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July 9, 2012 7:33 pm

Brazil: After the carnival

 
 
Drought in Amazon, Brazil, November 2010. The Amazon region faces a dry season every year, but the 2010 drought was the worst in over a century.©Eyevine
A hard walk: while many Brazilians rely on river ferries, much infrastructure of the same vintage is rickety and needs a massive overhaul




Chen Zhizhao, the newest addition to Brazil’s champion football club, Corinthians, already seems at home at the team’s training ground on the edge of São Paulo.




Recruited this year from a club in Guangzhou, southern China, the young footballer has quickly started speaking some Portuguese.
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Although the club claims he was recruited purely for his talent, most suspect the real role of Mr Chen, the first Chinese player to join a major Brazilian team, is to lift the club’s profile in China so that it can sell its distinctive black-and-white team merchandise there.



Corinthians may not realise it but, through its canny use of an area in which Brazil has a natural competitive edgefootball – to tap the Chinese market, the club in its own small way is providing a pointer for a country whose economy suddenly seems to have lost direction.



Elsewhere, exporting success from such kinds of innovation has proved elusive. Over the past decade, Brazil has largely relied on exports of commodities such as soy and iron ore to fuel spectacular economic growth, which peaked at 7.5 per cent in 2010.
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But this growth has slowed to a crawl and the world’s second-largest emerging market is expected to expand only 2 per cent this year. Much of its industry, in spite of a seemingly endless series of stimulus measures, has become globally uncompetitive. Only the consumer seems to be holding the fort but even here, there are signs of fatigue. Despite surging growth and investment, infrastructure and education have lagged behind and their weakness has prevented the country from realising its full potential.




After the first decade of the century, in which everything seemed to fall into place for Brazil, policy makers are now abruptly being forced to rethink the country’s strategic direction. The issue at stake: what kind of economy does Brazil want and how big the role of the state should be?



“We want to consume like US consumers, we want to have the public services of the Europeans but we want to grow like an emerging market, so something has to give,” said Ilan Goldfajn, chief economist at Itaú, Brazil’s largest private sector bank.




It is a question troubling not just Brazil but all emerging markets. With the European, US and Japanese models looking battered, there are few global gold standards left to guide policy makers through the gathering storm clouds. Indeed, the next few years will be critical for the direction of the world economy as each of the Bric nationsBrazil, Russia, India and China – is tempted to revert to old socialist or statist habits to protect jobs and markets.



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“This is where you’ve got to navigate without a lighthouse,” says Raghuram Rajan of the University of Chicago and a former chief economist of the International Monetary Fund. The challenge, he says, will be for countries to take what has been learnt in the west without “abandoning the western model totally”. “How do you get the good side of markets without being exposed to the underside?”


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Much of Brazil’s remarkable run of prosperity was characterised as the “Lula model” of development, named after former President Luiz Inácio Lula da Silva. During his two terms between 2003 and 2010, he saw the size of Brazil’s middle class increase by more than 30m people through welfare transfers, rising salaries and increased consumer credit.



Helped by the windfall of rising commodity prices, the country also tamed its old enemy, inflation, and reaped the benefits of macroeconomic stability, accumulating reserves of more than $370bn. It survived the 2009 economic crisis with gusto, posting the highest gross domestic product growth in decades in 2010.




Furthermore, this year President Dilma Rousseff, a taciturn technocrat compared with Mr Lula da Silva’s rough-edged unionist charisma, pushed unemployment down to record lows of below 6 per cent and increased the minimum salary. This has rewarded her with a staggering personal approval rating of 77 per cent.




But the Lula model, skewed towards state-led consumption, also lacked an effective strategy to increase the capacity of the country’s infrastructure or education systems to handle the surge in growth. Inflation, the nation’s longstanding curse, which hit 2,477 per cent in 1993, began to return, forcing the central bank last year to increase interest rates to levels that brought the party to an abrupt halt.



Brazil’s strong currency also squeezed industry, sending it into recession. Auto companies have begun suspending or laying off workers, while private banks are holding back on lending after defaults hit a record high during May.


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“We are exactly in this turning point,” says Mr Goldfajn. “There was a need to decelerate the economy, so wages continued to rise but prices could not follow and that meant margins got squeezed.”



