Brazil - The BRIC laggard?

Author: Felipe del Pino

Date published: 12 Mar 2007

Of the four BRIC economies, Brazil has consistently underperformed in terms of real GDP growth. This is due to outstanding structural impediments, notably the need for an overhaul of the public sector. Without greater commitment to reform, Brazilian economic growth will continue to under-perform, constraining consumer markets and reducing investment opportunities.

Issue

The root cause of Brazil's slow growth has been the inability of governments to implement structural reforms that would allow the economy to reach its full potential. The cost of this is borne by the private sector, in the form of high taxes and interest rates. This hinders both investment and consumption growth.

Importance

It is widely agreed that Brazil, Russia, China and India, four of the world's largest emerging economies (BRICs), have massive growth potential:

Under the right conditions, the combined economies of these four could be worth more in US dollar terms than the G6 (Germany, France, Italy, Japan, UK and USA) by 2041;

As early as 2009, the annual increase in total US dollar expenditure from the BRICs could be greater than in the G6.

The implications of this and the shift in demand from the developed to the developing world will be significant for businesses:

As growth accelerates and per capita incomes rise in the heavily populated BRICs, they will become the world's most important consumer markets.

Being invested in these consumer markets will be of fundamental strategic importance to international companies, particularly as leading Western economies become less important to global demand.

However, the average growth of the BRICs is being held back by Brazil, which has consistently posted the lowest rate of real GDP growth:

Brazilian annual real GDP growth averaged 2.6% since 2000, compared to 9.6% in China, 6.7% in Russia and 6.7% in India.

Brazil's weak performance is largely due to outstanding structural impediments that result in high interest and tax rates, which effectively block faster growth. Chief among these is a massively bloated public sector, in addition to an outmoded labour system and an overtaxed and overregulated business environment.

Real annual GDP Growth in BRICs: 2000-2006

Source: Euromonitor International from International Monetary Fund (IMF), International Financial Statistics.

Note: 2006 data are preliminary.

Implications

The root cause of Brazil's consistently slow growth has been the inability of successive governments to implement structural reforms of the public sector (pension and labour reform) that would enable the economy to reach its full potential.

The cost of this failure is borne almost exclusively by the private business sector and Brazilian consumers, in the form of a high tax burden and high interest rates. This hinders both investment and consumption growth:

Brazil's overall tax burden was approximately 39% of GDP in 2006, one of the highest in the developing world acting as a deterrent to investment;

Although in decline, real interest rates remain high at just under 10%. Brazil's benchmark rate of 12.75% in March 2007 compares poorly to Mexico's 7.0%. Within global emerging markets, only Turkey has higher rates. This limits the pace of credit expansion for consumers and businesses;

In 2003-2005, private consumption growth averaged 2.0% in annual real terms, while gross fixed capital investment growth averaged 2.2%. This is significantly lower than in the other BRICs.

High public spending also has the effect of crowding out much needed capital investment:

Brazil's investment rate was a low 20% of GDP in 2005 much lower than 41% of GDP in China.

A prolonged dearth of capital investment has left Brazil with a crumbling infrastructure, meaning that it has not been able to fully leverage the recent commodities boom to achieve stronger growth.

Gross Fixed Capital Investment (GFCF) as a percentage of GDP in BRICs: 2005

Source: Euromonitor International from International Monetary Fund (IMF), International Financial Statistics.

In the absence of greater market liberalisation, Brazil will continue to grow below the rate needed to alleviate poverty. Moving forward, this could see Brazil losing global market share not only to the other BRICs but also other rapidly expanding Asian and Eastern European markets.

Future scenarios

Despite sluggish growth, Brazilian domestic demand has rebounded strongly since 2003, thanks to a period of macroeconomic stability, bolstered by favourable external conditions and successful new government policies to redistribute income:

The consumer market is blossoming amid higher incomes, a gradual decline in inflation and interest rates and increased private sector credit. Investment is also rising for similar reasons, in spite of the complex regulatory and tax constraints.

However, this is not sustainable without faster and more diversified growth, which would enable Brazil to wean itself off its reliance on commodity exports (accounting for 40% of the total) and avoid another boom-bust scenario once the current commodity run ends. There is an urgent need for the government to facilitate this by enabling the private sector to invest and expand.

The government has begun to implement reforms:

A recently unveiled growth package is aimed at unlocking faster growth via increased public and private sector investment (focused on infrastructure and housing);

It has also lined up tax reforms for the corporate sector aimed at reducing the costs of doing business;

Regulatory agencies are being strengthened and the credit market expanded, particularly for infrastructure investments and mortgages;

The government has also committed to stabilising current expenditure as a percentage of GDP, via payroll and minimum wage growth ceilings.

Unfortunately, there is little political appetite for more radical measures such as pension and labour reform. Until these are tackled, Brazil's structurally high expenditure burden will remain entrenched, and with that the need for above average tax and interest rates.