Introduction

As it has been common practice for several years, in the last quarter of 2021 we have also worked together with some clients in their process of revising the business plan and the possible scenarios to set up an outlook on Brazil 2022. This time there were six companies from the sectors automotive suppliers, engineering oil and gas, mining, B2B startup and a local coffee shop franchise group. The national origin of the companies was from Brazil, France and North America.

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Challenge: strategic view

This year, as a result of its high strategic implication, the report was published exclusively through the Diplomatic Council think tank in mid-January 2022. iManagementBrazil is the national hub of the Diplomatic Council in Brazil.

Impact on social media

Within a few days, the report was read and downloaded more than 19,000 times globally through various social media channels. This makes this report one of the most widely read publicly published papers globally on the current situation in Brazil in the first quarter of 2022.

Readers interested in Brazil should re-read the report. An astonishing number of things have been clarified and manifested in the meantime.

To understand today's national scenario, one simply has to know the history since about 2014 to be able to classify the current narratives. The report provides this context as well.

Mutual review

A few days ago, we once again spoke intensively with all participants. Taking all the information from the companies together, it was already more than clear in the second half of 2021 that inflation will go through the roof, contrary to the pronouncements of the central bank and a dubious government. Thus, we already wrote in the Outlook 2022 that up to +52% material cost increases will manifest themselves in the calculations in Q2 2022. Why the central bank and the current government were talking in Q4 2021 about inflation coming to a standstill in the first months of 2022 and then declining massively was already more than a mystery to us at the time.

But if you take the trouble to look back systematically, it immediately becomes clear that this narrative has been repeated like a prayer mill since Q3 2019. It was precisely in this quarter that the depreciation of the real began very visible and the inflation curve started to rise. At the same time, the Brazilian central bank really stepped on the gas pedal again, following a kind of self-deception, expressed in the so-called forward guidance, that the major reforms would start in the following quarter and therefore interest rates were lowered to an irresponsible 2%. This forward guidance has been stoically applied since around the end of 2016, always with the same narrative.

And this is absolutely not new. Those who regularly follow blog posts or vlogs from iManagementBrazil will remember that we have been addressing the issue since mid-2019 as one of the most massive strategic problems for national Brazilian business models.

From the inflation scenario, we deduced for ourselves as a group that a neutral interest rate would probably have to be at least 14%, at most 16%.

The Brazilian central bank claimed that the interest rate could not rise above 10.5%. Currently, the key interest rate SELIC is at 12.75%. Tendency: still rising.

War in Ukraine

Now one or the other reader may justifiably object that the war in Ukraine was not fed in. That is correct. Or was it? In our group of clients there was a global system supplier of the oil and gas industry. Their executives repeatedly mentioned in Q4 2021 and early 2022 that a massive conflict between Russia and Ukraine was around the corner.

A magnifying glass on the startups

On page 26 of the report, we had already taken a special look at the expectations for Brazilian startups at the beginning of the year. Since 2016, we have been able to repeatedly conduct project missions in this segment with iManagementBrazil and therefore have a pretty good view of the sector and the problems that have been looming for some time.

In our report, we outlined the scenario that investors would accept significantly lower entry amounts. That is exactly what has happened. The background to this was, of course, the increasing risk aversion of investors.

Now, however, the situation has developed more dramatically than anticipated. Currently, more and more Brazilian startups have to implement sensitively noticeable layoff programs. The local business press is trying to paint the picture that this is due to higher interest rates and the dramatic deterioration of the geostrategic situation.

Without a doubt, the war in Central Europe has not helped. However, rising interest rates are not the problem, but rather an expression of an imbalance that has been looming for a long time. Further above, we have already described the fatal strategy of the Brazilian central bank, called forward guidance, whereby the key interest rate was pushed to an irresponsible 2% per annum without foundation.

When the devaluation of the Brazilian Real started in Q3 2019, the root for the emerging crisis of Brazilian startups was planted deep in the ground. As the real devalued, the constant need to invest in technology became more costly.

A startup needs a significant expansion of server capacity in the cloud? The service is billed globally in US$. Another startup needs to lease more hardware? At least a significant portion of these costs are global costs and are invoiced in US$. As the Brazilian Real depreciated, the exposure of the cost structure to US$ grew proportionally more and more. Stopped growing? No, it continues to grow.

In addition, unemployment is increasingly reducing the consumer base, whether B2C or B2B, for Brazilian startups. Also, price increases from US$ exposure cannot be passed on.

Brazilian startups are facing an accelerating crisis.

A plausible view of things

In our conversations, our clients repeatedly cite the following formula to describe the culpability of the accelerating crisis:

• blame of the Brazilian Central Bank: 40% (keyword: forward guidance, key interest rate lowered to an irresponsible 2%, import of inflation),

• blame of the current Brazilian government: 40% (keyword: the current president does everything to destroy a solid investment climate, or not to let it develop at all) and

• blame the current global situation: 20%.

Of course, the percentages cannot be clarified in their composition. However, the trends appear more than plausible. You take the exchange rate of the Brazilian Real since the beginning of the current government and compare it with the closing rate of last week, you will see that we have a devaluation of about 30%. If we apply the 40-40-20 view and extract only the 20% that is depressing exchange rates globally, as with all other emerging markets, it becomes clear that we should have a maximum US$ vs. R$ exchange rate of 4.06 today. Reality? 4.88, and rising. This means that the exchange rate is undervalued by at least 20%.

The urban legend

A great many people in Brazil are complaining that the now sharply raised key interest rates are jeopardizing economic recovery and investment. A quick look at the “glorious” past with 2% key interest rate SELIC shows the truth: even in the period of irresponsibly low interest rates, investments of the private sector, as well as those of public institutions, are not increasing.

Currently, it is not the interest rates that generate or prevent a favorable investment climate. It would be more than advisable for the players to get rid of their self-deception and look at what is necessary. Without ideology, without so-called culture wars and similar smoke screens.

Face up to reality!

Particularly with a view to the devaluation of the Brazilian real, it quickly becomes clear that Brazil is thus among the top 3 in a global comparison.

That should not be so at all!

After all, the country realized export records like never before. Here one must know that many exporters did not transfer the hard currencies extensively into the country.

There is a lack of confidence in the current government.

If one were to take the exchange rate at the beginning of Q3 2019 and add only the 20% attributed to the global scenario, one comes close to other emerging markets. Therefore, this simple 40-40-20 formula seems understandable.

It is repeatedly expressed that it is hoped that the elections in October 2022 will allow a much more economy-friendly government from January 01, 2023.

Thinking in scenarios, not just tactically

The Outlook Brazil 2022 shows only too well how valuable it is to bring together a wide variety of information and realities to generate a plausible baseline scenario.

Frank P. Neuhaus is co-author of "Interim Managers Report from the Field: Automotive" from the book series "Learning from Interim Managers". This is published by the Diplomatic Council Publishing House together with UnitedInterim.