Research Briefing Emerging markets Brazil’s economic growth has roughly doubled over the past ten years, increasing from 2.0-2.5% a year to almost 4%. Admittedly, the 1980s and 1990s set a low standard for such a comparison and the past decade provided an unusually favourable backdrop to economic growth in the emerging markets. Brazil’s economic fundamentals remain very sound. Record-high FX reserves and a very manageable current account deficit would allow Brazil to withstand even a severe balance-of-payments shock in terms of systemic financial stability. Gross government debt remains high, but is controllable given the underlying fiscal stance. China has been a major factor behind the shift in Brazil’s export mix. Whatever one’s view of Brazil’s intensifying trade relations with China in terms of economic development, it is incontrovertible that Brazil has taken advantage of the commodity boom to improve its external and, to a lesser extent, government finances. In cyclical terms, the weakness of the Brazilian economy can be largely explained by sluggish global demand and a strong currency weighing on manufacturing output. While bank lending has slowed down somewhat, aggressive central bank rate cuts will sooner or later lead to strengthening domestic demand and increasing investment. The good news is that the cyclical recovery will be accompanied by structural reforms. Many (but not all) measures aim to raise productivity and both public and private-sector investment. On balance, the measures have a greater focus on supply than demand than in the past. The reforms, combined with a cyclical recovery, will underpin higher savings and investment, making it very unlikely that the economy will grow less than 3.5% over the medium term. Author Markus Jaeger +1 212 250-6971 markus.jaeger@db.com Editor Maria Laura Lanzeni Deutsche Bank AG DB Research Frankfurt am Main Germany E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 www.dbresearch.com DB Research Management Ralf Hoffmann | Bernhard Speyer October 26, 2012 Brazil: Fair economic prospects Or why the doomsayers are wrong -4 -2 0 2 4 6 8 10 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Slowing growth momentum DX Real GDP, % yoy Source: IBGE Brazil: Fair economic prospects 2 | October 26, 2012 Research Briefing Brazil benefited from favourable global economy Brazil’s economic growth has roughly doubled over the past ten years, increasing from 2.0-2.5% a year to almost 4% (chart 1). Admittedly, the 1980s and 1990s set a low standard for such a comparison. After all, the 1980s were a “lost decade”, when Brazil struggled to resolve its external debt problems. The 1990s saw significant structural reform and economic liberalisation. Monetary stabilisation was also being achieved by the middle of the decade. This was followed by repeated financial crises due to an exchange-rate-based stabilisation that was insufficiently supported by fiscal policy. This led to currency overvaluation and repeated currency crises, weighing on economic growth. In a comparative perspective, Brazil’s economic performance in the 2000s was solid, but not spectacular. After a choppy beginning with the US equity market crashing, neighbouring Argentina defaulting and foreign investors taking flight in the run-up to the 2002 presidential elections, the 2003-08 period provided a near-perfect backdrop to stronger economic growth. First, global growth underpinned by a strong US economy and an emerging China led to a rapid expansion of global trade. Second, global interest rates, led by the Fed and underpinned by the so-called Asian savings glut, were extremely low by historical standards, causing capital flows to emerging markets to grow rapidly. Third, commodity prices started to rise across the board and reached levels not seen in many decades, largely due to surging Chinese demand. This benefited natural-resource exporters like Brazil. Against such a favourable backdrop, Brazil was not the only emerging economy to experience higher economic growth (chart 2). China had been growing at more than 10% p.a. for more than two decades but saw its growth accelerate during the past decade. India experienced a growth acceleration on the back of the economic reforms of the early 1990s with real GDP growth accelerating to almost 8% from 5.5%, while Russia also registered strong growth of almost 5% following the recovery from the 1998 default, subsequent stabilisation and rising energy prices. The external environment no doubt supported growth, and not just in Brazil. Structural reform and financial