Pessimism about Brazil’s growth explained

Cornelius Fleischhaker on why the Brazilian economy is like a shell fish

The Maracanço is one thing. But can Brazil overcome the ghost of low growth?

How fast should we expect an emerging market economy to grow? Particularly one that can count on abundant natural resources, favorable demographics, and political stability?

Surely it should be growing at more than 2 or 2.5 percent over the longer term, smoothing out the usual volatility of the business cycle, at what economists call the “potential growth rate”.

Yet growth in Brazil, a country that meets the above criteria, has only averaged about 2 percent over the last three years and growth expectations have also been repeatedly downgraded, not just for the near term, which could be reaction to cyclical developments, but also for several years in the future.

The median of economists’ forecasts for growth in 2016 as published by the Brazilian Central Bank has recently fallen to 2.5 percent.

Why are economists increasingly pessimistic about Brazil’s capacity to grow?

This is the question explored by World Bank economists Otaviano Canuto and Philip Schellekens in a recent Economic Premise, blog post and article at Huffington Post, in which they present three explanations offered by market analysts as well as their own views.

One view offered by Brazilian as well as international analysts is that Brazil’s framework of prudent macroeconomic management, painstakingly established in the 1990s and early 2000s is being undone and low growth is only a harbinger of macro-instability to come.

The authors rightly discount this view as exaggerated. Analysts voicing this view are often politically motivated (after all this is an election year in Brazil) or looking to gain more attention by painting a picture of imminent doom.

While there is plenty that can be criticized about the economic policies implemented by the Rousseff administration in recent years, they do not constitute the undoing of the Brazil’s macroeconomic tripod (inflation targeting, flexible exchange rate, primary fiscal surplus).

They rather constitute the usual flexibility exercised by policy makers trying to respond to adverse conditions, even though their interventions have clearly not had the desired results.

A second view often voiced by international observers attributes the Brazilian slowdown, present as well as expected, to a changing external environment which is shifting from being a driver of Brazilian growth to becoming a drag as commodity prices and international financial conditions adjust. Much has been made of a hard landing in China and its potentially devastating consequences for Brazil.

This view however has one big fallacy: External demand constitutes only a small part of the Brazilian economy. Indeed, Brazil is the least open of any major economy in the world, with exports only accounting for 12 percent of GDP (as a comparison, it’s over 30 percent in Mexico or China). Exports to China make up less than a fifth of Brazilian exports or less than 3 percent of GDP.

While there are more than just direct effects such as through commodity price channels and growth spill-overs, it is therefore difficult to argue that the growth capacity of the Brazilian economy should be set primarily by external factors. As the authors note: “Growth in Brazil is still largely made in Brazil”.

Much of Brazilian growth pushed internally

So the why is Brazil, an emerging market, growing at the slower rate of an advanced country?

This is where the third perspective comes in, the one the World Bank economists find most convincing. In their view it is the lack of improvement and, in some cases, even deterioration of the microeconomic fundamentals for growth, which is holding back Brazil.

The tricky part about the absence of “microeconomic improvements” (which broadly encompassed various elements of the “structural reform” agenda), including things such as the tax regime, infrastructure, labor regulation, business environment and skills of the workforce), is that by now, these are not new issues.

Brazil has been expected to address these issues years if not decades, surely through the “Brazil takes off” years (2004-2010).

So how can we explain slow growth now when these factors already existed when growth was high?

The explanation is simply that given other changes and the growth that occurred up through 2010, these constraints have become more binding as of late.

One could think of the economy as a sort of shellfish, where the supply or production capacity of the economy is the shell and demand is the body filing the shell. The body can grow faster than the shell as long as there is space left (economists call this space “slack” or “output gap”).

At the same time, the productive capacity can also grow, by adding workers, adding capital (investment) or using the two more efficiently (productivity).

In the case of Brazil, the boom years started with plenty of wiggle room in the shell and a growing labor force, resulting in an expanding shell that for several years was able to accommodate a body expanding even more quickly.

Now, with demographic change reducing employment growth and space in the shell used up, the body is increasingly pushing against the shell, which is revealed in rising imports (7 percent a year) and high inflation for non-tradable goods and services.

Hence the high growth observed in the 2000s was really a transitional phenomenon which was bound to end in the absence of productivity enhancing reforms regardless of the external environment.

This insight is important, as it should guide us to what needs to be done to overcome the current state of low growth and pessimism in Brazil: It’s nothing new, it’s not the outside world’s fault, it’s the old structural reform agenda.

The twist however is that this agenda has become more important than ever given that other sources of growth such as demographic dividends, macro stabilization (in the 1990s) and commodity boom (in the 2000s) have passed.