Brazilian Supplement: Sun Goes Down on the Economy

Not long ago, Brazilians were watching declines in the global economy with a certain dose of schadenfreude as internal demand and the commodity boom continued to progress smoothly and decoupling talk was all the rage. Higher inflation, rising rates and an over-valued currency with a background of volatile commodity prices are showing up the limits to Brazilian immunity.

That the long-term future of the Brazilian economy has been transformed by stable macroeconomic policies and opening markets is not in doubt. Until some four years ago, most economists thought Brazilian growth would remain limited to 2.5-3% thanks to structural limits, notes Pedro Jobim, chief economist at Banco Itaú BBA.

Instead, GDP growth was comfortably over 5% in 2007, Jobim notes. Partly that is thanks to the strengthening commodity cycle, but it is also thanks to growing investment, he notes. There has also been a diversification of the industrial base, more open capital markets and the development of a banking system that is investing in the productive economy.

Nonetheless, the short-term outlook economic outlook is deteriorating and fast. Unibanco sees GDP falling to 4.8% in 2008 and continuing to fall to some 3% by the third quarter of 2009, says chief economist Marcelo Salomon. In addition to a worsening global economic outlook, inflation has also been ticking up on stronger domestic demand and is likely to breach the ceiling of 6.5% before it can be brought down, he adds.

Higher inflation has already led to a rapid response from the Central Bank with an abrupt reversal in interest rate policy in April: rates then moved from 11.25% to 13% in the space of two months. For the near future, the outlook is for continued, swift rate rises, economists agree. The likelihood is that the current cycle of interest rates will top out only when rates reach some 14-15%, believes Ilan Goldfajn, portfolio manager at hedge fund group Ciano Investments.

The burden of tackling inflation is entirely on the shoulders of the Central Bank as there are no signs of fiscal austerity, Salomon notes. The government has been awarding fat pay rises and there are growing signs of restlessness in key industries whose workers react to civil servant pay rises and higher inflation with dismay, says Goldfajn. A recent strike by one of the key unions in Petrobras was partly opportunistic; other industries are likely to follow, he notes. Pressure points are likely to be focused on areas where demand is strongest and are likely to encompass the automobile industry, he believes, as demand for cars continues to outstrip supply.

The interest rate moves are already causing banks to look afresh at their giddily growing credit portfolios, which have been fuelling domestic demand. The global crisis in the banking sector on the back of US sub-prime loans is not going to contaminate Brazil which does not have the same history of problems, reckons Márcio Cypriano, president of Banco Bradesco. He is, however, concerned by the recent bout of inflation and says his bank has been tightening credit conditions with more rigorous credit scoring and stricter controls over the tenor of consumer loans. Salomon, whose Unibanco has turned more austere in lending, predicts that smaller banks; those that are concentrated on non-guaranteed loans; and those dealing with less creditworthy customers, such as those buying used cars, will be most affected. Ninety day non-performing loans may go back up to levels of 7.6-7.8% which would represent a yellow alert for the economy, he warns.

Rate increases and tighter access to credit will slowly reduce consumer appetite for goods. But higher rates and strong growth has had the effect of pushing up the currency from already high levels by encouraging short-term portfolio flows into fixed-income. The city of São Paulo jumped in one year from 62nd in 2007 to 25th place this year in a Mercer ranking of most expensive cities, overtaking Stockholm, Brussels and Munich.

An expensive real has seen export growth slow fast; indeed, volumes were flat in the first five months, though revenues were up thanks to stronger prices, says Jobim. Meanwhile, imports have been flooding in, pushing the current account deficit to a near six year high at $14.7 billion in the 12 months through April. For now, that is being compensated by high levels of foreign direct investment, which still has plenty of scope for growth as it represents a piffling 1% of GDP, Jobim notes.

The effect of a slowdown on the political outlook remain relatively benign. President Luiz Inácio Lula da Silva has maintained his popularity with the effects of growth feeding through the economy and feel-good pay rises for lower paid workers and the Bolsa Familiar. That means that next month’s [October] municipal elections will be mostly a test of just how much Lula can sway voters to pick his preferred candidates, reckons Salomon. It will be a useful barometer of his popularity and shape the fortunes of his Workers’ Party in the run-up to Presidential elections.

All this popularity is not conducive to deep change, though. “The DNA of the government is not reformist – it doesn’t see the need not the need to streamline the public sector, far from it,” says Salomon. There has been a mild acceleration in investments to 16% of GDP, but it is not matching Brazil’s huge needs. “We have moved from the top of the second division into the bottom of the first,” he says.

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