Itaú BBA - What Surprises Does 2016 Have in Store for Brazil?

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What Surprises Does 2016 Have in Store for Brazil?

January 5, 2016

In Brazil, almost anything could be qualified as a surprise, since no scenario seems plausible

The year 2015 was much worse than expected. For 2016, the prospects are not much better. During my trip to the U.S. in the last week of the year, I was bombarded with questions about the twists and turns of the current economic and political crisis. Back in Brazil, I find that many hope 2016 will be better than expected. It feels like a New Year's resolution. Or perhaps hope really is the last thing to die. Which makes me think about potential surprises for this year. In fact, positive surprises are possible, but so are the more negative ones. In order to assess them, I decided to write down this list of surprises.

In Brazil, almost anything could be qualified as a surprise, since no scenario seems plausible. Three more years of the current situation are hard to imagine. But so are the political and economic changes needed to escape current crisis.  Any scenario would be, in some ways, a surprise – and yet it would not surprise (given that it would probably already have been considered due to the lack of other options).  

Abroad, surprises are divided between positive and negative, and the latter are a cause for concern. The fragility of the domestic situation in Brazil is such that a negative external shock could lead to a deepening of the crisis in Brazil, with unpredictable social consequences. The only certainty is that any future external shock would take the blame for the entire crisis, including the pre-existing situation. A positive shock, by contrast, would provide valuable time for local politics and the economy to stabilize and find a way out of the crisis.  

Which surprises could occur?

U.S. interest rates. If interest rates rise much faster than expected in the U.S., there may be a rapid reversal of capital flows direction.  Outflows from Brazil would weaken the balance of payments, precisely the last fundamental buffer of the Brazilian economy. The government would probably react by selling dollars (via swap or spot markets) to smooth the shock.  But the lack of financing and the depreciation of the Brazilian currency would deepen the recession, further impacting inflation. This would create an even more difficult situation, socially and politically.

Luckily the Fed, despite the recent rate hike, is more concerned with the consolidation of growth in the U.S. than with the return of inflation in the future. Therefore, the implicit interest path in the market pricing tends to be very gradual and benign.

A stronger rate hike path would suggest the Fed was behind the curve, which is the last thing that Brazil needs right now.

The opposite shock is also possible. A disappointment with growth in the U.S. economy (in line with the current and famous "secular stagnation" view) would lead the Fed to be more cautious with interest rate hikes, slowing the pace and perhaps even interrupting the current hiking cycle. The maintenance of U.S. interest rates close to zero (with the postponement of monetary policy normalization) would extend the incentive for investors to hold on to risky assets with higher yields. Brazil would benefit from this situation, with capital remaining in the country, which would help Brazil avoid pressure on the balance of payments and gain valuable extra time to adjust its economy. This favorable surprise does not guarantee that Brazil would be out of the woods, but it would provide the international conditions and the time for domestic politics and the economy to find a way out. .

China gains or loses control. The crisis in the emerging economies, the end of the commodity cycle and the slowdown in China are entwined phenomena. If China decelerates more than expected, a new sharp drop in commodities may occur, causing further loss of income in emerging economies. In Brazil, a new round of commodity price declines would depreciate the exchange rate further (leading to higher inflation and interest rates) and subtract income from the economy. The recession would deepen, aggravating the current crisis. It would be difficult to manage a new significant loss of income, given the current fragile state of domestic affairs.

China so far has handled the slowdown in an orderly manner, despite the difficulties and the need to rebalance the economy (towards more domestic demand, more consumption), and despite market anxieties. GDP growth between 6%-7% this year would represent the continuation of the soft landing strategy. The final proof of success for emerging markets would be the stability of commodity prices.

The opposite surprise in China is hard to imagine: the return of rapid double-digit growth and a new commodity boom. It would be the salvation of Brazil, at least in the short term. Growth would come from abroad and improve tax revenue and the control over the fiscal deficit (and the growing debt) would gain a powerful ally. This surprise would lead many to believe that God truly is Brazilian.

Shifts in economic policy in Brazil. The need for fiscal adjustment and the current political fragmentation (which stalls the approval of reforms and adjustments) remain the core of the problem in Brazil. A shift in any direction on this issue would be a surprise. A shift to abandon the fiscal adjustment would be the beginning of the end, or perhaps the end of the end. Spending what one does not have would be a real "expanicide", an illusory expansion leading to an economic/political suicide. Thus, an irrational policy shift (whether announced or silent) would be surprising.

A positive surprise would be a renewed ability by the government to approve the necessary fiscal measures, including social security reform (introducing a minimum age requirement, for instance). It would bring about a major confidence boost, which could lead the way back to growth.

I've just remembered, as I finish writing this article, that surprises in the economy rarely happen in the way we imagine. True surprises actually catch us, true to the word, off-guard. Perhaps the surprise this year will be the lack of surprises. In this case, we would end up with the expected scenario, a continuation of 2015 – or something worse. I have the impression that this is the option no one wants.


Ilan Goldfajn is chief economist and partner at Itaú Unibanco.

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