Brazil Central Bank Raises Interest Rates Another 0.75%

Brazil's central bank raised its benchmark interest rate three-quarters of a percentage point yesterday. Three of the eight directors expressed the view thatthe raise was excessive, which seems to indicate that the monetary tightening process may be nearing its close in this cycle. Policy makers voted 5-3 to raised the so-called Selic rate a fourth time since April to 13.75 percent from 13 percent in an attempt to keep a tight grip on inflation, and to confirm the Banks growing reputation as the "Bundesbank of Latin America". The decision raised Brazil's real interest rate - which is the nominal rate adjusted for the 6.17% CPI inflation -  to 7.58, the highest among emerging and developed economies alike. The dissenters on the board voted for a half-point increase.






Real Decline

Despite the interest rate rise the real fell below the 1.80-per-dollar level today for the first time since January an indication more of deteriorating global sentiment - today's drop was triggered by speculation Lehman Brothers is about to collapse. The real dropped 1.8 percent to 1.8202 per dollar at 11:03 a.m. New York time, from 1.7878 yesterday. Earlier it touched 1.8374, the weakest since Jan. 22. Lehman's 38 percent fall today pushed the Standard & Poor's 500 Index to its lowest since November 2005. As wer can see in the chart below, the real had been rising steadily in 2008 until the start of August. Then the wind clearly changed, and the dollar had been rising and the real falling.

If we look at the three month chart things are even clearer, and we can see that sentiment had been deteriorating since mid July, and then really to a hard jolt downwards in late August. Most of this evidently has no direct relation with the strength of the Brazilian economy, or with any deterioration in the inflation outlook (quite the contrary, see below) but rather with global factors, like, of course, commodity prices, since the movement conforms reasonably well wilh the downward shift in the price of oil.




Brazil's stock market, the Bovespa index (about half of which consists of raw material companies), is also vulnerable to concerns about global growth, and the has dropped around  23 percent so far this year, hurt by both inflation concerns and a decline in commodity prices.

But we need to ask ourselves some basic questions about the current USD rally and the extent to which a continuing US slowdown would will lower growth in key global movers like Brazil and India. It is also worth asking the question whether there is any real danger of capital flight from either of these two economies to the dollar perceived as a safe heaven currency. This whole argument seems to be very overstretched at this point. Indeed it seems to be a real paradox that the USD continues to be considered a safe heaven despite US credit markets being the epicenter of the current global economic turmoil, and especially at a time when returns on USD assets continue to be negative, while any continuing upward movement in the dollar can only help the trade deficit deteriorate again, Thus it is my view that the current USD rally unsustainable as seen against a select group of emerging economy currencies (and in particular the rupee and the real, is not justified, and basically not sustainable with increasing all those imbalances people had been working so hard to try and correct.


And Is Inflation Already On The Wane?


At the same time Brazil's consumer prices rose at their slowest pace in 11 months in August after food and beverage costs fell for the first time in more than two years. The August price increase as measured by the benchmark IPCA index was just 0.28 percent, compared with 0.53 percent in July, as a result annual inflation slowed to 6.17 percent from a three-year high of 6.37 percent.

Food and beverage costs dropped 0.18 percent last month, the first decline since June 2006, after rising 1.05 percent in July. On the other hand, non-food inflation actually accelerated, indicating the central bank is quite right to try to squeeze out second round effects at this point. Service prices rose by 0.73 percent in August, up from 0.51 in July. Prices for non-food goods not subject to government regulation also rose 0.5 percent in August, up from 0.3 percent in July.

The Impact Of Energy Prices

Energy prices also seem to be easing, and rapidly.


Oil prices fell to their lowest level in five months today as investors worried that the ongoing economic slowdown would continue to chip away at the demand for energy. Light, sweet crude for October delivery fell $1.88 to $100.70 a barrel on the Nymex, after dropping as low as $100.10 a barrel at one point. The contract settled yesterday at $102.58 — the lowest close since April 1. The last time crude traded below the $100 mark was April 2 Oil prices have now fallen more than $40 from the record high of $147.27 a barrel on July 11, two months ago, as a struggling global economy has cut into demand for energy. The US is leading the way in the decline in demand for oil, and the US Energy Information Administration reported last week that imports of crude in August were 200,000 barrels a day below the same four-week period last year. This pattern is repeated to some degree or another in economy after economy across the globe.

Now this decline in oil will evidently have a floor, but where exactly does that floor lie? My own view is that the decline will continue, but that it may hit bottom around $80, since at some point inflation will ease back as a major problem in a number of significant economies, and growth will rebound in some key movers (deciding which those are going to be is the tricky issue at this point), and then of course the oil price will start to head up again.

