Category: Brazil

Chinese Auto Exports Threaten the Auto Industry Worldwide

Benefiting from technology transfers from multinationals and massive government subsidies, China has made itself the dominant force in the automotive industry over the past two decades. It has achieved this supremacy at a time when the industry is undergoing the most significant technological shift in 70 years: the transition from the internal combustion engine (ICE) to the electric motor. China had the foresight to anticipate this transition and leapfrog to the forefront of EV (Electric Vehicle) technology by harnessing subsidies and private capital. However, given the current reality of global geopolitical conflict and economic stagnation, China’s dominance of this critical industry may increasingly be seen by many countries as an unacceptable strategic and security threat.

Since the launch of Ford’s Model T in 1908, the automobile industry has been at the forefront of mass production manufacturing. By the 1950s, when the industry reached its peak impact on the American economy, the industry’s core technologies had been developed, and it entered its maturity stage. Since 1960, auto manufacturing has barely grown in the U.S., and the leading firms in the industry focused on disseminating their mass production skills around the world, a process that culminated with major multinational auto companies setting up plants in China between 1984 and 2004.

The chart below shows the auto industry’s annual growth rate since the 1950s. Global growth peaked in the 1960s, driven by Europe, Japan, and Latin America, and then has fallen every decade, except during the 2000s because of the precipitous rise in Chinese domestic demand. Growth for the twelve-year period ending in 2022 has been at a record-low 0.8% annually, despite a 50% increase in China’s output. U.S. production growth stalled much earlier, already in the 1950s, and only recovered in the 1980s and 1990s because protectionist policies were introduced to force foreign firms to make their cars in the U.S. There has been no increase in U.S. output since 1990.

The decline of the U.S. as a manufacturer of motor vehicles and the rise of China can be seen in the following chart (source: OICA, International Organization of Motor Vehicle Manufacturers). The U.S. emerged from World War II with nearly 80% of world output, was overtaken by Japan in the 1980s and 1990s, bottomed at a 10% share in 2010, and in 2022 had a 12% share. Since 1990, when the first joint-ventures with foreign firms began operating, China has grown its share of world output from 1% to 32%. The dominance of China in EV manufacturing is even more pronounced, reaching 59% of world output in 2022, compared to 19% for the United States. Germany, Japan, and South Korea followed, with shares of around 10%, 8%, and 6%, respectively (Canalys).

The following two charts show emerging market producers: first, mature players (Mexico, Brazil, Korea); and second, newcomers still enjoying growth (India, Indonesia, Thailand, Turkey, and Eastern Europe). Brazil’s share of global output peaked in 2010 but is now below 1980 levels. Mexico, despite NAFTA, is back to the level of 1990. Korea is also losing global share. In the case of countries growing their share of the global automotive pie, India and Eastern Europe stand out. Indian manufacturers benefit from trade protectionism (70% tariffs) and rapid economic growth. Eastern Europe has taken advantage of favorable EEU (Eurasian Economic Union) policies allowing firms to move production to places with lower wages.

The Market’s Reaction to the Inception of Chinese Vehicle Exports

The slowdown of China’s economy and low consumer confidence, combined with sustained investment in new production capacity, has caused excess manufacturing capacity and a surge in Chinese motor vehicle exports over the past two years. According to the China Association of Automobile Manufacturers, domestic sales of ICE (Internal Combustion Engine) vehicles peaked at 2.4 million monthly in 2018 and are now running at a monthly rate of 1.6 million, 36% lower. Exports of ICE cars have surged and are expected to reach 3.2 million units in 2023, an increase of 45% over 2022 levels. EV exports may reach 1 million units this year, a 60% increase. Remarkably, in three years, China has gone from almost no participation in auto exports to the leading position. China surpassed Korea in 2021, Germany in 2022, and long-time export leader Japan in 2023.

In the case of ICE cars, most of these exports are going to Russia, Eastern Europe, and developing countries in Asia and Latin America, undermining the competitiveness of manufacturers in those regions. EVs are mainly exported to more developed regions, such as Europe, which have high “climate change” incentives for EV sales, but this is also changing fast. For example, BYD has had enormous success exporting electrical buses to major emerging market metropolitan areas suffering from high pollution levels.

China’s increasing EV exports are creating a huge dilemma for traditional auto manufacturing countries around the world. In Europe, politicians are committed to promoting EVs but are also determined to support an important domestic industry that needs time to navigate the transition to EV technologies. This week the European Commission launched an anti-subsidy probe into EVs coming from China, aiming to protect European firms from “competitors benefiting from huge state subsidies.”

The situation today is different than in the 1980s when Japanese firms were required to build their cars in the U.S. At that time, the Japanese, a key strategic ally which had outcompeted U.S. firms with marginal improvements in manufacturing efficiency (just-in-time process) and better quality, were pressured into accepting a political concession. Today, Xi’s China is a strategic geopolitical adversary competing with “unfair” advantages and seeking dominion in a frontier technology of critical economic, social, and ecological importance.

Developing countries face, perhaps, even bigger challenges. Countries with long-established automotive industries cannot sustain competition from China’s ultra-competitive, modern, and highly subsidized auto sector, and, even in a best-case scenario, would lose regional customers in markets without the industrial base. For example, in Chile, a country that imports all of its cars, China has captured 40% of the market over the past few years. Half of the car models available for sale in Ecuador are Chinese, and these brands have captured nearly half the market since 2020. Also, China’s BYD has captured half of the bus markets of Santiago and Bogota with its electric buses over the past five years.

Moreover, any shift to EVs implies the importation of batteries and motors, which leaves only minimal value-added in final assembly. EVs also pose a mortal threat to local part suppliers that are an intrinsic part of the ICE value chain. The shift to EVs implies a transition from a mature industry with processes and technologies fully assimilated by countries like Brazil and Mexico to an industry on the technological frontier, which these countries have little hope of dominating.

 

If China’s Boom is Over, Where Will Demand for Commodities Come From?

China’s economy has experienced a multi-decade period of high growth, similar to “miracle” surges previously witnessed by other countries. Today’s wealthy nations once went through these surges as well: the U.K., the U.S., and Germany in the late 19th century; and Japan in the early 20th century and again in the 1960s. Various developing countries have also seen periods of so-called “miracle” growth, such as Brazil and Mexico in the 1960s, and Korea, Taiwan, and Malaysia since the 1970s, with China starting its own in the 1990s. A significant contributor to these periods of accelerated growth is a broad and powerful one-time build-out of physical infrastructure. This will be especially true in China, which has witnessed one of the greatest construction booms in history.

The amount of infrastructure investment undertaken by China is breathtaking. For example, Shanghai had four crossings of the Huangpu River in 1980 and now boasts 17. Shanghai did not possess a subway system in 1980, and now it encompasses over 800 kilometers of lines, making it the world’s longest. China claims eight of the top ten longest subway systems globally, with a total extension of 9,700 kilometers across 45 cities. In comparison, the U.S. has 1,400 km of subway lines in 16 cities. Since 2000, China has constructed 38,000 km of high-speed train lines, more than tripling the amount built by Europe since 1980. China’s National Trunk Highway System, primarily built over the past 20 years, now totals 160,000 km, compared to the 70,000 km of the U.S. Interstate Highway System.

China’s construction boom over the past decades can be measured by its share of the world’s production of basic building materials. For example, China consistently produced more than half of the total world cement output over the past decade, securing 56% in 2019. China also commands a similar share of the world’s steel output, reaching 57% in 2020, according to the American Iron and Steel Institute (AISI). The chart below illustrates China’s increasing share of world steel output, surpassing the level the U.S. had at the end of World War II.

The following chart displays steel output since 1950, with China’s ramp-up beginning in 2000.

Major infrastructure expansions do not need to be repeated. For instance, New York City’s infrastructure (bridges, tunnels, highways, subway system) was largely completed by the 1920s, and the bulk of the U.S. highway system was constructed between 1959 and 1972. The London Underground and the Paris Metro were built before the First World War, and France established most of Europe’s best high-speed train network between 1980 and 2000. The chart below illustrates this historical process and how it has impacted the production of steel in countries undergoing these surges in investment. Steel production surged in Europe in the late 19th century (railroads, steamboats, bridges, etc.) and again in the 1920s and 1930s (automobile infrastructure) and finally in the post-World War II “Golden Years.” The U.S. followed a similar path but also had a massive expansion of automobile infrastructure in the 1950-1970 period due to suburbanization and interstate highways. Brazil experienced an infrastructure boom in the 1960-1980 period, as did Korea in the 1970s. Invariably, these booms come to an end, and steel output plateaus, tapers, and eventually decreases.

The following table presents this data in percentage terms, with the total increase in steel output for the previous ten years. The data shows that multi-decade expansions in steel output are not uncommon: Europe and Japan (1970-1900); U.S. (1970-1940); Japan (1930-1970); Germany (1950-1980); Brazil (1950-1990); and Korea (1950-2010). China has been expanding steel output since the 1950s, which provided a high base for the mammoth expansion since 1980. India has been growing output at a swift rate even before reforms were launched in the 1980s, and it is already, with over 100 million in annual steel output, at a much higher level than China was when it started its “miracle” phase of economic growth.

Eighty-seven percent of the increase in world steel production over the past 22 years occurred in China, raising the question of which countries can pick up the slack if China’s construction boom is over. The hope is that India and emerging Southeast Asia can step up. Assuming China’s steel output remains flat, to maintain the 3.5% annual increase in global steel demand of the past twenty years, it will be necessary for India, Vietnam, Indonesia, and a few more high-growth economies to more than double their steel output every decade.

 

The Persistent Decline of Latin American Competitiveness

In a globalized world, capital will flow to the countries that provide the best conditions for businesses to operate. The IMD business school in Lausanne, Switzerland conducts a survey annually to measure how well governments  “provide an environment characterized by efficient infrastructures, institutions, and policies that encourage sustainable value creation by enterprises.” This survey is particularly significant because previous efforts by the World Bank (Doing Business) and the World Economic Forum (World Competitiveness Report) have been abandoned. The latest editition of the IMD World Competitiveness Report provides more damning evidence of the poor performance of many emerging markets, particulalry those in Latin America.

The IMD survey focuses on the 64 countries considered most relevant for multinational businesses. The latest rankings are shown in the chart below. Of the 15 largest countries in the MSCI Emerging Markets Index, only seven make it in the top half of the rankings (Taiwan, Saudi Arabia, UAE, China, Malaysia, Korea and Thailand). The two  in the top quintile (Taiwan and UAE) are rich countries, only included in the EM Index because of market access issues. On the other hand, in the bottom quintile, there are eight EM countries (Philippines, Peru, Mexico, Colombia, Brazil, South Africa, Argentina and Venezuela). Every Latin American country, except for Chile,  is in the bottom quintile, and four are in the bottom decile (Colombia, Brazil, Argentina and Venezuela. (Latin American countries are in bold and remaining EM countries in red)

The poor performance of Latin America has worsened over time. This can be seen in the following chart that shows IMD rankings since 1997 in decile form. There is a pronounced deterioration in the region’s rankings over this period, particularly after the commodity boom of the mid-2000s and the Great Financial Crisis. The decline of Argentina, Brazil and Chile, all commodity producers suffering from acute “Dutch Disease” (the commodity curse), is most pronounced, but even Mexico with the great advantage of NAFTA, has done poorly over the past ten years.

