Eco Emerging

Some difficult choices lie ahead

10/05/2020

Six months after the start of the epidemic in the country, Brazil has seen more than 140,000 deaths (665 per million people) and more than 4.72 million confirmed cases. The toll is grim, but the epidemic has started to show signs of slowing down: the rolling 7-day average death tally has been falling for several weeks, after stagnating for a number of months. The contagion rate (R0) has also returned to around 1 (the country had an R0 of 2.81 in May, the highest rate in the world). This slowdown has come as the easing of containment measures has spread across the country. Schools are soon set to reopen in Sao Paulo and Rio de Janeiro.

A faster than expected recovery but highly uneven

National accounts data showed a heavy drop in economic activity in Q2, with GDP contracting by -9.7% q/q (-11.4% y/y). Output losses were however less pronounced than expected, and the recovery initiated in May has proved to be more vigorous than anticipated.

On the supply side, Q2 figures showed a sizeable contraction in industrial activity as well as in services. Agricultural output, on the other hand, expanded slightly over Q1. On the demand side, only net exports made a positive contribution to growth.

FORECASTS

The economic recovery initiated in May has strengthened but is very unevenly spread across sectors. The grains[1] and mining sectors have performed well, benefiting from the weakness of the BRL, rising prices and the economic recovery in China. The partial suspension of poultry imports by China, following coronavirus outbreaks in a number of slaughter houses, have not yet significantly affected the performance of the cattle industry. Overall, strong commodity and livestock exports have contributed, amongst others, to the reduction of the current account deficit by nearly USD?30?bn over the period from January through August (12 months cumulative sum).

PORTFOLIO INVESTMENTS BY NON-RESIDENTS

On the other hand, services, which account for around 70% of GDP and 47% of formal employment, are still struggling to forcefully recover (up 2.6% m/m in July, after falling by around 20% between February and May). The performance across the sector is however highly heterogeneous with the aggregate picture overshadowing some bright spots. Transportation services, the event industry, tourism and personal services are still facing substantial difficulties. By contrast, information and communication technology services have experienced more dynamic growth. Meanwhile, activity levels in industry are returning to pre-crisis levels (February). The bounce back has been generalized to all the subcomponents of industrial production (capital goods, intermediate goods, durable and non-durable consumer goods).

On the expenditure side, the government’s emergency aid package has helped underpin strong retail spending especially on construction materials, household furniture and appliances. This has enabled broad retail sales to experience a V-shaped recovery with July’s sales only 2% below those of February.

For the time being, the improvement in economic activity has yet to feed through to the labour market. The unemployment rate (13.8% in July) and the underemployment rate are still at peak levels, whilst the contingent of discouraged workers remains high at an estimated 5.5 million. In services, job losses have been reported in the last 6 PMI surveys. Some improvements are however to be noted: employment figures in manufacturing and construction have started to recover, new unemployment insurance claims fell by nearly 20% in August, while the labour market in July saw more formal jobs being created than being lost, a first since February.

End of the easing cycle. Forward guidance makes its debut

RECORD-BREAKING FISCAL DEFICITS

After proceeding to 9 consecutive cuts of its key policy rate, the BCB interrupted its easing cycle in September, holding the SELIC at 2% (from 6.5% in mid-2019). The monetary policy committee (Copom) also indicated its intention not to raise rates until its central inflation scenario converges towards its targets for 2021 (target of 3.8%) and 2022 (3.5%). This novel and more active communication stance on behalf of the BCB shows that it has embraced forward guidance as an additional monetary policy tool. The policy is intended to better guide market expectations at a time when the slope of the yield curve is facing upward pressure due to increased uncertainties surrounding the government’s fiscal position.

Since July, the policy rate in real terms has been in negative territory following the slight rise in inflation. Indeed, the higher food and fuel prices, the stronger recovery of consumption supported by disbursements of government aid and the emergence of bottlenecks on the supply side due to insufficient inventories and logistical difficulties have jointly contributed to an increase in the consumer price index from 1.9% in May to 2.4% in August. At the same time, prices of inputs in industry have risen rapidly, as a result of shortages faced by suppliers and the enduring weakness of the BRL.

For the time being, the BCB does not seem to be too concerned about inflation risk as core inflation (excluding energy and food) has remained broadly stable and inflation expectations have remained well below the target. Nor does it seem to be concerned about the weakness of the currency (the BRL has been down 30% against the USD since January). On the other hand, the BRL’s volatility continues to be a real challenge for the authorities (the BCB has intervened in the FX market some twenty times this year). Since June, there has been a measured return of portfolio inflows from non-residents. However, the weakening trend of the BRL, its volatility, as well as the structural fall in interest rates are all factors that contribute to keeping investors away from local markets. Between January and August, net portfolio outflows have amounted to USD 25 bn.

A record high budget deficit. Difficult choices looming

The central government’s budget deficit has more than doubled over the course of this year (11.9% of GDP in July, from 5.5% in January on a 12 months rolling basis). This increase reflects a sharp deterioration of the primary deficit (7.9% of GDP, from 1.1%) – as the interest burden has continued to fall over the period, dropping to 4% from 4.5% of GDP in January (pro memoria, the interest burden stood at 7.2% of GDP in January 2016). According to the IPEA’s calculations, 70% of the increase in the central government’s primary deficit relates to the increase in primary expenditure – the remainder being the result of a fall in revenues estimated at BRL?150 bn between January and July, representing some 2% of GDP. The budget deficit is likely to end the year at just over 17% of GDP, due in large part to the partial extension of the emergency aid programme through the end of the year[2]. The programme has helped President Bolsonaro witness a resurgence in popularity. This uptick could end up benefitting his government in the run-up to the municipal elections scheduled to take place later this year in November.

