Itaú BBA - The ’Impossible’ Brazilian Trinity, by Ilan Goldfajn

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The ’Impossible’ Brazilian Trinity, by Ilan Goldfajn

February 3, 2015

The year began with hefty challenges for the Brazilian economy.

The year began with hefty challenges for the Brazilian economy. We would say that we are dealing with a perfect storm — but in Brazil that is potentially good, if only the storm filled up our reservoirs! Let’s just say that many risks to the Brazilian economy are now materializing. The economy will face water shortages, power rationing, a worse legacy in public and balance-of-payment accounts, the fallout from corruption investigations and political difficulties. It is no coincidence that growth estimates for the first quarter and for the full year are already in negative territory. With a weaker starting point, what are the changes in the outlook for 2015? 

Certainly, it is now more difficult to simultaneously implement the many needed adjustments in the economy. The list of adjustments is long: restoring the credibility of fiscal policy, reaching the center of the inflation target range, realigning regulated prices, reducing the current account deficit, eliminating other distortions and building confidence to resume growth.

Such adjustments are costly in the short term. Restoring fiscal credibility requires an increase in public savings, i.e., cuts in spending or tax increases; reestablishing realistic regulated prices will likely push inflation above the upper bound of the target range; and improving the trade balance requires a weaker exchange rate, which will affect inflation. At the same time, driving inflation back to the center of the target range next year would require higher interest rates.

All of this must (and can) be done. After all, the short-term costs are more than compensated for by future gains, which could come from restored credibility, increased investments and growth recovery.

But economic adjustments require a firm conviction and political support, a resource that becomes scarcer as the economy deteriorates.

I dare say that the Brazilian economy faces an impossible trinity this year. (Or if not impossible, then at the very least quite challenging.) This “impossible” trinity includes: i) achieving the fiscal target in full this year; ii) tightening monetary policy enough to reach the center of the inflation target range next year; and iii) preserving political support for economic measures. Our expectation is that one of these three will likely not be fulfilled.

So-called impossible trinities have a long history in economics. They are combinations of policies that economists doubt could be implemented at the same time. A classic example is the idea that nations cannot simultaneously control interest rates, have a fixed exchange rate and allow capital to move freely. When the exchange rate is fixed and capital is fully mobile, interest rates are ultimately defined by international conditions.

The “impossible” trinity for the Brazilian economy is the result of worse initial conditions. The primary budget deficit of 0.6% of GDP last year was only disclosed long after the government announced its commitment to a primary surplus target of 1.2% in 2015. The already-tough fiscal adjustment of 1% of GDP now needs to be 1.8% for the same target. And not meeting this target is not an easy option. With public debt at 63.4% of GDP and the nominal deficit at 6.7% (one of the largest in the world), Brazil must restore fiscal credibility and avoid losing its investment grade status to prevent a sharp increase in funding costs.

While the needed adjustment is tougher than anticipated, the economy is more fragile than envisaged. The economy has weakened further in December. With still-low levels of business confidence, consumer confidence at an all-time low and high industrial inventories, there are no expectations of recovery in the first quarter.

There are, also, more headwinds to slow down growth. In the oil industry, investment cuts and a reduction in forecasted production growth will hurt economic activity. Legal difficulties involving some construction companies will impact the execution pace of their infrastructure projects in the short term.

All in all, GDP is forecasted to decline at least 0.5% this year.

There are also risks of water and electricity rationing going forward. Low rainfall levels may lead to additional mandatory cuts in water consumption in large cities in the Southeast. Power rationing is also likely. A combined rationing of electricity and water would have an additional effect on GDP growth of at least -0.5 percentage points.

In a context of weak activity, monetary policy becomes more challenging. The commitment to do whatever it takes to reach the center of the inflation target range (4.5%) next year is desirable, but it may require an even larger increase in interest rates this year, weakening activity even further.

Economic weakness does not necessary translate into lower inflation, at least when it arises from supply shocks and increases in regulated prices. The change in regulated prices will likely top 10% this year, pushing headline inflation above the upper limit of the target range. We naturally expect disinflation in service prices, but maybe not in the desired magnitude.

Under worse initial conditions, the challenge is to preserve political support for the tougher economic adjustments. Supporting adjustments that accelerate future recovery makes total sense. But I would not be surprised if, as time goes by, some adjustments are postponed, such as reaching the center of the inflation target range next year. Then we would no longer have an “impossible” trinity.


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

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