In addition to the devastating effects of the boom-to-bust commodity boom (2002-2012), the region suffers from multiple ills.

  • Political turbulence throughout the region, with the important exception of Mexico.
  • Poorly designed economic policies, often anti-business and generally poorly executed and unsustained.
  • Rampant capital flight, as elites and middle classes seek the security of Miami, Lisbon, Dallas, Punta del Este, etc…
  • The onslaught of Asian mercantilists, dumping manufactured goods in Latin American domestic markets.
  • Rising wealth inequality, as governments are unable to formulate and/or execute policies to provide employment or income to large segments of the population.

 

The Beautiful Deleveraging From Financial Repression

Historically, the most effective manner to reduce excess debts held by the government and the public at large has been to inflate it away. This tool has been successfully implemented both by emerging markets and developing countries, most significantly by the U.S. during the 1950s. We see it at work once again today in a big way, with some countries making remarkable progress at reducing debt levels.

Financial repression consists of imposing negative real returns on the holders of fixed income securities by allowing inflation to be higher than interest rates. This can be done either through Central Bank monetary policy or by regulators forcing financial agents to hold unattractive securities. The winners in this game are the debtors at the expense of the creditors, which can lead to a significant redistribution of wealth.  For example, the archetypical old lady living off interest payments suffers badly, while the millennial with a fixed mortgage gains handsomely. Governments with high debt levels are big winners.

The chart below shows the one-year evolution of total debt to GDP (left side) and government debt to GDP (right side) for a broad group of emerging market and developed economies, based on Bank For International Settlements (BIS) data through December 2022. These numbers show the remarkable different paths countries have taken over this period. Most remarkably, highly indebted countries in Europe (UK, Spain, Italy) have achieved large reductions in total debt to GDP ratios through financial repression. For example, negative interest rates in the UK have brought the total debt to GDP ratio down by 52.4 percentage points, from 297.5% to 245.1%, and government debt to GDP, from 134.2% to 93.7%.  British monetary authorities must be delighted at the result of their policies, which they have continued to pursue through the first semester of 2023. China, on the other hand, with massive debt accumulating at a  furious pace, saw its total debt to GDP ratio rise from 285.1% to 297.2% and government debt to GDP rise from 71.7% to 77.7%, mainly because overcapacity and malinvestment have persistent deflationary effects.

In emerging markets, most countries have benefited from financial repression. In addition to China, Korea, South Africa and Argentina can be singled out as countries with rising debt ratios over the past year.

Unfortunately, this positive effect from financial repression may not persist for all. Continued winners in 2023 include the UK, the U.S. and the Euro area, all of which continue with negative interest rates while pretending to execute tight monetary policies. However, countries like Brazil now have very high real interest rates and are seeing renewed increases in debt ratios.

Brazil’s debt ratios increased in the 4th quarter of 2022 and will surge through 2023 unless the Central Bank  changes its current ultra-orthodox posture, repeating the policy mistake of the 2015-2019 period when high real rates led to a ramp up of debt levels, as shown below.

A New Path for Industrial Policy in Brazil

In recent decades, very few developing countries have reduced the income gap with rich nations, and those that have are either in East Asia or Eastern Europe. The successful “climbers” have prospered by integrating themselves into an increasingly globalized economy, gradually increasing the volumes and complexity of their exports. The “laggards” across the developing world have typically suffered from economic and political instability and shunned the competition of global markets. Brazil, the “poster child” for the laggards, has been stuck in a “middle-income trap” for over thirty years, caused by public policy errors resulting from political dynamics.

Since the 1980s “lost decade” Brazil’s politicians have pursued “distributional politics” aimed at correcting wealth disparities between regions and social classes. The previous model (like China’s current model), which for three decades (1950-1980) had been aimed at building mass production manufacturing and infrastructure, was largely discarded as inefficient and costly.

The new development model for Brazil, still very much extant today, has been driven by the “Welfare” Constitution of 1988 that imposed an extreme form of federalism which gives scarcely populated states enormously disproportionate representation in both chambers of Congress.

Unlike the successful economies of Asia and Easter Europe, since the 1980s Brazil’s industrial policy has been inward looking and aimed directly at achieving social objectives instead of economic results. The main goal of industrial policy has been to relocate industrial activity from rich states to poor states by providing abundant tax incentives to investors. The result has been the hugely wasteful Manaus Economic Free Zone and some uneconomic and nonproductive relocation of manufacturing facilities from the south to the north. Consequently, since 1980, Brazil has gone from being the prominent industrial nation in the developing world to a minor player undergoing large-scale deindustrialization.

The major winner from federal political dynamics has been the farm sector which is broadly diffused geographically in states with low population density. In this case the policies have led to massive increases in output and productivity.

In essence, Brazil’s farm sector is a disguised “Asian Tiger.”  Like in Asia, government support for Brazil’s farmers has been broad and extensive and consistent for decades. In addition to substantial fiscal, credit and export subsidies, the sector has benefitted greatly from the work of the national Brazilian Agricultural Research Corporation (Embrapa), which is widely recognized as a global leader in tropical agriculture research and has been instrumental in boosting crop productivity. Furthermore, the farm sector benefits from two more characteristics integral to the “East-Asian” development model. First, domestic competition is acute, therefore, even though state support is available to all, only the most productive farmers can thrive.  Second, because agricultural commodity markets are global in nature, the sector is export driven. This means that Brazilian farmers compete with American farmers and must remain at the forefront of technological innovation.

Unfortunately, the farm sector is not a good substitute for industry. In contrast to the job creation, work training and other multiplier effects that are integral to Asian industrial policy, the farm sector in Brazil is highly capital and technology intensive and does not generate many jobs or ancillary economic activity. Also, its success has significantly increased the commodity dependence of the Brazilian economy and led to a structural appreciation of the Brazilian real. Finally, this commodity dependence generates economic and currency instability which further undermines the competitiveness of the manufacturing sector.

The challenge for Brazil is to find new growth sectors which can secure sustainable political support and lead to productive investments that generate quality jobs. The markets are very skeptical that this can be done.

A brief effort at industrial policy during the first Lula Administration collapsed under mismanagement and corruption and was followed by an equally brief romance with neoliberal policies under Bolsonaro.

Lula’s return to power this year has revived talk of industrial policy in Brazil, abetted by a shift away from neoliberalism in the United States and China’s aggressive state-led push to achieve industrial self-sufficiency in all “strategic” industries. Unsurprisingly, given Lula’s track record, market skepticism is high. Initial signs from the new government do not give much hope. The best that the new administration has come up with so far is a hare-brained scheme to provide temporary subsidies for purchases of automobiles.

Any viable industrial policy will need broad and sustainable political support in Congress. This means that the benefits must be broadly distributed geographically. Unfortunately, Lula’s atavistic vision of development is rooted in the state-led, capital-intensive model of the 1970s (e.g. Petrobras leading investments in refining and infrastructure).

A better approach would be to focus on strategies that have been successful in other countries: tourism and “green” energy, for example. Building a national consensus with political support to provide long-term  incentives for private businesses to invest in tourism and alternative energy could set Brazil on a new growth path. Policies should be structured so that  investors face both domestic and foreign competition to weed out the weaker players.

These are two sectors that are labor intensive and with potential for broad geographical dispersion of benefits. Brazil’s woefully underdeveloped tourism industry can learn from countries like Mexico and the Dominican Republic. In the case of alternative energy, the policies pursued by the Biden Administration in the U.S., the roll out of wind and solar capacity in Texas and initiatives pursued in many other countries can be copied. The roll out of wind and solar energy in Texas is highly relevant, as Brazil has outstanding conditions  to do this, with many locations in poor states. 150,000 well-paid clean energy jobs have been created in Texas over the past eight years and the sector is growing fast.

Mexico’s Bull Run

Despite the antics, the atavistic fondness for state intervention and control, and the frequent attacks on both local and foreign business interests, Mexico’s populist leader Andres Manuel Lopes Obrador (AMLO) is presiding over the country’s best financial markets  in years.

AMLO can be credited for a sound fiscal policy and for letting the orthodox  Central Bank  do its job. This hasn’t resulted in better economic growth but it has allowed for a more stable economy than most of Mexico’s peers around emerging markets. However, the main cause for market enthusiasm seems to be the hope that Mexico will be a major beneficiary of  “friend-shoring” investments, as global manufacturers look for ways to diversify away from China.

The performance of Mexican assets has been remarkable. As shown below, the Mexican peso is the strongest currency in the world for the past one and three years,  periods marked by considerable chaos in currency markets in many other emerging markets

The Mexican stock market also has done exceptionally well, as shown in the chart below. The Bolsa is a top performer for both the past one and three years. For the past five years it is near the top, surpassed mainly by tech-heavy markets (U.S., Taiwan,  Netherlands, Denmark). This is impressive given that Mexico does not have a tech sector.

The current sectorial composition of the Mexican market relative to other markets is shown below.  A characteristic of the Mexican market is the high weight of defensive stocks, mainly consumer oriented telecom, food and retailing businesses. Unlike in most other emerging markets, the Bolsa is not dominated by state companies or mature cyclicals, but rather by well managed private concerns. The combination of a stable economy and well-managed private companies is a rarity in emerging markets.

The ten largest stocks in the MSCI Mexico index are listed below. With the possible exceptions of Banorte and Cemex, these are profitable world class companies with dominant market positions, all trading at near all-time high stock prices.

After this impressive bull run, what are the prospects for the Mexican market?

It should be noted that both the currency and stock prices started this run at low levels in both relative and absolute terms. As the chart below shows, Mexico’s Real Effective Exchange Rate was at historically low levels in 2019, and it remains competitive today. Over the past 20 years the peso has been managed like an Asian currency, for stability and export competitiveness. The Brazilian REER,  shown for contrast, is much more volatile, which causes havoc for managing the current account and promoting manufacturing exports.

 

The next chart shows that the cyclically-adjusted price earnings ratio (CAPE)  for Mexico was at historically low levels in 2019, and the PE ratio was well below trend. The CAPE ratio has now normalized but is still far from stretched.

Mexico’s CAPE ratio based on expected earnings for 2023 is currently at 17.2 which is in line with the country’s average for the past three decades. As shown below, based on historical returns, prospects for future seven- and ten-year returns are moderately positive.

 

Bull runs are not usually stopped by valuation concerns. Along with India, Mexico may continue to be one of the few large emerging market with a credible narrative and the capacity to absorb foreign capital. Nevertheless, in coming years, investors will need to see “Friend-shoring” capital flows go from hope to reality to sustain the Mexico story.

 

 

 

 

 

 

Growth and Economic Complexity

Rich countries have complex economies, and poor countries get richer by increasing the technological content of what they produce. This requires many things, such as good institutions (e.g., law and order, property rights) as well as an educated population and research institutions that drive innovation. The Atlas of Economic Complexity (AEC) , a joint project of the Massachusetts Institute of Technology and Harvard University, provides  insight into the progress countries around the world are making towards increasing their innovative capacity by measuring the degree of complexity and diversity of what they produce for global markets.

