Brazil: Less Abundance?

Our 2008 Brazil forecast is fairly benign. The global environment will bring less abundance, and the balance of payments is the key transmission channel for Brazil. The current account is set to fall into deficit, and capital inflows will slow. Still, the balance of payments should remain sufficiently strong to avoid any major currency devaluation. Inflation stays under control, monetary easing resumes, and overall real GDP growth remains robust. The main downside risks come from a worse-than-expected turnaround in capital flows. In all, Brazil in 2008 still looks good, although less spectacular than in 2007. However, long-term challenges remain: Sustaining faster growth over time will require further reforms.

Decoupling or not? As the US economy slides into recession and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil will be able to “decouple” from the developed world’s troubles. The decoupling debate is misplaced, in our view, at least in its binary version. “Decoupling” should not be seen as a binary yes or no proposition, but rather as a spectrum of possibilities. As usual with these matters, in medio stat virtus: The truth is somewhere in the middle.

The balance of payments is the main channel of transmission from global turbulence into Brazil. In our out-of-consensus view, Brazil’s trade surplus is likely to narrow much faster than the market believes. Robust domestic demand and a strong currency should keep imports growing rapidly, while exports are set to struggle amid a less encouraging global environment. The market consensus calls for only a modest decline in the trade surplus in 2008. By contrast, we see the trade surplus falling by half, to about $20 billion in 2008. Correspondingly, while the consensus view still looks for a current account surplus next year, we are confident that the current account will fall into negative terrain in 2008.

We look for a slowdown in capital inflows into Brazil in 2008. As the global economy decelerates, and global risk aversion re-emerges after being dormant for years, recent all-time high capital inflows seem unlikely to persist. Net foreign direct investment should prove relatively resilient, as this type of flow tends to follow slow-moving perceptions about longer-term trends. But we suspect that the peak in flows into IPOs in the local stock market is behind us. Likewise, we fear that an environment of less global risk appetite might take a toll in capital inflows into the local fixed income market. We assume that these inflows slow towards levels seen prior to the 2007 boom. In all, capital inflows into Brazil should slow from an unprecedented high of about $90 billion in 2007 to almost a third of that level in 2008.

Still, the balance of payments should remain robust enough to keep the BRL relatively strong next year. Consistent with our bearish current account view, our 2008 forecast sees a modest currency weakening by next year. That is more cautious than the market consensus view, which sees the currency at end-2008 unchanged at recent levels. Still, given strong starting points, sufficiently robust capital inflows should keep the currency relatively strong in 2008 from a multi-year point of view. If our numbers materialize, Brazil would still be able to accumulate foreign reserves next year, albeit at a slower pace than in 2007. We think that the sharp devaluations we used to see in the past are unlikely to repeat.

CPI inflation should remain below the 4.5% official target. We assume that the strong investment which has taken place over the past many quarters will mature in time to boost Brazil’s supply response to strong domestic demand. Rising domestic output capacity, in turn, should help allay inflation concerns. Our 2008 forecast also assumes some moderation in food price inflation, which by far was the main culprit for the increase in headline inflation in 2007.

Monetary easing should resume in 2008. After pausing in October 2007, the central bank is set to stay on hold for many months, given its risk-management approach and in light of its asymmetric perception of risks: It prefers to err on the side of caution. However, if our scenario of below-target inflation materializes, the central bank should be able to eventually resume cutting rates next year. Our forecast sees a total of 50 bp rate cuts to 10.75% at end-2008.

Fiscal policy will remain pro-cyclically expansionary. Amid strong tax revenues, the authorities should be able to continue to deliver a sufficiently large primary surplus, despite the defeat on the CPMF tax renewal for 2008, and the public sector debt/GDP ratio should continue to edge down. But the long-term health of fiscal policies in Brazil remains debatable. Pro-cyclical fiscal policies feel great as long as revenues are growing fast, but can prove regrettably painful when the cycle takes a downturn.

Domestic demand growth should remain strong, amid a combination of expansionary policies, rapid domestic credit growth, supportive labor market conditions, upbeat consumer confidence and positive business sentiment. Strong data for 2007 Q3 suggest that real GDP growth in 2007 could turn out a bit above the 5.0% mark, higher than our official forecast for 4.9% this year. But overall real GDP growth is set to slow to 4.3% next year, as the drag from net trade intensifies.

What are the risks to our forecast? Risks are mainly related to the international environment. The main downside risk to our scenario would be a sharper-than-expected turnaround in capital inflows. If the capital account really dries up, on top of what seems to us an inevitable deterioration in the current account, then the Brazilian real would suffer, even though the central bank could lean against currency weakening by selling reserves. In turn, currency devaluation could push inflation expectations up, arguably forcing the hand of the central bank to tighten. Monetary tightening, for its part, could take the punchbowl from the domestic demand party. To be fair, there is potential upside risk, too. Large interest rate differentials and global weakness of the US dollar itself could support Brazil’s bilateral exchange rate. If capital inflows prove more resilient than we assume, resulting currency strength will reinforce Brazil’s virtuous-cycle story.

Brazil’s near-term outlook is positive, but long-term challenges remain. All in all, our Brazil forecast for 2008 is fairly benign. We assume that capital flows will remain sufficiently strong, the currency avoids major devaluation, inflation stays under control, monetary tightening is avoided, and overall real GDP growth remains robust. However, sustaining faster growth over the years would likely require further reforms. Macroeconomic reforms (ranging from fiscal and tax reforms to labor and social security reforms) could go a long way in boosting Brazil’s growth potential. And microeconomic reforms would be key to improve Brazil’s business environment. Infrastructure bottlenecks, in particular, may eventually prove a binding constraint on Brazil’s ability to grow fast. Sadly, recent years of global market abundance run the risk of going down in history as a missed opportunity for Brazil’s reforms. Unhappily, too, investors should not hold their breath for fast advances on structural reforms during the remainder of the second term of the current administration, ahead of presidential elections in late 2010.

By Marcelo Carvalho Sao Paulo
Morgan Stanley
December 16, 2007