5 April 2019

In elections last year, voters in both Brazil and Mexico opted overwhelmingly for populist candidates. To be sure, Latin American populism takes many shapes. In Mexico, Andres Manuel Lopez Obrador’s version  (AMLO) promised significantly higher spending on social programs and infrastructure. Brazil’s new President Jair Bolsonaro has pledged assertive efforts to clamp down on crime and boost security. However, the two leaders also have shared challenges. The top chart illustrates GDP growth in the two Latin giants has lagged far behind other Emerging Market economies for decades. In addition, the following Chart illustrates that the gains from past growth (lacklustre as it has been) have not been widely shared. Higher inequality than elsewhere (high Gini coefficients indicate greater inequality) was a key reason the electorate in both countries chose populist leaders. And, while the gap narrowed in Brazil during the Lula years, the situation has again deteriorated more recently.

So, while the two nations will have different priorities, both aim to produce stronger, more inclusive economic growth, which can reduce high levels of poverty. Foreign commentators tend to view AMLO and Bolsonaro with a high degree of scepticism, which is at odds with the popularity both leaders enjoy domestically. Pundits tend to believe a new  Administration’s overall policy direction is revealed during its first 100 days in office. As both leaders are around that milestone, let’s assess the impact of populism in the Latin America’s two largest economies.

Mexico: AMLO Opts for Fiscal Continuity, So Far!

Financial markets have been concerned that the AMLO government’s ambitious spending plans would reverse the recent improvements in Mexico’s public finances. Indeed, AMLO inherited a reasonably healthy position.  For example, the overall budget deficit, which ballooned from near balance in 2008 to 4.5% of GDP in 2014, decline to 2.5% of GDP last year.  The following Chart also illustrates Mexico’s success in reducing its reliance on oil tax revenues, while boosting non-oil receipts.

As a result, public sector debt (as a percent of GDP), which rose sharply since the Global Financial Crisis, peaked in 2016, and is now on a downward trajectory.  And, while Mexican government liabilities remain above other Latin American countries and other EM peers, the debt level is manageable.

The news, however,  is not all rosy. The following Chart highlights that past fiscal consolidation relied heavily on sharp cuts in public sector investments, while current outlays continued to rise.

To the relief of financial markets, the AMLO government’s maiden budget appears to have chosen continuity and conservatism over populism, at least for now. In particular, the overall deficit will remain at 2.5% of GDP in 2019. And, the non-interest balance will rise to a surplus of 1% in the coming year. Moreover, Mexico signaled the pragmatic fiscal approach would continue, as the debt/GDP ratio is forecast to remain stable for the next three years (although it will no longer decline).

AMLO: Using Fiscal Space to Fight Poverty

AMLO’s prudent fiscal approach does not mean he has given up on his ambitious plans to reduce poverty and inequality. Indeed, the Chart above illustrates that Mexican poverty ranks closer to poorer Latin American nations rather than EM peers. And, poverty levels differ widely within Mexico. The level of impoverishment is 4 times higher in the southern states compared to the more prosperous regions. And while declining overall, poverty has risen recently in Chiapas, Veracruz, and Oaxaca,  suggesting the benefits of growth have not been evenly shared.

There are two ways Mexico’s budget can play a role. The Chart above illustrates that not only is inequality is high, but the current taxation and spending regime does not reduce the gap, as it does in most other countries (which leads to lower post-tax Gini coefficients). Therefore, existing spending programs should be more targeted at the poor. However, the real potential lies in raising tax revenues. In Mexico, for example, government receipts amount to only 23% of GDP compared to 37% of GDP in the OECD overall. An important way to improve tax compliance is to reduce the very high level of “informality” in the economy (Chart). Firms working outside the formal economy often avoid taxes. Likewise, workers in the informal economy (often agricultural and service jobs) are often poorly paid, which is contributes to poverty. Fortunately, informality is declining, which could boost government revenues over time.

Economists tend to take a simple approach to boosting long-term GDP growth and reducing poverty. The key to sustainable improvements in living standard is via expanding opportunities in the labour force and higher productivity: people tend to be poor when efficiency is low. The AMLO government should build upon the reforms of the previous government which were beginning to remedy Mexico’s dismal productivity track record (next Chart).

The World Economic Forum points to key areas for reform which will help boost productivity. Of course, reducing crime and corruption are at the top of the agenda.  The next Chart indicates Mexico has the amongst the world’s worst track record on crime, and lags well behind peers on corruption.

Deficiencies in Mexico’s educational system at all levels are crucial to the nation’s poor productivity performance, and will be a focus of future government spending (next Chart).