The work of the AEC was summarized in the 2011 book The Atlas Of Economic Complexity: Mapping Paths To Prosperity,  by Ricardo Haussman and Cesar Hidalgo, and it is  periodically updated by the Harvard Growth Lab (link) and the Observatory of Economic Complexity (link). The AEC solves the complex problem of measuring technological advancement by focusing on the degree of complexity and the diversity of a country’s exports and comparing this over time and with trading partners.

The chart below uses the AEI data to compare the top 25 most “complex” economies of 1995 to those of 2021. Not surprisingly, the leaders  of the Economic Complexity Index (ECI) are mainly the highest income countries. But this is less true in 2020 when compared to 1998, as Asian and Eastern European middle-income countries are moving up the ranking.

 

Although the list is relatively stable, there are five changes: five entrants, China, Malaysia, Mexico,  Taiwan and Romania,  replacing  Canada, Norway, Spain, Netherlands and Brazil.

All of the new entrants are countries well integrated into regional or global trade value chains that import almost all their commodity needs, while three of the departees (Canada, Brazil, Norway) are commodity producers.  This is interesting because the period saw the commodity super-cycle (2002-2012),  which greatly boosted the incomes and exports of commodity producers. The drop in the rankings of these countries is evidence of the “commodity curse” at work, whereby commodity boom-to-bust cycles create economic turbulence with long-term debilitating effects. In 2020 there are no commodity producers in this top 25 group, unless one counts the United States, which, in any case, saw its ranking fall from 9th to 13th.

The significant deterioration suffered by commodity producing countries is shown in detail below. These include the highly financialized Anglo-Saxon economies (Canada, Australia, New Zealand and the United States); and the traditional emerging market commodity exporters (Brazil, Chile, Argentina, Peru, Indonesia and South Africa). Brazil shares some of the characteristics of the Anglo Saxons, as it is also a highly financialized economy suffering rapid deindustrialization.

The change in the rankings from 1995 to 2020 for commodity producers is shown below. Indonesia is the only commodity exporter with an improved ranking, no doubt because it has been influenced by the mercantilist policies followed by its neighbors in South East Asia.

The contrast with the manufacturing-export-focused economies of Asia and Eastern Europe is shown below. These are all countries that have benefited from free trade and regional integration policies.

 

Finally, the following chart highlights the different paths taken by Brazil, Mexico and Turkey. Brazil has deindustrialized dramatically since 1995 and further  increased its dependence on commodities. Moreover, it has rejected globalization and regional integration.  On the other hand, Mexico and Turkey have embraced regional integration and successfully found their place in global value chains.

 

 

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries  no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related  economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil  has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle  driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

 

 

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and  capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields,  has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

 

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets  (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance.  Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of  15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

 

 

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in  1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring  multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

Brazil and the Return of Neomercantilism

The principal challenge of emerging markets policy makers is to provide the business environment for private enterprise to invest in activities that generate sustainable and equitable growth.

When they fail to do this they face the crippling flight of both financial and human capital. The ease  of communications, travel and capital movements make it easier than ever for wealthy and cosmopolitan elites to move their families and capital abroad.

Human and financial  capital drain can be devastating for emerging markets. Some 4.5 million Indians,  generally well-educated, have immigrated to the U.S. and the U.K. since 1980, contributing greatly to these developed economies. Venezuela has lost most of its educated elite and middle class over the past 15 years, leaving the country with dire prospects of ever recovering the middle-income status it once enjoyed. The past decade of slow growth and political unrest in Latin America has caused massive  capital flight from historically more stable countries like Brazil and Chile.

Brazil, which in the past largely avoided the drain of human and financial capital, now faces an exodus, with Portugal and the U.S. as the favorite destinations. With the return to power of the leftist Lula — reenergized, more bitter and radical after his two-year prison confinement — this flight from Brazil is sure to accelerate.

Ironically, the policies proposed by Lula are no longer on the ideological extreme. On the contrary, the new government’s policy proposals – government support through subsidies and credit for industrial onshoring and green technologies, all justified under the banner of national security and sovereignty – are a carbon copy of those promoted by the Biden Administration in the U.S. Moreover, the quote below, which was made this week by President Biden, could have come out of Lula’s mouth

“What it’s about is giving working folks a chance. I’ve never been a big fan of trickledown economics. In the family I was raised in not a lot trickled down to our table. When the middle-class does well, everybody does well. I campaigned on build from the bottom and middle out and when that happens the poor have a chance up, the middle class does well, and the wealthy always do well.”

In many ways, Biden’s quote applies even more to Brazil than it does to the U.S., as Brazil’s has suffered more deindustrialization than the U.S., and its inequality is one of the worst in the world and worsening.

Brazil desperately needs a new policy framework which promotes investment in productive activities with jobs that provide a middle-class lifestyle, not the service jobs (e.g. food delivery) that have been the only source of jobs in recent years. Or else, it will continue deeper into a peripheral role as a  supplier of commodities, mainly to China. The core of any economic strategy has to be to improve the income of the mass of Brazilians that currently barely participate in the productive economy.

According to the World Inequality Database, the poorest 50% of Brazil’s populations have about 8% of the country’s income and none of its wealth.  The consequence of this is that Brazil is really two countries: one country of some 20 million people  who have the income level of southern Europeans and are genuine consumers; and another country of 200 million people – including  a large poor segment relying extensively on government handouts – that has little purchasing power. The charts below compares Brazil to other countries in this regard. With a little over 20% of its population able to consume, Brazil’s consumer market is small. Worse, it hasn’t grown much over the past twenty years, increasing only during commodity booms.

Given the size of its available market, Brazil does not underproduce. For example, production of motor vehicles per potential consumer is comparable to other countries. Given current circumstances opportunities for capturing foreign demand are scarce, so the only opportunity for growth would come from an increase in the population of consumers.

Brazil’s new government understands Brazil’s challenges and has ambitious plans to relaunch the economy through an active promoter-state. Unfortunately, it maintains its traditional penchant for doing this through state companies and a big-state mentality.

However, Lula’s main problem is that his Labor Party lacks credibility. Lula pretends that the rampant corruption and incompetent management of the last PT government (2002-2016) never happened, but for most Brazilians the memory of that period is still vivid. No one has forgotten that the previous PT government’s (2002-2016) efforts to implement similar policies were crippled by graft and poor execution, and expectations are high that the same will occur again.

The tragedy of Brazil is that it is likely to miss the boat again. It was a major loser of the past 40 years of neoliberalism and globalization (starting the process at its end with Finance Minister Paulo Guedes) and now, as the world turns to neomercantilism, it is unprepared to respond adequately.

 

 

 

 

 

Long Technology Waves and Emerging Markets

The poor performance of many developing economies in recent decades has many explanations. Thought leaders such as prominent mainstream economists, the World Bank and the IMF tend to attribute failure to weak “institutions” which engender corruption, bureaucracy, lawlessness and poor human capital formation, and, consequently, result in a difficult environment for productive investments and capital accumulation to occur. In the countries themselves structural reasons often are preferred which tend to blame external forces: the legacy of colonialism and foreign oppression or the inequitable dependency of the “periphery” (developing countries) on the “center”  (rich countries). A third approach, put forward by experts on historical technological cycles, gives significant incremental insights on the question, and, more importantly, guidance on a path to better performance in the future.

The Russian Nikolai Kondratiev and the Austrian Joseph Schumpeter developed the idea during the 1920s that  long technological waves drive  the course of economic growth. Both of these “political economists” sought to understand the miraculous growth created by the industrial revolution over the previous century to better explain the post W.W. I  environment.

Schumpeter is best remembered for the idea that “creative destruction” is fundamental for progress and occurs in a recurring process: innovations made by scientists and tinkerers are turned into inventions by profit seeking entrepreneurs; eventually, the wide diffusion of disruptive technologies lead to widespread creative destruction as entire industries and sectors are transformed.

The chart below, from Visual Capitalist, summarizes the long-term technological cycles defined by Kondratiev and Schumpeter. Though the precise dates are debated by historians, the chart seeks to cover the entire era of the “Industrial Revolution.”  Five distinct “long waves of innovation” are described, each one of which was deeply transformative, not only for the firms and industries involved but also for the socio-political fabric of society. This framework puts us today in the fifth wave of technological progress, the Information and Communication Technologies Age (ICT).

Following  in the path of Schumpeter, the Venezuelan economist Carlota Perez and others have advanced the discussion of technological waves by incorporating the role of capital markets and exploring the implications for the development of “periphery” countries. Perez’s book, Technological Revolutions and Financial Capital (2001), has been hugely influential and is required reading in Silicon Valley boardrooms and venture capital firms.

Perez talks about technological revolutions as “great surges of development” which cause structural changes to the economy and profound qualitative changes to society, and she sees capital markets at the core of the process. Her “revolutionary waves,” as shown in the chart below are in line with Schumpeter’s, but she increases the scope to show the broad reach of these technologies on communications and infrastructure and, consequently, trade and commerce and society as a whole.

Perez’s technological cycles are divided into three distinct phases, which are determined by the diffusion rate of technologies.

During the initial phase – Installation – new innovations are slowly adopted by entrepreneurs with disruptive business models. As the kinks are worked out and the technologies become cost effective more entrepreneurs adopt the technologies with the backing of financiers (e.g. venture capital) who seek the high potential payoff of backing a future champion. This leads to a frenzy of capital markets speculation, which invariably results in overinvestment, hype, financial bubbles and financial crisis.

As shown below, every Installation phase has ended in a bubble, followed by a financial crisis, which Perez call the Turning Point. The canal mania of the British industrial revolution, the British railway mania of the Age of Steam, the global infrastructure mania (sometimes called the Barings mania) of the Age of Steel, the roaring twenties stock market bubbles of the age of mass production and the  Telecom, Media and Technology (TMT) bubble of  the ICT revolution all ended in financial crises.

For illustration purposes, the chart below shows Perez’s process at work for the current Information and Communications Technologies (ICT) revolution that we are currently living. The cycle is a typical S-curve which has a long incubation period of slow growth, followed by a sharp ramp up and an eventual flattening.  The current cycle can be said to have started in 1971 with the launch of the first commercial micro-processor chip by Intel, but this was only possible because of a prior decades-long incubation period of scientific research and tinkering. Financial speculation built up between 1995-1999 led to the great TMT bubble and the crash in 2000-2001. Following the crash, the Deployment Phase has caused the rise of the major winners through a consolidation process (FAANGS). (These consolidations are normal, according to Perez. For example, hundreds of auto companies engaged in brutal competition before consolidating into the three majors in the 1920s).

The Deployment Periods, which Perez calls the “Golden Ages”, is when the technologies become cheap and ubiquitous, and their benefits are widely diffused through business and society. Perez argues that we are on the verge of another “golden age” today, as we approach broad access to smartphones and the internet and massively powerful micro-chips are becoming almost ubiquitous in basic consumer products (the chip in an Iphone has a trillion times the computing power of those used by IBM’s mainframe computers in 1965.)

If it doesn’t feel now like we are entering another “Golden Age” it is because we are still experiencing the after-shocks of the previous phase of financial frenzy and economic collapse and its consequences: high inequality and populism. Perez argues that the successful countries of the next decades will be those that have governments that understand the moment and can actively promote the diffusion of ICT technologies to achieve broad societal goals (e.g. “green” technologies).

