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Brazil's Commodity Conundrum

March 04, 2008

Seeing is believing, or so the saying goes, but that is not always the case. Often, we fail to realize what’s apparent, preferring instead to stick with our beliefs. Picasso and his cook would see two different bowls when looking at the same colorful, circular object. In economic analysis, we cannot ignore that both Picassos and cooks exist.

According to the news, if the American economy is not yet in recession, it is coming soon. The question is not one of whether it will happen, but rather how bad and how long it will last. Meanwhile, the Brazilian economy is showing signs of renewed vigor. After rains postponed the energy crisis to 2009, nobody doubts that 2008 will be a year of strong growth. In fact, a study by the Ipsos Institute reveals that 59 percent of Brazilian consumers believe 2008 will be better than 2007.

Despite this rosy outlook, some skeptics believe Brazil will eventually respond to external variations and that the effects of slow global growth will be felt in due course. Discrepancies in perception are also common. In 2003, the general perception was that Brazil was in hell, but that global growth would open new opportunities. In 2008, Brazilians now think heaven is here to stay, even if the rest of the world is showing signs of deterioration.

But while Europe and Japan, together with the U.S., face slower growth rates, China remains buoyant. So far, an increase in China’s internal demand is compensating for weak performance in external markets. The growth of emerging markets, including that of Brazil, depends on this Chinese phenomenon.

Commodities are the key. The foundations of China’s growth—industrialization, urbanization and infrastructure development—are closely linked to commodities, which, in turn, affect the global price of these products. For example, between 2002 and 2005, China was responsible for a 100 percent-plus growth in the consumption of zinc and lead.

Brazil’s growth is intimately linked to commodity prices. Comparing 1998 to 2002 with 2003 to 2007, a decrease in commodity prices (excluding fuels) for the first period (on average, -4 percent per year) was witnessed as Brazilian GDP growth hovered at around 1.7 percent per year. In the second period, global growth jumped from 3.4 percent to 5 percent per year, a phenomenon that coincided with commodity prices (excluding fuels) increasing 13.3 percent annually. This allowed for the Brazilian GDP to witness an average growth rate of more than 4 percent.

The question is whether a fall in commodity prices can reduce growth in Brazil. Despite the incredible readjustment of the price of iron ore announced by Vale in February, commodity price forecasts by the IMF, for example, point to a fall. According to Marcelo Carvalho, Chief Economist for Latin America at Morgan Stanley, a 5 percent worsening of Brazilian terms of trade could lead to a fall of 0.8 percent to 1 percent in Brazil’s rate of growth over a one-year period.

A fall in commodity prices and reduced global demand will severely impact Brazil’s trade balance. Its export prices are intrinsically linked to commodity prices. Over the last few years, commodities have accounted for total export revenue growth, allowing for increased imports without compromising the trade balance.

This situation is changing and, by the end of 2008, many economists project a current account deficit of 1 percent of GDP. It is worth noting that, in 2007, the inflow of capital (approximately $90 billion) was exceptional, and in 2008, this flow could decrease. Despite continued differences between internal and external interest rates, in the case of global turmoil, fear could counteract the greed for profits. With that, the real’s period of sustained appreciation could be coming to an end.

For the moment, however, investors seem justified in their Brazil euphoria. In accumulating reserves, Brazil has turned into a liquid external creditor, boosting prospects for receiving investment grade classification in 2008.

The bad news is that the less than brilliant external results being observed, compared to those from the recent past, will focus investors’ attention on the disheartening details of Brazil’s fiscal accounts. But the good news is that a tax reform finally seems to be on the way. Either way, the future seems bright.

Eliana Cardoso is a Professor of Economics at Fundação Getúlio Vargas in São Paulo. She served as Lead Economist and Sector Manager at the World Bank as well as Secretary for International Affairs at the Brazilian Ministry of Finance in Brazil.