Order and Progress. For many, these words are associated with Brazil. It is the phrase transcribed across the middle of the nation’s flag, and it will be prominently displayed as the country hosts the upcoming 2014 World Cup and the 2016 summer Olympics.
For emerging markets investors, however, the investing climate in Brazil was characterized by anything but order and progress in 2013. Brazil’s real GDP growth was stagnant and well below government forecasts, while inflation was stubbornly high. The Brazilian equity market was one of the worst performers in the world in 2013, the Brazilian real (BRL) was a chronic underperformer, and the corporate sector struggled through a maze of regulatory uncertainty. At the same time, nominal and real interest rates that ranked among the highest in the world seemed to crowd out private investment.
To make matters worse, Brazil’s BBB credit rating was put on negative watch by Standard & Poor’s (S&P), marking the first time in a decade that a credit agency signaled that the trend in Brazil’s creditworthiness was deteriorating and not improving. And, as we saw in the news, citizens protested in the streets against a wide variety of issues relating to price hikes for public services and the implied fiscal profligacy that surrounded preparation for the World Cup itself.
Yet, things could improve from here, if policymakers rethink their remedies for Brazil’s challenges.
A policy mix that does more harm than good
Faced with a changing and less accommodative external backdrop – as Chinese growth moderates, commodity prices move sideways and U.S. interest rates normalize – Brazilian policymakers have failed to appropriately adjust their policy mix to restore confidence in their economy and attract sufficient investment. Indeed, GDP growth likely stagnated below 3% of GDP for the third year in a row in 2013, and another year of sub-3% growth is expected in 2014.
Worried about economic, political and market backlash, the administration has focused on two areas to stimulate activity: 1) fiscal spending and 2) increasing public banks’ share of credit formulation at subsidized interest rates. Unfortunately, increased spending, captured clearly by the deterioration of the primary surplus from a 3% average from 2002 to 2012 to just above 1.5% in 2013, was channeled through historically inefficient pipes and contributed to S&P’s review of the sovereign credit rating for downgrade (breaking a string of 11 years in which Brazil moved steadily higher from single B to BBB). It has also eroded investor confidence in the government. As investors demand higher interest rates in Brazil, the trend exerts a slowing impulse on growth – exactly the opposite of the intended consequence of higher government involvement.
The government has “doubled down” by ramping up dramatically the amount of state-directed credit at heavily subsidized interest rates. Indeed, in the last five years, public credit extension as a percent of GDP has increased by roughly 10 percentage points, while private sector credit to GDP has basically remained unchanged. As a result, roughly half of the credit extended as a percent of GDP in 2013 was publicly directed versus less than one-third five years ago (Figure 1).
There are several drawbacks to this approach.
- As publicly directed credit is issued at a massively subsidized interest rate, a natural skepticism regarding the creditworthiness of these loans is pervasive. Given the scale with which subsidized loans have increased over the last five years, a large contingent liability now hangs over the sovereign balance sheet and adds to the doubts regarding Brazil’s fundamentals.
- While the surge of subsidized credit amid already tight capacity utilization puts extra pressure on the central bank to maintain inflation within Brazil’s well-defined band, it is very ineffective to combat that impulse by adjusting a policy rate that controls less and less of the credit in the economy. Indeed, recent work from the Brazilian Central Bank suggests that monetary policy rates need to rise by 100 basis points (bps) to reduce inflation expectations by just 30 bps! So while the Brazilian Central Bank has seemingly flexed its muscles and raised market rates by 325 bps in this cycle to 10.50%, the benchmark long-term interest rate (TJLP) on subsidized credit has counterproductively remained unchanged at 5% (Figure 2).
- Artificially high policy rates also crowd out the private sector and, when accompanied by ever tighter monetary policy, can distort the value of the exchange rate, which erodes the competitiveness of the export sector and impacts the balance of payments. Brazil has been struggling with these problems for many years, and as the traps of these policies are realized over time, unwinding them becomes complex and can create further market disorder. The dysfunction of the BRL currency market in 2013 is a great example of the consequences; it has required a massive central bank intervention program to stem losses and contain second-order effects on inflation, country risk premium and local interest rates.
