Archive for September, 2009

US/China trade policy blasted in NYTimes Editorial

September 19, 2009
Source: Google Images Source: Google Images

An update on a post I did last week on the Obama administration’s swing toward trade protectionism with its action against Chinese tires:  enclosed is this nicely written NYTimes editorialnot an Op-ed, an editorial. 

The Times editorial board understands economics.  American workers in the tire industry, many represented by the United Steelworkers Union, may well lose their jobs with or without the new 35% tariff against Chinese tires.  The reality about trade, the Times points out, is that Americans will likely buy low-cost tires from other countries in any case, perhaps in Latin America, rather than from American factories.  These Latin tires will cost more than the Chinese variety, making American consumers worse off.

The Economist article I attached to the last post included a comment from an analyst suggesting that President Obama, by imposing these tariffs, is shoring up his left flank in order to achieve support for health care reform, that $900 billion budget-buster.  Maybe the linkage is far-fetched, but if true, putting at risk the global trading system in order to expand entitlements, is that what sound economies are built on? 

I hope the president deploys his considerable charm and intellect next week, talking things out with Chinese President Hu Jintao at the G-20 Summit in Pittsburgh in order to avoid a nasty trade war.  That venue would likewise be a fine place for the president to tell the truth to Rust Belt workers, the truth John McCain started telling in Michigan last year:  that the economy is in transition, we cannot artificially protect manufacturing jobs, job training and outplacement will be required.  The higher value-added, knowledge-based economy beckons…

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Trade: the test of Obamanomics

September 15, 2009
Chinese workers load tires for export.  Source:  www.financialpost.com
Chinese workers load tires for export. Source: http://www.financialpost.com

During the Great Depression, international trade contracted by a third, as countries around the world erected barriers to trade, aggravating a sharp decline in output already under way and throwing millions out of work.  Thus far, in the Great Recession of 2008-09, the end of which some observers may have called too soon, the major powers have avoided trade protection.  Enter the Obama administration.

Last year, I published a piece calling for those supporting Democrats in America’s national elections to make sure they keep the Dems honest on trade.  Concerns about Obama’s commitment to free trade, due to his campaign strategy in Midwestern states last year, were dismissed as mere election-year politics.  His commitment to satisfying his friends in America’s trade unions is now abundantly clear, not only because he parrots their unfair accusations about abuses by the Colombian government, but also in the latest action by the Obama administration to raise tariffs against Chinese tires (see NYT imes article).

Trade wars can spiral out of control, even if this is not the original intention of protectionists.   During the 19th century, Britain, the unrivaled power at the time, ensured global prosperity through its commitment to free trade.  The U.S. since 1945 has played this role, through both Democratic and Republican administrations.  Doubts about President Obama’s commitment to free trade, a key pillar of international cooperation and a key strategy for broad-based global prosperity, have re-emerged, a point quite ably discussed in this Economist article.

Photo:  Chinese workers loading tires for export.  Source:  www.financialpost.com

Focus: Brazil’s economy

September 11, 2009

Nilson Teixeira (nilson.teixeira@credit-suisse.com) and his team at CreditSuisse Brazil, one of the formidable analytical teams among Brazil’s brokerage firms, today published a comprehensive 170 page guide to the Brazilian economy.  Timely, given that the world’s eighth largest economy is now one to be watched, invested in, and profited from.  CSFB says this guide is good for experts in Brazil’s economy as well as neophytes.  The summary pages can be found below.

An old Brazil hand myself who met annually for years with Teixeira and his predecessors (who included a number of members of the board of Brazil’s central bank), I found the work interesting and noticed only a few points that I would stress differently, add to or subtract.  They are as follows:

