How Sensitive Is Brazil To A Global Slowdown?

Marcelo Carvalho is again spot on in this Tuesday's MS GEF post:

As the US economy appears to slide towards recession, and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil would be able to ‘decouple’ from the developed world’s agony. The ‘decoupling’ debate is misplaced, in our view, at least in its binary version. If the US goes into recession, does Brazil necessarily have to contract sharply? We think the answer is no. But then is Brazil fully immune? Our answer is again no. Decoupling should not be seen as a yes or no proposition, but rather as a spectrum of possibilities, in a continuum of outcomes. As usual with these matters, in medio stat virtus: the truth lies somewhere in the middle.

As the US economy appears to slide towards recession, and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil would be able to ‘decouple’ from the developed world’s agony. The ‘decoupling’ debate is misplaced, in our view, at least in its binary version. If the US goes into recession, does Brazil necessarily have to contract sharply? We think the answer is no. But then is Brazil fully immune? Our answer is again no. Decoupling should not be seen as a yes or no proposition, but rather as a spectrum of possibilities, in a continuum of outcomes. As usual with these matters, in medio stat virtus: the truth lies somewhere in the middle.

The balance of payments is the main channel of transmission from global turbulence into Brazil. We have already made the point that Brazil’s trade surplus is likely to narrow much faster than the consensus believes (see “Brazil: Waiting for Godot”, EM Economist, October 26, 2007, and “Brazil: Trade Consensus – What Is Wrong with This Picture?” EM Economist, November 16, 2007). Robust domestic demand and a strong currency should keep imports growing rapidly, while exports are set to struggle amid a less encouraging global environment. The market consensus is calling for only a modest decline in the trade surplus from roughly US$40 billion this year to around US$35 billion in 2008. By contrast, we see the trade surplus falling by half, to about US$20 billion in 2008. Correspondingly, while the consensus view still looks for a current account surplus next year, we are confident that the current account will fall into negative terrain in 2008. But the current account is just part of the picture. In this note, we take a closer look at the other side of the balance of payments: the capital account.

Das Kapital account

Swings in the capital account have been by far the main driver behind changes in Brazil’s international reserves, much more so than the relatively less volatile current account balance. Indeed, an unprecedented surge in capital inflows this year has allowed the central bank to speed up its pace of intervention in the foreign exchange market, and to more than double its stock of reserves from the US$85 billion mark seen at end-2006.

Capital account strength has been broad-based, across net foreign direct investment (FDI), equities and fixed income. Net FDI has surged to record-highs, even without the help from privatization-related inflows which boosted FDI figures at the beginning of the decade. Macroeconomic stability has expanded companies’ planning horizons. Declining real interest rates have unlocked investment opportunities. And robust domestic demand has enticed firms to expand their output capacity. Coupled with favorable global conditions, the improving domestic environment has attracted FDI into Brazil, mainly in the form of new operations (although also through inter-company loans, to a lesser degree). Interestingly, net outward direct investment has risen in recent years too, as Brazilian companies expand abroad.

Where is FDI going?

Net FDI inflows are widely spread across the economy. Services (including financials and retail) account for about half of the total, although the broadly defined agribusiness-mining complex has gained importance (especially mining). Within industry, the main recipients of FDI include sectors such as metallurgy, fuels, chemicals and food processing.

Capital inflows into the equity market have also boomed to unprecedented highs, spurred by a record-high number of IPOs. The expansion and maturing of the local capital market has brought a deluge of new companies to the local stock market. Foreign participation in IPOs has been high at about three-quarters of the total, and so it is unsurprising that capital inflows through this channel have boomed.

Registered inflows into the local fixed income market have jumped high as well, in part supported by tax and regulatory changes aimed at facilitating direct foreign participation in the local market. Brazil’s Treasury has steadily bought back its external debt, migrating its financing towards the local market. That brings hope of redemption from the so-called ‘original sin’ (or emerging markets’ historical inability to issue long-term debt in local currency). It also lures foreign investors into the local fixed income market.

The outlook for 2008

What to expect for the capital account going ahead? We look for a slowdown in capital inflows next year. As the global economy decelerates, and global risk-aversion re-emerges after being suppressed for years, recent all-time high capital inflows seem unlikely to persist. Net FDI should prove relatively resilient, as this type of flow tends to follow normally slow-moving perceptions about longer-term trends. We suspect that the peak in IPOs in the local stock market is behind us. Likewise, we fear that an environment of less global risk appetite might take its toll on capital inflows into the local fixed income market. We assume that these inflows slow towards levels seen prior to the 2007 boom.

All in all, we assume that capital inflows slow from about US$90 billion in 2007 to almost a third of this in 2008, although admittedly the capital account is harder to predict than the current account. How does that compare with expectations about global capital flows into EM overall? The latest report from the International Institute of Finance on this subject sees a modest decline (to still-high levels) in capital flows to emerging markets in 2008 after a peak in 2007. To be frank, such a projection now looks a bit sanguine in light of ongoing downgrades in the global environment for next year, in our opinion. For Brazil in particular, our assumptions are less smooth than the IIF’s: we see a higher peak in capital inflows in 2007 and a larger decline in 2008.

What are the risks around our forecast? If our numbers materialize, Brazil would still be able to accumulate foreign reserves next year, albeit at a slower pace than in 2007. That should prove to be a relatively benign backdrop. We suspect that the main downside risk to our scenario would be a sharper-than-expected turnaround in capital inflows. If the capital account really dries up, on top of what seems to us to be an inevitable deterioration in the current account, then the Brazilian real would suffer – although the central bank theoretically could lean against currency-weakening by selling reserves. In turn, currency devaluation could push inflation expectations up, eventually forcing the hand of the central bank to tighten. Monetary tightening, for its part, could take the punchbowl away from the domestic demand party. To be fair, there is potential upside risk too. If capital inflows prove more resilient than we assume, resulting currency strength would prolong Brazil’s virtuous-cycle story.

Bottom line

The current account balance is bound to fall into deficit next year, and capital inflows look set to take a hit too, in our view. We assume that the overall balance of payments will remain sufficiently robust to allow further reserve accumulation, albeit at a slower pace. The main downside risk: if capital inflows really dry up, then the currency could weaken significantly, pushing inflation expectations up, forcing interest rates higher, and entailing a downturn in the growth outlook.