Tue | Sep 26, 2017

Walter Molano │ Brazil is losing the plot

Published:Friday | October 2, 2015 | 10:00 AMWalter Molano
A woman shouts slogans and bangs on a pan during an anti-government protest demanding the impeachment of Brazil's President Dilma Rousseff in Rio de Janeiro, Brazil, on august 16, 2015.

Winter gives way to spring, as the southern hemisphere tilts towards the sun, yet none of the optimism that is associated with the arrival of warmer weather is on display.

There is a prevalence of shuttered storefronts along the thoroughfares of Sao Paulo.

There are good reasons for the sour mood. Unemployment has been rising for seven straight months. The national statistics agency, IBGE, reported that the unemployment rate hit seven per cent in August, marking the highest level in five years. With the economy contracting 1.9 per cent y/y during the second quarter, and expected to fall by more than 2.5 per cent y/y for the entire year, some economists worry that the unemployment rate may reach 10 per cent by next year.

As a result, households are slashing spending. Supermarket sales are down, and there are less people visiting abroad. To make matters worse, the inflation rate was 9.53 per cent in August.

At first glance, the rise in consumer prices could have been due to the massive devaluation of the BRL. However, that was not the case. The increase was mainly the result of utility tariff increases. These effects should fade by year end, and the central bank estimates that the inflation rate should fall to 5.8 per cent in 2016.

This is forcing the monetary authorities to keep interest rates high, for now, which is only adding to the malaise. At the same time, the government is under a great deal of pressure to stabilise the country`s debt load.

A few weeks ago, Finance Minister Joaquim Levy was forced to admit that the primary fiscal deficit would reach 0.7 per cent of GDP by year`s end. With such a large fiscal deficit, Brazil's debt-to-GDP ratio will balloon to 70 per cent by the end of next year.

The announcement forced Standard & Poor's to downgrade the country's sovereign credit rating to junk. Having lost its coveted investment-grade rating, it seemed like the wheels were coming off the proverbial bus.

Brazil now finds itself adrift. With three years to go until the end of the term, there is a clear lack of leadership and direction. President Dilma Rousseff remains embroiled in a corruption scandal that has eviscerated her party, and is threatening to implicate her.

So far, the evidence is mainly superficial and hearsay, but the noose is drawing ever tighter. The opposition does not appear to be moving aggressively for an impeachment, even though there is a great deal of public resentment against her.

It seems like they would rather wait out her term, while Levy tries to clean up the fiscal accounts and the PT implodes. The party holds a vast array of positions across the country, and it will take some time to drum them out of office.

The question is whether Brazil can survive three years of drift. So far, the political institutions have held up. Their judiciary remains independent, and there are no questions about the democratic regime. Yet, we have to see what will be the case when the unemployment rate becomes double digit.

As we have seen in Greece, the United States, United Kingdom and Spain, an ugly crop of populists pop out of the woodwork when things get bad.

More important, external events can get worse. The tightening of US monetary policy will not help. Also, a further devaluation of the renminbi - RMB - could have disastrous effects on Brazil. A strange event happened two weeks ago that did not get much analysis.

There are two markets for the Chinese currency the CNY is the onshore market, and the CNH is the Hong Kong market. In August, the People's Bank of China (PBOC) devalued the CNY. However, a month later, there was a strong intervention in the CNH market. The two currencies usually moved in lockstep, but the correlation broke down after the devaluation.

To make matters worse, the gap between the two currencies is growing. Although no one officially took responsibility for the intervention, it was rumoured that it cost about US$20 billion.

The only institution with those resources was the PBOC. So, the question became: Why did China spend so much money on appreciating the CNH after it had just devalued the CNY? There are many possibilities. One of them is that the CNY is not undervalued. It is really overvalued, and any further deregulation of the foreign exchange market could lead to a rout in the RMB.

What happened to the Malaysian ringgit, the Colombian peso and the Brazilian real, could be a prelude of what lies ahead for the CNY.

A massive devaluation of the RMB (20 per cent-plus) would be devastating for Brazil, particularly when no one has their hand on the helm. Brazil has lost the plot, and it is in danger of entering into a deeper crisis if things in China deteriorate further.

 

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com