Technology Cycles and Emerging Markets

Looking back at history, one can see how this process has played out before for developing countries. We will focus on the last three technology cycles: The age of steel and mass engineering, the age of oil and mass production and the current ICT revolution.

The age of steel and mass engineering (1875-1908): This was the age of the wide diffusion of the steam engine and steel through mass engineering to provide the infrastructure for the first wave of trade globalization. The rise of Japan (the first of the Asian Tigers) occurred over this period as it methodically diffused all of the technologies developed in the West.  Latin America experienced its own “Belle Epoque,” as steamships and railroads made its commodities competitive in global markets. During this time, Argentina and Brazil were considered at the level of development of most European countries and attracted millions of European immigrants.

The age of oil and mass production (1908-1971) – Interrupted by two devasting world wars and marked by profound socio-political change, this age still generated wide-spread prosperity, though China, India and Eastern Europe did not participate. Initiated by the launch of Henry Ford’s Model T automobile in 1908, it saw the diffusion of the internal combustion engine, electrification, and chemicals under the structure of the modern corporation. Following the Second World War, broad diffusion of these technologies led to a “Golden Age” of capitalism throughout the Western World. This was also a period  of “miraculous” growth throughout Latin America as the wide diffusion of the mass production process, supported by import substitution policies and foreign multinationals, created abundant quality jobs in manufacturing and the rise of the middle class consumer.

The  Information and Communication Technologies  (ICT) Revolution (1971-today): All phases of technological revolutions overlap with their predecessor and follower as the diffusion process plays out. In the case of the ICT revolution the overlap has been particularly important and has created unexpected winners and losers. China’s economic reforms (1982) and the fall of the Berlin Wall (1989) had the effect of radically expanding the length and scope of the Mass Production Age at a time when the “creative destruction” of the ICT Age should have been undermining it. Instead of increasing productivity German corporations moved mass production to Eastern Europe and American corporations outsourced to China, to exploit cheap labor. Companies also were able to avoid expensive environmental costs by offshoring carbon-intensive, heavily polluting industries to China and the Middle East, delaying the diffusion of “green” technologies for decades. The Mass Production Age, with its high environmental costs, was extended to the enormous benefit of China and a few countries in Eastern Europe, at the expense of workers in Europe and America who were pushed into low-productivity service jobs, and the “Golden Age” of the ICT revolution has been delayed. ( U.S. productivity and growth have declined and inequality has risen sharply while Amazon makes it ever easier to buy Chinese-made goods.)

The slow diffusion of the ICT age and the extension of the mass production age has had very uneven consequences for emerging market countries. The winners of the ICT age have been those countries that were late comers to the mass production paradigm and understood that the ICT revolution would lead to massive reductions in communication and transport costs and a new wave of globalization. The Asian Tigers (Korea, Taiwan, China, Vietnam) and to a lesser degree Eastern European countries (Poland, Czech, Hungary) have been the champions by integrating themselves in global mass production value chains and assiduously working to add value. South-East Asian countries (Indonesia, Thailand, Malaysia) initially did well but increasingly find themselves sandwiched between newcomers like Vietnam and Bangladesh, which are competitive in low value-added products, and China for higher value-added products. Both India and the Philippines almost completely missed out on the mass production age revival but have made small niches for themselves in the ICT world with Business Process Outsourcing (BPO) and IT Services Outsourcing.

The big loser of the ICT age has been Latin America, which has undergone severe deindustrialization and has become mired in the middle-income trap. Mexico has suffered the greatest frustration. This country, led by its brilliant technocrats, did everything right to position itself for the mass production to ICT transition, entering into the groundbreaking NAFTA trade agreement with the U.S. and Canada. The thinking behind NAFTA was brilliant. It would facilitate a smooth transition out of mass production to ICT for U.S. firms while extending the benefits of the mass production age to a friendly neighbor operating under controlled conditions (labor, local content, subsidies, environmental, etc…). Unfortunately for Mexico, the dramatic rise of China as the factory of the world undermined all of these objectives, as China successfully dominated global value supply chains without having to meet any of the conditions Mexico had to comply with.

South America has not fared better. As high-cost producers with very volatile currencies and economies, these countries were unprepared to compete with China. These disadvantages were compounded by (1) the false hope created by the commodity boom  (2002-2012) which resulted in a typical boom-to-bust cycle and a vicious case of Dutch Disease (natural resource curse) that these countries have yet to recover from and (2) the adoption of “Washington Consensus” financial opening dogma (free movement of capital) which increased volatile flows of hot money and destabilized currencies.

The following chart shows economic convergence since 1980 (in terms of USD GDP/Capita) for a sample of developed and emerging market countries, which is illustrative of the winners and losers of the ICT Revolution.

The Golden Age of ICT

If Perez is correct and we are on the verge of a Golden Age of  extensive diffusion of ICT technologies through all segments and geographies what should countries be doing?

Perez and Raphael Kablinsky in his recent book, Sustainable Futures, An Agenda for Action, argue for activist government using its resources to incentivize private investment to achieve desirable societal goals (e.g., environmental sustainability, equal opportunity). The Biden Administration’s recent Inflation Reduction Act (IRA) and the Chips and Science Act are both in that spirit, aiming to promote investment in clean energy and energy efficiency and the re-shoring of  semiconductor production away from the Asian mass production value chain. These initiatives, as well as President Xi’s Made in China 2025 Plan, all assume that the great Mass Production Age extension through China-centric global value chains has run its course, and that ICT diffusion will now result in, without excess short-term costs, a return to more local/regional manufacturing and a more autarkic or segmented global trade system. Through massive state subsidies China already has taken a commanding lead in the production of “green” products such as electric vehicles and batteries and solar panels.

The return of activist government, coming after a 40-year period of neo-liberalism and government retrenchment, raises the question of what policies countries should pursue to fully reap the benefits of this final phase of the ICT Revolution.

Perez recommends two basic courses of action that many emerging economies and developing countries can pursue. First, governments should be active in promoting ICT diffusion in industries where competitive advantages are evident. For example, commodity rich countries like Brazil, Argentina and Chile can increase productivity by being at the forefront of ICT innovations applicable to farming and mining and, at the same time, aggressively move up value chains for these products. (Brazil, with its low carbon-dependent economy and enormous potential in solar, wind and biofuel energies, is well positioned to become a global leader in “green” farming and mining).  Second, Perez sees large opportunities for countries or regional groups to capitalize on climate change initiatives by deploying alternative energy sources and capturing their value chains through localized production. (Once again, Brazil with its large local market opportunity can achieve leadership).

The consulting firm McKinsey provides a roadmap for the future in a recent article, “Accelerating Toward Net-Zero; The Green Business-Building Opportunity” (Link). The following chart from McKinsey maps out the sectors expected to have the largest economic importance in a “greening” economy and, consequently, where governments and firms are advised to focus their efforts.

Another Emerging Markets Debt Crisis?

After ten years of extraordinary accommodative monetary policy, marked by a 2020 peak of $19 trillion in negative yielding debt, it is understandable that debt levels have grown to record high levels. Markets have been complacent about this accumulation of debt because of low servicing costs and persistent deflationary trends. However, recent developments that point to resurging inflation are now forcing central banks to seriously consider restrictive monetary policies, including positive real rates, that would lead to much higher servicing costs for highly leveraged governments, households and corporations. This is worrisome for emerging markets which do not tend to fare well during tightening cycles occurring after long periods of debt accumulation.

As the following chart from the Financial Times shows, developing countries debt levels are at record levels and have grown precipitously since the Great Financial Crisis. The total debt to GDP ratio for developing markets has more than doubled since the GFC.

 

The following chart shows the evolution since the GFC in more detail for EM countries. Debt  to GDP ratios  have nearly doubled for total debt as well as for government, household and corporate debt. These ratios would be even worse if not for the extraordinary policies of financial repression and negative real interest rates pursued in 2021, as central banks allowed inflation to surge.

 

Debt levels of many key EM countries, shown in the chart below, are now at levels which leave them highly vulnerable to economic stagnation and financial crisis. Asian EM countries (with the exception of Indonesia) and Chile and Brazil are all at very high levels in absolute terms and relative to their histories. China (considering SOE debt and overstatement of GDP), India (considering overstatement of GDP),  Brazil and Argentina all have levels of government debt close to 100%, a level which is considered highly debilitating by students of debt dynamics. China, given its capital controls and state-controlled banking system, may have the means to avoid financial disruptions but that is less true for the others, particularly for Latin American countries which have a history of rapid and profound shifts in capital flows and currently face strong capital flight from their own citizens.

 

The pace of increase in debt levels in recent years is also cause for concern. The chart below shows the increase in debt to GDP ratios over the past five years and during 2021.  Historical precedents point to countries facing high risk of debt-related crisis following a surge of their debt to GDP ratio  of 20% or more over a 5-year period. Last year was a year of acute financial repression by most central banks, so it is no surprise that debt levels came down for most countries. We can see the positive impact that this had for Brazil, in the next chart which shows how interest rates lagged inflation. Unfortunately, as the Scotiabank chart projection below shows, this effect will reverse in 2023, leading to high real rates.

Below, we focus on several key EM countries, each with its own vulnerabilities.

China

Debt levels have more than doubled since the GFC. If we assume that GDP figures need to be adjusted downwards by 20-25% to make them comparable to other countries, then debt ratios could be approaching 350%. Government debt has more than doubled over this period, and if we consider that almost all corporate debt is held by SOEs, then government debt would be well above 100%. The issue in China is not government solvency as the state has all the tools to keep the financial system operating smoothly. Rather, the vulnerability is that very high debt levels are choking the economy, and that the economy relies on unproductive debt-fueled growth to sustain growth. The consequence is that future growth levels can be expected to be low.

Brazil

Brazil’s debt levels are much too high for the economy to function properly and condemn the economy to low growth unless a serious fiscal reform or a productivity miracle occurs. Brazilian debt levels are at record high levels and they have risen by 60%  since the GFC, a period during which growth and investments have been very poor. The government debt ratio has risen by 50%, to finance current spending, while corporate debt  has risen by 70% and household debt has doubled. Government debt will likely reach 100% over the next year, which is much too high for a country with a structural deficit and which suffers from capital flight and political turmoil. Unlike in China, Brazil’s banks are private and managed very conservatively.

Korea

Kore’s debt ratio has risen by 50% since the GFC and is now one of the highest in the world. The government debt ratio has doubled over this period but remains at reasonable levels, and corporate debt has risen by 30%. Household debt has risen by 50% to 107% of GDP, an exceptional level, even higher than that of the consumption-happy United States. These very high debt levels would become a significant burden for the economy if interest rates rise, and could be a source of popular unrest with political consequences.

The Fed’s decade-long experiment in free money now may be at its end, leaving behind mountains of debt everywhere. Already weakened by the pandemic, political tensions and slowing growth, many emerging markets will add higher interest bills to their woes.

Global Growth Prospects

The World Bank has significantly reduced its growth outlook for 2022 and is  concerned that we may be facing “global stagflation.”  The World Bank’s “Global Economic Prospects June 2022″ report   highlights  the vulnerability of lower income economies in the current environment of lower growth and rising food and energy prices. Nevertheless, the bank  retains a relatively sanguine view, as it sees a persistently vibrant U.S. economy and declining commodity prices in both 2023 and 2024.

