By Rachel de Sá
Brazil. The land where women are beautiful, food is delicious, everyone knows how to dance “samba”, play football, and of course, the future is bright and the time to shine is just around the corner. Right? Sometimes, I honestly wish this was true, and I lived in this great and welcoming cliché, as I also wanted my country not to have become an example of “what not to do” as an emerging and prospective economy.
As you probably know, Brazil is not facing its best moment. A political crisis feeds into an unprecedented economic recession, leading to what appears to be a never-ending vicious cycle. While a worryingly high public deficit (10% in nominal terms) and debt/GDP ratio’s fast upward trend triggered sovereign downgrades, households suffer with high unemployment (11.2%), stubborn inflation (8,89%) and tight credit (base interest rate at 14.25%).
Nonetheless, not all is bad news. Incipient signs of recovery show we may have hit rock bottom, so we have nowhere to go but up. The recession continues, as the economy still contracts. However, better than expected results for 1Q 2016 in leading indicators, such as investment, consumer and business confidence, signal at least stabilization, though too soon to call it recovery. At the same time, the external sector continues to improve, leading the country’s current account deficit from 4.31% of GDP in 2014 to 1.48% expected by end 2016. This places some doubt on the pessimistic OECD projections of a -4.3% contraction this year and -1.7% next, particularly, when compared to more optimistic numbers by Brazilian market specialists – consensus at 3.4% contraction for 2016 and 1% growth for 2017. However, first things first. Let’s see (or at least try to) how we got to this mess.
How did we get here?
To handle this tricky question, I’ll borrow some words from Brazil’s IMF Executive Director Otaviano Canuto, who earlier this year perfectly summarized how the combination of four main elements resulted into the perfect storm that reached Latin America’s biggest economy [1].
The first, and perhaps the most obvious one, is the end of the commodity-price super cycle. As a net exporter of primary goods, Brazil benefited from the large improvement of its terms of trade in several fronts: external surpluses, the accumulation of foreign-exchange reserves, positive wealth effects, and higher investment in natural-resource-related sectors. Add to that exchange-rate appreciation and rising minimum-wage floors – not to mention public-sector disbursements indexed to the latter – and Brazil enjoyed a virtuous domestic cycle featuring positive feedback loops between demand for services and formal employment [2].
However, as the grasshopper in the famous fable of the ant and the grasshopper, Brazil wasted its summer singing, instead of working for a inevitable coming winter. In other words, Brazil did not use the positive external scenario in the form of a commodity boom to conduct the necessary structural reforms to alter its growth model for the inevitable bust. Productivity flattened, while real wages grew, at the same time as industry became increasingly uncompetitive, losing importance not only globally but also domestically. Investments remained low, and infrastructure and education remained poor (despite the quantitative improvements in the latter).
This context brings us to the second factor shaping Brazil’s fortunes: the adjustment to the country’s growth pattern, following the 2008-2009 global financial crisis, which was heavily based on fiscal and monetary stimulus. These policies were effective and well regarded as post shock responses, as an immediate demand constraint was successfully addressed. The problem came afterwards, when these policies became the rule rather than the exception, and counter-cyclical measures turned into government’s main economic policy – ignoring not only long neglected supply side obstacles, but also the negative impacts of a wrong diagnostic. In this context, the main outcome of this second round of stimulus was fiscal deterioration [3].
Fiscal deterioration leads us to the third factor undermining Brazil’s current economic performance – although it dates back to more than 20 years ago. That is, the existent structural trend of rising primary government expenditure as a share of GDP. This increase reflected a political desire to address the poverty and inequality that had gone unaddressed during previous decades. To support the increase, Brazil’s government increased taxes on consumption and promoted progress toward labor-market formalization [4]. To illustrate, primary government expenditure went from 22% in 1991 to almost 40% in 2015. This rise, of course, became unsustainable throughout the years, especially when other obstacles refrained Brazil from growing at “Chinese rates”.
Last, but not least, is the storm that came bearing down the country, named Car Wash. The unexpected corruption investigation involving the state oil giant Petrobras engulfed the country’s biggest political parties and constructions firms, triggering a collapse of private investment in the oil and gas sector, cascading down to the whole production chain. Direct and indirect impacts of the corruption investigation are equivalent to 2.5% of Brazil’s GDP contraction in 2015 [5]. On top of that, the political instability that ensued from the scandal resulted in a growing uncertainty that we see in Congress, largely constraining government’s ability to approve necessary measures to reverse the economic crisis.
How could Brazil get out of this mess?
Of course, if there was an easy answer to that question, we would not find ourselves in this situation. Nonetheless, regardless of who is in power in the coming years, Brazil’s economic situation and related problems will remain the same. In this sense, I highlight some of these challenges and suggest a few first steps.
