Itaú BBA - China: Impact of a New Growth Model on Brazil

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China: Impact of a New Growth Model on Brazil

October 31, 2014

Markets fear a global slowdown.

Markets fear a global slowdown. Recent troubles in Europe and the theory of secular stagnation in the U.S. are some of the uncertainties surrounding a sustainable recovery in growth. For Brazil, China’s performance in the future will be paramount. 

We do not foresee a hard landing in China, but deceleration is now a reality. 

China has been one of the growth engines of the global economy, with a growth model driven by exports and investments, which favored commodity exporters like Brazil.

The Chinese model is being transformed, and the local economy is losing steam. Looking ahead, we expect Chinese growth to be lower than in the previous decade and driven by increases in household spending. This shift in demand patterns will have a negative impact on the prices of international commodities, including those exported by Brazil.

The Chinese contribution to external demand for Brazilian products will be smaller. However, the outlook for a weaker real and a stronger renminbi implies a reduction of wage differentials, which could be favorable to Brazilian manufacturers. Therefore, this new growth model in China creates growth opportunities for other segments of the Brazilian economy, especially if Brazil resumes productivity gains, narrowing the current cost differential between the two countries.

The evolution of the Chinese economy and its impact on Brazil since 2000

The Chinese economy expanded at a brisk annual rate of 10.7% between 2001 and 2008, boosted by exports and investments, while domestic consumption expanded more slowly than GDP. At such a dizzying speed, China’s weight in the global economy soared to 11.6% in 2008 from 7.0% in 2000.

This growth fueled a sharp increase in commodity demand, increasing international commodity prices. For instance, domestic consumption of soybeans in China jumped 116%, while steel production advanced 298% between 2000 and 2008. The stimuli to global demand pushed up international commodity prices, which climbed 227% in the period (according to the Itaú Commodity Index, adjusted for U.S. inflation – see Chart 1).

Brazil and other commodity exporters benefited from this move. Starting in 2002, Brazilian exports advanced substantially, ensuring surpluses in the trade balance. In six years, Brazil’s trade surplus widened to USD 40 billion from USD 2 billion. This expansion was largely driven by China’s impact on Brazilian export prices and volumes, with iron ore (combined with coal for steel production) and soybeans standing out.

Despite such significant growth in the period, the Chinese model seemed unbalanced and unsustainable from numerous perspectives. Investments, already topping 50% of GDP, could not keep growing faster than the rest of the economy. China’s size compared with the rest of the world would make it difficult to sustain the export-led growth. Moreover, China’s industrial sector as share in GDP was already hefty, while outstanding loans as a share of GDP kept expanding more and more.

The response to the 2008 crisis deepened those imbalances. Facing a slide in exports, the government launched a fiscal incentive package focused on infrastructure and real estate investments. The program widened the gap between investment and consumption growth rates (Chart 2) and increased leverage in the economy, as financing to the non-financial sector (including from shadow banking) advanced to 172% of GDP in 2010 from 130% in 2008.

Rising investments in infrastructure and real estate boosted some commodity prices (such as iron ore, which is used in production of steel, an input for construction) and offset some of the price declines seen in 2008-09. In 2011, metal prices in particular were higher than their pre-crisis levels. Brazil benefited once again, as its exports to China advanced nearly 30% between 2008 and 2009, and China surpassed the U.S. and Argentina as the main destination for Brazilian exports (Chart 3). China now accounts for nearly 20% of Brazilian exports and is the main destination for Brazilian commodities. In 2013, the Chinese bought 49% of iron ore exports and 57% of soybean[1] exports from Brazil.

Given the limitations of a model biased toward investments and exports, the Chinese government gradually came to recognize the need to rebalance the economy, boosting the participation of consumption and the tertiary sector. Speeches by officials and five-year plans came to express the acceptance of lower GDP growth rates, but with a more sustainable profile.

The growth pattern seen between 2011 and 2013 already showed a slight reduction in the imbalances. Average growth, at 8.2%, is lower than in previous years, and its composition is also quite different. While investments expanded somewhat in line with GDP, household spending grew faster, by 9.1%. The share of net exports continued to slide throughout this period, to 2.5% in 2013 from 3.8% in 2010. Both the economic slowdown and the rebalancing process (that is, change in growth composition) help to explain the slower growth of Chinese demand for metals and energy commodities and the ensuing drop in international prices in the period.

Outlook for China and commodities

It is our view that the transition in China’s growth model is set to continue in coming years, with growth rates converging to approximately 6.0% by the end of the decade. The slowdown will be sharper for investments, while household consumption will probably sustain the pace of the previous decade. This process will require an increase in household income as a share of GDP.

