Brazil - Further currency strength ahead (2007)

The BRL has appreciated more than 100% vis-à-vis the USD under the Lula administration. In real terms the BRL appreciation was somewhat less pronounced. The factors driving exchange rate appreciation have varied. Following a massive depreciation in the run-up to the October 2002 presidential elections, the currency appreciated in late 2002 and early 2003. From then until 2005, the currency remained stable-to-appreciating while Brazil took advantage of the emerging surplus on the current account and recovering portfolio equity inflows to retire external bond and loan obligations (including IMF loans). In 2006 net debt inflows turned positive again, driving a huge balance-of-payments surplus and leading to aggressive central bank FX intervention. Strong non-debt-creating foreign currency inflows (portfolio equity, FDI and current account flows) and the resulting increase in FX reserves led to a sharp decline in net external debt over the entire 2002-2007 period.

Source: Banco Central do Brasil

All major balance-of-payments items will stay in surplus in 2008. This will keep the BRL under appreciation pressure, especially vis-à-vis a weakening USD. Equity inflows will remain strong on the back of lower domestic interest rates. FDI investment looks more attractive than in the past thanks to improved medium-term economic growth prospects and greater macroeconomic stability. The positive carry will continue to attract fair debt inflows. We expect the balance-of- payments to register a surplus of USD 50 bn.

If and how much the exchange rate will appreciate will depend on the reaction of the authorities. Open macroeconomics suggests various options how to prevent the exchange rate from appreciating. First, the authorities may seek to restrict short-term borrowing by banks. But the government seems committed to keeping the capital account open and changes restricting short-term foreign-exchange on prudential grounds (e.g. changes in rules governing commercial banks’ foreign exchange exposure during this summer).

Second, the government will not implement steep cuts in real primary spending. This would lower primary spending and raise the primary fiscal surplus, limit domestic demand and weaken upward pressure on the prices of non-tradables, allowing for lower interest rates. Unfortunately a substantial slowdown in real primary spending is unlikely, as “mid-term” elections are less than a year away.

Third, in the absence of fiscal tightening the central bank will not implement a large interest rate cut in order to weaken the currency while strong domestic demand is putting upward pressure on inflation. The central bank focuses on inflation and is concerned about safeguarding its autonomy. It will also not want to give the markets the impression that it targets a specific exchange rate level. (It is not clear that given the composition of capital inflows, heavily skewed towards equity flows, an interest rate cut would do much to reduce capital inflows. With the Fed easing, the carry would remain substantial and lower interest rates might even lead to a further surge in equity inflows on the expectation of higher corporate earnings.) 

Finally, the central bank is unlikely to absorb the entire balance-of-payments surplus. The benefits of further reserve accumulation are declining from the central bank’s perspective. (The current level of FX reserves provides a more than adequate level of “risk insurance”. At more than USD 160 bn, FX reserves are comfortable giving Brazil enough of a war chest to weather a “sudden stop” in capital inflows. The carrying costs amount to around 1% of GDP. This won’t break the bank, but the incentive to accumulate further FX reserves is clearly limited.) But for political and economic reasons, it will also not want to open itself unnecessarily to political attacks in the run-up to the mid-term elections. The central bank is therefore likely to continue to intervene, but less aggressively. Assuming that the central bank purchases USD 30 bn in 2008, the remaining USD 20 bn surplus will be enough for further currency appreciation.

The BRL looks strong, but not massively overvalued relative to its historical average. This does not mean that the BRL cannot temporarily weaken. From a fundamental balance-of-payments perspective, the currency should remain under appreciation pressure though. If our analysis is broadly correct, the exchange rate will strengthen to around 1.6/USD next year. Some of the capital inflows are clearly speculative, pushed by ample global liquidity.

