A Glance Back, and a Hard Look Forward ‘ October 2015.

A Glance Back, and a HardLook Forward

‘October 2015

Geert AalbersSenior Managing Director &

Head of BrazilSão Paulo

2

Marcos CasarinSenior Economist Brazil

London

RISKMAP

2015

Region is facing external headwinds

• End of commodities super cycle

• The China factor (instability, demand)

• Middle-income “trap”

And also internal vulnerabilities

• Low productivity and large informal economy

• Lack of investment, infrastructure

• Weak governance and rule of law

And Brazil...changes ahead?

Lula (2003-2010)

External tailwinds(commodities, China)

Macroeconomic “tripod”(primary surplus, inflation targeting, floating FX)

Social programs; active (and leftist) foreign policy

High approval rating + consensus-building skills = political stability

Rousseff (2011-)Same party, different policies

Less favourable external scenario, lack of competitiveness

“New economic matrix”

Social programs expanded + state intervention (BNDES, Selic, gasoline,

electricity)

Riffs with PMDB = defeats in Congress since 2012

Rousseff’s approval ratings nose-dive to single digits (9%);

mass anti-government rallies

2015 The “perfect storm”?

• Weak mandate and low approval ratings

• An unruly ruling coalition

• Petrobras scandal

• Need to implement a unpopular austerity plan

• Possible water and energy crisis

• Loss of investment-grade status

Gavin commentary on Car wash

• Reach of investigation?• Reach of litigation: international, class action?• Limits of institutional stress?• Regional contagion?

Car Wash investigation: What next?

Gavin commentary on Car washDesigning a New Brazil Playbook

• Corruption risk has increased: H x H• Risk Assessment: deepen the exercise• Tailor training: behaviours, not laws• Third parties: deepen pre-transaction scrutiny and DD• Monitoring and audit rights: use them, and lower the threshold• Whistleblowing lines: never a better moment

Car Wash investigation: What does this mean for you?

Impeachment?

Court of Audits(TCU)

The TCU recommends government accounts for 2014 be rejected; the Rousseff administration is being accused of “fiscal maneuvering”

Supreme Electoral Court

(STE)

Opposition PSDB claims that Rousseff received illegal funds

during the 2014 presidential campaign

Petrobras scandal

Allegations could emerge, specifically implicating RousseffMust relate to offenses made since January 1, 2015

A shrinking coalition

PT + PMDB • Two largest parties in Congress• A marriage of convenience during much

of PT’s term in power (since 2003)• PMDB has traditionally focused more on

power than ideology• Relationship turned sour under

(because of?) Rousseff, particularly since 2012

• PMDB currently split between supporters and opponents of Rousseff

• Key stakeholders• Michel Temer (VP)• Eduardo Cunha (speaker of Chamber

of Deputies)• Renan Calheiros (speaker of Senate)

The “new normal” in Brazil

Politics- Opposition to Rousseff will remain fierce, in Congress and in the streets- Political uncertainty to persist- Silver lining: Rousseff has never been more market-friendly!

Corruption- Petrobras scandal will continue to broaden; reputational risks - Silver lining: part of a wider improvement, business practices are changing

Economy- Recession in 2015, poor 2016- Silver lining: change in economic policy is real, the government is truly concerned about rebalancing public finances

Where are the opportunities?

Consumer goods

Health and education

Renewables (wind, solar) Agriculture Petrobras

assets

Construction and

infrastructure

Several mid-sized companies, lack of dominant players; low penetration for certain sub-sectors

Installed capacity for solar to increase from to 35 MW to 3.5GW by 2023; positive precedent from wind power

Divestment plan worth USD 15bn - 30% E&P, 30% downstream and 40% gas & power

Local firms enduring a credit crunch and in need of cash

Middle class under strain, but still sizeable

Brazil is a powerhouse

Economic outlook for Brazil:

No pain, no gain

October 2015

Marcos Casarin│Senior Economist

[email protected]

Oxford Economics• Oxford Economics is one of the world’s foremost

independent providers of global economic research and consulting

• Founded in 1981 as a joint venture with Templeton College in Oxford University

• Team of more than 150 in-house economists

• Forecasts for 200 countries, 100 industries and 3,000 locations globally

• Unique Global Economic Models

• Detailed scenario capability

• Links to Oxford University and other leading research institutes

Agenda

• A glance back…

• How did we end up here?

• Why now?

• …and a hard look forward

• Is there a way out?

• The adjustment scenario: no pain, no gain

A glance back…

How did we end up here?

