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Emerging Markets

Reality check

Brazil’s leaders thought the financial crisis would pass them by. Not any longer. As the economy contracts sharply, policy-makers are facing up to reality.

By Thierry Ogier

Brazil’s leaders thought the financial crisis would pass them by. Not any longer. As the economy contracts sharply, policy-makers are facing up to reality.

Until recently, as financial and economic turmoil convulsed the industrialized world, Latin America was filled with optimism that it would escape the worst. Brazil’s president Luiz Inacio Lula da Silva famously called it George Bush’s crisis. Other leaders lined up to proclaim the region’s resilience in the face of global headwinds.

That was then

This month Brazil revealed it had suffered its sharpest slump in over a decade in the fourth quarter of last year, putting paid to any residual optimism that Latin America’s largest economy was immune from the global crisis. Industrial indicators from the beginning of 2009 now suggest Brazil may be heading for a recession.

As significantly, for the first time during his second term, President Lula’s popularity rate declined in March, according to a Datafolha survey, from 70% last November to 65%.

Policy-makers are waking up to their toughest choices in years as they scramble to maintain the country’s much vaunted macroeconomic record. 

“There has been no shortage of crises in Brazil’s history, but the magnitude of the recent growth slump beats them all,” says Marcelo Carvalho, chief economist at Morgan Stanley in Sao Paulo, who forecasts zero growth in Brazil this year.

The central bank has slashed the Selic rate by 1.5 percentage points, the steepest cut in five years, to 11.25%, while signalling it’s prepared to reduce borrowing costs to a record low next month.

Policy puzzle

But while there’s still scope for action on the monetary side, it’s Brazil’s fiscal position that has many worried. Government officials have vowed to stick to orthodox policies thanks to a mix of budget cuts and targeted fiscal stimulus, ruling out any U-turn in policy. 

But the current downturn is so severe that questions over the appropriateness of policy measures have again taken centre stage. “It is inevitable that fiscal numbers are going to worsen,” Carvalho tells Emerging Markets.

Gross general government debt (including various categories of public-sector assets) remains at a high of 64% of GDP, but Brazil’s net debt to GDP ratio, one of the key solvency indicators, has fallen sharply from more than 50% of GDP in 2002 to 36% last January (the nominal debt is still sizeable, though, at nearly 1.1 billion reais, or some $460 billion). 

“Brazil has a relatively weaker fiscal position [than its peers in the investment grade category],” notes Sebastian Briozzo, sovereign risk director at Standard & Poor’s, the US credit rating agency that raised Brazil’s sovereign ratings to BBB- last year. 

This will limit the scope to pursue counter-cyclical fiscal policies to sustain the level of economic activity, following a bumpy 5.1% GDP growth last year compared to 2007, according to preliminary figures from the Brazilian Institute of Geography and Statistics ( IBGE).

Still, 10 years of primary fiscal surpluses have cut the nominal budget deficit to 1.5% of GDP at the end of 2008 – the lowest level on record – when Brazil posted a high 4.1% primary budget surplus; it also set aside an extra 14.2 billion reais ($7.8 billion, equivalent to 0.5% of GDP) for a sovereign wealth fund which, in theory, can now be used as a counter-cyclical policy tool amid declining tax revenues. 

An additional 0.5% of GDP could yet be shaved off the official target to invest in infrastructure, following a 2005 agreement with the IMF known as the pilot investment project (PPI in Portuguese). All this provides some leeway. But analysts point out that while the country is not facing imminent danger, the medium-term outlook contains real risks.

The government has already indicated it may relax its stringent primary surplus target of 3.8% of GDP. Says IMF economist Alvaro Piris, “We expect the government to meet its [fiscal] target. There is some room to accommodate a lower primary surplus from the financial side. I would not be too concerned about this.” But, he adds: “We would advise caution as Brazil still faces large gross financing needs.”

Last in, first out

Finance minister Guido Mantega argues that Brazil’s economy, one of the last to be hit by the global financial crisis, will be one of the first to bounce back. Taking his cue from President Lula, Mantega, like many of his peers in government, has long preached the virtues of optimism. 

During increasingly frequent bouts of self-congratulation, Lula reckons his long-standing commitment to state-led development has received a fillip from the current crisis, as the role of state is gaining ground globally; these days he seldom fails to point out the irony in the fact that investors and liberal politicians – who once preached the virtues of a free market – have muted their criticisms of the state, swallowing their words. 

On the whole, Brazilian officials believe that the strong policy response led by state-controlled institutions, including the central bank, will succeed in containing the impact of the global financial crisis and keep public finances well on track. Luciano Coutinho, head of the national development bank (BNDES) and a rising star of the Lula government, tells Emerging Markets that “the BNDES can temporarily substitute the market”. 