The negotiations over the 2021 budget (presented at the end of the summer) are likely to crystallise tensions between the executive and Congress over compliance of the constitutional spending cap[3]. Some parliamentarians are pushing for the abandonment or flexibilization of the fiscal rule. Adherence to the spending cap has also been a bone of contention within the executive, between supporters of fiscal discipline and those in favour of an increase in social spending[4] and public investment.

With a projected primary deficit of 3% of GDP, the proposed 2021 budget – in its current configuration – is in compliance with the spending cap but leaves practically no room for the government to support the economy through stimulus spending. In the coming months, the credibility of fiscal policy is likely to remain a hotly debated issue especially in light of the strong pressures exerted on the political class to maintain or further expand social safety nets.

On the reform front, the government has proposed to unify two federal consumption taxes (PIS and Cofins) into a single federal valued added tax. The executive has also presented its administrative reform, aimed at restructuring careers in the civil service and adjusting salary plans for civil servants. According to Minister of the Economy, Paulo Guedes, these reforms could generate savings of nearly BRL?300 bn over 10 years. However, the impact on public finances will only become visible over the medium term.


[1] The national statistics agency, IBGE, estimates that 250.5 million tons of grains will be produced this year, a new record and a 3.8% increase compared to 2019. Rice, soy beans and maize crops are expected to account for more than 90% of the total yield.

[2] The aid of BRL600 per person has been halved to BRL300; some 5 million Brazilians will also no longer qualify for the programme. Thus far, some 65 million people are estimated to have benefited from the programme, with an estimated cost of BRL45 bn or so. By way of comparison, the Bolsa Familia programme cost BRL33 bn in 2019.

[3] According to the cap, primary spending cannot increase faster than inflation. The fiscal rule, which was first introduced in 2016, was exceptionally suspended in 2020 as a result of the pandemic.

[4] The President, for instance, wanted to introduce a new social programme, Renda Brasil, which was to take over from the emergency aid program at the end of 2020.

THE EXPERT ECONOMISTS WHO PARTICIPATED IN THIS ARTICLE

Other articles from the same publication

Emerging Countries
Loss of momentum

Loss of momentum

The recovery in economic activity that began at the end of the spring continued through the summer, with China leading the way, and oil and metals prices have picked up [...]

Read the article
China
Households are still worried

Households are still worried

The economy continues to recover. Initially driven by a rebound in industrial production and investment, the recovery broadened over the summer months. Exports have rebounded and activity has also picked up in the services sector [...]

Read the article
South Korea
Resilient

Resilient

Once again, South Korea seems to be withstanding the crisis better than developed nations generally [...]

Read the article
India
The recovery will be slow

The recovery will be slow

Between April and June 2020, India’s economy contracted by nearly 24% compared to the same period last year. This unprecedented contraction can be attributed to the collapse of domestic demand [...]

Read the article
Indonesia
A difficult recovery

A difficult recovery

For the first time since the 1998 crisis, Indonesia is expected to enter recession in 2020. In Q2 2020, the economy contracted by more than 5%, and the recovery should be slow [...]

Read the article
Argentina
Still under emergency measures

Still under emergency measures

The health crisis has slammed an economy that was already suffering from more than two years of recession. GDP will probably contract by more than 10% in 2020 [...]

Read the article
Hungary
The importance of being earnest

The importance of being earnest

The Hungarian economy was hit particularly hard by the effects of the Covid-19 pandemic in the 2nd quarter of 2020, due to the weight of exports in its GDP [...]

Read the article
Turkey
Leaning against the wind

Leaning against the wind

Since late spring, Turkey has enjoyed a rapid, buoyant recovery. This is rather typical for an economy regularly hit by external shocks that are magnified by capital outflows [...]

Read the article
Egypt
Looking for a balanced monetary policy

Looking for a balanced monetary policy

The Egyptian economy has performed pretty well in the face of the pandemic. Activity has been bolstered by major public investment projects, whilst inflation has fallen well below the central bank’s target [...]

Read the article
Lebanon
An economy on the brink of collapse

An economy on the brink of collapse

Lebanese GDP could fall by a quarter in 2020 under the combined effect of the deep economic crisis that has taken place since 2019 and the Beirut port explosion. In the short term, hopes of a recovery are limited [...]

Read the article
Morocco
A delicate balancing act

A delicate balancing act

Despite rapid support measures, the economy will not escape a severe recession this year. With the abrupt halting of tourism activity, the drop-off in exports to Europe and the collapse of domestic demand in Q2, GDP will contract by about 6% [...]

Read the article
Angola
A worrying situation

A worrying situation

With the country in recession for the fifth consecutive year (latest estimates put the contraction in 2020 at 4%), the current crisis is acting as a catalyst for existing weaknesses and further damaging the country’s economic prospects [...]

Read the article