The spending cap bill passed through by the lower house of Congress this week marked another milestone for president Temer and his government in their efforts to reform the struggling economy.
A steep currency depreciation and deep recession over the past two years helped rebalance trade, which brought a gradual reduction in Brazil’s current account deficit, narrowing from US$4.1bn to just US$579mn.
But, economic activity has been dropping at record rates, with the IBC-Br index indicating a fall of 0.91% in August, following a 0.18% decrease in July.
So far, ratings remain unchanged, and Brazil is not forecast to return to investment grade for the next 3-4 years. It could hamper the large capital inflows needed to support a variety of infrastructure and social development projects.
“When the downgrades came, the fiscal mess was already priced into the market – the real was starting to fall sharply, equities began to sell off,” explained Edward Glossop, EM economist at Capital Economics. “Brazilian markets were one of the best performers in the world since February, which suggests that investors are not too concerned about the lack of investment grade rating.”
Temer’s Big Wins
Not all of the positive developments were down to the new administration’s efforts, but its input was very significant.
A sharp drop in inflation has been a key driver in the Central Bank’s decision to cut rates for the first time in four years, although the 25bp figure was below market expectations. Low interest rates are essential for easing the fiscal strain and promoting economic growth.
Provided that the spending cap is approved, the fiscal outlook will start to improve in the coming years.
Ted Rhodes, the Office Managing Partner at CMS Brazil, agrees that Temer recognises the need to use foreign investment as the main driver of growth given reduced public sector or consumer spending.
“This commitment was exemplified by the appearance of the President and his government officials at the Rio Oil & Gas event this week, espousing the end of de facto monopolies within the industry, more open competition and regulatory reforms that the industry has demanded for many years, for instance the end of Petrobras’ sole operatorship of the pre-salt reserves, and more flexible local content rules,” Rhodes noted.
While plenty of lip service was paid by the previous Dilma administration, access to the oil and gas sector remained largely restricted to private and foreign capital, but the new government is finally showing the willingness to reverse that dynamic.
“Much is still to be done in terms of concrete reforms, but investors have reacted very positively, because they can see that there is some momentum in the right direction,” Rhodes concluded.
Long Road Ahead
Looking at the negative factors, both analysts agree that the main concern is the time these reforms will take to implement, and the time lag between implementation and the reforms’ impact on the real economy.
“Temer’s strategy of tackling the underlying drivers of rising expenditure by changing the constitution and fiscal code is all very positive. It should lead to improvement, but will take time,” Glossop conceded, adding that both the fiscal deficit is unlikely to change significantly over the next 12 months, which leaves the local currency vulnerable.
“The economy, while showing some signs of recovery, is still deep in recession. So far signs from Q3 suggest it is performing worse than expected,” Glossop said.
With the ‘lava jato’ scandal and strong political opposition still dominating the environment, some observers question Temer’s long-term prospects.
“Michel Temer’s term only runs until the end of 2018, and he has said that he will not stand again,” Rhodes elaborated. “But, in the context of daily revelations of political corruption, and fierce opposition from the left, who feel they were robbed by Dilma’s impeachment, it is difficult to anticipate who will succeed Temer in 2019 and whether they will be able to continue his reforms, which are bound to be unpopular with a wide range of vested interests.”
Various corruption scandals and challenges that continue to be faced by some of the country’s largest companies have prompted concerns over the health of the corporate sector.
Embraer, the world's third-largest commercial aircraft maker, last week inked a US$205mn settlement following a six-year bribery investigation over allegations it paid millions of dollars to secure government contracts. The settlement agreement caused its share price to spike by 22% following multi-month lows.
Troubled mining giant Samarco Mineração SA, struggling to recover from last November’s Bento Rodrigues dam disaster, has seen its bonds plummet to eight-month lows on after missing its second interest payment.
Many industry experts are pessimistic about the company’s chances to meet its debt obligations in full, indicating that will need to renegotiate with its creditors, the success of which rests on Samarco’s ability to resume operations in the near future. Opinions are divided on whether these problems are idiosyncratic, or symptomatic of an “infection” spreading through the industry.