The chart below resumes the World Bank’s latest real GDP forecasts for emerging market economies  and several  important frontier markets (Nigeria, Pakistan, Bangladesh and Vietnam.) The bank’s forecast provides growth estimates through 2024. The chart ranks countries in terms of their 3-year average real GDP growth for the 2022-2024 period. The two columns on the right show the changes since the bank’s prior forecast six months ago which was made prior to the Ukraine invasion and the COVID lockdowns in China. Given its mandate, the bank tends to be “politically correct” in its forecasts. Historically, this has resulted in the bank usually accepting China’s official targets, and in this case it may explain the optimistic forecast for the U.S.  The relatively low economic cost to Russia  for the invasion of Ukraine (well below most other estimates) is difficult to explain.

As we have come to expect, most of the world’s growth will come from Asia where the bank expects stellar GDP growth in India, Bangladesh, Vietnam, the Philippines and Indonesia. This kind of growth is probably not priced in for the stock markets of Indonesia and the Philippines.  Egypt’s high expected growth is also surprising good news for this normally struggling economy and should be supportive of  higher asset prices. Though Malaysia’s expected growth is not as stellar, stock prices there are very low and also provide good prospects.

Also, in what has become the  “new normal,” growth prospects in Latin America and South Africa are dismal. Chile and Brazil are at the bottom of the chart, and would be last if not for the dramatic woes inflicted by Putin on Russia. In the case of both Chile and Brazil these GDP forecasts are likely optimistic if Chile’s new constitution is approved as currently expected and if Lula wins the election in Brazil as is also the most likely scenario. The one  Latin American exception — Colombia — is a big if, as the World Bank’s forecast is certainly wildly optimistic should the former guerilla fighter Gustavo Petro win the election on June 19. As in the case of Chile, Colombia faces capital flight and low investments for the foreseeable future.

High Commodity Prices for Brazil Probably Mean Another Wave of Dutch Disease

It is an unfortunate reality that for most countries natural resource wealth is counterproductive. This phenomenon is known in economics as “Dutch Disease,” in reference to the Dutch natural gas boom in the 1960s which resulted in currency overvaluation, declining manufacturing exports ,  higher unemployment and lower GDP growth.

In the Post W.W. II period, which has been marked by declining trade transaction costs and more open borders, few countries have avoided the resource curse. Norway, having learned from the Dutch experience, carefully managed the windfall from its oil boom in the 1970s by creating a Sovereign Wealth Fund to distribute benefits over generations. The United Arab Emirates has also squirreled away oil income into Sovereign Funds which make long-term investments to reduce dependence on finite oil resources.

In emerging markets it is difficult to exercise this discipline because of weak institutions and the pressing needs of the poor. Rent-seeking elites, crony capitalists and corrupt politicians inevitably take advantage of this institutional fragility to appropriate a disproportionate share of the resource windfall.

Brazil is perhaps the best recent example of the curse at work. A discovery of very large offshore oil reserves in 2006 was expected to be transformational for a country with a history oil deficiency. Predictions were made for an expansion of oil production from 2 million b/d to over 7 million over the next decade. The discovery sparked a euphoric mood, and  investors and policy makers projected positive effects on GDP growth, fiscal accounts and the balance of payments.

Brazil’s oil discovery  turbo-charged the commodity super-cycle (2002-2010),  which was already underway,  causing  a positive terms of trade shock, currency appreciation, and a massive credit boom. Instead of saving for the future, the government dramatically increased spending on social welfare programs and public sector benefits.

Unfortunately, the commodity boom brought all the negative consequences which are associated with “Dutch disease.”

  1. Worsening governance and corruption

The commodity boom brought forth the worse tendencies of  Brazilian governance,  well described by former Central Bank president Gustavo Franco as “An obese state  fully captured  by parasites and opportunists always  fixated on protecting their turf.”  We can see how governance (government effectiveness), as measured by the World Bank, deteriorated in the following chart.

Corruption also reached unprecedented levels over this period, as measured by the World Bank.

  1.  Currency appreciation followed by eventual depreciation.  Instead of squirrelling away the commodity windfall, Brazil allowed the currency to sharply appreciate. International reserves were also increased significantly, but without sterilizing the impact on domestic supply, which fueled credit growth.

 

  1. Deindustrialization

The huge appreciation of the BRL caused an accelerated loss of competitiveness of the manufacturing sector, which we can see in the fall of manufacturing share of GDP and an accelerated decline in manufacturing complexity. The first chart below shows the evolution of manufacturing value-added  as a share of GDP for resource-rich economies  compared with resource-poor economies, highlighting that Dutch Disease impacted all commodity exporters. The next two charts also show the evolution of manufacturing by comparing economic complexity in Latin America and  Asia.

  1. Lower Potential Growth. The erosion of manufacturing capacity led to massive replacement of “quality” industry jobs with low valued-added service jobs, and, consequently, a collapse in productivity. Potential GDP growth was about 2.5% annually before the commodity boom and has now fallen to less than 1.5%. As shown below, over the past decade total factor productivity has collapsed in Brazil.

 

 

As a result of this aggravated case of Dutch Disease, Brazil is more than ever dependent on its world class natural resource sectors: export-oriented farming, and export-oriented mining. Both of these sectors are highly competitive globally but very technology and capital intensive , providing  few jobs (Vale’s enormous iron ore operations generate only 40,000 jobs in Brazil.) Paradoxically, Brazil’s  farm sector has similarities with South-East Asia’s “Tiger” economies. Like in Taiwan, Korea and China, Brazilian farmers have benefited from ample credit,  state R&D support and export subsidies.

Ironically, current prospects for rising commodity prices are not necessarily  good news for Brazil as there  is no evidence that lessons have been learned from the past.

Chile’s Constitutional Trap

Latin America’s persistent economic decline relative to other emerging markets over the past 40 years can largely be attributed to poor governance. The region has become the main example for the “Middle-Income Trap” which results when rent-seeking interest groups institutionalize policies that make reforms nearly impossible in the future. Typically, these policies are introduced at times when social turmoil leads to “regime changes,” often through constitutional reforms. Brazil went through this process in the 1980s. Chile is going through a similar experience today.

Over the past thirty years, Chile has been the only successful major economy in Latin America. Until recently,  it was considered a serious candidate to join the club of high income and developed economies. However, inconsistent economic policies over the past decade and an explosion of social turmoil in 2019 appear to have brought about a regime change, which would reverse most of the pro-investment policies introduced during the military regime by its free-market “Chicago Boys.” A Constitutional Convention, firmly dominated by progressive and parochial interests, is now in session to define the rules of this new regime.

The example of Brazil should make Chileans very nervous. Brazil’s military regime (1965-1985) collapsed during the Latin American debt crisis of the early 1980s, a period  of increased political and social protest. Amidst this popular demand for change, progressive politicians filled the political vacuum left by the military. A Constitutional Assembly dominated by progressives came up with the “People’s Constitution,” which, according to its President, Ulysses de Guimaraes, would protect Brazil’s “suffering poor, massacred, humiliated and abused throughout history.” The new Constitution was a full rejection of the Military Regime’s trickle-down, investment-led approach in favor of one focused on securing social rights and economic safety nets.  Important interest groups with political influence, particularly civil servants, captured for themselves juicy windfalls. (One lone dissident voice at the convention, Senator Roberto Campos, a leading figure in economic policy during the military regime, decried the new constitution as “a mix of panaceas and passions…a catalogue of utopias… a civic Carnival… a hodgepodge of pettiness, xenophobia, irrational economics, corporativism, pseudo-nationalism and other foul “isms.”)

Very soon following its approval in 1988, more sober economists and policy makers began arguing that the Constitution – particularly its extremely generous provisions for civil servants–would prove a fiscal straitjacket and a severe burden on public policy.  For the past thirty years, successive governments have sought, with little success, to reform the Constitution to allow more flexibility in fiscal spending

One of the first critics was Raul Velloso, an expert on public finances with a PhD from Yale University. From day one, Velloso warned that the fixed expenditures mandated by the  Constitution  would prove catastrophic for economic growth. This week Velloso published an article in the Estado de Sao Paulo newspaper (Link) summarizing the consequences  of Brazil’s “Citizens Constitution.”

Since 1988 fiscal expenditures in Brazil have become dominated by mandated disbursements for social welfare benefits and civil servant salaries and pensions. We can see this in the chart below, based on Velloso’s data. Government expenditures have become increasingly channeled into constitutionally mandated social spending and civil servant benefits, leaving  scarce resources for anything else. The biggest victim has been investments, which according to Velloso, fell from 16% of the budget to 3%. Public sector investments in infrastructure have fallen from 5.1% of GDP to 0.7% over this period.

The lessons of Brazil are clear. Idealistic social mandates written into Constitutions during times of social upheaval have predictably nefarious long-term consequences. Once granted, benefits are extremely difficult to withdraw. Economic growth and prosperity lose. For Chile, Brazil provides a roadmap for what to avoid.

Emerging Markets are Loaded with Debt So Pick Your Countries Carefully

The world is awash in debt. Much of this debt has been accumulated over the past 20 years, and has served to support consumption, government spending and financial markets during a period of declining productivity and slowing economic growth.  Unfortunately,  because this debt was not acquired to increase productive activities, it is not self-sustaining and has become a drag on economic activity.

The chart below shows the steady accumulation of debt in both advanced and emerging market economies. Advanced economies had steady debt accumulation over the past twenty years with peaks around the Great Financial Crisis and the Covid pandemic. Emerging markets saw most of the debt accumulated over the past decade, a period that has had depression like characteristics for most countries and has seen a dramatic decline in the level and quality of China’s economic growth. (All data is from the Bank for International Settlements, BIS Link)

 

The growth in debt in emerging markets has been general. We can see in the following chart that practically all emerging market countries have ramped up debt over the past decade and now find themselves at record levels.

However, not all emerging economies are in the same condition. We can differentiate by both debt levels and rate of accumulation, which is shown in the next two charts.

 

Several countries stand out in having very high debt levels and accelerated accumulation: China, Korea, Chile and Brazil. In none of these countries has the debt been used to increase productive activities. In China, debt mainly supports the real estate bubble and infrastructure investments of marginal utility; in Korea, debt increases have flowed mainly to support consumption. In Chile and Brazil, debt has served to support government current spending and capital flight. Moreover, China, Brazil and Chile face serious economic challenges. Both Brazil and Chile will likely be in recession in 2022, and China’s sustainable growth level is in steep decline.

On the other hand, Indonesia, Mexico, Turkey, Poland Russia and Colombia all have lower debt levels and slower debt accumulation. These economies are coming out of the pandemic in relatively good shape and with the prospect of healthy economic rebounds in 2022-23.

Given a world awash in debt and suffering from low GDP growth, investors should focus on the few countries with good debt profiles and positioned for a rebound.

The Count of Ipanema’s Real Estate Fiasco

There are two streets in Rio de Janeiro that commemorate the passage of Jose Antonio Moreira. One is the Rua Barao de Ipanema in the neighborhood of Copacabana Beach and the other the Rua Conde de Ipanema in the adjacent barrio of Ipanema Beach. Not much has been written about this influential Brazilian businessman of the Portuguese colony who was active during the reigns of  Dom Joao VI , Pedro I and Pedro II. He happens to be my ancestor, and so I have  put together a short and sketchy biography which relies on public documents and family archives. His story reflects the modernization of Brazil in the 19th century – from a slavery-manned plantation economy to a modern industrializing nation. It is also a tale of poor timing in real estate speculation and the dissipation of wealth by idle descendants.

