Brazil at a Crossroads: Dilma, Version 2.0?

Uwe Bott

December 6, 2014

Ever since Dilma Rousseff's re-election as President of Brazil in a narrow victory over centrist candidate Aécio Neves on October 26, there has been much debate about the direction of Dilma's second term. Dilma's left-leaning Workers Party (PT) has now been in power for twelve years and as is so often the case after such a long reign, there is a sense of creeping wear and tear.

Dilma drifted more to the left during her first term by abandoning some of the accommodating policies of her PT mentor and predecessor, Luiz Inácio Lula da Silva. Markets were, therefore, thrilled when she appointed Joaquim Levy soon after her re-election to become the country's new Finance Minister. In a sense, this was an abrupt about-face since she had fought her electoral opponent with the charge that he would turn the country over to the bankers.   

After all, Mr. Levy is a proponent of orthodox neoliberalism, quite the opposite of Dilma's worldviews, and he is a banker. Most recently, he was the head of asset management at the Brazilian banking conglomerate Bradesco. He worked for the IMF and he got his PhD at the conservative University of Chicago.

Levy served under two previous administrations. He ran the Brazilian treasury under President Lula and he was a senior official under President Fernando Henrique Cardoso who had preceded Lula. Fernando Henrique, on the other hand, is a member of the Social Democracy Party (PSDB), the party of Dilma's last opponent.

So, what is the meaning of all this? Dilma is a very hands-on president who is considered a micro-manager. However, during her first term the global economic environment changed dramatically. Many of these developments were outside of her control. Yet, the end result was a considerable slowdown of the Brazilian economy. Consequently, her administration was blamed for this setback and Dilma's micro-management made her personally vulnerable.

So, let us step back a bit and look into past accomplishments and challenges ahead in order to predict whether the experience of the last four years has led Dilma to believe that it is time for a change.

Under Presidents Cardoso and Lula, Brazil made measurable progress.  This was quite a feat, because Brazil had underperformed economically and become a serial defaulter on international debt over several decades in spite of its vast resource wealth.

One of the major accomplishments of the Cardoso and Lula presidencies was the containment of inflation. Inflation had been Brazil's scourge for decades. While Brazil's inflation rates are still higher than in advanced countries and have trended upwards lately, they are no longer the tax on the poor, they once were.

As an emerging market, Brazil's higher comparative inflation rate is partly explained by the fact that it depends and on imports to further its development and requires foreign savings to pay for those imports.  

Moreover, Brazil does not use hedonic quality adjustment of prices as most advanced countries do. The latter adjust inflation, for example, for the fact that a computer that cost $1,000 three years ago and now costs $1,100 has double the computing power today. This adjustment for higher quality lowers inflation rates in those countries and widens the inflation gap to countries like Brazil, which do not apply this statistically very complex adjustment.

In many ways, hedonic quality adjustment is distorting. Quality improvements do not impact what is left to people's disposable income after price increases and that is what inflation ought to measure.

Third, Brazil's inflation is higher because its basket of goods and services is far more tilted towards food and energy than in advanced countries. Food and energy prices are notoriously volatile.

The Cardoso and Lula administrations also made great strides on the fiscal front. They accumulated large primary budget surpluses and lowered the country's debt/GDP ratio. True, they also benefited from a generally benign external environment, but major reforms changed the trajectory of Brazil's fiscal position.

Under President Rousseff, this fiscal discipline has slowly eroded. Mr. Levy, the new Finance Minister, has been nicknamed "Scissorhands" for his budget trimming approach and he gives President Rousseff some cover on this front for months to come.

There was also meaningful progress under the Cardoso and Lula administrations with regard to income inequality.  Under Cardoso, the control of inflation was a big benefit to the poor. Under Lula, certain poverty alleviation programs helped. Dilma added her own social programs during her first term.

As a result, there is a much stronger middle class in Brazil today. According to the OECD, Brazil's middle class rose from 29% of the population in the 1980s to 52% in 2009. Unsurprisingly, Brazil's Gini Index, a measurement of income inequality, has markedly improved (see chart below).[1]  It fell from 61.0 in 1990 to 52.7 in 2012.


                       Sources: Index Mundi and World Bank

Still, in 2009 Brazil had the 13th most unequal income distribution out of 153 countries. While this issue is certainly one of social fairness, it is more importantly an economic problem. Different people may have different views over what defines "social fairness", but there should be little dispute over the economics.