  • CSFB highlights as Brazil’s number one economic challenge to improve the quality of the country’s primary and secondary education system, including by adding more schools.  I couldn’t agree more. 
  • Brazil’s sovereign default in the 1980s-90s is blamed on the oil shocks and consequent balance of payments pressures, which is well and good; however, blame should be layed as well at the doorstop of  Brazil’s Import-Substituting Industrialization (ISI) policies and massive government borrowing program.  Brazil’s problems were (and are) everywhere and anywhere a fiscal problem.  While CSFB does mention Brazil’s “fragile fiscal accounts,” it does not stress this aspect enough.
  • I agree with the outlook for stronger potential GDP growth in the coming years (in the neighborhood of 4-5% growth per year, not stellar relative to other emerging market economies, but not bad, given Brazil’s history).  I agree that this is due to a decade of sound macro policies since 1999 — with the arrival of Arminio Fraga at the central bank — including inflation targeting, a floating exchange rate, and the Fiscal Responsibility Law.
  • On the other hand, I would stress more the role of the sharp rise in commodity prices earlier this decade, driven to a great extent by demand from China, for Brazil’s improved growth performance. Brazil is a major exporter of soy and other agricultural commodities, minerals, and soon, oil.
  • Brazil’s sound policy management has underpinned its weathering of the 2008-09 Global Financial Crisis.  In previous global crises, Brazil was always one of the first dominos to fall.
  • CSFB says that Brazil, in spite of running a countercyclical fiscal policy during this crisis, should see net government debt decline in the coming years, unlike in most countries where debt will be rising.  Fitch Ratings, which expressed its worries about fiscal policy in a publication earlier this month, may beg to differ.
  • Brazil, in spite of experiencing economic contraction last year and into this year, began expanding again in 2Q09, a good indicator for the future.
  • Brazilian banks are well capitalized.  I might stress a bit more concern about recent rapid credit growth in Brazilian banks.
  • I agree that Brazil’s infrastructure needs are sizable, and investment here could go far to raising potential GDP growth.
  • Likewise, Teixeira and his team were correct in highlighting the challenges of reforming a distorted tax regime, reining in social security deficits, and freeing up a very rigid labor market.

All to say, well worth the read.  Start with the summary below:

“In recent decades, the Brazilian economy has oscillated between periods of strong economic growth (late 1960s and early 1970s) and periods of low growth with high inflation (1980s). Despite the introduction of several economic plans since the second half of the 1980s, inflation was not effectively reined in until 1994, when the Real Plan was implemented.

In step with recurrent balance-of-payment crises in emerging countries, imbalances in Brazil’s external accounts persisted, and average GDP growth was relatively sluggish until the mid-2000s. As the global outlook improved and Brazil maintained responsible macroeconomic policies, the economy’s average growth gained speed in 2004, resulting in the longest cycle of growth and investment since the 1970s.

This growth cycle was interrupted by the global crisis of 2008, but the Brazilian economy has proved much more resilient to crises than in the past. The evolution of its economic fundamentals suggests that, after several decades, the country is likely to experience higher and – even more importantly – less volatile economic growth than in the past. But after fulfilling many of the necessary prerequisites, we believe there are still challenges to be overcome for Brazil to reach a higher level of development in the next decades. For instance, it will have to consolidate the process of making elementary and secondary education universally available, not only by expanding its network of schools, but also by improving the quality of education provided.

Brazil is a federal republic composed of 26 states and a Federal District, which comprise 5,565 municipalities. It is the world’s fifth largest country both in terms of population and land area and has the eighth-largest Gross Domestic Product (GDP). The Brazilian population has grown 1.5% annually on average over the past few decades to 189 million inhabitants in 2008, most of whom reside in cities.

From 1964 to 2008, GDP grew 4.5% per year on average. In the late 1960s and early 1970s (period referred to as the “Brazilian miracle”), GDP grew by more than 11% yearly in a scenario of heavy investment. At that time, Brazil was known as the “country of the future,” a title that has not been revisited in subsequent decades.
In the 1980s, referred to as “the lost decade,” Brazil’s economy was marked by high inflation and low GDP growth. During that period, an oil shock destabilized the global economy, and consequently several developing economies, including Brazil, were unable to roll over their large foreign debt and were forced into default. The balance-of-payments crisis was associated with high interest rates, a sharp depreciation in currency, and high inflation. In the second half of the 1980s and the first half of the 1990s, Brazil implemented several stabilization plans to thwart skyrocketing inflation. Some of these plans included price controls, a freeze on bank deposits, and some unorthodox inflation-reduction measures.

