Latin America Economics

Brazil: stuck in the slow lane

Latin America Economics Focus
Written by William Jackson

The prevailing view that this will be the year when Brazil’s recovery finally shifts up a gear looks overly optimistic. We expect that GDP growth will come in at just 1.5% over 2020, which leaves us close to the bottom of the consensus range.

  • The prevailing view that this will be the year when Brazil’s recovery finally shifts up a gear looks overly optimistic. We expect that GDP growth will come in at just 1.5% over 2020, which leaves us close to the bottom of the consensus range.
  • ‘This year will be better’ seems to have underpinned forecasts for Brazilian GDP growth over the last few years, only to result in constant disappointment. The median forecast for 2018 started the year at 2.7%, but growth ended up being just 1.3%. Forecasts for 2019 began at 2.6% but the economy probably only managed growth of 1%. For this year, the consensus expectation is that growth will accelerate to 2.3%.
  • In principle, GDP growth in Brazil could accelerate sharply. The deep 2014-16 recession created a large output gap. And three years into the recovery, real GDP is still some 3.6% below its 2014 peak. As a result, the economy could enjoy a period of above-potential GDP growth by drawing on underutilised resources to meet a rise in demand. The fundamental problem is that demand has been weak.
  • Admittedly, domestic demand has started to strengthen in recent quarters. And the loosening of financial conditions that has accompanied the government’s pursuit of economic reforms should provide further support over the course of this year.
  • However, we don’t think that a strong recovery in demand is likely. First, households’ real income growth is likely to slow in 2020 due to weaker employment growth and higher inflation. Second, it looks like private sector savings are now low. To the extent that savings have been reduced to fund higher consumption in the last few years, this is unlikely to last.
  • Third, fiscal policy is likely to tighten in 2020. After all, the government’s recent pension reform hasn’t solved all of Brazil’s fiscal problems. Fourth, we think that Brazil’s terms of trade will worsen in 2020, mainly due to a decline in iron ore prices caused by a slowdown in China’s residential property sector. That will reduce incomes and weigh on domestic demand.
  • And, finally, it’s hard to see external demand coming to the rescue. The recent de-escalation of the trade war could shift Chinese demand for agricultural imports away from Brazil. And regardless of how this plays out, Brazil’s agricultural exports will be hit by the impact of African Swine Fever on China’s demand for soybeans. On top of this, external demand will also be hampered by the ongoing recession in Argentina.
  • As a result, even though many analysts are currently revising their 2020 growth forecasts up, we are revising ours down, to 1.5% (previously 2.0%). This would still be stronger than in 2019, but it leaves us well below the consensus (2.3%). We are sticking to our 2021 forecast of 1.8% (consensus: 2.5%).
  • One consequence of weak growth is that the central bank will have little reason to tighten monetary conditions this year. We expect that the policy rate will remain unchanged at 4.50% over the course of 2020 whereas financial markets are pricing in interest rate hikes in the second half of the year.
  • The absence of a significant pick-up in growth may also cause the government to lose faith in the value of the reform agenda, particularly as municipal elections come onto the agenda later in the year.

Brazil: stuck in the slow lane

In this Focus, we explain why the widespread view that 2020 will be the year in which Brazil’s recovery shifts up a gear is overly optimistic. We start by looking at why Brazil’s recovery from the 2014-16 recession has been so slow, before turning to the factors that will (or won’t) drive growth this year.

Optimism the order of the day

‘This year will be better’ seems to have underpinned consensus forecasts for Brazilian GDP growth over the last few years, only to continually disappoint. Chart 1 shows the consensus forecast for GDP growth, as published in the central bank’s survey, in each year since 2017 (with T set as the first working day of the year in reference).

The median forecast for 2018 started the year at 2.7%, but growth ended up being just 1.3%. Forecasts for 2019 began at 2.6% but the economy probably only managed growth of about 1%. For this year, the consensus expectation is that GDP growth will accelerate to 2.3%.

Chart 1: Analysts’ Median GDP Growth Forecast (%)

Source: BCB

These expectations for a pick-up in growth seem to be based on the depth of Brazil’s 2014-16 recession. GDP fell by 8% from peak to trough and, three years into the recovery, the level of real GDP is still 3.6% lower than its high point in 2014.

The recession was the result of a collapse in demand, caused primarily by lower commodity prices which reduced incomes, and was exacerbated by the country’s domestic political crisis. This created large amounts of slack in the economy. Surveys suggest that capacity utilisation rates in the manufacturing sector are far below pre-recession levels, while the unemployment rate is much higher. In other words, there is a large output gap.