The WEF also highlights the need for labour market reforms. In particular, the low-level of female participation in the labour force both reduces the pool of workers and contributes to poverty.

Long-term GDP growth is also hampered by Mexico’s low rate of business investment, which is below the OCED average. The WEF suggests deregulation would help improve the business climate and encourage capital spending  (the earlier WEF Chart illustrates the deleterious impact of Mexican regulation relate to EM peers), especially in technology and R&D where Mexico lags significantly (next Chart). The earlier WEF Chart also highlights Mexico’s infrastructure ranks far behind EM peers such as China and Chile. And, while AMLO’s decision to abandon the Mexico City airport project has raised concerns, infrastructure spending (especially in poorer regions of the country) will be a key government spending priority for this Administration.

Brazil: Pension Reform Promising, But Only the First Step

Unlike Mexico, Brazil’s lack of fiscal credibility lies at the heart if its problems. However, it has not always been the case. The following Chart shows that during the Naughties (2000s), Brazil consistently ran primary surpluses, and governments debt was declining steadily.

No longer. The sharp expansion of government spending following the GFC accounts for all of erosion in the fiscal balance. As a result, government debt (as a percent of GDP) will continue on a unsustainable upward spiral unless urgent belt-tightening is implemented.

Of course, there is widespread recognition that deep-seated pension reforms must play a big role in the adjustment. Indeed, these expenditures amount to 10% of GDP, and nearly one-third of overall government spending. The following Charts illustrate the generosity of all features of the current program: low retirement age, short contribution periods, high replacement rates, etc. Note especially the high level of spending compared to Brazil’s youthful population. Additional strains will emerge as Brazil’s population ages in coming decades.

President Bolsonaro’s recently announced pension reform is a good start — more aggressive than the proposal of the previous government.  Even though Congress is expected to water down the plan, adjustments aim to save nearly $300bn (approaching 20% of GDP) over the next decade.

To be sure, these changes are welcome. However, they must represent only the first installment of the necessary budget alterations. Indeed, I estimate additional spending cuts of roughly 2-3% of GDP annually (similar to the scale of the pension savings) are required in order to stabilise the public sector debt ratio. These cuts, however, will be far less politically acceptable, as they will almost inevitably require sharp reductions in public sector compensation.

The following Chart puts Brazil’s bloated government payroll into international context. Indeed, government pay accounts for nearly 40% of Brazil’s overall public sector outlays. Cuts of this magnitude, which have not yet even been proposed, would confront substantial political and public opposition. Likewise, Economy Minister Paulo Guedes’ privatisation plans have the potential to reduce the public sector debt ratio by up to 15% of GDP (Real 800bn). However, these proposals are already facing opposing from traditional elements within the Bolsonaro administration.

Boosting Long-Term Growth: Micro-Reforms to Face Opposition

President Bolsonaro also inherits an economy whose long-term GDP growth potential growth has slowed below 2% during the previous chaotic government. Even deeper micro-reforms than in Mexico will be required to reverse this slide, boost Brazil’s very low-level of productivity (next Chart), reduce poverty ,and return Brazil to a path of inclusive economic growth.

Deep-seated reforms in Brazil’s educational system are needed to boost labour efficiency. In fact, Brazil’s spending on education is relatively high, but this is not reflected in pupils’ performance.

As the earlier WEF Chart highlighted, improvements in the business climate, e.g. reducing government corruption (Brazil ranks dead last when it comes to the public’s trust in politicians, think about that!), crime, and deregulation will be important in order to boost Brazil’s very low-level of business investment.

Likewise, cuts in other areas of public sector spending will required to create the fiscal space to upgrade the nation’s crumpling infrastructure.

Finally, the following Chart illustrates that Brazil relies less on international trade than other G20 economies. Deeper integration into the global economy would contribute to productivity improvements and support long-term GDP growth.

Strategic Implications

• Brazil’s pension reform plan is encouraging. However, additional, unpopular fiscal austerity will be required to stabilise the debt ratio and restore fiscal credibility. President Bolsonaro may prove unwilling to resist the significant political and public resistance to micro-reforms and public sector pay cuts.  If successful, however, Brazilian real bond yields — which are amongst the highest in the world — could decline 100 to 200bp (see Chart).

• Despite previous weakness, the Brazilian real is not undervalued.  As Brazil aspires to integrate further into the global economy, I believe the pro-growth Bolsonaro government would prefer lower interest rather than BRL appreciation.
• If AMLO’s fiscal conservatism continues — combining future government spending with higher tax revenues —  interest rate reductions  of 100 to 150bp could begin late this year or early 2020.
• The Mexican peso is significantly undervalued. With the US Federal Reserve on hold for the remainder of this year, MXN could appreciate 5-10%.