Brazil is in the early stages of a possibly long and sinister journey
Rule of law termination adds a whole new dimension of uncertainty to a most adverse economic perspective
With little less than a month to go before the expected start of the new government, the prospects for the country are somber. Not because of the situation left by the current administration, which, on the economic level, handled the shocks of recent years with unparalleled dexterity. This became even more clear after the latest revisions of the national accounts recently published by IBGE, the official statistics agency.
Using new sector data, IBGE revised the drop in GDP in 2020 from -3.9% to -3.3%, and growth in 2021 from 4.6% to 5.0%. Investment rate reached 19.6% in 2022, the highest value in eight years. Labor market is also strong: unemployment reached 8.3% in October 2022, also the lowest rate in 8 years. Working population is now close to 100 million people, an absolute record, which reflects both the post-pandemic reopening process and the benefits of the 2016 labor reform. Gross public sector debt reached 75% in October 2022, the same as 2019, before the pandemic. Central government expenditure as a proportion of GDP will end 2022 lower than it was in 2018, an unprecedented achievement for governments in the post-1988 period. This constitutes unequivocal evidence of sound fiscal management, especially under the duress observed in recent years.
No other major economy displayed stable debt and falling primary government spending over the last quadrennium. The IMF fiscal monitor for October 2022 shows that, on average, the gross debt of emerging economies rose 10pp of GDP in the period, and that of mature economies, 8pp of GDP. The presence of the spending cap mechanism, which, contrary to what some narratives try to disseminate to this day, remained active throughout the period (with the 2020 expansion being treated, correctly, as an exceptionality); maintenance of civil servants' salaries, in nominal terms; the effects of the pension reform greater than originally anticipated, among other factors, were fundamental variables for the materialization of this success.
The economy experiences, however, a certain cyclical exhaustion. Bank credit concessions to individuals rose too rapidly, and as a result defaults are now quickly growing. Economic slack has been diminishing, and inflation, although receding, does not look like it will converge to levels compatible with the 2023 and 2024 targets (3,25% and 3,0%, respectively). Confidence indexes plunged after the election, reflecting the coming inflection in economic policy. Preliminary data suggest a contraction in economic activity in 4Q 22.
Oblivious to these circumstances, future government economists and politicians articulate a raising of the spending ceiling by at least R$ 150 billion for the coming years. This value goes far beyond what is necessary to maintain a comprehensive support to the most vulnerable families, being totally inadvisable, at the current state of the economic cycle, from almost any point of view - except for that of politicians and public works contractors who will eventually benefit from these expenditures.
If a raise in the spending cap was all that changes were about, the situation would be bad, but not critical. There is much more to come, however. The balance sheets of state-owned banks, in particular BNDES’ (the state investment bank), have been fixed by the correct leadership of the past six years. The bank boasts a Basel index close to 50, prompting it to be used, by a reckless administration, as a support - in the form of economically unadvisable loans, and stake acquisitions in crony businesses - to an economy approaching a cyclical recession, whose organic consequences, in absence of artificial bolsters, would include lower Central Bank rates, which would, in time, create conditions for a new cycle of leverage and growth.
After the damages to BNDES’ balance sheet inflicted by the policies of PT (Worker’s Party – to which Lula is affiliated) between 2008 and 2014, a bill which prohibits the bank to grant loans at rates below market was passed, an action which in theory significantly limits its use for the discussed purposes. We shall see shortly if this will prove an effective barrier to the repetition of practices which caused enormous harm to the Brazilian economy.
Lula and several other PT politicians have already made it clear, on several occasions, that Petrobras' management will change, and the practices that led to the company's decapitalization, in the period prior to 2016, will be resumed. The international price parity rule will likely be scrapped, and investments in refineries and other low-return activities probably reinstituted. One should keep in mind it was under Lula that the worst investments in the company's history - the Abreu e Lima refinery and Comperj were initiated. Each of these projects burned down more than US$ 15 billion, in the form of bribes and overpriced purchases. In contrast, in this year of 2022, Petrobras, alone, collected more than R$ 400 billion (or 4% of GDP) to federal and states’ treasuries in the form of royalties, dividends and taxes. The company contributed significantly to improve the dynamics of the public debt, while at the same time remaining extremely profitable. Sadly, this period is now over.
The potential set of bad policies can, of course, always be enlarged. For example, in a recent article, two likely members of the future economic team (one of whom is currently highly regarded as future Finance Minister) listed a complete menu of economic nonsense, including a Brazilian version of the doomed MMT experience; the introduction of an Argentinean-style export tax, and a proposal for a single South American currency. If this last idea is as stupid as it is difficult to implement, the others are just as bad, and easier to execute. Well, why not, then?! The people who are about to return – who happen to be the same whose polices triggered the largest recession ever recorded in the Brazilian economy - are saying that they are going to repeat all the recipes that led to it. Why should we expect different results, this time?
The direction of the economy under PT rule is clear, and it is the opposite of that suggested by the cynicism of a group of so-called liberal economists, who disguised their own prejudice against the current administration through pretending Lula’s future policies to be sound. With more spending, more taxes will be needed. This combination will generate more inflation and will demand higher interest rates, which will, in time, induce less growth. The coming dilapidation of state banks balance sheets and decapitalization of Petrobras have the potential of further disorganizing the economy, induce a crisis of confidence, and eventually lead to a recession. Furthermore, uncertainty should increase as the term-end (Dec 2024) of the current Central Bank chief approaches, what may erode currency support.
The local circumstances of the economy thus point to a very adverse scenario, which could be smoothed if commodity prices remain high in 2023.
The situation in Brazil, however, is extremely worrying, for reasons that go far beyond the economy. The behavior of the superior courts during the electoral process was biased, engraving it with vices which continue to fuel challenges to the legitimacy of the elected government. Courts’ illegal actions in recent months include, but are not limited to, prior censorship and imprisonment of current and elected representatives affiliated to the President; persecution of businessmen who support the President; ban on disclosure of certain plainly true information on the president-elect, and censorship of media vehicles, among other arbitrary actions (see my previous article for further background on this). Such a wave of violence left huge scars in the social fabric that remain open, and tend not only to not heal, but rather, to deepen, as the perspective for rule of law and due legal process re-establishment remain unclear ahead.
Such elements of political anomaly add an additional dose of uncertainty to the economic scenario, in a dimension that had not been present in recent decades. An aging and indebted Brazil seems to be embarking on a potentially catastrophic course, and the contours of the country that could show up at the other side of this long tunnel tends to be much worse than simple debt simulation spreadsheets are able to capture, even in the most pessimistic scenarios.
.