Brazil-o-nomics Part 2 – The Country of Tomorrow has finally arrived.

Continuing the previous post on Brazil-o-nomics, today’s post is going to explore the current state of Brazil’s economy and peer a little way into the future. Without a doubt, Brazil is riding the crest of a wave, and with international money seeking buoyant markets, the trend is set to continue. But can this wave of expansion be managed in a way that will ensure the long-term health of the economy and what are the immediate challenges?

*I’m aware of my total lack of economic training, so I won’t be making any original claims. This will ensure that when these predictions completely fail to materialise, I can deftly pass the buck.

Bringing Brazil under control

To summarise recent economic developments in Brazil, it is necessary to start with the 90’s. Brazil was emerging from a deep recession, where hyperinflation had plagued the currency and an outdated political system made it virtually impossible to push through vital reforms. As the economy languished, infrastructure was left to crumble and Brazil was buffeted by the ebb and flow of the international markets. After a series of unsucessful resuscitation attempts, President Cardoso orchestrated the famous ‘Real Plan‘. His scheme finally rescued the economy and opened the door for Brazil to integrate with the global economic system – or at least that was what was hoped. Before stabilisation could be turned into growth, the shock of the Asian collapse and Russian default in the late 90’s threatened to sink Brazil once more. The Real was seen as overvalued and the spectre of a sovereign debt default loomed on the horizon (when a government can´t cover its own IOU´s, which are owned by e.g. other governments). Cardoso unpegged the Real from the dollar, which gave a boost to exporters and took the exchange rate out of the hands of the decision makers. Cardoso also cut public spending and, working closely with the IMF, secured a multi-billion dollar loan to act as a buffer against international destabilisation. He also talked the government into letting him run for President again, to reduce political uncertainty during a difficult period. The efforts succeeded and Brazil repaid the IMF on schedule. Some say that Cardoso worked too hard on stabilisation and structural reform, forgetting about growth, and that his neoliberal policies needed overhauling before Brazil saw any real development. But however Cardoso’s first term is interpreted, the message was clear – Brazil was ready to control its own destiny.

During Cardoso`s second term (`99-`03), there was an initial virtuous-circle effect, as confidence in the Brazilian economy grew and the fallout of currency devaluation subsided. The central bank’s base interest rate fell and foreign investment inflows increased. For a while, a genuine recovery seemed within grasp. However, once again, international developments undermined Brazil’s ambitions. In 2000, the American economy faltered as the dot com bubble burst and South American neighbours Argentina were suffering badly from a currency crisis, threatening contagion. This was followed by the terrorist attacks of 2001, which made foreign investors seek low-risk safe havens for their money – not a status Brazil could realistically claim. These events all served to cool growth in the economy, postponing the boom that many saw as imminent.

Domestic events were also dampening growth, as support for Lula`s opposition PT party began to swell and talk of an intentional loan default was in the air – a rumour that was hurting the countries international credibility. This political uncertainty was further compounded by an energy crisis, caused by low rainfall levels that starved Brazilian hydroelectric reservoirs, bringing them to a halt and triggering brown-outs. The pressure was mounting on the establishment and the breaking point was reached when a funding scandal broke. The public faith in the government plummeted, giving Lula the unassailable lead in the polls that delivered him to power.

The giant awakes

When Lula was inaugurated in 2002, the international markets feared that this ex-union man would steer the country towards socialism and populism, introducing radical structural reforms. As the reins were handed over, hot money was flooding out of the country and the uncertainty threatened to cripple Lula’s presidency before it got out of the starting gate. With little alternative, Lula opted to keep the previous administration’s financial team in place and to honour a large IMF stabilisation loan. The international markets and middle-class voters were placated, although left-wing socialists resented the missed opportunity to exact revenge on imperialist western powerbrokers. However, this overall merging of socialist and conservative values finally delivered the bedrock stability that the business craved and accordingly, the economy began to gather momentum.

