By Gerren Bethel – International Banker
2016 is the year that the Olympic Games come to Rio de Janeiro, Brazil. The world will descend on a country going through its worst economic crisis since at least the 1930s. It has now endured six consecutive quarters of negative growth, with last year’s third quarter contracting by a massive 4.5 percent.
Brazil’s annualised GDP growth 2006-2015 (source: IBGE|Trading Economics)
Economic crises are not new to Brazil, a country that in the last 25 years has experienced hyperinflation, long periods of stagnation, a presidential impeachment and the uncovering of several political scandals. The circumstances today, however, are unprecedented, given the number of internal and external factors that seem to have conspired together to create one of the most turbulent periods in Brazil’s history. The situation is even more catastrophic given that not even five years ago, it was widely thought that Brazil had broken out of the cycle of instability and was entering a new phase of economic development. Upon being grouped among the four vaunted BRIC (Brazil, Russia, India, China) economies in the early 2000s (with South Africa being added at a later date), Brazil was set to become the world’s new star of emerging markets, and indeed, it seemed for several years as though the country would finally fulfil its potential. 2010 saw Latin America’s biggest economy grow by 7.5 percent, overtaking France and the UK in the process to become the world’s fifth largest economy. In fact, it was in such a comfortable position that it even managed to lend $10 billion to the IMF (International Monetary Fund) to boost the availability of credit for developing nations.
Such good times now appear to be firmly consigned to the past. Today, it finds itself mired in recession, political scandals and unsustainable levels of debt. Worse still, its sovereign debt has been demoted to junk status by two ratings agencies. Indeed, economic conditions have deteriorated to such a degree that Brazil’s most iconic annual event—the Carnival—has been cancelled in approximately 50 towns and cities across the country.
While much of the country’s woes at present can be attributed to internal factors, China’s economic slowdown over the last few years has played a crucial role. Indeed, it seems fitting that it is China, the engineer of the inspired commodity market super cycle of the 2000s and the predominant driver of Brazilian economic growth back then, that is now the country that has contributed the most to its ongoing demise. As China’s demand exploded after the turn of the new millennium, its appetite for commodities spiked, many of which Brazil possessed in abundance, such as oil, beef, soy beans and iron ore.
Brazil’s exports to China, 2002-14, in USD (source: Brazilian Trade Ministry|Wall Street Journal)
From $2 billion in 2000, annual trade between the two countries rallied dramatically over the next 13 years to hit $83 billion by 2013. China’s annual investment into emerging markets had already topped the $1 trillion mark by this point, with Brazil one of the leading targets for the world’s new superpower. With exports driving Brazil to new heights by the turn of the current decade, the country’s growth model was being held up as an example for other emerging markets to replicate. So it is perhaps rather unsurprising that when China’s once-insatiable demand for commodities began to dry up, its biggest dependants would suffer. In Brazil’s case, this was exacerbated by the over-optimism shown by both internal and external parties. The ruling government at the time, under the leadership of Luiz Inácio Lula da Silva, embarked on ambitious infrastructure projects, while some forecasters predicted that Brazil’s economy would grow by nearly 5 percent indefinitely. On the perception of perpetual good times, therefore, Brazil’s government, corporates and citizens began to spend excessively.
With investment projects being established on the basis of an expected continuation of booming Chinese demand, Brazil’s commodity exporters were among the most severely impacted by the eventual slowdown. Indeed, a barometer of just how bad things have now become lies in the visible struggle of many of Brazil’s biggest companies. The country’s mining giant Vale has been forced into tapping emergency credit lines to the tune of $3 billion. The world’s biggest iron-ore producer has been unable to secure financing to complete deals to sell some of its operations, as banks have become extremely averse to financing commodity-based transactions during the current price rout. In a familiar tale for many of Brazil’s commodity multinationals, China’s explosive growth in steel-making—of which iron ore is the principal constituent—was intended to be fully capitalised on by Vale. As demand cooled in China, however, iron-ore prices plummeted, from more than $180 per tonne in 2011 to $40 per tonne in January 2016. China itself has not helped matters during this period by dumping its own excess supply of steel onto the world market, thus adding further downward pressure on iron-ore prices. Mine expansions, however, continued for some time as global iron-ore producers (as well as other commodity giants) were caught off guard by China’s sharp drop in consumption. Today this has meant that Vale, along with fellow market leaders Rio Tinto and BHP Billiton, has had to resort to securing emergency financing, selling operations and shutting down mines in order to stay afloat. While Vale has managed to maintain its A-rated credit status from Standard & Poor’s, the three major ratings agencies now have negative outlooks for the company.