Fundamentally we are witnessing an economy and financial markets transitioning to a permanently lower level of risk. Lower country risk, lower domestic interest rates and a declining equity risk premium are pushing up asset prices and leading foreign investors to increase their exposure to Brazil. The prospect of Brazil reaching investment grade by 2009 will further underpin this largely structural trend in foreigners’ willingness to take Brazil exposure.

Brazil - Can the financial and economic boom last? (2007)

Brazilian capital markets are booming. Equity and bond issuance has reached all-time highs. FDI inflows are approaching levels last seen during the privatization-driven FDI boom of the late 1990s and early 2000s. The real has been among the best performing currencies over the past couple of years. Is this yet another episode in the long history of boom-and-bust cycles suffered by Brazil since 1970s? The answer is a decisive “no”. The outlook for Brazilian financial markets is very good.

Macroeconomic stabilization following the 2002 crisis has finally begun to bear fruits. Under the Lula administration, disciplined fiscal and monetary policies have coincided with a booming world economy. In combination with a (post-crisis) undervalued exchange rate, sharply rising commodity prices have allowed the economy to undergo a dramatic external adjustment. Not only has Brazil repaid its IMF and Paris Club debt, it has also managed to increase its FX reserves dramatically. The Treasury continues to buy back external market debt.

Last year the public sector became a net external creditor and under current trends the economy as a whole will follow suit in 2009. Market consensus is looking for economic growth of 4-5% in 2007 and 2008, a rate substantially above the ten-year average of 2.5%. With economic growth picking up and nominal interest rates declining to record lows, the political consensus in favour of “orthodox” macroeconomic policies is strengthening further.

This consensus is unlikely to be questioned anytime soon. The political right converted to the current policies during the 1990s, leaving the left as the only place from where a populist challenge could emerge. But it is the left that has hugely benefited from this very policy. It allowed it to retain the presidency in 2006 and to expand its electoral base to the North- and North-East. Current economic policies are very likely to be maintained beyond 2010.

The prospect of long-term economic stability, higher economic growth and lower interest rates (lower cost of capital) have led to an unprecedented surge in financial market activity. Only the short-lived boom following the 1994 real plan comes close to the current surge in economic and financial activity. But that boom was based on a deteriorating fiscal and external position. This time the boom is taking place against the backdrop of declining public debt and an improving external position. The lower level of country risk has led to a surge in FDI inflows. Lower interest rates have led to a “crowding in” of private investment. Bank lending to the private sector has been increasing.

Domestic private bond issuance has surged. Even the mortgage market is taking off, while second-tier domestic corporates have started tapping international bond and loan markets on the back of much lower Brazil risk. The BOVESPA has reached all-time highs. The growth prospects for financial markets are excellent. Of course there is a cyclical element in the current boom. The world economy has been expanding at the fastest rates in decades, commodity prices are high and ample global liquidity has helped keep down interest rates, fuelling financial market activity and asset price appreciation across most EMs. But there is reason to believe that global factors will fundamentally remain supportive of Brazilian asset valuations over the medium term. The integration of China and India into the world economy will affect Brazil via the financial and trade channel. The high commodity-intensity of Chinese growth will lend support to the Brazilian commodity and agricultural (and related) sectors. Over time, Chinese exports could put pressure on the Brazilian manufacturing sector. But over the next few years, China’s integration into the world economy will undoubtedly benefit Brazil.

Brazil also stands to benefit from increased Chinese investment. Chinese ODI has been quite limited so far. Only a trickle of the USD 100 bn in Chinese ODI supposedly promised by President Hu during his 2004 visit to Latin America has taken place. But over time China will increase ODI in order to satisfy its increasing demand for commodities. Brazil as a resource-rich economy stands to benefit. 

Brazil remains a relatively closed economy and as such most of the growth will have to be generated domestically. A favourable external environment helps, but once asset prices have adjusted to the lower level of risk and interest rates, continued above-average asset price appreciation will require economic growth. There remain considerable obstacles to higher medium-term growth ranging from the need to improve infrastructure and regulatory regimes over raising human capital standards to ensuring medium- to long-term public sector solvency. The nature of Brazil’s political system will make rapid progress on the structural reform front unlikely. Still, even if little reform takes place, the medium-term outlook for Brazilian financial markets and asset prices will remain favourable.

