Is Brazil ready to regain credibility?

After two and a half years of political & economic turmoil, Brazil seems to be finally consolidating on the basis of its economic recovery and thus attractiveness for investors. In the middle of 2014, the Brazilian economy plunged into its worst and longest economic recession in the last 120 years, registering during eleven quarters a total decrease of 8.6% in its GDP. Last month, the government announced that the shrinkage of the Brazilian economy has finally cessed in the fourth quarter of 2016, and has started to moderately grow again. Furthermore, the market expects a GDP increase around 0.8% for 2017 and between 2.5% and 3% for 2018, in comparison with the 3.6% decrease registered in 2016. However, despite the favourable international economic environment as well as the recent good results of economic indicators that confirm the scenario of a cyclical reversal in the short run, it is necessary caution to not be over optimistic about the Brazilian future. This report will discuss the improving economic environment in Brazil, outline the inherent risk Brazil faces due the lack of political capability to approve necessary social-economic reforms as well as present an investment recommendation regarding the Brazilian bond.

Even those who know little about the Brazil’s economic history

may have heard that it is marked by erroneous economic policies that leads to a volatile and circular up and down cycles. The past 30 years are not an exception to the rule. Despite the promising economic boom of the early 2000’s especially due the high price of commodities, the Labour Party government has left a legacy of destruction, including institutionalized corruption scandals involving the main public authorities and Brazilian biggest companies and the enormous disarray in the public accounts. The government attempt to keep the economy growing at a rate that was no longer consistent with the Brazilian economic scenario, by keeping forcefully the demand heated was nothing but clumsy. Even though Dilma Rousseff was removed in mid-2016, the economic consequences of her government are still resonant and can be summarized by a 3,77% and 3.6% decrease in GDP in 2015 and 2016 respectively, and a inflation of 8.74% in 2016 after, the 9.03% rate in 2015, both considerably greater than the established target of 4.5%, an unemployment rate of 12% in 2016 (not considering the lagging effects, outpacing the highest value of the series in the first quarter of this year 13.3%), and finally, a high record public sector primary deficit of R$155.791 billion (approximately £36.145 billion) – corresponding to 2.47% of the country’s GDP in 2016. The economic authorities in Brazil have been making a great effort to regain credibility, especially amid the political catastrophically scenario.

The basic rate of interest, Selic is an important monetary policy instrument in Brazil, being recurrently adjusted to smooth the effects in the economy of both internal and external crises. When first implemented in 1999 the rate was 45% a year, in a desperate attempt of the Brazilian Central Bank (BCB) and the IMF to contain inflationary pressures. This still defines much of its role nowadays: despite the “Real Plan” successful implementation more than two decades ago (responsible for bringing the spiral inflation back into control), Brazil still has interest rates significantly higher than those of other emerging markets, since the countless attempts to cut rates were limited by inflation pressures. This rate is the average of the rates used in interbank loans and part of the public debt is fixed on it. For this reason, its high level means a great increase to the financial obligations of the government as well as availability of monetary resources for the society.

A little more than one year ago, in attempt to reheat the economy,

the BCB has started a cycle of cuts of its basic interest rate (Selic) from the value of 14.25% yearly in October last year to a current value of 7.5%, the lowest level since April 2013. These cuts have been possible in a scenario of more disciplined Inflation (2.7% - year-to-year) and have been in part responsible for the reduction of the cost of credit to individuals, hence boosting household consumption. The next and last meeting of the year of the monetary policy committee is scheduled for the 5th of December and macro analysts are expecting a further decrease to 7%, the lowest value of the series in 20 years.

Despite the recent cuts of the Selic, the economy still has real rates of return significantly higher than those of other emerging markets. Furthermore, the low interest rates in the rest of the world responsible for generating a great liquidity for emerging markets, combined with Brazil’s better economic conjecture make the higher-yielding Brazilian government bonds an attractive investment. The last Brazilian bond issuance happened on the 3rd of October and had the lowest spread since 2014 and after Brazil lost its investment rate in 2015. This reflects a significant improvement in perception of foreign investors in relation to Brazil. Furthermore, following the global movement for emerging market this year, Brazilian country risk measured by the CDS has decreased 34% this year, helping to attract more foreign investment as well as providing some stability to the Brazilian currency. Furthermore, the IMF expects a 0.75% growth in 2017.

The yield of the Brazil Government Bond 10 Y started to strongly decrease already in the first quarter of 2016, signalizing the expectations over Dilma’s impeachment, hence the likely recovery of the fiscal positions, due public expenditure control and approve of economic reforms, deceleration of the inflation as well as the decay of the basic interest rate. However, it seems that the yield has encountered a resistance barrier around 10%, since the market believes that the Central Bank will not find the necessary conditions to decrease the Selic below 7% in 2018.

Increased, foreign investment, combined with the lagged economic impact of the interest rate cuts and the currency stability, has given the Brazilian government more room to deal with its fiscal issues. On the other hand, the favourable circumstances may bring Brazil’s government back to its comfort zone and cause them to malinger on overdue reforms that are needed for a sustainable recovery of the public accountability. The problem is that the lack of public opinion support has been hampering the proposals, leaving out sensitive reforms that are key to Brazil’s economic recovery story. The loss of comprehensiveness of these reforms is only part of the problem and approving them as soft as they might get is a first step for further modifications. The biggest problem is that the government's lack of agility to approve such reforms later this year makes it unlikely that they will be approved next year as the presidential elections take place in October. It is even more unlikely it will get approved right after elections given the political profile of the candidates. Brazil is playing with fire and there is no other scape. This lead us to wonder how critical will the Brazilian economic scenario need to get to a probable populist elected candidate realize the necessity of these reforms and displease his? Will be the damage then very great to be reversed? IMF forecasts that the general government net debt as percent GDP will increase up to 61.29% in 2019.

In case Brazil does not take advantage of its critical scenario to get the reforms through as well as recreate its political and economics practice, it will miss a great chance to finally get into a sustainable economic growth, reduce further the Selic and get its public debt back into a sustainable path. The unpredictability of the Brazilian elections adds a political risk to the Brazilian Bonds. However, it is possible to observe a stable situation in the short run, consisting of a good opportunity for bond holders given the high yield. Keeping track of the political scenario in Brazil as October 2018 approaches will be an important task for longer term investors, since it may affect its conditions of paying its debts.