By Ilan Goldfajn and Felipe Salles (via Itau BBA).
The Brazilian economy is taking time to show a strong rebound. The global scenario is not favorable, production costs in Brazil are currently very high and investment plans are waiting for a more consistent pickup. The government has adopted new incentive measures, but will they work?
If by “work” we mean that the economy will grow faster than the latest GDP reading (0.4% quarter-over-quarter), the answer is yes. Cyclical components – reversal of the inventory cycle, monetary and fiscal stimuli, and stabilization in the global slowdown – will contribute to a rebound in the economy at some point in the near future. But it is hard to tell whether Brazil can sustainably grow at a higher rate in the medium term, say until 2020.
The international context has changed and what used to be global stimuli became headwinds.
The reversal ecloded when the housing bubble bursted in the U.S., affecting markets and the banking sector, and peaking with the collapse of Lehman Brothers in September 2008.
Following a period of recovery and optimism, which came as a consequence of actions by governments and especially central banks, new problems arose in the most fragile regions of the global economy. Peripheral countries in Europe began to show trouble due to a long period of abundant and cheap credit after the euro was adopted. The expansionist fiscal policy in the last decade, which included the reaction to the crisis, took its tool: several nations, including Greece, Portugal, Ireland and Spain, saw their public deficits rise sharply, creating doubts regarding the sustainability of their debt and hindering access to markets. Stocks of banks in peripheral countries tanked, signaling that the sector’s health was frail, and households and companies proceeded to withdraw their deposits from banks in some countries.
In slow, fumbling and irregular steps, European authorities took a series of measures that, though necessary to avoid a debacle in the region, have not yet solved the problem. The European Central Bank has been critical to avoid the collapse, purchasing troubled sovereign bonds in the secondary market and providing cheap liquidity. Recently, the ECB promised to intervene even further.
Notwithstanding all these efforts, growth has been a struggle for countries in the eurozone. The dynamics of debt (as a share of GDP) worsened not only because of the public deficit, but also due to lower growth. The balance sheets of banks and companies deteriorate as revenues fall and delinquency rises. High unemployment prompts social and political instability.
Will a disaster fall upon Europe with the end of the eurozone? We believe the euro will endure, but maybe without the exact same composition we see today (with a Greek exit, for instance). In this scenario, Europe will advance falteringly on key issues, such as fiscal adjustments, structural reforms and institutions that contemplate greater fiscal and regulatory integration. Such advances are slow and, while measures are adopted, the ECB will probably need to acquire a large share of debt issued by peripheral countries to avoid rupture in the region, effectively executing a huge quantitative easing (QE). We see a long period of adjustment with low growth ahead of Europe.
In the U.S., we do not expect the economy to fall back into a recession or to have a strong recovery. Aggressive monetary expansion adopted by the Federal Reserve was able to avoid deflation, which could have complicated the aftermath of the crisis. Just as high inflation reduces the real value of debt, deflation hinders the deleveraging process. Unemployment remains high, but nothing compared to what followed the crisis in 1929. The budget deficit needs to be reduced, but there are no doubts about the government’s ability to honor its debt.
The private sector advanced toward the necessary adjustments to resume sustainable long-term growth. The balance sheets of banks and companies are relatively healthy, while households increase their savings and pay off debt. Real estate prices stabilized, the inventory of properties for sale declined and demand started to show signs of life.
The problem is that a large part of the adjustment in the private sector was shouldered by the public sector. The stock of public debt increased, the public deficit rose and the Fed’s balance sheet widened significantly. The public sector’s adjustment still needs to be done, and uncertainties linger. For instance, will the Fed be able to reduce its balance sheet when financial conditions normalize completely? The risk is higher inflation in the future.
The outlook is for low but steady growth: on one hand, the necessary fiscal adjustment gets in the way of the rebound; on the other hand, at some point, the currently-stagnant construction sector may go back to normalcy, stimulating the economy.
Structural conditions for long-term growth are not favorable for the U.S. and Europe. First, demographic conditions tend to get worse. In the U.S., growth in the workforce will be lower than in the recent past. In Europe, the situation is even bleaker: the ageing population and migratory dynamics are bound to cause a decline in the working-age population. Second, the growth rate in the capital stock will be lower. In order to keep growth in the capital stock at pre-crisis levels, the U.S. would need to deepen the current account deficit, given its low domestic savings; such situation that seems implausible.
China also faces challenges. The model geared toward investment and exports is giving signs of exhaustion since the 2008 crisis and domestic spending must pick up. This is not a trivial transition, as a number of institutional reforms must be implemented. The increase in consumption requires a decline in household savings, thus requiring greater social security coverage, more public services (healthcare and education), policies to raise real wages and some degree of liberalization of the local financial system. The adoption of such adjustments is followed by an increase in production costs, lowering the country’s competitiveness in tradable goods.
