Author: Markus Jaeger +1 212 250 6971
April 23, 2012
Brazil’s economy has been benefiting from a positive balance-of-payments shock, namely rising commodity prices and strong capital inflows. This has allowed it to pursue a policy of domestic-consumption-oriented economic growth. Unless the world economy is being in the midst of a protracted commodity super-cycle, Brazil will not be able to rely on improving terms-of-trade forever. Sooner rather than later, Brazil will need to shift to a more investment-oriented growth strategy – not least because it will need to deal with the adverse consequences of gradually, but inevitably deteriorating demographic trends.
Brazil has had a good run in the past ten years. Economic growth has picked up. Poverty has declined. Foreign investment has been abundant seeking to take advantage of the country’s resource wealth and consumption-oriented emerging middle class. While all these improvements are real, the next ten years will be more challenging in terms of sustaining economic growth at the level of the past ten years.
A stylised history of Brazil’s economic performance over the past decade goes something like this. Following the financial crisis in 2002, Brazil experienced an acceleration of economic growth. Initially, tight monetary and fiscal policies were offset by a massively depreciated exchange rate, providing the impetus for export-driven growth. Later, fiscal and, less so, monetary policy turned supportive of more domestic-demand and especially consumption-driven economic growth. Finally, global commodity prices and Brazil’s terms of trade began to improve on the back of accelerating global growth and, especially, rapidly growing Chinese demand for primary products, allowing further expansion in terms of final consumption.
From a supply-side perspective, the consolidation of economic stability under President Lula (2003-2010) enabled the wide-ranging structural reforms introduced under President Cardoso (1995-2002) to finally come to fruition. By granting the central bank operational autonomy and tightening fiscal policy, the Lula government managed to regain confidence. Brazil’s growth rate almost doubled in the 2000s compared with the 1980s and 1990s, (chart).
Brazil benefited considerably from a positive shock to its balance of payments, namely rising commodity prices and a surge in capital inflows. In the past few years, the resulting relaxation of the balance-of-payments constraint allowed economic growth to be heavily driven by domestic consumption. In other words, rising export prices allowed Brazil a far more significant increase in domestic consumption than would otherwise have been the case. Domestic consumption itself was supported by rising social transfers and the greater availability of domestic credit due to various reforms (e.g. credito consignado, bankruptcy code) and the decline in domestic interest rates in the wake of economic stabilisation. On balance, fiscal policy has been more supportive of consumption rather than investment, PAC 1 and 2 (Programa de Aceleração do Crescimento) notwithstanding.
To the extent that Brazil has relied on rising commodity prices and capital inflows to finance its consumption-led growth, it has become more sensitive, if not systemically vulnerable, to future negative shocks. Such a shock would not result in the return of longer-lasting financial instability, for official FX reserves are very large, the public debt position is generally fair and the banking sector (as a whole) is solid. In order for consumption-driven growth to continue, however, the terms of trade would have to continue to improve.
Brazil is running a trade surplus, but its current account is registering a deficit in the order of 2-3% of GDP, due to deficits in the services and income balance. The current account deficit is being financed largely by foreign equity investment (incl. FDI). It is worth keeping in mind, however, that without the improvement in the terms of trade, Brazil would be running a massive trade deficit (all other things being equal). A shock to either the current (commodities) or capital (portfolio) flows would therefore force a precipitous slowdown in domestic consumption on Brazil. Brazil’s sensitivity to a combined current and capital account shock has also increased due its increased reliance on commodity exports and the large stock of relatively liquid foreign portfolio investment – even though the latter is largely denominated in local currency (chart).
The point is this: unless we are in the midst of a commodity super-cycle, Brazil will not be able to rely on improving terms of trade (and rising commodity exports) forever. Instead, Brazil needs to shift to more investment-oriented growth. It can do this by changing the mix of consumption/transfers and investment in total government expenditure. Or it can reduce current expenditure, while maintaining investment, and thus engineer a decline in interest rates, which in turn would stimulate greater private investment.
The government is trying to do this, albeit too timidly. It predicts that investment will rise to 20% of GDP in 2012. Even if this is achieved, this would still be very low by emerging economy standards. A low savings rate remains the most important factor holding back growth and forcing the economy to rely on external savings. The household savings rate amounts to 5% of GDP and the corporate-sector savings rate is 10% of GDP. Importantly, the government savings rate has not changed much in spite of rising revenues over the past few years. This is a concern not least because over the medium term demographic trends will put increasing pressure on public finances by way of rising social-security deficits.
A major cause of Brazil’s low household savings rate is the existence of a pay-as-you-go pension system which provides individuals and families with little incentive to save (cf. China). Large-scale reform will take time given accrued pension rights. However, de-linking social-security (and pension) benefits from the minimum wage and limiting the nominal increase in benefits to below the rate of nominal GDP growth could help raise the savings rate – or should help contain the projected rise in transfers – over the medium term. As long as productivity gains are fully passed on to pensioners it will be difficult to raise the household savings rate. A recent study demonstrates that, contrary to common belief, it was social transfers rather than government consumption that accounted for almost all the increase in government expenditure over the past decade.
Incidentally, a more decisive policy shift would help address, albeit only over the medium term, the high level of interest rates and, possibly, currency overvaluation to the extent that the latter is related to high domestic interest rates. Raising savings, especially government savings, would help lower interest rates, while increased investment should help raise productivity, thus making it easier for industry to live with a strong exchange rate. Whichever way one looks at it, that is, in terms of long-term growth or short-term concerns about currency valuation and de-industrialisation, Brazil needs to consume less and invest more. If it fails to do so, it will struggle to generate real GDP growth of more than 3.5-4.0% over the medium-term.
Author: Markus Jaeger +1 212 250 6971
© Copyright 2013. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite “Deutsche Bank Research”.
The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.
In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product.