As a result of these factors, the interest rates paid on BBB rated, Brazilian local debt exceed those demanded by investors in BBB rated Russian debt by over 500 bps, despite inflation in Russia that is 60 bps higher than in Brazil (Figure 3). The signaling has become so poor that investors now demand significantly more compensation to lend money to Brazil in BRL than they do to Greece in euros!
A different approach
Fortunately, Brazil has a number of attributes (including a healthy demographic profile and abundant natural resources wealth) which support the potential to generate strong economic growth and lower inflation. In addition, because of its very low stock of foreign-currency-denominated and floating rate debt as a percent of GDP, high degrees of international reserves self-insurance, and a floating exchange rate that should naturally act to rebalance its economy, Brazil’s balance sheet is both very strong and resistant to shock. So despite the current malaise, change to a more robust path is readily achievable.
Rather than running the current combination of excessively loose fiscal policy, augmented by a profusion of subsidized public credit, and compensated for by ever tighter monetary policy, Brazil needs to alter this mix dramatically. The government should revert to the policy framework that served it so well during the first Lula administration and anchor its economic policy around a stringent and credible primary surplus target.
While the impulse of tighter fiscal policy may be an initial headwind for economic activity, second-order effects would likely be enormously positive and serve to boost the economy. Given the strong initial conditions of Brazil’s balance sheet, credibly anchoring the fiscal side would immediately dispel concerns about the deterioration of Brazil’s credit profile and would put to rest any discussion of a sovereign credit downgrade. Reinforced credit quality would meaningfully lower the interest spread Brazil is charged by the market, be well-received by the equity markets and boost consumer confidence. This would help facilitate and incent much-needed investment, and would likely improve sentiment in the currency market.
A more stable currency would break pernicious expectations of pass-through effects from today’s weakening BRL, and along with the tighter fiscal stance, would significantly change the inflation outlook. This would likely be expressed immediately in the market by a significant inversion in the Brazil local interest rate curve, allowing both the government and the private sector to term out financing at much more affordable long-term interest rates.
As the economy absorbs the tighter fiscal stance and inflation expectations are better anchored, it is possible that monetary conditions would be loosened amid a GDP slowdown. Critically, and for reasons described above, this should not be done through expanding subsidized loans from the state development bank (BNDES). Instead, the central bank could begin to normalize its monetary policy stance from the anomalously high real and nominal rates it is forced to
Replacing subsidized credit with traditional monetary policy to ease credit conditions would be a significantly more transparent and effective stimulus, while mitigating all the negative externalities that have been associated with the past explosion of public credit. This would also allow the exchange rate to naturally find equilibrium, help rebalance the economy, and do so without undermining inflation. This would go a long way to helping Brazil achieve more robust growth, with lower inflation, and an exchange rate whose value is not artificially distorted.
Investors in emerging markets may now be wary of Brazil, especially given the recent underperformance. Nevertheless the long-run ingredients for attractive total returns in Brazil fixed income are in place.
The policy mix that has eroded confidence, distorted the local interest rate market, undermined the currency and injected credit risk premium into sovereign assets is readily fixable. At the same time, valuations, while subject to overshoots, are attractive in the sense that credit default swaps already imply a ratings downgrade, local nominal and real rates are hundreds of basis points higher than in other major emerging markets, and the currency has depreciated meaningfully to a level that is more consistent with restoring a sustainable current account balance.
But with the volatility currently being experienced by emerging markets as the Federal Reserve tapers, and ahead of October Brazilian presidential elections, the scaling of Brazil investments among non-dedicated emerging markets investors should be moderated, even as our dedicated emerging markets strategies underwrite this heightened uncertainty. The bar has been raised for the Brazilian authorities to show progress in restoring a policy mix that attracts investment, restores confidence and delivers robust growth with moderate inflation. Without this, the outlook for order in financial markets (and on the street) in Brazil is less certain.