After several unsuccessful attempts, the government implemented the “Real plan” in 1994, which established the Real as its new currency and rapidly reduced monthly inflation from around 50% to less than 1%. Even after lowering inflation, the country experienced several balance-of-payments crises in the late 1990s and early 2000s, some originating in emerging economies and others homegrown. Brazil faced some onerous constraints for financing its foreign debt on several occasions. In order to keep inflation low, the government kept real interest rates very high for several years, which in turn led the economy into a sequence of stop-and-go business cycles. Fragile fiscal accounts and risk of insolvency revealed the weaknesses in the economic adjustment during this period and produced a steep devaluation in Brazil’s currency and a return of inflationary pressure. Despite lower inflation, economic growth remained weak during these years.

In 1999, the government adopted economic policy based on three main points: an inflation target regime, a floating exchange rate policy and adoption of fiscal responsibility law. After decades of huge economic uncertainty, observance of these policies for ten years has helped increase the predictability of the Brazilian economy.
Combined with a favorable global scenario in recent years, characterized by strong economic growth and high liquidity in financial markets, these policies contributed to a significant improvement in Brazil’s macroeconomic fundamentals. From 2003 to 2008, the government maintained relatively low inflation, bought back all sovereign debt originated from the 90s’ debt renegotiation, improved the risk profile of its government securities, maintained primary surpluses, and substantially increased the level of international reserves, contributing to Brazil becoming the fourth-largest holder of U.S. treasury bonds. The global crisis that began in 2008 has proven that the macroeconomic policies adopted in recent years have been effective; despite its magnitude, the impact on the mid-term fundamentals of Brazil’s economy have been rather moderate. One of the main differences versus other countries has been the absence of any balance of payments crises within Brazil. This greater freedom in relation to external accounts has allowed the government to implement a set of countercyclical fiscal and monetary policies to reduce the negative impact of the 2008-2009 crises on economic activity. The primary surplus has fallen, raising net debt to GDP in 2009. In upcoming years, we expect the net debt to GDP ratio to retract, unlike the forecast for many countries hit hard by the crisis. For the first time since the 1970s, the Brazilian economy has proved more resilient than most developed and developing countries, in our view.

Brazil’s potential output growth has increased substantially in recent years. Despite the retraction in 2009 brought on by the international crisis, we believe average GDP growth in the next few years will likely reach 4% or 5%, much higher than the average pace of 3% during the first half of the decade. This higher growth should be associated with a return to investments, which grew consistently from 2004 to 2008, forming the longest investment cycle since the 1970s. Over the past few years, investments have been spread out over various economic sectors, especially infrastructure and commodities. But despite this long growth cycle, the country’s infrastructure is still quite deficient. Heavy investments in infrastructure are needed to foster higher growth in areas ranging from transportation to expansion of the power grid.

Sectors with clear competitive advantages in the last few years are primarily those associated with commodities. Brazil is the largest producer of many soft commodities, such as sugar, coffee, and oranges, the second largest producer of soybean and ethanol, and the number one exporter of all these products. The country is also the second largest producer of beef and ranks third for chicken and fourth for pork. Brazil exports more beef and poultry than any other country. The cost of production in the Brazilian agricultural sector is currently lower than for most producer countries. The agricultural sector is likely to see sustained growth in upcoming years and reap benefits from existing competitive advantages, even if the elimination of non-tariff barriers and improvement within the logistics infrastructure are gradual.

Brazil has huge mineral reserves – especially iron ore, aluminum, copper, chromium, gold, tin, nickel, manganese, zinc, and potassium – and clear advantages in sectors associated with these commodities. Notwithstanding the halt in heavy investment in these sectors on account of the 2008-2009 global crisis, investments will likely remain high in the next few years to meet the growing demand, especially from emerging markets. At the same time, the huge discoveries of oil reserves in the pre-salt layer in recent years should make Brazil a major player in the world market and a net exporter of fuel in the next decade. In principle, much of the massive investments in this sector will be financed by government institutions, but the participation of private corporations, especially from abroad, will tend to attract rugged investment in years to come.

The capital ratio of local banks has been well above the Basel requirement for many years, resulting in a lightly leveraged financial system. This has prevented the international financial crisis from contaminating local banks. The government’s economic policy reaction has brought relatively low fiscal costs and has managed to contain the negative effects of the contrition in external credit. The economic policy response has shown that the banks are able to efficiently intermediate private savings and contribute to sustained high growth in credit, which reached nearly 45% of the GDP in mid-2009. Credit expansion in the next few years will probably have a different profile from the most recent cycle. The new phase will be marked by the lowest basic interest rate in 30 years, which will require a different set of financial instruments available to depositors. At the same time, financial institutions will change their focus, offering longer-term credit and reaching out to more corporate and real estate borrowers.

