Bloomberg Línea — The growth of Brazil’s Gross Domestic Product (GDP) above expectations in the second quarter surprised most market analysts. An exception was David Beker, Chief Economist for Brazil and Latin America Strategy at Bank of America (BofA).
Beker revised the GDP estimate days before the data was released in early September and came close to the actual result. The growth for the period was 0.9%, slightly above BofA’s projection of 0.8% and far from the market consensus of 0.3%. Afterward, the market raised its estimates for Brazil’s economic activity in 2023 to nearly 3%.
David Beker’s outlook for Brazil in 2024 is also more positive than the market average. He expects a GDP growth rate of 2.2% for the next year, above the consensus of 1.5%, and a smaller primary deficit than most analysts.
On the fiscal front, Beker predicts a primary deficit of 0.4% of GDP for 2024, while the market projects 0.8%. The government’s target, as indicated in the Annual Budget Bill for 2024, is to eliminate the deficit, with a tolerance range of -0.25% to 0.25% of GDP, as outlined in the fiscal framework.
“We have to start from the premise that the framework has to be challenging. If there’s an easy-to-meet target, it’s wrong. I think it will be challenging, but the difficulty of compliance was already expected,” said the analyst in an interview with Bloomberg Línea.
Beker stated that international investors are less concerned about the fiscal issue compared to domestic investors. Therefore, Brazil is well-positioned to attract significant capital inflows.
Some aspects of the economy may be better in Brazil, according to the analyst, which would explain the strong growth in 2022 and 2023, exceeding market expectations, and the potential for 2024 to continue to surprise. Among these factors are the capacity for economic growth without generating higher inflation, known as potential GDP, as well as a lower natural unemployment rate, where inflation is also not pressured. This explains the strength of the current labor market.
Here are the main points from the interview:
Bloomberg Línea: What led you to project a 3% GDP for this year before other analysts and the release of official data for the second quarter?
David Beker: Errors in predicting economic growth, especially on the margin, have not been unique to Brazil. We have been surprised by the resilience of the labor market worldwide and the performance of the post-COVID services sector... So there’s a general component.
When we look at Brazil, we were surprised by agribusiness. It was indeed an important explanation. We were surprised by how robust the harvest was in the first half of the year. There is also another aspect: there may have been structural changes that are supporting the economy, and the forecasting models have not yet adjusted to them. Some of the points under review include potential GDP, natural unemployment rate, and neutral interest rate... There is uncertainty in the modeling.
Bloomberg Línea: How do you see the second half of this year?
David Beker: We have already experienced the best part of the year, and it is natural for a slowdown ahead. The data on the margin show a weaker economy. For GDP to reach 3%, for example, we assumed some slowdown in the rest of the year in BofA’s forecast. If we assume stability, GDP would reach 3.1%. If we assume acceleration, it would have to increase. We kept it at 3%, expecting a slowdown.
For 2024, I have a projection above the market. I expect GDP growth of 2.2% for next year, while the consensus is at 1.5%, coming from 1% earlier when we were at 1.8%. Perhaps because of the fear of an upward surprise, the market is also revising its estimates.
Bloomberg Línea: In your accurate revision of the GDP, was there any specific data that justified it?
David Beker: It was a combination of data. We saw stronger confidence indicators, the perception of government-implemented measures, such as the “Desenrola” [debt renegotiation program]. When we make the call, it’s for the whole year, so we were trying to look at the bigger picture.
We have our own activity indicator, and it was stronger. The inputs for this indicator include some leading data, which we combine in modeling and showed stronger activity.
But it was a risky call, without a doubt, a revision a week before the second-quarter GDP.
Bloomberg Línea: Qualitatively, how do you evaluate Brazil’s GDP? There were strong gains in agriculture and extractive industries in the first half. Was the GDP higher but of good quality?
David Beker: Our economy has a structure very similar to that of the United States. It is an economy in which the domestic market is very relevant, and that won’t change. There has even been greater trade openness in recent years: if you look at the ratio of exports and imports to GDP, we have seen an increase in the presence of the external market. A decade ago, exports and imports accounted for 20% of GDP. Now we are closer to 30%. This is from the demand side.
From the supply side, the direct impact of agribusiness growth is small. Agriculture represents less than double digits in GDP, but when you look at the multiplier effects in other sectors and when some value is added to production, there is indeed a greater representativeness. This sector will continue to be very dynamic.
The big challenge is reinventing the industrial sector, where we have lagged behind, but that doesn’t happen overnight. The consequence of all this is that the services sector will continue to be very dynamic, driven by technological innovation and financial services.
One thing to keep in mind is tax reform. It is one of the transformations that we need and is quite positive. If we simplify our system, we will gain productivity.
Bloomberg Línea: You mention industrial growth, education, and now tax simplification. Is there any other homework that Brazil should do to become a high-income country?
David Beker: Education is crucial, just look at the Asian economies. Research, innovation, and structural reforms. There’s no miracle. We have to create conditions for individuals and businesses to invest easily. At the moment, the tax issue is crucial. In an ideal world, we would simplify the system and lower the tax burden, but we can’t do that.
As for some structural points you mentioned, such as potential GDP growth, the natural unemployment rate, and the neutral interest rate, what could have caused a shift in these estimates?
These are the questions that give us the most frustration when it comes to answers. They are unobservable variables in the economy. We model them to try to observe. In the case of the neutral interest rate, for example, the Central Bank cannot know in advance. They have an estimate, but they will only know when they get there. There is a lot of trial and error.