In principle, then, Brazil’s economy could enjoy a period of above-potential growth by drawing on underutilised resources to increase output. Indeed, historically, the Brazilian economy has rebounded quickly from recessions. If this recovery was anything like previous ones over the past few decades, real GDP would be about 10-15% higher than it currently is. (See Chart 2.) The fundamental problem holding back the recovery this time has been weak demand.

Chart 2: Real GDP (T = Pre-Recession Peak)

Sources: Refinitiv, Capital Economics

Chart 3 attempts to decompose this. It shows the change in GDP between the pre-recession peak and its level four years later, and the contribution to the change in GDP by expenditure component. The black bars show the data for the latest recession; the blue bars show the average of the previous four recessions since 1996 (when a detailed GDP breakdown was first published).

Chart 3: Contribution to Change in Real GDP Four Years from Pre-Recession Peak (%-pts)

Source: BCB

Net trade has made a significant positive contribution to the recovery from the latest recession (although it has turned into a drag on growth over the past year). Instead, the recovery has been held back by domestic demand. Household spending explains about two-thirds of the weakness compared with past recessions, and investment accounts for most of the rest. This can be pinned on several factors including continued low commodity prices, which have depressed incomes; fiscal tightening; and ongoing corporate deleveraging following the credit boom in the early 2010s. (See here.)

Recent revival built on shaky foundations…

The latest activity data suggest that things may be starting to turn around. GDP expanded by 0.5% q/q in Q2 of last year and by 0.6% q/q in Q3, driven by strengthening consumer spending and fixed investment. What’s more, the loosening of financial conditions (see Chart 4) that accompanied the government’s pursuit of economic reforms should provide support to the recovery this year.

Chart 4: CE Brazil Financial Conditions Index

Sources: Refinitiv, Bloomberg, Capital Economics

That being said, we don’t see the conditions in place for a strong recovery in demand. First, some of the tailwinds supporting consumer spending growth are likely to fade. Admittedly, the release of funds from the FGTS (a compulsory social security fund, which usually only allows funds to be released in certain events, e.g. unemployment or house purchases) could provide some support to household consumption. But the majority of these withdrawals have probably already occurred.

In the meantime, real disposable income growth is likely to slow. Employment growth has already started to weaken, part of which is due to softer public sector hiring. With the government likely to tighten its belt (more on this later), employment growth will probably remain softer.

Perhaps more importantly, inflation is likely to be higher this year than last, eroding real incomes. The impact of African Swine Fever on China’s pig stocks has led to a sharp rise in demand for beef from Brazil, raising domestic prices. This caused inflation to jump to 4.3% y/y in December. (See here.)

Beef inflation is close to peaking, but it will remain high over the course of 2020. Meanwhile, petrol price inflation is set to increase, and inflation of some fruit and vegetables is likely to pick up from current low rates. As a result, inflation is likely to be higher in 2020 than in it was last year. (See Chart 5.) For reasons we will discuss in more detail later, this shouldn’t trigger a policy response though.

Chart 5: Consumer Prices (% y/y)

Sources: IBGE, Capital Economics

Second, it looks like private sector savings are now low. To the extent that savings have been reduced to fund higher consumption in the last few years, this may not last. Unfortunately, Brazil’s statistics office only publishes a detailed breakdown on income and savings by sector with a long delay – the most recent data on the household savings rate are for 2017. However, we can calculate aggregate private sector savings (including households, but also private companies) from national accounts and public finance figures to infer trends in household savings.

Chart 6 shows the household savings rate and our own estimate of private savings, which have generally moved together. Private savings have declined sharply since 2017, suggesting that the household saving rate may have followed a similar path. It’s not clear how much further savings might decline. But it seems most plausible to us that they won’t continue to drop at the same pace as in the last few years. That would remove one prop to consumption.

Chart 6: Savings Rates

Sources: Refinitiv, IBGE, Capital Economics

Third, fiscal tightening is likely to intensify. Even though the much-vaunted pension reform was passed last year, this will only help to stabilise the debt ratio – and only by the mid- to late-2020s. Further fiscal consolidation will still be needed to bring the debt ratio down.

Indeed, this seems to be on the cards this year, after what appears to have been a broadly neutral fiscal stance in 2019. The 2020 budget suggests that spending will rise by no more than inflation, which is necessary to comply with the constitutional spending cap. That means that expenditure will fall as a share of GDP.

The spending cap will be met through, among other things, a planned 9% reduction in investment expenditure and a lower minimum wage increase (to which a large portion of public benefits are tied). The IMF’s projections suggest that the structural budget balance – that is, where the budget balance would be if the economy were at full employment – will narrow by around 0.3% of GDP this year, implying a fiscal squeeze of a similar magnitude.