Greater stability in the local economy should continue to encourage a shift from short- to longer-term investments in addition to increased participation by foreign investors. The need for heavy investments in Brazil within the next few years will require increased risk capital, both from here and abroad, to finance activities. This favorable scenario is expected to stimulate growth in equity markets. Although investments in Brazil have historically been financed largely by public-sector institutions, corporations have been able to raise funds lately in capital markets to finance their investment plans. The private sector will account for a growing percentage of long-term investments in the next several years, either through bank loans or direct financing through equity offerings. High-risk investments will account for a large portion of these funds, and primary and secondary equity offerings are projected to increase significantly in the next few years.

The effects of the 2008-2009 global crisis were less drastic than expected at the outset, which signifies to us that Brazil’s growth pattern is less susceptible to changes in course as a result of the external outlook. However, this does not mean that the Brazilian economy is immune to the global crisis. On the contrary, the crisis has caused Brazil’s GDP to backtrack from an average expansion of 1.6% quarter on quarter from 1Q2008 to 3Q2008 to a peak-to-trough fall of 4.4% in 4Q2008 and 1Q2009. But the return to economic expansion has already taken hold in 2Q2009, demonstrating that Brazil’s solid fundamentals have enabled rapid adjustment to the change in global outlook.

This greater resilience to the external crisis has favorable consequences for the middle- and long-term outlook for the Brazilian economy. Uncertainty regarding the resilience of the country’s economic fundamentals dissipated fairly significantly as the crisis unraveled. Overall country risk and real interest rates should decline even further in the next few years, since severe macroeconomic crises in Brazil do not seem as likely as in the past, leading to higher investments and, therefore, higher potential output growth. Thus, the path of Brazil economic fundamentals suggests that, after several decades, potential GDP growth should be higher than in the past and, even more importantly, less volatile. We, therefore, think this dynamic should allow Brazil to regain its reputation as the “country of the future.”

There are still several challenges to be overcome. First, the country needs to consolidate the process of making elementary and secondary education universally available, not only by expanding its network of schools but by improving the quality of education. Second, Brazil needs to address certain structural constraints, such as its highly complex tax system, imbalances in social security and very rigid labor legislation. It will also be up to future administrations to reopen debate concerning the state’s role in the economy, particularly with regard to its efforts to stimulate manufacturing and strengthen the regulatory framework. These reforms will require serious discussion, because congressional approval tends to lag in light of the complexity of the issues. For example, although there is a consensus in society that the country’s tax structure is complex and tax burdens too high, approval of tax reform is uncertain, because it requires debate regarding which specific fiscal expenditures need to be reduced.

During the preparation of this publication, its target audience focused on those readers with a basic understanding of Brazil, wanting to learn more about the country’s fundamentals and economic outlook. For this group, this guide can hopefully serve as a starting point. Nonetheless, we believe the in-depth scope of this report will also interest readers with a more comprehensive knowledge of the country. We note that this publication is not meant to provide a complete guide to Brazil; it is not intended to offer extensive coverage of the individual topics included. This guide contains a sizable number of graphs and tables, which together provide a relatively general review of information we believe will be relevant for our readers, offering a broad reference base, with information and statistics supporting our overall view that Brazil meets many of the prerequisites needed to take it to the next level of economic development.

The guide is divided into nine chapters, including this introduction. The second section provides a panorama of the country’s geography, climate, mineral resources, biomas, and water resources. The third addresses topics related to population, age ranges, life expectation, labor market, and income distribution. Chapter four contains a brief history of economic policy since the mid-1960s and details policies implemented in the past decade, especially inflation targeting, the floating of the foreign exchange rate, and fiscal responsibility. This chapter also highlights the organization of the country’s political institutions. Chapter five describes the primary characteristics of Brazil’s infrastructure – especially modes of transportation and power generation, transmission and distribution. Chapter six enumerates the primary industrial sectors, such as oil, petrochemicals, steel, automobiles, mining, and construction.

In chapter seven, we present the most important issues in relation to farming, listing the main crops and herds, and describing how they are distributed throughout regions. Chapter eight addresses services, with an emphasis on financial services. In chapter nine, we discuss current business trends in Brazil and certain aspects of the local tax structure. Finally, the appendix provides useful reference material, acronyms, and Web sites to access for additional information.”

