Brazil is enjoying a bull market, based on hopes that the rising level of sovereign debt could stabilise, and even begin to reverse. These hopes have been piqued by a series of dramatic political reforms, which are currently underway. However, as is common in Brazilian politics, longevity cannot be guaranteed. While the Olympics has stolen the limelight in Brazil, fiscal and monetary policy leave us cautiously optimistic that the golden glow could outlast the games.
The next few months are critical on the political front for Brazil. The Senate will give its verdict on former President Dilma Rousseff early in September. If this goes as expected, with Dilma definitively departing the presidency, the Fiscal Ceiling Amendment will be tabled by October. This amendment would cap government salary adjustments at inflation and reform social security more broadly, de-linking pension payments from the minimum wage and extending retirement ages. However, these reforms would not survive extensive popular debate, prompting Brazil’s interim President Michel Temer to attempt to pass them through political wheeling and dealing in the style of Frank Underwood from House of Cards, rather than through anything resembling a referendum. Neglecting to marshal support for austerity measures is a shaky foundation for long-term policy.
Municipal elections scheduled for October will add to the excitement and could increase the government’s political capital. Depending on conditions, the Banco Central do Brasil could start to cut interest rates, providing desperately needed relief to highly indebted consumers and businesses. If the economy recovers as a result of lower rates and greater confidence, the population will tolerate these reforms – until the next cycle or shock, at which point a change in government could herald their unwinding.
Whether the confidence induced by the current direction of policy is sufficient to sustain a recovery is unclear. Most observers cite the need for a substantially lower cost of capital to spark fresh investments, although the carry trade attracts capital at the sovereign level. The cost of capital at the corporate level may not decline as much as the market believes. The central bank is widely expected to cut the SELIC (reference) rate from 14.25% to about 12.00%, but part of the reforms involve replacing loans from the National Development Bank (BNDES) at 6% with bank loans at a several percentage point spread over the SELIC. Borrowing costs for corporates are likely to rise to about 14% for the best companies, much higher than the current subsidised cost.
A higher cost of debt means a higher cost of capital, all else being equal. Of course, subsidies ultimately come from borrowed government money and so getting rid of them will make the sovereign balance sheet healthier. This could translate to lower real rates, a stronger currency, a lower risk free rate and a lower cost of equity, plus the potential for more cuts in the SELIC rate, a promising scenario that has a lot of traction in the market at present.
However, there are political risks which could prevent this outcome. These include Interim President Temer being implicated in a lava jato or a similar scandal, former President Luiz Inacio Lula da Silva gaining enough strength to contest the presidential election in 2018, or Finance Minister Henrique Meirelles stepping down, having decided that the political class lacks the will to implement necessary reforms. If any of these occur, all bets are off. The CDS on government debt, currently at 300, could rise to 400 rapidly, there could be a 10% move in the real, and a 20% drop in the stock market.
The key factor in Brazil’s economic recovery remains stabilising its sovereign debt. Temer has put a good economic team in place and the economy appears to have reached a trough. In reality, Brazil has the potential to grow at about 2% each year in real terms. But the economic team's job is made easier by the global liquidity environment as investors continue to reach for Brazil's real 6% yield on government debt. Locals are hopeful that the political departments will deliver what the economics department requires.
The central bank is expected to start cutting rates in October and we estimate that it has room to ease between 2%-3%. If the currency stays strong, which is possible due to the carry trade and a smallish current account deficit of 1.5%, it may not stop at a 3% cut in order to keep the currency from significantly strengthening. Some local infrastructure investors are talking about real rates in Brazil reaching 2% in the next three-to-five years. This is different to the central bank’s preferred strategy, which is to cut slowly, keeping the curve inverted and anchoring long-term rates, but pressure to cut substantially to provide economic relief will be intense. Given global (and domestic) uncertainties, the direction of travel is subject to change at any time.
An improvement in the country’s sovereign balance sheet, a strengthening currency and positive action by the central bank should all aid a broader economic recovery in Brazil. Yet, although there appears to be strong policy support for Brazil’s economy, the nature of the country’s politics means this is never guaranteed in the long term, leaving any recovery unstable.