In the face of international turbulence, the country may be better placed than before, but it is still not immune.
Recent wild gyrations in the global financial markets have added fuel to the debate on implications for emerging markets like Brazil. To be sure, Brazil’s much improved balance sheet, large stockpile of foreign reserves, and reduced vulnerabilities leave the country in a much better starting position than ever before to weather the global storm. Yet Brazil is hardly immune to international turbulence. Overall, how might the global turmoil affect Brazil? We would emphasize four main effects.
First, the balance of payments could weaken. This is probably the most important effect. Global slowdown could hurt Brazil’s balance of payments through both its current account and its capital account. Morgan Stanley was the first house to warn that Brazil’s trade surplus in 2008 will shrink faster and by much more than the market consensus believes. Global growth slowdown will debilitate Brazil’s export performance (through volumes as well as prices), and strong domestic demand will keep pushing imports up. We see the trade surplus falling by half, from US$ 40 billion in 2007 to US$ 20 billion this year. We have strong conviction in this call.
The consensus for the 2008 trade surplus has fallen for more than eight weeks in a row, to about $30 billion recently, from some $35 billion before. We think there is more to go. In our view, disappointing actual trade data and darkening global growth clouds will drive the trade consensus forecast farther down. As a consequence, prospects for the current account will worsen too. Our out-of-consensus call continues to see a current account deficit of 1 percent of GDP in 2008, a deficit for the first time after five years of surpluses. Likewise, last year’s record-high capital inflows will not repeat. We see capital flows in 2008 slowing to about a third of their 2007 level.
Second, global turbulence could complicate monetary policy. The impact from global growth slowdown on Brazil’s monetary policy is ambiguous. On the one hand, lower net exports would reign in overall aggregate demand, and a weaker outlook for international commodity prices could help slow Brazil’s own inflation. On the other hand, global slowdown and accompanying global risk aversion could hurt Brazil’s balance of payments, as described above. In turn, this could bring potentially negative implications for the currency, and thus for inflation. In all, if anything, global turmoil probably adds uncertainty to the environment facing Brazil’s monetary policymakers.
Third, local financial markets could wobble. Besides implications for Brazil’s currency, global market turbulence could hurt other Brazilian asset prices. In turn, prolonged declines in the local stock market would risk spooking local retail investors. Luckily, Brazil’s stock market represents still only a tiny fraction of the Brazilian average consumer wealth. Therefore, broader macroeconomic implications for consumption decisions are negligible. For its part, a steeper local yield curve, in part reflecting higher risk perceptions amid less global risk appetite, could work to tighten overall financial conditions. Happily, Brazilian banks have no direct exposure to the issues currently afflicting banks in the developed world.
Fourth, local sentiment might be affected. This channel is admittedly the fuzziest, but remains potentially relevant. Consumer and business confidence have risen to record highs over recent quarters, on the heels of very supportive domestic conditions. That shows in strong domestic private sector consumption, as well as in robust investment in the form of ongoing capex expansion. Local sentiment can prove resilient to global jitters, but this remains a potential channel to monitor.
Will global turmoil derail Brazil’s growth?
Real GDP growth is set to slow in 2008, with a shifting composition. We see real GDP growth slowing from about 5 percent last year towards around 4 percent this year. We assume that domestic demand (consumption plus investment) proves resilient. But we see a widening negative contribution from external demand. In fact, net exports have already been a drag on growth for a while, as import volume growth has outpaced export volume growth. Indeed, net exports already subtracted about 2 percent from overall real GDP growth last year. In 2008, this drag will widen to 3 percent in our forecast.
Domestic drivers look supportive, at least for now. Domestic demand has grown rapidly, on the back of improving labor market conditions, and – crucially – expanding credit, with greater availability at lower rates and longer maturities. Ongoing job creation and rising real wages have boosted disposable income and spurred consumer sentiment. Given time lags and the slow-moving nature of labor markets, it would surprise us to see a sudden collapse in the labor market environment soon. For its part, Brazil’s domestic credit has expanded fast for years (from a depressed starting point), for reasons that seem to go beyond just cyclical considerations – see “Brazil: What Credit Crunch?” in Global Economic Forum October 2, 2007. Of course, if domestic credit expansion falters, then the domestic demand outlook would darken.
Statistical carry-over supports the headline 2008 growth reading. Because the economy accelerated through 2007, it started 2008 with plenty of momentum. The statistical carry-over for 2008 is about 2.5 percent. That is, even if the economy stays flat throughout 2008, its average level this year would be about 2.5 percent higher than the real GDP average level in 2007. Risks around our 2008 growth forecast seem biased to the downside. But it would be hard to see the headline 2008 growth figure falling much below the 3 percent mark. However, headline average figures can mask growth dynamics through the year. We suspect that year-on-year real GDP growth will have peaked at almost 6 percent around 2007 Q3, and we look for growth deceleration through 2008. We expect average year-on-year real GDP growth of 4.7 percent in the first half of the year, slowing to 3.8 percent in the second half.
Long-term potential growth estimates may be called into question. In a sense, the debate about the 2008 growth outlook misses the point. Even if the headline 2008 growth figure proves resilient, a worsening global environment may raise questions about Brazil’s underlying long-run growth potential. Brazil enjoyed an exceptionally favorable global environment over the last several years, since 2003. Indeed, average global growth accelerated from 3.4 percent during 1998-2002 to 5.0 percent during 2003-2007. Similarly, international prices for non-fuel commodities (highly correlated with Brazil’s own average export prices) had declined 4.0 percent every year on average during 1998-2002, but jumped 13.3 percent each year on average since 2003. Perhaps unsurprisingly, Brazil’s annual real GDP growth jumped from 1.7 percent on average in the five years before 2003 to 3.8 percent on average since then. But the global environment is changing now. Note that Brazil’s headline growth in 2003 was still weak, the first year of transition to better times. Will 2008 prove a positive headline growth year in transition to tougher times?
Structural reforms hold the key for sustained long-term growth. Years ago, estimates for Brazil’s potential growth used to fall mostly in the 2 percent to 3 percent range. Growth acceleration in recent years has led some observers to upgrade that estimate to as high as the 4 percent to 5 percent range. Under tougher global conditions, however, we would not be surprised to see popular estimates of potential real GDP growth eventually being revised down again – perhaps to 3 percent to 4 percent range. In the end, there is little doubt that structural reforms would be crucial to boost Brazil’s long term growth potential in a sustained way. Regretfully, abundance often entails complacency. In retrospect, it would be sad if the exceptional stretch of global abundance seen during 2003-2007 enters history as a period of missed opportunities for Brazil’s reforms.
What to watch going ahead? What would make us change our mind about Brazil’s 2008 outlook in the face of global turbulence? We would keep an eye mainly on three variables. First, watch capital flows. We assume that capital inflows slow down from last year’s record-highs but still remain positive. An outright sudden stop in capital inflows would darken the outlook, through its implications for the currency. Second, watch signs from monetary policy makers. We assume no rate hikes this year. If we are wrong and the authorities instead quickly embark on an outright monetary tightening cycle, then growth prospects weaken. Third, watch whether global turbulence starts hurting consumer and business sentiment indicators, as well as banks’ willingness to extend credit.
Brazil is better positioned than ever before to weather the global turmoil. But it is surely not immune. The main transmission channel is the balance of payments, which is set to weaken from last year’s extraordinary strength. We stick to our out-of-consensus call for worse trade and current account numbers. In turn, net trade will be an increasing drag for real GDP growth this year, which is set to slow from last year’s peak.
By Marcelo Carvalho, Chief Economist for Brazil at Morgan Stanley.