Crunch Time for Brazil

Brazil at a crossroads

This week rioters and police clashed in the favelas of Rio de Janeiro. Dramatic pictures of the confrontation, which took place alongside Rio de Janeiro’s famous Copacabana beach district were beamed around the world. It was further bad pr for the region’s economic powerhouse, which has had a tough time of it of late. Falling economic growth, high-profile bankruptcies and social unrest have all undermined its reputation as an investor darling. And with the upcoming World Cup drawing global attention to the country, every bad event is getting lots of coverage. Is Brazil living up to the old joke that says, ‘Brazil is the country of the future and always will be’? Or is this just a momentary blip?

Growing pains

There’s no doubt that the last few years have been tough for Brazil. The economy, which grew by 7.5% in 2010, has stumbled by with an average growth of 2% per year since then. It even suffered the humiliation of being overtaken by the UK, which has managed to retake its place as the world’s sixth-biggest economy. The faltering economy caused consternation in Brasilia, where a desperate government has tried to pump growth with its ‘new matrix’ of economic policies. Interest rates were cut to record lows, price controls and subsidies were used to control inflation and unorthodox accounting methods were used to ensure the government could maintain fiscal largesse while sticking to official limits. But Tony Volpon, analyst at Nomura, believes the government policy was the wrong medicine. “Unfortunately policymakers misdiagnosed the problem as an issue with demand and their remedies – such as lower interest rates and higher government spending – just served to exacerbate supply constraints and fuel an import boom, which led to widening current account deficits.”

Productivity is a major problem. Many Brazilian manufacturers are uncompetitive and in some cases they are losing out in the local market, despite receiving favourable tariffs. One reason for this is that generous social welfare systems have pushed up wages in the private sector, without being matched by a commensurate rise in productivity. Another factor is transport infrastructure. Brazil’s creaking network of roads, trains and airports has failed to keep pace with the economic growth of the last decade. That makes it more expensive for manufacturers or commodity producers to ship their goods. A lack of investment also plays a part. Brazilian firms invest just 18% of GDP, less than half the proportion of other emerging markets like China. Without modern plants, tools and equipment it is difficult for Brazilian workers to become more productive.

And of course, all of this affects government finances. Low growth, high inflation and expensive welfare programmes were one reason that ratings agency, Standard and Poors, downgraded the country’s long-term debt earlier this year.

A crucial six months

Yet the outlook isn’t all negative. Brazil is taking steps to improve its infrastructure problem by awarding private-sector concessions for a huge building programme. Admittedly this has suffered some delays but early successes, such as the completion of the Brasilia airport this month, show that it can be done. With 18 concessions awarded last year there is hope for more success stories.

Meanwhile the achievements of the government shouldn’t be overlooked. Brazilhas helped an estimated 35 million people move from poverty to the middle classes in the last ten years. That’s an incredible social achievement that should also help the economy. The country’s record low unemployment, record high reserves and 12-year track record of sticking within its inflation target, are also points in its favour.

This year is a massive one for Brazil. The World Cup could either be a roaring success that unites the country, or a catalyst that exacerbates some of its underlying social issues. Meanwhile the elections in October could prompt the government to rethink its economic strategies, or maybe even lead to a change of power. Either way, investors will be watching closely.

You can read more on Brazil in the latest edition of LatAm INVESTOR's quarterly magazine. To download the e-version for free and sign up to receive subsequent print editions for FREE click here