Declining powers: the US debate on health care reform

September 10, 2009
Cartoon on U.S. budget deficit from Washington Examiner.  Source:  www.pennlive.com/.../2009/03/bobby_jindal.html Cartoon on U.S. budget deficit from Washington Examiner. Source: http://www.pennlive.com/…/2009/03/bobby_jindal.html

It wasn’t Paul Kennedy who first said that great powers who over-extend themselves — either externally or internally — fast-forward the date of their decline, but he wrote about imperial over-extension and decline so convincingly in a best-selling book in the late 80’s.  Political Scientist Robert Gilpin in War and Change in World Politics argued that both internal and external over-extension overburdens a hegemonic power such as the U.S. and results in an early decline. 

A colleague on the Global Markets blog and other FPA bloggers have applauded President Obama’s economic policies for rescuing America and the world from an early demise.  The stimulus package was the right thing to do at the right time, I agree, as was the bank rescue, which began under Bush’s watch, spearheaded by Republicans Paulson and Bernanke as well as Democrat Geithner, a year ago, lest we forget.  I wrote about that on my blog, applauding all those involved on both sides of the aisle.  Yes, Paulson was helped along by Democrats Pelosi and Reid and brave Republican Mitch McConnell, whereas the rest of the Republican caucus abdicated all responsibility in the name of free market capitalism.  Like Lenin said, the last capitalist will sell the rope to hang the second-to-last capitalist.  I did hear, nonetheless, from not a few Democrats at that time who opposed the bank bailout, including some so-called New Democrats.

In any case, I applaud President Obama’s continuation of Paulson’s policies (and remember, these were policies backed wholeheartedly by the much-maligned George W. Bush). 

But why health care reform?  Okay, I know why health care reform.  But why now?  Why now, with U.S. General Government Debt set to reach nearly 100% of GDP within two years??!! 

The answer:  because Dems have majorities in Congress and they’re afraid they’ll miss this opportunity to extend entitlements.  The prudent thing to do — the thing leaders of a great power wishing to prolong its great power status would do — is:  tackle health care reform when (and if) the ship of state is not in hock.

An Economist article points out the fine job accomplished last night by the Great Communicator (II).  It also points out that President Obama put a figure on the cost last night — $900 billion, or 5-10% of GDP.  Obama in his speech committed to convening an independent panel of experts to find savings in Medicare and other health schemes and to putting in mandatory cuts if cost restraint doesn’t materialize.  Hats off to the president for including these two commitments in this expansion of the role of the state.  Nevertheless, to those of us worried about the decline of a great power so important to the liberal institutions of the world, this health care reform remains an awful lot of the farm to bet on the Great Communicator’s promises before a joint session of a Democratic Congress.

Mexico proposes sound fiscal plan, says CSFB

September 9, 2009

I discussed Mexico’s fiscal woes and compared them to Brazil’s in a previous post.  Today, financial market analysts reacted positively to the Mexican government’s fiscal plan, set to limit the widening of the federal deficit in 2010.  Like Barack Obama’s unwillingness to confront Congress on the cap-and-trade carbon emissions plan or health care reform, Felipe Calderon’s government once again skirted the issue of expanding Mexico’s narrow VAT tax to cover food and medicines.  Instead, the government will tax income more heavily.  CreditSuisse’s Alonso Cervera applauds this move because of the virtual impossibility of moving a budget through the Mexican legislature with a VAT expansion in it.  Calderon faces a congress in which his PAN party is dwarfed by the opposition PRI party, unlike the commanding position of Obama’s Democrats in both houses of the U.S. Congress. Nevertheless, Mexico’s budget, if passed, is a step in the right direction, especially since it controls spending and raises the share of non-oil taxes in government revenues. 

