Reassessing Brazil's Economic Outlook

(EVARISTO SA/AFP via Getty Images)

Brazilian President Luiz Inacio Lula da Silva (center) speaks during a ministerial meeting on infrastructure investment projects in Brasilia, Brazil, on Nov. 3, 2023.

After years of economic stagnation and heightened political uncertainty, Brazil will find itself on a more stable and predictable economic path in the next few years; however, the country's medium-term economic growth will remain modest despite government efforts to accelerate it, including by developing the country's abundant offshore oil reserves. Over the past decade, Brazil's economy has largely stagnated. Starting in 2014, a major corruption scandal coincided with the end of a decades-long commodity boom, which weighed on investment and economic growth. This was followed by the COVID-19 pandemic, which caused a sharp recession. In economic terms, the 2014-2024 period differed sharply from Brazilian President Luiz Inacio Lula da Silva's first term (2003-2010), which was characterized by solid economic growth and increased macroeconomic stability in the context of increasing commodity prices and stability-oriented macroeconomic policies.

Real GDP growth in Brazil averaged 2.5% over the past four decades, but only 0.6% in the past decade. The ten-year average is inconsistent with Brazil's medium-term growth potential of 1.5-2.5% on account of its investment levels. In 2023, the South American country's real GDP growth is forecast to have increased to nearly 3%, though this level of growth will be unsustainable due to continued low investment.
Brazil's savings and investment ratios are a mere 16% and 18% of its GDP, respectively. This is low by emerging markets standards and helps explain Brazil's modest economic growth compared with many of its emerging economy peers. Historically, such a low investment rate is consistent with a real GDP growth rate of around 2%.

Brazil's economic outlook is stable and the risk of serious macroeconomic instability is manageable. Brazil has a high level of government debt (which exceeded 85% of GDP in gross terms at end-2022) and a large public sector deficit (which the International Monetary Fund forecasts to reach 7% of GDP in 2023). However, the bulk of government debt is denominated in local currency, and the public sector is a net foreign currency creditor, which sharply limits the economy's vulnerability to external shocks and makes a sovereign default unlikely. Moreover, Brazil runs trade surpluses and modest current account deficits, which are largely financed by non-debt foreign direct investment inflows. A flexible exchange rate, combined with an independent central bank, enables Brazil to absorb even severe external shocks. The central bank's proactive monetary tightening in the wake of the COVID-related inflation surge has also recently earned it greater credibility; the bank's inflation target for 2024 is 3%.

Brazil's five-year sovereign credit default spreads, an important measure of sovereign default risk, are trading at less than 150 basis points, pointing to a very low level of sovereign default risk. On Dec. 19, Fitch Ratings raised Brazil's long-term credit rating from BB- to BB, citing the country's recently approved tax reform as a major reason for the change.
The International Monetary Fund projects Brazil's government debt-to-GDP ratio to keep increasing gradually from 85% of GDP in 2022 to 95% of GDP in 2027. While this will help keep interest rates high relative to a scenario where government debt falls, it is unlikely to trigger a fiscal or financial crisis before the country holds its next presidential election in 2026.
With a net debt-to-GDP ratio of 60% of GDP and a real interest rate of 5% and real GDP growth rate of 2%, the Brazilian government would need to run a primary surplus of 1.8% to stabilize debt levels. This means that even if the government meets its fiscal targets, government debt will continue to increase, even if slowly, over the next few years. If the government were to hit its target, the debt ratio could begin to stabilize at the end of President Lula's mandate in 2026.

