In the first of a four part series looking at the BRIC regions, Craig Botham, Emerging Markets Economist at Schroders, shares his views on Brazil.
First quarter GDP had not been published at the time of writing, but weaker high frequency data reinforce our negative view of the Brazilian economy. The central bank's GDP proxy, industrial production and to a lesser extent retail sales have been trending down this year. Car sales are also nearing five year lows – they fell 16% year on year in March. Consumer credit demand is also slowing, as higher interest rates, lower consumer confidence and high inflation erode consumer demand.
Political uncertainty has increased since our last forecast, with the incumbent Dilma falling in approval polls, increasing the chances of a second round. Markets have been cheering Dilma's fall, on hopes that it implies a more business friendly candidate will triumph in October. However, she remains the clear frontrunner for now, and in any case whoever wins will have substantial challenges; there will be no instant turnaround. The boost to investor sentiment would be helpful but a number of bottlenecks will take legislation and time to resolve. Until then, Dilma seems to be resorting to populism to shore up her vote; her government has increased welfare payments by 10% and provided additional capital injections to the development bank to maintain credit expansion (further undermining the shaky fiscal position). All this implies sharper cuts post-election and motivates our 2015 growth downgrade. Also affecting our growth outlook is the impact of the recent drought, which has continued almost unabated since we mentioned it in February's forecast. Depleted reservoirs have seen increasing use of high cost thermoelectric plants (for which fuel must be imported) rather than hydroelectric. This has resulted in a number of firms in the metals and chemicals industries reducing production and selling excess power on the spot market instead, where the price is at the government-fixed ceiling. Local media reports a number of firms are struggling to operate with electricity costs at this level.
We suspect the central bank must be increasingly frustrated by the refusal of government policy to truly co-operate in containing inflation, which remains close to the upper band of the target range despite the 375 bps of rate hikes since the start of 2013. Inflation is, of course, a backward looking indicator, but worryingly inflation expectations remain elevated as well, suggesting the problem is likely to persist. Despite this, the central bank opted to keep rates on hold at 11% at its latest policy meeting. Though the accompanying statement suggested further hikes would be considered, it seems likely that we will have to wait until after the elections now for rates to increase again. Despite this, inflation pressures look set to remain elevated in 2015, in part due to the ongoing need for high cost thermoelectric plants to stay online, and in part due to the inevitable increase in regulated prices, which have been suppressed in the run up to the election.