stabilisation were also important. Structural reform under Cardoso (1995-2003) – e.g. privatisation, monetary stabilisation and trade liberalisation – put in place the conditions for the higher, sustained economic growth of the 2000s. The definitive economic-financial stabilisation under Lula (2003-10) allowed Brazil to reap the benefits of previous reforms, supported by improving terms-of-trade and favourable international financial conditions. The 2008-09 financial crisis and economic downturn appeared to be merely a speed bump. After growing almost 8% in 2010, growth slowed to less than 3% in 2011 and is set to average less than 2% in 2012. It would be a mistake, however, to extrapolate this trend and regard this as the beginning of longer-lasting economic stagnation. First of all, Brazil was never going to grow more than 4% or so and it was never going to grow faster than the other BRIC countries, Russia possibly excepted. It is certainly likely that Brazil will face less favourable external circumstances over the coming years than it did during the past decade. But thanks to solid economic fundamentals, overall sensible macro-policies and ongoing structural reform efforts, we see little reason why real GDP growth should average less than 3.5% over the medium term. -1 0 1 2 3 4 5 6 7 8 1995 2000 2005 2010 Annual average Period average Cyclical or structural? 1 Real GDP, % change Sources: IMF, DB Research -2 0 2 4 6 8 10 12 Brazil China India Indonesia Mexico Poland Russia Saudi Arabia Turkey 82-91 92-01 02-11 Source: IMF Tide lifts all boats? 2 Real GDP, %, avg 0 50 100 150 200 250 300 350 2000 2002 2004 2006 2008 2010 2012 EFR* "Safe" level Source: DB Research Strong external liquidity 3 % of FX reserves *Current account plus external debt amortisation due over next 12 months. Brazil: Fair economic prospects 3 | October 26, 2012 Research Briefing Brazil continues to enjoy solid fundamentals Brazil’s economic fundamentals remain sound. The sovereign, for what it is worth, carries an investment grade rating. By contrast, a decade ago, Brazil was heavily exposed to balance-of-payments shocks, as evidenced by repeated currency crises. Today, it is well positioned to absorb virtually any external shock without running the risk of broader financial instability. As the 2008 global crisis demonstrated, Brazil, like most other (emerging) economies, may not be able to avoid negative consequences in terms of lower growth (read: no de- coupling). But, unlike in the late 1990s and early 2000s, such shocks do not prove destabilising anymore in the sense that the economy does not sustain “structural” damage, leaving its growth potential undiminished. Brazil is a net external creditor 1 . The public sector (basically: government, central bank and state-owned enterprises) is also a net foreign-currency creditor, allowing it to provide foreign-currency liquidity to the private sector if necessary. Even a severe balance-of-payments shock can be absorbed through a combination of exchange rate depreciation and provision of foreign-currency liquidity to the private sector (as happened in 2008). In the early 2000s, external financing requirements amounted to 200% (chart 3). Today they are a mere 50%. The current account deficit is currently running at less than 3% of GDP and is easily financed (in fact, overfinanced) by FDI inflows. Central bank FX reserves have reached record-high levels of almost USD 400 bn. While the private sector as a whole is exposed to a sudden stop in capital inflows, the systemic impact of individual corporate defaults would be negligible. Last but not least, the systemically important banking sector runs manageable foreign exchange rate risk. While gross government debt remains elevated by emerging markets standards, the net debt of the public sector is significantly more favourable. Gross government debt amounts to 64% of GDP (under the IMF definition), but net public-sector debt stands at a much lower 35% of GDP (charts 4 and 5). The liability structure, historically a major vulnerability, has also improved significantly, with a much greater share of debt consisting of fixed-rate or inflation-linked rather than foreign-currency or interest-linked instruments. The 2008 shock decisively demonstrated that Brazil can survive even the severest of shocks. In fact, currency depreciation led to a decline in net debt (chart 6). Gross public-sector financing requirements remain elevated, but are significantly lower than in the past. The outlook for public-sector debt sustainability is fair. If the government maintains a primary