Brazilians lived beyond their means for years culminating in 2014 with large twin deficits – a current account deficit of 4.4% of GDP and a fiscal deficit of 6.2% of GDP. At the end of last year we highlighted that the labor market was particularly exposed to a correction in economic policy (see Brazil: Unsustainable “job-full” stagflation). The unemployment rate has already increased about 1% from the lows (approaching 6% now) and taking into account a weak outlook for economic activity, there is still more to go.
Despite the challenging economic outlook, we’ve seen a rally in Brazilian assets since mid-March (across the currency, equities and credit). Some local factors supported the rally: i) a new economic team setting up a more sustainable economic policy; ii) Petrobras publishing its audited results; and iii) the absence of energy rationing in 2014. That said it is not a coincidence that the rally in Brazilian assets took place basically at the same time when the USD peaked, the market moved out the call on when FED tightening would occur, and commodity prices bottomed out.
Although a supportive external backdrop can sustain the rally for a while, we remain cautious. Brazil is now moving in the right direction, but the road is quite long and crucial decisions are still ahead of us. The adjustments on fiscal accounts and on relative prices (between tradable and non-tradable goods) have barely started following years of distortions. Furthermore, the widespread price/wage indexation makes it much harder to adjust.
Starting from a 0.6% of GDP primary fiscal deficit in 2014 the new economic team is targeting a 1.2% primary fiscal surplus for this year and a 2.0% surplus for 2016. So far the Congress has watered down fiscal measures that have been proposed and added changes that actually increased liabilities in the medium term. Brazil is in the sharpest recession since 1990 (-1.5% yoy GDP growth is expected for 2015). This will make it almost impossible to achieve the fiscal target this year due to falling revenues, which in turn should result in higher taxes. The problem is that Brazil already has a very high tax burden (36% of GDP before recent measures), especially for a relatively poor country (Brazil’s tax burden is comparable with US but its per capita income is almost 5 time lower – see chart below). So for the next two years, we should continue to expect large fiscal tightening with growing risks of an increasing tax burden.
Source: IMF, 2013 data
The other key adjustment in the Brazilian economy refers to the competitiveness lost during many years of FX appreciation along with relatively high inflation. As productivity gains have not followed wage increases the result was a significant increase in unit labor cost between 2003-2011. The latest BRL depreciation we have seen does not change this story appreciably (see chart below). Wage pressures are also keeping services inflation elevated (a key component of core inflation) particularly when compared to goods prices, which points again to the difficulty of increasing competitiveness in the tradable sector.
Source: Central Bank of Brazil, Brazilian Bureau of Statistics. As of April 2015.
What makes this relative price adjustment more painful is that Brazil is well known for a large indexation of prices/wages and therefore the pressure (as textbooks would suggest) is more on quantity instead of prices. For example, despite the ongoing economic recession and the upward trend in the unemployment rate, minimum wage must increase about 8.5% at the start of next year (due to indexation to past inflation). This will put an extra hurdle on the Central Bank that is trying to slow down inflation to 4.5% in 2016. This is why the Central Bank remains in tightening mode with the policy rate approaching 14% despite the sharp recession. This tight monetary policy should hurt 2016 growth as well. While a painful adjustment is still ahead, if appropriate measures continue to be implemented then the attractiveness of local rates will increase substantially. This is the low hanging fruit investors can find in Brazil – abnormally high rates in a ZIRP* world.
*ZIRP: zero interest rate policy