88848 JUNE 2014 • Number 148 Three Perspectives on Brazilian Growth Pessimism Otaviano Canuto and Philip Schellekens Over the last few years, Brazil’s growth has significantly decelerated. Accompanying this slowdown, a change in com- mentary on Brazil’s economic future has emerged, and is reflected in a recent ratings downgrade of Brazilian sovereign paper and an overall much-bleaker growth outlook both for the near and medium term. This note examines three contrib- uting factors to this change in sentiment: macroeconomic management, the external environment, and microeconomic fundamentals. Among these, this note argues that the relative lack of progress on the microeconomic reform agenda has been far more detrimental to the growth outlook than either the credibility cost of recent macroeconomic management or the negative influence of a less supportive external environment. Against this backdrop, the recent ratings downgrade is not inherently negative: while Brazil is not about to slide down a slippery slope of macroeconomic mismanagement or on the verge of an externally powered economic meltdown, the downgrade can serve as a call to action for government to enact the necessary structural reforms to energize and sustain productivity growth. Slower Growth, Diminished Expectations It has become increasingly evident that Brazil’s growth dynamism of the mid-to-late 2000s was a short-lived phenom- Brazil’s postwar era was marked by a protracted boom period, enon and that the economy’s growth engine has run out of followed by alternating episodes of macro instability and sta- steam over the last few years. Despite the country’s resilience bilization. Between 1947 and 1980, Brazil’s national income during the global financial crisis and seemingly quick recovery grew at 7.5 percent per year, lifting the country into upper- amid a difficult external environment, economic growth middle-income status. Between 1981 and 2003 were two de- cades of instability and crisis management that reduced aver- slowed to just 1 percent in 2012 and remained subpar in age growth to just 2 percent. A brief uptick occurred after 2013, settling at an uninspiring rate of 2.5 percent. The most inflation control imposed by the Real Plan in 1994, only to be recent data available suggest that economic weakness persist: interrupted by the currency crisis of 1999. Subsequently, Bra- during the first quarter of 2014, the economy grew at an an- zil introduced inflation targeting and strengthened its fiscal nual equivalent rate of just 0.6 percent. Looking ahead, little framework, efforts that laid the foundations for future improvement is expected in the near term. Indeed, as of early growth. Aided by favorable external tailwinds, growth subse- June, the median forecaster predicted growth of 1.4 for 2014 quently accelerated to 5 percent in the period 2004–8. Im- and 1.8 percent for 2015. Looking even further ahead, a mut- proved macropolicy fundamentals also resulted in resilience ed recovery is anticipated that would bring growth to 2.5 to 3 during the global financial crisis: following a dip of 0.3 per- percent between 2016 and 2018. cent in 2009, the economy grew 7.5 percent in 2010 and 2.7 The recent weak performance of the Brazilian economy percent in 2011. and its subdued economic outlook are disappointing in at 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 1. How Growth Optimism Turned into Pessimism (daily These same three factors once responsible for Brazil’s median forecast of GDP two years later averaged over the year) growth acceleration—the credibility of the macroeconomic 4.5 policy framework, the support of the external environment, 4.5 4.5 and the reform efforts on the microeconomic front—under- pin the three strands of growth pessimism that have become 4.0 4.1 4.2 prevalent in recent economic commentary on the future di- 4.1 3.9 rection of Brazil. However, as will be argued below, the dete- percent 3.8 3.5 3.7 3.7 rioration in sentiment appears to go beyond what is warrant- 3.5 3.5 3.5 ed by fundamentals and appears to reflect an excessive degree of pessimism about Brazil’s economic growth capacity—not 3.0 unlike the earlier period of exuberance when expectations 3.0 were equally distorted, although then on the upside. 2.8 2.5 Macroeconomic policy credibility 01 02 03 04 05 06 07 08 09 10 11 12 13 14 The first strand of growth pessimism espouses the view that Source: Central Bank of Brazil; World Bank staff calculations. recent macroeconomic management has eroded the hard- won credibility of a macroeconomic policy framework built least two respects. While not atypical for an advanced econo- on fiscal prudence, exchange rate flexibility, and inflation tar- my that has exhausted the benefits of catch-up growth, the geting. In response to slow growth coupled with high infla- slow growth observed in Brazil is neither typical nor desirable tion, policy makers have relaxed fiscal policies, accommodat- for an emerging market in need of further per capita income ed sticky inflation at the upper end of the target range, and growth and shared prosperity. Recent growth rates also disap- introduced large currency market interventions to dampen point in comparison to recent