Brazil: global and domestic uncertainties, economic growth in Q2 2022 - and inflation.
Prextext
Just over 10 days ago, we received a survey sent to us by a renowned consultancy. A few hundred companies in Brazil participated in the survey, which was conducted between the mid-Q1 and the middle of Q2 2022. Data which immediately and then surprisingly catches the eye are:
1. Revenue has halved in 55% of the companies surveyed compared to 2019.
2. Debt increased to 40%.
3. Lack of working capital threatens 85% of these companies. This ranges from an acute crisis situation, to being unable to invest at all.
Is this congruent with our observations?
If we look at our current clients where we are on project missions and add conversations with former clients as well as service providers, such as accountants and auditors, we can confirm the picture. And this is especially true for companies in the manufacturing industry.
Of course, we also have the big mix here of the end of the pandemic, the geopolitical situation as a result of the war in Europe, as well as the national situation and the upcoming elections. However, in this context, the 40-40-20 formula is heard again and again, which we as iManagementBrazil already explained in a recently published blog post. If you want to read it again, here is the link.
Industrial sceneries from our project missions
Focus: Forward Guidance and Self-Deception
In this context, it is of course of high interest for all parties to understand how the Central Bank of Brazil is positioning itself in this scenario.
This is also particularly interesting in light of the fact that one is certainly not wrong in claiming that the national central bank bears a considerable share of the blame for the massive devaluation of the Brazilian real and thus for the import of inflation, a key component of the crisis. After all, according to the formula 40-40-20, 40% alone would be attributable to the irresponsible actions of the Brazilian central bank. If one adds the time component and considers that the irresponsible behavior has been at work since somewhat late 2016, the central bank takes on a prominent position in the assessment of responsibility for having installed the crisis conditions in full awareness.
After all, without any visible basis, the central bank had been following a stoic direction of forward guidance since around the end of 2016: every six weeks, without looking at the forming scenarios, it was assumed that "gigantic reforms" were just around the corner after all, and thus a "storm of economic recovery and investment" would be unleashed. Well … .
Thus, policy rates were cut to a toxic 2% even though inflation was already raging and the depreciation curve was clearly pointing north since Q3 2019. Nevertheless, the central bank had not reacted and continued its blinkered policy, underpinned by a kind of self-deception disguised as forward guidance, unperturbed.
Now the institution complains that it stands alone in the fight against inflation, without fiscal support from the federal government in Brasília.
Is it possible to be so naïve?
Reconciling reality with the monetary authority: the Brazilian Central Bank.
For many years, we at iManagementBrazil have regularly read the Executive Summary of the Central Bank of Brazil after each meeting of COPOM, the Monetary Policy Committee. The meeting is held on a 6-week cycle. In the most current report, the central bank has opted for a more cautious stance.
In an environment that is more uncertain than usual, the Monetary Policy Committee (Copom) has chosen in its latest published minutes to describe in more detail how it sees this scenario, rather than giving more signals about its next steps. Even though the central bank's (BC) collegial board gives the impression of thinking longer term and adopting a cautious stance, the deterioration in the inflation scenario is likely to continue in the short to medium term.
In the last meeting, the Copom had raised the prime rate from 11.75% to 12.75% per annum. In the report in which it presents the reasons for its decision, the Committee included a section on "Scenarios and Risk Analysis" that is much more extensive than the previous one.
In it, the Brazilian central bank addresses risks ranging from the “war in Ukraine” to "Chinese policies to combat Covid-19" to "continued high demand for goods," including in the United States. Noticeably few words on the state of their own Brazilian nation. Well … .
Thus, the Monetary Policy Committee also acknowledges that in the meeting it discussed "some of the possible reasons for the difference between its own projections in the reference scenario (forward guidance) and the projections of various analysts" - a point that has attracted the attention of the financial market, entrepreneurs and investors for some time.
And this is in the second quarter of 2022!
The direction of monetary policy has been followed unwaveringly since the end of 2016. Since Q3 2019, it is evident that the situation turned.
Is it possible to be that naïve?
Perhaps more telling is the fact that the Brazilian central bank has included its own inflation scenario in the risks section. In March 2022, for example, this scenario was presented in the section on the economic situation only. Some minor things. Well … .
Let's put it clearly for a moment. The main pillar on which the Brazilian Central Bank bases its decisions regarding the key interest rate has lost reliability. At least to put it cautiously.
Yes, lost reliability.
Is it possible to be so naïve?
For example, the current report states that the Central Bank of Brazil's Monetary Policy Committee believes that uncertainty regarding its premises and projections is currently greater than usual. Premises and projections refer to the so-called baseline scenario, that is, that self lie of forward guidance, followed since the end of 2016.
Is it possible to be so naive?
