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Wednesday, August 20, 2008

Where Now for Brazil?

By Claus Vistesen Copenhagen

In case you did not notice, the Eurozone recently slipped into a near recession and so did Japan. Together with an already limping and essentially recessionary US economy this has prompted some analysts to ponder the probability of a global recession or more aptly; a significant and serious widespread global slowdown. Nouriel Roubini, who recently got some fine words in the NYT by Stephen Mihm (hat tip: Stefan Karlsson), massages the probability of a global recession in a recent piece. This is a topic also taken up, in a US context, by Joachim Fels in his recent installment over at Morgan Stanley's Global Economic Forum.

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more.

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

  • One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.
  • The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?
I clearly have my bias and some have theirs; now let us wait and see what happens. It will be an important test for many hypotheses and views.


[1] - Although not so booming as of late.