Brazil: In A Hole And Still Digging

by Thierry Ogier at Emerging Markets

Brazil’s finances have gone from bad to worse and it is still hard to gauge when Latin America’s largest economy will bottom out

Brazil has long been hailed as the country of the future. But the decision last month by Standard & Poor’s to strip Latin America’s largest economy of its coveted investment grade status provided confirmation — if any were needed — of its fall from grace.

“Brazil is going through its worst period,” says Nicola Tingas, chief economist at Acrefi, a credit association for non-banking institutions. “There is structural disorder, which goes beyond the mere economic cycle. It destroys capital. Confidence has been destroyed. The economy has been weakened.”

For a long time, the resilience of the Brazilian economy had confused the most pessimistic economists and offered bright opportunities for high yield investors. Dilma Rousseff herself challenged such “pessimists” during the latest presidential campaign.

But a year after she won a second presidential term, Brazil is in a terrible mess. Debt financing costs have soared and Brazil’s CDS spreads became greater than Russia’s that month when they neared 400 points. “The fiscal deterioration is now faster than our baseline scenario and the political risks remain challenging,” said Shelly Shetty, head of Latin American sovereigns at Fitch Ratings, during Fitch’s global sovereigns conference in New York in September.

Joaquim Levy, the embattled finance minister, has publicly admitted the scale of the problem. “Obviously, the house is not in order,” he said in Congress after the government presented a budget blueprint that included a R$30bn ($7.6bn) deficit in early September. This marked the beginning of the end of the fiscal credibility of the government, according to most observers.

“People were aware of the risk of a downgrade,” says Monica de Bolle, a researcher at the Peterson Institute in Washington “Under these circumstances, nobody could have sent a budget that includes a deficit just under the nose of the credit rating agencies. And even after the downgrade, the [Brazilian] government has kept adopting a form of ostrich policy.”


Recession has now settled in. The official forecast is one of a severe GDP contraction of 2.44%. Figures were revised last month from 1.5%. Marcelo Carvalho, the BNP Paribas Latin America chief economist, has forecast a further 2% decline next year.

“A recession that lasts for two consecutive years is a very rare occurrence in Brazil. We have data that span a hundred years and this only happened once before in the early 1930s, just after the Great Depression. So we now have a scenario that is similar, despite the fact the world economy is not as ugly as it was after the 1929 crisis,” he says.

The inflation rate, meanwhile, is expected to reach 9.3% due to price realignments of electricity and fuel rates. This is more than twice the official target of 4.5% (the tolerance margin is 6.5%).

Inflationary pressures will likely persist due to the devaluation of the currency. The dollar has appreciated by more than 50% between the beginning of the year and 22 September, when it reached four reals to the dollar for the first time.

The gloomy atmosphere has led to the destruction of more than half a million jobs since the beginning of the year and unemployment has showed no sign of abating. Tax collection fell by 3.7% between January and August compared with the same period last year, which has crippled public finances.

“The current recession is not a cyclical phenomenon,” says Arminio Fraga, a former central bank governor who is now close to the opposition leader, Aécio Neves. “The situation is more precarious. The size of the fiscal gap has started to emerge. It is not only a cyclical phenomenon. The way things are, the country is not going to grow. This is extremely serious and messy.”

“We have a perverse mix of ideology and incompetence — a disaster. There was some expectation that we had reached the bottom of the pit. But the bottom does not actually exist. It is still possible to dig further down,” he says. The crisis has now reached so many dimensions that it looks increasingly hard to find an exit.

Joaquim Levy would certainly not be Rousseff’s preferred choice as finance minister in normal times. But these are not normal times.

Levy, who served as treasurer under the first Lula government — Brazil was also facing a financial crisis at the time — is also a reassuring figure to the financial sector: he headed Bradesco Asset Management (BRAM), a division of the second-largest domestic financial institution, before joining the Rousseff team at the beginning of the year.

But his authority has been repeatedly challenged, not least by Nelson Barbosa, the budget and planning minister who is much closer to Rousseff, and also by a rebellious, sometimes hostile Congress. Leading figures of the centrist PMDB party, which is part of the ruling coalition, have publicly called for his replacement.

“There is no cohesion,” says Ramon Aracena, Latin America chief economist at the Institute of International Finance (IIF) in Washington. “Everybody can see through these things.”

The government’s fiscal credibility has been eroded by its seemingly ever-changing moods. Levy originally announced a primary fiscal target of 2% of GDP for next year, but that was cut a few months later to 0.7%.

Then a few days later, the government announced plans that included a budget deficit of 0.5% of GDP in 2016. The shock was so great that Rousseff herself back-pedalled in a matter of days and allowed Levy to pursue the positive 0.7% of GDP target after some terrible confusion.

Now, Levy’s priority is to redress fiscal accounts. “Fiscal strength is the basis of our economic growth,” he has said. “The government can achieve a surplus of 0.7% if society understands the need to put the house in order.”

“If we have to go from A to B, we have to show how we can get there. We have to build a fiscal bridge (to go from A to B) and harness all the resources. The strategy is very simple, but it is important to understand that our economy goes through a period of re-engineering, with a re-allocation of resources, which is aimed at increasing the growth potential of the country.”

The budget package of R$65bn of spending cuts and tax increases (around $16bn) includes more tax increases than spending cuts (R$40bn and R$25bn, respectively), most of which have to be approved by Congress.

“If one needs to ask for an additional effort, President Dilma will make such a proposal and will lead the drive to have the budget approved in Congress,” said Levy as he presented the revised 2016 budget blueprint in August.

But Levy knows that raising tax amid a recession will not be easy, especially when he plans to re-introduce the unpopular financial transaction tax, known as CPMF, which was voted out in 2007. He was originally reluctant to do so, but the CPMF alone would put a much needed R$32bn, almost half of the total adjustment, into the government coffers next year, according to official estimates.