The trail of the Ipanema de Moreira family starts in the city of Sao Paulo, Brazil in the late 18th century.  Jose Antonio Moreira, the future Count of Ipanema, was born in Sao Paulo, October 23, 1797, the son of Jose Antonio Moreira (Father) and Ana Joaquina de Jesus. The family was of noble origin, from the Braga District of northern Portugal. Moreira is a common name in Portugal, meaning mulberry tree.

Jose Antonio Moreira (father) was a prosperous merchant in Sao Paulo with close links to the colonial administration.  He had a key role in developing Brazil’s first modern industrial enterprise, the Ipanema iron works (Fundicao Ipanema).

Napoleon’s invasion of Portugal caused the Portuguese court of Dom Joao VI to flee to Rio de Janeiro in 1808. Dom Joao VI immediately eliminated all existing mercantilist restrictions on domestic manufacturing and actively supported industrial self-sufficiency. Iron smelting was considered a high priority and an area of with iron deposits in the vicinity of the city of Sao Paulo was chosen as a site for development.

The existence of iron ore deposits on the Ipanema Hills in an area known as the Fazenda Ipanema, nearby the village of Iperó, 125 km northwest of the city of Sao Paulo, had been known since the early days of the Portuguese colony. The site chosen for the iron smelter was located on the Ipanema River, a tributary of the Sorocaba River, and was surrounded by forests which could be used as fuel for smelting. The area had previously been inhabited by Tupi Indians, who had named it “Ipanema,” a reference to a river that has its source there. Ipanema means “stagnant or barren water” in Tupi-Guarani.

The company was established by Royal Charter in December 4, 1810 as a mixed capital shareholder company, with 13 shares belonging to the Portuguese Crown and 47 to private shareholders, businessmen with connections to the court. Jose Antonio probably represented the crown’s interests and was a founding investor. The project was of keen interest to Dom Joao IV who enlisted technical support from Swedish and German specialists, and he is s known to have visited the mill on multiple occasions.

The Fazenda Ipanema Ironworks, known as the Real Fábrica de Ferro de São João de Ipanema, smelted its first iron in 1816 and operated until 1895.  A picture from 1890 is shown below.

The enterprise, which can be considered Brazil’s first modern industrial undertaking, included a dam and a 4-km railroad connecting the iron ore deposits with the plant. The area is now a national park and a popular tourist attraction. The structures of the mill are intact, as shown in the pictures below, and can be visited by the public.

The geographical location of the site is shown in the maps below.

Jose Antonio Moreira , both father and son, were actively involved with the Fundicao Ipanema.  The future Count of Ipanema, who will be referred to as Jose Antonio Moreira from now on, was involved with the Ipanema Fundicao from an early age, and he would remain connected to industrial ventures in metallurgy and metal-working in Brazil’s first wave of industrialization during the imperial regime.

From the time of the Fundicao Ipanema, the Moreira family remained closely tied to the imperial court in Rio de Janeiro. By the early 1820s, Jose Antonio Moreira had settled in Rio De Janeiro where in 1823 he married Laurinda Rosa Ferreira dos Santos, the daughter of a Portuguese aristocrat from Porto.   She was born in Rio de Janeiro in 1808 and died in Brussels in 1881. They has six children: José Antonio Moreira Filho, future 2 º Barão de Ipanema (1830-1899); João Antonio Moreira (1831-1900); Joaquim José Moreira (1832-?); Manoel Antônio Moreira (1833-?); Laurinda Rosa Moreira (1837-1920); Mariana Rosa Moreira (1842-?) and Francisco Antônio Moreira (1845-1930). (Francisco Antonio Moreira is my great-great-grandfather.)

Jose Antonio’s success as an entrepreneur and his service to the Imperial Court was recognized on numerous occasions with the highest honors:  Comendador da Imperial Ordem de Cristo and Dignitário da Imperial Ordem da Rosa (Commander of the Order of Christ and Officer of the Imperial Order of the Rose), 1845; Baronato  de Ipanema (Barony), 1847;  Grandezas de Barão de Ipanema (Barony Grandee), 1849; Viscondado com Grandeza  de Ipanema (Viscount Grandee), 1854; and Conde de Ipanema, 1868 (Count).  Jose Antonio’s association with the Ipanema Iron Works and metallurgy are made clear by the choice of the Ipanema name.  (Imperial titles of nobility were awarded on the basis of merit and service to the crown and. Generally, were not hereditary.)

 

The heraldic shields of both the Portuguese Moreiras and the Brazilian Ipanemas are shown below. Notice that both shields have the flourished cross, which in Portugal was the symbol of the Knights of  Saint Benedict of Aviz, an order of chivalry founded in 1146. The Ipanema shield also has a blue line with five stars (representing the Ipanema River) and a Caduceu of Hermes (wisdom).

 

In 1844, during the reign of Pedro II (1831-89), Brazil adopted policies to promote industrialization and the import-substitution of manufactured goods which included stiff tariffs of up to 60% on imports.  Prior to this reform, the country had relied extensively on British imports. The policy shift resulted in Brazil’s first wave of industrialization, which had as its leading entrepreneur Irineu Evangelista de Sousa (Visconde de Maua). Jose Antonio Moreira was an early investment partner and investment adviser to the Visconde de Maua.  It is clear that Jose Antonio put his court connections and expertise in metallurgy to good use over this period, and he coinvested with the Visconde de Maua  in steel, shipyard, banking, steamboat and railroad ventures.

Jose Antonio Moreira was the first president of the Banco do Brasil, a Visconde Maua venture that was crucially important in financing Brazil’s early industrialization and still plays a vital role in Brazil’s economy today.

Interestingly, in the Banco do Brasil’s founding charter documents Jose Antonio is described as a “national businessman involved in the business of ships and national goods” (comercio de navios e generos nacionais).

Jose Antonio also had business partnerships with foreign investors, including steel concerns in Belgium. From the mid-1850s Jose Antonio is connected to Brussels, and in 1860 his wife, Laurinda Rosa Ferreira dos Santos, takes up residence there. From this time, four of their six children are established in Brussels: Manoel Antonio, Marriana-Rosa, Laurinda Rosa and Francisco Antonio Moreira. Manoel remained in Brussels where he served a Brazil’s general consul, and his son, Alfredo de Barros Moreira, would serve as Brazil’s first ambassador to Belgium.

We have two portraits of Jose Antonio. The first is a sketch of him as a young man; the second, dating from the 1860s, shows him in his prime.

 

It is during the final phase of his life in the 1870s that Jose Antonio Moreira purchased an estate located some 12 km south of the center of the city of Rio de Janeiro. This area with more than 3 km of beaches facing the Atlantic is now known as the Ipanema Beach neighborhood.

The estate was purchased in 1878 and initially it was used as a country house (chacara). An artistic rendition of what the area may have looked like in the 1870s by the painter Eduardo Camoes  (b. 1955- ) is shown below.

The map below shows the estate in the context of today’s Rio de Janeiro. The chacara extended from  the southern tip of Copacabana Beach (delineated by the current Rua Barao de Ipanema) to the canal that connects the ocean with the Rodrigo das Freitas Lagoon and creates the division between the neighborhoods of Ipanema and Leblon. The property stretched into parts of modern-day Leblon, including the current site of the Monte-Libano sports club.

 

The land purchased by Jose Antonio Moreira was known at the time as “Praia de Fora de Copacabana,” which was part of a larger area called the “Fazenda Copacabana.” Most of the property was purchased from Charles Le Blond, a French entrepreneur who ran a whaling operation called “Alianca,´ and had secured a monopoly on supplying Rio de Janeiro with whale oil. Le Blond went out of business in the 1860s when the Visconde de Maua introduced gas lighting to the city of Rio de Janeiro, and this may have provoked the sale of the property.  Vestiges of Le Blond’s whaling operation include the names of the Leblon Beach neighborhood as well as Arpoador  (Harpooner) Beach at the easternmost point of  Praia de Fora. The rocky promontory which separates Arpoador Beach from Copacabana  played an important part in the whaling operation as an ideal lookout to detect migrating pods of whales.

The area was originally occupied by Tamoia Indians, and, briefly, in the 1550s it was the site of a French military outpost. Reportedly, an early Portuguese governor eradicated the Indian population by furnishing them with blankets infected with smallpox (apparently a common practice in the 16th century).

The southern and western parts of the “Fazenda Copacabana” also were widely used for large sugar cane milling operations and cattle grazing from the 16th to the 19th centuries in the area which stretches from Leblon to the Jardim Botanico. The eastern part of the Fazenda Copacabana (modern day Copacabana and Ipanema) were inappropriate for farming because of sandy, acidic soil (restinga) and, in the case of Ipanema, frequent flooding from the lagoon.  One of the few structures in the area was the Igreja of Nossa Senhora de Copacabana, a Carmelite hermitage founded in the early 16th century. The hermitage had a copy of a statue of the Virgin Mary from the Church of Nossa Senora de Copacabana on the shores of Lake Titicaca in Peru which was said to have miraculous qualities, and that is the source of the name of the beach.

In all likelihood, the purchase of the Praia de Fora was made as a farsighted speculative real estate bet. As a prominent businessman with close ties to the Viscount of Maua and the imperial administration, the Count of Ipanema knew the city’s plans for urban development. Central to this vision was the Companhia Ferro-Carril Jardim Botanico, a Viscount of Maua venture, that was planning to expand its tramway coverage to the southern beaches of Rio de Janeiro. Moreover, he was certainly aware of the mid-19th century European boom in beach resorts made possible by railroads and by a newfound appreciation for the health benefits of the sea. Unfortunately, the Count passed away in 1879, leaving the future development of the area in the hands of his eldest son.

Jose Antonio Moreira Filho was 49 years old when his father passed away.  He appears to have been a successful businessman in his own right and highly regarded by the Imperial Court, and he was decorated on several occasions:  Commander of the Military Order of Christ and  the  Order of Our Lady of the Conception of Vila Vicosa (the paramount award given by the sovereign for services rendered to the Royal House). He received his baronage by decree in 1885, and the grandeeship by decree in 1888. He married Luisa Rudge, daughter of George Rudge and Sofia Maxwell.  His father-in-law was Joseph Maxwell (1772-1854), one of Brazil’s richest men, founder of the Maxwell Wright commission house. This was a trading house with strong links to the American and British markets which was a leading participant in the coffee export boom and a facilitator of the Atlantic triangle trade (imports of grains and manufactured goods from America, exports of coffee and slave trading with Africa). The Rudges were business partners with Joseph Maxwell. Both the  Rudge and Maxwell families were originally merchants from Gloucester, England.

The only portrait we have of Jose Antonio Filho is the one shown below, made in the 1870s before he had become the Baron of Ipanema.

Jose Antonio Moreira Filho’s plans for “Praia de Fora” depended on improved access to the southern beaches. The estate had been accessed primarily from the sea by occasional tourists. This changed when in 1892 the Companhia Ferro-Carril Jardim Botanico inaugurated the Copacabana Tunnel (today known as Alaor Prata), linking Botafogo Beach with Copacabana Beach, and providing tram service between the center of Rio and the southern beaches. A tram line covering the entire extension of Copacabana beach was completed by early 1894.