economic history and, most exchange rate volatility (figures 2 and 3). Critics point to notably, the 2004–8 period when growth, as noted, reached 5 these developments—alongside interventions to control infla- percent; instead, the slow growth rates evoke memories of the tion with administered prices and support growth through earlier 1981–2003 period, when the economy grew at just 2 less than fully transparent para-fiscal operations—as the begin- percent annually, even if the latter period is different in many ning of a slide down a growth-reducing slippery slope (Wheat- other respects. ly 2014). These critics believe that the recent downgrade of This disappointment has been accompanied by a sig- Brazilian sovereign paper to just one notch above junk vali- nificant degree of growth pessimism that appears to have dates their claims of recent macroeconomic mismanagement. sunk into the minds of analysts and observers of Brazil’s These factors however are unlikely to account for the economy (figure 1). Market forecasts regarding Brazilian moderation of growth forecasts observed in recent quarters. economic growth two years out have dropped considerably, While a return to macro instability of the sort seen in Brazil’s with similar forecasts also at three years out. Remarkably, pre-stabilization period can be discounted as a remote possi- however, market forecasts have deteriorated not only rela- bility, the policy framework did suffer a credibility loss as the tive to the zenith of 4.5 percent reached in 2010–11, but authorities struggled to respond to the evolving macroeco- also relative to the estimates of 3.5 percent earlier in the last decade. Figure 2. Inflation Hovers at Upper End of Target (year-on-year, percentage change) What Explains Growth Pessimism in Brazil? 10 headline inflation 10 The answers may be found in what underpinned the growth free prices 9 9 administered prices acceleration of the mid-to-late 2000s. That growth spurt was 8 8 the result of delayed effects of reform efforts from the 1990s 7 7 and the first half of the 2000s, when Brazil got its macroeco- 6 6 nomic house in order and implemented reforms in the finan- 5 5 cial, trade, and social sectors (Ter-Minassian 2012; Canuto, 4 4 Cavallari, and Reis 2013). Risk premiums on all Brazilian as- 3 3 sets fell systematically after it became clear that commitment 2 2 1 1 to fiscal discipline, inflation targeting, and flexible exchange 0 0 rates would be preserved regardless of the political parties in Oct -12 Oct -13 Jul -12 Jan -12 Jul -13 Jan -13 Apr -12 Jan -14 Apr -13 Apr -14 government. In addition, favorable external conditions prior to the global financial crisis relaxed financial constraints and financed growth. Source: Haver; World Bank staff calculations. 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 3. Primary Surplus Has Diminished (percent of GDP) and geographically, both on the export and the import side. 4.0 year-end target 12-month cummulative 4.0 Furthermore, the role of the external environment in accel- primary surplus erating growth during 2004–8 must not be overstated. Im- 3.5 3.5 portant components of growth acceleration during that pe- 3.0 3.0 riod were the delayed effects of earlier macro- and 2.5 2.5 microeconomic reforms that produced stabilization gains 2.0 2.0 and enhanced productivity (Canuto, Cavallari, and Reis 2013; Canuto 2013). 1.5 1.5 Microeconomic growth fundamentals 1.0 1.0 The third strand of growth pessimism concerns the lack of 0.5 0.5 improvement in the microeconomic fundamentals for 0.0 0.0 growth. This strand is of far greater concern than the credibil- ity cost of recent macroeconomic management or the eco- Aug -13 Nov -13 Aug -12 Nov -12 Feb -14 Aug -11 Nov -11 Feb -13 Feb -12 May -13 May -12 May -11 nomic impact of the deterioration in the external environ- ment. Indeed, the microeconomic environment is critical for Source: Haver; World Bank staff calculations. growth, even more so today than in the past. This is because demographic dynamics have reduced the growth of Brazil’s nomic environment of slow growth and high inflation. But labor force. Higher growth therefore requires first and fore- these interventions took place at a time when the flexibility most increased worker productivity. But productivity growth implied by such actions was warranted to counter economic remains constrained by a cumbersome business environment conditions and stabilize asset prices. Importantly, despite and a slow pace of physical and human capital accumulation such interventions, the pillars of the macroeconomic frame- (figures 5 and 6). For Brazil to energize and sustain productiv- work have remained broadly intact and Brazil continues to ity growth, it will need to enable the enabling environment enjoy large external buffers. While care will need to be taken and disable the disabling one. to ensure that fiscal buffers are restored and inflation returns Yet, during the recent period of slower growth, little to the mid-point of the target range, the credibility losses in- progress was made in tackling long-standing structural bottle- curred so far are unlikely to have been a driving factor in stall- necks, and therefore the structural reform agenda