surplus of 2.5% of GDP (below the present 3.1% target), net debt will fall to below 30% of GDP by 2015. In other words, the current primary surplus target of 3.1% of GDP is more than sufficient to keep the debt to 1 Disregarding foreign holdings of domestically-issued public debt. Impact of market shock on net public-sector debt* 6 % of GDP** 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Interest rate 1.8 2.1 1.9 1.8 1.5 1.6 1.7 2.1 1.9 1.9 FX 15 11.4 1.9 2.1 -0.9 -4.6 -5.3 -5 -5.2 -7.1 Total 16.8 13.5 3.8 3.9 0.6 -3 -3.6 -2.9 -3.3 -5.2 *Footnote: Stress scenario assumes a three-standard deviation shock to the real interest and exchange rates, similar to the 2002 shock. ** Net public-sector debt Source: Treasury -20 -10 0 10 20 30 40 50 60 02 03 04 05 06 07 08 09 10 11 12 Net foreign-currency Net debt Source: DB Research Public sector debt, % of GDP Gradually declining government debt (1) 4 0 10 20 30 40 50 60 70 80 90 02 03 04 05 06 07 08 09 10 11 12 Domestic debt External debt Source: DB Research Gross general government debt, % of GDP Gradually declining government debt (2) 5 Brazil: Fair economic prospects 4 | October 26, 2012 Research Briefing GDP ratio on a declining path. In fact, we estimate that under fairly conservative assumptions of 3% real GDP growth and 5% real interest rates, a primary surplus of 1% of GDP would be sufficient to stabilise the debt ratio at 35% of GDP or so. In other words, the government enjoys sufficient policy space to let automatic stabilisers help absorb the growth impact of an external shock and even to implement anti-cyclical policies, if necessary. Rise of China and Brazilian growth China has rapidly emerged as a major factor in the global economy. Having overtaken Japan and Germany, it is today the world’s second-largest economy. Double-digit real GDP growth, combined with a particularly resource and investment-intensive economic development strategy, has been a major contributor to the sharp rise in commodity prices and rapidly rising Brazilian exports to China. China is today Brazil’s largest trading partner (if the EU is not counted as a single entity), accounting for more than 17% of total exports in 2011 (chart 7). China has also been a major factor behind the shift in Brazil’s export mix. Strong demand for commodities and an appreciating exchange rate have resulted in commodities’ growing and manufactures’ declining share in Brazilian exports (chart 8). Brazilian trade relations with China are unbalanced, or very complementary, depending on one’s point of view. Soy, iron ore and oil represent the lion’s share of Brazilian exports to China, while 98% of Chinese exports to Brazil consist of manufacturing goods. This reflects China’s comparative advantage in manufacturing goods and Brazil’s advantage in commodities. To what extent Brazil’s rising dependence on China is a blessing or a curse is subject to debate. Some worry about the “Dutch disease” (whereby rising export prices appreciate the exchange rate and undermine the competitiveness of the manufacturing sector). Others will argue that a reliance on commodity exports nonetheless allows a country to climb the value-added ladder and foster economic development. Whatever one’s view, it deserves highlighting that Brazil has taken advantage of the commodity boom to improve its external and, to a lesser extent, government finances. Government dependence on direct commodity revenues is quite limited, unlike in other Latin American economies (e.g. Chile, Mexico, Venezuela). Brazil is also unusually diversified in the commodity space with exports ranging from agricultural raw materials, food and energy to iron ore and metals, not to mention continued sizeable manufacturing exports. It is possible, perhaps even likely, that Chinese demand (growth) for iron ore will slow down once it shifts towards a more consumption-oriented growth model; but Chinese demand for soy is unlikely to decline over the medium term. It is incontrovertible that Brazil is far less sensitive to a downturn in commodity prices than many other emerging economies, including Russia, which runs a huge non-oil deficit. China is also becoming an important source of foreign (direct) investment. Unfortunately, data availability is poor given that a lot of Chinese FDI is routed through offshore financial centres. Nonetheless, anecdotal evidence based on publicly announced deals suggests that Chinese FDI has been rising tangibly. Last but not least, it is important to remember that Brazilian exports amount to a mere 11% of GDP. Brazil’s export dependence is