The opportunity brewing in Brazil’s economic crisis
Brazil’s political implosion may be a turnoff for foreign investors, but in reality, this crisis will likely facilitate a much needed break from the toxic combination of overspending and excessive government credit expansion seen in recent years.
Having once been part of the quartet of so-called BRIC nations powering global growth, Brazil has become a laggard, falling deep into recession, its worst since the 1980s. Unemployment is at its highest since 2009. By the end of 2015, inflation soared to 10.7% from a low of 4.92% in mid-2012; government bond yields breached 16% from below 9% in 2012; and the real has depreciated by more than 150% since 2011.
Brazil’s problems cannot simply be blamed on the fall in commodity prices. Rather, they are largely the result of poor and overly pro-cyclical economic policy. Government-directed lending has been excessive, with state-subsidized credit crowding out the private sector and overwhelmingly dominating the country’s total net credit expansion from the end of 2011 through the end of 2015. Central bank policy was also far too loose.
The central bank’s inflation-adjusted benchmark rate hit a low of just 1% in 2013. The previous period of fiscal prudence, which saw Brazil’s debt-to-GDP ratio fall from 79% in 2002 to 61% in 2011, was abandoned. And since 2011 new debt equivalent to almost 10% of GDP had been accumulated, with little to show for it.
The situation sounds bleak, but statistics don’t tell the full story. This crisis presents an opportunity to make tough reforms that should pave the way for a return to health. A return to more responsible fiscal and monetary policy should allow Brazil to realize its enormous potential. On the back of better policy, we have seen and continue to see an attractive long-term opportunity in local currency bonds, which have notably been one of the best performing assets in all of emerging markets this year.
Prior to the blow up last year, we had liked inflation-linked local bonds, but after the currency imploded and yields went through the roof, we made sizeable investment in fixed rate local currency bonds in early October 2015. We saw the crisis as a trigger to force a change in government policy, which now has expanded to likely involve a change in the government.
If evidence is needed that drastic action can pull a country back from the brink, we need look no further than Ireland. Back in 2011, the consensus was that Ireland was insolvent. Irish sovereign bond yields were sky-high, reflecting a real fear that the country could go bust.
The markets were wrong. The government understood that recovery was achievable through tough measures to reduce the deficit — implementing so-called fiscal consolidation, maintaining low tax rates to attract future foreign direct investment despite pressure from many other European nations to do the opposite, and allowing labor market flexibility to facilitate a temporary move lower in real wages necessary to regain export competitiveness and refuel growth. The policies were painful in the short term, but they allowed Ireland’s strong fundamentals to shine over the long term. Ireland’s growth rates are now once again one of the highest in Europe. Jobs are growing, exports are booming, and large amounts of foreign investment are flowing in.
It is far from an isolated example. Take Hungary. At the time of the euro-zone crisis, Hungary was on the brink of insolvency, leading the ratings agencies to downgrade its debt to junk status. The government took unpopular decisions that proved exactly the right approach to shore up the economy and stimulate growth. Policies ranged from forcing banks to shoulder some of the cost of reckless Swiss franc mortgages, to revamping unemployment insurance from a welfare model to a Roosevelt-like workfare system, and rationalizing the outdated Soviet-era health, education and transport systems.
The changes paid off. Today, Hungary joins Ireland as one of the most buoyant economies in the EU, with government yields in the low single digits and a stable currency.
While Brazil faces its own challenges, like Ireland and Hungary, we can see a path to regaining economic health.
If Brazil accepts short-term pain for long-term gain, there are good reasons to believe that it, too, will recover. Over the next few years, the country should be able to realize its true potential as one of the world’s most resource-rich economies if the central bank maintains a sufficiently tight stance to turn the tide on inflation and the government returns to running a primary fiscal surplus. These polices will also allow Brazil’s growing middle class to re-emerge as a key driver of growing consumer demand.
Can Brazil stay the course while these policies are implemented and take hold? I believe it can. Brazil is sitting on healthy levels of foreign currency reserves — equivalent to more than a year of imports — and while its debt-to-GDP ratio has risen, it is still lower than many Western economies, sitting at 70% at the end of 2015. More than 90% of this debt is held in local currency, so the weaker real does not cause it to balloon.
Additionally, gross foreign direct investment in Brazil remains resilient, representing some 4.2% of GDP, more than enough to offset the current account deficit of 3.3%. While its debts are manageable, Brazil’s banks are relatively well capitalized, and have passed stress tests, meaning the country has time on its side.
While the government’s recent policies have been disastrous, things are changing. Encouragingly, the brake has already been applied to past budgetary irresponsibility, and there is a growing political consensus that serious fiscal consolidation is needed to deliver a turnaround.
The central bank has also made moves to regain credibility and start anchoring inflation expectations. Interest rates were raised from an overly accommodating low of 7.25% to a more appropriate 14.25%. A self-engineered recession, while painful, was the only way to prevent runaway inflation from leading to a huge rise in poverty and social instability. This vigilance must continue.
If tackled head-on, a crisis can be a necessary catalyst for positive change. We are confident that Brazil will thrive again if it does not return to the unsuccessful policies of the past and instead makes new, tough decisions needed to return fiscal and monetary health.
Let us here in the U.S. also not ignore the lessons of Brazil — overly easy monetary policy and overspending will only lead to a short-term boom with dire long-term consequences.
Michael Hasenstab is chief investment officer with Templeton Global Macro, a unit of Franklin Templeton Investments.
The piece was originally published in Barron’s on May 12, 2016.