Economic growth will remain robust in Brazil

Since Q4 of 2009, the country has seen a strong and broad-based recovery, thanks to a rebound of exports to Asia, investments and buoyant consumer demand.
Analisis Credito y Caución
Madrid - 10-out-2011

In 2009, Brazils economy experienced a mild recession, with a 0.7% GDP contraction, due mainly to falling industrial output of -7.4% year-on-year caused by a sharp drop in exports and investments [-10%]. However, since Q4 of 2009, the country has seen a strong and broad-based recovery, thanks to a rebound of exports to Asia, investments and buoyant consumer demand. Industrial output and exports grew 11.5% year-on-year in 2010 and retail sales generally were exceptionally strong last year, increasing in volume by 10.9% year-on-year as a result of labour market improvements, with many new jobs both temporary and permanent being created. Credit conditions remained flexible and financing costs have reached historic low levels, providing a stimulus to household consumption, which increased 7.0% in 2010. While exports of goods and services increased 11.5% last year, imports rose substantially more: by 36.2%. For the whole of 2010 output grew 7.6% year-on-year.

2011: Slowdown of growth and higher inflation

This rebound slowed down towards the end of last year, suggesting economic growth to cool down in 2011: GDP grew 4.2% year-on-year in Q1, and is forecast to increase 4.3% in 2011. Gross fixed capital formation [+8.8%] and household consumption [+5.9%] grew considerably year-on-year in the first quarter of 2011. Growth of industrial production has markedly decelerated in H1 of 2011 compared to H1 of 2010, and even decreased 1.6% year-on-year in June 2011.

One of the side-effects of the boom has been rising inflation, which has increased steadily since September 2010 and, with the economic upswing and higher food prices, rose to 6.7% year-on-year in July 2011. This is the highest rate since November 2008, and above the Central Banks target of 4.5%. For the whole of 2011 consumer price inflation is forecast to increase 6.6% year-on-year.

Policy measures to tackle economic overheating

The banking sector is in reasonable condition with strong regulation and supervision. There are already signs that the credit cycle is building up pressure, leaving commercial banks with a rapidly rising proportion of disputable debts in their portfolios. In order to slow down credit growth, which grew 20% between April 2010 and April 2011, the central bank has imposed stricter reserve requirements for banks and the government increased taxes on consumer credit.

In a bid to counter domestic economic overheating and inflation, the Central Bank has been raising the SELIC benchmark interest rate [its overnight lending rate] since April 2010. In June 2011 it rose for the fourth time this year: by 25 basis points to 12.5%, 3.75 basis points higher than in April 2010.

The sharp real appreciation has hurt Brazilian exporters

However, the higher interest rates attract more short-term investment capital, and these capital imports are right now the last thing Brazil needs: capital inflows and higher inflation force the real [R$] exchange rate to appreciate. The R$ has gained nearly 50% against the US$ over the past two years, favouring imports [which increased 32% in the January-July 2011 period in US$ terms], while causing increasing worries for Brazilian exporters of manufactured goods due to their eroding competiveness. The export of cars decreased 8% year-on-year in the first seven months of 2011.

To stem the currency appreciation, the Brazilian government imposed capital control measures in October 2010, such as higher taxes on foreign investors´ fixed income purchases, and, in January this year, it increased reserve requirements on short US$ positions held by local banks. End of July 2011 the administration announced to additionally levy a tax on foreign exchange derivative trading.

Fiscal tightening underway

President Rousseff has also taken urgent fiscal policy measures to address the overheating economy, which owed much to increased public spending in the past couple of years. Massive government loans and tax breaks helped to avoid a deeper recession during the credit crisis, but much of the 2009 stimulus was directed at employing public sector workers and increasing pensions and social benefits, instead of improving the countrys poor infrastructure. And even as the economy began to show strong signs of recovery last year, public spending remained high in the run up to the October 2010 parliamentary and presidential elections. Government spending accounts for more than 20% of Brazil's gross domestic product, and public sector debt amounts to 59% of GDP.

Prospects: Good, but the risk of economic overheating remains

The outcome of the presidential and parliamentary elections has brought continuity but has not changed the political fragmentation and the poor legislative progress in Brazil. Low party discipline and lack of coalition loyalty in Brazils political system still hamper decision making. This is a major obstacle for urgent reforms to strengthen the structure of the domestic economy in the long-term.

Economic growth will remain robust

GDP growth is expected to remain robust in 2011 [4.3%] and 2012 [4.7%], still driven by domestic demand, investments and exports. However, the inflation forecast for 2012 has been revised upwards, to 5.1%, which means that there is still a risk of the economic upswing spinning out of control and the economy overheating.

The main objective for the authorities is to obtain a GDP growth that is sustainable while keeping inflation and the increasing current account deficit [3.1% of GDP] under control, i.e. a soft landing. Adequate foreign capital inflows will prevent the widening current account deficits from jeopardizing this solid liquidity and solvency position. That said, besides large amounts of foreign direct investments [US$ 48 billion in 2011 after US$ 26 billion in 2010] more short-term capital flows to Brazil, complicating the central banks strict monetary policy of inflation targeting even more. The R$ appreciation increasingly undermines the competitiveness of Brazils export business, keeping Brazils central bank in an awkward position of either rising interest rates [to fight inflation] or lowering them [to stem the real appreciation]. The central bank is expected to increase its benchmark interest rate further and/or take additional measures to curb credit growth, e.g. an increase in reserve and capital requirements. In July 2011 it stated that it does not expect an inflation slowdown to around 4.5% [the target rate] until the first half of 2013. At the same time the Brazilian government unveiled plans to help businesses hurt by the R$ appreciation.

The problems of fiscal tightening

Further fiscal tightening is necessary to avoid an economic overheating and to reduce the public sector deficit, but the government faces the fact that less than 10% of the yearly budget consists of items that can be cut, while payroll, health care and education spending are fixed. One measure could be a reform of the complicated tax and the generous pensions systems, but this seems improbable due to the political circumstances.

Infrastructure improvement is essential for sustained long-term growth [the poor state of many roads, airports and harbours and overstretched power supply systems have already prevented additional growth]. To accomplish such improvements, however, the government would have to implement additional public sector investments: extra stimuli that would further increase the risk of economic overheating.

Brazils oil wealth: Blessing or curse?

Exports from Brazils huge offshore oil reserves will underpin the external position in the longer term. However, the exploration also poses a challenge for the country: to manage these reserves skilfully without letting the competitive position of non-oil exports be overly weakened by a strong currency, a phenomenon often referred to as the `Dutch disease´.

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