In other words, societies with large or growing income inequalities have diminished GDP growth potential, because large parts of the population cannot participate in discretionary spending. This should be a major economic worry not only in Brazil, but also in many advanced countries, including the United States and Germany to name only two.  

It is President Rousseff' s challenge during her second term to build on these accomplishments of lower inflation, improved public finances and falling income inequality. But she must do so in the context of a much less favorable external environment. Therefore, she must aggressively offset this less favorable external environment by doubling up on the many structural weaknesses of the Brazilian economy.

Brazil has to exit a state of denial. In many quarters, the country has successfully marketed itself as having a strong manufacturing base and a well-diversified economy. True, there is Embraer, the country's large aerospace conglomerate, which is highly competitive internationally. There are also other noteworthy examples.

But by and large, Brazil remains a producer of a wide and diversified range of commodities. Sometimes these commodities are masked as "manufactured products" (following international classification guidelines, to be sure) because processed foods, such as orange juice, require some industrial input. That being said, orange juice comes from oranges, clearly an agricultural commodity.

Brazil's wealth in agricultural and mineral commodities was a big boon since the beginning of the century. Double-digit growth in China led to an almost unprecedented appetite there for commodities, of which Brazil is so rich.

However, the medium-term outlook for China is one of much-reduced growth. There are many reasons for that; from demographics to a change of the country's growth model from investment-driven to demand-driven growth. The latter is forced upon China because its economy has reached critical mass as the world's second-largest.

All of this as well as sluggish demand in the advanced countries following the financial crisis has led to plummeting commodity prices (see chart below).


     Source: IMF

Starting in 2006, Brazil also made huge offshore oil discoveries in a geological formation also referred to as the pre-salt layer. Exploitation requires highly sophisticated technologies. A lot of this means breaking new ground in exploitation techniques.

The Lula and Rousseff administrations made two strategic mistakes in managing this potential wealth. First, it is a legal requirement that 70% of goods and services used in exploiting these offshore fields are made or provided by Brazilians (so-called local content).

It is understandable that Brazil wishes to reap the secondary benefits of oil exploitation by creating jobs in supplying industries, because oil production in and by itself is not very labor intensive. However, the country lacks the capacity to build oil platforms and provide helicopter services, to name just two examples. As a result, costs are high and production is delayed. 

The second mistake is the requirement that the country's state-owned oil company, Petrobras, become the operator of all pre-salt oil fields. Again, this is understandable as many countries wish to reserve the rights of exploitation to their domestic state oil companies rather than foreign conglomerates.

However, Petrobras has a rather poor performance record. It has rarely met its production targets. Its workforce is large, but often less than well-trained. To be sure, state-owned oil companies can be just as efficient as privately-owned ones. Venezuela's oil company, PdVSA, was arguably one of the best-run oil companies in the world, before Hugo Chávez took power in 1999. PdVSA became politicized and it was bled dry of its considerable profits thereafter. Today, Venezuela's oil sector is in decline due to insufficient capital investments.

In Brazil's case, privatization of Petrobras is politically out of the question and certainly nothing President Rousseff would contemplate, but the business must be reorganized and more professionally staffed.

This is all the more important, because the inefficiency of Petrobras as well as local content laws have raised an already high cost of deep-water oil production. When oil price peaked at $147 in 2008, this might have been an affordable luxury, but markets have turned (see chart below).



There are three reasons for that: (i) low global demand; (ii) growing market share of renewables; and (iii) U.S. shale exploration which will catapult the United States to become the largest oil producer in the world, surpassing Saudi Arabia in the months to come.

The combination of these factors has deeply depressed oil prices, which are now below $70 a barrel. There will likely be further downward pressure on prices due to this oversupply.  At such price levels, some producers will begin to lose money. Growing efficiencies in shale production have led some to estimate that the breakeven point for shale stands around $42. In contrast, Brazilian offshore production probably demands a price between $80 and $100 per barrel.

This is a serious economic and fiscal threat to Brazil. Moreover, it is a threat to Dilma's agenda of much needed improvements in infrastructure and the extension of social programs. In this context, it is particularly disappointing that the country has largely failed to effectively use the huge windfall of the commodity boom years for these purposes. 

