By Thierry Ogier and Taimur Ahmad
As ironies go, this one seemed especially bitter.
Having for years called for a weaker currency, Brazil's
finance minister Guido Mantega finally got what he wished for
By August, the Brazilian real had plunged to near five-year
lows against the dollar, having lost 16% after the US Federal
Reserve first hinted in May it would pare back its stimulus
The sharp decline in the real had dwarfed its rise of three
years earlier, which at the time prompted Mantega to coin the
term "currency wars" to describe the effect of Western monetary
policy on emerging market exchange rates.
All of a sudden, the prospect of a reversal of the very
policies he had lambasted now threatened Brazil's currency with
a full-scale rout. Fears grew that a sharp fall would stoke a
resurgent inflation that had already forced a hike in the
country's borrowing costs.
The ferocity of the sell-off in the real - one of the
worst performing currencies in the world this year - has
taken both markets and officials by surprise. It also raised
the alarm when set against a dramatic loss of investor
confidence in the world's biggest emerging economies, including
India and China.
But in a move some consider - at least for now - a
game-changer, bold intervention by Brazil's central bank in
late August helped establish a floor under the exchange rate.
The bank announced a $60 billion series of currency swaps and
loans, to be carried out at $3 billion per week for the
remainder of 2013.
"The hedge program from the central bank has been very
relevant. It was decisive in reducing exchange rate
volatility," says former central bank director Luiz Fernando
Figueiredo, now a partner at Mauá Sekular, an asset
manager in São Paulo.
Latin American currencies had already weakened earlier in
the year following a sharper than expected slowdown in China's
growth rate, weighing on commodities prices and the exchange
rates of raw materials-exporters. Pressure mounted in August as
investors weighed the implications of a less accommodative US
monetary policy, but a broader retreat from the currencies and
bonds of the region's natural resource producers was already
Mantega, however, has remained defiant throughout, saying a
weaker currency would help local industry - long one of
his priorities. While politicians start to turn their focus to
the next general elections in October 2014, when President
Dilma Rousseff is likely to seek a second term, Mantega has
publicly dismissed what he called a "mini-crisis". He blames
external factors for a decline that has slammed emerging market
currencies globally at the prospect that the Fed will normalize
its monetary policy.
Despite market anxiety over the currency's decline, experts
have also played down its significance. "People get scared when
the real goes from 1.70 to 2.40 [per dollar]. But it's welcome
by the industrial sector, so what's the problem with
depreciation?" says Eduardo Levy-Yeyati, director of
consultancy Elypsis Partners and a former chief economist at
Argentina's central bank. "The fact is that if you smooth out
some of the high frequency volatility, it's actually a welcome
Authorities are likely now to "essentially let the exchange
rate drift maybe to 2.55 by the middle of next year, while
containing inflation pressures through monetary policies," he
says. "From here to the election, the approach will be a
slightly tighter monetary policy with the exchange rate
relatively under control."
The pass-through rate from a weaker real to consumer prices
is "abnormally high" in Brazil at around 20%, around twice the
regional average, he says. But interest rate rises are likely
to tackle the problem.
The benchmark inflation rate has remained in the upper range
of the official target of 6.5% for more than three years. An
expected fuel price hike will likely add further pressure.
The central bank raised borrowing costs for a third
consecutive meeting by half a percentage point, to 9%, in
The rate hikes came after a lengthy period in which Brazil's
economy had cooled from its rapid expansion of recent years.
Latin America's largest economy grew by just 0.9% last year,
down from 2.7% in 2011 and 7.5% in 2010.
Such dismal performance has weighed heavily on the country's
benchmark stock index, the Ibovespa, which was down 21% in the
year to mid-September, compared to a decline of just 5% for the
MSCI Index of 21 emerging nations' equities (see
Brazil Capital Markets: Points of view).
Many are nevertheless quick to point to the strength of
Brazil's external position. Joaquim Levy, chief executive of
Bradesco Asset Management and the country's former treasurer,
points out that, at $370 billion by September, international
reserves are five times larger than gross external public debt
and ten times the value of outstanding sovereign
bonds. Such a war chest is enough to finance "close to
five years of current account deficits" says Levy. "It would be
hard to describe the country as vulnerable."
The industrial sector, which suffered from a strong currency
through recent years of developed-world quantitative easing,
may now even benefit from the normalization of global economic
conditions, Levy says. "Brazil has a large and diversified
industrial sector, and it will respond - maybe not within two
months, but it will," he says.
However, global forces were not the only factors behind the
sharp drop in Brazil's currency: overseas investors had started
to question the sustainability of an economic model excessively
dependent on credit growth.