“Speaking of Samarco, Embraer and other recent scandals, the strongest impact is likely to be felt in the investment sector. But so far we have seen investment picking up in Q2, and anticipate further growth in Q3. The big drag from corruptions scandals like Petrobras is now unwinding, and it would really take another big blowout for negativity to return,” Glossop concluded.
Rhodes is less optimistic, expressing concern over safety regulations and the financial challenges faced by the sector more broadly.
“Many smaller producers have been unable to compete with the likes of Vale and Rio Tinto, which have much lower production costs, and many higher cost mine development projects have been mothballed until an eventual recovery in iron ore prices,” he said, citing MMX and Manabi as a couple of recent examples.
While most analysts and investors are viewing the recent developments in favourable light, expectations are high for more urgent reforms to follow soon. The spending cap legislation has to be passed into law, and the government needs to clarify what the priority targets for austerity will be. The next step is pensions reform.
“Pensions reform is high on the government’s agenda, and should include the whole of the public sector, including the military, judiciary, and members of parliament, who have very generous and unaffordable pension entitlements,” Rhodes stated.
A recent report by BNP Paribas on Brazil suggests that it would be convenient for policymakers to seek measures that improve long-term fiscal dynamics without too much near-term pain – for example, a gradual transition to a minimum retirement age.
Tax hikes are inevitable, but these should be introduced with restraint as the limited public service tax burden already weighs heavily on businesses and the public. What will be more crucial is increasing revenues through structural reform that address barriers to Brazilian competitiveness and public sector wastefulness.
“The list of potential reforms is long, but priorities should be a dramatic simplification of Brazilian taxation and more flexible employment legislation. Current tax and labour laws are a major factor in Brazil’s poor performance in international business environment league tables,” Rhodes proposed.
Finally, the monetary policy needs to become more transparent and independent to boost investment. As the BNP report indicated, introducing formal, legal central-bank independence – in the form of fixed, overlapping mandates for the central bank’s board members – could go a long way symbolically to boosting monetary-policy credibility while carrying little, if any, practical near-term cost.
Brazil is already reaping some benefits from these new policies on the investment front, with a lot of interested parties originating from Asia.
Earlier this week, Brazil and China signed a memorandum of understanding (MoU) to set up a US$20bn investment fund to finance infrastructure projects in Brazil. Since 2009, China has been Brazil's largest trading partner, with trade amounting to US$80bn in 2014 and over US$66bn last year.
Temer has also made efforts to strengthen ties with India, meeting his Indian counterpart at the BRICS summit, and to re-establish the relationship with Japan, as was made clear during his recent diplomatic visit to Tokyo.
“Brazil offers Japan a chance for a big investment opportunity,” Prime Minister Abe told reporters at a joint news conference. “Brazil is a country of two hundred million people and represents a huge market.”
Opinions vary about the significance of these deals for the macroeconomic outlook, but most still see them as a positive step.
“I think these investments are already having an impact on the Brazilian economy,” said Rhodes, who has been following Asian investment trends into Latin America closely. “Recent acquisitions by these companies are something of a vote of confidence in the long-term potential of Brazil and have generated some positive headlines, which are helping to change the narrative regarding Brazil.”
“The profiles of Chinese investment and Japanese investment are quite different,” Rhodes explained. Chinese investment in Latin America has generally been driven by the desire to secure commodities and, more recently, to employ the resources of construction and infrastructure companies, as their domestic economy rebalances away from infrastructure investment driven growth towards domestic consumption.”
“On the other hand, many Japanese companies have been present in Brazil for a long time, attracted by cultural links with Japanese Brazilians and by the large population, which represents an important market for their consumer goods and production machinery.”
Others, however, are not convinced that an Asian capital influx will be a game-changer. Brazil is less reliant on Asian investment than some smaller LatAm economies, like Venezuela and Ecuador, who are starved of external financing. But its openness to capital markets, strong FDI levels and the fact that it has been present on the map for Asian capital since the start of the commodities boom mean we may see more of these deals materialise.
Investors, it seems, are focussing on long-term prospects and are determined to persevere through this drawn-out recession. Perhaps the real question now is whether this determination will be reciprocated by the Brazilian public, as painful reforms set in.