China will be this century's manufacturing centre, India the service platform, and Brazil the food giant. Spurred by that generally accepted truth, attention is again being focused on Brazil and its undeniably impressive potential. A few figures: Brazil boasts surface area equal to that of the United States excluding Alaska, almost half Latin America's GDP and population, vast mineral reserves, extensive arable land, a role as the world's carbon sink with the Amazon Forest, and very good labour productivity.
However, the results achieved, especially in the past two decades, have fallen short of that potential. During that span, economic growth has not exceeded 2% on average, a growth rate comparable to that of France. Current growth has been a far cry from that of Asia including India, affected by severe constraints, mainly insufficient investment and a very heavy debt burden that distinguishes Brazil from emerging Asia. Euphoric periods have thus tended to alternate with more difficult phases.
The current growth has appeared to be healthier, however, with the current account in surplus and debt ratios easing, which has given cause for more optimism than in the past. Nonetheless, Brazil still exhibits some weaknesses with a country @rating of B (under positive watch) persisting for Brazilian companies.
The robust growth of 2004 buoyed by exports should slow in 2005-2006
After three years of stagnation, growth was robust in 2004 (up 5.2%), driven by both domestic and foreign demand. Exports rose sharply from 2003 with Brazilian sales benefiting not only from a price effect linked to higher prices for raw materials and intermediate products (notably iron and steel) but also from an increase in quantities shipped (up 18%). That dynamism is partly attributable to strong demand from China, now Brazil's number-two customer after the United States, and the manufacturing sector's good competitiveness. That sector now represents 55% of Brazil's exports with sales volume abroad up 26% in 2004. The food industry has also continued to post very good performance.
However, inflationary pressures have prompted the Central Bank to increase its SELIC rates with growth slowing in consequence. At 7.5%, the end-2004 inflation rate exceeded the 5.5% target set by monetary authorities. The price pressures — generated mainly by increased prices for raw materials (including oil) and high capacity utilisation rates — prompted the Central Bank to raise the SELIC gradually from 16% in September 2004 to 19.75% by 18 May 2005.
The growth should continue in 2005 and 2006 but at a less robust pace, due notably to the tighter monetary policy. The current high SELIC rate, needed to fight inflation, could impede investment and consumption as evidenced by the disappointing results registered in the first quarter this year. However, a monetary easing may be possible in the 2005 second half provided the inflation rate and international financial environment develop favourably. Moreover, export growth will probably slow this year. GDP growth should thus be about 3.1% in 2005 and 4% in 2006, or about half the growth rates expected in Asia.
Two main constraints have been preventing the country from achieving sustainable growth above the 3-4% level: the debt burden and insufficient investment (21% of GDP in 2004).
The necessary easing of debt ratios
The improvement in foreign debt ratios achieved in the past five years has certainly been impressive: The debt was only two times export earnings in 2004, down from four times in 1999. Substantial progress was made in 2004 alone with the ratio still at 260% end 2003. That is attributable not only to rapid export growth but also to tight fiscal policy and reduced reliance on debt financing thanks to the current account surplus. Debt service now represents under 50% of foreign exchange earnings down from nearly 100% five years ago.
Although undeniably spectacular, the improvement process did begin in a critical situation. Only three years ago, the ratios were unsustainable and the highest for all emerging countries just behind Argentina. Brazil's foreign debt-to-export earnings ratio is nonetheless still the highest among large emerging countries. Continued strong export growth will thus remain essential in reducing that ratio to more reasonable levels. That will require continuation of tight economic policy, maintenance of market confidence, and favourable trends on raw material prices and world demand.
Brazil will remain vulnerable to shifts in market confidence as long as it financing needs remain the highest for emerging countries behind Turkey. Increasing liquidity flows toward emerging countries have doubtless benefited Brazil since early 2003. Those financial conditions could nonetheless turn around should an aversion to risk reappear or should domestic political tensions develop in Brazil in the run-up to elections in 2006. In such case, Brazil would again encounter greater difficulties in covering its financing needs. Thanks to export dynamism, however, Brazil now has sufficient foreign exchange reserves to cope with a momentary crisis, which allowed it to decide not to renew its agreement with the IMF.