As Levy puts it: "more than pricing-in a huge weakness or
vulnerability about Brazil, markets overreacted to some
ambiguities in our economic policy."
Yet such "ambiguities" in policy - rather than fears over
macro-financial instability - are precisely what a growing
number of experts now take to be Brazil's main economic
Monica Baumgarten de Bolle, an academic at the PUC Rio
University and director of the Galanto MBB consultancy in Rio
de Janeiro says the darkening mood over Brazil is partly a
reaction to changes in the global economy. "The background for
Brazil has changed completely compared to the one we had until
2010," she says. "Now, there is no longer such growth impulse
However, she adds that investor anxiety and the currency's
slide was mainly a function of the "macro fragility within
Brazil" - a combination low growth, high inflation,
expansionary fiscal policy and a large current account deficit.
The real was hit, she says, as investors questioned Rousseff's
ability to attract investment and cut the government spending
that has exacerbated inflation.
Given the country's legacy of high inflation, investor
confidence remains shaky and has taken a further hit from
persistently sluggish economic growth. At the same time the
current account deficit - it now stands at 3.4% of GDP,
surpassed in the emerging world only by India's - has been
deteriorating while an expansionary fiscal policy has damaged
In response to sharply slowing growth in 2011, the
government pushed ahead with a fiscal stimulus that included
costly tax breaks and subsidies. The strategy not only failed
to support the economy, but also worsened its fiscal woes.
Public expenditure continued to rise as a percentage of
"The markets have now woken up to the fiscal policy risks,
as usual with a lag," says Teresa Ter-Minassian, a former
director of the IMF's fiscal affairs department.
The government announced spending cuts of 10 billion reais
($4.5 billion or 0.2% of GDP) for 2013, but such a sum "is
clearly insufficient to reverse the downward trajectory of the
public sector primary surplus," says Ramón Aracena,
chief economist for Latin America at the Washington-based
Institute of International Finance (IIF).
The IIF forecasts a primary surplus below 2% of GDP,
although the government has pledged that it will be 2.3%. But
further spending cuts are unlikely as the government gears up
for 2014 elections.
Brazilian officials were nevertheless encouraged by a
rebound in activity in the second quarter of the year, when GDP
expanded by 1.5%. This provided some ammunition to defend their
Mantega tells LatinFinance that the Brazilian economy has
now passed the worst, and insists the country still enjoys the
confidence of investors. Having declined last year amid weak
growth, investment continued to recover in the second quarter,
jumping 3.6%. "Investment was the driver [of growth in the
second quarter], as it was in China," he says. "Investment is
growing faster than consumption."
Yet, a series of what analysts have described as "policy
inconsistencies" have seriously damaged business confidence,
according to a number of surveys. In the financial markets,
this has translated into a sharp steepening of the sovereign
bond yields in recent weeks, although this had abated somewhat
in early September.
Mantega expects GDP to expand by 4% in 2014. Despite his
optimism, many economists beg to differ. The IIF's Aracena
expects growth to fall in the coming quarters "due to worsened
confidence and on-going monetary policy tightening".
"The question is whether the fiscal position is likely to
continue to provide stimulus to demand, particularly to
consumption but also in part to investment," says
Ter-Minassian. "We will see a continuation of anemic growth. I
would be surprised if growth was very much in excess of 2.5%
Figueiredo says a recession may be on the cards. "The yield
curve has not behaved as well as the exchange rate, and
financial conditions remain very tight. This has cooled
economic activity," he says. "There is also a very widespread
lack of confidence. We now estimate there is a 70% chance that
we will have two consecutive quarters of negative growth."
While he rules out a deep recession, the economy has lost
nevertheless lost its momentum, he says: "It is rather stalled
than going forward."
Mantega, though, is adamant that as the ranks of the
Brazilian middle class swell, domestic consumption - a primary
engine of the economic growth in recent years - will continue
to expand strongly, even if at a more moderate pace than
"The Brazilian consumption rate is going to continue
increasing, but slower than in recent years. It is still
perfectly okay for economic activity. Families in Brazil at the
moment are more indebted and therefore there is less credit
available for them," he tells LatinFinance.
"Consumption has grown. It continues to grow, and this is
because 40 million Brazilians have been included in the
consumer market. Our population has now just reached 200
million, which means that the consumer market has a population
of 100 million people," he says.
But others argue that Brazil's much-vaunted consumer-driven
boom is over. Arminio Fraga, founder of GÃ¡vea
Investimentos, a Brazilian asset management firm with $7
billion under management, says the economy has hit a wall - and
that without deep structural reforms, its prospects will remain
bleak. "This is a bad moment for Brazil," he tells
LatinFinance. "Here is a country that has done reasonably well
over the last 12 years or so, but which has struggled to invest
more. As a result, it is now unable to grow very fast."