far less significant than that of its BRIC peers. Brazilian exports to China amount to less than 2% of GDP, not exactly an exorbitant figure. The bottom line is that Brazil has undoubtedly benefited from China’s rise, but unless China suffers a complete economic meltdown, the downside risks stemming from Brazil’s increasingly close relationship with China appear quite manageable. China 17.3 US 10.1 Argen- tina 8.9 Nether- lands 5.3 Japan 3.7 Others 54.7 China is single largest export destination 7 % of exports Source: MDIC 0% 20% 40% 60% 80% 100% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Manufacture Food Agriculture Fuel Ores & metals Source: World Bank Changing export structure 8 % of merchandise exports 60 80 100 120 140 160 180 04 05 06 07 08 09 10 11 12 Brazil China India Mexico Russia Strong exchange rate 9 REER, 2004=100 Source: BIS Brazil: Fair economic prospects 5 | October 26, 2012 Research Briefing Is the slowdown cyclical or structural? In cyclical terms, the weakness of the Brazilian economy can be largely explained by sluggish global demand and a strong currency weighing on manufacturing output. The currency is softer than a year ago, but in real terms it has appreciated the most among the BRIC currencies on the back of improving terms-of-trade and strong capital inflows over the past ten years (chart 9). The Brazilian government appears adamant about preventing further appreciation of the currency and has proved its willingness to supplement FX intervention with so-called capital flow measures. Commodity exports are weaker but commodity prices have not crashed and are likely to rise as soon as a broader global economic recovery takes hold. Bank lending growth has slowed down some- what from very high levels, but aggressive central bank rate cuts will sooner or later lead to improving household finances and a greater willingness among (private-sector) banks to lend (chart 10). Unemployment remains very low (chart 11). In other words, the conditions for demand to recover are in place. Brazil does face significant supply-side constraints. The so-called custo Brasil limits the economic growth potential. It is, however, unclear that Brazil’s growth potential, approximated by its actual growth performance of the past few years, has declined. If it has, Brazil is certainly able to soften this constraint with the help of structural reform. Even if the current slowdown is more structural than cyclical, it won’t be too diffcult for Brazil to maintain 3.5-4.0% annual growth if it continues down the path of structural reform (see below). The most important constraint on growth is a low savings and investment rate. Many Asian emerging economies invest 30-40% of GDP a year. Public and infrastructure investment also tends to be high, often in the 4-8% of GDP range. By contrast, total investment in Brazil has averaged less than 20% of GDP and public and / or infrastructure investment (excluding SOE investment) has typically been less than 2% of GDP (chart 12). Not surprisingly, Brazil is suffering from well-known bottlenecks with regard to infrastructure. Fixing infrastructure bottlenecks will be key to raising potential growth (chart 13). As far as savings are concerned, Brazil suffers from low household and government savings rates. The public sector is in fact a net dissaver. Multiple explanations have been put forward, all of them quite plausible 2 . Two explanations seem particularly relevant. First, large government transfers, especially social-security-related transfers, limit households’ incentives to save. Implicit pension (and health) liabilities are significant in Brazil and a broader social-security and, above all, pension reform would be desirable, especially given adverse medium-term demographic developments and the concomitant pressure this will put on government current expenditure and transfers 2 De Faria, J.C. (2012), Brazil: The quest for growth, Deutsche Bank; OECD Economic Survey: Brazil (2011); Jaeger, M. (2009), Brazil 2020, Deutsche Bank Research. Brazil suffers from structural deficiencies, including infrastructure 13 Rank Overall Infrastructure Health & primary education Higher education & training Goods market efficiency Brazil 48 70 88 66 104 China 29 48 35 62 59 India 59 84 101 86 75 Russia 67 47 65 52 134 Source: World Bank 0 10 20 30 40 50 60 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Public Private Foreign Continued credit expansion 10 Bank credit to private sector, % of GDP Source: BCB 0 2 4 6 8 10 12 14 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Strong labour