“People should not be short-sighted as far as taxes are concerned,” pleaded Levy, when he explained that the tax would cost 0.2% on each transaction for a period of four years. “It’s something that is extraordinarily simple. What is important is that it reduces uncertainty and it can speed up economic recovery.

“When you make a small investment, you may well accept paying a bit more tax in order to rest assured that our economy will be in better shape so that it is not at the mercy of any surprise, of any major stumble, and that as a result it can grow faster.

“It is a question of arithmetic. Maybe people have to pay a bit more tax and thanks to this, the economy will grow faster. If you are paying an extra half a percentage point and GDP grows faster, you can have your money back eventually.”

Nevertheless, not everybody is convinced that a government whose popularity is at single digit levels can approve such a tax increase against a background of rising unemployment and falling purchasing power.

“We are not assuming inaction over time, but in the nearer term we see greater stress,” says Lisa Schineller, sovereign analyst at Standard & Poor’s. “We do expect the government to put forward a series of measures. We are not assuming a significant success with these measures.”

Moreover, the re-introduction of the financial transaction tax would probably require the approval of a constitutional amendment, which entails the vote of a qualified majority of 60% of lawmakers in each house of Congress (with two votes in each house), which is, under any circumstances, a tall order.

The former president Fernando Henrique Cardoso has his doubts: “For sure, the opposition must act with a sense of responsibility,” he says. “But I am also aware that this is very difficult [to approve the CPMF] due to the present situation. It is very difficult due to this lack of popularity and due to this lack of confidence,” he says. “We just do not know what is going to happen.”

Brazil has indeed been gripped by a sense of uncertainty. On the external front, a bitter mix of falling commodity prices, weaker Chinese demand and a looming interest rate rise in the US, has unnerved investors.

But it is rather domestic factors that have sent the real tumbling down. “All the forces have been moving against [Brazil]. The global conditions, the cost of borrowing abroad is going to be higher and commodity prices much lower than before,” says the IIF’s Aracena.

And then internally, there is the perception that the fiscal adjustment may not be implemented because of strong political resistance; there is not the political support to approve the fiscal adjustment. The fast deterioration of the fiscal accounts, which are expected to reach 70% of GDP next year, needs to be addressed. “It’s the same old story,” says Fraga. “It is a process of indebtedness that is self-feeding and that cannot go on.”

There are also the sequels of the unfolding Petrobras corruption scandal, which has involved several officials who are close to the government. “The economic and financial crisis will be difficult to overcome,” says Aracena.

“If Brazil does not get its act together, we are facing a long period of no growth or sluggish growth. Fiscal adjustment is at the core of policies that are needed. But execution risks are extremely high. We are not very optimistic.”

Still, Levy is unrepentant and wants to signal a clean break from the policies of the past. “We do not benefit from the help of [high] commodity prices [any more],” he says. “People slowly realise what this new reality means and that we need to grow. We need imagination, but we cannot live with the illusion that we can use a magic formula, we could also say a heterodox formula to achieve a more accelerated growth.”

And raising tax is not an end in itself. It is only part of the “bridge” that Levy intends to build before implementing structural reforms, such as the revamp of the state tax system that will lead to the creation of a VAT system and the simplification of other social contributions.

Levy describes this as “changing the electrical wires of the house to make it great”. The worsening pension deficit will also have to be addressed as part of a wide-ranging reform as the Brazilian population is getting older.

“Brazil’s problem has been related to the misuse of public funds. It is not only the size of the state. Instead of helping people, the state is a burden; it is an additional cost,” says Tingas at Acrefi.

Now the crisis has put the country up against the wall. But what are Levy’s chances of success? Fernando Honorato

Barbosa, chief economist at BRAM , is among those who reckon the loss of investment grade from Standard & Poor’s and potentially other credit rating agencies will act as a wake-up call.

“Now the government has decided to act,” he says. “If they manage to approve the fiscal measures, then debt stabilisation may be on the horizon. And asset prices are already attractive.”

“On the other hand, if there is no political co-ordination, Congress will not approve the fiscal package and there will be a gap of around R$30bn in the budget to be financed.

“Financial investors will ask for a higher premium to roll over the debt and its maturity will shorten. This would lead to higher, more persistent inflation as monetary controls would have to be relaxed.” If the wake-up call fails, the risk of the return to populist policies may rise.

“Joaquim Levy is the only one who has a clear perception of what to do to face the current difficulties, but he has been completely sidelined by his colleagues, unfortunately,” de Bolle says.

Indeed, Levy’s efforts to put the house in order have been bravely resisted by an army of spendthrifts who have a dominant position in Congress — and some influence within the government too.

President Rousseff, like her predecessor Lula, has remained ambiguous. While asking the population to prepare to swallow “bitter pills”, she has done little to cut spending or to push through structural reforms. And Levy alone will not be able to appease the markets.

“You cannot just rely on Neymar to score,” says the IIF’s Aracena comparing the finance minister with the country’s star football player. “You need to have a good team. You need good comprehensive planning to resolve the problem of Brazil, which is low economic growth. Levy is a little bit led by himself, that is the impression that we have from here.”

Brazil needs a statesperson to “break the impasse”, according to Tingas who clearly does not see Rousseff as that person. “You need some institutional leadership with an ability to negotiate and set up an agenda. But today, the president is unable to do that,” he says.

He says that Brazil has failed to make any improvements. “Sometimes it does improve a bit but then it gets a lot worse. Brazil could be a powerful country but there is no planning. The country of the future? Maybe in 500 years!” he says.


Source: Brazil: in a hole and still digging | Emerging Markets