An excellent showcase for a more forward-looking macroeconomic strategy is Turkey. Since 2002 and during a period of high growth, Turkey contained inflation, drastically reduced the fiscal deficit and cut the country's debt/GDP ratio from 79% in 2001 to 38% in 2013. And yet, Turkey invested heavily in its physical infrastructure.

Between 2003 and 2013, the country nearly tripled its road network and built a huge system of high speed railways, while doubling the number of the country's airports. Effectively and for the first time in its history, it has now connected the more affluent West of the country with the poorer East. This has allowed the private sector to build factories in the East, where wages are lower, because transportation is far less of an impediment than in the past. The result has been more balanced growth across the country.

But Turkey has also made huge investments in education with a concentration of investing in the poorer areas of the country. As a result, the OECD PISA report shows a dramatic improvement of Turkey's ranking, while Brazil has been fairly stagnant. To be sure, Turkey still ranks far below the EU average, but much higher than Brazil. What is more, most of the improvement of educational attainment has been in towns with less than 100,000 inhabitants; again, laying the groundwork for a more equitable society.

Brazil has failed on both fronts. Its infrastructure investments have been predominantly concentrated on hosting big sports events, such as the World Cup in 2014 and the Olympics in 2016. To be fair, hosting these events is part of the legacy of President Lula.

In general, hosting the Olympics has caused huge losses to the organizing cities and infrastructural improvements in preparation have little impact on long-lasting productivity increases. Such investments also largely benefit more affluent urban areas.  Large demonstrations in Brazil during 2013 were to a significant degree directed at this perceived misallocation of public resources.

And yet, improving the physical and human infrastructure are necessary conditions in order to deal with another of Brazil's challenges: Low national savings rates. Even after the public sector began to act more prudently about its fiscal affairs, these savings rates have barely budged. The reasons for this dilemma are not easy to identify. But consistent and sustainable increases of real incomes (based on increases in productivity - only achievable with better physical and human infrastructure) are probably part of the solution. Additionally, national savings rates can be raised by the introduction of an effective system of forced savings, for example through mandatory pension savings.

The political class, including President Dilma, has failed to address these issues and for a long time this neglect was afforded by the commodity boom. There is much pride in Brazil about the country's low unemployment rates (the rate stood at 4.9% in September 2014; measured in six Brazilian metropolitan areas). But participation in the labor force is a full ten percentage points below that of the United States, meaning that just 55% of the country's workforce are active.

Moreover, this says very little about the value of that labor. Germany brags about its low unemployment numbers too, but truth be told, 25% of Germans do not earn a living wage. It would seem that things are likely worse in Brazil. Labor reform is necessary in Brazil, but a lesson from Germany should be not to confuse more labor market "flexibility" with "willful impoverishment" of the labor force. 

All of these challenges also put Brazil's fiscal position under the microscope. Therefore, it is important, but politically difficult, to reduce Brazil's dependence on direct or indirect revenues from commodities, to improve its inadequate tax collection, to reduce its large informal sector, to simplify its tax code, to re-direct spending to increasing future productivity and to create greater fiscal transparency, especially by reducing off-balance sheet fiscal spending.

Whatever one's political ideology, however, these are almost insurmountable tasks for any Brazilian administration, in particular because of Brazil's complicated constitutional framework. The political system is fragmented, the states have too much power and regulation is duplicated and triplicated (as well as contradictory).

In fact, the leader of the IMF delegation to Brazil, Argentine economist José Fajgenbaum, had suggested as much in 1991, when he recommended that Brazil change its constitution in order to reduce generous transfers from the federal government to the states and municipalities. Mr. Fajgenbaum was removed from his position by the IMF in July of that year at the urging of Brazil's then-President Fernando Collor de Mello.

But without streamlining the political framework, it will be difficult to make the hard political choices that are now necessary.

All in all, Brazil is still the "land of opportunity". Given current circumstances, Brazilian growth will probably range between 2-4% in the medium term. This is not enough for a country with a very young population.

President Rousseff has some room to maneuver and some opportunity for course correction, even acknowledging the mentioned political constraints. Her cabinet appointments may be the result of rethinking her own strategy. The next four years will show whether changes to her "Operating System" create a better version or are just Windows dressing.

[1] The Gini Index ranges between 0 and 100. Roughly speaking, a Gini Index of "100" means that one person has all the income in a given country. At "0", all inhabitants have the same income.

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