RIO DE JANEIRO, BRAZIL – Be it due to the impact on the financial market, or due to sharp breakdowns in public accounts, the rise in American interest rates due to higher prices may cost Brazilians dearly.
When the dollar downpour has passed, when the weather opens up for the American economy, rolling down the window and watching the sun may not be as trivial as it may seem to Brazil.
Yes, the multi-trillion-dollar investments in infrastructure by the White House tend to benefit, for eight years, commodity sellers. But a country, as we know, is not built only by selling iron ore and steel.
“This issue is more serious than most people realize and the Federal Reserve itself has considered. It would be one of the great surprises of my life if the ultra-mega-power-expansionist fiscal [trillion-dollar government spending] and monetary policies practiced in the United States did not result in high inflation,” economist Espirito Santo says.
Since March 2020, when the Fed’s stimulus blitz began, with his three decades in the business and a classic economics textbook under his arm, Espirito Santo has been on the lookout for an inflationary bomb in the making in the United States. And for a needle in the hands of the local monetary authority ready to burst the bubble it created in the New York stock markets, inflated by tech giants. All it takes is to start pulling the team off the field.
Espirito Santo bases his argument on a past bubble, the dot-com bubble. It was when, in the last years of the last century, shares of technology companies were lifted to the top on the ballast of the Internet gaining scale. And then, much of it melted away at the turn of this millennium. “When I look at the charts, I get scared. The gap between today’s New York prices and the average of the past five years is the second largest in history. It is second only to the Internet bubble,” he says.
The size of the damage done when the bubble bursts depends on how the Fed reacts in the coming months. “If it has to move faster than it wanted with the end of the stimulus, we will have 10-year interest rates in the United States rising from the current 1.7% to 2%, rivaling the dividends paid in the stock market and, consequently, forcing a quick sell-off,” he says.
This eventual violent bursting of the bubble predicted by the economist, without it gradually withering away, would have a strong impact on the riskiest stock markets in the world, as strong as the risks offered by the countries.
“Is it because the homework has not been done here?” says the economist. “What is homework? The reforms that we can’t stand talking about anymore, but which do not get off the ground.” According to him, the recent favorable winds in the stock market and the exchange rate have nothing to do with improvements in national fundamentals. Rather, they have to do with the appetite abroad, sharpened by the commodities rally.
“It would be much better if we could celebrate this recent drop in the dollar, for example, but this was not the case. And, for this reason, it may not be sustained for long,” he says. “There is also the political issue. Reforms like the tax reform are difficult enough to pass by themselves, and the Covid CPI (investigative committee), in progress for 90 days, gets in the way even more.”
“It is not only in the United States, high prices, such as those of minerals, 50% this year, and soybeans, 40% up to now, are pushing up the cost of living worldwide,” he says. “And this should be diluted over time. I understand that the pace of U.S. inflation should not change the Fed’s plans to delay the start of monetary adjustment until closer to the turn of 2022 to 2023.”
In a similar line of reasoning to Espirito Santo, Menezes is apprehensive about the fiscal conditions in which Brazil will face the American interest rate hike. All over the world, and in Brazil it won’t be any different, countries tend to raise their interest rates in line with the Fed’s, thereby preventing the widening of the differential in the yields offered, in order to hold on to dollars. But with a fiscal situation even more convoluted than that of emerging peers, which would become even more severe with the increase in the cost of public debt under a SELIC seeking higher steps.
“The external short term favors Brazil, the Brazilian trade balance will surprise, potentially resulting in growth above what has been projected for the economy by the market average,” he says. This is not due to Brazilian merits. Which, Menezes says, may take its toll when interest rates in the United States and other large economies start to drive higher rates in Brazil too.
“I believe that some tax or administrative reform may be passed this year, but nothing that will lead to greater sustainability of the federal debt or result in great productivity gains,” he says. “Next year, with the electoral race, nothing will come out.”
He points out that if it weren’t for the raw material sellers, the picture of the Brazilian market would be quite different. “The best thermometer to measure the market’s distrust of Brazil is the yield curve, which even with the Central Bank raising the SELIC has not appreciably reduced its inclination,” he says. “The market doesn’t feel comfortable.”
For example, instead of engaging in the economic agenda, Bolsonaro went to Maceió to try to defend himself against some of them. And he didn’t go alone. He was together with Chamber president Arthur Lira, who is the one who in practice could gather consensus on the reforms in Congress. In between his errands, leaving what is important for the economy in the background, he played Jesus Christ and called Senator Renan Calheiros a “bum”.
Summing up the worst possible soap opera for Brazil when U.S. interest rates rise:
The price of the dollar tends to be pushed up whenever some uncertainty looms ahead. Investors tend to run after it in these situations, either to have a reserve value in a strong currency, or to later exchange it for investments abroad, in a safer economy;
In addition, the upward pressure on the Brazilian stock market recently from foreigners is not negligible. They tend to flee from riskier markets when the going gets tough. And among the major emerging markets, Brazil leads the risk perception, among other things, because of the endangered public accounts. Therefore, sharp losses, and stock market slumps may lie ahead, should the American interest rates rise abruptly;
And furthermore: interest rates in Brazil, which are currently high, tend to rise even more to keep up with this pace. It would be a way to try to reduce the differential in relation to the United States. And, thus, also hold back Brazilian inflation. How? By containing the eventual flight and, consequently, the rise in the price of the dollar;
Which, in turn, would create another problem. If interest rates in Brazil rise too much, the federal debt would become even more expensive to pay. This, by itself and without reforms carried out along the way, would drive away foreign capital. Therefore, there would be no point in raising interest rates to hold down the price of the dollar. Given the weakness of public accounts, what economists call “fiscal dominance” would occur in monetary policy.
Is this an extreme case? Yes, but nothing out of the realm of possibility.
Source: Valor Investe