It was bound to happen sooner or later. The Central Bank of Brazil is now the directional factor in the country. Political policy is upside down. If not for the central bank and external forces, Brazil would be in trouble again this year. Maybe even recessionary.
Consumer price inflation in Brazil hit a nice and low 4.7% in mid-March from 4.8% in February according to the IPCA-15 price index, thanks in part to the demand destruction caused by two years of economic contraction. Inflation in personal expenses was 6.6% after 6.7% the month before. Bill Adams, a senior international economist with PNC Financial in Pittsburgh wasn't all that excited about the numbers. He'd like to see them go lower, especially on the services side. "The persistence of inflation in domestically-determined prices poses downside risk to the Brazilian outlook," he says. "If domestically-determined inflation stays sticky, it will become a roadblock to further interest rate cuts," he says. It goes without saying that would throw a bucket of ice onto the Bovespa. Last year it was the hottest market around.
Admans thinks that services inflation (health and personal care costs went up to 10.49%) and personal expenses inflation might fall because of unemployment. Thanks to that, the central bank will continue cutting interest rates further in an attempt to get Brazil moving again. At this point, lowering capital costs is pretty much all Brazil's got in terms of sure-things.
On Monday, its biggest markets for beef were closed following the discovery of yet another bribery scandal, this time in the food industry. Brazil is the world's largest exporter of beef. Europe and Hong Kong banned it.
On Tuesday and again at the opening bell in Sao Paulo today, Brazil's stock market followed the outflow in U.S. but it also sold-off on news that the contentious pension reform plan will exempt one of the biggest recipients of public retirement money: state and municipal public servants. "This is not welcome news by the market," says Rafael Sabadell, a fund manager with GGR Investments in Sao Paulo with roughly R$480 million ($155 million) under management. "Even though the government is arguing that by taking them out of the discussion makes for less resistance to pension reform in the congress, it is still a really negative sign."
In other words, congress is treading water. At best investors can say that treading water under this new government led by Michel Temer is better than drowning under the old government led by Dilma Rousseff.
The two biggest policy shifts under the Temer have been changes to rules allow for full foreign participation in certain Brazil offshore oil and gas fields; and the late 2016 amendment to cap spending. The Petrobras participation rule is good for Petrobras' budget, and by default, the government, because it does not have to spend money drilling where it doesn't need to. The amendment change is good too for those concerned about runaway spending in a relatively poor country. But it is of no use if the government cannot reform its pensions. At the very least, the market was banking on changes to the retirement age. Many public employees can retire after certain years of service, meaning that public school teachers and other government workers were retiring in their 50s at nearly full pay, depending on the job.
Later today, Brazil's budget officials will meet to discuss stripping a reported R$45 billion ($14.5 billion) to R$65 billion ($21.03 billion) from the 2017 budget in order to meet its deficit target of around R$139 billion ($45 billion). That's an unlikely target to hit this year because the economy is forecast to grow between 0.5% and 0.7%, down from previous central bank survey forecasts of 1%. A slower economy means less tax revenue to fund things like schools, hospitals and...retirement accounts of public servants.
Finance Minister Henrique Meirelles says he does not want to raise taxes, but if he does, Brazil will become an austerity trade and that could trigger a sell-off in Brazil. It may be safe to assume some sort of tax hike is coming if Brazil wants to get religious about its budget and fiscal targets. It is worth noting that Meirelles is a stickler for targets. When he was the central bank governor in the early 2000s under president Luiz Inacio Lula da Silva, inflation was in the high teens. He raised interest rates to over 22% to finally get inflation down to target. He succeeded thanks in part to a very strong local currency that hit R$1.54 to the dollar in the summer of 2008. The Brazilian real is now trading at R$3.09.
Any tax hike announcement would change the narrative on Brazil from a country in recovery to a country in full austerity mode. In this case, the only positive would be external factors (out of Brazil's control) and monetary policy run by ex-Itau economist Ilan Goldfajn. He and Meirelles are the back stop to Brazil retreating into recession again, especially if commodity prices weaken in the quarter ahead. Nearly all of agriculture commodities are important to Brazil, including sugar, soy, coffee and orange juice.
The latest pension ploy suggests for investors that Brazil is still heading more in the wrong direction than the right one. For this reason, Brazil's central bank is needed to play a stabilizer role not unlike what the Fed did to keep the U.S. economy alive after the Great Recession began in 2008.
