Brazil's Threat to the Global Economic Recovery
In today’s world of very easy central bank money, there would appear to be many instances of irrational exuberance in the emerging market economies. However, given its size and the considerable political risks that it faces next year, the emerging market country that could pose the greatest threat to the global economic recovery is Brazil, by far Latin America’s largest economy. US economic policymakers would ignore the Brazilian economic threat at their peril.
Judging by the market’s favorable pricing of Brazilian risk, one could be forgiven for thinking that the country was in the pink of political and economic health. Over the past year, the Brazilian stock market has performed strongly, Brazil’s dollar bond yields have declined to close to record lows, and its currency has firmed markedly against the US dollar.
The truth of the matter, however, is that Brazil remains in the midst of a major corruption scandal centered on Petrobras, the state controlled oil company. That ongoing scandal has seriously tainted the country’s political class and has undermined confidence in the economy.
Already Dima Rousseff, the former Brazilian president, has been impeached and there have been more than 100 criminal indictments against senior political figures. In addition, serious charges have been leveled against Michel Temer, the current president, and many members of his cabinet. This has contributed to a decline in Mr. Temer’s poll rating to low single digit levels and to the general loss of public confidence in the political class.
Adding to political uncertainty is the fact that general elections are to be held in October 2018 in what is likely to be an atmosphere of widespread public discontent. It is generally expected that Brazil’s political center will collapse and that the main beneficiaries of the country’s unsettled political setting are to be populist candidates on both the far-right and the far-left of the political spectrum. That hardly bodes well for disciplined and market friendly economic policies in the years immediately ahead.
If investors seem to be turning a blind eye to Brazil’s rather bleak political outlook, they also do not seem to be paying much attention to the country’s shaky economic fundamentals. The country is only now very gradually emerging from the deepest and longest economic recession in its history. At the same time, its public finances are in considerable disarray as indicated by the fact that the government’s budget deficit has now risen to around 9 percent of GDP.
A recent IMF economic report highlighted the precariousness of Brazil’s public finances. It did so by noting that, in the absence of early remedial action, the country’s public debt to GDP ratio would rise from its already high level of 85 percent to around 120 percent by 2022. The IMF correctly maintains that these sort of debt levels in an emerging market economy would be simply unsustainable. For which reason, it is urging the government to stick to its strict public expenditure control plan and to introduce far reaching pension reform to curb the rapid rise in social security spending.
One would think that it must only be a matter of time before investors begin to focus on the forthcoming Brazilian elections. When they do so, they are likely to question whether the country can sustain its economic recovery in a very unsettled political climate. They are also likely to seriously question the chances that a meaningful pension reform will be enacted next year and they are also likely to fear that a populist and fiscally irresponsible leader could be elected. This is all too likely to lead to a sharp rise in the government’s borrowing costs that will only make its public finances even less sustainable.
Should investors indeed take fright, the consequences for global financial markets could be serious. After all, over the years foreign investors have poured large amounts of money into Brazil, while the Brazilian bond market is among the largest such markets of the emerging market economies.
All of these would argue for close monitoring of the Brazilian economy by the Trump Administration in the year ahead. They would also argue for close cooperation between the Trump Administration and the IMF, in the preparation of contingency plans for a Brazilian economic adjustment program should the need arise to stabilize that country’s economy. The last thing that the world economy needs is a country of Brazil’s systemic importance spinning out of control especially at a time that the world’s major central banks will be in the process of normalizing their monetary policies.