In the medium term, the greatest challenges facing Brazil's economy include limited growth and high levels of government debt. President Lula has committed to eliminating the primary deficit, which has helped maintain investor confidence in the short term. Since taking office in January 2023, the Lula administration has passed a new fiscal framework that aims to increase revenue and stabilize government debt by eliminating tax loopholes, reducing tax-related subsidies and enhancing tax enforcement. It's also passed a historic tax reform that will help streamline Brazil's tax system by replacing five consumption with two value-added taxes. However, the Lula administration has encountered obstacles in taking sufficiently forceful measures to raise the additional revenue needed to meet its near-term fiscal targets, not least due to opposition in Brazil's Congress. Under Lula, the Brazilian government has also increased spending, which will further lead Brasilia to miss its near-term fiscal targets. This does not spell financial disaster, as even if Brazil's debt-to-GDP ratio continues to increase in the coming years, it will do so gradually. Besides, markets continue to believe that the Lula administration will pursue the pragmatic measures needed to avert a more destabilizing fiscal deterioration. But Brasilia will need to run primary surpluses even higher than what it targets for 2024-26. This means that in the medium-to-long term, the government will need to make a greater effort if Brazil's debt-to-GDP ratio is to be stabilized.

Rather than increasing revenue through new taxes, higher taxes or cuts to spending, the Lula administration has focused on closing tax loopholes.
The new fiscal framework replaces the spending cap introduced in 2016 under then-Brazilian President Michel Temer, which limited annual government spending increases to the rate of inflation. The framework targets a zero primary deficit (+/- 0.25 percent points) for 2024 and gradually increasing surpluses thereafter; these targets need to be approved in each year's annual budget.
Rather than raise revenue, the tax reform should modestly boost Brazil's long-term economic growth by making the country's tax system more efficient.

Brazil's economic stabilization is largely owed to the normalization of international and domestic economic conditions following a mass corruption scandal and the COVID-19 pandemic, rather than significant macroeconomic adjustment or structural reform. In a sense, Brazil's improved economic growth outlook represents mean reversion. In 2014, a corruption scandal known as ''Operation Car Wash'' erupted in Brazil and quickly ballooned into a massive, yearslong anti-graft probe that implicated major companies and many of the country's politicians. The crisis left Brazil mired in political upheaval for years and effectively paralyzed infrastructure investment. Then came the global fallout from the COVID-19 pandemic, serving another blow to Brazil's economy. But the domestic uncertainty created by both the corruption scandal and COVID-19 has since eased, enabling Brazil's economy to restabilize. Brazil will remain vulnerable to possible future shocks, including a sharp slowdown in Chinese economic growth or a prolonged U.S. economic recession. Either of these scenarios would negatively affect Brazil's economic growth by reducing demand for Brazilian commodities, thus cutting into the country's export revenue. However, Brazil's degree of geographic export diversification and generally limited trade openness should help limit downside economic risks. The sharp slowdown in domestic investment in the wake of the car wash scandal or the collapse in domestic demand during COVID-19 had a far greater negative impact on Brazil's short- and medium-term growth outlook than a worsening of external demand in an economy where exports represent only about 20% of GDP.

Merchandise exports account for less than 18% of Brazil's GDP, which is very low and makes the country less sensitive to a deterioration of international economic conditions compared with most other emerging economies.
Brazil's exports benefit from diversification. While 25% of its exports go to China, 15% go to the European Union and over 10% to the United States. Brazil's exports to Argentina represent less than 5% of total exports, limiting the impact of a sharp economic recession in Argentina on the Brazilian economy.
Lower U.S. and European interest rates will also boost capital flows to Brazil and lead to an easing of financing conditions.

An independent judiciary and a strong (or at least obstructive) Congress — along with the relative stability of the country's institutional framework — will limit Brazil's ability to enact radical policy change and productivity-enhancing economic reform. The Brazilian state has proven resilient in the face of political polarization. However, this also means inertia in terms of reform, particularly in the context of an improving, more stable economic outlook. While large-scale reform is difficult in all political systems, it is particularly difficult in Brazil due to the high number of veto players. Congress is highly fragmented and party discipline is low; this forces presidents to carefully build diverse and heterogeneous majorities, which limits their ability to implement wide-ranging reform due to the need to reconcile politically divergent interests. Brazil's constitution is also very detailed and many important economic reforms require super-majorities in both chambers of Congress, which is difficult to secure. The country's judiciary, meanwhile, is independent and both willing and able to constrain government action. In addition to institutional constraints, Brazil's relatively stable economic outlook further reduces the potential for growth-enhancing structural reform, as sweeping policy change typically occurs during times of significant economic stability or after devastating economic crises. Relative economic stability limits the incentives of the government to pursue wide-ranging economic reform, often leading it to prioritize smaller, less meaningful reform. Instead, the Lula government will continue to rely on fiscal spending to accelerate economic growth. But this will eventually run into budget constraints and will do little to increase Brazil's economic productivity, judging by the success of similar growth programs under the previous governments.