Under Lula, with favourable international winds, the economy has gone from strength to strength. One of the main drivers of this growth is the increased Chinese demand for Brazilian commodities, such as soya and iron ore. The boom was further enhanced by the inflow of cheap capital imports from the US, where interest rates were being kept low by Greenspan. The boom has resulted in a two-pronged attack on poverty, one from increased revenues and one from a better funded welfare state. In turn, this has led to a significant increase in quality of life for the working poor of Brazil. The growth has also translated into resilience for the economy, with well-executed financial strategies ensuring Brazil emerged rapidly from the recent global downturn.

Lula and his hand-picked successor, Dilma

As would be expected from a centre-left labour party, the state grew immensely under Lula, with many public jobs awarded to former PT-members. Privatisations were cancelled and the state took control of many industrial sectors. This suppressed market mechanisms that might have streamlined administration, and, according to some, cements the PT’s stranglehold on power. However, it guaranteed profits would stay in Brazil and that the state could focus on job creation. The creation of large public bodies led to state budget overruns became commonplace and the tax burden increased. These steps bloated the economy, but held Brazil on a stable course. By 2007, Brazilian companies were reaping the reward of this stability and 75 IPO’s led to an rising inflow of foreign capital. Lula was proactive in his macroeconomic policy as well, anticipating the increase in global food prices, and, in order to head off inflation, raising the benchmark interest rate (to persuade people to keep cash in the bank). He also advocated tactics to prevent the value of the real increasing too rapidly, such as buying back their own currency (known as a dirty float). The meant that companies like China are able to continue buying Brazilian commodities.

Lula´s presidency ended on a high note, proving wrong the old adage that all political careers must end in failure. The success of the PT and the continued strength of the commodity market ensure that there was no change in the government during the last election, with Lula virtually naming his successor. Dilma has kept many of the previous policies in place, and the growth spurt continues unabated. So that brings us to today – what are the strengths and weaknesses of the Brazilian economy and what are the immediate challenges?

Strengths

Natural resources – Brazil has huge supplies of wood, iron ore, water and gold. All of these resources are in high demand globally, so there are profits to be made. Poor infrastructure makes accessing these resources a challenge and the environmental costs of resource extraction are high, but in economic terms, commodity export is at the heart of Brazil’s recent economic success.

Tourism – Brazil is a major tourist destination and has a strong international profile. With football, beach culture and music leading the way, Brazil expects to see a large rise in the number of visitors over the coming years. It is perceived as a laid-back, open culture, which chimes well with the average tourist’s idea of a good time, and Rio is the most popular tourist destination in South America.

Agribusiness – Brazil is the world’s biggest exporter of sugar, coffee and orange juice, ethanol and frozen chickens, as well as the second-largest producer of soybeans. Agribusiness is huge in Brazil and it’s rapid expansion has been fuelled by China’s insatiable demand for raw materials. Brazil has been investing heavily in food production and export, with rail new networks and ports planned. Other countries are struggling to find the land or the water to expand agricultural capacity, but Brazil still has 70 million hectares to farm, and an abundance of water in a tropical climate for extended growing seasons. Along with raw materials, food stuffs are the driving force behind the Brazilian economic awakening.

Olympics / World Cup – Brazil will host the 2014 World Cup, and Rio de Janeiro will host the 2016 Olympics. This means a PR boon for the country and especially for Rio. Advertising revenues will spike, and the deadlines will force infrastructure projects off the drawing board and into reality.

Discovery of oil reserves – Off the coast of Rio state, below 1000’s of metres of rock and salt (hence the name, pre-sal), a series of oil reservoirs containing around 90 billion barrels of oil have been discovered. If confirmed, this would put Brazil in the top 10 oil producing nations, with similar reserve levels to Canada and Russia. It has been estimated that over the next 10 years, $400 billion will be spent putting the relevant infrastructure in place. Petrobras’s recent IPO raised R$67 billion. That’s a lot of spending money.

