Levy Talks the Talk, Will Rousseff Wallk the Walk?

(from my colleagues Dr. Win Thin and Ilan Solot)

Yesterday we attended an event with Brazil’s Finance Minister Levy.  Our takeaway was that policymakers are willing to accept a subpar 2015 in the hopes of getting the economy on track by 2016, when the summer Olympics will be held in the country.  As one would expect, Finance Minister Levy said all the right things about arresting fiscal slippage, encouraging foreign investment, and basically fixing past mistakes.  But he also stated that it is possible to achieve the 1.2% primary surplus target without “draconian measures.”

Just as everything seemed to go wrong for Brazil in 2014, we think the stars need to be aligned for Brazil in 2015 if Levy’s (and Rousseff’s) lofty goals are to be attained.  Until those stars align, we believe Brazilian assets will continue to underperform within EM.

POLITICS
The popularity of the Dilma government has plummeted even as the Petrobras corruption scandal has intensified.  The latest polls showed that those who rate her government positively fell from 42% to 23% – the worst ratings for a president since 1998, when President Cardoso devalued the currency.  Moreover, 77% of the people interviewed believe that she knew about the corruption at Petrobras.
Recent political developments have many starting to talk about impeachment.  There is a pro-impeachment protest scheduled for the 15th of March.  In our piece last week, we downplayed the risks of a successful impeachment.  However, it does mean that the opposition and the coalition parties could gain some extra leverage.  

This could, in turn, deepen the government’s institutional crisis and consolidate Dilma’s second mandate into a premature “lame duck” position.  This suggests that the process of undertaking serious economic reforms will slow, raising the likelihood that Brazil being downgraded.  All in all, the heightened political uncertainty will be just another item in the growing list of headwinds for Brazilian assets, which should continue to suffer.

It’s also important to appreciate the level of polarization and sensitivity in the Brazilian society.  We doubt the Brazilian people will be willing to tolerate a considerable fiscal adjustment.  Recall that a few years back, a small increase in bus fares led to nationwide protests.  And that was before the elections, the droughts, and the Petrobras scandal.

ECONOMICS
On the fiscal side, Minister Levy noted that it won’t take much adjustment in discretionary spending to help attain the 1.2% of GDP primary surplus goal for 2015.  Yet that’s obviously easier said than done, since the December 2014 fiscal numbers were the worst since November 1998 for the primary balance (at -0.6% of GDP) and the worst since August 1999 for the nominal deficit (at -6.7% of GDP).  Furthermore, tightening both fiscal and monetary policy during recession is a very risky proposition.  

The drought and ensuing energy shortages will be a big headwind on the economy.  The recent rains have improved the levels in major reservoirs, but the situation remains critical. The weekly central bank survey shows consensus GDP growth for 2015 and 2016 at -0.4% and +1.5%, respectively, while consensus for IPCA inflation those same two years is 6.7% and 5.8%.  GDP contracted y/y in both Q2 and Q3 2014, and this trend is expected to continue well into 2015.  

Despite the drought, the latest estimates suggest a record harvest for 2015.  Production is expected to grow by 4.4% from 2014, and planted areas are seen expanding by 1.6%.  This is one of the bright spots for Brazil, but it will likely be muted by ongoing softness in agricultural prices and also overshadowed by the ongoing y/y contraction in IP and exports.

 
The latest weekly central bank survey shows markets looking for COPOM to deliver 50 bp of further tightening to 12.75%.  COPOM is then expected to ease 125 bp to 11.5% in 2016.  This interest rate path is predicated on many things, the first being that inflation finally turns lower.  That’s not a sure thing, given what we see as the inevitable energy price hikes.  While this should result in a big one-shot boost to IPCA inflation, it is not clear yet if the second round effects will require more tightening.

On the exchange rate, Levy was very cautious, and rightly so.  He said any decisions about the FX swaps program is the domain of the central bank, but added that the program is doing its job of lowering exchange volatility.  We take this to mean that there will be no imminent change in the swaps program, unless we see a dramatic move.  He noted that the real has depreciated significantly in recent years, not only against the dollar but against Brazil’s major trading partners.  This is certainly true, and we think he made this point to emphasize that Brazil policymakers do not wish to weaken the real further.  The BIS measure for Brazil’s Real Effective Exchange Rate (REER) is near the cycle low from August 2013, and is about 20% weaker than the all-time high from July 2011.

INVESTMENT
FDI flows remain strong, totaling $62.5 bln in 2014 and covering almost 70% of the current account gap.  While down from full coverage as recently as February 2013, this still allows Brazil to enjoy relatively little reliance on hot money to finance the current account gap.  Still, at -4.17% of GDP in 2014, this gap was the highest annual shortfall since 2001. 

Levy did not dwell on the Petrobras scandal, instead focusing on how the government is working to make Brazil an attractive investment destination.  Yet by not making a stronger statement on the widening corruption probe, we think Levy missed an opportunity to regain some investor trust.  Until the Petrobras scandal has been addressed comprehensively, we believe foreign investors will be reluctant to commit funds to the country’s equity market.

While some may be tempted to shrug of corruption as “business as usual”, we note that Brazil ranks 120 out of in the World Bank’s “Ease of Doing Business” index.  This puts it below Ecuador (115) and Nicaragua (119) but just above Argentina (124) and Pakistan (128).  This is not a good neighborhood to be in, and points out the hard work needed to really transform Brazil into a globally competitive powerhouse.

CONCLUSION
Investors remain very negative on Brazil right now, and rightly so.  However, positioning seems very one-sided, and so BRL and the Bovespa could see periodic short-covering rallies on positive headlines.  Yet the fundamental backdrop will not turn around quickly, giving investors a long window this year to decide on whether or not Levy and Rousseff have done enough to turn the ship around.  Downgrade risk remains high, as our model shows Brazil right at the cusp of a BB+ rating.  If the fiscal numbers don’t improve soon, then the agency honeymoon for Levy will end.