In anticipation of the further extension of the tram service, in April 1894 the Vila Ipanema real estate development project was officially launched. The land holdings owned in Copacabana and Leblon were not included in Vila Ipanema, and may have been donated to the city or incorporated into other developments being actively promoted at the time.

The layout of the Vila Ipanema can be seen in the two documents below. The first, dating from 1894, is the original urban design commissioned to Luiz Rafael Vieira Souto who was the Chief Engineer of the Municipality of Rio de Janeiro.  The second, dating from 1919, is from a marketing brochure.

Vila Ipanema divided the area into 45 blocks.  The standard block was broken into 40 lots, each measuring 10 meters by 50 meters. More than a million m2 of real estate were put on the market.

 The initial launch included 19 streets and two public squares (General Osorio and Nossa Senhora da Paz). Most of the street names honored family members, associates and political allies of the Baron and his partners. For example, the main road at the time of launch was the Rua 20 de Novembro (Visconde de Piraja), which commemorated the date of birth of Luisa Rudge. Of the original names few remain: Alberto Campos (brother in law) remains; Avenida Vieira Souto, in honor of the urban planner, still graces the waterfront.

Jose Antonio Moreira Filho had several partners in Vila Ipanema: Coronel Antonio Jose Silva, Jose Luis Guimaraes Caipora and Constante Ramos.  The Coronel incorporated land he owned in Praia de Fora into the Vila Ipanema project. In 1901 the shareholders of Vila Ipanema were:  Ipanema de Moreira family, 90%; E. de Barros, 6.5%; Coronel Silva, 3.5%; Ulysses Vianna, 1.0%.

Jose Antonio Moreira Filho’s luck seems to have run out in his final years. He was 64 years old when Vila Ipanema was launched and in bad health. Given his intimacy with the imperial court, the deposition of Pedro II in 1889 and his exile to Paris may have seriously undermined his business affairs. Surely, when the Count acquired the estate he had not countenanced an end to the imperial regime. The proclamation of the First Republic in 1889 was followed by political instability and economic crisis, and the flight of both human and financial capital. In the five years from the time of the coup-d’etat which ousted Pedro II to the launch of Vila Ipanema in 1894, the real, the Brazilian currency, lost 60% of its value relative to the U.S, dollar, and it would lose another 40% before stabilizing in 1899. The 1890s would also see the rise of Sao Paulo as Brazil’s dynamic economic center and the magnet for waves of Italian and Japanese immigrants.

By the mid-1890s almost all of the Ipanema de Moreira family was settled in Europe, either in Paris or Brussels. Brazil was far away and becoming a distant memory. When the Baron passed away in 1899, the majority control of Villa Ipanema went to Francisco Antonio Morreira who resided in Paris and had not lived in Brazil in 40 years.

 

The following account from Francisco Antonio’s son (nephew of the baron), Alberto Jorge de Ipanema Moreira, gives some color:

“In the spring of 1898 we travelled to Rio, my father, my aunt and I. My father and my aunt went to try to salvage what was left of a brilliant fortune. Their brother, the Baron of Ipanema, who was their proxy, was old and sick and his business affairs had collapsed. The only thing left were the immense land holdings in Copacabana and the “Praia do Arpoador’” now renamed “Villa Ipanema.” Following the death of the Baron of Ipanema, an agreement was reached with his heirs on one side and my father and my aunt on the other, that the remaining land for sale would be divided  so that the heirs would keep 35% and my father and my aunt would receive 65%. Though born in Rio, my father,  my aunt and my mother – she of English descent, Rudge by her father and Maxwell by her mother – had spent little time in Rio, having been sent at a young age to study in England. They had little notion of the assets they had in Brazil.”

Franciso Antonio Moreira, my great-great grandfather, was a bon vivant living the high life between Paris and Nice. He was married to Maria Tereza Rudge, the second daughter of Joseph Maxwell, and, presumably they both had inherited large fortunes from their parents. However, it seems that they lived well beyond their considerable means. More on this from his son Alberto Jorge:

“It would seem that this family settlement had been very favorable for my parents. It didn’t turn out that way; quite the contrary, they lived for the next thirty years receiving only crumbs. This great capital withered away, used only to cover the most basic and indispensable expenses. The lots in Ipanema sold poorly, and my father wanted to sell at any price. He was born a great lord, and had no notion of thrift. Very elegant and handsome, he loved sport, especially horses; generous and extremely charitable, of an uncommon righteousness, he saw no evil and was not made to manage a fortune.”

Francisco Antonio had six children: Alberto Jorge (Brazilian diplomat), Maria Luiza (my great grandmother who married Eugene Robyns de Schneidauer who was a Belgian diplomat), Leonora, Maria Thereza and Jose. All of them resided and passed away in Europe. The first photo shows him around 1900 in ceremonial Court regalia. The second photo is a family portrait taken in 1929, near the end of his life, where he is seated next to his wife in the middle, up front.

The following pictures shows Ipanema Beach at the turn of the 19th century and in 1930. Notice how poorly developed it remained in 1930, still marked by the characteristics of the “restinga.”

The sales of the Vila Ipanema lots were painfully slow, as no one wanted to invest in that “fim do mundo.” This was in part because of competition from developers in Copacanana Beach who offered plenty of supply with closer proximity to the city and public transport. Moreover, though both Ipanema and Copacabana were marketed as “healthy and hygienic,” Ipanema was plagued by mosquito swarms when the lagoon periodically overflooded.

Poor sales also were caused by the delayed expansion of the tram service, which reached the General Osorio Square only in 1902. By the end of that year only 112 lots had been sold, which represented about 6% of the available inventory.

Development expenses also ran out of control. Capital, administrative and selling expenses were still taking up over 60% of revenues in the early 1900s.  High construction costs led to the farming out of development work to a contractor in 1905, the Companhia Constructora de Ipanema, which did similar work in Copacabana and Leblon. In 1906, this company completed the embankments of the lagoon, providing a permanent solution to the flooding.

The table below shows the Vila Ipanema sales revenue stream from 1900 to 1930, by which time very few lots remained. These numbers are presented in 2020 U.S. dollars, adjusting for inflation and currency depreciation. The real lost half of its value over this period. The peak of sales occurred between 1911-1915, a period of economic strength and real appreciation. The evolution of the real from 1984 to 1930 is shown in the following chart.

 

Over this 30-year period, total Vila Ipanema gross revenues were $15.1 million (constant 2020 USD). Net revenues after all expenses amounted to $12 million, of which $6.5 million went to my great-great grandfather, Antonio Francisco Moreira. By the time of his death in November 1930, a small fraction of that capital remained.

Of course, in retrospect it I easy to say that this capital was grossly and irresponsibly dilapidated. Ipanema today is prime luxury real estate and a beachfront apartment on Ipanema Beach may cost 3 to 4 million dollars. Unquestionably, the best strategy for a long-term investor would have been to build a big wall around the property and wait.

However, the reality is that Ipanema remained a sleepy and distant neighborhood, particularly compared to Copacabana, until recent decades.  It was not until the 1960s that it received some notoriety as a fashionable destination. Since the 1960s, the social and cultural center of Rio de Janeiro has moved rapidly to the southern beaches, leading to huge appreciation in real estate.

When Antônio Carlos Jobim’s family moved to Ipanema in 1933 it was because his mother was recently divorced and could not afford to live in a nice neighborhood. For the same reason, a wave of immigrants settled there after W.W. II.  In the 1960s, Antonio Carlos (Tom) Jobim’s generation made Ipanema famous with the Bossa Nova.  It was from the terrace of the Bar Veloso on the Avenida Prudente de Moraes that Tom spied the “girl from Ipanema”, Helo Pinheiro, walking home bikini-clad from the beach, and the rest is history.

There are thousands of covers of Girl From Ipanema; the most recent from Anitta.

Astrud Gilberto Version

Getz Gilberto

Anitta

 

 

 

The Girl From Ipanema

https://apnews.com/article/anitta-girl-from-ipanema-rio-brazil-bb45163a74e7d47c23a38f09a4cbe1e3

 

 

Internationalization and Economic Convergence

Very few countries in emerging markets have sustained high GDP growth levels long enough to  aspire to convergence with  the developed world. These include the members of the club of Asian “tigers ,” originally formed by Taiwan, Korea and Singapore,  and now being joined by China, Vietnam, Thailand and Malaysia. Outside of Asia, Poland, Hungary and other formerly Comecon states have made huge strides towards catching up.  One thing all of these success stories have in common is openness to trade and integration into international supply chains.

The chart below shows the internationalization rate for the primary emerging markets.

The successful convergers have a high level of internationalization of their economies, as measured by total trade (imports plus exports) divided by GDP  minus net trade.  Asian countries have followed  a mercantilistic framework of  industrial planning and subsidies supported by  currency manipulation to maintain export competitiveness. Eastern Europe and Mexico have relied more on integration into regional trade networks. The focus on international trade has required that these countries focus on comparative advantages and market-based decisions, and this process has facilitated an accumulation of knowledge and skills which can lead to gradual moves up the industrial value chain.

This path of convergence is obviously not easy to follow or else more countries would do it. It requires long-term planning and economic stability, including a stable and competitive currency. Countries that experience frequent boom-to-bust cycles because of economic instability or commodity cycles will not succeed in this path. Moreover, many countries fall into the “middle-income trap”  which is caused by  dominant interest groups lobbying against open-market policies and other reforms.

Latin America is where the middle-income trap has become most prevalent.  The region suffers from a high dependence on commodities and repeated  phases of “Dutch Disease,”  the destructive aftermath of commodity busts, such as the one the region has experienced since the end of the 2002-2012 commodity super-cycle. The region also bought into the wrong elements of the neo-liberal “Washington Consensus.”  It adopted financial liberalization while failing  on fiscal reforms.

Brazil has become the poster child of the middle-income trap. Its gross mismanagement of the commodity boom (overvalued currency, corruption) left behind increased de-industrialization, debt and financialization of the economy. Ironically, while developmentalist policies are back in favor in Biden’s Washington, they are totally out of favor in Brazil where the finance minister espouses 1970s style Chicago School economics.

 

Latin America: Before and After the Pandemic

Latin America has been hit  hard by the pandemic.  The region’s economic and social concerns have worsened.

Both cases and mortality rates are some of the highest in the world, and probably under-reported relative to many countries (eg Mexico).

The region was the epicenter of the pandemic from late spring through the summer (the winter region in the southern cone).

The IMF forecasts that the region will be hit harder and recover more slowly than other regions, especially Asia. This comes in the wake of a decade of economic underperformance.

The fiscal response has varied tremendously, as elsewhere in the world, depending on ideology and politics, not so much fiscal space. Brazil and Argentina, the two most fiscally constrained countries, have spent the most. Mexico, which has most fiscal space, has spent the least.

Fiscal generosity in Brazil created a financial windfall for low-income families which resulted in a financial and consumption boomlet.

In Brazil the fiscal response has caused a deterioration of public finances which is likely to have  negative consequences for growth prospects.

Brazil’s debt levels are very high given its history and volatile economy.