Other companies have not been so fortunate. The most publicised of all of Brazil’s recent disasters has been the unrelenting slide at state-owned oil company Petroleo Brasileiro SA. The country’s biggest company, known as Petrobras, is now deeply entrenched in a political scandal following the company’s former head of refining’s initial confession, which related to construction-company contract winners diverting money into slush funds that supported political parties. More than 30 sitting members of the National Congress are now being investigated by the Supreme Federal Court for accepting bribes and kickbacks, with the majority being from current President Dilma Rousseff’s Workers’ Party. Most notable of all is the former president, Silva, although Rousseff herself has been recently cleared of any wrongdoing. Given that Petrobras only a few years ago accounted for 10 percent of Brazil’s GDP (gross domestic product) and was one of the 10 biggest companies in the world with a valuation over $200 billion, the scandal has rocked the confidence of the public, as well as the credibility of the government, restricting its ability to get the economy back on track. Indeed, corruption-related losses at Petrobras were estimated to have run to more than $5 billion by the end of last year.
By the third quarter of 2015, Petrobras had more than $130 billion in liabilities, its debt-to-earnings ratio had spiked to an unsustainable 6.5, while the first nine months of last year saw its debt-to-equity ratio jump from 115 percent to 174 percent. Petrobras is now the most indebted company in the oil and gas sector, which undoubtedly contributed to its credit rating being downgraded to junk status last year. The producer has also struggled to fully develop oil fields in deep water, which meant that oil production actually fell during certain years in this period. The situation has only worsened as global oil prices have collapsed. In mid-January, Petrobras announced it had slashed its 2015-19 investment plan to cope with the low price environment, while also projecting that production in 2016 will drop significantly. Indeed, should oil level out at $20 per barrel for the next 12 months—an outcome that could realistically transpire in the near future—Citigroup estimates that bailing out the state oil giant could cost the government up to $21 billion. By early January this year, the company’s shares had dropped to a 12-year low, indicating the extent of the loss of investor confidence in the oil producer.
There may also still be a moderate chance of impeachment proceedings against Rousseff being initiated, which has delayed any ostensible implementation of fiscal measures. The country’s electoral tribunal is currently examining Rousseff’s second-term election victory in 2014 in relation to financial irregularities in campaign donations, with proceedings being launched on the basis that Rousseff tampered with public accounts to mask the real size of Brazil’s swollen budget deficit. Rousseff’s popularity is now among the lowest of any Brazilian president on record.
The Petrobras scandal has ultimately meant that economic policies have had to be delayed, which has been significant in restricting the government’s attempts to correct the economy. Indeed, after Fitch became the second ratings agency to downgrade Brazil’s debt to junk status, the ratings agency cited the deepening political crisis as being the key reason for the economy’s continuing downward spiral. Moreover, contagion from the Petrobras fallout has been widely evident, none more so than at BTG Pactual, one of Brazil’s leading financial institutions. For reported interference in the Petrobras investigation, BTG CEO André Esteves was arrested last November, which duly destroyed investor confidence in the lender. A 50-percent decline for 2015 has been recorded in mutual fund assets at BTG’s asset-management arm, falling from $30 billion at the start of the year to $17 billion by the end of November. With a jittery investment climate in Brazil at present, reputational risk is now driving the exodus of funds from BTG following Esteves’ arrest.
