Brazil’s recession is over, but the crisis is not

</p> <h3>“Mayday, Mayday! We lost an engine”</h3> <p>Brazil’s economy was faring well for awhile. The country managed to avoid the turbulence caused by the 2008 financial crisis, and its GDP fell only 0.1 percent in 2009, whereas the world economy dipped 1.7 percent.</p> <p><script id="infogram_0_dca027be-f976-4aab-a510-9942bfaba266" title="GDP Brazil vs World" src="https://e.infogram.com/js/dist/embed.js?94b" type="text/javascript"></script></p> <div style="padding: 8px 0; font-family: Arial!important; font-size: 13px!important; line-height: 15px!important; text-align: center; border-top: 1px solid #dadada; margin: 0 30px;"><a style="color: #989898!important; text-decoration: none!important;" href="https://infogram.com/dca027be-f976-4aab-a510-9942bfaba266" target="_blank" rel="noopener">GDP Brazil vs World</a><br /> <a style="color: #989898!important; text-decoration: none!important;" href="https://infogram.com" target="_blank" rel="nofollow noopener">Infogram</a></div> <p>The maneuver, however, would prove costly. Direct interference in microsystems and demanding too much from public investment led to a generalized breakdown. The economy slowed down, as growth slowed down, from 3 percent in 2013 to 0.5 percent the following year. Then, it simply nosedived. A recessive freefall pulled down the economy by 8.2 percent between the second quarter of 2014 and the end of 2016.</p> <p>The 1 percent rise registered in 2017 indicates that Brazil’s economy was stabilized. However, a critical area was damaged during its plunge: investments dropped 27 percent. An essential part of maintaining a healthy economy, it was as if the Brazilian economy were a plane that lost an engine. There was no way for the economy to rebound to its previous conditions, and the alarming truth of the situation is that this context is not going to change anytime soon. Here’s why:</p> <p>Trying to get the country out of its second-worst crisis in history, the federal government attempted to ensure economic growth by injecting money into the economy: vast public investment, widespread subsidized credit, generous tax breaks. And these are only a few examples.</p> <p>Since 2014, the federal government has been spending more than it earns. Brazil’s annual primary deficit deepened from R$ 20.5 billion (US$ 6 billion) in 2014 to R$ 159.5 (US$ 48 billion) in 2016. The situation is so critical that for the past few years, the Ministry of Finance has not even tried to achieve positive results by making primary surpluses, as economic jargon defines it. The country’s fiscal target is set to be negative from the start. It is sort of a “damage control” operation since the worsening of the public accounts is inevitable.</p> <p>In this scenario, government debt spiked from 60 percent of the GDP in 2013 to 74 percent in 2017, a peak since 2002. What took 11 years of fiscal discipline to achieve was gone in just a third of that time. The country has the highest indebtedness among all emerging markets, according to the International Monetary Fund (IMF). And the trend will persist in the years to come. The institution forecasts such a ratio to reach 91.7 percent by 2021.</p> <p><script id="infogram_0_31fb825b-5acd-4665-b4d8-2bca6154c579" title="Brazil: Debt-to-GDP ratio" src="https://e.infogram.com/js/dist/embed.js?Ivq" type="text/javascript"></script></p> <div style="padding: 8px 0; font-family: Arial!important; font-size: 13px!important; line-height: 15px!important; text-align: center; border-top: 1px solid #dadada; margin: 0 30px;"><a style="color: #989898!important; text-decoration: none!important;" href="https://infogram.com/31fb825b-5acd-4665-b4d8-2bca6154c579" target="_blank" rel="noopener">Brazil: Debt-to-GDP ratio</a><br /> <a style="color: #989898!important; text-decoration: none!important;" href="https://infogram.com" target="_blank" rel="nofollow noopener">Infogram</a></div> <h3>But who will pay the bill?</h3> <p>In society, people cannot just spend more than they earn and get away with it. And at some point, banks will no longer loan them money. Something similar happens at the national level. When a country is clearly incapable of managing its budget efficiently, flags are raised.</p> <p>In the financial markets, the credit rating agencies are the ones pointing fingers. Yes, the same ones blamed for the 2008 financial crisis. Their work, however, is still closely watched by investors worldwide. Especially the “institutional” ones at pension and hedge funds, who deal with &#8211; literally &#8211; trillions of dollars.</p> <p>To prevent them from taking chances with people’s “big money,” most statutes bind them to invest only in countries accredited with “investment grade” ratings by at least two of the three major credit agencies. That is why their calls are so crucial for emerging economies.</p> <p>On that front, however, Brazil is lagging. By 2015, Fitch, Moody’s and Standard &amp; Poor’s had downgraded the country’s rating to junk in reaction to the critical fiscal imbalances. In the following year, the outflow of dollars topped the inflow by US$ 15.8 billion, as foreign investors sold local assets and moved onto markets with better ratings. The move was more significant than the one recorded after the 2008 crisis, according to the Central Bank’s data.</p> <p>And the repercussions are felt to this day. Standard &amp; Poor’s last downgraded Brazil in January 2018, putting its rating three steps below investment status. Moody’s currently has it two degrees down but improved the outlook from negative to neutral in April this year. This is the first positive news regarding Brazil’s ratings in four years. Until the country rearranges its public accounts and regains international trust, financial investment will be limited. And climbing up the credit rating ladder will take time.</p> <p>Downgraded countries took an average of 7.2 years to regain their investment-grade status, according to research by Itaú Unibanco, Brazil’s largest private bank. For a smaller group, it took longer: 10 years. What distinguished them from the rest of the sample was high debt and low saving rates – also traits of the Brazilian economy. Those countries, however, implemented fast and intense fiscal adjustments and posted significant economic growth in the years following the downgrade. Brazil did not.