remains ing growth or depressing expectations. long and unfinished (Canuto 2014; World Bank 2014). Un- External support factors surprisingly, slow growth has, for that reason, primarily be- The second strand of growth pessimism laments the lack of a come a supply-side phenomenon of a structural nature. This supportive external environment. This view is intricately re- is indicated by the fact that, despite slower growth, the output lated to the hypothesis that the growth acceleration before the gap is as good as closed, inflationary pressures are pronounced, global financial crisis was largely the result of external rather than domestic factors. Rapid capital inflows, better terms of trade, and lower global interest rates all played to Brazil’s favor Figure 4. Brazil Ranks Lowest on Export Share of World’s 10 Largest Economies (share of exports in GDP, 2011, percent) when times were good. In turn, as conditions changed for the worse, so did Brazil’s economic fortunes. Looking ahead, this Germany 50 view paints a depressing outlook for Brazil based on the ex- United Kingdom 32 tent to which its premier trading partner, China, continues to Mexico 32 slow, major advanced economies remain stuck in the dol- China 31 drums, and global capital becomes more expensive and less Russian Fed. 30 readily available, as the U.S. Federal Reserve tapers off its pur- chases of long-term securities. All of the above are thought to France 27 present a clear and present danger for Brazil (Wentzinger India 24 2013). Japan 15 While external factors continue to play a role in Brazil— United States 14 both by affecting the real and financial side of the econo- export share Brazil 12 my—they are all too often overplayed (World Bank 2014). Growth in Brazil is still largely made in Brazil, given the 0 10 20 30 40 50 percent overwhelming share of its domestic market in GDP and its Source: WDI; World Bank staff calculations. limited external orientation (figure 4). Brazil’s external Note: Largest 10 economies selected in terms of 2011 GDP (PPP-adjusted current trade accounts also remain well diversified product-wise international dollars). 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 5. Capital Accumulation Remains Slow (capital stock at Figure 6. Human Capital per Person Improves, But Continues to constant 2005 national prices per worker, 2005 US$ thousands) Lag (index of human capital per person, based on years of schooling and returns to education) 1,000 Brazil Japan China Korea, Rep. of 4 United States 100 3 2 10 Brazil 1 China Japan 1 Korea, Rep. of 1950 1960 1970 1980 1990 2000 2010 United States 0 Source: Penn World Tables version 8.0; Feenstra, Inklaar, and Timmer (2013); 1950 1960 1970 1980 1990 2000 2010 World Bank staff calculations. Source: Penn World Tables version 8.0; Feenstra, Inklaar, and Timmer (2013); Barro and Lee (2012); Psacharopoulos (1994); World Bank staff calculations. and the labor market is buoyant with unemployment at re- cord lows. References The key challenge going forward is therefore to energize the momentum of progress on this agenda of structural re- Barro, Robert, and Jong-Wha Lee. Forthcoming. “A New Data Set form. In this respect, the recent ratings downgrade is not of Educational Attainment in the World, 1950–2010.” Journal unwelcome, nor is it a signal that Brazil is about to slide of Development Economics. http://www.barrolee.com/papers/ Barro_Lee_Human_Capital_Update_2011Nov.pdf down the slippery slope of macroeconomic mismanage- Canuto, Otaviano. 2013. “Brazil: Chasing Animal Spirits.” The ment, or on the verge of an externally-powered economic New World Post. meltdown. Rather, it is a call for action on the structural re- ———. 2014. “What’s Holding Back Brazil?” Project Syndicate, form front. For the main risk facing Brazil and its economy June 15. is the specter of mediocre growth over a protracted period Canuto, O., M. Cavallari, and J. Reis. 2013. “The Brazilian Com- against a counterfactual potential of opportunity. Such a petitiveness Cliff.” Vox, Feb. 27. scenario would not only exacerbate current concerns about Feenstra, Robert, Robert Inklaar, and Marcel Timmer. 2013. “The macroeconomic vulnerability but also—and more impor- Next Generation of the Penn World Table.” NBER Working tantly—imply that Brazil is unable to live up to its develop- Paper No. 19255, July. http://www.nber.org/papers/w19255. ment potential. Psacharopoulos, George. 1994. “Returns to Investment in Educa- tion: A Global Update.” World Development 22(9): 1325–43. About the Authors Ter-Minassian, T. 2012. “Structural Reforms in Brazil: Progress and Unfinished Agenda.” IDB Policy Brief IDB-PB-158. Otaviano Canuto is Senior Adviser and former Vice President of Wentzinger, Alexandra. 2013. “Brazil.” BNP Paribas. the World Bank. Philip Schellekens is Senior Country Economist Wheatly, J. 2014. “Brazil’s Economic Policies: More Nails to the for Brazil, also with the World Bank. The opinions expressed Coffin.” Financial Times, April 7. here are the authors’ and do not necessarily reflect the views World Bank. 2014. “Implications of a Changing China for Brazil: A of the World Bank. New Window of Opportunity?” Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise