BRAZIL: Sharpening the Instruments to Break the Vicious Circle

No crisis lasts forever. But the present one in Brazil is testing the patience of everyone. GDP has contracted now for seven straight quarters, after a 2014 that was largely lethargic in terms of output. Nor is there any discussion of an inflection point to a cyclical upturn in activity. The only thing on the horizon is economic stabilisation.

An underlying problem is that since the productive sector is very fragile, the economy is susceptible to new retractions. The risk of a longer cycle of rising unemployment due to the financial challenges in the productive sectors is palpable. As a result, the situation might get worse before it gets better.

The idea of a tumble of the economy followed by rapid recovery, as happened in 2009, does not apply in the current context. In 2008, there was a tremendous global shock that had a strong effect on the credit market in Brazil. There existed some room for countercyclical measures, and the financial health of companies was not greatly affected by the credit crunch as in other parts of the world, which was transitory.

Unlike in 2008, the origin of the present crisis is domestic and eminently fiscal in nature, although greatly aggravated by the political crisis. This reduces room for countercyclical policies. The country has simply lost the ability to deploy fiscal instruments for the time being, and the monetary conditions are too tight due to the high inflation.

In an attempt to stem the economy’s erosion, pro-cyclical policies were put into practice in 2015. The best choice would have been to combine this with structuring fiscal policies to reduce the medium/long-term fiscal risk, helping the Central Bank fight inflation. Dilma failed and the result was more crisis: the country lost its investment grade rating and the financial contagion hit the already debilitated productive sectors with a vengeance.

As a result, loan defaults reached record high levels, in large part aggravated by the lack of credit; new loan origination has never been this low. An indicator that helps illustrate this point is the index of access to credit by industry calculated by the National Industrial Confederation (CNI). Its current level, 30 points, has been consistent since the middle of 2015. In 2009 it was slightly above 32 points, and more importantly, this only lasted for two quarters. Unlike the current moment, the credit market returned to normal quickly, reducing the risk of financial crisis faced by firms.

This page is being turned with the structural fiscal adjustment agenda, which is continuing to make progress despite political hiccups. All the same, the credit market continues to deteriorate, with a vicious circle of tight credit and high loan defaults, each feeding the other, setting in. The result is a contracting economy.

There are few doubts about the role of the restrictive monetary conditions here. After all, monetary policy is supposed to depress demand in this instance. Monetary policy is tighter now than at any time since the advent of inflation targeting, and has been so for at least a year and a half. The impact on the economy has been inevitable, particularly on the credit market.

It’s true that spreads have been rising more than expected, in light of the behaviour of the Selic rate and default rate, acting as a drag on the economy. Various reasons can be put forward, such as the increased participation of dearer credit lines (such as check overdraft coverage) and the lower volume of credit, reducing the base for banks to dilute their fixed costs. Although these are relevant factors, the main point is that when the interest rate is higher than necessary to reduce inflation, or above what economists call the neutral interest rate, demand contracts. And since monetary policy takes time to run its course, demand will continue to be subdued for some time.

The good news is that unlike in 2015, there is room to cut the interest rate, because inflation is yielding and inflationary expectations are well anchored. Indeed, the Central Bank has already started this movement, although timidly.

Other elements are also weighing on the economy, such as the political crisis, which affects investment decisions, and the fiscal crisis of the states, which reduces government spending. In the jargon of economists, these two negative demand shocks have reduced the short-term equilibrium interest rate, meaning there is ample leeway to normalize monetary policy. In a benign scenario, the economy could reach an inflection point in the middle of next year.  

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Zeina Latif is chief economist at XP Investments. She holds master and doctorate degrees in Economics at University of Sao Paulo (USP).

Previously she worked at Royal Bank of Scotland as senior economist for Latin America, and ING, ABN Amro and HSBC Asset as chief economist for Brazil.

She is columnist at the newspaper Estado de São Paulo and she is counselor at the Social and Economic Development Council of the Republic Presidency.

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