How did we end up here?

• It’s impossible understand ‘where we are now’ without

going back and looking closely to what happened to:

• Labour market

• Credit and leverage

• Supply and demand balance

• Fiscal policy

Labour market: more is better, isn’t it?

4

5

6

7

8

9

10

11

12

13

8

9

10

11

12

13

2003 2005 2007 2009 2011 2013 2015

Brazil: Employment and unemploymentMillions

Source: Ministry of Labour and Employment and Haver

Formal employment (LHS)

Unemployment rate (RHS)

%+145%

90100110120130140150160170180190200210220230240250

2003 2005 2007 2009 2011 2013 2015

Brazil: WagesQ1 2003 = 100

Source : Ministry of Labour and Employment

Nominal wages

But what about productivity?

4

5

6

7

8

9

10

11

12

13

8

9

10

11

12

13

2003 2005 2007 2009 2011 2013 2015

Brazil: Employment and unemploymentMillions

Source: Ministry of Labour and Employment and Haver

Formal employment (LHS)

Unemployment rate (RHS)

%+145%

+32%

+16%

90100110120130140150160170180190200210220230240250

2003 2005 2007 2009 2011 2013 2015

Brazil: Wages and productivityQ1 2003 = 100

Source : Ministry of Labour and Employment, IBGE, Haver

Nominal wages

Real wages

Labour productivity

No wonder Brazil lost market share in world trade!

+50%

-40%50

75

100

125

150

175

200

2003 2005 2007 2009 2011 2013 2015

Source : Oxford Economics

Mexico

Brazil

2003Q1=100

Source : Oxford Economics/Haver Analytics

Relative unit labour costs in US$

Credit and leverage: the only way is up!

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

90

110

130

150

170

190

210

230

250

2003 2005 2007 2009 2011 2013 2015

Nominal wages (LHS)

Retail sales (LHS)

Consumer Credit (RHS)

Brazil: Wages, credit and consumptionQ1 2003 = 100


% of GDP

But there’s no free lunch: leverage also went up!

15

16

17

18

19

20

21

22

23

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: BCB\Haver Analytics

Brazil: Household debt service ratio% of disposable income

Peak level in the US in 2007

What about the supply side?

90100110120130140150160170180190200210220230

2003 2005 2007 2009 2011 2013 2015

Retail sales (LHS)

Brazil: Supply and demandQ1 2003 = 100


What about the supply side? Well, not so great…

+100%

+17%

90100110120130140150160170180190200210220230

2003 2005 2007 2009 2011 2013 2015

Retail sales

Industrial production

Brazil: Supply and demandQ1 2003 = 100


And what happens when demand outpaces supply?

2.53.03.54.04.55.05.56.06.57.07.58.08.59.09.5

10.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Brazil: Inflation (IPCA)% year (end of period)

Source: IBGE

Inflation target

Linear trend

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015


Brazil: Current account balance% of GDP

Linear trend

Fiscal policy: spending like there’s no tomorrow!

-1.0

0.0

1.0

2.0

3.0

4.0

2003 2005 2007 2009 2011 2013 2015


Brazil: Public sector primary surplus% of GDP

50

52

54

56

58

60

62

64

66

68

70

2003 2005 2007 2009 2011 2013 2015


Brazil: Gross government debt% of GDP

Where do we end up? With a collection of imbalances

Q1 2008 Q2 2015**Public financesFiscal balance (% GDP) -2.2 -8.2Primary fiscal balance (% GDP) 3.7 -0.8Interest payments (% GDP) 5.9 7.3Gross public debt (% GDP) 57 63

External accountsCurrent account (% GDP) -1.1 -4.3FX reserves (months of imports) 15 21External debt (% GDP) 13 16

Economic activityGDP growth (2-year average) 5.2 0.1Inflation (2-year average) 3.8 6.7Public banks' balance sheet (% GDP) 19 26

Brazil: Summary of macroeconomic imbalances*

** Arrows denote improvement/deterioration since Brazil's upgrade to investment grade in Apr-08* 4-quarter moving average, unless otherwise stated

A glance back…

Why now?

Why now?

• We just saw that Brazil has been accumulating macro

imbalances for quite some time…

• …but why are we in crisis only now?