</p> <p>Therefore, it is reasonable to expect that South America’s largest economy will have to say goodbye to institutional investors for more than a decade. The perspective that the U.S. Federal Reserve can implement its monetary tightening cycle faster than expected is another red flag for emerging markets. The rate increase in the U.S. could push financial investments further away from emerging markets, including Brazil.</p> <h3>“At least we tried”</h3> <p>As it watched this scenario unravel, the federal government must be given credit for not standing by passively. This, however, does not mean that the government made the right choices. In 2016, a spending cap bill was proposed by President Michel Temer and passed by the Senate.</p> <p>The constitutional amendment limits the increase of the federal budget to the inflation rate of the preceding year – for two decades. Changes can only be made in 10 years and would demand support from three-fifths of Congress.  It was meant to show international markets that the country is committed to fiscal discipline and would be able to control the expansion of its public deficit – a clear response to the credit agencies’ downgrades.</p> <p>The decision, however, is controversial, not to say questionable. <a href="https://www.vox.com/world/2016/12/15/13957284/brazil-spending-cap-austerity">Vox</a> classified it as the “harshest austerity program in the world,” highlighting that government’s expenses in health care, education and infrastructure will be stuck in real terms until 2037.</p> <p>But that’s not all. On top of the limited space to manage its budget, Brazil has a bomb-clock pension system that will increasingly demand more resources in the upcoming years if no reform is passed. An IMF study estimates that pensions, which currently account for 11 percent of the country’s GDP, will represent 18 percent by 2030.</p> <p>With the public spending ceiling, the federal administration will be forced to comply with the law by defunding other components of its budget, including public investment. <strong>The Brazilian Report</strong> has already revealed how <a href="https://brazilian.report/2018/04/23/public-investments-brazil-recovery/">falling public investments</a> threaten Brazil’s economic recovery. Looking ahead, that factor plays a strong role in limiting economic growth.</p> <h3>The invisible hand</h3> <p>If the potential for financial and public investments is clearly compromised, business enterprises could be a viable solution for economic recovery. That, however, is also an unlikely scenario.</p> <p>Brazil has undergone a drastic process of deindustrialization. The sector’s share of the GDP hit 11.8 percent in 2017, its lowest level since the 1950s according to Brazil’s statistics agency, IBGE.</p> <p>The recession made matters worse. People and businesses were buying so little from the industry that factories countrywide started simply shutting down part of their machinery, letting go of their employees and working at a slower pace.</p> <p>To be precise, as of April 2018, Brazilian industries were operating at only 76.5 percent of their existing capacity, according to a monthly survey by FGV, ranked Latin America’s leading think tank for eight years in a row. This number means that even if consumption spikes and demand increases, factories can increase their production by almost 30 percent with no need to invest in new machinery or expansion, for instance.</p> <p>This is directly linked to the country’s extremely low level of investments, aggravated by the 27 percent decline over the past four years. The Gross Fixed Capital Formation (GFCF), the term economists use for investments, accounted for only 15.6 percent of the GDP in 2017. That is its lowest rate since it first started being tracked in 1996, and is also lower than nearly half of the average of developing countries, according to the World Bank.</p> <p>This data is critical because productive investment is what gives economies the strength to grow. They can be compared to muscles in the human body. The case here is one of a person in a coma for two years, whose muscular mass has decreased by a third. That person may have regained conscience already, and that is a good thing, but it is unfortunately not good enough to take on a sprint race – not to mention a marathon.</p> <p>Against this backdrop, there are also no conditions for private investments to play a role in the country’s upturn. Initial studies on the topic have already shown that productive investments have been recovering at a slower pace than usual. A study indicates that GFCF grew 3.9 percent in the 12 months following the end of this recession.</p> <p>That is less than half the average rate of 8.8 percent registered after the previous eight recessive periods in Brazil’s history, as demonstrated in an article by Aloisio Campello and Gilberto Borça, economists at the Brazilian Institute of Economy (Ibre) and the Brazilian Development Bank (BNDES), which was published by the newspaper <em><a href="http://www.valor.com.br/opiniao/5410479/espera-do-investimento">Valor Econômico</a></em>.</p> <h3>Can the crisis get any worse?</h3> <p>Unfortunately, it can. On top of all this, Brazil is gearing up to face the bumpy political road that lies ahead. The <a href="https://brazilian.report/2018/02/01/2018-presidential-election-shaping/">presidential election</a> set to occur in October is considered the most unpredictable since the country’s democratization in the late 1980s.</p> <p>In the eyes of business leaders and investors, this scenario comes down to one word: uncertainty. And having that label attached to an economy is among the most effective ways to repel investors. Ibre’s Economic Uncertainty Index escalated from the “moderately high” level to “high” in April.</p> <p>If anything, these elections will translate into decision paralysis until ballots give their verdict. After that, Brazil can expect to find itself on a path of weak and slow recovery due to all the reasons discussed above. But it could be worse: should the country fall into the hands of a populist, on either the right or the left, it risks facing additional decline in its already weakened economy.</p> <p>The results of this crisis are felt mainly by average Brazilians via the conditions of the labor market. In our next article, <strong>The Brazilian Report</strong> will follow Eduardo Intrieri’s quest for a job and examine how unemployment, working conditions and income also impact the path for recovery that lays ahead for Latin America’s largest economy.