The debate continues on what caused Brazil’s most recent economic crisis, the deepest and longest the country has experienced since the Great Depression.
Nobel Laureate, Paul Krugman, gave his view in his New York Times column a few weeks ago (“What the Hell Happened to Brazil?”, Link). Krugman points to “bad luck” in the form of a severe terms- of- trade shock caused by falling commodity prices, which in turn led to an unwinding of excessive household debt and a severe drop in domestic consumer spending. Brazil, according to Krugman, underwent a debt deflation process, not the typical “sudden stop” emerging market crisis where a build-up in foreign debt reverses when foreign capital abandons a country. The duration and depth of the recession, Krugman believes, were caused by bad policy mistakes: a combination of fiscal austerity and monetary tightening, at a time when Keynesian stimulus could have been effective.
Barron’s Magazine has also chimed into the debate with two articles by Mathew Klein (“Understanding Brazil’s Latest Depression” and “What Triggered Brazil’s Crisis,” Link). Klein points to a massive increase in private debt between 2005-2015 which was accompanied by a large increase in foreign capital inflows, mainly into stocks and bonds. When the capital flows reversed in 2012-14 and the downturn began, the Brazilian authorities tightened both fiscal and monetary policies and deepened the fall, Klein writes echoing Krugman. Klein notes a fiscal adjustment of 5% between 2013 and 2016 (from a surplus of 2% to a deficit of 3%) but still agrees with Krugman that the authorities were too conservative on the fiscal front and focused largely on the tightening of monetary policy to stabilize financial markets.
Both the Krugman and Klein articles are insightful, but I take issue on several points. First, both Klein and Krugman make a glaring omission by not considering political factors. The reelection of President Dilma Rousseff (October 2014) was a great disappointment for the business community and financial markets and probably triggered the start of the recession. At the same time, Brazil entered an enormous political crisis, with the explosion of the “Car Wash” graft probe (initiated in 2014, and still going on)) which implicated hundreds of businessmen and their political cronies. This was soon followed by the impeachment of President Dilma (2015). These unsettling political events certainly played a big role in deepening and extending the downturn.
Second, both Klein and Krugman somewhat mischaracterize the crisis: Krugman, by arguing that Brazil’s woes were more akin to a developed market crisis and could have been alleviated through stepped-up fiscal spending; and Klein, by stating that the commodity cycle (2003-2012) should be considered largely irrelevant to the discussion.
I think the evidence does no support Krugman’s idea. In fact, the crisis should be seen as a garden-variety boom-to-bust emerging market crisis. This is clear if we put the event in the context of the many EM crises of the past decades. Ray Dalio’s book Principles for Navigating Big Debt Crises (Link) provides a good account of the record. Dalio’s “Economic Machine” concept is that financial crises are linked to debt cycles which evolve in predictable patterns and all go through three phases: the bubble build-up, the depression adjustment and the reflationary recovery. Dalio looks at the specifics of 48 crises, 23 of which occured in major emerging markets and are summarized in the chart below. Brazil’s latest crisis is not included in Dalio’s book but I have added it for comparative purposes. The chart shows each country’s characteristics at the peak of the boom cycle in terms of the following criteria:
- Expansion of the Debt to GDP Ratio of at least 5%
- Foreign Debt to GDP of at Least 30%
- Fiscal Deficit at least 2% of GDP
- GDP Output Gap of at least 5% (GDP 5% over trend growth)
- Currency at least 10% overvalued
- Current Account Deficit over 3% of GDP
When a country meets most of these criteria its economy is considered very overheated and vulnerable to a serious downturn.
Not every crisis is the same. Every crisis has its own particularities, but by-and-large they follow the same pattern, meeting the criteria over 80% of the time. Russia, with its structural current account surplus, is the only anomaly, with both booms and busts dictated by oil-driven terms-of-trade shocks.
Brazil’s crisis fits like a glove, amply meeting all the criteria with the exception of “foreign debt to GDP.” But, even this exception is due only to nomenclature, because foreign capital inflows this time took the form of direct investment in Brazil’s liquid bond markets instead of foreign debt. Brazil does in fact experience a pretty standard “sudden stop” when the end of the commodity boom leads to a reversal in capital flows.
In regard to Klein’s discounting of the relevance of commodities as a major factor, I think this is very unlikely. Brazil, with its historical dearth of domestic savings, has always been very sensitive to terms-of-trade shocks. This latest boom-to-bust cycle for Brazil starts with the China-driven boost in commodity prices in 2003 and comes to an end with the collapse in prices that begins in 2012. A glance at any commodity chart confirms this.
Though Brazil is not nearly as sensitive to commodity prices as Russia, they still do matter a lot in that they drive the current account; and when they rise a solvency effect occurs which lowers country-risk perceptions and attracts foreign capital flows.
I think we can safely say that Brazil experienced an entirely traditional boom-to-bust cycle triggered by an increase in commodity prices.
However, the duration and depth of the crisis are more difficult to explain. In the past, Brazil’s economy always proved to be resilient and bounced back quickly from downturns, but this decline has lasted longer and caused more pain. So, what happened?
Why Did Brazil’s Recession Dragged on for so Long?
