Wed | Nov 14, 2018

Walter Molano | Brazil: Full steam ahead

Published:Friday | February 2, 2018 | 12:00 AM
In this March 26, 2017 file photo, people march against corruption and in support of the Car Wash investigation on Copacabana beach, in Rio de Janeiro. Brazil has been downgraded by S&P and the corruption probes continue, but amid it all, the Brazilian economy is in the midst of a powerful cyclical recovery. (AP)

Standard & Poor's decision to downgrade Brazil's credit rating did more to bruise Brasilia's political pride than to sound a warning on the country's economic condition.

After the deepest recession in a century, the Brazilian economy is in the midst of a powerful cyclical recovery, and there is almost nothing that can derail it.

Moreover, the synchronised global recovery, after the devastating financial crisis of 2008-2010, along with the corresponding improvement in commodities prices, is also creating favourable external conditions that will add to Brazil's economic momentum.

Pent-up demand

After enduring such a prolonged economic slump, it is only natural that Brazil is experiencing a great deal of pent-up demand. Brazilian households are rushing to replace run-down automobiles and white goods. General Motors recently added a third shift at its Gravatai Plant, reflecting the increased demand for its products.

The pace of Brazilian economic activity broke into positive territory during the third quarter of last year, with GDP expanding 0.3 per cent year-on-year.

The economic expansion should accelerate to almost three per cent year-on-year in 2018, and it could crest over four per cent year-on-year in 2019, if the electoral outcome is good. As a result, the situation in Brazil is looking good - and it is going to get even better.

This year is an electoral year in Brazil, and the stakes are high. There is a long slate of candidates and the electoral field is pretty dispersed across the political spectrum.

Former President Luiz Inacio Lula da Silva may be leading the pack, but it is unlikely that he will be allowed to run, given his legal woes. A convicted criminal cannot hold high public office in Brazil, even though he will try to again appeal the recent court decision. In a distant second place is Jair Bolsonaro, the outspoken right-wing congressman from Rio de Janeiro.

However, these two candidates have very high rejection rates. Given Brazil's two-round electoral system, it is unlikely that they would ever survive a run-off election. That is why most political analysts are focusing their attention on S„o Paulo Governor Gerardo Alckmin. The centre-right PSDB candidate would probably have the political clout necessary to secure the \passage of the much-needed pension reforms.

Although the polls currently show his support in the high single digits, and there was some noise related to Lava Jato, he does not have the level of baggage or rejection as do the leading contenders.

A better horizon is what is allowing many Brazilian business leaders to boost investment. Fixed investment is at the highest level in more than four years. Right now, their focus is on adding to depreciated capital stock, but a better outlook after the presidential elections will lead many businesses to boost capacity.

A glimpse at high-frequency economic indicators, such as consumer and business confidence, shows the drastic improvement in sentiment. The fact that the BOVESPA is at an all-time high reflects the positive mood. Of course, the improvement in economic activity will eliminate the deflationary pressure that was weighing down the economy, and inflation may inch up to four per cent in 2018.

Nevertheless, the COPOM still has room to reduce interest rates to the 6.5 per cent range by midyear. A similar upbeat story exists in the external accounts. Brazil's current account balance was close to flat in 2017, and it should post a shortfall of about one per cent of GDP in 2018. This is remarkable for a country that persistently suffered from large deficits in its external accounts.

Unfortunately, not all of the news is good. Problems persist on the fiscal side. The primary fiscal deficit is stuck at two per cent of GDP, and the government needs to raise it to a surplus of 0.5 per cent of GDP in order to stabilise the debt.

The biggest problem is the pension system, and the government's failure to pass the pension reforms explains why the country's credit rating was downgraded. Still, it is notable that the government has been able to pass other important pieces of legislation, including the revamping of the labour code, the implementation of spending limits, the removal of BNDES loan subsidies and the launch of a new privatisation programme. All of these measures will help streamline the Brazilian economy and move into a higher pace of sustainable growth.

The downgrade also raised the heat on the congress to act. President Michel Temer quickly responded that he would continue to push for the pension reforms. Other members of the political leadership also moved to downplay the effects the downgrade.

It is true that S&P's decision was mostly priced in. Still, it was a nice wake-up call. Nevertheless, we cannot ignore the fact that the Brazilian economy is in the midst of a powerful cyclical recovery. Therefore, full steam ahead!

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