First, as wisely said by XIX century US presidential candidate Will Rogers, we have to stop digging [6]. The confidence boost brought by the highly qualified economics team established by the interim government was a good first move into this direction. However, the current crisis uncovered the need for long awaited structural reforms, making the task of fully restoring confidence and resuming sustainable growth not only harder, but also contingent on the first.
As perfectly captured by Ricardo Paes de Barros, one of the most prominent experts in income inequality and one of the designers of Bolsa Familia [7], the problem is not that Brazil is a poor country, rather that it spends too much. How does a government spend almost 40% of GDP, if 40% of its population lives with only 10% of the country’s total income? A short answer for this is “because it does not spend well”.
The best and most urgent example of this point is social security. With only 12.5% of its population above 60, Brazil spends more in social security than the UK, for example, whose elderly population represents 22.4% of total population. In 2015, social security spending accounted for 40.6% of government’s primary spending in Brazil; pensions alone amount to more than half (27.64%), compared to 7.4% in the UK.
But how did this happen? You may ask. As in other areas, spending in social security has grown faster than GDP for a long time now; from 1995 to 2014, it grew by 8.2% average yearly, while GDP increased by 2%. Moreover, social security rules were created more than 20 years ago; therefore, they don’t reflect Brazil’s current demographic reality anymore. To illustrate this, by the late 90s, formal employment was minor, and the ratio between active/non active citizens presented an upwards trend. Now, formality amounts to almost 50% of total jobs, while the demographic trend will revert by 2030, and elderly population will reach 30% of Brazil’s total population by 2050. This results in a situation where social security deficit reached 3.7% of GDP in 2015 – without social security reform, our grandchildren will say goodbye to any kind of pensions.
Unfortunately, social security is no exception. The same pattern of bad public spending can be found in a number of other areas. Several empirical studies show that, in Brazil, an increase in spending in education did not translate into better educational levels. Government expenditure in this area rose from 3.5% to 6.6% of GDP from 2000-2013, surpassing the OECD average of 5.6%. In truth, we should not underestimate the improvements achieved: between 2003 and 2012, the ratio of children in school at the age of 15 increased from 65% to 78%, while grades for math exams by the OECD also improved from 356 to 391. Nonetheless, large qualitative problems remain. Illiteracy ratios fell only by 10% from 2005 to 2010, while spending more than doubled. By the same token, a recent study reveals that for every 10 children that start primary school, only 5 will finish high school, and even less will reach university – out of which the best are public, and attended in its majority by children of wealthy families who could afford private school.
As one can imagine, several other examples could easily fill 10 pages. However, for the sake of argument, I’ll just add one more. Tax subsidies for “chosen” industrial sectors. Although these subsidies cost the Brazilian government around US$100bn from 2011 to 2015, and most of them didn’t have any formal monitoring or test to confirm its effectiveness since implementation. A recent study by the Federal Auditing Court found that five of the government’s main subsidy programmes, which will cost US$ 15bn in 2016, are maintained without any guarantees for the investment in research as counterpart agreed by companies granted with such tax reliefs [8].
In this context, an effective fiscal adjustment should focus at the same time on reducing spending and increasing the quality of expenditure. From social security to taxes and spending in education, health and infrastructure, well-structured policies should aim at extinguishing protected and subsidized interest groups while targeting the right audience with a realistic and sustainable budget.
Finally, concerning the anti-corruption investigations and its consequences, I borrow my favourite Disney character to say, “Let it go”. The medium-term silver lining is that the Petrobras investigation demonstrates Brazil’s commitment to the rule of law, implying that the country’s reputation among investors will recover [9]. In other words, despite negative short-term impacts on GDP, the Car Wash and related investigations reduce long term reputational risks for Brazil as oversight and punitive institutions grow stronger. Moreover, dismantling the cartel of Brazilian construction giants opens room for medium size business, foreign competitors and partnership opportunities. As for the political uncertainty resultant from it, may it serve to bring long needed new leaderships for Brazil’s political scenario.
In sum, we all know Brazil is not for beginners, as once said by famous poet Tom Jobin. The current crisis is a perfect picture of this. Hopefully, we may look at this in the future and think about the lessons learned. In the meantime, at least there is food for thought and topics for article-writing.
References
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] http://www.bbc.com/portuguese/noticias/2015/12/151201_lavajato_ru
[6] “If you find yourselves in a hole, you have to stop digging”.
[7] Bolsa Familia is a Brazilian distributional policy implemented in Lula’s administration. Designed as a conditional cash transfer programme linked to children’s attendance to school, the policy helped lifting millions out of extreme poverty, becoming a successful example of inequality reduction worldwide.
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