BRAZIL: Between the Cup and a hard place
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Emerging Markets

BRAZIL: Between the Cup and a hard place

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The Brazilian economy is in serious trouble. The next government will have to overhaul the system if the country is to return to winning ways

It was not meant to be this way. Football fans and tourists from around the globe flocked to Brazil during the World Cup and spent $1.6bn in June and July. But in the meantime, Brazilians abroad continued to spend even more than foreigners did in their country, which widened the current account deficit further. In the month of July alone, while the Brazilian football team was being humiliated by Germany and the Maracanã was hosting the tournament final, Brazilian tourists continued their oversees shopping spree and spent $2.4bn outside their home turf.

Brazil has become such an expensive country that many families would rather travel abroad than explore their own backyard — it is often cheaper to fly to Florida to visit Mickey Mouse and look for bargains on the way, courtesy of a still overvalued currency and the not-so-hidden costs of the Brazilian economy.

Twenty years after the Real plan, which tamed hyperinflation, there are still plenty of distortions in the local economy — which extend far beyond the anecdotal evidence of Brazilians spending their savings abroad. Those current distortions may look mild compared to Brazil’s troubled history — the Latin American country has indeed come a long way — but they do hamper Brazil’s global performance and whoever assumes the presidency on January 1 will have to sort them out.

In spite of official denials, the economy is technically in recession (following a drop of 0.2% and 0.6% of GDP in the first two quarters of the year respectively), inflation is much too high for comfort (around 6%), the fiscal target (a primary fiscal surplus of 1.9% of GDP) will not be met and twin deficits are approaching 4% of GDP. Policymakers have a lot to do.

“The [main] challenge of the next government is to overhaul the fiscal regime,” says Mansueto Almeida, an economic adviser to the presidential candidate Aécio Neves, from the social democratic party. The tax burden has increased since the return to democracy and the adoption of a new constitution in the late 1980s. Together with the complexity of the tax regime itself, this has become the main concern of nine out of 10 CEOs in Brazil.

Eduardo Giannetti da Fonseca, an éminence grise in the economic team of the socialist party candidate Marina Silva, has suggested that the Brazilian state has become too big to fit its GDP. “This is a structural problem that requires a long term dialogue with the society as a whole,” he says. He is not alone. Public demonstrations ahead of the World Cup, which reached their climax in July 2013, pointed the finger at the poor quality of public services, in contrast to the new football stadia, which were built or modernized according to “Fifa standards”.

Such spectacular protests helped capture the public mood before this year’s elections. “As always, the voice of the streets is the voice of God,” says Joaquim Levy, CEO of Bradesco Asset Management (Bram). “The message from the streets is to improve the quality of public expenditure,” he says. “People meant: ‘no more taxes’ and ‘I don’t like the way you have been using my tax money’. Any fiscal strategy will have to take this into account.”

According to Levy, this may be a matter of common sense and using existing resources in a natural way to increase productivity, rather than the need to adopt austerity measures.

Nevertheless, candidates’ pledges to implement a structural tax reform after the elections do not look credible to independent experts (those who are not working for the presidential candidates themselves). “Nothing will happen. It is simply not feasible,” says Fernando Zilveti, a tax lawyer in São Paulo, as several states of the Brazilian federation refuse to be included in an overhaul of the current system, therefore blocking any change.

STALLED ECONOMY

In spite of the World Cup excitement, the economy has stalled. The external environment has certainly caused some uncertainty and volatility but several domestic issues need to be addressed. “Fiscal policy needs to point to a sense of strength, which would pave the way to a decline in long term interest rates — whoever will be the next president will have to work towards this,” says Levy. “If you want to lower interest rates, it has to be a priority — so you need to revamp other policies in order to allow for a fall in interest rates.”

