Cristiano Romero By
Economists are still uncertain about the Brazilian economy’s recovery pace from the “Long Recession,” but some good news is already starting to appear. There is a consensus that the worst has passed. A considerable number of economists points to a gradual recovery. But there is one certainty: the recovery will only materialize if Congress passes the fiscal reforms proposed by the government.
The economy has improved in the last few months mainly due to rising consumer and business confidence, motivated by the impeachment of ex-president Dilma Rousseff. Marcos Casarin, an analyst with Oxford Economics, says that business owners and managers are not in “crisis mode” anymore but “in recovery mode.” Yet, he notes, a recovery based solely on confidence has its limits.
The confidence is not only based on Rousseff’s fall but on the fact that President Michel Temer appointed a well-regarded economic team, led by Henrique Meirelles and committed to making the adjustments that Brazil needs right now. The government has also assembled a cabinet that while not representative of a coalition (which in fact doesn’t exist) but of a parliamentary front, with politicians from over a dozen parties, to vote tough measures that can correct the imbalances created by the Workers’ Party (PT) administrations since 2009.
This first confidence push had a positive impact on two of the main economic prices – the real has gained on the dollar, helping lower the price pressure on goods and services, while the long-term interest rate also fell – and also on the stock market. The first results of these moves are here – inflation has declined and the Central Bank (BC) is preparing a monetary-easing cycle, something unseen since 2012.
The first signs that Brazil is leaving the last three years’ nightmare, when GDP rose 0.1% in 2014, fell 3.8% in 2015 and could drop another 3.14% in 2016, according to the median of market expectations gauged by the BC’s Focus Survey, are encouraging analysts like Mário Mesquita, a former economic policy director of the BC who is now the chief economist of Itaú Unibanco, to believe that Brazil could achieve reasonable growth in the next two years.
The economic recovery path foreseen by Mr. Mesquita and his team at Itaú projects 2% GDP growth in 2017 and 4% in 2018, and goes more or less like this:
1. After two years of recession, the Brazilian economy shows stabilization signs. The recovery will be gradual and initially driven by an inventory cycle;
2. The recovery’s sustainability will depend on a wider acceleration of demand further on;
3. Corporate deleveraging (the reduction of the net debt-to-EBITDA ratio), lower interest rates and the recovery of commodities prices will allow an expansion of investments;
4. Household consumption starts growing again in 2018, bolstered by an improving job market and cheaper credit.
The chief economist of Itaú has two reservations: this scenario, seen as reasonably optimistic given the uncertainties still surrounding the political and economic scenario of Brazil, will only be possible if the government manages to advance the fiscal agenda forwarded to Congress – it basically means passing the Constitutional Amendment Proposal (PEC) capping public-sector spending for 20 years. The projected recovery is cyclical, that is, it will not be driven by an increase in potential GDP.
The recovery of business investment is a key variable for betting on an economic revival, Mr. Mesquita says, because the item explains most of the contraction of the last few years. Gross Fixed Capital Formation (GFCF), which mirrors corporate investments in machines and equipment and in construction, fell 4.5% in 2014, 14.1% in 2015 and should drop a further 7.8% this year, according to Itaú’s estimates. It has fallen 26% since peaking in the third quarter of 2013.
Mr. Mesquista says such investment is determined by a combination of external factors (commodity prices) and domestic ones (interest rate and corporate leverage). High levels of corporate indebtedness would be the main culprit behind the investment retreat of the last few years. Itaú’s team estimates that every additional 1 percentage point of corporate leverage lowers investment as a share of GDP by 0.6 percentage point.
Leverage would have contributed 8 percentage points to the 24% contraction of investments in 2014-2015. High interest rates and the drop in the price of commodities would have negatively affected investment by 6 and 5 percentage points, respectively. Why should someone believe that such conditions will be reversed?
First, because rates will fall. Mr. Mesquista, who headed the top BC department for four years, becoming one of the biggest experts in the inflation targeting regime and who was even rumored to be a prime candidate for BC president in the Temer administration, believes the BC will cut policy rate Selic by 0.75 percentage point still in 2016, bringing it to 13.5%. The easing will continue in 2017, favoring an expansion of demand the following years. In addition, Mr. Mesquita believes that commodity prices, which saw a reasonable improvement this year, will stay strong in the next few years, also helping investments.
Corporate deleveraging will be trigged by the recent appreciation of the real against the dollar and the expected rate cut. Profit margins, in turn, tend to be boosted by falling production costs – which are likely to drop thanks to high idleness levels and also unemployment, forecast to continue high in the next two years. Both factors will help cut leverage ratios and open room for an investment recovery.
Mr. Mesquita and his team expect household consumption, which declined 4% last year and may recede another 4.2% in 2016, returning to the level of 2011, to only strengthen again in 2018. The reason is the job market, which takes longer to recover. But the trend of lower rates and employment recovery (thanks to investment) still favors consumption.