Itaú BBA - How is Brazil getting out of this one?, by Ilan Goldfajn

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How is Brazil getting out of this one?, by Ilan Goldfajn

June 5, 2015

The implementation of the adjustments will remove a major obstacle, but will not be enough on its own to restore confidence.

Lately, this is the question that I have been hearing most. There are concerns about the recession and political fragmentation, not to mention the impact of the ongoing corruption investigations. It is a lot to take in. Many fear that the current state of affairs will persist for some time. Some hope that the worst is behind us and an economic recovery is on the way. The majority of economists forecast some improvement in the future (albeit a quite gradual one, in up to one year). Thinking rationally, what are the potential drivers of this improvement?

The answer is not easy. People tend to think that current forces will continue indefinitely. Thinking about a potential change is difficult, as it requires defining how that change will take place.This is a tough task in Brazil nowadays.

However, economic recessions do not last forever. Most end in two or three quarters. Recessions that last for years typically come after financial crises, reflecting a long deleveraging process. Deleveraging is a process that takes a while to materialize and is the antithesis of a default, as in deleveraging debts decrease slowly until they reach a balance. The book This Time Is Different: Eight Centuries of Financial Folly, by Kenneth Rogoff and Carmen Reinhart, shows this empirical regularity. It correctly predicted the prolonged recession that followed the international financial crisis of 2008. So far, a full recovery in global economic activity is still just a promise.

If prolonged recessions are exceptions, long periods of low growth are not. There are many historical examples of such slow periods around the world, such as Japan in recent decades. However, this is not a “privilege” of rich economies. Mexico’s economy expanded by only about 2% per year over the past few decades, and not until recently did the government implement reforms that will enable faster growth going forward.

Low growth rates are more common than most people think. Only a few developing economies manage to reach the income levels of rich economies. Most countries are stuck in the so-called “medium income trap”. Although several are successful in upgrading out of very-low per-capita income, they are unable to make further progress. The difficulty is in transforming a “perspiration-based model” into an “inspiration-based model”. The first model generates growth through its ability to accumulate factors (capital and labor), by putting people to work and investing more. The second model relies on the capacity to do more with the same available resources, by boosting productivity; it is the search for efficiency through improvements in education, management and innovation. Brazil still has to sweat (invest more), but growth will increasingly depend on inspiration (productivity, efficiency).

Thus, it will be easier for Brazil to get out of the current recession than to achieve rapid growth afterwards. But neither of these feats will be easy.

Last Friday, Brazil’s census bureau, the IBGE, released the GDP results for the first quarter of 2015, showing a 0.2% decline from the previous quarter (or an annualized drop of approximately 1%). There is now no doubt that the economy is going through a recession. The outlook for the second quarter is even worse, as we are forecasting a GDP decline of 1% (or an annualized drop of 4%). Will that be the bottom?

So far, there are no signs of stabilization; Brazil is in free-fall. At its current pace, growth will still be negative in the third quarter. However, the prolonged recession also provides a lower basis for comparison: the economy just needs to stop shrinking for the situation to improve.

In order to assess the magnitude of the recession, it is important to get the diagnosis right. The current weakness is the consequence of past actions. The attempt to artificially prolong the economic performance of the previous cycle, in a very different global context, has not only failed but also introduced macroeconomic uncertainties that have undermined confidence, reducing investment and, growth. Ultimately, this insistent approach has led to a lack of macroeconomic discipline, and now painful adjustments are required to avert a crisis (i.e., a crisis here is the loss of investment grade status, capital outflows, an exchange-rate crisis, economic depression).

Five adjustments are currently taking place: fiscal (primary budget balance target), quasi-fiscal (public resources beyond the primary balance), regulated prices correction, balance-of-payments (back to floating exchange rate) and inflation-targeting (aiming for the center of the target range). If implemented, these adjustments will likely prevent a crisis, which is essential. Just the possibility of a crisis is a big hurdle to restoring confidence.

Restoring confidence is one of the few paths toward ending the recession. The retreat in investment must be reversed. Other demand components are more difficult to reverse. Consumer spending is being hurt by the decline in purchasing power due to higher inflation – on the back of a correction in regulated prices – and a weak labor market, which is likely to continue losing steam for some time. The government, which is committed to the adjustment, needs to spend less, not more. Finally, net exports are improving, but there are not large enough to pull up the large and relatively closed Brazilian economy.

Confidence in the economy also depends on the political situation. It is not clear which path the government wishes to take. The fragmentation of political forces is behind this uncertainty. Low approval ratings fuel doubts whether the government will again change the direction of its policies.

In a nutshell, Brazil’s first step should be to get out of recession. A reversal of the decline in confidence is vital for that purpose. The implementation of the adjustments will remove a major obstacle, but will not be enough on its own to restore confidence. Politics keep the economy clouded by uncertainty. The second step will be returning to a sustainable growth track. Doing so will require political cohesion, to guide Brazil onto the right path and put the focus on increasing productivity and efficiency. Seen from today, this second goal seems much more difficult than getting out of the current recession.


Ilan Goldfajn, Chief Economist and Partner of Itaú Unibanco.


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