The slowdown, which is being worsened by softening commodity prices and the eurozone crisis, has reopened a debate about why Brazil seems unable to grow faster than its long-term trend growth of about 4 per cent before inflation kicks in.



Perhaps most disturbing is an astonishing lack of international competitiveness of many Brazilian industries, even in sectors that should enjoy a natural advantage.


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Gerdau, Latin America’s largest steelmaker, blamed weak profit growth in its latest results on an increase in raw material pricesiron ore, mineral coal and scrap. This is even though Gerdau is based in a country that is one of the world’s biggest exporters of quality iron ore.




The company spoke of the “deindustrialisation” of the steel supply chain in Brazil, as cheap imports from Asia undercut its products. Indeed, Carlos Ghosn, chief executive of Nissan-Renault, complained last year that it was cheaper for him to import steel made in South Korea from Brazilian iron ore, than to buy local products.




Most critics also point to infrastructure, particularly Brazil’s roads and ports, as another impediment. The cost of exporting a container from Brazil is $900, more than double the price from China and 1.5 times that from India. Meanwhile, importing costs are almost triple that of China and nearly double that of India, according to the World Bank.


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“It is a disaster, ships sometimes have to stop for 90 days,” Eike Batista, Brazilian oil and logistics billionaire, told an investor meeting this year.


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The other huge bottleneck in Brazil is skilled and semi-skilled labour. In the globalPisatest measuring average reading and mathematics scores, Brazil ranks near the bottom of the league tables, behind many other developing countries.


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Thanks partly to poor education, productivity in Brazil has increased by only 1.5 per cent a year over the past decade compared with 4 per cent in China, according to Marcos Troyjo, of Columbia University.



A shortage of local professionals is now affecting growth industries. Ricardo Guedes, head of recruiter Michael Page in Rio de Janeiro, says some clients in the booming oil industry have been so desperate to fill positions they will pay almost anything. “For a couple of positions, we don’t even mention salary.”



Many of Brazil’s problems, however, are not bad ones to have. They often stem from rapid economic growth, preferable to the stagnation afflicting Europe, the US and Japan.




Indeed, the crisis has cemented a consensus in Brazil about the need for greater investment. At current levels of about 19 per cent of GDP, investment is short of the 22 per cent Brazil needs to expand its economy at about 4 per cent a year.



The government’s response to this issue has been more constructive than in 2009, when it unleashed massive state lending, analysts say. This time it has encouraged the central bank to lower Brazil’s extraordinarily high benchmark interest rate – a legacy of its history of runaway inflation. This has fallen to a record low of 8.5 per cent and is expected to drop further this week.


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Lower interest rates will help to foster greater investment in infrastructure. Until now, investors were able to earn such high returns from short-term deposits they had little incentive to invest in riskier, long-term infrastructure projects. In addition, companies could not afford to borrow long term because rates were too high.




“There is a clear perception we need to get the investment going, the difficulty is how,” Itaú’s Mr Goldfajn says.



Among the challenges are an unwieldy government bureaucracy and tax system – even when the funds are available for investment, projects often get stuck because of red tape. Vale, the country’s largest miner, for instance, complains that it takes more than three years to get environmental clearances for its mines.




There is also the problem of a lack of savings. Brazilians only save 16 per cent of GDP, a fraction of the levels in China and India. The Brazilian government is a big part of the problem – it taxes like a European government yet wastes most of it on salaries, pensions and interest payments. Brazilian public revenue is equal to about 36-38 per cent of GDP compared with about 25 per cent in South Korea.




But shrinking government will be hard. As analysts point out, big government is a choice the Brazilian voter has made. Even faced with the decline of the European economies, the average Brazilian is still more likely to opt for a state-led model, such as China, than pure US-style, free-market capitalism.




“It used to be that all of Latin America looked to Europe as its ideal model, and that one day Brazil, Argentina and Colombia would become a Portugal, Italy, Greece or Spain, if it was lucky. But now, given the eurozone crisis, that is no longer the case. And, increasingly, China is becoming a more attractive or plausible model,” says a Brazilian diplomat.




