Weekly Report - 8 March 2012 (WR-12-10)

The central bank’s monetary policy committee (Copom) cut the benchmark Selic interest rate by a full 75 basis points (bps) this week, taking it down to single digits (9.75%) for the first time since 2009. In a curt one-line statement, the Copom revealed that the larger-than-expected cut was not unanimous, with five votes in favour and two in favour of a smaller (50 bps) cut. The Copom took the opportunity to act more forcefully in support of domestic economic growth after the national statistics institute (Ibge) this week reported a weak real annual GDP growth rate of just 2.7% for 2011 and a steep fall in industrial production (IP). The IP index fell the most in three years in January 2012, declining 3.4% year-on-year, its biggest drop since December 2008. It also fell 2.1% month-on-month over December 2011.

The GDP result, though the weakest since 2003, was cushioned by the continued domestic consumption boom, with private consumption running much faster than overall GDP growth at 4.1% year-on-year. Government consumption rose 1.9% year-on-year in 2011, in line with the official efforts to rein in public spending. Gross fixed capital formation was up 4.7% year-on-year, which the government took as a reassuring sign. The combination of the domestic consumer boom and a strong Real stimulated strong import growth of 9.7% in 2011. In contrast, export growth was slower (though still respectable) at 4.5%, thanks largely to the Asian demand for commodities. In effect, Brazil is running a two-speed economy at the moment; domestic consumption continues to boom, but domestic industry is struggling to compete, both externally and against a flood of cheap imports at home.

The Rousseff administration, which is facing its first electoral test this October in municipal polls, is anxious to shore up growth. Finance Minister Guido Mantega – who began last year forecasting a GDP result of 4.5%, only to backpedal every quarter – insists that Brazil will rebound over the course of 2012, with the pace of growth accelerating back towards 4.0%-4.5% (in annualised terms) in the second half. Arguably, the central bank is frontloading its planned interest rate cuts now; it might not get the same opportunity again come the second half if Mantega’s rebound gathers pace.

Local producers and exporters are clamouring for the government to take urgent measures to re-balance the economy away from its current reliance on private sector consumption as the main engine of growth. This, they say, is leading Brazil into an uncomfortable reliance on a strong Real so as to fund imports, avoid higher inflation and also to attract external financing. Brazil needs to boost its domestic savings rate (17.2% in 2011) so as to be able to lift its investment rate from below 20% of GDP (19.3% in 2011) to the estimated 25% of GDP required to sustain targeted annual growth of 4.5%-5.0%.

In fact, this is only the second time ever since inflation targeting was first introduced in 1999 that the Selic has been in single digits. In mid 2009, the Copom reduced it to 9.25% (from 10.25%) and then again to an all-time low of 8.75%, where it remained until late April 2010. When the Copom first began its current easing cycle last August, the central bank president Alexandre Tombini signalled that the bank would seek to leverage the crisis in Europe to bring down Brazil’s structurally high interest rates. Tombini and President Dilma Rousseff strongly agree that permanently lower interest rates are key to ensuring more sustainable (read, domestic-led) investment growth in Brazil, reducing its historical over reliance on external financing.

In theory, lower interest rates should help temper the strong appreciatory pressure on the Real which, at R$1.74/US$ (8 March), has risen by almost 6% against the greenback to date this year, heaping the pressure on domestic manufacturers and exporters. To date this year, capital inflows have amounted to a whopping US$15bn, compared with outflows of US$3bn in the final quarter of 2011, as global investors pile back in. In Germany this week, President Rousseff warned that her government was prepared to take strong measures to protect local manufacturers from the “monetary tsunami” unleashed by the quantitative easing policies (i.e. money printing) being pursued in the US and Europe.

The obvious upside to a strong Real is that it protects Brazilian consumers from higher inflation. In January annual inflation was 6.22%, down from last year’s September peak of 7.3%. However, with virtually full employment, price pressures will remain to the fore. Local economists surveyed by the central bank expected year-end inflation of 5.24% on 2 March. Although Mantega is adamant that inflation will gradually return towards the targeted 4.5% this year, the truth is that the Rouseff government can live with a slightly higher figure in order to ensure economic growth.

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