Regarding potential GDP, we spent a long time thinking that potential GDP growth would be below 1.5%. We don’t have any conclusive studies, but now we understand that it is closer to between 1.5% and 2% than between 1% and 1.5%. Apparently, it’s higher. It’s difficult to say what led to this.
There have been a series of microeconomic reforms that cannot be disregarded. In the case of the natural unemployment rate, there was the labor reform that increased labor market flexibility.
When we think ahead, the key variable to consider for higher productivity and growth potential is education.
Interest rates are falling, but they are still above neutrality. It is natural to expect that this will still have an effect on the economy, and this will lead to an increase in the unemployment rate. Our view, then, is a slowdown. As interest rates approach neutrality next year, the economy may accelerate again at the end of 2024.
Bloomberg Línea: Considering that you expect higher GDP than the market in 2024, what is your expectation for compliance with the fiscal framework, which requires a primary deficit of zero relative to GDP?
David Beker: We have to start from the premise that the framework has to be challenging. If there’s an easy-to-meet target, it’s wrong. It will be challenging, but the difficulty of compliance was already expected.
The second point is that this framework has just been implemented. So the market is already discussing changing the target... Can they change it? It’s not my base scenario. But the market is already having that discussion. It’s not the time for that.
Our forecast for a primary deficit of 0.4% of GDP for next year is also better than the market’s, which is at 0.8%. It won’t be trivial to reach that 0.4%. This value would also be a non-compliance with the target (the new framework allows for a tolerance of up to 0.25% of primary deficit). But if we have a framework that foresees consequences in case of non-compliance, what we cannot do is change the target to meet it. If that is done, the rule of restricting expenses in the following year in case of non-compliance will no longer apply.
My forecast of 0.4% is not too far from the permitted 0.25%. What I think is that it’s difficult, but I understand that the government and Fernando Haddad will continue trying.
Bloomberg Línea: Do you believe that Minister Fernando Haddad might be willing to accept a reduction in expenses in 2025 as a consequence of not meeting the framework in 2024?
David Beker: We have to deal with each problem in its own time. The fiscal issue is a global problem. The United States has a deficit above 6% of GDP, and it’s growing. Japan’s debt/GDP ratio, obviously much higher than Brazil’s, has never been a problem, but when global interest rates start to rise, fiscal becomes a giant problem.
The starting point for fiscal matters in Brazil is not good, but the trend after COVID has been much better than in many other countries. Credit rating agencies looked at that and upgraded their ratings, with S&P signaling an increase and Fitch already changing the rating.
Compared to other countries, in a relative context of fundamentals, Brazil is doing well. When we look only at our own issues, we see many problems, but in a relative context, Brazil stands out and is in a position to attract a lot of foreign money. Why isn’t the money coming? Because it’s still uncertain what will happen with China and the Fed’s interest rates. When that is resolved, there will be money left for Brazil.
Bloomberg Línea: Do you believe that the risk associated with Brazil is overestimated? There is a discussion, for example, that people look more at gross debt than net debt, and because net debt is lower, it indicates healthier fiscal conditions than what is commonly understood.
David Beker: Yes, we have a structurally higher interest rate than most countries. But, looking at the current situation, the country raised interest rates earlier and can now cut them earlier. When it comes to fiscal matters, we have to look at the whole picture. Ultimately, the goal is a declining debt-to-GDP ratio because it is high, but we have to look at the whole picture. Net debt, gross debt, primary result, nominal result...
What have you been hearing about Brazil from abroad and about foreign investment prospects?
The outlook for Brazil is optimistic, mainly because there have been positive growth surprises, and the country is already reducing interest rates. Of course, the fiscal issue is a concern, but I don’t see international investors as concerned as domestic ones.
That said, we haven’t seen large flows yet. At the beginning of the year, we saw inflows into fixed income as the interest rate curve at the time priced in an increase. A new inflow depends on a more predictable global environment, whether in fixed income or the stock market. One of the main drivers of our stock market is the commodities sector, which depends heavily on China.
As for Foreign Direct Investment (FDI), we saw a recovery after the pandemic, reaching $80 billion. Brazil continues to be a candidate to receive these resources, and it improves if we advance in structural issues. Companies see the Brazilian market with growth prospects.
Bloomberg Línea: What is your assessment of the final level that interest rates should reach? And how will this stronger activity and fiscal risk factor into the Central Bank’s decisions?
David Beker: We had the view that the Central Bank could start cutting interest rates earlier, in the second quarter. The Central Bank was correctly waiting for the definition of inflation targets. When we moved the call to August, we were one of the few who thought the cycle would start with 50 basis points cuts. It would be strange to start with 25 [points] and then go to 50 [points] in the next meeting when the interest rate was already at the level it was.
I thought the communication from the Central Bank in the last decision was perfect. The diagnosis is correct. Our terminal rate is 9.5% [per year]. Today, I am comfortable with that. For the Fed, we expect one more hike, of 0.25 points.
Do you see a chance for the Selic rate to return to levels below 5%, as it was before and during the pandemic?
We would need to improve the efficiency of the economy to have lower structural interest rates. It’s very difficult to reach a level below 5% real interest rates. Plus, we have 3% inflation, which is the target, so we would have a nominal Selic rate close to 8%. Unless we have a crisis that requires pushing interest rates below that, it’s very difficult to return to a 2% level. The new normal is between 8% and 10%.