How many recessions does Brazil need to learn?

On Friday, Brazil released their latest GDP data and it was horrendous. GDP growth was contracted for a second consecutive quarter, which ended in June. In addition, first-quarter results were revised, to show a decline in growth as well. According to the economic definition that two consecutive quarters need to show GDP contracting, Brazil is officially in a recession. This shouldn’t come as a surprise though; Brazil has been struggling for years, being dependent on its commodity boost and foreign direct investment (FDI).

Source: The World Bank

History seems to be repeating itself. Back in the early 1970s Brazil had severe reductions in its export, caused by an overvalued currency and the oil shock of 1973. To fix that, the government introduced policies, which promoted import substation of steel, aluminum, fertilizers and petrochemicals, make large investments in the expansion of infrastructure and promote exports. This heavily import dependent strategy, raised the already large current-account deficit, which had to be financed using foreign debt. By the late 1970s, Brazil was enjoying high growth, averaging about 7% a year, but causing non-sustainable debt levels and high inflation.

Reality caught up in the 1979, when the second oil shock hit the country, doubling the price of imported oil. This caused the International Monetary Fund imposed an austerity program on Brazil to help stabilize the country. This allowed the country to meet interest payments on debt, at the price of declining growth and increased inflation. Due to an increasing indication of financial balances, wages and other value of inflation, the government allowed the situation to escalate into hyperinflation, as these factors counteracted normal measures of decreasing inflation.

After a decade of hyperinflation, constant government changes, public unrest and many failed stabilizing plans President Itamar Franco, introduced Plano Real (“Real Plan”) to jump-start the economy. The new stabilization program introduced many new policies, the most important being a new currency, the Brazilian Real, which was pegged to the dollar. The plan, which instituted in 1994, successfully brought down inflation to a single digit annual figure and regained the confidence of international investors. Through that, Brazil was able to slowly claw its way back to become one of the strongest Latin American countries.

Source: Instituto Brasileiro de Geografia e estatistica

Starting from 2004, Brazil was enjoying on average a sustainable growth of 4.5% per annum. The vast landmasses, favorable climate conditions and rich in minerals soil fueled commodity exports, which experienced price increases during that time. In combination with good economic policies, focusing on reducing the economic inequality, thereby allowing the bottom of the market to join to fuel internal consumption and an increase in labor force powered the strong GDP growth. This ended in 2010, when Brazil reached its peak of 7.5%, a falsified number mainly caused by lavish government spending to help win political support for the elections.

Unsurprised, the structural problems that were shadowed by commodity price increases finally caught up in the next few years. The increase in labor force did not translate to an increase in productivity, while labor force increase has reached saturation. Furthermore, Brazil has become too expensive, contributed by rising labor cost (due to increase in minimal wage), transport cost and tax cost. This is reflected in households, who are not able to increase consumption due to high levels of debt, even with low interest rates.In addition, the high inflation and rising exchange rate makes exports non competitive against other commodity exporters. In combination with stable commodity prices, Brazil is not able to ignore the structural problems as before. This causes investor confidence to drop, represented by a 5.3% investment contraction in the second quarter.

The Brazilian Government is spending more than the average middle-income country, 38.5%. Still public infrastructure is strongly underdeveloped, streets are unpaved and the youth is uneducated. Wrong management of government spending is the root of the problem. Pensions receive 11.3%, education on the other hand 5.3%. While this value is higher than the ODEC average, the majority goes to universities and teacher pensions. Government infrastructure projects announced in 2007, are years behind schedule and over the allowed budget.

The last hope for the government came in 2014 when the World Cup was held in Brazil, promising an influx of tourism, investment and media attention. Unfortunately, things turned sour; construction was a nightmare, costs were higher than anticipated and local protests threatened the event. Although the World Cup was executed smoothly (ignoring Brazil’s 4th place finish), more harm than benefit was caused. Production reached lowest levels, caused by closed factories who sent employees on vacation and a lower than expected influx of tourist.

President Rouseff is in a tight spot, Silva is gaining popularity fast and people are frustrated by the economic situation. To be able to overcome this problem, Brazil needs to overhaul its policies, focusing on decreasing pension, lowering and simplifying taxes and simplifying labor laws. Furthermore, by partnering up with the public sector for infrastructure projects ensures timely execution. Perhaps the release of Friday’s economic data will give the shock needed to make the government realize it is time for change. It is a long hard climb for Brazil, but drastic actions need to be done to avoid repeating the mistakes of the past.

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