market 11 Unemployment, % Source: IBGE 0 10 20 30 40 50 60 Argentina Brazil China India Indonesia Korea Mexico Poland Russia Taiwan Turkey Investment Savings Investment, avg Savings, avg Source: IMF Suffering from low investment & savings 12 % of GDP, 2002-11, avg Brazil: Fair economic prospects 6 | October 26, 2012 Research Briefing (chart 14). (The reform of the social security regime for civil servants earlier this year was a good start.) Second, and relatedly, the government spends too much in terms of current expenditure and hence does not save (and invest) enough. Limiting government current expenditure would be welcome and is discussed intermittently in Brasilia. It is crucial that Brasilia does not waste the income generated by higher growth entirely on consumption. Keeping down public-sector consumption and other current expenditure would go a long way in terms of generating higher economic growth. Other factors also contribute to the low level of savings and investment: lack of a functioning domestic, local-currency, long-term capital market, directed lending, high bank reserve requirements, a cumbersome legal system, a high level of short-term government debt etc. But addressing infrastructure bottlenecks and raising investment (and savings) will be key to unlocking the economy’s growth potential. Improving the conditions for private-sector investment (read: structural reform, including legal, labour, tax) would also be welcome. After all, Brazil ranks 126th out of 183 countries in the latest World Bank “Ease of Doing Business” survey (behind Uganda and Swaziland) (chart 15). Economic policy & structural reforms under Dilma 3 The administration of President Dilma Rousseff has recently launched a new string of reforms aimed at improving competitiveness and productivity (chart 16). In other words, the government is not solely relying on demand-side measures to maintain growth. The Dilma government has thus far maintained a relatively tight fiscal policy in the face of below-potential economic growth and has instead relied on aggressive central bank monetary easing. The reliance on monetary rather than fiscal stimulus seems quite sensible given continued high interest rates and the relatively high level of government debt. In this context, the government’s stance on public-sector wage claims is welcome and signals a 3 Brazil after the elections – what’s next (2010). Deutsche Bank Research. Selected indicators for upper middle income countries (out of total of 49 countries) 15 World Bank 'Doing Business' Survey Rank Starting a Business Dealing with Construction Permits Getting Electricity Registering Property Getting Credit Protecting Investors Paying Taxes Trading Across Borders Enforcing Contracts Resolving Insolvency Thailand 1 28 4 2 6 17 5 27 2 5 10 Malaysia 2 13 30 18 17 1 1 10 5 8 8 South Africa 6 9 10 33 24 1 3 11 43 21 21 Chile 7 6 23 11 16 12 11 12 17 17 34 Peru 8 16 27 25 5 6 8 21 13 32 32 Colombia 9 26 9 37 15 17 2 25 25 44 1 Mexico 13 27 12 39 40 11 19 31 15 21 2 Turkey 22 22 39 21 10 23 24 19 24 12 38 China 31 44 48 30 9 17 35 33 16 4 20 Argentina 38 42 43 17 39 17 39 40 30 10 27 Russia 40 35 47 49 11 30 39 29 46 1 17 Brazil 43 37 33 16 32 30 28 41 34 34 41 Venezuela, RB 49 43 29 42 25 48 48 49 47 20 46 Source: World Bank -50 0 50 100 150 Russia Brazil China India NPV of pension spending change, 2010–50 NPV of health care spending change, 2010–50 GG debt, 2011 Source: IMF Large implicit liabilities to weigh on public savings 14 % of GDP Brazil: Fair economic prospects 7 | October 26, 2012 Research Briefing more determined attitude to keep public-sector wage expenditure low and allow greater room for monetary easing. This should be seen as an attempt to kick- start investment rather than supporting consumption through increased expenditure and only moderate (rather than aggressive) policy lending. The government continues to provide funding to public banks in order to boost credit. The government has taken measures to support industry (Brasil Maior) 4 . Basically, the objective is to raise investment from less than 19% of GDP to 23% of GDP by 2014. This looks ambitious, but the general thrust of this policy is to be welcomed. The government has announced payroll-tax cuts and reduced the rates industry pays for power and has offered / will offer private companies licences to build and operate roads and railways as well as major airports and ports. As already mentioned, the government also pushed a public-sector pension reform through congress. While the latter’s immediate financial effects are limited, it