My feeling is also that we could then see quite a quick turnaround in inflation in some emerging economies like India (from the current 13% to say 7%) or Brazil (back down to the 4.5% range?) and this will then mean the negative "lose-lose" dynamic we have been seeing across a number of emerging economies of rising inflation, rising trade deficits, rising interest rates, falling currencies and falling growth can transform itself once more into the "win-win" dynamic of falling inflation, falling trade deficits, slightly lower (but still very yield differential attractive) interest rates, rising currencies and rising growth.

The interesting question is when will we hit the inflection point? Well, if we look at the NYMEX chart below, we will see that oil prices really started to take off in October 2007, and that at current rates of decline in oil prices the two curves should cross (ie 2008 prices should be below 2007 ones) sometime between October and November. Now this will be quite an important event in the emerging market economies, since given the weight which has been attached to energy and food rises in the total inflation picture, once these (for so called base effect reasons) start to clock negative readings, headline inflation should start to sink back.




GDP Growth Remains Strong

The key question then is, of course, how much will Brazil's economic growth be negatively affected by falling commodity prices, and how much will it benefit from the easing back in inflation? In the short run this is a hard one to call (although I think in the longer run commodity prices are likely to remain relatively high, and this will be more to Brazil's advantage than anything, especially if the central bank can manage to squeeze second round inflation effects out of the system.

Brazil's economic growth actually accelerated in the second quarter, so at this point there is no great sign of any formidible slowdown.  Gross domestic product in fact was up 6.1 percent from a year earlier, beating all the main forecasts. Growth was fueled by a mixture of investments and exports, and was up from a revised 5.9 percent rate in the first quarter. The economy was also up 1.6% quarter on quarter, from the first quarter of 2008.

Capital investment in Q2 was up an annual 6.2 percent, the fastest pace since the second quarter of 1995. Household spending grew 6.7 percent after a 6.6 percent expansion in the first quarter. The volume of exports rose 5.1 percent, reversing a 21 percent decline in the first quarter.

Finance Minister Guido Mantega argued today that he expected Brazil's economic growth this year to be above the current government's 5 percent forecast. Mantega, who has to some extent been a critic of central bank rate increases, said economic growth wasn't stoking inflation because supply was keeping up with demand.

The Iara Field

Basically it is hard to see why some people are so pessimistic for the outlook on the Brazilian economy. The favourable demographic moment Brazil is facing in terms of the share of the population in the working age groups means there is plenty of available capacity, and the continuing development of Brazil's oil industry means that there should be a constant and adequate inward flow of capital.  As if to ram this point home, Petroleo Brasileiro, Brazil's state-controlled oil company (otherwise know as Petrobras), said yesterday that its Iara offshore field contains 3 billion to 4 billion barrels of oil, making it the second giant find in a year and offering enough oil on its own to keep Brazil supplied for up to five years.

The assessment  is the first estimate of recoverable oil since the discovery of the field was announced on Aug. 11. Petrobras  said in January its Jupiter field in the same region contained gas quantities similar to its Tupi area, the largest oil find in the Americas since 1976. Iara is in the Santos Basin to the north of Tupi, a 5 billion- to 8 billion-barrel field announced in November. If confirmed, Iara and Tupi, which sit in non-adjacent parts of the same exploration block, could almost double Brazil's 12.6 billion barrels of proven oil reserves. 

The Iara estimate is based on a well drilled in 2,230 meters (7,315 feet) of water. The final well depth is 6,080 meters. Petrobras has not said whether Iara is an extension of Tupi. Unleased and unexplored areas sit between the two fields. The block, named BM-S-11, is in two, non-contiguous parts. The Iara portion is less than a quarter the size of the Tupi portion, according to a map supplied by Petrobras.

The Outlook Is Solid

So my feeling is that within six months or so of the oil "cross-over" we should see the Brazilian economy really start to pick up speed again, and in particular we should see a strong rebound in industrial output. Brazil, remember, is still growing at a 6.4% annual rate, and while this may well drop back in Q3 and Q4, this velocity will quite possibly be attained again as the key emerging economies start to "break sweat" and head upwards towards their earlier strong upward paths. Brazil will be there amonst the leaders, as will India. But when the role call is taken, just who will be present and who will be absent is going to make interesting reading. 

Brazil Consumer Prices Fall In August According To The IGP-M Index

Brazil's broadest measure of inflation fell in August for the first time in more than two years, led by a larger-than-forecast drop in food prices. Consumer, construction and wholesale prices, as measured by the IGP-M price index, decreased 0.32 percent when compared with July.

