Faster and Slower
March 28, 2007
By Gray Newman and Luis Arcentales | New York
It may not be enough to stop the critics from demanding that Brazil be stripped of its BRIC membership, but Brazil’s growth is getting a double boost this year. After lagging behind Mexico’s growth rate last year, Brazil’s economy is showing signs that it should outpace Mexico in 2007.
Part of Brazil’s improvement is little more than an accounting exercise thanks to the newly released and newly weighted national accounts series from Brazil’s statistics institute (IBGE), which shows that GDP has been growing more rapidly in recent years than previously reported. For example, based on 2002-05 revisions reported last week where GDP jumped from an average of 2.4% to 3.1%, we expect that 2006 GDP growth is likely to be closer to 3.6% than the originally reported 2.9% (revised 2006 data are set for release on March 28). But part of Brazil’s improvement would also show up even under the old methodology. Even without the newly weighted GDP data, the latest economic releases from Brazil and Mexico suggest that the steady decline in interest rates in Brazil is having an impact on boosting growth into 2007, just as Mexico’s growth cycle appears to have turned down. We’ve been arguing for a while that Brazil and Mexico would switch places on the growth front in 2007 (see “Latin America: Stability Brings Complacency” in This Week in Latin America, January 8, 2007). The economic indicators released to date suggest that Brazil’s economy is accelerating, even as Mexico’s economy is showing a more pronounced slowdown than was expected by most Mexico watchers just a few months ago. But first, let’s deal with the issue of Brazil GDP revisions. Revise, re-weight, re-measure Unlike the noisy and abrupt changes in inflation-measuring methodology taking place in Argentina, Brazil’s GDP revisions have been in the works for years and are likely to prompt little controversy. The revisions, the first major undertaking of national accounts in ten years, took account of a 2002-03 household spending survey as well as numerous sector surveys and a new classification of economic activity. The result: the new series gives a much larger weight to Brazil’s service sector and shrinks the contribution from Brazil’s industrial base. For example, the service sector now accounts for roughly two-thirds of GDP (up from around 54-56% under the previous measures). In contrast, industrial production loses nearly 8-9 percentage points of GDP, going from 36.1% in 2000 under the old series to 27.7% of GDP under the new series. Consumption also gets a boost using the new methodology. With the new series more heavily weighted to services (which tend to be consumed domestically at a higher pace than goods), it should be of little surprise to see GDP, which has been led by consumption of late, move higher in the 2006 revisions as well as in 2007. Once the 2006 revisions are released this week, we expect to move our 2007 GDP forecast upward closer to 4.4-4.5% from 4% currently. Recall that in 2006, while GDP disappointed at 2.9%, consumption spending under the original series was just less than 4% (3.8%). Some might ask why, if the government revises upward the 2006 GDP data, should we be revising upward our 2007 forecasts? After all, isn’t the new base year that much larger, making an increase over it that much more daunting? Remember, however, that our forecasts of the relative importance of consumption versus investment and services versus industrial production have now changed: strong household demand and strong service growth now account for more, while modest growth in other sectors matters less. Given the nature of Brazil’s growth, the new weights are likely to boost growth forecasts from all Brazil watchers. The GDP revisions also ‘shrink’ Brazil’s debt-to-GDP ratios, lopping off nearly 5% from the ratios, bringing net public total debt under 45% from near 50% previously. Of course, while debt looks smaller, as does the fiscal deficit, so does Brazil’s current account surplus. Moreover, Brazil’s primary surplus efforts are likely to prove more challenging. Brazil: Rate cuts and growth The good news on Brazil’s real economy front, however, is not limited to statistical changes. Since 3Q06, we have seen a steady improvement in the pace of growth in Brazil on a quarter-over-quarter basis. And on a year-over-year basis, 4Q06’s 3.8% growth — the best report in a year-and-a-half — suggested that the economy was entering 2007 on an upswing. From industrial production data for January (up 4.5%) to electricity and use of checks and credit cards data through March, the high-frequency measures suggest that the Brazilian economy should be able to grow near 4% under the previous methodology and likely well above it using the new weights. Electricity usage in the first half of March, for example, showed one of its sharpest monthly jumps on a seasonally adjusted basis in the past year. And data from the leading manufacturing chamber, CNI, suggest that manufacturing sales remain growing at a healthy pace, roughly 6%Y as 2007 began. Wages are also growing at 7.7%, providing for significant real wage growth, given muted inflation (which has averaged around 3% in recent months). With wages growing handsomely, along with employment and credit, we believe that Brazil is set to see improved growth in 2007. Inflation in Brazil has plummeted even as real rates have remained largely unchanged. And that should set Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates. We expect the targeted Selic interest rate to reach 11.25% by the end of 2007 and for it to fall further in 2008. With projected real rates at their lowest level in decades, we expect Brazil’s growth path to improve. Of course, the challenge for Brazil is not simply a matter of monetary policy. The economy needs a stronger investment platform, and that means changes in the regulatory environment, improved infrastructure and a healthier public sector. But the benefits from stability and hence lower interest rates are likely to prove powerful forces boosting the investment cycle in Brazil. Mexico In contrast, Mexico’s economy is showing signs of a more pronounced slowdown than was expected by most Mexico watchers just a few months ago. We have long been criticized for our 3.3% forecast for GDP growth for 2007: it seemed out-of-synch almost as soon as we published it at the beginning of last year with the easy extrapolation exercises that many were engaged in. After all, 2006 was Mexico setting itself up to be the strongest year since 2000 (as it was), so why shouldn’t 2007 be a repeat? We argued then and argue now that a slower US economy, lower oil prices and the absence of massive election