During ''normal'' economic times, structural reform in Brazil has typically been gradual at best, with the focus of economic policy shifting toward redistribution and pump-priming the economy rather than growth-enhancing economic reform. Former Brazilian President Jair Bolsonaro put forward an ambitious reform agenda during his term (2019-2022), but was ultimately only able to implement smaller, less ambitious policy changes. The COVID-19 crisis was far from normal, but it did not push the country close to a financial default. By contrast, former President Fernando Henrique Cardoso saw several financial crises during his term (1995-2002), which enabled his government to push through significant structural reform in the late nineties and early 2000s. Similarly, during his first presidential term (2003-2010), Lula managed to implement significant macroeconomic adjustment in the context of heightened financial instability and default risk in 2003.

The government's plan to develop its energy exports will help boost export revenues, but this will not fundamentally alter the economy's medium-term growth trajectory. Even if the government succeeds in implementing its energy plan, the boost to medium-term economic growth will be limited. First, Brasilia would need to convert higher export revenues into savings and investment. But political-electoral pressures mean at least part of the windfall will likely be consumed. Second, the increase in domestic oil and energy production will not entirely translate into increased net exports. Third, even though Brazil is projected to become the fifth-largest oil exporter a decade from now, oil exports as a share of GDP will remain small compared with other major oil exporters, which will limit the impact of expanding production, exports and higher prices on Brazil's medium-term economic outlook. Brazil's long-term economic growth is thus highly unlikely to exceed 3% over the medium term, and this assumes that the underlying growth potential will not deteriorate in the next few years. But higher economic growth will help keep a lid on public debt, provided the government manages to eliminate the primary fiscal deficit. Even if the Lula administration falls short of its original fiscal targets, the country will not experience a fiscal crisis right away, given that the debt is largely denominated in local currency. Markets rightly believe that President Lula and lawmakers in Congress are pragmatic enough to do what is necessary if signs of fiscal distress emerge. But even a best-case fiscal scenario will be insufficient to raise aggregate investment to a level where it would make a significant difference to Brazil's medium-term economic growth outlook.

Brazil is not only the world's largest net agricultural exporter, but a top-five producer of three dozen agricultural commodities. Agricultural products account for 40% and fuels and mining for 33% of total exports. Energy exports account for about 10% of total exports. Total exports are relatively low at 20% of GDP, which accounts for the limited boost to savings from a higher energy export volume drop.
Brazil is much more reliant on agriculture than energy exports. While agricultural prices are difficult to forecast, Brazil will benefit from a continued, if gradual, expansion of agricultural exports over the next decade. Given overall low export levels, which account for around 7% of GDP, and even if any price-related windfall is saved, the increase in domestic savings levels will be limited
Brazil sits on the largest recoverable ultra-deep oil reserves in the world. Between 2018 and 2022, the country's total oil production increased from 2.6 million barrels per day (bpd) to 3.0 million, while gas production increased from 112 million to 138 million bpd. The government's Energy Expansion Plan foresees crude oil production to reach 4.9 million bpd by 2032. This would turn Brazil into the world's fifth-largest crude oil exporter.
Brazil's nominal GDP is $2 trillion. Even if net crude oil export volumes increased in line with targeted production increases and export prices increased by 50%, oil-related export revenues would increase from $30 billion to only $75 by the early 2030s. If the entire increase in revenues stemming from exports were to be saved (and invested), this would boost the investment ratio by less than 2% of GDP. Raising the investment ratio from 16% of GDP to 18% might boost annual real GDP growth by 0.2-0.4% points (assuming all else is equal).