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The Boom
After flying high for more than a decade and a half, the $ Two trillion Brazilian economy has come down with a thump and the reverberations are beginning to be felt around the world. In the last fifteen years, the economy grew strongly on commodity demand and was even the inspiration for a new acronym that took the financial world by storm; BRICS. This was coined by Jim O'Neill a Goldman Sachs economist to encapsulate what he considered the new economic movers in the world. Namely, Brazil, Russia, India, China and South Africa.
Brazil's economy boomed on the huge demand for commodities generated by China. By 2010, the country had achieved full employment and millions had been lifted out of poverty.'Brazil experienced a decade of economic and social progress from 2003-2013 in which over 26 million people were lifted out of poverty and inequality was reduced significantly (the Gini Coefficient has fallen 6% in 2013 to 0.54).The income of the bottom 40% of the population grew on average 6.1% (in real terms) between 2002 and 2012, compared to an 3.5% growth in income of the total population. However the reduction in poverty and inequality shows signs of stagnating since 2013', according to the World Bank.
Digging a deep hole
Yet today Brazil's economy is in a tailspin. Huge declines in commodity prices over the last couple of years coupled with slowing demand for commodities have considerably weakened an economy whole main powerhouse was and continues to be commodity exports. The country is facing the worst recession since the Great Depression. The economy is expected to slump 3% this year and is expected to post a further decline of 2% in 2016. The latest budget shows a primary deficit (before interest payments) of 0.5% and an overall huge 9% deficit. In July,in an increasingly desperate effort to rein in galloping inflation, running at 10%, Brazil's Central bank raised interest rates by 50 basis points to 14.25%.
"We are entering a different phase," says Bhanu Baweja, emerging market strategist at UBS in London. "For the longest time we have thought that even if EM growth is weak, EM balance sheets, or their ability to service their debts, have been broadly OK. But now things are getting more serious." (Financial Times September 11, 2015)
The blow falls
For some time now, many analysts have been wondering when and not if Brazil's credit rating would turn junk. The surprise is that it happened so soon, when Brazil is sitting on top of $300 billion plus reserves.
"There is such a wide variety of metrics and [gauging ability to pay] has become so complex that it is very hard for the agencies to allocate a weight to specific factors in a matrix," says Simon Quijano-Evans, EM strategist at Commerzbank in London. Rating agencies are looking more at structural issues like ease of doing business, overall business environment and corruption and diversification for commodity dependant economies. Even more importantly they are looking at the actions taken to rectify defects in these areas. The perception that Brazil was not likely to act on these issues was enough to convince S&P to downgrade.
If one more rating agency follows suit, overseas investors will have to sell their Brazilian holdings, as the rating would become solid.Twenty percent of Brazil's debt is held by foreigners.
Inability to climb out
Having learnt from past experience, Brazil has kept its sovereign or national external debt low. The ratio of debt to GDP declined from 78% in 2002, to 61% in 2011; though it has risen since then. However many companies have borrowed in US dollars to finance their operations. As the dollar strengthens and the Brazilian Real weakens these companies would find that they would have to pay more and more to service and repay their debts."The issue is the dynamics of the debt and the lack of any coherent policies to address it," says Mr Quijano-Evans.
The Current Account deficit has widened from 2.1% of GDP in 2011 to 4.2% in 2014 reflecting worsening terms of trade and declining exports of manufactured goods. While the deficit remains largely financed by FDI inflows (2.9% of GDP), portfolio flows have been volatile, highlighting vulnerabilities to capital flow reversals. Despite the poor economic performance and the pressures on the external sector, there is no immediate threat of an external crisis as Brazil has $360 billion of reserves (about 17% of GDP), and a solid financial sector. (The World Bank)
It's all about politics
The reason for Brazil's inaction must be sought not in economics but in politics;or more accurately the politics of economics. Dilma Roussef the President finds herself in a bind. On the one hand her personal popularity has plummeted, while on the other, markets expect her to reform Brazil's swollen public sector. She has left economic management to Joaquim Levy, whose conservative if sensible policies have not found support amongst a majority of Brazil's lawmakers. He has been stymied by politicians who still believe that they can spend their way out of trouble. If Brazils fails to reform now, it would not be the first time that this has happened.
To compound matters further, the state owned oil giant is embroiled in a huge corruption scandal. Though Roussef has not been personally accused of wrongdoing, both speakers of the two houses of Congress as well as many of her friends are implicated. Her opponents have pounced on this issue, stonewalling on much needed reforms, trying to extract political concessions. This is important since 90% of Brazil's budget is 'ringfenced', that is, legislative action is necessary before the budget can be altered. Thus room for cutting the expenditures is limited.There is little evidence that the political class has the will to reform. An effect of the unexpected downgrade may be that politicians now have little incentive to carry out reforms to avoid just such a downgrade.
This situation is likely to weaken Mr Levy's standing further. Investors will certainly take a negative view of the government's capability to reform public finances if he is forced to quit. 'Beyond, quite possibly, lies the kind of financial badlands Brazil has travelled through before. The journey worked out badly then, and would again now.' (Financial Times September 13, 2015)
Some capital flight is inevitable. Pension and mutual funds which can only hold investment-grade assets will now offload Brazilian government bonds at a brisker pace, in anticipation of similar downgrades by Moody's and Fitch (typically, two of the big three rating agencies need to declare junk status to force divestment). (The Economist Sep 10th 2015)
Is Brazil alone?
The problems are not confined to Brazil alone. "Balance sheets are deteriorating and EMs have not delivered the diversification we thought they would," Baweja says. "Policymakers are finding it very hard to get their house in order and as the downgrades come and credit spreads widen, the medicine is going to get more and more bitter." (Financial Times, September 11, 2015)
The world economic situation too is not bright. South Africa, Turkey, Malaysia look likely to be the next candidates for downgrades; followed closely by Russia."In places like Brazil, Russia, South Africa and now China, things have been going on a downward spiral. Policymakers have had time to get on the reform path and it hasn't happened," says Mr Quijano-Evans
The impact of the downgrade on India is likely to be minimal, except on those companies which have exposure to Brazil's market. Brazil would do well to get its act together and push through the much needed reforms and rejoin the high growth economies. It would be good for Brazil, and even more importantly it would be good for the world at large. For India, the sorry state of politics in Brazil and its debilitating impact on the economy and on international perception, serves as a grim reminder that we cannot afford petty politics to come in the way of our own much needed economic reforms.
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