Indeed, BTG is just one of many examples of Brazilian companies that have experienced an investor flight to safety. Wealthy Brazilians in particular moved their assets offshore in droves last year, with Rio de Janeiro-based Fides Asset Management in June estimating that they sent around 30 percent overseas, about double the amount compared to five years previous. As a result, the country’s domestic wealth-management firms began to feel the pinch, with the Brazilian Financial and Capital Markets Association recording a notable slowdown in private-banking assets under management in both 2014 and 2015. Much of the exodus has been triggered by a general loss of confidence in emerging markets in the wake of currency depreciations occurring in numerous countries, and which has intensified following the US Federal Reserve’s interest rate hike in December. The Brazilian real has been among the very worst performers over the last 12 months, falling by 32 percent last year and by more than 5 percent so far in 2016.
Brazilian real vs US dollar (2014-2016)
The central bank expects the currency to continue tumbling this year, past R4.25 against the US dollar. This is making it increasingly difficult for Brazilian firms to repay dollar-denominated debt, of which they have amassed the world’s second biggest amount, according to the Bank for International Settlements. During the seven years to March 2015 in which Brazil had an investment-grade credit rating, banks and non-financial companies more than doubled their dollar-denominated debt to $154 billion and $114.7 billion respectively. After the nation’s credit rating was cut to junk, moreover, companies’ funding costs rose substantially. The country’s new finance minister, Nelson Barbosa, has suggested that the central bank will imminently begin to offer programmes to Brazilian companies to hedge their exposure to the collapsing real. Whether this measure is enough to alleviate the debt that has already accumulated, however, seems unlikely.
A debilitating consumer-credit crunch has also made the situation much worse for the Brazilian public. Capital inflows massively increased during the commodities boom, which led to a sizeable reduction in interest rates from a level consistently in excess of 15 percent during the first half of the 2000s, to below 10 percent by the end of the decade. With consumers looking to take advantage of the new, hugely favourable lending rates, and with unemployment at desirably low levels pushing up wages, the country experienced an unsustainable spike in credit that, between 2007 and 2015, jumped from 50 percent to 83 percent at its peak. With interest rates having also reversed course and headed north again, and with unemployment soon expected to scale the 10-percent mark, the ability of consumers to repay loans taken out during the credit boom has been considerably diminished, which has resulted in consumer confidence dropping to its lowest level in more than 10 years. According to the central bank, bank loans overdue for at least 90 days have risen to their highest levels in more than three years as of December, while the average annual percentage rate on Brazilian credit cards climbed to an astonishing 431.4 percent during the same month.
Brazil’s problems have also been made significantly worse by a series of economic policy missteps under the Rousseff government. Perhaps the most inexplicable of these was the decision to increase government spending and cut tax revenues at the same time as the central bank slashed interest rates, in 2011-12. More than anything, the three measures combined allowed inflation to skyrocket towards unmanageable levels. During Rousseff’s first term, she spent a particularly excessive amount on pensions, while also providing tax breaks for several industries. Between 2010 and 2015, therefore, Brazil’s fiscal deficit grew from 2 percent of GDP to 10 percent. The previous finance minister, Joaquim Levy, did make attempts to correct this ever-deepening hole in the government’s finances. He trimmed discretionary spending by a record R70 billion ($18 billion) last year, while also tightening unemployment-insurance eligibility requirements. With the recession pulling down overall tax revenues, however, Levy’s measures were too little too late. With the mandate to shrink the deficit not achieved, therefore, Levy quit his post in December—an indication if it was ever needed of the extent of Brazil’s fiscal instability.
Structural problems within Brazil have made any possible recovery from this recession more difficult. The country’s transition to democratic rule instigated the creation of a new federal constitution in the late 1980s, which enshrines numerous economic rights for its citizens. The majority of these rights remain in place, which in turn imposes rather inflexible restrictions on the levels of public spending. Pensions, for instance, currently consume more than 11 percent of GDP, which is comparatively high on an international scale—they even outstrip Japan, which has a significantly older population.
