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 in 2013.
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 measures
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 underway.
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 development."
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 August.
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 vulnerability.
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 from outside."
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 public finances.
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 GDP.
"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 economic approach.
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% next year."
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 before.
"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 capital."
"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 measures".
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 rhetoric.
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 actions.
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 misunderstanding."
"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 divergent interpretations."
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 sound."
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 Paulo.
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 Rousseff."
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 inflation."
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 Garças.
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 rating.
"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 urgency.
"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