Instead of doing this, the outgoing administration of President Dilma Rousseff aggressively cut base rates between July 2011 to March 2013, to slash bank spreads in line with her political pledges, without tightening fiscal policy. But the strategy backfired. Inflation pressures resurfaced and the central bank had to hike interest rates again — they are now at a higher level than when Rousseff took office (10.75%).

Levy, a former Treasury secretary under the first Lula government 10 years ago, says this should be Brazil’s priority: “If you have five or six years of consistent fiscal policy, you can adjust the tax regime, implement simplification, facilitation... in other words, prepare the ground for cutting interest rates in a natural way,” he says.

For the time being, the Brazil house is still far from being in order. “The current situation is much worse than the one we could have imagined two or three years ago,” says Marcelo Carvalho, chief economist at BNP Paribas in São Paulo. At that time, the market consensus view was that economic growth and inflation would both be at around 4.5% by now (which would be close to both the country’s potential growth potential and inflation target). “But this has changed. One went up (inflation, currently at more than 6%), while the other one went down (growth expectations are below 1%). There has clearly been a deterioration in the growth/inflation trade off.”

The outgoing administration has repeatedly blamed the external environment for its lacklustre performance. Yet many of the issues it has been facing are home grown. “Domestic factors are weighing more heavily than external ones,” says Carvalho. “If you compare with other Latin American countries, Brazil clearly is in a worse situation. If you take the growth average for the past three years, you have 3%-5% a year with inflation at 2%-4%. Meanwhile, Brazil has been faring worse, with growth at around 2% in recent years and inflation near 6%. This is mainly a domestic issue.”

MISSED OPPORTUNITIES

But again, things could have been different. “When I look at Brazil in recent years, I see a series of missed opportunities,” adds Carvalho. “During the golden era of high commodity prices, we did not take advantage of this period of international bonanza to implement the reforms that were needed for us to grow at a higher pace.” Economic policy was less efficient to boost output and supply. “We now have this mismatch in Brazil between supply and consumption,” says Carvalho. “This results in pressure on inflation and pressure on the external accounts.”

According to Neil Shearing, chief emerging markets economist at Capital Economics, “Weaker growth has been due entirely to constraints on the supply side of Brazil’s economy. The key to restoring economic vigour lies in rebuilding Brazil’s supply potential.”

Yet it would not be fair to say that the outgoing administration did not try. It pledged to improve the supply side of the economy when it launched a vast concession programme in infrastructure to attract private investors two years ago, but results have so far failed to materialise, apart from some isolated examples, such as a few airports. The investment rate, which was supposed to reach 24% of GDP by the end of this year, actually fell to 16.5% of GDP in the second quarter.

Meanwhile, the end of the commodity boom has highlighted the weakness of the local industry, which has been unable to improve its export performance. Alarm bells have started to ring in government circles. “We need a very strong export bias,” says Luciano Coutinho, president of the National Development Bank (BNDES). “We cannot rely on commodities alone. The trade surplus is a macroeconomic imperative... The current account deficit is too high, already at around 4% and possibly toward 5% of GDP,” he says.

This may be a new direction to be explored by a future government. “I have never heard [current] government officials speak in those terms. To me, it is a welcome surprise,” says Renato Baumann, director of international affairs at the Brazilian presidency’s think tank IPEA [Institute of Applied Economic Research]. “At long last, people seem to acknowledge that something has to be done,” says Baumann, who also used to be a director at the European Commission on Latin America and the Caribbean.

The short term problem is that if the government lets the currency depreciate to give a breathing space to its flagging industry, it may add to inflationary pressures and blow its official target. The same would happen if government set prices (mainly fuel) were deregulated. There are so many distortions that short term fixes will not be enough. Not to mention the challenge posed by the looming change in US monetary policy, which is yet to materialize.

Now is the time for Brazil to go back to basics. Its football team failed to win the World Cup after opening the tournament with an own goal last June, but if it manages to choose the reforming path following the elections, it may well improve its ranking in the global economic league again. But it will be no walk in the park.

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