Brazil’s natural advantages are clear — a young and expanding population, a growing middle class, abundant fertile land, a modern agricultural industry, a plethora of natural resources, and beautiful beaches that are tourist magnets. While all of these things could be expected to lead to business opportunities and prosperity, the country also has many impediments to investment—the poor quality of its education system, underdeveloped infrastructure, weak institutions, burdensome red tape, an extremely complicated tax system, a rigid labor market, and rampant corruption.
Bad policy choices in recent years have exacerbated rather than countered Brazil’s inherent weaknesses. Nevertheless, the commodities boom associated with the Chinese investment splurge after the global financial crisis masked Brazil’s problems for several years. Once commodity prices fell and the tide went out, however, the damage from bad policies became more apparent, notably in Brazil’s fiscal accounts. This culminated in a massive corruption scandal at the state-owned oil company, which shocked markets and paralyzed the economy, pouring fuel on the fire. In hindsight, however, this probably should not have been all that surprising. Brazil’s business environment is notoriously laden with corruption. When economic times are good and money becomes plentiful, that money tends not to be tracked closely and accounted for, leading to opportunities for graft. When the money spigots are shut off, more scrutiny often uncovers the excesses that were previously ignored. Brazil now finds itself in its worst recession in decades.
We believe that part of the explanation as to why this recession has been so deep and enduring is the renewed market focus on the long-term path of Brazil’s fiscal accounts, which have deteriorated meaningfully. While the country does not yet have a particularly high debt burden, the rigidity of its budgeting process has left it uniquely ill-equipped to deal with a crisis of the magnitude Brazil finds itself in. Not only are expenditures highly indexed (some to inflation, some to the minimum wage, some to both), but the vast majority of spending also is constitutionally mandated, requiring a change of the constitution to set it on a sustainable path. Over the long term, the pension system is the piece that really threatens the sustainability of Brazil’s public finances. Brazil is frankly off the charts on metrics that compare the relative amount of pension spending to the age structure of the population. Here we have a very young country spending more on pensions than many very old countries.
As countries such as China seek to develop a comprehensive social safety net over time, Brazil has already constructed a very inflexible one that it simply—mathematically—cannot afford. When we compare the political and economic systems of these two countries, the result should not be all that surprising. China is a one party technocratic communist state. Brazil is a huge, economically-diverse democracy with low education levels where voting is compulsory. While China’s system clearly has its own issues, Brazil’s sociopolitical structure sets it up for a toxic brew of populism, where people paying no taxes increasingly vote for benefits from the state.
A quote often attributed to the Scottish historian Alexander Fraser Tytler states:
A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship.
This idea summarizes the barrel that Brazil was potentially staring down very recently, with a growing chorus of market commentators highlighting the increasing risk of “fiscal dominance” in late 2015 and early 2016. Essentially, this is a paradox whereby interest rates cannot be hiked to cool inflation because doing so causes concerns of rising interest costs leading to unsustainable deficits, resulting in currency weakness and higher inflation. That a country with so many promising natural advantages was facing this type of bizarre economic scenario amidst a global backdrop of low inflation and overcapacity demonstrates the extent to which the economy had been mismanaged for so long. At the same time as neighboring Argentina was experiencing a political watershed change in late 2015 and freeing itself from years of economic mismanagement, it appeared that Brazil was at risk of becoming more like the Argentina of yesterday. Brazil was truly at a crossroads and needed urgent change.
Brazil appears to be getting the change it needs. The currency and the market bottomed around February amid a low in Brazil’s terms of trade, aided by a rebound in commodity prices, and more importantly rising speculation of the impeachment of President Dilma Rousseff. Rousseff ultimately was ousted in late August, but a virtuous cycle of improving confidence and signs of the economy bottoming out had already been set in motion given hopes of a new government and more orthodox, business-friendly policies. Despite its continued woes, Brazil appears to be at an inflection point. The new government led by Michel Temer has formed a supportive coalition in the country’s fractious legislature, appointed well respected personnel to key cabinet posts, and demonstrated an understanding of the economic and policy issues that currently plague the country. In short, they are making all of the right noises.
Given the rise in unemployment and compression in real wages that has resulted from the recession, Brazil has experienced a pretty substantial external adjustment, with its current account deficit falling significantly as imports fell. More recently, export growth has turned into a tailwind for growth as demand for key exports has increased. Moreover, the funding of the deficit has become more manageable as foreign direct investment (FDI) has remained resilient. We see this as testament to the value and potential that long-term investors see in Brazil’s positive demographics and diversified economy. A current account deficit that is fully funded by FDI (i.e., a positive basic balance of payments) should lead to less external vulnerability to global events and less currency volatility. We tend to view FDI as a “sticky” form of funding, and this was confirmed during the recent economic downturn.
We believe that the improvement in the economic rate of change can be sustained, and we are optimistic on the prospects for the government to usher in a period of needed structural reform, but the market is now likely going to require more proof that the heavy lifting can be achieved. Fiscal austerity will act as a headwind to growth as the government tackles the massive budget deficit. The near-term impact will depend on how much medium-term spending cuts can be passed, which could lessen the need for immediate cuts if budget credibility can be restored. Specifically, we are watching for reforms to impose a spending cap on public expenditures in real terms, and also pension reform to deal with the unsustainable path of spending down the road as the population ages. These reforms should restore confidence in the country’s fiscal framework and allow interest rates to fall, supporting an economic recovery. Additionally, reforms targeting the return structure and regulatory environment for infrastructure projects could help the government to support the economy without fiscal stimulus by attracting FDI. We see this as “free money,” and we have been pleased thus far with initial proposals on this front. We will likely receive more clarity on the government’s intentions and probability of success in the coming weeks, now that the Senate vote to oust Rousseff is behind us.
While there is no certainty that meaningful reforms will be passed (Brazil’s young democracy does have a penchant for throwing curveballs), we are optimistic that the government will cobble together support to put the country back on track. What is clear is that market expectations are high, judging by the run in the market. So long as the government can deliver, we would expect to see inflation continue to roll over, interest rates to come down, and confidence to lead activity higher. Now that the commodity tide has gone out and the world has focused on Brazil’s structural issues, political gridlock and failure to chart a sustainable economic path are the biggest risks to the economy and the market. The divisions within society, exacerbated by the political and economic upheaval, will take time to heal. Whether the recent trauma has been positive or negative for the country’s democracy is still hotly debated. On one hand, corruption is being brought to light and venal leaders are being held accountable. On the other hand, some point out that the removal of a popularly elected president, on what they see as a technicality, was politically motivated and amounted to a coup.
As investors, we believe that the changes taking place in Brazil have led to a greater probability of economic recovery, and this should help to heal fresh wounds over time. Whether or not political change happened in pure democratic form, we believe that Brazil’s chances of becoming another Latin American basket case have receded, and its chances of realizing its vast untapped potential have increased in the past year. If its new leaders can follow through, investors in Brazilian assets, as well as the country’s more than 200 million people, will be more prosperous in the future than they are today.