In this context, it is also interesting to compare the sections of the report, which deals with the discussion on the conduct of monetary policy, i.e. interest rate policy. It reiterates that the decision has been made to probably signal an extension of the cycle to raise the policy rate. However, it is signaled that the following adjustments will be carried out with a lower degree, that is, below the usual 1% rate.
It can be widely read that the committee decided to signal this, among other things, because it would reinforce the cautious stance of monetary policy and underline the uncertainty of the scenario.
Only now? In the middle of 2022? Can anyone be that naive?
The attentive reader will then notice that it is apparently assumed that the inflation scenario will not worsen in the short term. In the previous report, the Brazilian central bank had underestimated inflation for the period under review by no less than 59%: 1.02% was assumed, but then 1.62% had to be conceded. Not for the first time. Well … .
Then, already for Q2 2022, the official inflation indicator showed an increase of 1.73%. This was the highest monthly increase since February 2003, taking the 12-month cumulative indicator from 10.79% in March to 12.03% in April. In June 2022, the same indicator seemingly signaled a brief respite.
But how important is pure inflation?
Besides the high inflation figures, however, it is rather the qualitative aspects of inflation that should be highlighted negatively - the so-called diffusion index.
This index measures the quantity of products and services whose prices have increased over the period under review.
According to the accessible reports, the indicator reached 76% in the end of Q1 2022, which is the highest value in two decades.
Has the peak been reached?
Street scenery at Av. Faria Lima, Sāo Paulo
2022: Brazil's central bank throws in the towel
In order to control the inflation rate, the Brazilian central bank is currently apparently aiming for 2023. 2022 is assumed to be lost.
Now, in the fine tradition of self-deception, the inflation target for 2023 is 3.25%, with a tolerance interval of 1.5% up or down.
However, inflation that is currently so high and widespread across almost 80% (Q2 2022) of industrial sectors and products makes it difficult to steer price developments toward this target.
More than obvious!
Even more so, taking into account that even the Brazilian Central Bank assumes that inflation expectations can deteriorate sharply. So one wants to reduce inflation by 70-75% within 12 months. How high must the interest rate be then?
Is it possible to be so naive?
Floating 2022-2023 and an attempt of historical classification
Many reports that we at iManagementBrazil have received in the last few days, as well as conversations with current clients in projects, as well as former clients, indicate that the cumulative inflation over 12 months until August 2023 will remain in double digits.
If this assessment is indeed confirmed, it would be the longest double-digit plateau in the consumer price index since Q4 2002, when the index peaked at 17.24% in Q2 2003, the first year of then-President Lula's term.
At that time, the Central Bank was forced to raise interest rates to 26% to curb price increases.
But! …
The Brazilian central bank had a strong ally in this task: the fiscal policy of the government of the time and the other construction of a limit on deficit spending contributed massively to the rapid recovery of budgets.
The Lula government of the time had defined the so-called primary surplus in the constitution as the budget limit. According to this, the government could not spend more than it took in. A primary surplus had to be generated. No ifs, no buts. Period.
Thus, in its very first year, 2003, the Lula government managed to achieve a primary budget surplus of 4.25% of GDP, considering a interest rate of 26% and investments starting to rise strongly. This was the starting signal for the Brazilian upswing and the complete elimination of the foreign debt of the 1980s, as well as the buildup of one of the largest global US$ reserves.
Office compound in the south district of Sāo Paulo
Historical flash analysis of the economic situation
To avoid analyzing year after year, we divide the period from 2000 to the present into three phases:
the years 2000 to 2012 represent the boom,
the years 2013 to 2015 represent stagnation and the first signs of crisis,
the years 2016 to the present represent the crisis years in their full spread and unfolding.
The graphs below were generated from figures provided by the Brazilian Central Bank, the Federal Statistical Office IBGE and a large Brazilian private bank.
Correlation of exchange rate, inflation and interest rate
Without a doubt, the trend toward falling interest rates has been a global phenomenon. And Brazil has not been immune to it. However, especially in phase 01, care had been taken to strike a sensitive balance between interest rates, the exchange rate and inflation trends. The current situation is anything but sustainable and without question represents a kind of tipping point for Brazil. Despite massive interest rate hikes by the Brazilian central bank in recent months, the country is arguably still behind the level to catch ongoing inflation. This seems all the more critical when the spread of inflation across already almost 80% of all industrial sectors, including the service sector, is fed into the scenario in this context.
Whether one can say that the Brazilian central bank is reacting too late is probably impossible to assert conclusively. But one can state without question that the key interest rate was lowered to an insane level without sound justification and that inflation was imported, or is still being imported, with a rocket launch. A glance at the cost structures of companies is enough to manifest this with certainty.
In this context, the argument can be heard that investments are impossible with high interest rates. Counter question: was the investment level higher when interest rates were at 2%? No! Thus, it should be clear to everyone that there are even more significant factors than just the interest rate level.
