brazil economy down

Call: Brazil is threatened with inflation because of its budget deficit
Short-term trajectory: NEGATIVE
Long-term trajectory: NEGATIVE

Analysis: External conditions put pressure on Brazil (15%)
According to the World Bank, 13% of Brazil’s GDP is comprised of exports.1 Of the exports, 32.6% is comprised of commodities—iron, soybeans, crude petroleum, and raw sugar.2 Most of the top exports were to fuel China’s massive growth. However, since China’s economy has slowed, so has Brazil’s. While China only makes up a small percentage of Brazil’s GDP, China’s influence on the world economy is noteworthy because many nations that trade with Brazil are likely to be tied to China. As the world becomes more intertwined, so does the systemic risk.

brazil export countries

brazil exports commodities

Analysis: Brazil’s budget and interest rates are unlikely to align (20%)
Brazil’s growth under President Dilma Rousseff has moved negatively to a point where there is a projected negative growth of 3.5% for 2016 by the IMF.3

Inflation rate has shot up from 7.14% in January 2015 to 10.67% in December 2015.4 The target inflation rate is 4.5% and the upper limit was supposed to be 6.5%. Current interest rate hovers around 14.25%, which makes borrowing money to service government debt very expensive.

While the simple solution is to cut government spending, unfortunately, roughly 90% of government spending is protected from cuts by 1988 constitutional rights. To exacerbate the situation, because of Brazil’s reliance on commodity exports, there were many job losses in recent years; unemployment rate is at 8.9% and increasing. Furthermore, men could retire at age 54 and women could retire at age 52. High pension payments, high unemployment benefits, and early retirement as constitutional rights coupled with a slow economy is a recipe for financial trouble.5

Analysis: Brazil won’t fix infrastructure and red tape (15%)
To make things worse, Brazil has poor infrastructure—ranked 120th out of 144 countries. The lack of government investment (2.47% of GDP) and excessive red tape make it difficult to attract foreign investors. Without railways, airports, cargo terminals, or highways to move goods and people, raw and processed goods would sit in silos until infrastructure is set up.6

Analysis: President Dilma Rousseff will likely survive impeachment (20%)
President Dilma Rousseff is undergoing impeachment. She has an approval rating less than 10%. Rousseff is also tied to the state-owned Petrobras oil scandal and 2016’s Olympic corruption, which reduce faith in political leadership.7 Who would want to take over this toxic position at this time? Who could rally a majority with over 30 political parties?

Brazil needs a strong leader to make fiscal budget cuts to pull the economy out of its slump. It got away from doing so in the past because the world desperately needed commodities, but that boom has ended.

Analysis: Brazil is threatened with inflation because of its budget deficit (20%)
Brazil’s investment-grade credit was cut to junk bond status by S&P.8 With political instability and fiscal deficit, it’s very possible for the government to issue debt that no one wants to buy and for the Central Bank to be pressured to monetize the debt (prints money to buy debt), which causes inflation. The government would have to issue more unwanted debt to pay for new state expenditures and constitutional pensions, mind you, at a higher price because of inflation, which would pressure the Central Bank to again monetize the unwanted debt. If unchecked, this could spiral into hyperinflation (γM + γV = γP + γY with γM as the growth of the money supply, γV as the growth of velocity, γP as the growth of price (inflation), and γY as the growth of real GDP).

hyperinflation

A clear signpost of the Central Bank losing autonomy is when it starts buying debt from the Treasury. Even though the Central Bank is supposed to be independent of the government, political pressure can be very cajoling.

The upside to Brazil’s government debt is that most of the borrowing is in the local currency. Therefore, it would be difficult for the country to default on itself since it could, technically, print more money and pay itself off. Unfortunately, that would lead to more than just inflation; it would lower the confidence of its citizens and foreign investors.

Analysis: The Zika virus will scare away investment and hurt the distant future population of Brazil (unknown)
According to the CDC, “The most common symptoms of Zika are fever, rash, joint pain, or conjunctivitis (red eyes). Other common symptoms include muscle pain and headache. The incubation period (the time from exposure to symptoms) for Zika virus disease is not known, but is likely to be a few days to a week.”

However, what is more scary is the effect that it has on pregnant women. Infants (embryonic) affected would get microcephaly, which would pose birth defects. Assuming that all Brazilians hold off on childrearing until the mosquito or virus is eliminated, then there would be a gap in working professionals for the distant future.

Counterfactual: Brazil fixes fiscal policies (10%)
In order for Brazil to fix this mess, it first needs to rally a strong political leader soon. He or she would need to amend the massive welfare spending, which needs congressional approval. This would slow the bloating budget deficit. Unfortunately, the next presidential election is in 2018. Since Rousseff is likely to survive impeachment, I do not speculate much change to happen soon.

Furthermore, since the Brazilian real has depreciated to an all-time low, imports are going to be very expensive. Consumer confidence needs to be reinvigorated with government projects that would create jobs. Brazil should start with infrastructure and schools, especially since the population is unskilled and relies on exporting commodities.

All of this starts with a charismatic leader. It’s not impossible, but it will be extremely difficult for Rousseff to be that person since her reputation is tainted in so many areas.

Why client(s) should care
The risks identified demonstrates that the country has not diversified its investments. It relies heavily on commodity exports and has very high expenses. The citizens are angry. In 2015 alone, there were five major protests with as many as 3 million Brazilians marching in one day. However, there are investment opportunities. As one example, one could buy put options against the currency. Furthermore, there are opportunities in infrastructure projects just as long as the currency is stable. The worst nightmare would to be stuck with a currency that is devaluing without end.

References

  1. “Exports of Goods and Services,” World Bank. http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS. Accessed 2016-01-17.
  2. “Brazil,” The Observatory of Economic Complexity. http://atlas.media.mit.edu/en/profile/country/bra/. Accessed 2016-01-17.
  3. “Brazil’s bust is worse than we thought,” CNN Money. http://money.cnn.com/2016/01/19/news/economy/imf-brazil-recession-worsens/index.html. Accessed 2016-01-19.
  4. “Brazil Inflation Rate,” Trading Economics. http://www.tradingeconomics.com/brazil/inflation-cpi. Accessed 2016-01-16.
  5. “Brazilian waxing and waning,” The Economist. http://www.economist.com/blogs/graphicdetail/2015/12/economic-backgrounder. Accessed 2016-01-07.
  6. “Delays ahead,” The Economist. http://www.economist.com/news/americas/21653949-government-getting-serious-about-attracting-private-investment-roads-railways-and-airports. Accessed 2016-01-15.
  7. “Rio corruption scandal raises red flag on Olympic plans,” USA Today. http://www.usatoday.com/story/sports/olympics/2015/03/22/rio-de-janeiro-corruption-scandal-olympic-preparations/25184271/. Accessed 2016-01-15.
  8. “S&P Cuts Brazil’s Debt Rating to Junk,” WSJ. http://www.wsj.com/articles/s-p-drops-brazil-debt-rating-one-notch-to-junk-1441838102. Accessed 2016-01-18.
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