The government has so far acted on several fronts to contain the impact of the financial crisis and avert all-out recession. The logic calls for massive support of already planned large infrastructure works (which are included in Lula’s flagship growth acceleration programme, PAC), many of which come from Petrobras, the state controlled oil company.

BNDES, which late last year received a 100 billion real injection ($35 billion) from the Treasury (to be disbursed by 2010), will provide long-term financing to Petrobras and others, including private companies building dams, power plants and other contributions to infrastructure. Lula has pledged not to cut any of these strategic outlays, even though the government may have to increase its budget cuts (which officially amount to 37 billion reais). 

Meanwhile, the central bank has also been active in providing resources to refinance corporate debt, and securing a swap agreement with the US Federal Reserve ($30 billion until April) to prevent a speculative attack on the real. Brazil has also benefited from the support of the IMF, although its strong international reserves have meant it hasn’t needed fund resources.

Officials argue that the global rout stopped at Brazil’s doorstep in part because of the country’s strong economic policy record – much to the relief of many investors. Yet the government faces a tricky fiscal curve ahead, which could reignite longer term concerns, especially if the global recession proves deeper than projected. 

“Fiscal issues have not been on investors’ radar screens for some time, but this might become an issue again going forward,” says Carvalho. “It may become harder [for Brazil] to finance its growing debt, and it raises issues about the longer term outlook.”

Target or mirage?

Not so long ago, Mantega and central bank governor Henrique Meirelles envisaged achieving a zero deficit target by the end of next year. But the crisis has now dashed such hopes. “The longer the recession, the larger the pressure on the fiscal side... Tax revenues are coming down, and there is little appetite for spending cuts. This is detrimental to market perception of risks as well as sovereign creditworthiness,” says Carvalho. 

Left unchecked for too long, fiscal deterioration may start to jeopardize investor confidence over time. “At the moment there is no sign of stress in the market but that possibility exists,” says the IMF’s Piris.

Standard & Poor’s expects some deterioration in the fiscal position, but the agency views the recent trend as “a minor slippage in a very difficult global environment”. Lisa Schineller, Standard & Poor’s Latin America economist in New York, says: “A little bit of slippage is not something that is going to turn a credit profile, especially if you see it in the context of a broader policy commitment, which we believe Brazil has ... Brazil, like Mexico, still has higher debt levels. They have less room on the fiscal side than Chile and Peru.”

Adds Briozzo: “The scope to introduce counter-cyclical fiscal policy is limited by the debt level, which is still high, as well as fiscal rigidities and the fiscal revenue to GDP ratio, which is so high in Brazil. They may have some margin, but the margin is limited.”

Brazil-based economists, such as Luiz Guilherme Schymura from the FGV think-tank, also express similar concern about future fiscal strategy.

Buffer zone

Schineller points to substantial improvement in Brazil’s external debt profile. Its international reserves provide “a comfortable cushion thanks to its near creditor position”, even though the bank has had to intervene in the foreign exchange market to prop up its battered currency. But while liquid international reserves are around $200 billion, on the cash concept, reserves in January came to a total of $188.1 billion, down $5.7 billion compared to the final 2008 position – “not as great as it once was, but still much better than in the past,” says Carvalho.

As a result, analysts argue, monetary policy is better suited to counter-cyclical strategy than fiscal policy. The traditionally cautious central bank has waited until it was clear that the impact of the decline of commodity prices on inflation would be greater than the strong depreciation of the currency before it started to slash its benchmark Selic rate, first by a full percentage point in January, and more recently by 1.5%.

“As long as we stick to common sense and a fairly orderly fiscal policy, we have the potential to cut interest rates that no other country has,” says Coutinho. “We can go down this alley, we have an upside here. Fortunately we can now see the possibility of having a normal interest rate curve in the future. We expect interest rates to be cut substantially within the next two years.”

Central bank president Meirelles refuses to be drawn on whether he will act as decisively as Chile, which cut its rates by two full points in February. But his predecessor Arminio Fraga says that real interest rates in Brazil could fall to 4% – unprecedented in Brazilian history – while IPEA, a government think-tank, advocates nominal interest rates at 7% in order to save some 43 billion reais (some $18 billion) in interest payments.

BNDES’ Coutinho is adamant: “Investments will not enter free fall. They will be affected, but Brazil has elements of strength that few economies in the world have. The big issue is our ability to maintain the growth of the domestic market”. 

But Coutinho is also eyeing investors with deep pockets in other countries. “There are sovereign wealth funds that are very powerful, whose performance with Treasuries is negligible. If large institutional investors would like to reallocate a small fraction of such assets towards a reliable country, go to Brazil. The actual flight to quality these days is here.”

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