spending in 2007 would all conspire to produce a slowdown this year. That is now precisely what we are seeing. The first warning sign perhaps came earlier this year when 4Q06 GDP came in a weakened 4.3%, below the 5% average of the first three quarters. And more importantly, private consumption slowed to 3.1% versus an average of 5.7% during the first three quarters of the year. Indeed, according to the seasonally adjusted series provided by the national statistics institute (INEGI), private consumption actually contracted by 0.8% during 4Q when compared with 3Q. The slowdown in Mexico should not come as a surprise. After all, its principal trading partner, the US, has been undergoing one of the strongest reductions in import demand that we have seen since the last recession in 2001. While we recognize that Mexico’s economy — thanks to the growth of credit — cannot be simply reduced to the link between its industrial plant and that of the US, nonetheless the link between the two countries is still very much alive and still cuts both ways. With credit to consumers slowing and employment and wages in the manufacturing sector likely to follow a weakened industrial plant — trend growth in industrial production and manufacturing appears to be shaping up to be the weakest in two years — it is no surprise that retail sales are showing some softening in demand. Bottom line Brazilis likely to have a place in the sun in 2007 and 2008 as real interest rates finally begin to experience some of the reduction that we have seen in nominal rates in recent years. That is hardly enough to provide for strong, long-lasting growth, but we would argue not to underestimate the power of lower rates and stability in a country which has rarely seen either. In contrast, Mexico seems on track to slow more rapidly than many had expected. The downside, however, appears limited, thanks in part to the growth in credit and a fiscal regime that is still heavily fueled by oil revenues. But it should serve as a reminder that absent significant reforms designed to boost Mexico’s competitiveness, growth rates near 5% as seen in 2006 are likely to remain scarce, unless all the stars are aligned in Mexico’s favor.
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When a Prime Minister Makes Monetary Policy
March 28, 2007
By Serhan Cevik | London
With loose macroeconomic policies, Egypt’s consumer price inflation keeps rising. The consumer price index increased at an annual rate of 12.6% in February, up from 12.4% at the end of 2006 and 3.1% in 2005. This is a partly a result of higher food prices and administered price adjustments last year. First, food prices — representing 38% of the CPI — recorded a sharp year-on-year increase from 4.1% in 2005 to 16% by the end of last year. Second, the reduction in energy subsidies raised inflation rates in the fuel-sensitive housing and transportation sectors from 0.2% and 1%, respectively, at the end of 2005 to 7% and 10.4% last December. However, even though these supply shocks have eased in recent months — lowering the rate of increase to 15.7% in food prices and stabilizing it at 10.4% in transportation prices — the headline inflation rate keeps rising, albeit at a slower pace. As we have long argued, despite all the statistical shortcomings of the official price indices, Egypt’s inflation problem is not just about one-off developments, but really stems from loose macroeconomic policies that have led to overheating of the economy. Administrative measures may stabilize inflation, but will not address the underlying problem. The quality of statistics is low in Egypt, making it difficult to do analysis and conduct monetary policy. Realizing this challenge, the Central Agency for Public Mobilization and Statistics and the Central Bank of Egypt are working to expand and improve economic datasets. Until then, of course, we have to work with available figures. Given the high share of food and administered prices in the CPI, base effects may stabilize inflation rates, but the expansionary policy stance — negative real interest rates coupled with a large budget deficit — is the real problem and results in unbalanced growth and inflationary pressures (see Too Loose, November 29, 2006). Against a 940bp increase in the annual rate of inflation since the end of 2005, the central bank tightened its monetary policy stance by just 75bp to 8.75% last year and has left it unchanged so far this year. Likewise, the government has not adjusted incomes policy to contain inflationary pressures and relied on windfalls to lower — only marginally — the budget deficit. Instead, the authorities have introduced administrative measures such as imposing export tariffs on steel and cement and cutting import tariffs on food products. In our view, this approach contradicts the spirit of the reform agenda and does not really address underlying imbalances in the economy. The Egyptian economy, fuelled by loose policies and abundant liquidity, is growing too fast. All countries aspire to achieve faster growth, but the question of sustainability is as important as the rate of employment and income growth. After all, boom-bust growth cycles lead to underperformance in the long run and hurt the poor more than others. And this is exactly the risk the Egyptian economy is facing today. After growing at an annual average of 4.4% in the 1990s, real GDP soared by 6.9% in the last fiscal year and 7.2% in the first quarter of the current fiscal year — the fastest expansion in the last two decades and well above the sustainable rate of growth. No one can deny the benefits of reforms implemented in recent years, but we should not overlook the nature and composition of growth. Supported by petrodollar liquidity and low rates, bank lending to the household sector is growing at an annual rate of 25% (from 4% in 2002) and the real estate sector is experiencing an unprecedented boom, together explaining the surge in consumption and core inflation. When politicians get involved, monetary policy tends to become less effective. The signs of overheating in the Egyptian economy are clear, as are the reasons behind it. However, even though the central bank acknowledges the need to normalize negative real interest rates, monetary tightening is not easy with the country’s prime minister heading the Coordinating Council for Monetary Policy, where politicians have more weight than central bankers. Furthermore, the original sin of fiscal imbalances keeps creating inflationary pressures and limiting the effectiveness of monetary policy. This is why we think that Egypt urgently needs an independent central bank and fiscal consolidation through maintaining primary budget surpluses.
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