August 30, 2004
Gray Newman (New York)
Brazil: Gaining Breadth and Length
Even as global storm clouds arrive — in the form of higher oil prices and nagging questions over the pace of US growth — Brazil’s economy keeps getting stronger. After posting a 2.7% year-over-year upturn in first quarter GDP, Brazil is expected to announce on Tuesday, August 31, that second quarter GDP grew by close to 5% year-over-year. The report is likely to lead to another notch up in growth expectations, almost closing the gap between the consensus for 2004 and our 4.4% forecast.
The much more important story, however, is the changing composition of growth which bodes well for 2005. The changes we have seen in recent months in Brazil reflect a new breadth and length to the recovery that was lacking when it first began last year. Both are crucial to our call that growth in 2005 should once again be strong — reaching just under 4%. (Our 2005 GDP forecast remains at 3.8%).
While exports are showing remarkable strength — exports were up 47% in July and up 35% in the first three weeks of August — they are no longer the principal driver of growth. Instead, two new drivers have taken the lead. First, incomes are gaining ground and providing the recovery with much needed breadth. Second, investment spending has kicked in, providing the recovery with much needed length.
Indeed, the recovery has gained so much strength that Brazil watchers are beginning to wonder if the economy may be suffering from “overheating” that could lead to a rebound in inflation. We think the risks of overheating are a bit overdone and doubt that inflation is about to reemerge as a principal concern. Still, that may not stop Brazil’s central bank from hiking interest rates at either the mid-September or mid-October meeting. While the move could cause some concern, we suspect that any hike will be short-lived. Good growth in Brazil, in our view, is likely to lead to lower interest rates during the course of the next six to eighteen months, rather than to higher rates, thanks to improving inflation expectations improve and declining country risk.
Gaining breadth
While export growth remains strong, its contribution to overall growth—once surging imports are netted out of exports—has begun to cede ground. Instead, the strength in industrial activity is spreading to job growth throughout the economy. According to data on formal employment from the Labor Ministry, employment growth has been broadening to domestic-intensive sectors like construction, retail and services, after first recovering in export-focused sectors including mining, manufacturing and agriculture. While unemployment remains high—July’s unemployment reached 11.2% — it represents a substantial improvement from last year as well as from earlier this year.
And average real wages are showing important gains. The latest July data show real wages up not only compared with the prior month but now having recovered above levels seen last year. While much of the gains in employment during 2003 appeared to have been concentrated in lower-paying jobs—permitting the “wage mass” to rise even as average real wages fell—the most recent data suggest that there has been some improvement in the quality of jobs. Unlike 2003, when the “wage mass” (the product of wages and number of workers) improved even as average wages fell, we are now seeing an upturn in average wages.
The emergence of income-driven growth is crucial to boost consumption. While it may provide for less spectacular growth going forward, it should help reduce Brazil’s vulnerability to the global trade cycle.
Gaining length
Investment spending is also picking up and providing longevity to the recovery. One of the most frequent criticisms that we heard last year when industrial activity and durable goods were turning up was that the recovery would stumble in 2004 or 2005 without investment spending. The good news is that the recent data are replete with signs of a rebound in investment. Imports of capital goods—which had begun to turn up late last year after three years declining—were up 26% in the three months ending in July. Furthermore, the best proxy for investment spending—the apparent consumption of capital goods (the sum of domestic production of capital goods and imports less exports of capital goods) is also showing a rebound. And construction—which accounts for nearly 60% of investment spending—is now showing a turnaround as well.
Capacity Utilization Myth
The strong rebound in activity has begun to raise concerns that capacity utilization is maxing out and could easily trigger a new bout of inflation. The concern appears reasonable enough. However you measure capacity utilization—we examine two quarterly surveys as well as a monthly survey—it is approaching the highs for the past decade. Indeed, Brazil’s central bank raised the concern in its mid-August Copom minutes that while investment spending was returning, it might not return quick enough in those sectors where capacity constraints are the greatest. It was natural after all, the central bank noted, for investors to remain cautious on their capital expenditure plans after the pattern of weak and irregular growth that Brazil has exhibited in recent years. But while the central bank is right to be cautious on the capacity utilization front—it certainly could represent a problem—we do not think this is the most likely scenario.
First, while it is never wise to argue that because something hasn’t happened, that it won’t—you’ll miss all inflection points with such logic—it is interesting to note that Brazil has rarely had an inflation problem spurred by strong growth. Each of the most recent rebounds in inflation—in 1999 and 2001 and again in late 2002—were all fueled by currency weakness (once thanks to the move to float the currency, later thanks to a slowdown in capital inflows as the Nasdaq-led privatization bubble burst, and later still thanks to a bout of capital outflows as political events spooked bondholders.) The classic textbook case of strong aggregate demand producing inflation is a risk, but it has rarely in recent decades been the proximate cause.
Second, Brazil’s dramatic trade surplus and record current account surplus should help reduce inflationary pressures as strong demand can be met with imports (or less exports) without creating a worrisome trade outcome. Interesting enough, Brazil’s greatest challenge on the investment front appears to be in infrastructure—from roads and ports to electricity—all “non-tradables,” the demand for which cannot easily be met by imports. However, given Brazil’s abundant rain and current reservoir levels, it seems unlikely that the economy will face an electricity shortage in the next two years at least. While insufficient infrastructure in ports and roads is a concern, it appears that if it has any immediate impact it is more likely to crimp exports than to produce a significant inflationary problem.
Finally, capacity utilization rates appear to be highest for Brazil’s exporters. In contrast, more “domestic-focused” industries appear to have lower capacity utilization rates.
Bottom line
Looking through the rear-view mirror can be dangerous whether in forecasting or in driving if it takes your attention away from what is ahead of you. While many will undoubtedly celebrate the strong second quarter GDP report in Brazil, we think a much more important dynamic is taking place, which provides the basis for broader and more prolonged growth. Thanks to the emergence of an incomes-driver to growth, along with a new resurgence in investment, Brazil has the chance to ensure that the uptick in growth seen since last year—and recognized by most observers since May of this year—can continue into 2005.
While we could be faced with new noise in September or October if Brazil’s central bank insists on raising rates, we would expect any hikes to be temporary. Indeed, to the extent that the central bank is successful in bringing down inflation expectations, we expect today’s hawkish tone to pave the way for lower rates. Add to that the positive impact that good growth is likely to have on investors’ perception of country risk — and the impact that it is likely to have on strengthening the resolve of the authorities to stay the course on prudent fiscal and monetary policy — and we should see even more room for interest rate reductions in 2005.
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