To fill the investment gap, therefore, Brazil must attract foreign capital. Foreign direct investment hit a record $66.7bn last year, up from $48.5bn in 2010, but outsiders will demand adequate returns to continue coming. In the long run, these returns can only come from improvements in productivity. Brazilians and Brazilian companies will need to work smarter and become more innovative.




Private sector initiatives, such as that on display at Corinthians, offer hope. Even here, however, some of the comments from Mr Chen on the differences he has noticed between Brazil and China say much about why South America will not be another Asia anytime soon.




“In China, not much people [are] interested in football. The children are studying too much.”


 

As growth slows focus shifts to the home front





As in Brazil, so in other emerging economies: growth is slowing, and as it slows it is raising serious questions about the economic future of the developing world, writes Stefan Wagstyl. Growth in emerging markets’ gross domestic product will slow this year to 5.7 per cent, from 6.3 per cent in 2011, according to the International Monetary Fund.



That is well above the 1.4 per cent increase forecast for the developed world. But it is a hefty discount to the 8 per cent recorded up to 2008. The decreases are driven mainly by a slowdown in the developed world, principally Europe.



Commodity exporters, headed by Russia, have profited mightily from the price boom that followed the 2008-9 economic crisis. But the recent price fall is starting to hit their economies.
Developing countries also face growing domestic difficulties, however.



In India, for example, decades-old bottlenecks in infrastructure and labour supplies have kept inflation high, forcing the central bank to maintain high interest rates even at the cost of hurting investment. Elsewhere, notably China, Brazil and Turkey, there are concerns that recent loan growth fuelled by sustained low credit flows from the west – has generated unproductive investments and will trigger rising bad debts.


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Policy makers have contained these threatsso far. But slowing growth increases the dangers. Even a slight slowdown can exert a disproportionate impact on sensitive credit-fuelled sectors.


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Once a few investors run scared, others can quickly follow.




In the long run, the rise of the emerging economies is likely to continue. Investment flows to countries where it can achieve the best returns – and these are still to be found in the developing world with opportunities for low-cost exports and for local domestic market growth.




The developing world’s growing middle classes will not want to be denied their desire for western-level living standards. The pace of emerging market growth is likely to be slower than 8 per cent, however. It will also, most likely, depend less on exports to the rich world and more on emerging-world demand, both within countries and in expanding south-south trade.



However, the adjustment could be hard, especially for countries with poor reform records, not least Russia. Much will also depend on the availability of cross-border credit and investment. The bigger the financial shocks from the eurozone and other as-yet-unexploded financial bombs, the harder the transition will be.


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With additional reporting by John Paul Rathbone and Jonathan Wheatley in London



Copyright The Financial Times Limited 2012.


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The conventional wisdom is that the investments with the lowest risk are U.S. Treasuries. If you ever took a course in finance, this is one of the first things that you learn. Consequently, many investors choose to hold U.S. Treasuries because they are afraid, and they believe that these vehicles represent a safe haven.


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The problem with people choosing to hold U.S. Treasuries is that they most likely do not understand what they are. If they did understand them, they would not hold them. When you buy U.S. Treasuries you become a lender to an entity called the U.S. government. Consequently, you must be bullish on this entity and/or you think that you will get your money back.




If you wanted to lend money to a really bad company, what kind of characteristics would you look for?



  • Consistently losing money, meaning spending more money than you are taking in

  • Increasing expenses every year
  • Borrowing money to cover losses from operations and interest payments on previously borrowed debt
  • Issuing (i.e. printing) shares to cover losses that borrowing did not cover
  • Incompetent management




If you are lending to the U.S. government, it is like lending to a company with these characteristics. The U.S. federal government consistently loses money almost every single year. In 2012, it will receive approximately $2.3 trillion in revenues and it will spend approximately $3.8 trillion. This means that it will have an operating loss of $1.5 trillion.



This represents 65% of revenues.

This kind of deficit would not be possible if it wasn't for the continuous increase in expenses from year to year. In 1996, the expenses were approximately $1.6 trillion. Now, they are $3.8 trillion.

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To cover the losses, the government has to borrow money. Consequently, the total debt continues to increase. In 2000, the total debt was less than $6 trillion. Today, it is approaching $16 trillion. Over the course of about a decade, the government took on an additional $10 trillion worth of debt.