Weaknesses

Lack of domestic savings – Brazil lacks a saving culture, particularly compared to other developing countries such as China or India. Perhaps this is due to past economic cycles, which made long term financial planning impractical. As Brazilians don’t save much, borrowers need to rely more heavily on foreign loans, which require high interest rates and a reliance on hot money.

Limited growth in mid-tech and high tech sector – Despite spectacular success in the commodities export sector, growth in Brazilian mid- and high-tech industry is still lacklustre. High import duties protect Brazilian manufacturers, but they also guarantee a domestic market and create globally uncompetitive companies. Diversifying the economy will provide greater resilience, especially in the face of a commodity price crash.

Budget deficits common in the public sector – Public deficits are the norm in the public sector, and it is proving a hard habit to kick. If infrastructure renewal is to succeed, then accurate budgets need to become the standard, rather than the exception. Rebudgeting is a wasteful process and lax accountancy is a haven for corruption.

Possible asset bubble – With a public perception of favourable economic conditions ahead, some assets have been rapidly increasing in price. In Rio for example, house prices are increasing way above inflation, as the local market anticipates the boom in tourists in the run up to the World Cup and the Olympics. If credit becomes cheaper in Brazil, this trend may only get worse, leading to an eventual crash. Capital controls may help, but this will only add to the legislative burden the government already places on the population.

Interventionist government – Potentially a controversial ‘weakness’, depending on your point of view, but if Brazil wants to reap the benefits of being a market economy, then intervention can only be seen as a bad thing. Beyond direct intervention, successive generations of government and dictatorship intervention have left a patchwork of legislation and bureaucracy that can make business impossible, or at least painfully complicated. Law’s are often flouted to avoid this legislation, which often solves problems in the short term, but leads to complications in the long-term.

Stifling labour laws – Brazil suffers from unbalanced labour relations, as official contracts entitle employees to pensions, healthcare, bonuses and a host of other benefits. In an advanced economy, such as Norway or Germany, these additional benefits may welcomed by the employer as a means of maintaining worker stability, but in Brazil, this makes official contracts prohibitively expensive. This means official contracts are often bypassed. Accordingly, budgets can stretch further, but also puts both employers and employees at risk, as either party can call off the sub-legal arrangment at any time. For the employer, there is the additional risk of the employee blowing the whistle, as the courts often settle in favour of the employee, resulting in hefty fines.

Large pension burden from early retirees – Brazil has been suffering from old legislation that has failed to keep up with the countries changing demographics. A minimum retirement age was only introduced in 1998 and has been applied progressively, while public sector pensions have long been seen as overly generous. This means Brazil has a pension deficit similar to that of a developed economy, which hampers the governments capacity to stimulate growth. Revisions to pension legislation have been pushed through, but these have been deeply unpopular with the electorate.

Low educational spending – traditionally, the rich have educated their children in private schools, leaving the lower and middle classes to fend for themselves in a woefully underfunded education sector. Illiteracy is still high and investing in education may offer the key to converting the present boom into lasting change in Brazil.

Solutions

Reduce public spending – the Brazilian economy is on the verge of overheating. Hot money is flooding into the country and with access to credit for the first time, consumers are spending more, driving up prices. The benchmark interest rate has been raised already, to try to encourage saving. The government are also reducing public spending by cancelling public infrastructure projects, reducing running costs in the public sector and building up cash reserves. The cancelling of infrastructure projects is unpopular, although this trend may just be a result of pre-election commitments that the government had no intention of delivering.

Encourage domestic saving – higher interest rate and tough lending legislation can help to keep money in the bank, giving the government more domestic capital to play with. It can also give domestic consumers a buffer, if the Brazilian economy does encounter trouble waters in the future.

Invest in infrastructure – Although overspending can cause overheating, infrastructure should still be a top priority for the government. Road and rail networks in the northeast, urban infrastructure, power generation and Olympic and World Cup developments are all vying for funding.