Brazil: Riding the Commodity Wave?

18 February 2021

Pundits are projecting the onset of the next Commodity Supercycle. To be sure, prices of primary products have spiked dramatically in the past year, and many commodity-linked currencies have begun to rally.

The Brazilian Real, however, has been noticeably absent, despite the country’s heavy reliance on this sector (Chart above). Unfortunately, the Rio Carnival was cancelled this year, but will Brazil eventually join the commodity party? To be sure, the nation suffered severely as prices of primary products collapsed following the Global Financial Crisis. Moreover, the Covid emergency and the GFC both have exposed deep divisions and structural weaknesses in Brazil’s economy. In order to reap the benefits of the unfolding commodity cycle — and pave the way for an inclusive economic recovery — wide-ranging reforms on both the macro and micro-economic levels are necessary. I wouldn’t say I’m overly optimistic, but I do expect the Real to rally during the next 12-18 months.

Covid Emergency: Serious Risks Still Remain

As in all countries, Brazil’s nascent economic recovery will remain uncertain until the Covid crisis is finally brought under control. In March 2020, Brazilian lawmakers declared a “state of calamity”, and it is hard to escape the toll the pandemic has taken on the country. Despite Johns Hopkins ranking Brazil’s ability to cope with pandemics as 22nd best in the world (out of 195 nations), the Chart above illustrates that Covid fatalities have been amongst the world’s highest. And, while Latin America overall has suffered greatly, Uruguay’s experience has been considerably different (for more, see my blog “Latin America: Another Lost Decade?”).

Current trends suggests Brazil has yet to turn the corner decisively. The Chart above (provided by Worldometer) illustrates that new cases remain at worrisome levels, and daily fatalities are still rising. To be sure, the availability of Covid vaccines offers hope. However, the roll-out in Brazil is just getting started. The following Chart highlights the global inequity in the availability of life-saving vaccines. It’s unlikely that the majority of Brazilians will be immunised until 2022. Brazil is doing a bit better than the poorest South American nations, but lags behind Chile.

Macro Headwind: Recovery Reliant on Fiscal Support

Despite the challenges (and failures) posed by the Covid crisis, the fiscal support provided by the government has been an important achievement. Indeed, the scale of the fiscal stimulus — amounting to over 8% of GDP — has been twice the size in other Latam and Emerging market countries. Even though 2020 GDP declined 5%, it could have been much worse.

As a result, however, the budget deficit is now over 11% of GDP. And, public sector debt, whch is approaching 100% of GDP, will continue to rise in the coming decade unless reforms are implemented (Chart above). Thus, fiscal restraint is likely to be a headwind both in 2021 and over the medium term. Pre-Covid reforms on pensions (2019) and the decision to cap government spending in real terms (2016) are positive developments. The declaration of a “state of calamity” provided President Bolsonaro leeway to exceed last year’s budget spending targets. Unless the state of emergency is extended, however, Brazil will undergo a significant fiscal contraction in 2021. Despite considerable pressure to provide additional support to households and businesses, the government still aims to rein in spending in 2021.

In the next section, we will discover Brazil will face enormous demands to boost government spending in the medium term. As an example, the Chart above highlights Brazil’s uneviable track record on climate change. As in other countries, Brazil’s post-lockdown economic recovery is losing momentum. Financial markets, therefore, will remain wary, as Brazil juggles both the demands for additional near-term budgetary support and the need to implement reforms to stabilise the public sector debt ratio over the medium term.

Unlocking Potential: Micro-Reforms Critical

As is often repeated, Brazil is a country of enormous potential. Nevertheless, the Chart above highlights Brazilian GDP growth has lagged both other Emerging and advanced economies by a large margin. Furthermore, slowing population growth will pose an additional structural headwind in coming decades.

Recent OECD and IMF studies provide numerous recommendations about how to unlock Brazil’s enormous potential. To make a long story short, Brazil confronts an urgent need to implement micro-levels reforms aimed at boosting its flagging productivity performance. The Chart above speaks for itself, but declining efficiency inevitably hits living standards. Just ask Italy!

I highlight just a few priorities. Brazil’s education system is failing. Despite spending more than most OECD countries, the World Economic Forum (WEF) ranks the skills of Brazil’s workforce 131 out of 141 countries (with digital skills especially poor). In addition, the WEF rates the burden of Brazilian government regulation as the most distorting in the world! Trade openness — tariff and non-tariff barriers — are the most restrictive of all OECD nations. And, both the legal framework and labour market regulations are ranked 126th (of 141) by the WEF. Brazil also scores poorly on crime and security — 132 out of 141. Finally, Brazil’s infrastructure is rated at 78 — a poor result for a country at Brazil’s income level.

I could go on, but the message is clear. In order to produce both stronger and more inclusive economic growth, Brazil must act on this extensive reform agenda. Furthermore, micro-reforms impact government budget dynamics in important ways. First of all, many of these reforms, e.g. education and infrastructure, will be costly. And, unless the underlying pace of Brazil’s economic growth accelerates, stabilising the nation’s government debt/GDP ratio will be even more challenging.

External Balance Sheet: Reserves Provide a Cushion

At the start of this commodity cycle, Brazil’s external balance sheet is considerably stronger than in the past. Indeed, as the Chart above illustrates, the stockpile of foreign exchange reserves is twice the nation’s 2021 external borrowing requirement (sum of the current account deficit and amortisations of external debt). Moreover, Brazil’s situation is far healthier than in other “problem” currencies, e.g. Turkey (TRY) and South Africa (ZAR).

The deeply undervalued ZAR has ridden the commodity wave, despite last year’s 300bp interest rate cut and South Africa’s vulnerable external position. On the other hand, TRY’s recent appreciation required a 900bp tightening of monetary policy in order to restore the central bank’s deeply damaged credibility.

In this regard, Brazil has more in common with South Africa. The Brazilian Central Bank (BCB) will maintain ultra-loose monetary conditions until domestic spending strengthens, especially if fiscal policy becomes more restrictive. Indeed, the BCB may resist any BRL appreciation, at least initially. Monetary policy is likely to remain on hold during the next 12 months. Nevertheless, the BRL is now arguably the world’s cheapest currency (Chart above), and should strengthen if commodity prices rise and the economic recovery continues in the next year.

Strategic Considerations

  • If commodity prices rise, BRL could appreciate towards USD 4.8 during the next 12 months.
  • Brazilian fiscal policy should remain supportive of economc recovery. Financial market volatility will increase, however, if spending targets are exceeded excessively.
  • I project GDP growth of 3% and 2% in 2021 and 2022 respectively. However, per capita GDP declines occurring during the pandemic will not be recouped fully until 2025.
  • Income and wealth inequality in Brazil is extreme, and has worsened during the GFC and Covid calamity. Deep-seated micro-level reforms (along with more progressive taxation) are required to ensure an inclusive recovery in coming years.
  • BCB monetary policy is likely to remain on hold during the next 12 months. The recent rise in inflation to 4.6% in January, largely reflects an out-sized 14% hike in food costs. Core inflation remains at 2.5%, but has edged higher recently. I expect the BCB to achieve its 3.75% inflation target in 2021, and a stronger BRL could help.
  • Brazil’s yield curve has steepened considerably since last summer, reflecting worries about inflation and public finances. If inflation concerns abate, 10-year bond yields could rally towards 7% this year.