Last week, we got the latest round of abysmal economic data out of Brazil. To summarize: GDP is in “free fall mode” (to quote Barclays), inflation hit double digits for the first time in over a decade, and unemployment soared to 7.9% in August, up sharply from just 4.3% a year earlier.
Put simply: it’s a full on economic meltdown.
The situation is made immeasurably worse by the country’s seemingly intractable political quagmire. The standoff between President Dilma Rousseff (who has been accused of cooking the fiscal books) and House Speaker Eduardo Cunha (who has been implicated in a kickback scheme tied to Petrobras) has led to a veritable stalemate that’s made it exceedingly difficult for Rousseff and her embattled finance minister Joaquim Levy to push through badly needed austerity measures.
Rousseff scored a victory on the austerity front on Wednesday when lawmakers approved her veto of a bill that would have raised retirement payments alongside the minimum wage, but this is an uphill battle and while incremental wins may be enough to give the beleaguered BRL some temporary respite, the medium- to long-term outlook is abysmal.
As Brazil continues to muddle through what has become a stagflationary nightmare, Barclays is out with a fresh look at the country’s debt dynamics and unsurprisingly, the picture isn’t pretty.
The road ahead depends on fiscal policy, Barclays begins, and that, given the current dynamic, is not a good thing. “Even if politics were uncomplicated and policy unconstrained, Brazil would still face enormous challenges adjusting to far less supportive local and global conditions,” the bank notes, referencing the now familiar laundry list of EM problems including slumping commodity prices, lackluster demand from China, the yuan deval (bye, bye trade competitiveness), and the incipient threat of a Fed hike and thus an even stronger USD.
“Investors are also grappling with the prospect of a prolonged, unsustainable fiscal policy framework,” Barclays adds.
And here’s Antonio Pascual doing his best Alberto Ramos impression by rattling off a comically long list of problems:
“Brazil is confronting a toxic combination of a primary budget deficit, high public debt (relative to EM countries), very high real interest rates (the Selic stands at 14.25%), sluggish trend growth, a negative commodity price shock and potential contingent liabilities for the sovereign, which together spell trouble for public debt dynamics.”
Yes they sure do “spell trouble for debt dynamics” and if the prospect of further imperiling the economy wasn’t enough to tie Copom’s hands, the relationship between public debt and rates leaves the central bank virtually paralyzed:
The combination of high debt/GDP and high interest rates means that Brazil suffers from ‘fiscal dominance’, a situation where monetary policy is driven by sovereign solvency concerns. Given the sensitivity of public debt to high interest rates in Brazil, the central bank is unlikely to tighten policy despite high inflation.
And even as Brazil doesn’t necessarily have an “original sin” problem (at least when it comes to public debt), the outlook is still rather dire:
How much time does Brazil have before markets push sovereign yields higher, accelerating the unsustainable debt dynamics? There are some important risk mitigants. Brazil’s debt is predominantly payable in local currency, and what is payable in foreign currency is covered many times over by its international reserves. The problem is that, by our estimates, public debt in Q4 2015 will be more than 71% of GDP with average funding costs at more than 12%, with no prospects for a turn-around towards a sustainable primary surplus or stronger growth prospects.
Going forward, “the prospects of success are bleak”:
The challenges of fiscal consolidation in Brazil are only beginning, and without policy changes, prospects of success are bleak.
In a stressed scenario, in which there is a lack of full Congress support and an unsuccessful asset sales program, we see the fiscal adjustment for 2016 amounting to only 1.0% of GDP.
This scenario is consistent with increased market pressure for the remainder of 2015 and 2016 (Figure 9). Market stress could increase, for example, due to a potential impeachment of the President, a loss of confidence in the fiscal outlook, and/or a significant increase in contingent liabilities. Our projection assumes that the primary balance worsens relative to our base case, reaching -2.3% of GDP in 2016. The deficit falls gradually thereafter but a deficit persists until 2019 (-0.5 percent).
The recession lasts for longer than in the base case, but inflation rises further because further BRL depreciation pushes actual inflation and inflation expectations higher. Inflation rises to 9% in 2015 and remains high (but gradually falls) thereafter. Interest rates rise 2pp more than in the base case in 2015 and 2016, as higher risk premia push up the cost of debt.
The end result, Barclays warns is that "in the stress scenario, debt/GDP rises to over 100% of GDP by 2020 and does not stabilise." And while the bank admits that "there are various negative developments compounding this scenario, including higher average interest rates and weaker growth," Barclays cautions that it "does not view [the] assumptions as unrealistic" given that for instance, the projection only assumes interest rates rising 200bp relative to the base case which "is half the increase in the cost of debt seen during the global financial crisis of 2008, and considerably less than the pressure seen in 2002 when the Selic rate rose by 800bp in less than six months."
What happens if the cost of debt rises in line with what we witnessed in 2008, you ask? This:
The chart depicts 40 paths for debt/GDP associated with increasingly higher interest rates in steps of 10bp, starting from the baseline path for debt/GDP to the last path corresponding to the baseline scenario for interest rates plus a 400bp shock. The shock is applied to the interest rate in the transition years, not to the steady state interest rate (set at 8%). The key takeaway is that as the cost of debt rises in the baseline scenario, public debt/GDP increases rapidly and stabilizes later relative to the base case. In the extreme case of a +400bp increase in the average cost of debt, the public debt/GDP ratio peaks at a whopping 114% in 2021.
So what's the takeaway besides the fact that Brazil is, for lack of a better word, screwed (because we already knew that)? Well remember, Brazil is representative of the problems facing EM as a whole. Slumping commodity prices, currency carnage, FX pass through inflation, sensitivity to decelerating Chinese demand and to Beijing’s yuan deval, Brazil has it all - they even have a seemingly intractable political crisis, and as we never tire of pointing out, idiosyncratic political risk factors have become an important part of the EM calculus (see Turkey and Malaysia for instance). In short, the country is a proxy for EM as a whole. With that in mind we close with what Barclays says are the wider implications of Brazil's deteriorating fiscal picture and challenging debt dynamics:
"The prospect of such deterioration is likely to lead to a further sell-off in Brazilian assets and could create contagion – especially to vulnerable EMs – given Brazil’s systemic importance."