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Aug 19, 2015 | 09:00 GMT

In Brazil, Economic Recovery Stalls

In Brazil, Economic Recovery Stalls
(MARIO TAMA/AFP/Getty Images)
Summary

All signs suggest that Latin America's largest economy will continue to struggle well beyond 2015. Brazil's economy is already expected to contract this year, and problems such as rising inflation, high interest rates, corruption scandals and the political uncertainty surrounding Brazilian President Dilma Rousseff's administration are unlikely to disappear anytime soon. As these issues pressure Brazil's business and investment climate, they will likely delay any significant economic recovery until at least 2017. However, these same difficulties could motivate Brasilia to change its regulatory structure, ultimately improving the country's business climate and broader economic trajectory in the long run.

Brazil has had to grapple with an increasingly challenging foreign economic environment in recent years. The commodity boom largely driven by China through the 2000s has slowed dramatically since 2012. The global prices of many of Brazil's primary commodity exports, including crude oil, soybeans and iron ore, have plummeted. And Brazil's exports to one of its largest trading partners, Argentina, have declined because of Argentina's weakening domestic economy. Together, these factors contributed to Brazil's sluggish 0.1 percent gross domestic product growth in 2014.

But Brazil's domestic environment — both economic and political — forewarns of even greater trouble ahead. Chief among Brasilia's concerns is the fallout from the Operation Car Wash corruption scandal involving state-owned energy firm Petroleo Brasileiro, also known as Petrobras. A federal police investigation launched in early 2014 revealed that Petrobras' suppliers and subcontractors had bribed executives in return for inflated contracts. Over the past year and a half, the scandal has led to the arrest and imprisonment of several prominent politicians and executives. Its effects continue to ripple throughout the economy; the government recently announced that Operation Car Wash would likely lead to a 1 percent contraction of Brazil's GDP in 2015.

Complicating Matters

As a result of the scandal, Brazil's investment climate has significantly deteriorated. Petrobras, already under heavy financial stress because of low oil prices, has had to severely curtail its $220 billion investment plan for the next five years by about $90 billion. The energy firm has been shut out of most international credit markets for much of the scandal's duration, forcing it to seek financing from other sources, such as the sale of some strategic assets and the China Development Bank.

The corruption scandal has also hurt many of the contractors that provide services to Petrobras, including some of Brazil's largest construction and engineering companies, such as Odebrecht and OAS SA. These companies are some of the primary participants in Brazil's infrastructure auctions, but with some of their executives now imprisoned, Brasilia has had to temporarily table many of the auctions. Lingering legal uncertainty is only adding to the downward pressure on domestic investment and encouraging state-owned banks like Caixa and the Bank of Brazil to tighten their credit conditions. Officials recently announced that the investigation into the scandal could last another 500 days, which would extend the uncertain investment climate beyond not only this year but also the next. Still, volatility in foreign direct investment into Brazil appears to be diminishing. Investment declined relatively slowly from $64 billion in 2013 to $62 billion in 2014, and it is expected to drop by another $2 billion in 2015.

Growing inflation is only complicating matters for the country's weakening economy. Brazil's inflation rate is projected to reach over 9 percent by the end of the year, well above the 6.5 percent ceiling set by the Central Bank of Brazil. The Brazilian real has been one of the world's worst-performing currencies in 2015, so far losing more than 24 percent of its value against the U.S. dollar. The central bank has responded by periodically raising interest rates in a bid to fight inflation and mitigate currency volatility. The most recent hike took place July 30, increasing interest rates from 13.75 percent to 14.25 percent.

While containing inflation is important to Brasilia's attempts to keep protests and political dissent from cropping up, it has further weakened the country's investment climate. On Aug. 11, Moody's Investors Service downgraded Brazil's credit rating to just one level above "junk" status, while Standard & Poor's warned that Brazil could soon be relegated to junk status. If U.S. interest rates increase, Brazil could face even greater inflationary pressure. However, the Central Bank of Brazil has enough international reserves (around $300 billion) to slow the depreciation of its currency, a decision that could also provide some relief to the country's manufacturing industry by making Brazilian exports cheaper.

Brazil's fragile political environment is adding to the country's long-term economic uncertainty as well. While Brazilian President Dilma Rousseff has yet to be implicated in the Operation Car Wash corruption scandal, some opposition members are campaigning for her impeachment. Even if Rousseff manages to avoid impeachment, which seems likely now but could change over the course of the investigation, she still has extremely low approval ratings of around 8 percent and weakening support from her allies in Brazil's National Congress, particularly in the Chamber of Deputies. The centrist Brazilian Democratic Movement Party, a key ally of the ruling Workers' Party, has announced that it plans to run independently in Brazil's next presidential election, slated for 2018. Two smaller allies, the Brazilian Labor Party and the Democratic Labor Party, recently followed suit, announcing their plans to break away from the ruling coalition to become independent. The fractures in Rousseff's coalition have prevented the government from passing necessary fiscal measures, contributing to Brazil's downgraded credit rating.

Hard Times Ahead

Brazil's domestic troubles and an unfavorable global economic climate are driving projections of the economy contracting between 1.5 percent and 2.5 percent in 2015. If the estimates are correct, they would be Brazil's worst economic performance in over a decade. Economists from Swiss financial services firm Credit Suisse have predicted that Brazil's economy will shrink even more in 2016, which would mark Brazil's first consecutive annual contraction since the Great Depression. Though the Brazilian government is attempting to counter the country's economic contraction with several initiatives, including a more aggressive trade strategy and export promotion plan, the impact will be limited since exports account for only 13 percent of Brazil's GDP. Given the scale and complexity of the problems facing Brazil's economy, the country's economic growth is unlikely to recover until at least 2017.

But the same vulnerabilities signaling hard times ahead for Brazil could also presage economic progress farther down the road. The corruption scandal, though temporarily painful, will likely force the Brazilian government to overhaul its regulatory structure and create a more favorable investment climate in the coming years. The ruling Workers' Party will be in a substantially weaker position in the next election, and if the economy continues to stall, voters may favor the more business-friendly policies of the Brazilian Social Democracy Party and the Brazilian Democratic Movement Party over the ruling party's protectionist policies. So while Operation Car Wash will continue to damage the Brazilian economy for the next year or two, it could lead to a stronger business climate — and consequently, better economic performance — in Brazil later on.

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