The country's benchmark index for consumer prices showed a 6.23 percent increase for the 12 months through mid-August, the central bank said last week.

Today's report obviously doesn't mean that the central bank should ease up on its bid to contain inflation by raising interest rates, but it is, nonetheless, welcome news. Policy makers have raised interest rates three times since April, to 13 percent from a record low 11.25 percent, to slow inflation running near the 6.5 percent upper limit of its target range.

Policy makers, led by bank President Henrique Meirelles, are still expected to raise the key rate 0.75 percentage point for the second consecutive time at their Sept. 10 meeting, and the rate may yet reach 14.75 percent by the end of the year according to the consensus view.

A 30 percent monthly drop in the wholesale price of tomatoes led all food items lower, helping reverse a 1.76 percent increase in the IGP-M in July. The index is measured by the Rio de Janeiro-based Getulio Vargas Foundation.

Mid August Brazil Inflation Slows

Brazil's inflation through mid- August slowed for the second consecutive month, bolstering confidence that the central bank will bring consumer prices back to target next year. Brazil's inflation rate as measured by the benchmark IPCA-15 index decreased to a monthly 0.35 percent from a monthly 0.63 percent through mid- July as food prices eased, the national statistics agency said today.

Today's report showed that the annual inflation rate for the 12 months through mid-August slowed to 6.23 percent from 6.30 percent in mid-July. Month-on-Month food prices rose 0.25 percent, compared to 1.75 percent at the mid-July reading. Now we need to wait and see what the central bank decide to do about this.

Brazil Unemployment Rises In July

Brazil's unemployment rate unexpectedly rose to 8.1 percent in July from the previous month, the national statistics agency said today. Unemployment in Brazil's six largest metropolitan areas was up from 7.8 percent in June.

This is a surprising number since we saw seasonally adjusted year on year job creation of 184,000 in July, down from the even higher 250,000 registered in June, but still pretty healthy I would have thought, and 3-month average continued to move up from 172,000 to 182,000. In fact on an unadjusted basis Brazil added 203,218 government- registered jobs last month, the best July performance ever.

That was a 60 percent over the 126,992 formal jobs created in July 2007, Labor Minister Carlos Lupi said in a statement. Brazil will add a record 2 million new formal jobs in 2008, according to Lupi, compared to his forecast of 1.8 million made at the start of the year. Of course, we need to remember the demographics here, which while they are currently extremely favourable to Brazil do mean that a very large number of new jobs do need to be created just to soak up the waves of new labour market entrants.



Meantime Brazilian Finance Minister Guido Mantega reiterated yesterday that Brazil's reference Selic interest rate will only begin to fall when inflation approaches the 4.5% center-point of the government's annual target. Until this happens, only then will interest rates be reduced” Mantega said in a nationally broadcast radio interview. He added that Brazil’s retail inflation would end 2008 at between 6% and 6.5%. The official IPCA index ended July at a 12-month rate of 6.37% fuelled by food prices.

In the minutes of its July monetary policy meeting, the Central Bank said it would aim to bring inflation to the 4.5% center-point of the government's official target range by the end of 2009. Brazil's inflation targeting program permits a margin of tolerance of two percentage points on either side of the center point, allowing annual inflation up to 6.5%.

Current Account Deficit Increase


Brazil's annual current account deficit widened to a six-year high in July, reaching$19.5 billion over the previous 12 months period. This compared with an $18.1 billion annual deficit June. The July deficit was $2.1 billion.

At the present time inflows of foreign direct investment and investments in fixed income are more than enough to cover the deficit, but in the longer term the government and central bank need to work together to bring it under better control.

Where Now for Brazil?

By Claus Vistesen Copenhagen

In case you did not notice, the Eurozone recently slipped into a near recession and so did Japan. Together with an already limping and essentially recessionary US economy this has prompted some analysts to ponder the probability of a global recession or more aptly; a significant and serious widespread global slowdown. Nouriel Roubini, who recently got some fine words in the NYT by Stephen Mihm (hat tip: Stefan Karlsson), massages the probability of a global recession in a recent piece. This is a topic also taken up, in a US context, by Joachim Fels in his recent installment over at Morgan Stanley's Global Economic Forum.

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more.

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

• One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.
  

• The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?
  

I clearly have my bias and some have theirs; now let us wait and see what happens. It will be an important test for many hypotheses and views.

Notes

[1] - Although not so booming as of late.