Read Alonso Cervera at CreditSuisse and Alfredo Thorne at JPM below:  

 From CreditSuisse’s Emerging Markets Economics Daily, Sept 9, 2009

“The government presented an ambitious budget proposal for 2010 that seeks to limit the widening of the deficit to 0.4% of GDP mainly by strengthening non-oil tax collections. The government released the comprehensive documents last night. Our first impression is a positive one, in that the government will seek to gain congressional approval for tax hikes equivalent to 1.4% of GDP, and for spending cutbacks equivalent to 0.5% of GDP. By applying an additional 0.7% from non-recurring revenues (those

currently existing in stabilization funds as well as projected ones), the government seeks to limit the widening of the fiscal deficit to 0.4% of GDP, from 2.0% this year to 2.4% of GDP next year. The government will also seek to strengthen the fiscal responsibility law by, among others things, eliminating the maximum reserve levels for stabilization funds so that the government can capitalize on the materialization of a revenue windfall.

The government presented in its policy guidelines document relevant comparisons that make it clear that non-oil tax revenues in Mexico are particularly low. The government made the comparison versus other OECD countries, Latin American countries and Brazil in particular. The government’s proposal to enhance non-oil tax revenues does not rest on the introduction of a value-added tax on food and/or medicines. We view this as a wise decision, given the strong opposition that both the PRI and the PAN had voiced in recent days regarding this potential proposal. Instead, the government is seeking to

achieve a combination of higher excise and income taxes, as well as the introduction of a new tax that has been labeled the “anti-poverty tax”.

Specifically, the government’s proposals on the tax front include: 1) the introduction of a 4.0% excise tax on telecommunication services that use a public network (excluding services in rural areas as well as public telephones); 2) increasing the excise tax on tobacco by 10.9 percentage points in 2010; 3) increasing the excise tax on beer from 25%to 28% in 2010-2012 and then reducing it back to 25% by 2014; 4) increasing the excise tax on lottery games to 30% from 20%; 5) hiking the maximum income tax rate on individuals and corporations to 30% in 2010-2012 from 28% at present, and then reducing it gradually back to 28% by 2014; and, 6) increasing the tax on cash deposits from 2% to 3% and broadening its application to cover smaller transactions.

Finally, the so-called antipovertytax would be a “2% tax on revenues generated by all types of economic activities, applied in all stages of production  in a non-cumulative manner”, according to the document. The proceeds, estimated at 72bn pesos (0.6% of GDP), would be applied to selected anti-poverty  programs. The government estimates that non-oil tax revenues could increase from 9.2% of GDP in 2009 to 10.8% of GDP next year. The bulk of the increase would come from income taxes, which would increase from 5.0% of GDP in 2009 to 5.6% of GDP next year. The government is also proposing some changes to the taxation of Pemex. Specifically, one of the proposals is to create a new flat tax rate of 15% for natural gas and crude oil extraction activities in selected fields, as opposed to taxing them based on a variable rate that is capped at 20%.

On the spending front, the government is seeking a reduction of 0.6% of GDP in programmable expenditures as well as the re-allocation of other expenses in favor of pension payments, health coverage and overall anti-poverty measures. Some specific measures to cut spending include the closing of three major government offices, 5% headcount reductions for high ranking officials and administrative staff, and 10% cutbacks in Mexico’s representative offices abroad. On the debt financing front, we highlight that the government will seek a net domestic indebtedness ceiling of 340bn pesos, which compares favorably to the ceiling it requested (and got from congress) of 380bn pesos for 2009. We think that this should be a relief for the local market, as the government will seek more actively than usual non-market financing sources abroad (mainly IFIs and other non-traditional sources). As for market debt issuance in external markets, the government’s plan is to simply issue an amount equivalent to market amortizations coming due in 2010 ($2.9bn).

Finally, the government’s outlook on the global economy in 2010 is somewhat cautious. The government’s documents presented to Congress yesterday state that the global situation continues to show a significant degree of fragility and that the global economic recovery will be moderate. Mexico’s real GDP is projected to expand at an average rate of 3.0% in 2010, with average annual growth seen at 4.2% in 2011-2015. This is partly based on the Blue Chip survey that puts US real GDP growth at 2.3% in

2010 and US industrial output growth at 2.5%. The government’s oil price assumptions are based on the formula set out in the budget responsibility law. Taking historical and projected prices, the formula yields an estimate of $53.9 per barrel for Mexico’s crude oil export mix in 2010 (roughly $60 for the WTI mix), which increases gradually towards $64.6 by 2015, which we view as conservative. Finally, in terms of oil output, the assumption is that it will average 2.5mn barrels per day in 2009 and in subsequent years, down from slightly over 2.6mn barrels per day in 2009. This assumption may be on the optimistic side, in our view.

