Itaú BBA - From Misadjustment to Adjustment. Now What?, by Ilan Goldfajn

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From Misadjustment to Adjustment. Now What?, by Ilan Goldfajn

May 14, 2015

While adjustments are saving Brazil from falling off the cliff, the misadjustments of the past still weigh on the economy

A little over two months ago, I sensed some improvement in investor sentiment toward Brazil. Not really renewed confidence in the economic recovery or hopes of new reforms, only that some people started to believe that Brazil would manage to avert a crisis: the economic adjustments were for good, surprisingly reversing policies adopted as recent as last year. This was enough for the stock market to react and rise about 20%, for the exchange rate to strengthen to around 2.90 reais per U.S. dollar from 3.30, and for Brazilian risk spreads (measured by 5-year CDS contracts) to fall to close to 220 bps from almost 310 bps. Is this renewed optimism justifiable? Can we expect further gains in the market?

Part of the improvement relates to the implementation of five broad adjustments: i) fiscal, ii) quasi-fiscal, iii) external accounts, iv) regulated prices and v) inflation targeting. Although crucial, it is important to emphasize that these adjustments are only fixes for macroeconomic problems created in the recent past. They are not reforms, which we understand as medium- and long-term measures that improve productivity and raise sustainable growth.

We discuss below the evolution of these five economic adjustments so far:

  1. Fiscal – This is the most important adjustment, as it affects debt dynamics and the risk of a sovereign rating downgrade, which could trigger a crisis. In the first three months of the year, there was a restraint on spending — a big restraint, in fact. Federal expenditures fell 2.0% in real terms in the first quarter. The reversal of past spending splurges is vital. We expect the fiscal adjustment to lead to a drop of 6.0% in real terms in 2015 (vs. increases of 5.2% in 2014, 6.4% in 2013, 4.8% in 2012 and 3.5% in 2011). However, there are many challenges ahead, including recognizing hidden past expenditures. But the main current fiscal challenge is the decline in revenues, which is happening despite the tax rate hikes and elimination of subsidies, due to weak economic activity. Ultimately, these challenges will prevent the government from reaching its primary fiscal target in full (1.2% of GDP). We believe the effort will suffice to reach a large part of its goal (0.8% of GDP) and avoid a downgrade to speculative grade. The fiscal adjustment must continue and deepen next year.

  2. Quasi-fiscal – This adjustment refers to stimuli and subsidies outside the direct debate about the primary surplus target. Funds seem to have thinned everywhere. Disbursements by the national development bank BNDES are falling considerably from last year. The same goes for other entities, including the student loan fund FIES. Broadly speaking, loan conditions in the public sector became more restrictive and interest rates climbed. The long-term interest rate (TJLP, applied to BNDES loans) is rising, as are interest rates that get even more government subsidy, such as those applied to the investment-support program PSI. Caixa Econômica Federal (CEF) is now more restrictive in its mortgage loans granted under the low-income housing program, Minha Casa Minha Vida. It looks like money is short everywhere.

  3. External accounts – It is necessary to reduce the current account deficit, which is currently around 4.4% (under the new methodology). The most effective way to do this is to allow the exchange rate to float, and to depreciate if needed. Lower commodity prices and less external financing should contribute to weaken the currency and help the current account adjustment (by making imports more expensive and exports cheaper). The government’s decision to interrupt foreign exchange intervention goes in this direction. But the adjustment in the current account will be slow, in the absence of a sudden stop – certainly slower than market timing.

  4. Regulated prices – The trouble with suppressing prices is that they must decompress in the future. Regulated prices rose just 1.5% in 2013. This year, society will pay for it, with 14% inflation in regulated prices. Average electricity tariffs will climb around 50%. The silver lining is that this adjustment helps get rid of price distortions. I do not expect prices to be repressed again. The recent mistake is still fresh in everyone’s minds. In fact, it was surprising that price controls returned in a country plagued by price-freeze failures in the past.

  5. Inflation targeting – The central bank’s current task is to bring inflation back to the center of its target range after years of above-target readings. This won´t happen this year, due to regulated price inflation and depreciation, which will drive inflation to around 8.5%. Convergence is postponed to the future. We expect the Selic benchmark interest rate to reach at least 13.5% this year. Inflation expectations for 2016 are still around 5.5%.

In sum, there is indeed progress in terms of the adjustments, justifying the recent improved market mood. As adjustments go on, the more adverse scenario (a crisis) is becoming less likely and markets can be expected to improve, particularly if international conditions allow it. However, there are limits to what simple adjustments (fixes) can achieve in the absence of structural measures.

While adjustments are saving Brazil from falling off the cliff, the misadjustments of the past still weigh on the economy. The recession is real, and unemployment is set to rise for some time to come. Once we had the illusion that pro-cyclical adjustments were a thing of the past. We were wrong. Brazil continues to still misadjust right up to the edge of a crisis, and then go through adjustments under adverse conditions. Political support will be needed during the adjustment period, which is only beginning. Markets always try to anticipate the future. They have been up these recent weeks. They will be the first to react in case of any failure.


Ilan Goldfajn is the Chief Economist and a partner of Itaú Unibanco.

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