Both Krugman and Klein blame Brazilian policy-makers for the economy’s extraordinary downturn. But, in arguing that traditional Keynesian fiscal stimulus would have worked, Krugman shows a lack of sensitivity for the “curse” of emerging markets, which is precisely the difficulty of implementing counter-cyclical policies. This “curse,” which is arguably the defining characteristic of EM, exists mainly because of “hot” and fickle foreign capital flows, and this is especially true for a savings-defficient economy like Brazil’s facing a term-of-trade shock.
Klein is closer to the mark by stating that policy makers obsessed over meeting inflation targets because of Brazil’s recent experience with hyper-inflation.
Dalio’s data-base is useful to determine how the recent Brazilian crisis may be unique in terms of how policy makers responded. In Dalio’s framework, the bubble is followed by a “depression,” typically resulting in a deleveraging which sets the base for an eventual reflation period and the start of a new cycle. The chart below looks how during past EM crises emerging market policy makers have typically “engineered,” willfully or not, this depression phase. We focus on the three main levers of adjustment: currency devaluation, current account adjustment and inflation.
What we see clearly is that adjustment periods are all essentially the same, and Brazil in 2012-2017 is no exception. Countries devalue to smoothen the adjustment in the current account and they allow inflation to ramp up. Both devaluations and inflation are taxes on consumption, which drive the adjustment.
But, policy makers in Brazil opted to “cushion” the adjustment. We can see this in the following three charts.
Devaluation – The Brazilian real was allowed to fall, but slowly and not nearly as much as in previous downturns, and not enough to adjust the current account. Brazil’s authorities probably felt that the huge foreign currency reserves accumulated during the commodity boom gave them the luxury to soften the BRL’s decline, and this was orchestrated in the name of financial stability.
Current Account – The current account adjusted, but only after commodity prices staged a rally in 2016-2017. The lack of a strong current account adjustment in the face of a terms-of-trade shock is very unusual.
Inflation – Inflation rose briefly, but was then squashed by extremely tight monetary policy. Brazilian real rates (after inflation) rose to as high as 7% at a time when U.S. and European real rates were negative.
Why did policy makers choose this path? First, politics interfered, as Rousseff primed the economy to ensure her reelection in 2013-14. This served to worsen conditions and delay the adjustment. Also, I agree with Klein that the the Central Bank’s obsession with inflation-targeting was rooted in historical experience. Policy makers understood that inflation is a direct and exclusive tax on the poor because the owners of capital in Brazil have safeguards. But, at the same time, the Central Bank in Brazil, like elsewhere, being a captive of financial markets may have seen its mandate to be to preserve financial stability at any cost. By allowing greater changes in both the value of the BRL and the level of inflation, authorities could have imposed a greater cost on foreign holders of domestic debt and domestic dollar-indebted corporates but they were very reluctant to do this.
Ironically, though financial stability was well maintained in Brazil and inflation was contained, it was still the poor that bore the burden of the crisis. This time it was not through the inflation tax but rather through a long and brutal decline in employment and wages.
Also, the policies had two highly perverse effects (shown in the charts below).
- Very high interest rates dramatically increased public debt levels, causing a new source of potential stress. Brazil failed to take advantage of the crisis to engineer a deleveraging of the economy and set a new base for a new reflationary debt cycle. The debt-to-GDP ratio actually increased by nearly 30 points since 2012, and now public debt sits at precariously high levels. We can contrast this with the significant deleveraging that occured in the 2002 recession, setting a base for the economic boom starting in 2004.
- The relatively strong and stable BRL encouraged Brazilian corporates to borrow in international markets, also creating a new source of stress. External debt to GDP has risen from 18% of GDP in 2012 to 27% in 2017 (World Bank data), now approaching dangerous levels.
If every crisis creates opportunities, in this case Brazil failed. On the other hand, the crisis led to the rise of Bolsonaro and the prospect of liberal reforms, so maybe it was not a total loss.
External Debt Metrics
Macro Watch:
Trade Wars
- The road to confrontation (NYT)
- The real China challenge (NYT)
- China and the uS are on a collission course (brookings)
- How Trump and Xi got into a trade war (WSJ)
India Watch
- Election uncertainty clouds Indian stock market (FT)
- India electrification to impact copper demand (Gorozen
- Can the rupee become a hard currency? (Livemint)
China Watch:
- China picks tobacco taxes above public health (WIC)
- How free is China’s internet? (MERICS)
- China extends its global influence (NYT)
- How cheap labor drives China AI (NYT)
- China’s property barons (SCMP)
China Technology Watch
- A profile of Bytedance, Chna’s short-video ap (The Info)
- Sense-time’s smart cameras (Bloomberg)
- China’s Electric Vehicle push (Bloomberg)
Brazil Watch
EM Investor Watch
- What drives the Russian state? (Carnegie)
- Russia’s big infrastructure bet (WSJ)
- Russia’s new pipeline (Business Week)
- Indonesia’s elections (Lowy)
- Chile’s renewable energy boom (Wiley
Tech Watch
- Why have solar energy costs fallen so quickly (VOX
- Asia leads in robot adoption (QZ)
- The new industrial revolution (WSJ)
Investing
- The top 100 asset managers in the world (Thinking Ahead)
- An evolve or die momeent for the world’s great investors (Fortune)
- Interview with William Eckhardt (Turtle Trader)
- Why momentum inveting works (Anderson)