, confidence-based momentum. But for a government with dwindling credibility across the board the dangers of such a policy backfiring are self-evident.

Or perhaps the “worst is over” proclamation belies a more serious problem. Maybe Mr Mantega and Ms Rousseff believe it to be true.

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