After an interlude between 2008 and 2014, Brazil returned to the “junk” league last year (S&P and Fitch downgraded Brazil) on the back of a major economic and political crisis. In fact, GDP contracted almost 4% in 2015 and a similar recession is expected for 2016 (which should be the worst two-year performance in Brazilian economic history), while the President faces the risk of impeachment (to be voted in 1H16).
As described early last year (see Brazil: Baby steps on the long road to adjustment) the new economic team that had just taken charge was facing a multi-year adjustment process that would be quite painful. Some progress was made on the economic front, but key challenges are still ahead of us and the magnitude of the political crisis is surprising even the most bearish analysts.
Two accomplishments took place in 2015 that are worth highlighting: i) the containment in fiscal and quasi-fiscal leniency and ii) the improvement in external accounts. On the first point it is clear that the pace of growth of fiscal expenses slowed appreciably and the state-owned banks adopted a more prudent attitude compared to the large increase in their balance sheets in previous years. On the external accounts, the combination of sharp economic contraction and large fx depreciation (more than 20% in REER terms) is resulting in a clear improvement in trade balance and reduction in current account deficits. From a US $4bn deficit in 2014, the trade surplus reached US $20bn last year and is heading to US $40bn this year. This will likely allow the current account deficit to shrink further this year to a manageable 2% of GDP (from 4.3% in 2014 and 3.6% in 2015).
The bad thing is that the fiscal deficit surged despite a decent effort to contain expenses. Overall, the fiscal deficit reached 10% of GDP in 2015, and the primary deficit increased to almost 2% of GDP. Primary revenues are collapsing on the back of falling activity while interest expenses are on the rise as the Central Bank lifts its policy rate. This is imposing an unsustainable debt dynamic which was a key driver prompting rating downgrades. Moreover, the new change in the economic team (followed by recent hints that state-owned banks will reaccelerate credit expansion) increases the uncertainty about the pace and timing of improvement in fiscal accounts.
There has been a significant control in discretionary expenditures lately but truth is that most expenses are mandatory (or ear-marked) which makes it even harder to adjust fiscal accounts (see chart 1). Therefore, meaningful improvement in fiscal accounts requires in most cases constitutional reforms, either to open room for lower expenses, or to increase taxes. In previous crises in the nineties, fiscal stress usually resulted in a higher tax burden (chart 2). However, Brazilian tax burden became excessive for a relatively poor country and now there is a strong opposition in society against additional tax increases at the same time in which there is no consensus around the reforms to trim expenses (like social security reform).
It is in this context that the impeachment process of President Dilma Rousseff (launched at the end of last year by the president of Lower House) complicates even more the turbulent political scene. President Rousseff can survive the impeachment getting 1/3 of votes in the Lower House, but 3/5 of votes are required to approve Constitutional changes needed to fix the fiscal challenges. This political deadlock in which the government surpasses the impeachment process but is never able to approve reforms can cause further rating downgrades sustaining the negative feedback loop between the economic and political crisis we saw in 2015. This is more so in a more challenging global scenario where commodity prices continue to drift lower – reinforcing the terms of trade shock.
With a more “fair” fx level, local rates above 16%, sovereign spreads close to 550bps, Brazil is becoming increasingly attractive to FI investors. But differently from Russia (that performed well in 2015) fiscal fundamentals are much more challenging in Brazil and a political compromise (not a geopolitical agreement) is the crucial component to trigger a rally in Brazilian assets. Until we approach this compromise, there is no rush to buy Brazilian assets.