Brazil is still far from fulfilling its economic potential and it is not going to overcome the considerable socio-economic challenges it faces overnsight. But the financial market and economic outlook will remain strong thanks to improved economic stability, declining interest rates, a much improved outlook for economic growth and supportive global developments.

Latin America - a region on the cusp of investment grade (2007)

Several Latin America sovereigns are on the cusp of reaching investment grade. The region has seen a surge in credit upgrades over the past five years and economic stability has increased substantially. Of the seven major LatAm countries two are investment grade (Chile, Mexico) and three are on track to reach investment grade (Brazil, Colombia, and Peru) before the end of the decade. The other two countries (Argentina and Venezuela) are unlikely to reach investment grade before the end of the decade. The improvement in creditworthiness and the increase in economic-financial stability are structural in almost all countries.

LatAm of course remains more sensitive to external shocks than other EM regions due to its lower degree of creditworthiness and/ or higher dependence on commodity exports. But even the riskier countries like Argentina and Venezuela have taken advantage of the export windfall and have reduced the level of their external liabilities. Governments have also taken advantage of higher growth to improve their fiscal position and to reduce (or at least stabilise) their debt. Perhaps most importantly, most governments have committed themselves to a stability-oriented medium-term economic policy. Again, Venezuela (and to a lesser extent Argentina) are the exceptions. Populism continues to lurk in the background in several countries, but is unlikely to affect the outlook until the next round of major national elections towards the end of the decade. Even if the external environment were to deteriorate, a combination of adequate policy response and improved fundamentals would limit the economic and financial fall-out. LatAm has changed fundamentally.

Latin American capital markets are gradually maturing on the back of increased stability. On the supply side, declining external financing needs have led to increased domestic sovereign and non-sovereign debt issuance. More liquid and deeper domestic government bond markets have allowed other markets to take off, ranging from domestic private bond markets over domestic derivative markets to structured finance. 

Domestic banks’ international issuance has also been increasing on the back of net sovereign redemptions. On the demand side, “strategic” real money investors are increasingly putting money into LatAm, especially investment grade countries and countries on the cusp of invest ment grade. In many cases stable domestic investor bases are emerging. Corporate governance reform has also increased domestic and foreign investor interest in local equity markets. In addition, greater economic and financial stability has lowered the cost of capital and pushed up equity market valuations. Primary equity issuance has been booming, especially in Brazil. The new markets will inevitably go through periods of increased volatility. But improved economic stability will gradually lead to deeper and more sophisticated domestic capital markets. This process looks irreversible, at least in those LatAm countries that are on the cusp of investment grade.

Brazil: From serial defaulter to net external creditor (2007)

Brazil is set to become a net external creditor by 2009. Brazil just about averted a sovereign default during the 2002 economic and financial crisis. But over the past five years, Brazil’s economic situation and stability have improved dramatically. The public sector became a net external creditor in 2006. The economy as a whole will become a net external creditor by 2008-09 on the back of rapid FX reserve accumulation. A solid current account position and continued net (direct) equity inflows over the next couple of years will lead to a further improvement in the economy’s net external position. Gross external debt currently amounts to a moderate 16.7% of GDP and gross public external debt to a mere 5.7% of GDP. External indebtedness, which used to be Brazil’s most important vulnerability, has ceased to be a risk to economic stability.

