The Brazilian economy is the seventh largest in the world and is currently experiencing a potent mix of political and economic problems. At the moment, it is difficult to say, with a lot of conviction where events will take us, but in this report we will look at;

  • What is happening in Brazil and why
  • What measures have been taken so far
  • Where do we go from here

What is happening in Brazil

The economy has technically fallen into recession, with Gross Domestic Product falling for two consecutive quarters in the first half of 2015. In Q2 alone, the economy shrunk 1.9%. Current expectations are for the economy to decline 2.5% in 2015 and to post another decline of 0.7% in 2016.

Brazil is suffering a potent cocktail of economic and political problems which are causing economic growth to slow sharply.

Lower global demand and falling commodity prices have had a big impact on Brazil. Iron ore, in particular, is an important commodity for the economy. Brazil is the third largest producer of the commodity in the world. In 2014, almost 12% of Brazilian exports were of iron ore. On top of this, demand from China has fallen as economic growth has slowed. This is important for Brazil as China is the economy's largest trading partner, accounting for 18% of total exports.

Added to these external factors has been a sharp rise in unemployment and interest rates which have hit consumers in Brazil. At the end of 2014, the unemployment rate stood at 4.3%. It is now approaching 8%. Over the same period, the benchmark interest rate (Selic Rate) has risen by 250bp to 14.25%, the highest level since mid-2006. Interest rates have been hiked as the central bank battles inflation. The headline rate of inflation is currently above 9%, considerably higher than the central bank's 4.5% target which they aim to meet by the end of 2016.

On top of these economic problems, Brazil is suffering a large corruption scandal which is lowering investor confidence and worsening the economic backdrop.

Petrobras, the large Brazilian oil company, is at the centre of an investigation called "Operation Car Wash". The parliamentary commission is looking into suspicious contracts worth billions of dollars, implicating a number of Brazilian businessmen and politicians. Current President, Dilma Rousseff, was Chairwoman of Petrobras during the time when investigators say much of the corruption took place. Although she has been cleared of any wrongdoing, the scandal has tarnished her popularity which has fallen sharply with many of Rousseff's Worker's Party politicians also embroiled in the scandal.

The government is also under pressure to reduce its level of debt. Gross government debt has risen to 65% of GDP, from just 53% at the end of 2013 (see chart above). In September, Standard's and Poor's downgraded Brazil's credit rating to junk status. S&P were unhappy with government changes to its budget targets – earlier in the year the government was aiming for a small budget surplus in 2016 but that was changed to forecast a small deficit.

All of these problems have contributed to a sharp depreciation in the currency, the Brazilian Real. During the first nine months of 2015, the currency depreciated by almost 50% against the US Dollar (see chart below). This sharp depreciation is adding to inflationary pressures in the economy.

On top of this, Brazil is facing the prospect of the US Federal Reserve starting to increase interest rates. Such a move could cause the Brazilian Real to weaken further against the US Dollar, increasing inflationary pressures even more.

What measures have been taken?

The Brazilian central bank has increased the benchmark interest rate to 14.25% (see chart). This takes the interest rate to the highest level since 2006.

The central bank has hiked the benchmark interest rate so aggressively to try and fight inflation and also to try to restore investor confidence in the currency and wider economy. Such a sharp move in interest rates does not come without complications. In particular, it has hurt consumers in Brazil, adding to the already high debt burden they have.

The government is also attempting to close the budget deficit to try and avoid other ratings agency downgrades. In fact, the Brazilian government announced a package of spending cuts in September, which if implemented, aims to deliver a primary surplus of 0.7% of GDP in 2016 – reversing the predicted budget deficit which triggered the S&P downgrade only a few weeks previously. The cuts include a halt to some big infrastructure projects, public job cuts, wage freezes and cuts to areas such as social housing programmes which aim to help the poorest in the country. There has also been talk of a reintroduction of the financial transaction tax.

Where do we go from here?

Further interest rate hikes cannot be ruled out in an attempt to lessen inflationary pressures and ease depreciation of the currency. But this will not be enough. More will need to be done to regain investor confidence and boost economic activity.

One way to regain investor confidence would be for the government to push ahead with spending cuts and tax increases to rein in the budget deficit and prove to investors that the government finances are on a more sustainable path. However, this could prove diffcult to do and will damage further the popularity of the current government. In recent months, protests have taken place calling for Rousseff's impeachment, highlighting the current level of dissatisfaction with the government. Further drops in popularity will leave President Rousseff vulnerable to impeachment. Only recently, the election watchdog opened an investigation into alleged illegal funding of Rousseff's 2014 election campaign. If she is found guilty it could end her presidency , potentially creating more political uncertainty.

Another more radical proposal is a bailout from the International Monetary Fund (IMF). Brazil is not a stranger to help from the IMF. The most recent bailout came in 2002 when Brazil requested $30bn in help when it was close to defaulting. Although the currency has depreciated to the same level, and surpassed the level seen in 2002, foreign reserves are considerably higher than they were back then. In 2002 Brazil's foreign currency reserves were around $37bn. In 2014 that figure had increased significnatly to around $355bn. This suggests that Brazil does not urgently need financial help which could rule out a bailout from the IMF.

There is no doubt that the Brazilian economy is facing an extremely challenging period, with the possibility that conditions will deterioirate further before we see some stabilisation and improvement.

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