by John Rumsey

Not long ago, Brazilians were watching declines in the global economy with a certain schadenfreude as internal demand and the commodity boom continued, and decoupling talk was all the rage. Higher inflation, rising rates and an over-valued currency – against a backdrop of volatile and declining raw materials prices – are testing Brazil’s immunity.

That the long-term future of the Brazil economy has been transformed by stable macro policies and developing markets is not in doubt. Until some four years ago, most economists thought Brazilian growth would be constrained for structural reasons to 2.5%-3.0%, notes Pedro Jobim, chief economist at Banco Itaú BBA. Instead, GDP growth was comfortably over 5% in 2007.

That is partly thanks to strengthening commodities, but it is also helped by increased investment. There has also been a diversification of the industrial base, more open capital markets and development of a banking system that is investing in the productive economy.

Nonetheless, the short-term economic outlook is deteriorating fast. Unibanco sees GDP growth falling to 4.8% in 2008 and continuing to decline to some 3.0% by the third quarter of 2009, says chief economist Marcelo Salomon. In addition to a worsening global economic outlook, inflation has been ticking up on domestic demand and looks likely to breach 6.5% before it can be reduced, he adds.

Higher inflation has already led to a rapid response from the central bank, which hiked rates to 13.00% from 11.25% in the space of two months. The outlook is for continued, swift rate rises, economists say. The likelihood is that the cycle will top out at 14%-15%, believes Ilan Goldfajn, portfolio manager at hedge fund group Ciano Investments.

The burden of tackling inflation falls entirely on the shoulders of the central bank as there are no signs of fiscal austerity, Salomon notes. The government has been awarding fat pay rises and there are growing signs of restlessness in key industries whose workers react to civil servant pay rises and higher inflation with dismay, says Goldfajn.

The interest rate moves are already causing banks to look afresh at their giddily growing credit portfolios, which have been fuelling domestic demand. Márcio Cypriano, president of Banco Bradesco says his bank has been tightening credit conditions, with more rigorous credit scoring and stricter controls over the tenor of consumer loans.

Salomon, whose Unibanco has also turned more austere in lending, predicts that smaller banks concentrated on non-guaranteed loans, and those dealing with less creditworthy customers, will be most affected. Ninety day non-performing loans may go back up to levels of 7.6%-7.8% which would represent a yellow alert for the economy, he warns.

Bottom of First Division
Rate increases and tighter access to credit will slowly reduce consumer appetite for goods. But higher rates and strong growth has had the effect of pushing up the currency from already high levels by encouraging short-term portfolio flows into fixed-income. The city of São Paulo jumped in one year from 62nd in 2007 to 25th place this year in a Mercer ranking of most expensive cities, overtaking Stockholm, Brussels and Munich.

An expensive real has seen export growth slow: volumes were flat in the first five months, though revenues rose thanks to stronger prices, says Jobim. Meanwhile, imports have been flooding in, pushing the current account deficit to a near six-year high at $14.7 billion in the 12 months through April. For now, that is being compensated by high levels of FDI, which still has plenty of scope for growth, from a piffling 1% of GDP, Jobim notes.

The effect of a slowdown on the political outlook remain relatively benign. But Lula’s continued popularity is not conducive to deep change. “The DNA of the government is not reformist – it doesn’t see the need not the need to streamline the public sector, far from it,” says Salomon. There has been a mild acceleration in investments to 16% of GDP, but it is not matching Brazil’s huge needs. “We have moved from the top of the second division into the bottom of the first,” he concludes. LF