Because the government cannot borrow the entire deficit/losses at a low cost (interest rate), it has to print money to cover the difference. The way this happens is the Fed buys a portion of U.S. Treasuries with money that was created out of thin air.


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None of this would have been possible without our incompetent leaders. I want to be clear here that I don't believe that they are evil. They just don't understand economics. They are politicians. What do you expect?



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If the current fiscal situation continues to follow the same course, by 2015, the U.S. will have $20 trillion in debt. If interest rates on this debt increase to 5%, the cost of servicing it will be $1 trillion.



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Remember, the government only takes in about $2.3 trillion in revenues. Therefore, at an interest rate of 5%, approximately one half of total revenues will go to interest on the debt. If interest rates go to 10% (if you don't believe this can happen, check out the rates on Portuguese government debt), the cost of servicing it will be $2 trillion or almost 100% of total revenues.


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To balance the budget under such circumstances would require the elimination of all government expenses, which would mean no more Social Security for retirees, no more Medicare, and no more defense for the country.



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With that being said, who said anything about balancing the budget? To balance the budget today, expenses would have to be cut from $3.8 trillion to $2.3 trillion, which is equal to the revenues. Can you imagine someone running for the president with the following message?



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"If you elect me, I will cut government spending by $1.5 trillion. This will require severe cuts to Social Security, Medicare, and defense. Unfortunately, many of the things that you have been promised by my predecessors will have to be revoked. We will have to learn how to live on less and pay off our creditors. But we need to do this for future generations."



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This is never going to happen. Our country is not educated enough about economics to ever elect a president with such a message. To me, it is pretty clear that the government will not be able to balance the budget and the total debt will continue to increase.



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Then, the level of interest rates on this debt will determine how bad things will get. If interest rates increase, the U.S. government will not be able to pay its bills. If they don't increase, we are also in bad shape because of the things that the Fed will have to do to keep them there. Here is what I mean.



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Currently, interest rates are extremely low and this is why the government's debt is not such a big problem yet. When interest rates increase, the government will not be able to afford the interest payment. What controls the level of interest rates?


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Interest rate levels are determined by the demand from investors around the world. If there are a lot of investors who want to buy U.S. Treasuries because they are scared of keeping their money anywhere else, they drive up the prices of U.S. Treasuries. As a result, they are willing to accept lower and lower interest rates, which allow the U.S. government to borrow cheaply.



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As long as the demand for U.S. Treasuries stays high, interest rates can stay low, keeping the U.S. government from bankruptcy. But the problem is that it is increasingly more difficult to keep the demand high as the total debt continues to increase and because there is not as much demand as there was in the past.



For years and years, foreigners kept buying U.S. Treasuries, but because the world is facing an economic slowdown, they are not buying as much as they used to.

Despite this lower demand for U.S. Treasuries, interest rates are still at record lows. The reason for this is the fact that the drop in demand from outsiders was replaced by a new "magical" buyer - the Fed. In other words, the government is borrowing money by selling Treasuries, and one of the buyers/lenders is the government itself. This is the same as printing money.


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Going forward, as more and more debt piles up, the interest rates are going to increase or the Fed will have to buy even more Treasuries (i.e. print even more money). If interest rates go up, the government will not be able to afford them. If the Fed keeps interest rates artificially low, it will destroy the value of the dollar by creating inflation or hyperinflation.


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Because it is much easier to print money than to cut government spending to balance the budget and start paying off debt, politicians are likely to choose the printing route. In this scenario, holding U.S. Treasuries will be the surest way to losing purchasing power.




However, some people believe that this is not a problem because the improving economy will take care of these problems. They actually believe that the economy is getting stronger and stronger.



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Under conventional methods of evaluating economic growth, the economy is improving as long as the GDP (gross domestic product) is growing. However, the GDP is mostly a measure of consumption and spending. In other words, as long as consumption and spending are up, the economy is fine.



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This is wrong. For example, going out and buying yourself a new house, a Ferrari, and a couple of expensive suits does not necessarily mean you are doing fine financially. Your neighbors might be impressed, but that would only be because they assume that because you are buying all these toys, you must be doing well financially.