Because we no longer have the two sources of easy growth1. Commodity super-cycle (2003-11)

90

100

110

120

130

140

150

2003 2005 2007 2009 2011 2013 2015

Brazil: Terms of tradeQ1 2003 = 100

Source: Funcex

2. Cheap money for EMs (2011-14)

65

70

75

80

85

90

95

100

105

110

115

120

100

200

300

400

500

600

700

800

900

1000

1100

2001 2003 2005 2007 2009 2011 2013 2015

EMBI+ (LHS) US$ vs major currencies (RSH)

EMBI+ sovereign spreads & US dollar bp

Source: Oxford Economics/Haver Analytics

Mar-73=100

Why is it important?

Growth model would have imploded sooner? Less portfolio inflows (and BRL appreciation)?

-6.1

-40

-20

0

20

40

60

2002 2004 2006 2008 2010 2012 2014

Brazil: Trade balanceUS$ billions




-6.1

-27.2

-40

-20

0

20

40

60

2002 2004 2006 2008 2010 2012 2014

Actual At 2002 prices





140

190

240

290

340

390

440

490

02-Jan-2013

06-May-2013

05-Sep-2013

07-Jan-2014

09-May-2014

10-Sep-2014

12-Jan-2015

14-May-2015

15-Sep-2015

EMBI+ Brazil

Source: Haver Analytics

Brazil: Exchange rate and risk premiumEMBI+ Brazil

140

190

240

290

340

390

440

490

1.90

2.10

2.30

2.50

2.70

2.90

3.10

3.30

3.50

3.70

3.90

4.10

4.30

02-Jan-2013

06-May-2013

05-Sep-2013

07-Jan-2014

09-May-2014

10-Sep-2014

12-Jan-2015

14-May-2015

15-Sep-2015

BRL per USD (LHS)

EMBI+ Brazil (RHS)

Source: Haver Analytics

Brazil: Exchange rate and risk premiumBRL per USD EMBI+ Brazil

A hard look forward…

Is there a way out?

Is there a way out?

• Brazil entered 2015 full of macro imbalances as policymakers

didn’t do their homework in the ‘bonanza’ years…

• …now the country needs to prepare for a ‘new normal’ of:

• China slowing (implying lower for longer commodity prices)

• Stronger US$ and higher borrowing costs in hard currency

• More selectivity from investors towards EMs

Who will benefit from this environment?

• Countries with:

• Limited exposure to the Chinese slowdown

• Fewer domestic headwinds (strong domestic demand)

• Good fundamentals (those who did their homework)

• Benefit from lower oil & commodity prices

• Can Brazil still thrive in such a challenging environment?

A hard look forward…

No pain, no gain

Yes, but policies need to be adjusted…

• Our baseline scenario is one of a political and economic

muddle-through…

• Political uncertainty, volatility, but no impeachment

• Very limited progress in structural reforms

As a result, growth will remain moderate…

-4

-2

0

2

4

6

8

2003 2005 2007 2009 2011 2013 2015 2017 2019

Source: Oxford Economics

Brazil: GDP growth% year

Forecast

…and debt will be unsustainable in the long-term

50

55

60

65

70

75

80

85

2003 2005 2007 2009 2011 2013 2015 2017 2019



Forecast

Alternative is to adjust policies and push through reforms

• Using our macro model, we ran an adjustment scenario.

• Key assumptions include:

• Restoring primary surpluses through tax hikes & spending cuts

• Limiting growth of gov’t spending to that of GDP

• Progress on productivity-enhancing reforms

First things first: put public finances back in order

-2

-1

0

1

2

3

4

5

2003 2005 2007 2009 2011 2013 2015 2017 2019

Baseline Adjustment


Brazil: Primary fiscal balance% of GDP

Forecast

50

55

60

65

70

75

80

85

2003 2005 2007 2009 2011 2013 2015 2017 2019

Baseline Adjustment



Forecast

No pain, no gain

6

8

10

12

14

16

18

2003 2005 2007 2009 2011 2013 2015 2017 2019

Baseline Adjustment


Brazil: Unemployment rate (PNAD)%

Forecast

-4

-2

0

2

4

6

8

2003 2005 2007 2009 2011 2013 2015 2017 2019

Baseline Adjustment


Brazil: GDP growth% year

Forecast

Bottom line• Where we are today is a result of imbalances accumulated in the past

• From now on, it will be the survival of the fittest – and Brazil needs to work out more!

• First things first: put the public finances back in order to build a bridge for growth-enhancing reforms once the storm is over

• No pain, no gain: any positive results from the macro adjustment will only show up after 3-4 years

• Hence, we see the adjustment as an unlikely scenario – politicians have no incentives to pursue adjustment now.

Perguntas?

[email protected]@controlrisks.com

A Glance Back, and a Hard Look Forward ‘ October 2015.

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