Brazil

Slowdown - Comfort or Caution?

July 28, 2010

By Gray Newman | | New York

Just when you thought that the pace of Brazil's growth had somehow accelerated to an Asian pace,
something odd has happened: the economy has begun to show signs of a marked slowdown. Just a month
ago, Brazil's economy seemed to be at risk of overheating: GDP had risen by 11.4% in real terms in the first
quarter. The central bank, which had first warned of "signs of overheating" in April when it hiked its policy
interest rate by 75bp, repeated its diagnosis of overheating in mid-June when it followed up with another 75bp
hike to 10.25%.

We moved our Brazil GDP forecast for 2010 up to 6.8% in late April and again to 7.9% in June, citing
signs of a "red hot" economy (see "Brazil: Red-Hot" and "Brazil: Going Strong" in This Week in Latin
America, April 26 and June 14, 2010, respectively). The market consensus also climbed sharply month by
month this year.

After GDP grew at an annualized pace of 11.4% in the first quarter, real GDP growth seems set to slow
to closer to 4-5% in the second quarter. The most striking evidence came from the central bank's relatively
new monthly GDP proxy, which showed that the economy stalled out in May, posting no growth (0%)
compared to the previous month - the first such monthly reading after an uninterrupted string of sequential
positive readings during nearly a year-and-a-half.

Reason to worry? I've been told not to worry by almost everyone I have spoken to in Brazil where I've spent
the first half of the month. When I raised the subject of an unusually pronounced slowdown forming, I've
received pushback on three fronts.

A Valid Proxy?

The first pushback I received is from those arguing that there simply wasn't much evidence of a
slowdown. After all, if you look at May's GDP proxy, it rose by 9.8% compared with the previous year.
Year-over-year comparisons, however, are of little value if faced with a turning point ahead and a deep
downturn and recovery from the previous year. A more sophisticated version of this first pushback questions
the validity of the GDP proxy. After all, the argument goes, it is only one data point.

I'd be very hesitant to highlight the central bank's May GDP proxy if it appeared to be an isolated data
point - but it isn't. Instead, there are mounting signs that activity - at least among industrialists - suffered a
downturn in May that appears to be repeated in June. Industrial output was flat in May (0%) and that came
after a 0.8% decline in April. The weakness in output stands in sharp contrast with a largely unbroken series
of sequential improvement. (The only other negative reading during the past year-and-a-half took place in
November 2009, and that appeared to be due to a refinery that was out of service.) May's IP weakness
showed up in refining again, but also spread to other areas such as food processors.

Is there a risk that the central bank's GDP proxy exaggerates the importance of (more easily identifiable)
sectors such as industrial production over (more difficult to measure) sectors such as services? This is
certainly a persistent problem, not only in Brazil, but also throughout many emerging economies. Still, a
review of the series' relatively short life-span suggests that the GDP proxy matches up fairly closely with the
quarterly GDP report by Brazil's national statistics institute and, more importantly, the GDP series showed a
much less pronounced decline in late 2008 and a much more rapid recovery in 2009 than did industrial output.
The two series are not mere mirror images.

Indeed, even retail sales, while up 1.4% in May (compared with April), had still not recovered to March levels
- after a sharp 3.1% drop-off in April. Again, this is the first such bout of weakness in the series since the time
of the Great Recession a year-and-a-half ago.

And the first signs of activity in June suggest another weak month, with monthly GDP possibly even
turning negative. Corrugated paper, used for packaging and closely linked to manufacturing shipments, fell
by 3.4% in June, as did auto production. Other indicators for the month - from traffic on toll roads to
electricity usage - suggest a sluggish June at best.
Of course, while a handful of the first warnings signs are emerging on the production side, consumer
confidence - buoyed by wage gains and good employment growth - remains high in the latest surveys released
in July.

Fiscal Stimulus Withdrawn?

The second pushback I have received regarding my concerns over the second quarter slowdown is that
it is temporary and a one-off result of a removal of fiscal stimulus during 1Q10. At the beginning of the
year (for white goods) and then in March (for automobiles), the authorities ended special tax incentives which
had been designed to help lessen the blow to Brazil's consumer during the weakness of 2009. If you open the
headline retail sales data, it seems clear that consumers brought forward their purchases of white goods;
moreover, in the broader retail sales measure (which includes automobile purchases), there is a clear drop in
auto sales in April after the tax breaks ended. There seems little doubt that consumers anticipated the end of
the tax incentives and accelerated consumption in 1Q. That, in turn, may have contributed to some of the
robust pace in 1Q when GDP accelerated to post an 11.4% annualized pace, up from a 9.3% pace in 4Q09.

If GDP were tracking 8% or 9% in 2Q, I'd be more inclined to accept the notion that the 1Q report was an
aberration. But when the pace of activity moves from 11.4% in 1Q to closer to 4% or 5% in 2Q, I'm skeptical
that the move can simply be explained away by the end of a handful of tax incentives. The tax incentives
removed in the first months of 2010 accounted for roughly R$15 billion or 0.5% of GDP.

