Rapid commodity-intensive industrialization, population growth and rising per capita incomes in the emerging markets should continue benefit the Brazilian economy over the medium term. An over-reliance on commodity exports, if not skillfully managed, tends to have a number of detrimental effects, however. Creating a solid framework for dealing with the expected pre-salt-related revenue windfall, reforms targeting productivity growth and a strong fiscal adjustment are necessary if a potentially risky shift towards an economic model that relies too much on domestic consumption and improving terms-of-trade is to be avoided.
Brazil has benefitted from a very significant rise in world commodity prices and an improvement of its terms-of-trade, recent volatility notwithstanding. Brazil’s export mix has also become more commodity-intensive and China has become Brazil’s largest single export market (not counting the EU-27 as a single entity) absorbing 15% of exports (and rising). The export structure remains relatively diversified and Brazil is far from being a pure “commodity play”. That said, high-tech goods make up less than 14% of manufacturing exports, which themselves represent less than 40% of total exports. That said, total exports as a share of GDP remain very low, meaning that a negative terms-of-trade shock would necessitate significant nominal exchange rate depreciation in order to preserve the external equilibrium. Brazil’s export structure may be diversified, product-wise and geographically – and Chinese growth has historically exhibited a low correlation with the US – but Brazil’s terms-of-trade remain susceptible to significant swings.
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| Source: World Bank |
Commodity booms frequently led to over-borrowing and are often followed by busts and sometimes default. According to Reinhart and Rogoff, Brazil defaulted (or “restructured”) its debt seven times during 1824-2010 (Brazil became independent in 1822) and was in default for almost a quarter of this period. Is this time different? Yes. The current account deficit as a share of GDP is manageable and fully financed by non-debt-creating FDI. Gross external debt is small and net debt remains around zero. The systemically important public sector is a net foreign-currency creditor, enabling it to provide FCY liquidity to other sectors of the economy, if necessary.
Fiscal policy is consistent with a continuous reduction in net debt. Rising government revenues (as a share of GDP) are in part attributable to a broadening of the tax base, improved tax administration, declining labour market informality and greater economic stability. Commodity-related revenues are not a very significant source of direct government revenue. That said, during boom times, economists often provide overly optimistic assessments of a country’s underlying (structural) fiscal position. Buoyant financial markets and higher commodity prices will have benefitted government revenues from capital gains and profit taxes. True, tax revenues largely fluctuated in line with nominal GDP growth during the 2008-09 downturn. But this still leaves open the question how revenues would evolve if Brazil were confronted with a permanent rather than temporary drop in commodity prices.
Economists (like investors) frequently underestimate the tendency of systems to “mean-revert”. We may find ourselves in the midst of a (super) commodity cycle underpinned by high-speed, resource-intensive growth in China. This may have caused a permanent upward shift in Brazil’s terms-of-trade, a permanent increase in income and wealth, and, indirectly, a tangible rise in government revenues. But high commodity prices may also turn out to be an aberration, which will end as soon as China shifts away from very resource-intensive growth and/ or as world interest rates start to rise (or risk aversion increases). A permanent decline in commodity prices would lead to currency depreciation and trigger negative wealth and income effects, which would, in turn, adversely affect economic growth.
For the time being, and recent market volatility notwithstanding, rapid commodity-intensive industrialisation and population growth and rising per capita incomes in the emerging markets should continue to benefit Brazilian exports over the medium term. Brazil is a “diversified commodity exporter”. Food and agricultural raw materials make up 2/5 of its goods exports. Brazil is the world’s leading exporter of soybeans, poultry, beef, orange juice, coffee and sugar. The top five export products in terms of value are iron ore, oils & fuels, transport equipment (aircraft), soy and sugar & ethanol. Moreover, Brazil’s agricultural potential is huge. Its potential arable land is estimated at over 400m hectares (FAO), but only 50m are currently being used, and Brazil has more spare farmland than the next two largest countries combined.
Similarly, the recent discovery of so-called “pre-salt (oil) deposits” has the potential to propel Brazil from 15th to 5th place in terms of proven reserves. It will, if successfully exploited, transform the country into an important oil exporter – and provide the government and the economy with a significant revenue windfall. This offers a huge opportunity to accelerate economic development, provided the windfall is spent wisely by investing in education and infrastructure and provided the country can avoid “Dutch disease” related problems. In short, Brazil is very well positioned to benefit from what may be a longer-lasting shift in the global economy: the economic rise of populous and relatively resource-scarce countries such as China and India.
Nevertheless, an over-reliance on commodity exports, if not skillfully managed, tends to have a number of detrimental effects. Economically, it tends to result in revenue volatility (due to occasional large swings in export prices), over-borrowing, lack of economic diversification and “Dutch disease”/ de-industrialisation problems. As regards Brazil, there are as of yet no signs of systemic over-borrowing, the economy and exports remain relatively diversified and the government does not over-rely on direct commodity revenues.
Revenue volatility and “Dutch disease” problems will be manageable if they are dealt with by way of a structurally tighter fiscal policy and the creation of an intelligently managed off-shore wealth fund. Industrial policy is another tool to address industrial competitiveness problems. But, at a minimum, its success will depend on both the design of intelligent policies and an autonomous state capable of implementing these policies efficiently and impartially. A dual strategy of raising domestic savings (and investment) and lifting productivity through targeted microeconomic reform is called for.
In short, creating a solid framework for dealing with the potential commodity-related revenue windfall and reforms targeting productivity growth are necessary if a potentially risky shift towards an economic model that relies too much on domestic consumption and improving terms-of-trade and too little on productivity growth is to be avoided. A strong short and long-term fiscal adjustment would go quite some way towards addressing related potential risks. It should ensure that rising revenues are invested (or at least saved) rather than spent on consumption and transfers, thus preparing the economy for a potential future deterioration in its terms-of-trade.