will help improve the outlook for long-term public-sector solvency. On the negative side, the government has also increased import tariffs to protect troubled industries, pressured banks to lower interest rates and compelled utilities to cut electricity rates in exchange for renewing their concessions. All of this is far from representing large-scale liberalisation, but the combined measures seek to address, however imperfectly, some of the supply-side constraints limiting savings, investment and economic growth. Last but not least, the government remains committed to PAC 2 – the govern- ment’s infrastructure and growth acceleration programme. The programme is encountering a number of problems and delays, but the basic thrust of the strategy aimed at raising public-sector infrastructure investment is sound. If interest rates experience a secular decline, the public sector will free up significant fiscal resources. It can then use these resources to pay down debt and accelerate the drop in domestic interest rates (and thus make private-sector investment cheaper), cut taxes (and enhance private-sector investment returns) or raise public-sector investment. This will help increase investment and support medium-term economic growth. Medium-term growth outlook remains fair Brazilian economic growth has been negatively affected by an unfavourable global economic backdrop. Most developed and emerging economies are suffering a similar down leg. A strong currency combined with weaker foreign demand has resulted in a stronger-than-expected slowdown in Brazil. Five-year trailing real GDP growth is still running at more than 3.5% (Chart 17). Brazil’s fundamentals remain solid (chart 18). The banking sector, despite increased NPLs, remains fundamentally sound and well-capitalised, the recent failure of some smaller banks notwithstanding. None of this is meant to deny that supply-side constraints may have become more important 5 . That said, domestic (real) interest rates will be lower in the coming years, providing the government with greater fiscal resources to foster private-sector and public-sector (infrastructure) investment thanks to lower interest payments on its debt (chart 19), provided it succeeds in keeping a lid on (or even reducing) government consumption and transfers. Structural reform, especially greater private-sector participation in infrastructure development and management, should also support higher investment and raise productivity. With a gently rising investment ratio, Brazil is quite unlikely to grow less than 3.5% a year over the medium term (chart 20). Flanked by ongoing structural reforms, real GDP growth of around 4% should be achievable, even if the global 4 For Brasil Maior, see http://www.brasilmaior.mdic.gov.br 5 DB Research, Brazil – Time to move towards a new growth strategy, 2012. Major policy measures & programmes (Brasil Maior, PAC) 16 Investment Airport, railway & road concessions Infrastructure (PAC 1 and 2) Tax measures Payroll tax cuts Other tax measures (e.g. IPI) Other Electricity tariff reductions Credit policy Export financing Government purchases FX policy Import duties Sources: MDIC, Fazenda, DB Research -8 -6 -4 -2 0 2 4 6 8 10 12 14 1986 1991 1996 2001 2006 2011 2016 Brazil China India Russia Sources: IMF, DB Research Real GDP growth,% BRICs in comparison 17 0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 01 03 05 07 09 11 Financial stability is here to stay 18 CDS spreads, bp Source: DB Brazil: Fair economic prospects 8 | October 26, 2012 Research Briefing economic backdrop this decade remains, as is likely, weaker than in the past decade. Markus Jaeger (+1 212 250-6971, markus.jaeger@db.com) © Copyright 2012. Deutsche Bank AG, DB Research, 60262 Frankfurt am Main, Germany. All rights reserved. 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Internet/E-mail: ISSN 2193-5963 0 1 2 3 4 5 6 7 China Korea Taiwan Poland Brazil Mexico Russia India Indonesia Turkey Brazil stands out 19 Government interest payments, % of GDP, 2011 Source: Fitch Argentina Brazil China India Indonesia Korea Mexico Poland Russia Taiwan Turkey 0 2 4 6 8 10 12 0 5 10 15 20 25 30 35 40 45 50 Real GDP growth, % Investment, % of GDP High investment = high growth 20 2002-11, avg Sources: IMF, DB Research . IBGE Brazil: Fair economic prospects 2 | October 26, 2012 Research Briefing Brazil benefited from favourable global economy Brazil’s economic growth. months. Brazil: Fair economic prospects 3 | October 26, 2012 Research Briefing Brazil continues to enjoy solid fundamentals Brazil’s economic fundamentals