Continuing With the Adjustment Despite the Costs

BRAZIL ECONOMICS - Report 08 Jun 2015 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

Executive Summary

There's no way to escape from the costs of the fiscal adjustment under way in Brazil. Besides sharp declines in industrial production and fixed capital investments, to name just two components of GDP, the unemployment rate is trending upward and real wages downward. The recession is deepening, and although it may not be as profound as in 2008-2009, it will be longer and the ensuing recovery will be very modest. The costs of this scenario will have to be supported by a politically weakened government. Brazil's CDS quotations do not reflect a risk of immediate loss of investment grade rating, but also do not reflect any confidence that the government will be able to complete the necessary adjustment.

Even with a recessive picture like this, the Central Bank is continuing to tighten monetary policy. Is it trying to regain the credibility lost in recent years and reduce inflation expectations over the horizon to the end of 2016, which would increase the likelihood meeting the 4.5% target? Or does it have a slightly more ambitious goal, which at the cost of a more accentuated recession would bring the benefit of lower real long-term interest rates, leading to a reduction in the primary fiscal surpluses necessary to put the gross debt/GDP ratio on a downward path? The venom of recession would then be the elixir to fortify belief in meeting the fiscal targets, helping to restore confidence.

The political costs of the recession would be lower if there were good perspectives for resuming growth. Only two forces can act in this direction in the near future: an increase in exports and an ambitious program of infrastructure investments. The weakening exchange rate favors stronger exports, but it's also necessary to reduce the unit labor cost measured in Reais, which will only happen with a softer job market. An infrastructure program can only be carried out by mobilizing private resources in the capital market, which faces the negative effect of high real interest rates.

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