Brazil: Deindustrialization, Japanification and Beyond

Brazil’s peripatetic, globetrotting elite brought home the COVID-19 virus.  In late January, a tourist returning from vacation in Lombardy was found to have contracted the virus . Yet, Latam Airlines did not cancel its daily flight from Sao Paolo to Milan until March 2, and thousands more passengers flew  from Milan to Sao Paolo through connecting flights. The viruses first Brazilian victims were treated in Sao Paolo’s world-class private hospitals, and social distancing and sheltering-in-place polices imposed by city governments were readily adhered to in the posh neighborhoods of Sao Paulo and Rio de Janeiro. Many of these people easily adapted to working online, enjoying relief from the usual traffic jams. Then, the pandemic ran into the reality of Brazil: a vast majority of the population lives day-to-day with no savings, no safety net and in precarious living conditions which are not suited to social distancing.

As elsewhere, in Brazil the pandemic has  worsened what were already fragile conditions.

In Brazil, like in the U.S. where educated coastal elites are more supportive of behavioral restrictions than the less educated and poorer small town and rural inhabitants of the “fly-over” states,  the gap between the “enlightened” elite and the “ignorant” masses has been accentuated. The pandemic has become intertwined with the “class warfare” of contemporary politics. President Jair Bolsonaro has infuriated the elites and the media by taking the side of the masses, a stance that is influenced by an evangelical “come-what-may, God-willing” view of the world.

More importantly, Bolsonaro is deeply worried about his political survival. Abhorred by Brazil’s media and intellectual establishment for his reactionary views on social issues and without broad support in Congress, Bolsonaro had been banking on a vigorous economic recovery this year after five years of recession. Instead, the pandemic is expected to cause Brazil’s worst downturn in a century. Moreover, this latest crisis will leave Brazil’s finances in tatters, seriously undermining its growth path in the future.

Over the past three decades Brazil has already undergone a process of severe, premature de-industrialization. Aside from a buoyant agro-industry, the economy has come to depend heavily on basic services and an increasingly bloated financial sector. Now, the expected increase in government debt may condemn Brazil to a state of “Japanification,” where the economy’s potential growth rate falls well below the level necessary to promote social well-being and political stability.

As the chart below based on BIS data shows, Brazil has increased its debt-to-GDP ratio at a reckless pace in recent years. A combination of recession, fiscal incontinence and extremely high interest rates pursued by the  Central Bank in a bout of radical orthodoxy pushed the ratio from  130% to 163% from 2014 to the end of 2019. This is an already enormous increase, but based on current projections, the ratio may reach 176% by year-end 2020.  All of these increases have come from the expansion of government debt, which by itself  will reach the critically important level of 100% this year.

These are very high levels of debt by any standards, and unsustainable levels for a country with a chronic lack of savings like Brazil. The experience of savings-poor emerging market countries is shown in the chart below. There is no case of a country reaching these levels of debt without having to go through an extended period of deleveraging, either through default, austerity or financial repression.

Unfortunately, almost none of this debt accumulation in Brazil has been or will be directed to investment. Instead, it has served to pay current expenses, pensions and interest payments. The following chart, based on IMF data, shows the extremely low and declining levels of fixed asset investments in Brazil as compared to other “savings-poor” countries.

Fortunately, unlike Argentina or Turkey, most of Brazil’s debt is denominated in local currency, reais (BRL). This means that the default route is unnecessary. In addition, after another lost decade of growth, austerity is not politically viable. Therefore, the only remaining path towards regaining public investment capacity and  to “crowd-in” private investments,  will be some form of financial repression. This will require an extended period of interest rates well below the growth in nominal GDP, which in turn can only be achieved by mandatory credit allocation schemes and some-form of capital controls. The irony is that these policies are anathema to the current finance minister who advocates for the Chicago School free-market policies which were popular in the 1980s and followed with some early success by Chile. Nevertheless, the markets are probably sniffing out that financial repression is unavoidable, as can be seen by the persistent capital flight, shown in the chart below.

Given the chaos of the current triple crisis (health, economic and political), no coherent policy framework can be expected out of Brasilia anytime soon. However, sooner or later a new economic regime will emerge.