Itaú BBA - What is the diagnosis for Brazil?, by Ilan Goldfajn

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What is the diagnosis for Brazil?, by Ilan Goldfajn

July 13, 2015

It has become clear that it is not feasible to maintain such inefficient cost structures in a world that is very different.

The first half of the year has ended, and there is no sign of stabilization. Everything points to continuing recession in Brazil. This will be the fifth year of a slowdown that seems endless. It is clear that something serious is happening in the economy, with important consequences for other areas, including the political realm, which is embroiled in its own crisis. For some it became clear that “the emperor has no clothes.” For others, what happened is that “the tide went out and we discovered who’d been swimming naked.” Nudity metaphors aside, we ask ourselves, what is happening to the economy? Without an accurate diagnosis, it will be difficult to move forward.

The view that the current recession in Brazil is only a consequence of the austerity policies recently implemented fails to pass the test of common sense. Growth has consistently slowed for several years, and the economy has been destroying formal jobs for more than a year and a half. As nothing in the present can have negatively affected the past - especially because the adjustment policies were not expected, at least not from this government – one should not blame only the adjustments for the recession.

In order to arrive at the correct diagnosis, we need to consider the facts. The first is that there has been no lack of spending or demand in the Brazilian economy. Despite all the government’s stimuli (until last year), the economy stubbornly decelerated. And the stimuli were numerous: public credit expansion, rapid government spending, artificially low regulated prices and all kinds of deficit. Policies were quite expansionary, breaching at times the limits of discipline. A loss of credibility ensued, and now it is difficult to regain.

And the stimuli did not work! The economy decelerated from an average growth rate of 4.5% in the golden years to a recession of at least -2% this year. In hindsight, this result should not be surprising, as lack of spending has never been a problem in Brazil, which has one of the lowest savings rates in the world. Looking ahead, no attempt to further stimulate demand, however tempting it may seem, will be successful. Repeating the mistake will not change the outcome. 

The second fact is that the change in the global scenario was indeed a significant influence. Looking at the rest of Latin America, the slowdown is widespread. Countries as different as Chile and Venezuela are posting notable growth deceleration. Also, the slowdown in China and the major decline in commodity prices have caused general damage. These global factors cannot be ignored in the current diagnosis.

But not all declines are equal. Venezuela and Argentina are suffering the most. Brazil comes next. It is always tempting to blame the rest of the world for our problems. Unfortunately, this would be a mistake. The vulnerability to the end cycle depends on domestic factors, such as the policy reaction. 

The diagnosis that the global scenario is solely responsible for the deceleration in Brazil led to the wrong policy reaction. Today, it is clear that stimulating consumption has magnified the impact of the crisis, instead of buffering it. The error proved costly. It is crucial to avoid repeating the same mistake again. 

Another misdiagnosis lays the blame on recent policy mistakes (over the last four years) to explain all the problems. This is only a partial truth, which leads only to a partially correct diagnosis.

Let me explain. The economy is undergoing very significant adjustments. The fiscal adjustment is the most important, but there are several other big adjustments under way, such as adjusting previously repressed regulated prices, letting the currency freely float to correct the deficit in the balance of payments, adjusting the so-called quasi fiscal imbalances (reducing public credit growth, limiting other programs) and bringing inflation back to the center of the target. All these adjustments are necessary steps in the right direction, crucial for the future recovery.

However, adopting these necessary steps may not be sufficient. The implementation of adjustments helps to repair past imbalances, but it does not automatically lead to higher growth. Adjustments are not reforms, the latter understood to be measures that would increase productivity and lead to sustainable growth in Brazil.

The diagnosis that I prefer is that high production costs in Brazil impair the economy’s ability to grow (supply-side bottlenecks). Costs in Brazil are high in many dimensions: a lack of adequate infrastructure; regulatory uncertainties; a heavy, uncertain tax burden that result from growing public spending; a closed and inefficient economy; low education standards; and wage growth that exceeds productivity, which increases unit labor costs.

These problems became evident after the global favorable cycle ended, and they were exacerbated by the stimulus policies of recent years, in the midst of what was known at the time as the “new macroeconomic matrix.”

Today, it has become clear that it is not feasible to maintain such inefficient cost structures in a world that is very different. This diagnosis, pointing to supply-side problems, is not new. But the way out, for those who previously identified it, was to “escape forward." This meant to embark on a series of reforms that would increase productivity.

Reforms, however, failed to materialize, and the problem persisted. Now, the economy is naturally trying to find its way out, forcing cost savings. Usually supply-side problems lead simultaneously to both price increases and reduced sales. Both work in the same direction. Today’s recession in Brazil encourages a search for efficiency and cost reduction as a means of survival. At the same time, higher inflation this year is the acceptable way of reducing real income in economies that do not accept nominal losses. 

The Brazilian economy needs a good diet (i.e., cost reduction). Without it, the economy will fail to grow sustainably. Everything suggests that, in the absence of structural reforms, this cost-reduction process will be long and painful. Or shorter but sharper.


Ilan Goldfajn, Chief Economist and Partner of Itaú Unibanco.


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