Fraga, a former governor of Brazil's central bank, says:
"Consumption is going to continue growing but at a much lower
pace. It will not be as exciting [to investors]."
It's a view echoed by many others. Otaviano Canuto, a senior
adviser to the World Bank and former finance ministry official
in Brasilia, said Brazil is in "the twilight of the
consumer-led boom". And José Serra, who was defeated by
Rousseff in his bid for the presidency in 2010, said: "We need
to shift the focus from consumption to investment. It is the
end of a cycle [the bonanza era], and government policies have
not been able to adjust."
Fraga says the roots of today's problem lie in former
president Luiz InÃ¡cio Lula da Silva's abandonment
of serious reforms during his second term (2007 to 2011).
"There was a change away from the model of macro-stability and
macro-efficiency to a model where macro-stability became less
convincing and there was less of a priority for solving micro
issues and productivity related matters," he says. "Brazil's
policies have become interventionist, more focused on public
government lending and less capable of mobilizing private
"There has been an error of diagnosis," says Jean-Louis
Martin, emerging market research director at Crédit
Agricole, who argues that the economic policy response to
weakening growth was flawed. He blames the government first for
having failed to admit there was a problem on the supply side -
and then for not taking action beyond "a few isolated
To many observers, Brazilian policymakers now appear
increasingly hamstrung. The central bank under president
Alexandre Tombini is widely criticized for a perceived lack of
independence. In the July minutes of its monetary policy
committee meeting, for example, the central bank referred to
the "expansionary" nature of fiscal policy. By August, that
description became "neutral", despite no substantive change in
policy. Many suspected government pressure for the change in
Credit expansion, meanwhile, has been supported by public
sector banks, which account for 50% of overall credit. Caixa
Económica Federal, a government-owned bank, increased
its lending by 42.5% within a year, between June 2012 and June
2013, for example.
Analysts say policymakers must define their priorities.
"They have a desire to achieve both things: low inflation and
strong growth, very fast," says Aracena. "It has created a
policy inconsistency which is permeating to the business
community and to the consumers. People see that the situation
is not sustainable and it really affects confidence.
"If you don't do the right thing, if you carry out
inconsistent economic policies in the medium run, you will lose
confidence. It is going to be harder for you to increase
investment, to increase the potential economic growth and
harder to keep inflation on target," he says.
In the short term, that means the central bank will have to
keep tightening monetary policy even though economic activity
is lackluster. "The government has not been extremely forceful
regarding fiscal retrenchment," says Levy.
Last year, the government resorted to what some termed
creative accounting to meet its fiscal targets. This included
incorporating dividends from state-owned companies and
borrowing from the sovereign wealth fund as well as excluding
some infrastructure spending in the primary budget balance
calculation. Mantega was hauled before lawmakers to explain the
Ter-Minassian says that such extra-budgetary moves have been
"very damaging to credibility".
A central question is how the government can restore
credibility in fiscal policy, having resorted to such practices
to paper over the deterioration of its performance.
Mantega downplays the issue, claiming it was all "a
"We are going to continue to reduce debt. We are seeking a
fiscal result that will give us strength," he says. "There was
a kind of misunderstanding but it is now clear. There will no
more creative accounting in the budget. Expenditure in the 2014
budget will include no operations that could let people have
Moreover, he says there is no need for the government to
change its approach. "We are not looking at a new economic or
growth model, but the continuation of an already successful
growth model," he tells LatinFinance. "The fiscal policy is
Fiscal discipline is nominally an official pillar of the
government's economic policy. It even stands as one of the
commitments that the president made in the aftermath of social
unrest in June.
But experts say any deeper structural reforms - including of
the pensions system, tax system and public administration -
that could put fiscal policy on a more stable footing will be
left until after next year's elections. A range of politically
sensitive microeconomic reforms to enhance the business climate
and boost competitiveness are also likely to languish.
A lack of progress could have profound implications for
Brazil's international standing. Standard & Poor's put
Brazil's triple-B credit rating on negative outlook in June,
citing persistently poor GDP expansion, weaker fiscal policy
and a decline in government credibility. Brazil's position has
now eroded to the point where credit rating agencies are
getting increasingly vocal about their next moves.
"If all remains the way it is, the trend is that Brazil will
get a triple-B minus," says Regina Nunes, Standard & Poor's
managing director in Latin America. A credit downgrade would
put Brazil's rating just one notch above junk status, making
corporate and sovereign borrowing more costly while further
crimping economic growth.
"A credit downgrade [by S&P] is not only not farfetched,
in fact it's quite likely," says Ter-Minassian.