The pandemic is increasing inequality and social division. ECLAC estimates a 45 million increase in poverty (30% to 37.5%) and 30 mm increase in extreme poverty (11% to 15.5%).

Poor, women and children most impacted.  The poor cannot social distance or work at home . Poor children do not have access to online schooling.

All is well in the “elite bubble,” and the “Gig Economy” is booming.

The poor and the rich used to watch the telenovelas together. Now the rich are on Netflix, HBO and Youtube.

The region’s problems predate the pandemic. The region has been characterized by low and volatile growth, deteriorating fundamentals, and premature deindustrialization.

Latin America is the poster child of the “Middle-Income Trap”

Investment is too low to promote growth.

The region suffers from acute premature deindustrialization.

Well-paid unionized manufacturing jobs are disappearing, replaced by the “gig economy.”  Brazil is Uber’s largest market measured by rides. There are  3.8 million delivery workers.

Latin America has had a lost decade. Before the pandemic it was crippled by Dutch Disease (The Natural Resource Curse), which is caused by boom-to-bust commodity cycles and entails vicious asset, debt and currency cycles and tends to result in the weakening of institutions and the worsening of long-term growth. This was the situation before the pandemic.

Asset Bubbles

Increased Corruption and Crime

Deterioration of Business Environment (regulation, laws, etc…)

Not one Latin American country ranks well. Chile has fallen from the elite to second class.

EM Asian countries are all improving, including India. Vietnam is the new Asian Tiger.

A terrible decade for the stock market.

The region suffered a huge hangover from the commodity boom bubble combined with the onslaught of slowing global growth and technological disruption. Emerging markets are a value trade and value has been out of favor because of low growth and worsening fundamentals.

Earnings and valuation started high and have drifted down.

The region has severely underperformed both EM and Asia.

Latin America has become irrelevant as an asset class. It peaked at nearly half the index during the 1990s. It is now 7% and declining.

The region’s sectorial composition looks like a flashback to the 1990s.

 

Tech disruption is the main driver of market performance.

But Latin America trades like a copper stock.

Tech is small but it outperforming.

 

 

A New Development Model for Brazil

Over the past fifty years, very few countries have successfully progressed from lower-income status to developed status. This very short list includes Korea, Taiwan, and the island city-states of Hong Kong and Singapore. We can also add coastal China, the extraordinary case of the past decades. These countries all have followed the model pursued by the United States, Germany and northern Europe, which was prescribed by the first Treasury Secretary of the United States in his seminal “Report on Manufacturers.”

Hamilton asserted that no country would prosper without a strong manufacturing sector, and noted that case for free-markets made by Great Britain was self-serving, to preserve its hegemony.”

In defense of trade tariffs, Hamilton argued that:

“There is no purpose to which public money can be more beneficially applied, than to the acquisition of a new and useful branch of industry; no consideration more valuable, than a permanent addition to the general stock of productive labor.”

Every successful country has followed this mantra. The “Asian Model” espoused by Japan, Korea, Taiwan and China, has relied intensively on manufacturing. The “ China 2025” industrial policy, which has annoyed the current hegemon, the United States, takes to heart Hamilton’s focus on “new and useful branch of industry” by focusing government support on frontier industries. In addition to targeting subsidies for industry the “Asian Model” prescribes the following:

·      The promotion of competition in manufacturing, with prioritization of exports.

·      Competitive currencies. (This has always been important but now more than ever in a world of low-cost container shipping and erratic capital flows.)

·      Create conditions for small farmers to thrive.

·      Channel agricultural surpluses and savings into productive investments by regulating lending by financial institutions.

The resilience of manufacturing promoted by the Asian Model is in sharp contrast to the “Latin American Model.” The result can be seen in the following chart. Brazil has essentially abandoned its manufacturing sector and faces a crippling state of premature deindustrialization. Mexico has done much better than Brazil, but has focused, almost exclusively, on serving as a “workshop assembly line” for the U.S. market, with little value added.

No alt text provided for this image

Brazil gave up on its industrial model in the 1980s. Since then, it has essentially followed policies that are the antithesis to the “Asian Model.” Unlike in Asia, where export-competitiveness was stipulated, Brazilian industry lost support because of a reputation for high costs and poor quality. Brazil’s foreign currency management has also been incongruous, leading to extreme volatility in the exchange rate and a persistent tendency for overvaluation, conditions that are unbearable for the manufacturing sector.

Furthermore, the Brazilian policy framework has promoted an oversized financial system which thrives on speculation, and serves almost no purpose in funneling savings into productive activities. The past ten years have seen the logical culmination of this process, as debt levels have exploded at a time of extremely low investments in productive activities.

The current conditions in Brazil don’t look propitious for a major change of course. For the short term investors can hope only for some progress in terms of current government initiatives to reduce the excessive cost of government bureaucracy, simplify the tax system and deregulate several industries to encourage more investment. None of this can solve the structural issues that the country faces, particularly the excessive debt levels

If the current Brazilian model has run its course, what lies in the future? What could a new Brazilian development model look like?

1.     First, the country will have to address excessive debt levels. Current debt levels asphyxiate growth, so some form of financial repression is inevitable to brings levels back to sustainable levels.

2.     Second, Brazil will have to stabilize its currency at a competitive level and convince markets of a long-term commitment to currency competitiveness.

3.     Third, Brazil needs to credibly commit itself to a new industrial policy. This is a huge challenge because of a lack of confidence in policy makers, but it is imperative. Legislation should be passed to provide long-term support or several “frontier industries,” while encouraging a competitive environment and a priority for exports. I suggest three candidates:

  1. Renewable energy – Brazil is well-positioned to be a global leader in solar, wind, and bio energy. It has ample resources, a large market and already a solid industrial base.
  2. “Green” farming – Agriculture is the one sector where Brazil has maintained global competitiveness, and it is well positioned to meet global demand for ecologically-sound farmed products.
  3. Deep-water oil production – Brazil has huge deep-water oil fields that will provide demand for capital goods for decades to come. However, the poorly structured policies and inconsistency of previous efforts have undoubtedly left a bitter taste.

Are Brazilian Stocks Cheap?

Brazilian stocks have rallied by over 50% since March 24, driven by bottom-fishers and a new generation of avid speculators trading through online brokers. The Brazilian trade has similarities with the “dash-to-trash” trade that has pushed up the worst performers and “zombie” stocks of the U.S. market (cruise-lines, airlines, malls, etc…). Brazilian stocks have also benefited from a weakening dollar, which, in itself, is a reflection of increasing investor appetite for risk.

The “risk-on” trade is underpinned by the following narrative:

  • The Covid-19 pandemic is in retreat, and vaccines and therapeutics are forthcoming. This implies a “V-shaped” recovery of the economy.
  • The U.S. Fed is fully committed to propping-up financial markets and provides a “put” which provides downside protection.

Moreover, according to the bullish-case, emerging markets such as Brazil from now on will benefit from a strong tail-wind from the following forces:

  • Strong stimulus in China, which is evident from rapid credit growth (27% y/y) and surging cement and steel sales. China appears to be implementing a mini-version of its gargantuan 2009 stimulus.
  • Commodity prices, which are at decade lows, will be pushed up by Chinese stimulus. We can see this already in iron ore and copper prices, which are both well off the bottom and trending higher.
  • After a decade-long strengthening, the dollar may have started a down cycle. This would be caused by a combination of (1) the reckless implementation of Modern Monetary Theory in the U.S. (eg. fiscal deficits financed by money printing) and (2) improving growth prospects outside the U.S.
  • Record-low interest rates around the world and persistent deflationary trends are allowing EM central banks to reduce benchmark interest rates. This is particularly true in Brazil where interest rates at historical lows are pushing the rentier class into stocks.

Finally, the bulls believe that a great rotation has started, from expensive “growth” stocks (eg, FAANGS) into dirt-cheap “value” stocks. This rotation has been happening in recent weeks and partially explains the rise in Brazilian stocks. Emerging markets in general and Brazil in particular would greatly benefit from such a rotation. This is because, aside from China, Korea, and Taiwan, which have buoyant tech sectors, growth stocks are exceedingly uncommon in emerging markets.

For the current rally in Brazilian stocks to continue this narrative will have to be confirmed. Given the enormous lack of visibility on several issues, however, a cautious positioning is warranted. In particular, the continued virulence of COVID-19 across many emerging markets, and especially Brazil, is of great concern, and the risk of a second-wave later this year is real.

Moreover, the bulls may not be giving proper consideration to the disastrous impact that the pandemic has wrought on present economic output and future growth prospects. Both the OECD and the World Bank this week released growth forecasts for Brazil pointing to the devastating effect of the pandemic this year and slow recovery next year. These forecasts are shown below.

Furthermore, the crisis will have a very debilitating effect on Brazil’s fiscal accounts and result in a massive increase in the debt-to-GDP ratio. This ratio has been ramping-up dangerously for the past five years and will surpass 100% of GDP over the short-term. The very high levels of debt in Brazil can be expected to significantly reduce the potential for GDP growth in the years to come. This is shown in the chart below.

Furthermore, the claim that Brazilian assets are cheap should be qualified.

First, let’s look at Brazilian stocks on a historical basis. The chart below shows price-earnings ratio (PE) and cyclically-adjusted price-earnings ratios (CAPE) for Brazil, with 2020 numbers from sell-side estimates. Based on history, Brazilian stocks appear relatively close to historical averages.

The following chart, based on MSCI data and sell-side estimates, shows the MSCI Brazil index and Brazilian GDP (LHS) and earnings (RHS), all in USD terms. What the chart shows is that the perceived cheapness of Brazilian stocks is the result of a decade of currency weakness and GDP stagnation, which have led to no earnings growth.

The unfortunate reality is that Brazil has undergone a disastrous lost decade, as far as corporate profits are concerned. Given the Coronavirus, the expected slow recovery and the poor prospects for GDP because of excessive debt, there is no clear end in sight for these woes. Remember that Brazil’s stock market is largely composed of banks, commodity producers and mature consumer businesses, none of which are benefited by the global environment of low growth and disruption. The chart below shows historical and expected MSCI Brazil dollar earnings. These assume a gradual appreciation of the BRL over the 2020-2029 period.

Applying a CAPE methodology to this earnings forecast, we put a  Brazilian normalized CAPE ratio of 13.6x on 2027 CAPE earnings (10-year average inflation adjusted earnings), which gives us a target MSCI Brazil index value of  2383 in 2027, vs. today’s 1633. This translates into an expected annual total real return of 5.7% (including dividends). Needless to say, these expected returns are not enticing.

Of course, these kind of forecasts are full of pitfalls. Many things could happen to improve the prospects for Brazil. These are the primary ones:

  • A strong weakening of the USD and sharp rise in commodity prices could dramatically improve economic growth, liquidity, the debt profile and earnings. This is not currently in analysts earnings forecasts, but the chances of this happening in coming years are relatively good.
  • Successful economic reforms implemented in Brazil. Low-hanging fruit to increase productivity and growth potential are enormous. For example, Brazil has an abysmal ranking of 124th in the World Bank’s Doing Business ranking and has made no progress over the past 15 years.
  • Successful financial repression, to allow a managed reduction in government debt.
  • An innovation renaissance in Brazil, resulting in “new economy” companies. If Argentina could spawn a Mercado Libre, perhaps Brazil will do the same.