Development of GDP
Development of GDP per capita
Considering the strong growth between the years 2000 to 2012, with a significant interest rate level and constant inflationary pressure, triggered by the demand for products and services by Brazil's new middle class, corresponding production capacities were naturally built up. In this context, it is also important to understand that it was precisely in those years that the positive generational surplus of young Brazilians entered the market. Thus, the balancing of the exchange rate, inflation and the interest rate must be considered a masterpiece of economic management.
If one also considers that GDP per capita multiplied by a factor of 3.5 from 2000 to 2012, it becomes clear how dynamic Brazil can be.
Reaganomics, in Brazil?
A few years ago, an American professor at the university as I was doing my Executive MBA commented that the Brazilian government at that time was applying the positive things of the so-called "Reaganomics" without accepting a deficit.
As you can quickly see, budget limits are more than necessary, but it depends on how you construct them. One can deliberately give room for growth, or deliberately curtail and cap growth, as in the current construction.
There is no right or wrong. What is the predominant element in the design of a budget framework is political power, trust and the view of the world. The glass is half full or half empty.
The structure of the Brazilian economy is forcing the central bank to take a more forceful approach
With rising fuel and food prices, double-digit inflation hit the lower income strata of Brazilian society hard. Today, 15% of Brazilians are again suffering from hunger. The figure was previously close to 0%. The percentage of households suffering from food insecurity is currently 60%. Brazil is one of the two largest producers of food in the world.
These figures are also reflected in Brazil's poverty rate (inflation-adjusted daily purchasing power <US$5.50):
Development of poverty rate
Scenery of extrem poverty in the central district of Sāo Paulo
The prices of industrial goods have also skyrocketed due to the shortage of raw materials essential for production, which has had an impact on consumers. The main driver here, however, is the massive devaluation of the Brazilian real, triggered in part by the Brazilian central bank's incomprehensible interest rate policy since late 2016. The gates were torn wide open to import inflation.
Many analysts argue that the central bank should not raise the policy rate, currently at 12.75%, as much as it did in 2003 because monetary policy should not use interest rates to combat the primary effects of supply shocks.
However, with the revival of the economy after the Covid crisis, cleaners, dentists, hairdressers and other professionals are adjusting the prices of their services under the pressure of the increased cost of living. In other words, in addition to product prices, the middle class is having to accept adjustments in services, in some cases in the double digits.
The current inflationary pressures have a supply shock as a backdrop, but the structure of the Brazilian economy, with the indexation of salaries and various prices, such as rents, forces the central bank to more vigorously address the plateau of inflation above 10% for a long time. And it calls into question whether the end of the rate hike will be in June or August 2022.
Artistic digital representation of urban environment
In this context, a brief look at Brazil's government share is of particular interest. Historically, Brazil's public spending ratio has always been between 34-37% since redemocratization.
At the beginning of the millennium, the ratio was around 40 %, and it dropped again to 36 % until the financial crisis. This was due to strong economic growth in conjunction with the primary surplus. At the moment of the financial crisis, the ratio rose again to 40 %, only to settle again at 36 % a year later.
President Dilma Rousseff's term in office was characterized by a government spending ratio of between 37-39 %, reaching 42 % at the moment of her impeachment. In the immediate aftermath, during the presidency of Michel Temer, the rate dropped back to 37%.
In the very first year of the current president, Jair Messias Bolsonaro, the state ratio rose to 40% and currently reaches an estimated 43-44%.
The ratio cannot be determined with certainty, because the institutions for statistical national accounts have been deliberately made non-transparent under the current government. In addition, the sharp rise in the national budget spending ratio is massively influenced by the opaque federal budget, according to which the ruling politicians already have no overview of the flow and use of public monetary resources.
Outlook
One should assume that the interest rate will have to continue to rise. It is likely that a neutral rate will be somewhere between 14 to 16%.
In all the discussions, we can clearly see that concerns about inflation are higher than they have been since the Real Plan. Quite a few companies are adjusting inflation expectations upward by another +10%.
Many are simply saying: things have gotten out of hand. 40-40-20. With a diffusion index near 80%, the situation is likely to tighten further.
Oh yes, there is also the question of whether one can be so naive.
Of course not!
There is, of course, the justified suspicion that many Brazilian institutions, including the current government, are very much stuck in old-school thinking.
Devalued currency is good for exports!
It used to be. But today, productivity should be sought. This consists of an appropriately educated workforce and the ability to constantly invest in new technology. And especially technology has in almost all cases today a globally equal price, invoiced in US dollars.
With increasing devaluation, the share of US dollar exposure in the cost structure increases exponentially and the ability to invest is lost.
Then only the commodity of cheap labor should apply and compensate? Well, the educated professionals then vote with their feet and one-way plane tickets and leave the country.
Or do people believe that a nation with a population of about 213 million can be developed solely through agriculture and mining?