Sustained growth will particularly depend on increased investment
An 83% capacity utilisation rate, the highest in ten years, and deficiencies in the energy, transport, and port infrastructure sectors have constituted major bottlenecks. However, budgetary constraints and the heavy debt have limited public sector investment possibilities.
To modernise infrastructure, the government has opted for partnership with the private sector (via the Public and Private Partnership Law adopted 26 December 2004). Private financing and management with a guaranteed minimum return for investors will thus be allied with a government guarantee to attract private funds and allow investment without inflating public deficits. However, this type of financing is not without risk for the country. Risks of slippage on government commitments or of foreign exchange outflows linked to investor earnings cannot be ignored. Finally, concerning the productive sector, the government is also planning to foster private investment through tax reductions and improvements in the business environment. Increased investment will nonetheless particularly depend on a substantial increase in savings — necessary to avoid increasing the debt.
Continued effort on reforms will thus be essential to increase the growth potential
The transition to higher growth rates will depend on both continued tight fiscal policy to reduce debt ratios and implementation of structural reforms to spur savings and investment.
Thus far, the government has demonstrated skill in getting reforms adopted, often succeeding where the previous president had failed. The most important reforms have included social welfare reform (particularly pensions), essential to the government's future solvency; bankruptcy law; judicial reform; and the law instituting PPPs, public-private partnerships for infrastructure financing. The business environment should thus improve thanks notably to the new bankruptcy law. The recently adopted judicial reform should also simplify legal procedures and reduce corruption. Those improvements will be necessary since, according to World Bank indicators, legal system inefficiency has been Brazil's main institutional weakness, ahead of bureaucratic inefficiency and corruption.
However, continuation of reforms should come up against a less favourable political context. Two years after his election and halfway through his term in office, President Lula's popularity has remained strong, buoyed by the growth recovery and increased purchasing power. PT, the president's party, has nonetheless appeared to be having difficulties. Major successes in municipal elections last October notwithstanding, it lost the race for mayor of Sao Paulo. Although that defeat is mainly attributable to the local political context, it demonstrated that the president's great popularity does not guarantee automatic electoral support for PT candidates. Moreover, with President Lula's party only having 17-18% representation in the two houses of parliament, it has remained dependent on sometimes-shaky alliances. Thanks to ideologically close parties, the government can count on 40% of the votes in the Senate and 50% in the lower house. However, to win broader majorities, it must also ally itself with the centrist PMDB party (Brazilian Democratic Movement Party), which could break away at any moment. Moreover, in February 2005, the PT lost the presidency of the lower house to the Progressive Party. That could hinder adoption of reforms with the government no longer controlling the legislative agenda. In the run-up to presidential elections in 2006, President Lula may hesitate to embark on new reforms with some PT members already considering some measures excessively orthodox. The President could thus step back from the most controversial reforms to avoid jeopardising his re-election.
In view of those various factors, adoption of tax reform (tax reductions, tax code simplification, VAT harmonisation nationwide) and establishing Central Bank independence may prove particularly difficult to achieve.
It is still too early to determine whether last year constituted a lucky but ephemeral exception in Brazil's very disappointing economic record over the past two decades or the starting point of a new, long-term growth cycle like the country enjoyed before the 1980s. Sustained growth will require significant increases in investment and savings, which will depend on structural reforms difficult to adopt in the run-up to elections in 2006. With its persistently high financing needs, Brazil has also remained very dependent on market sentiment. Moreover, raw material price trends will also be crucial. In that regard, China's economic dynamism, which strongly contributed to the good results achieved last year, will remain decisively important for Brazil. Despite those uncertainties and for the first time since the debt crisis in the 1980s, an optimistic scenario may be appropriate for the country, justifying positive watchlisting of the country @rating for Brazilian companies provided the reform process continues to go forward.