Source: Banco Central do Brasil

Public sector debt remains relatively high, though the debt-to-GDP ratio will fall to below 40% of GDP by the end of the decade from currently 45% of GDP. A combination of higher-than-expected economic growth and declining interest rates will lead to a further narrowing of the fiscal deficit and a continued improvement in debt dynamics. The government now talks about running a balanced budget by 2009. But to achieve this, the economy would need to grow at least 5% or the government would need to raise the primary surplus by 0.5% of GDP. Nonetheless, net interest payments currently running at 6.5-7.0% of GDP have been declining recently. If the government maintains the current primary surplus of around 3.5% of GDP, a “virtuous circle” of declining debt ratios and declining nominal interest rates could push the real interest rate down to 5%. 

Brazil is closely following Mexico’s example in terms of moving from major economic crisis to lasting economic and financial stability. Domestic fixed-income and equity markets are deepening and becoming more mature. Medium-term (> 5 years) debt sustainability will remain a challenge in spite of favourable near-term (<3 years) debt dynamics. External debt vulnerability may be a thing of the past. But the continued upward pressure on government current expenditure calls for reforms. In addition, if the government wants to achieve medium-term economic growth of 4% a year or more over the medium term, it needs to increase investment spending, especially infrastructure spending. Of course, Brazil is not that different from many other countries except for the fact that its social security outlays are particularly high given its per capita income and its demographic structure. In the short run, declining net interest payments will compensate for increasing social security outlays. But in the medium-term, the social security system needs to be reformed.

Latin America needs pro-Growth reforms and fiscal policy is the lace to start (2007)

It is a commonplace by now that having achieved macroeconomic stability Latin America needs to implement structural reforms in order to boost its growth rate. Higher growth is necessary to raise per capita income levels (which in many LatAm countries have stagnated over the past couple of decades) and to address the significant levels of social inequality. If governments fail to make their societies more equal, the political sustainability of the current emerging (but in some countries fragile) consensus in favour of stability-oriented macroeconomic policies will be at risk. It is important to remember just how precarious this consensus continues to be in some parts of Latin America. Higher and more equitable growth is a social and a political necessity.

Latin America’s economic growth performance has been very disappointing. Per capita incomes in the larger economies have stagnated during the past couple of decades. Economists attribute this to macroeconomic instability, microeconomic distortions and insufficient investment amongst other things. A recent IMF analysis titled “Sustaining Latin America’s Resurgence” bears this out, showing that in 1990-2003 labour productivity has risen 3-6 times faster in industrial countries and East Asia (excl. China) than in Latin America. Latin America has lagged in terms of total factor productivity growth. But the most important factor behind low labour productivity growth has been a lower level of investment, including in physical infrastructure and education. The World Bank estimates that the region has spent a mere 2% of GDP on infrastructure, while 55% of surveyed businessmen identify infrastructure constraints as a serious problem. The World Bank also reckons that the LatAm region would need to double or even triple its capital stock in order to reach Emerging Asia growth levels.

Brazil’s federal investment budget has averaged way less than 1% of GDP over the past few years, barely enough to keep the public capital stock at current levels. The larger Latin America economies typically invest slightly less than 20% of GDP. Emerging Asia invests around 25-30% of GDP. China invests an incredible 40% of GDP. No wonder China grows 10% a year and Latin America grows 3-4% a year.

Economists have compiled a long laundry list of reforms deemed necessary to lift the region’s growth potential. On the macro front, countries are supposed to maintain low inflation, limit fiscal deficits and reduce the external and public debt burden. Latin America has made huge progress in this respect in recent years. On the micro front, governments are supposed to reform cumbersome judiciaries, restrictive labour regulation, protected economic sectors, oligopolistic financial systems, unpredictable regulatory frameworks, distortionary fiscal policies and onerous social security regimes. No doubt, microeconomic distortions weigh heavily on the region’s economic growth potential. For example, it takes more than 70 days to open a business in Latin America compared with 46 days in Asia and 32 days in Europe & Central Asia. Enforcing a contract takes 660 days in Latin America against 477 days in Asia (World Bank “Doing Business” survey).