Despite the imbalances and difficulties in the rebalancing process, fiscal and external fundamentals in China reduce risks of a hard landing. In the fiscal sphere, the government has assets (state-owned companies) that could be used to reduce public gross debt (55.4% of GDP) or expand the social security network. On the external front, the country boasts a current account surplus and is a net external creditor, thus not much affected by adjustments in funding conditions for emerging markets.

Considering the economic slowdown and rebalancing, we estimated the impacts of this scenario on demand and international prices for metallic and agricultural commodities. Results show that demand for metallic commodities is more related to investments, while demand for agricultural commodities is more tightly related to household income.

Gains in available income in China boost meat consumption, and soybeans are a key protein source used in animal feed.

The outlook for sustained real growth in household income suggests that growth in agricultural commodity demand will remain high in the years ahead. In turn, the slowdown in investments may lead to deceleration in metal demand.

What are the impacts of the new Chinese growth model on the Brazilian economy?

In recent years, Brazil benefited from the export and investment-driven Chinese growth model. The outlook for slower growth and demand-rebalancing in China will likely have negative impacts on some key sectors of the Brazilian economy, but it may also create opportunities for other segments. This section of our report focuses on the potential effects of the rebalancing process in China on the trade balance (export prices and volumes), on investments and on the manufacturing sector in Brazil.

Table 1[2] shows a significant long-term relationship between steel consumption in China and iron ore volumes exported by Brazil: 1% more steel consumed in China translates into a 0.4% increase in the quantity of iron ore exported by Brazil. Steel consumption in the rest of the world is also a statistically significant determinant for Brazil iron ore exports. Hence, we expect the slowdown in investments (sharper than the slowdown in GDP) to have a negative impact on local steel consumption, hurting iron-ore exports from Brazil.

While Chinese growth will probably be less investment-driven, the increase in households’ available income resulting from the rebalancing process is set to continue to boost Brazil’s soybean exports. Table 2 shows a significantly positive long-term correlation between Brazil’s soybean exports and soybean consumption in China, which is not observed when it comes to soybean consumption in the rest of the world. Hence, although the Chinese slowdown in investments has a negative impact on the exported volume of iron ore from Brazil, the country’s soybean shipments are unlikely to suffer as much due to the expected increase in available income among Chinese households.

In addition to affecting exported volumes, the rebalancing in China also affects international commodity prices, trickling down to the value of exports and the exchange rate in Brazil. Higher export prices are favorable to the terms of trade, translating into a larger trade balance and an injection of foreign resources, which tends to trigger currency appreciation. That was the case between 2003 and 2008 and between mid-2009 and 2011. Charts 4 and 5 show the strong positive correlation between international iron-ore and soybean prices and the exchange rate, as price increases for Brazil’s two most important commodity exports create pressure for currency appreciation[3]. In the coming years, lower commodity prices will likely exert some pressure in the opposite direction, toward currency depreciation.

  

Investment growth in Brazil has long been tightly correlated with the commodity cycle (Chart 6) for several reasons. First, higher international commodity prices increase returns on projects that are directly or indirectly associated with the commodity sector, fueling more investments. Second, currency-appreciation moves associated with high commodity prices tend to lower prices of imported capital goods. Third, the improvement in external accounts thanks to gains in the terms of trade reduces the risk premium required by foreign investors, thus reducing capital costs for Brazilian companies. Conversely, the opposite effect holds when commodity prices decline.

According to our estimates, a 10% drop in commodity prices leads to a slide of 1.2% in gross fixed capital formation, all else equal.

In spite of potential negative impacts on the trade balance and capital expenditures, the rebalancing in the Chinese economy presents an opportunity for Brazilian manufacturers. In recent years, wages in the industrial sector have been expanding over 10% per year (in U.S. dollars) in China, narrowing the gap with wages paid in Brazil. Chart 7 shows the ratio between the labor cost per hour in the manufacturing sector in China and Brazil, which went from 15.8% in 2006 to 30.3% in 2013.

The outlook for a weaker real and a stronger renminbi, as well as for sustained wage growth in China, suggests that the wage differential in U.S. dollars will continue to decline in the coming years, creating an opportunity for Brazilian manufacturers to become more competitive abroad. To reinforce this tendency, Brazil must increase its productivity through additional investments in both fixed capital and worker skills and through reforms to reduce the so-called Brazil Cost.

All in all, we expect Brazil to benefit less from Chinese external demand and high international commodity prices than it did in the post-crisis period. Still, China’s new growth model (more driven by the domestic market) creates growth opportunities for other economic sectors in Brazil. Resuming productivity gains is vital to reduce the cost differential between the two nations.

Appendix:

Impact of international commodity prices on the exchange rate


 

Artur Manoel Passos and Julia Gottlieb


[1] Soybean complex: grains, oil and meal.

[2] Models estimated in log form.

[3] Table 1 in the Appendix shows the impact of prices for each of the main commodities exported by Brazil on the exchange rate.

 



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