Strategy Bulletin  

12/10/2015

HOW WORRIED SHOULD WE BE ABOUT BRAZIL?

We have been particularly concerned about the Brazilian economy for some time now, but the pace of economic deterioration has accelerated over the past few months. Given the fragility of the global environment, the potential risks and implications of such a slowdown cannot be dismissed.

Indeed, markets seem to be pricing in mounting odds of defaults in Brazil, with a collapsing currency and widening credit default swaps spreads.

At first glance, it would appear that the oil price decline since the summer of 2014 is the reason behind the Brazilian economic slowdown, since it was concomitant with a sharp deterioration of both the country’s current account and budget deficit. However, Brazil’s fundamentals had already been deteriorating for the better part of 10 years – even as commodity prices were booming. In addition, real household consumption expenditures and investment have been trending down since 2009. Brazilian issues thus go well beyond falling oil prices – the latter factor having served not to create them but to bring them to light.

WHAT THEN IS THE UNDERLYING CAUSE FOR BRAZIL’S WOES AND, MOST IMPORTANTLY, HOW WORRIED SHOULD WE BE GOING FORWARD?
We currently see three main risks for Brazil, the most important being political instability. Sustainable economic improvement in Brazil will not be possible without a stronger political landscape. To understand this, remember that Brazil has been a welfare state since the establishment of the social contract in the 1988 Federal Constitution. For instance, 90% of the government budget cannot be reduced without changing laws, and many variables, such as the minimum wage, are linked to inflation. As a consequence, the budget deficit keeps deteriorating, and the country desperately needs a strong government to implement the reforms required to put the country back on a healthier fiscal path. Unfortunately, President Dilma Rousseff is extremely unpopular, not only among the population, as evidenced by her sharp fall in opinion polls, but also within her own party, making it close to impossible for her to drive any substantial reform. While there have been talks of impeachment following her potential involvement in the Petrobras scandal, such a development would also generate instability and uncertainty, particularly since no political leader stands out today as a strong and credible alternative. The second risk for Brazil, although not our base case scenario, would be an acceleration of the Chinese cyclical slowdown, China being the country’s main trading partner.

The final key risk facing Brazil is fiscal. In terms of private sector debt, Brazil still compares relatively well to the rest of the emerging world. But the pace at which this debt is increasing could become worrisome, and we would not be surprised to see rising defaults in months to come. In addition, mounting private debt will inevitably weigh on consumption, savings, investment and growth. That being said, most of the private debt is now in public hands, like the Bank of Brazil.

This brings us to the second aspect of fiscal risk: adverse sovereign debt dynamics. Indeed, currency depreciation has brought about high inflation levels (currently at 9.5%), forcing the central bank to raise its policy rate (currently at 14.25%), weighing on already negative levels of growth which, in turn, puts further downward pressure on the currency.

This type of vicious spiral is obviously very difficult to break out of. As a result, real interest rates are well above growth levels, and total public debt can only rise. Moreover, the official public debt figure does not include another source of risk: substantial contingent liabilities (e.g. potential recapitalization needs of large private firms such as Petrobras, or pension deficits).

Somewhat reassuring, however, is the fact that the vast majority of Brazil’s public debt is denominated in local currency, rather than in US dollar terms. External default risk is thus low. And with the country ultimately standing to benefit from a weakening currency, no significant rebound of the Brazilian real is to be expected in the near future, quite the contrary – even though the currency does now look fairly valued relative to the deteriorated economic fundamentals.

Turning to the real economy, some key economic indicators are likely to worsen further, from already depressed levels. The unemployment rate has moved up sharply over the last few months, being the adjustment factor in an economy where many variables (including the minimum wage) are linked to inflation. Monetary growth has contracted and nonperforming loans rates, while still broadly stable, could definitely pick-up going forward.

ALL TOLD, THE MAIN TAKEAWAYS ON BRAZIL ARE THE FOLLOWING:
1) The country is in a difficult structural economic situation, which will not be resolved by a mere stabilisation of commodity prices.

2) Brazil’s major issue is political. Unfortunately, Dilma Rousseff does not have the necessary support to implement the reforms necessary to escape a dire fiscal path.

3) On the fiscal front, rising private debt will weigh on growth and public debt should keep increasing. That being said, a sovereign default remains very unlikely given that most of the debt is local currencydenominated.

4) As a result, Brazil should remain in recession for some time, with a weak, or even weaker, currency – which will likely be part of the solution.

5) Our base case global economic scenario is not significantly impacted by the Brazilian situation, particularly if we are correct in expecting a stabilisation of the US dollar/China/commodities complex, which is currently far more important to the world economy.

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