So what should Latin American countries do? Implementing optimal growth-enhancing reforms requires governments to make two types of assessment. It requires the authorities to identify what Ricardo Hausmann of Harvard University has called the “binding constraint(s) on growth”, the constraints that generate the highest pay-off when relaxed. It also requires an assessment of the political costs the government will incur due to the reforms. Governments do not have unlimited political capital when it comes to implementing reforms and they therefore need to set priorities. The economic reform with the highest growth pay-off may be politically impossible to implement. The political and economic circumstances will differ from country to country and a “one size fits all” approach does not exist. The growth-maximising reform agenda will therefore vary across countries. It is difficult to generalize then, but there is a case to be made in favour of tackling low growth, at least initially, through politically less cumbersome fiscal instead of microeconomic reforms.

Microeconomic reforms (so-called “second-generation reforms”) are meant to lift economic growth by increasing the quantity and quality of human and physical capital and lift the efficiency with which labour and capital are employed. The problem with microeconomic reform has been that they are cumbersome and politically difficult to implement, especially in Latin America where congresses are often fragmented and presidents, reform-minded or not, have limited control over the legislative process. In a sense the increased level of macroeconomic stability is not helping either, as it reduces the urgency to pass reforms. Microeconomic reforms are therefore bound to advance only very gradually, if at all. Often there is also a considerable time lag between the time when a reform proposal gets underway and when its benefits in terms of higher growth start to materialize. Once a reform is passed, it needs to b implemented administratively and then economic agents need to familiarize themselves with the new rules and gain confidence in their proper working and application. Microeconomic reform is absolutely necessary, but politically and economically it may be not the best way to kick-start economic growth.

Perhaps the most direct and fastest way to lift the economic growth rate in a sustainable way is to lift the levels of investment through fiscal policy. Latin American governments have often a greater degree of control over fiscal policy than over microeconomic reforms, thanks to fiscal responsibility laws and other legal provisions. Of course, the degree of political control varies substantially across countries and improving the structure of government revenues and spending will in many cases require “extra-budgetary” reforms (e.g. social security). But in these cases and in cases where radical fiscal reform is even more difficult than microeconomic reform due to restrictive constitutional provisions, like Brazil, governments often do have some degree of (short-term) flexibility. As a way to kick-start higher economic growth therefore, it may make sense to tackle the low growth problem by way of boosting investment levels through fiscal policy rather than politically more difficult micro-economic reforms outside budget policy. Clearly fiscal policy changes will very often be gradual. But if the government manages to credibly commit itself to a multi-year adjustment, the impact will be significant. In practice, this may involve governments saving more and opening space for private sector investment through lower taxes or greater tax incentives for private sector investment. It may also involve a shift from current expenditure to public investment spending.

Higher levels of investment especially in infrastructure and education are essential to lift the region’s growth potential. Limiting current spending in a situation where many countries have massive needs in terms of social and health spending is difficult. But bloated government wage bills and in some cases over-generous pension systems benefiting the middle class to the detriment of poorer social groups offer space for a re-allocation within current spending. Governments will be forced to challenge politically powerful groups and expend valuable political capital. But the “Bolsa Família” programme in Brazil shows how a government can buy political support at relatively limited fiscal costs. There are no easy economic and politically low-risk solutions. But if successful, the investment-enhancing fiscal reforms will generate higher economic growth and allow the government to use higher revenues to compensate the political and social groups opposing microeconomic reforms. Looking at the region’s track record of fiscal and microeconomic policy reform, this is all a bit of a long shot. But many countries in the region have managed to achieve a fair degree of macroeconomic stability over the past decade – and there really is no alternative. Latin America needs to increase its rate of economic growth and it needs to reduce social inequality. Tackling the low-growth problem through more investment-oriented fiscal policy, if possible flanked by politically achievable microeconomic reforms, is the economically and politically most promising strategy to kick-start higher economic growth and avert the populist challenge facing Latin America.