The Chinese government has demonstrated an option for moderate growth. The adoption of countercyclical policies during the Lehman crisis produced imbalances. The share of investments in GDP, which was already high, climbed to nearly 50%. The debt of local governments rose significantly; and there are doubts whether bank loans that financed this expansion will be paid off. The real estate sector gave signs of overheating, prompting the government to take measures to curb its expansion since early 2011. Facing challenges domestically (transition to a new growth model based on consumption) and externally (the continuing international crisis), the Chinese government opted for lower, albeit sustainable, growth in the long term. We do not fathom a return to fast, two-digit growth, neither a crisis causing growth to stop abruptly.
We forecast lower but sustainable growth in China in coming years. The transition to a growth model based on domestic consumption requires a reduction in investments as a share of GDP. Demographics will be less favorable, with a decline in the working-age population from 2015 onward. Finally, the migration of farm workers to urban centers will continue, but increasingly to the less productive service sector rather than to the manufacturing sector.
The world is apparently facing a long period of low or moderate growth rates. Developing economies will no longer benefit from a stimulating global environment: the time of fast export-led growth is behind us.
Putting it in numbers, we forecast the following growth rates: throughout the second half of the decade, the eurozone will resume moderate growth, around 1%; the U.S. will post average growth somewhat above 2% and growth in China will drop from about 8% to around 6.5% in 2020. And what about Brazil?
The end of the favorable period for the global economy has created challenges for Brazil.
The country has felt the impact of the crisis in 2008, but recovered quickly. With the contribution from the strong global rebound, led by China, and intense government stimuli growth accelerated to 7.5% in 2010 (from -0.3% in 2009).
In the process, there were some excesses in expansion and production plans. Wages rose much faster than productivity. Inflation accelerated and threatened to break the upper-limit of the Central Bank target range. The government responded to higher inflation by adopting a tight economic policy.
The deterioration in the external situation and government measures to cool down the economy, slowed the Brazilian economy. In 2011, growth slipped to 2.7% and continued to slide until mid-2012.
Looking ahead, we expect the domestic economy to recover by the end of 2012 and resume growth (above 1.5% in 2012 and above 4% in 2013).
We estimate average growth ranging from 3.5% to 4% in the second half of the decade. This expectation is based on a set of trends for the Brazilian economy which need to become clearer, including:
i. More investment is needed for GDP to keep growing. It will not be possible to continue to grow just by adding workers to production. In the last decade, employment rose and companies faced a shortage of workers. Unemployment hit a new all-time low. Now Brazil needs to accumulate more capital to keep these jobs and grow more.
ii. Increasing private investment is critical. Public-private partnerships and the recently-announced auctions of infrastructure concessions (highways, railways, airports, and ports) are one solution, but the private sector will need adequate returns if it is going to raise investments.
iii. Production costs are very high and represent a real bottleneck. There are several initiatives to reduce costs. It is becoming clear that a significant share of the cost reduction involves, to some extent, the government sacrificing its revenues. The package to reduce energy costs in Brazil and payroll tax cuts are the most recent examples. Petrobras’ investments will require fuel prices in line with the rest of the world, which may lead to additional tax cuts for gasoline and diesel.
These measures will ultimately lead to the reduction of the tax burden, which now stands at around 35% of GDP — very heavy for a developing country. It seems to be the ideal solution. The reduction in the tax burden could shrink production costs and encourage private investment, which is essential to further growth in the medium term.
But could fiscal accounts endure a more significant decline in revenues? Only if a permanently-lower interest expense materializes allowing a lower nominal deficit and more favorable debt dynamics, opening up fiscal room.
We are not among those who believe in the sustainable decrease of the benchmark Selic interest rate through a simple government decision. But we believe in the convergence of Brazilian interest rates to international standards in the medium term, enabled by macroeconomic stability and the consequent drop in risk spreads. The past trend has been a decline in interest rates, although at a slower-than-desired pace. Looking ahead, more moderate growth in government spending and credit may allow a more sustained drop in interest rates (avoiding a return to double-digit interest rates, even after the economic recovery).
High growth in public spending has been matched in the past by a heavy tax burden and also by higher interest rates. If current spending grows less (or is re-allocated for investment), the consequent drop in interest rates may allow for a lighter tax burden. For every 1% of permanent drop in the Selic rate, we estimate a possible reduction of the tax burden by 0.5% of GDP, without worsening public accounts (nominal deficit).
But the room for a decline in interest rates, if available, should be used to increase public investment or to encourage private investment. The temptation to increase government spending and encourage private consumption (with deductions) may derail the sustainability of falling interest rates, disrupt public accounts and cause higher inflation.
Recent measures have tried to promote investment through lower costs. But have also included efforts to reduce prices in the short term and encourage consumption. Ideally, Brazil should keep the focus on investment and sustainable growth in the medium term, especially in a less benign global economy.