More importantly, the overall fiscal stance of the government remains stimulative, even with the end of
certain targeted tax relief programs. If you look at revenues raised and spending executed, there has been
no meaningful slowdown in fiscal stimulus. Indeed, overall spending in May was higher whether measured in
local currency terms or as a percentage of GDP. And a combination of a new 7.7% hike in pensions in July
along with other transfers seems set to produce ample fiscal stimulus during the second half of the year,
despite such restrictions on spending in 2H in the run-up to the elections.

Indeed, a review of industrial output suggests that the slowdown is spreading among sectors. A diffusion
index shows a steady deterioration in recent months - the number of sectors posting positive growth peaked
earlier this year and is slowly declining. The broadening of the number of sectors not showing an uptick in
growth suggests that something beyond white goods and autos is driving the slowdown.

Don't Worry, Be Happy

Finally, I hear that the slowdown is precisely what Brazil needs: a turn away from the risk of
overheating that was mounting late last year and appeared to come to the fore during 1Q. I'd be much
less concerned if I thought I understood what was driving the apparent sharp slowing in growth. If it was
simply a result of fiscal stimulus being withdrawn or the response to some other policy action, then I'd agree
with the assessment that the move to slower growth is laudable. But the fact that the slowdown is taking place
even as overall public spending appears to be as stimulative in the second quarter as it was at the end of the
previous year leaves me puzzled.

Could it be that we are seeing some sign of a global synchronization of business cycles? I don't want to
push this point until I've had a chance to study the evidence of what explained weakness in other major
emerging economies during the course of 2Q. It is interesting to note that business confidence in Brazil
appears to have turned down sharply in July. According to the most recent survey by the manufacturing
association (CNI), the drop, at 2.6 points, to 63.4 was the largest one-month drop since the beginning of the
downturn in 2008 (and stands in contrast with upbeat consumer confidence surveys).

Another business survey, with data through June, shows that while Brazilian businesses remain upbeat
regarding current conditions, there has been a steady deterioration regarding expected conditions later
in the year and into next year. It is conceivable that Brazilian companies have looked at international
developments and decided that the recent inventory build-up, while adequate if demand remains strong, could
turn excessive if global conditions continue to deteriorate. That kind of softening in production could morph
into a self-fulfilling prophecy.

Ch-Ch-Ch-Changes...

I'm not willing to change our full-year GDP estimate at the present. Because of the double-digit 11.4%
reading in 1Q, it will take an important slowing of the pace of growth to reach our 7.9% forecast for average
growth in 2010. But perhaps more importantly, I'm keeping our growth forecast for 2010 unchanged at this
time because I am puzzled as to what is driving the sudden slowing seen in 2Q.

I suspect that an important part of the move in GDP growth from 9.3% in 4Q09 to 11.4% in 1Q10 can be
explained by an acceleration of purchases, particularly on the auto and durable goods front. That acceleration
undoubtedly played some role in the slowing in 2Q. But I also suspect that Brazil's business cycle is showing
that it is more closely linked to the global cycle as well.

And that may mean that the conventional wisdom in Brazil - split between those that ignore the slowdown
and those that see it as policy-induced or temporary but a healthy move to ‘Goldilocks' - could be
disappointed. At the very least, a careful examination of the real economy data in the coming months is
warranted.

However, a change to our interest rate forecast is inevitable after the central bank hiked the policy Selic
rate by only 50bp to 10.75% on July 21, pitting the central bank against virtually all of the economists who
had called (as did we) for a 75bp hike to 11% this past week. Indeed, up until the week before the central
bank's decision, the interest rate market was almost unanimous in calling for a 75bp hike. (An unusual ‘quiet
period' saw a sharp change in market pricing - but not economists' forecasts - towards a 50bp move during the
course of five trading sessions.)

While we will get greater clarity with the release of the minutes on Thursday, July 29, I suspect that the
central bank will pave the way for a 25bp move at the time of its next decision on September 1, bringing
rates to 11%. We have previously thought the year would end with a 75bp hike in July (50bp were
delivered) and 75bp in September. The sudden change in the central bank's pace - the June quarterly inflation
report and statements by the central bank all pointed towards a 75bp move in July - suggests, I suspect, a
rethinking of the pace of growth in Brazil. Like us, the central bank is likely to be puzzled and is likely to
point to the combination of better inflation prints of late, a slowing in growth and continued uncertainty in
external demand to bring to a close the rate-hiking cycle in 2010 at a lower pace. We now expect the policy
rate to end 2010 at 11% (versus our previous call for 11.75%). We still expect the central bank - that is, the
next central bank once new leadership is appointed by the new administration in January - to have to restart
interest rate hikes in 2011, with rates heading to above 12%.

Bottom Line

After the overheating scare at the beginning of the year, I'd like to be the first one to welcome the newly
uncovered evidence in recent weeks that the pace of growth is slowing in Brazil. A slower pace of growth
should ease both inflation pressures and the scope of central bank tightening. It also should reduce the risk of
a greater imbalance in Brazil's external accounts. There is only one problem: it is not clear precisely what is
driving the slowdown.

While the conventional wisdom in Brazil seems to be forming that this is either a temporary blip or a
much-needed response to policy tightening, I find neither explanation fully convincing. Until we have a
clearer understanding of what is driving Brazil's slowdown, the slowing in the pace of growth in Brazil remains
part mystery and hence reason for caution as much as for comfort.