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While you can fool your neighbors, you cannot fool yourself. If the money for these purchases came from a successful business or a job that pays well, then you are doing well financially. But if you borrowed this money because you cannot afford these things, then you are not doing that well.


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Actually, after your shopping spree, you are far worse off because you spent borrowed money on things that depreciate in value and do not produce anything. The debt, on the other hand, appreciates because you will have to pay back the original amount plus interest.


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By looking at this example, you are probably telling yourself, "Of course, this is obvious." I wish our leaders had such common sense. Instead, they judge the economy's health the same way your neighbor would likely judge your financial well-being after observing your purchases.


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Two of the variables that make up the GDP are private consumption and government spending. Because so many of our private consumers are unemployed and up to their eyeballs in debt, they cannot spend enough to keep the GDP growing. So what do our leaders do? They tell us: "To keep the economy recovering, we need to have the government do the spending since the private consumer cannot." What a great solution!


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I don't have a problem with the government spending money. What I have a problem with is the government spending money that it does not have. As I mentioned before, our government is running a deficit of more than $1 trillion each year, which means that they are spending more than they are taking in. The difference has to be borrowed. This is no different than if you bought expensive things, didn't have a job, and charged the bill on a credit card.

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Currently, we have an economy that is barely growing, but the cost of this growth is huge deficit spending and unsustainably large debts. If the government stopped its massive spending, our economy would crumble. Even though the unemployment rate is high, it would go even higher.


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However, the politicians will do everything in their power to keep the economy from crumbling. They will artificially try to prop it up for as long as possible.


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Consequently, they will increase spending by borrowing and printing money. In the long-term, this will likely destroy the value of the dollar. In other words, we will have inflation like you have never seen before.


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This time, the politicians won't be able to do anything about inflation. In the 1970s and early 1980s, we had high inflation in the U.S., and to stop it, Paul Volcker, who was the chairman of the Fed, chose to raise interest rates. This time, we won't be able to raise interest rates to control inflation because if we do, the U.S. government will be bankrupt. This is what happens when you have too much debt.


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As a result of these dynamics, holding U.S. Treasuries is financially suicidal. It might work well in the short run because investors do not really care if the U.S. government can repay its debt. Right now they get their money back because the U.S. government can repay them by borrowing from someone else. In other words, there are enough fools out there that are willing to lend them money. Sounds similar to the dot.com and the housing bubble, doesn't it? During the dot.com bubble, people didn't care what their stocks were worth as long as they were able to sell them to a bigger fool. The housing prices also kept rising because there was always another fool willing to pay more. But at one point, the last person buying at the top is the biggest fool.


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Sooner or later, people will realize that U.S Treasuries are not as safe as they think they are.


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I understand that you might be confused about a lot of the things that I said this article. I urge you to educate yourself on the subject of the economy because we are living in an unprecedented economic climate that will make history. Just as we cannot believe we didn't see the dot.com and housing bubbles coming, a few years down the road, we will not be able to believe we couldn't see the current economic forces taking place today.


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The one book that everybody should read is Economics in One Lesson by Henry Hazlitt. It is a very easy book to read for anybody. I just told my own mother to read it so that she can protect herself. She knows what it is like to live through hyperinflation because this is what we had in Poland when I was a little kid. All of my mother's savings were wiped out.



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At one point, she had enough money saved up for a down payment on a house. But by the time we bought the house, this money only bought us a washing machine. But we were all millionaires. I remember my mom was making approximately 10 million zlote per month (incidentally, zlote actually means gold). The Polish government just kept adding zeros to our currency but these millions kept on buying us less and less.



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Eventually, there were so many zeros that they had a hard time fitting them on one bill. So, they decided to cut off four zeros and introduce new bills.


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If you don't think this can happen in the U.S., then you are in denial. If you wanted to create inflation, all you would need to do is to follow the exact path that our leaders are following - spending more than you are taking in, borrowing excessively, and printing money to cover shortfalls. Inflation is not created by businesses raising prices. It is created by inflating the supply of money. The entity that controls the supply of money, the Fed, is the only entity that can inflate it. If you and I tried to inflate the supply of money, we would go to jail for counterfeiting. But, on the government's level, this is all legal. Because of huge deficits and unsustainably high debt levels, the government is inflating more than ever.