Few people believe the administration will amend its policy
mix in the run up to next year's vote. "Economic policy has to
change, but it is not going to, at least until the elections,"
says Besaliel Botelho, chief executive of Robert Bosch, a
technology provider to the industry in Campinas, São
If anything, the situation is likely to deteriorate. The IIF
stresses the "risk of further fiscal policy slippage as the
government scrambles to bolster popular support for president
Says Ter-Minassian: "Next year, the risk of a worse outcome
is significant. The government will have a difficult act to
balance on the one hand the risk of a more substantial
deceleration in growth and on the other had the acceleration of
She says authorities are likely to emphasize avoiding a
pickup in inflation "because that hits the working class and
the emerging middle class, which is very much the power base of
the current administration."
If macroeconomic performance continues to deteriorate beyond
the elections, the risk of stagflation will increase, says
Baumgarten. "If Dilma and her lot win [next year's presidential
elections] and do not improve the macro-management, I think
there will be a bout of bad humor towards Brazil."
"The institutional deterioration, the lack of strategy, an
inefficient and corrupt political system, and bad economic
management may lead us towards quite a difficult fiscal,
external and inflationary position. In this event, our position
would be similar to India's [today]," adds Baumgarten, who is
also a director at the liberal think tank Casa das
But the dynamic is further complicated by the external
environment, and in particular the prospect in the year ahead
that US monetary policy normalizes. Emerging markets have not
had to work hard to attract capital over the past decade,
thanks to strong growth, attractive yields and generally loose
monetary policy in the developed world. But as the US Fed moves
to withdraw its extraordinary monetary support, the tide is
once again turning.
The fear is that a disorderly withdrawal of capital when the
US eventually tightens policy could place Brazil in a dangerous
predicament - especially if it loses its investment grade
"This country is running a current account deficit of 3.4%
of GDP with growth at 2.5%. This is not a good underlying
situation," says Ter-Minassian. "If Brazil continues to hum
along without any improvement to its growth potential, people
are going to start worrying."
She says that government policy in the run-up to elections
could have major market implications. "Obviously if [the
Brazilian government] showed a very loose fiscal stance, if
their current balancing of priorities between growth and
inflation were to change dramatically in favor of fiscal
stimulus, then all bets are off."
The government, meanwhile, has ramped up infrastructure
spending as Brazil prepares to host the 2014 World Cup and the
2016 Olympic Games.
Authorities hope for a surge in investment on the back of
its 180 billion real concession program in logistics, which
kicked off in mid-September (See Brazil Infrastructure, page
58). Mantega has given a sop to the private sector by allowing
for higher rates of return in a bid to attract investors. He
tells LatinFinance he is adamant that investment will "grow two
times or three times GDP growth over the next few years".
His colleague Luciano Coutinho, president of the government
development bank BNDES, also says the concession program could
lift the economy sharply. "The conclusion of an investment
cycle in concessions will contribute decisively to boost the
aggregate investment and savings rate," he says.
Brazil's investment rate is due to increase from 19% of GDP
at present to more than 22% of GDP within five years, according
to BNDES projections. Every dollar invested in infrastructure
will inject four in the economy, according to Coutinho.
But an investment boom would first demand a recovery in
confidence, which in turn also depends on the credibility of
the macroeconomic policy. And many observers remain skeptical.
"I'm not sure they will get the investment they need," says
CrÃ©dit Agricole's Martin.
What's at stake
Brazil now faces choice a stark choice, he says. "This
country can either limp along at 2% for years or achieve more
than 4.5%. Brazil may have lived in illusion for 10 years
against a background of a supportive external environment with
high prices for steel, soya and other commodities. Now the
future is in their hands. They can go on like this for two or
three years without a major crisis. There is no sense of
"But if they want to take off, they have to tackle
infrastructure, downsize the state, revise the structure of
public expenditure and focus more on investment rather than
current spending. If they do not do this, Brazil is not going
to collapse, but it is going to fall below its growth
potential," he says.
Brazil's problem, says Levy-Yeyati, is ultimately one of
growth. Moreover, persistently weak expansion of an economy
struggling to support the demands of a restive population could
spell trouble ahead.
"Brazil was one of the poster children of the new emerging
middle class," he says. "At the beginning, people were happy
enough to get out of poverty, get better salaries, but that
period is over. People want better goods and services."
Such improvements will be difficult in an environment of
stubbornly low growth, which is unlikely to exceed 2% "for the
foreseeable future," he says.
While this may not result in economic crisis, it is likely
to mean that the image of Brazil as a dynamic leader among
emerging market economies is now a thing of the past. Says
Levy-Yeyati: "They will keep disappointing both international
observers and their own people." LF