In the remainder of this week we will expand our analysis of the comprehensive documents issued by the government last night. We reiterate that our initial reaction is positive, in that the government is putting on the table several measures that seek to close the gap created by falling oil and non-oil prices due to structural and cyclical factors. We also view the decision to keep off the negotiating table any proposal to introduce a valueadded tax on food and medicines as a good move by the government, one that may make negotiations smoother with the main political parties.

Finally, and on a separate note, the central bank will publish today at 10:00 am EST the inflation results for August; we estimate headline inflation was 0.28% last month (relative to July). If our estimate proves accurate, annual headline inflation will drop to 5.1% from 5.4% in July. Meanwhile, we estimate that core prices rose by 0.24% last month, which would put the 12-month reading at 5.1%, down from 5.3% in July. These would be the lowest 12-month readings since May 2008 in the case of headline inflation,

and since July 2008 in the case of core inflation. Market expectations are generally in line with our own. The latest survey released yesterday showed average forecasts of 0.26% and 0.25% for headline and core inflation, respectively. The survey also showed that the overwhelming majority of analysts (19 out of 24) thought that the central bank will keep the overnight rate unchanged at 4.5% in the remainder of the year.”

From JPMorgan’s Emerging Markets Today, Sept. 9 2009

“President Calderón yesterday announced the 2010 economic

package, calling for an austere budget with changes in the

public sector’s administration structure. To reduce expenses,

Calderón presented four administrative changes for next year

to be discussed by Congress. First, the Ministries of Tourism,

Agricultural Reform, and Public Ministry will be eliminated.

The first two entities will be reallocated to the Ministry of

Economy and Ministry of Social Development and

Agriculture, while the third will fall under executive powers.

Second, the federal government will reduce the large number

of civil servants and freeze salaries and compensation. Third,

spending on embassy, councils, and foreign activities will be

reduced. Fourth, other administrative expenses will be

reduced. The measures together are expected to reduce

budgetary expenses by MXN80 billion. Calderón

estimated that these expenditure cuts, combined with the

fiscal package (still pending at the time of writing), will

narrow the fiscal gap to MXN180 billion (1.4% of GDP).

Calderon also reiterated the government’s commitment to

reducing poverty noting that none of these expenditure cuts

will include social programs.”

Alfredo Thorne (52-55) 5540-9558  alfredo.e.thorne@jpmorgan.com

Brazil: Fitch Ratings not happy about fiscal deterioration

September 8, 2009
"G-2": Brazil's President Lula and Mexico's President Calderon: Whose fiscal ship faces calmer seas?  Source:  Google Images
“G-2”: Brazil’s President Lula and Mexico’s President Calderon: Whose fiscal ship faces calmer seas? Source: Google Images

Fitch Ratings published a report this month analyzing Brazil’s fiscal deterioration this year (see press release below).  Brazil’s public finances have slipped just like in just about every country in the world.  Fitch highlights Brazil’s heavy government debt burden relative to its emerging market peers.  Brazil’s fiscal deterioration — characterized by rising spending, tax cuts, and a poor tax intake — will at the very least slow any upward movement in Brazil’s credit rating, currently at BBB- for foreign currency debt, and could in fact lead to a downgrade if a fiscal consolidation is not forthcoming over the medium term, suggests Fitch. 

Yet Fitch rates Mexico fully two notches above Brazil (BBB+), albeit with a Negative Outlook (meaning the rating should go down within two years).  Brazil’s government debt to GDP ratio is nearly 70%, whereas Mexico’s is below 40%.  What they don’t highlight is that Brazil’s debt to tax revenue ratio is lower than Mexico’s (nearly 170% in South America’s largest economy vs. Mexico’s nearly 200%).  Mexico’s woeful tax performance is a perennial problem gone unfixed for decades.  Moreover, the Mexican government relies on oil-related revenues, even though oil production south of the Rio Grande is declining.  The Mexican government won’t allow private investment in the energy sector as a way to increase production (and can’t, due to popular opposition).  Mexico is a mess (not least because of its heavy dependence on one country, eh-hem, eh-hem, the United States), and Fitch acknowledged as much in July when it said it will monitor fiscal measures in the wake of the mid-term legislative election to decide whether or not to downgrade.  Signs are that an austere budget may be in the works.

