By Fernando Dantas
As Brazil prepares for election year 2014, economic uncertainty is pervasive. It is likely that 2014 will not be as spectacular as 2010, but forecasts of what will actually happen vary considerably. On the negative end, Brazil would encounter a perfect storm that might combine one or more downgrades of its sovereign rating with a steep devaluation of the exchange rate in the wake of rising U.S. interest rates. The most optimistic scenario anticipates a gradual recovery in economic growth, and inflation still below the government inflation target ceiling of 6.5% a year.
In the November seminar “Brazilian Economic Outlook for 2014,” sponsored by the Getulio Vargas Foundation in Rio de Janeiro, contrasting views on the forthcoming year were presented by Brazilian Institute of Economics (IBRE) researchers as well as other seminar participants.
Silvia Matos, coordinator of the IBRE Economic Outlook, set out IBRE’s baseline scenario, starting with GDP growth of 2.4% for 2013 and 1.8% in 2014. Matos pointed out that uncertainty about the 2014 outlook for the whole world is very high, making it even more difficult to predict what will happen in the Brazilian economy. Nevertheless, the baseline assumes a more favorable international scenario, with the euro area exiting from recession, continuing U.S. recovery, and stabilization of growth in China.
The baseline scenario assumes that U.S. growth will accelerate from 1.8% in 2013 to 2.4% in 2014; as Europe comes out of recession, it will grow 0.8 % next year after falling 0.5% in 2013; and China’s growth stabilizes at 7.3% in 2014 after hitting 7.5% in 2013. Matos noted that there has been a general economic slowdown in Latin America since 2010, but countries that have inflation under control, such as Chile, Colombia, Mexico, and Peru, have more room for monetary expansion to stimulate economic activity.
With its feeble GDP growth and high inflation, Brazil will have more difficulty conducting monetary and fiscal policies. Analysts consider it unlikely that the monetary tightening cycle that began last March will raise the benchmark interest rate much above the 10% set last November. The expectation is that early in 2014 the central bank will stop at 10.25% or 10.50%.
The GDP fall of 0.5% in the third quarter compared with the previous quarter (seasonally adjusted) was another indicator that growth for the first term of President Dilma Rousseff is likely to be a rather unsatisfactory 2%. Thus, the central bank is walking a tightrope between the possibility of halting the frail recovery of economic activity and the risk of inflation expectations entrenching at levels well above the target mid-point of 4.5%. IBRE is projecting that consumer price inflation will close at 5.8% this year and keep moving up in 2014, to 6.1%.
In the baseline scenario, Matos said, fiscal policy has a crucial — and very worrying — role. The fiscal primary surplus (nominal fiscal deficit excluding interest payments) to stabilize the public debt-to-GDP ratio should be about 2.5% of GDP, but IBRE projections of the effective fiscal primary surplus in 2014 (excluding nonrecurring revenue) are only 0.8% of GDP for 2013 and 0.5% in 2014. Clearly, monetary policy should not expect any support from fiscal policy to contain inflationary pressures.
Market participants also perceive that the fall in the fiscal primary surplus is not related entirely to the business cycle but is more permanent. Matos pointed out that expansion of the tax cuts has reached 1.6% of GDP, which means a substantial loss of tax revenues. While reversing some tax exemptions could recover about 0.5% of GDP in revenue, a large part of social spending (including education and health) is adjusted in line with increases in the minimum wage, and mandatory spending is already a large share of total expenditure. Thus, she said, the nominal fiscal deficit could reach 3.5–4 % of GDP in 2014.
The gathering storm
The likely fiscal underperformance creates uncertainty about how sustainable public debt is. Brazil’s gross public debt of about 60% of GDP is in the crosshairs of investors and international rating agencies; in 2013 Brazil saw its rating outlook worsen. Though Standard & Poor’s and Moody’s have not yet actually lowered the rating, their negative outlook may eventually cause a downgrade.
The perfect storm scenario would combine one or more rating agency downgrades of Brazilian debt with a significant increase in U.S. interest rates as the Federal Reserve tapers off its monthly purchases of US$85 billion in U.S. government bonds. The consequent strengthening of the dollar could trigger a sharp devaluation of the Brazilian real and unleash acute inflationary pressures that would force the Central Bank of Brazil to tighten monetary policy even more. That would certainly have negative consequences for economic activity and the employment..
Seminar participants also looked beyond 2014 to discuss 2015 policies to address Brazil’s economic imbalances — the consensus being that any serious policy adjustment in an election year was implausible.
Without policy adjustment
Armando Castelar, IBRE researcher, put forth the view that adjustment in such policies as controlled prices for fuel and bus fares might not take place even in 2015. He noted that the list of unpopular policies to contain inflation and reduce the external current account deficit is extensive: correction of fuel prices, elimination of tax exemptions, and tightening of monetary policy, which would be combined with rising unemployment and falling real incomes.
State-controlled banks have inflated their loan portfolios, Castelar charged, and a sudden slowdown of the economy would not only bring about loan defaults but also require the Treasury to recapitalize state-controlled banks. At the same time, high interest rates and slower economic activity would exacerbate the difficult fiscal situation, requiring a level of austerity that is politically unpalatable.
As a result, Castelar believes, a serious adjustment of the Brazilian economy is unlikely to occur by voluntary government action; it would only come if the international situation worsened. In that case, the administration might be forced to change policies in order to reduce the current account deficit, which has reached 3.7% of GDP.
In 2014, Castelar predicted, the administration will not abandon the ideological convictions embodied in its “new economic policy” — a combination of falling interest rates, a devalued exchange rate, and expansionary fiscal policy. However, postponement of the tightening of U.S monetary policy that was expected in September bought the time necessary for the Brazilian government to muddle through until the presidential election, in the hope that the fragile economy will not decisively affect the labor market.
The labor market has stayed strong even as the economy has been slowing since 2011. Unemployment remains low. This, of course, has contributed to the popularity of the government. If the poor performance of the economy had affected the labor market, pressure on economic policy would have been more intense, in Castelar’s opinion. But now growth in the employed population and in real incomes has slowed, and there is already a relative cooling of the labor market.
Nelson Barbosa, former executive secretary of the Ministry of Finance in the Rousseff administration, outlined what would be the optimistic scenario for 2014 — without claiming that the optimistic scenario was the most likely, but noting that it should not be ignored. Barbosa argued that policy correction is already underway. For example, he said, the monetary tightening cycle started in March this year could allow interest rates to fall early in the next presidential term in 2015 — assuming no new adverse demand shocks and that the government can manage to adjust controlled fuel and other prices gradually.
Barbosa also pointed to the recent government decision to reduce Brazilian Development Bank (BNDES) loan disbursements and thus transfers from the Treasury to the BNDES, which are to decline from R$190 billion in 2013 to R$150 billion in 2014. This measure would address concerns about off-budget spending and increase the fiscal primary surplus to 1.5–2.5% of GDP, depending on how the economy performs. He suggested that these policy measures would make fiscal policy more predictable and could build market confidence in the sustainability of public debt.
Assuming a more favorable international outlook and the absence of new negative shocks, the optimistic scenario would be 2–3% GDP growth in 2014, which would put GDP back on track toward an annual growth rate of 3.5–4.5%, which Barbosa considers to be the potential long-term growth rate of the Brazilian economy.
Republished with permission from FGV-IBRE’s The Brazilian Economy