The chaos on the government side, particularly with regards to corruption and fiscal policy, has added extra pressure on Banco Central do Brasil to achieve a solution via monetary policy. This has not materialised thus far, and is now arguably creating Brazil’s biggest headache of all. The decline in the real has made imports considerably more expensive for Brazilian consumers, which has spurred domestic competitors into increasing their own prices, while the government also increased prices in the key regulated markets of electricity and gasoline by 25 percent. Despite inflation now running at double digits, the central bank has been forced to keep rates on hold at 14.25 percent since July, however. The depth of the current recession, and more pressingly the size of the government debt, has severely strangled the scope of monetary-policy measures available to the central bank. The public debt now stands at just under 70 percent of GDP and is set to continue increasing, while merely servicing the debt in 2015 cost the government 7 percent of GDP. Furthermore, Barclays expects the debt to reach 93 percent of GDP by 2019—only Ukraine and Hungary will be more indebted among the world’s emerging markets. As such, increasing the interest rate would only destabilise the public finances further by adding to the interest bill. Although it is highly unlikely that Brazil will default on its debt anytime soon, if the debt-to-GDP ratio continues above 70 percent as expected in 2016, it will reach its highest level in 14 years. The spectre of high interest rates and high inflation, therefore, looms large over the economy at present.
Given that inflation in recent times has been immune to responding to high interest rates, changes in interest rates are currently being deemed as ineffective by the central bank. With rates having been left unchanged again in January, it suggests that policymakers are gambling to some extent on the inflation rate peaking in 2016 and coming back below 10 percent during the year. Inflation uncertainty might just be the sacrifice that Brazil’s monetary authorities are willing to bear while they attempt to stabilise the economy. While this could prove to be dangerous, given that inflation still has every chance of continuing to accelerate further upwards, many analysts are predicting that prices will indeed rise more slowly this year than they did in 2015 on the basis that the economy has now adjusted to the higher government-regulated prices. Estimates for 2016 are generally around 7.0 percent, however, which is still above both the government’s 4.5-percent target and its upper bound of 6.5 percent.
While there is no easy way out for Brazil, there do appear to be small glimmers of hope that have emerged recently. The silver lining at present appears to be its current account deficit, which has shrunk substantially. The collapsing real, as well as the impact of the recession, has resulted in Brazilians spending less on imports. December saw a 39-percent decline in local demand for imported goods compared to a year ago, which has allowed the overall deficit to fall from $11.6 billion to $2.46 billion over the same period, central bank figures recently revealed. Such news, while contributing relatively little to the overall picture, especially with government and public debts running at such exorbitant levels, will nonetheless be welcomed.
The government, meanwhile, established plans in late January to increase the credit available to farmers, home buyers, exporters and small businesses to finance the purchase of capital and consumer goods. Finance Minister Barbosa expects a total of R83 billion ($20.4 billion) to be injected into the economy if all proposed measures obtain congressional approval. Furthermore, the government has promised that the measures won’t induce further inflation nor will they add to the budget deficit. Indeed, Rousseff hopes to reduce the deficit via a law that was approved late last year and grants amnesty to Brazilians who bring unreported foreign funds home; they will pay a 30-percent fine in the form of tax. Again, however, the law is expected to be largely ineffective given the sheer size of the deficit.
With the US Federal Reserve in December implying they could raise US interest rates up to four times in 2016—although a lower number has been more recently anticipated by the market—the real is expected to continue weakening. With unemployment at a near nine-year high of 9 percent, Brazil’s labour-market woes have only compounded matters. Rousseff herself has stated that cutting unemployment is the government’s biggest concern, although spending on unemployment insurance has recently been cut. The IMF has also slashed Brazil’s 2016 growth forecast, which it expects to contract by 3.5 percent, with zero expansion predicted for the following year, before positive growth resumes again in 2018. If accurate, this would consign Brazil’s current economy to its worst overall performance in more than a century. Goldman Sachs thinks that the crisis will continue to worsen before it recovers and has warned there is a high chance that the country could soon face a depression. It is more than likely, therefore, that the world will be watching a more modest spectacle at Rio 2016 than what was initially intended.