Debt is measured against both GDP and revenues to indicate a country’s ability to grow out of its debt burden, i.e. to raise enough revenues to pay future debt obligations.  The debt to revenues measure is arguably a better proxy for this capacity, even though most analysts look at debt to GDP because GDP is more standardized…and perhaps out of laziness  Sure, Mexico has a vast untaxed portion of the economy it  could draw on to service its debt.  But it hasn’t ever done so and it won’t.  An owner of a Mexican trucking company once told me, he doesn’t pay any taxes.  So, Mexico’s fiscal picture is at least as bad, if not worse, than Brazil’s.  What’s more, Brazil’s external balance sheet is stronger than Mexico’s, with lower net external debt to exports and a stronger sovereign net external creditor position.  Its economy appears more resilient, not least due to its diversification.

Yet Mexico still remains two notches above Brazil due to sticky credit ratings and the inability of the rating agencies to take dramatic action.  Such dramatic rating action would suggest that rating agency analysts have been wrong for some time.      

Fitch: Brazil’s Fiscal Deterioration – A Slippery Slope
03 Sep 2009 2:05 PM (EDT)


Fitch Ratings-New York-03 September 2009: Fitch Ratings believes that Brazil will need to begin the process of fiscal consolidation, as an expected economic recovery begins to take hold, in order to preserve its fiscal credibility. Fitch has published a special report on Brazil’s deteriorating fiscal situation and the potential impact on its credit profile.

The degree of fiscal deterioration in Brazil’s public finances is quite evident when comparing the fiscal outturn of the first seven months of 2009 with the same period a year ago. The central government primary surplus has declined by 60% in the first seven months of 2009 compared with the same period in 2008 as a result of fast-paced spending growth and weak revenue performance.

‘The structure of Brazil’s public spending is deteriorating as a significant part of the increase is related to personnel and pension benefits, which will be harder to adjust in the future and cannot be classified as strictly ‘counter-cyclical’ in nature,’ said Shelly Shetty, Senior Director in Fitch’s Sovereign Group.

On the positive side, the scale of Brazil’s counter-cyclical fiscal stimulus package is modest by international standards, and the expected deterioration in the country’s fiscal balance is somewhat less than its rating peers. In addition, the government has domestic and external market access to fund the higher deficit. However, Fitch notes that the country’s starting fiscal position is weaker when compared with its peers. Brazil’s general government debt burden is significantly higher than the ‘BBB’ median (66% of GDP compared with 27% for the ‘BBB’ median) and will increase further this year.

Fitch recognizes that Brazil has a good track record in delivering and surpassing fiscal targets even when economic conditions are difficult, such as in 2002-2003. Across the globe, 2009 has been a challenging year, and many emerging markets have seen deterioration in their fiscal balances. However, the sharp increase in spending growth observed so far in 2009 needs to be curbed for the authorities to achieve even the reduced primary surplus target for this year, and more importantly, to return to the higher primary surplus target of 3.3% for 2010, as set under the Budgetary Guidelines Law.

‘Given the uncertainty in the pace of economic recovery and thus revenue growth, greater resolve to contain spending growth (especially current) would be positive for the credibility of fiscal targets,’ added Shetty.

While Brazil’s external finances remain strong and the country has weathered the global financial crisis relatively well, the deteriorating fiscal picture could potentially dampen the upward momentum of Brazil’s credit trajectory. On the other hand, persistent and significant deterioration of public finances and debt dynamics could undermine fiscal credibility, increase investor risk premia, and adversely affect investment and growth prospects, which in turn, could weigh on Brazil’s creditworthiness.

Fitch currently rates Brazil’s Long-Term Issuer Default Ratings at ‘BBB-‘ with a Stable Rating Outlook.

The full report ‘Brazil’s Fiscal Deterioration: A Slippery Slope’ is available on the Fitch Ratings web site at ‘www.fitchratings.com.’

Contact: Shelly Shetty +1-212-908-0324 or Erich Arispe +1-212-908-9165, New York.

Media Relations: Kevin Duignan, New York, Tel: +1 212-908-0630, Email: kevin.duignan@fitchratings.com; Sandro Scenga, New York, Tel: +1 212-908-0278, Email: sandro.scenga@fitchratings.com.