…And the external environment won’t help

Fourth, we expect that Brazil’s terms of trade will deteriorate, weighing on incomes and domestic demand. This is, in large part, because China’s residential property sector is likely to weaken this year, which will cause iron ore prices to fall. Overall, our commodity price forecasts imply a reduction in Brazil’s net exports of about 0.3% of GDP in 2020 compared with 2019. That will reduce incomes and, on past form, is consistent with weaker domestic demand growth this year. (See Chart 7.)

Chart 7: Change in Net Exports Due to Terms of Trade & Domestic Demand

Sources: Refinitiv, Capital Economics

Finally, foreign demand won’t come to the rescue. On the plus side, the drag on exports from the iron ore sector should fade. Output has now been raised after disruptions due to the Brumadinho dam tragedy in early 2019. However, we expect that global growth will remain weak this year. Argentina, Brazil’s third largest export market, is set to remain stuck in recession. And we also expect that China, the country’s largest export market, will slow.

Moreover, the combination of African Swine Fever, which has reduced China’s pig stock (and demand for soybeans which are used as feed), and the ‘Phase One’ US-China trade deal, which includes a pledge by China to purchase more US agricultural goods, could result in lower Chinese demand for Brazilian agricultural goods.

A decline in Chinese demand for Brazilian agricultural goods would not have a direct impact on GDP in the near term. Over a short time horizon, agricultural supply is highly inelastic and produce that is harvested but not sold will be stored instead. On the expenditure side of the national accounts, export growth would be weaker, but there would be an equal and offsetting rise in inventory investment. There would, however, be an indirect impact on the economy via lower export revenues. Producers would receive lower incomes, reducing their spending. To give a sense of scale, Brazil’s soybean exports to China are equivalent to about 1% of GDP.

Conclusions

For all the pessimism in this Focus, we still think that GDP growth will be stronger in 2020 than 2019. For one thing, the economy’s strong finish to last year creates a large positive statistical carryover. On the demand side, looser financial conditions will help to support credit growth and spending. On the supply side, the volume of both iron ore and crude oil production is likely to be higher in 2020 than 2019. Those two sectors could lift GDP growth by about 0.2-0.3%-pts compared with last year.

Even so, while most other analysts are in the process of revising their 2020 forecasts up, the weak outlook for demand has prompted us to revise our growth forecast down, to 1.5% (previously 2%). That’s up from about 1% in 2019, but it leaves us well below the consensus forecast (2.3%). Our 2021 GDP growth forecast of 1.8% is unchanged (consensus: 2.5%). (See Chart 8.)

Chart 8: GDP Growth (%)

Sources: Refinitiv, Capital Economics

There are three additional consequences of weak growth that we would draw attention to. The first is that falling export incomes are likely to cause the current account deficit to widen, reaching about 3.5% of GDP, by the end of the year, and put the real under pressure. We expect that the currency will end the year at 4.25/$, whereas the current consensus forecast is for the real to strengthen to 4.00/$ (compared with 4.14/$ now).

The second is that, with economic growth likely to undershoot expectations, the central bank won’t raise interest rates. While there are mixed views about the possibility of one additional 25bp cut in the Selic rate in early 2020, the broad direction for interest rates now being priced into financial markets is up. If growth doesn’t strengthen significantly, it will be difficult to justify monetary tightening.

Admittedly, inflation is likely to be higher than the central bank’s 4% target in the first few months of the year. (See Chart 5 again.) But we doubt that Copom will be concerned by this. For one thing, inflation will only marginally exceed target. More importantly, the rise in inflation is being driven by food and energy prices, over which monetary policy has no control. And the large output gap and low inflation expectations reduce the likelihood that a rise in food inflation will have second-round effects, feeding into stronger core price pressures. We expect that the Selic rate will remain unchanged at 4.50% throughout this year and next. (See Chart 9.)

Chart 9: Selic Interest Rate & Forecasts (%)

Sources: Bloomberg, Capital Economics

Finally, the absence of a significant pick-up in growth could cause many within the government to question the benefits of the reform agenda. It had in any case looked like the next steps – tax reform, civil service reform, trade liberalisation, etc. – faced more opposition than pension reform. It will be all the harder to push these through if a consensus begins to emerge that any benefits accrue over too long a time horizon, particularly if political energies start to focus on municipal elections, which are due in October. As reform momentum wanes, Brazilian assets are likely to go from being outperformers to underperformers. (See here.)


William Jackson, Chief Emerging Markets Economist, +44 20 7808 4054, william.jackson@capitaleconomics.com