Brazil : time to loosen the brakes on growth ?

The Central Bank of Brazil trimmed the Selic benchmark rate by one percentage point, 25 basis points more than expected by market analysts, to a record low 9.25 percent on Wednesday, June 10. However, it also said that from now on further reductions would be carried out "more parsimoniously". Markets applauded this bold move with the Real continuing to appreciate against the Dollar

So far this year, the Central Bank slashed 450 basis points off the Selic benchmark rate, in an unusually aggressive move that is intended to support the ailing Brazilian economy, which is witnessing its first recession since 2003. As a matter of fact, the economy shrank 0.8 percent in January-March from the final three months of 2008, which saw a 3.6 percent decline from the previous quarter.


While this monetary easing is much wellcome, we believe that the Central Bank should go further, reducing the SELIC rate down to potentially as low as 6.5%. At a time of faltering inflation, the Central Bank has now a historical opportunity to turn its focus temporarily away from an orthodox inflation targeting policy to a pro-growth policy, while preserving the hard-won benefits of macroeconomic stabilization, that have been acquired since the early 2Ks.

Even at 9 percent, the benchmark interest rate is still the highest in the world among the major global economies. It is important to recall that this high interest rate was the price that Brazil had to pay for decades of economic mismanagement that resulted in skyrocketing inflation rates and brought down the country several times on the brink of collapse.

But with inflation expectations now robustly anchored below 5%, the largest Latin American Economy could not afford to keep this monetary burden on growth at a time when it mostly needs to support domestic demand.

One of the key arguments often pushed forward by Brazilian policymakers to justify such a high interest rate is the "confidence factor". According to this thesis, Brazilians still remember the decades of lost growth associated with hyper-inflation much in a similar way as Germans are almost anti-inflationist by nature with memories of the post WWI hyperinflation still deeply rooted in their minds.

This "confidence factor" is also related to foreign investors' appreciation of the Brazilian economy, which triggers the fear of so called "sudden stops"in foreign capital inflows. But this story also belongs to the past, and international investors are now more concerned by the huge US deficit than by the current state of the Brazilian economy, which has shown quite a remarkable resilience in the wake of the worst global economic crisis since the Great Depression.

In addition, one technical explanation behing high interest rates in the context of inflation targeting, is the alledgedly high pass-through from the exchange rate to domestic inflation, which is reinforced by the volatility of the exchange rate.

However, recent studies have shown that the pass-through from the exchange rate to inflation has been substantially reduced in Brazil over the last years. With commodity prices surging again, there should be no reason to keep confiscatory interest rates solely for a "self-insurance" purpose against a potential exchange rate crisis. Again, this is an obsolete story.

The real challenge for Brazil now is to accelerate its transformation from an economy that is still highly reliant on commodity exports, to a diversified industrial economy and further down the road to a knowledge-based post-industrial economy.

Lowering the interest rate to "decent" levels would be one important step in this direction.

Can China lead the global recovery ?

There was much talk as of late on the potential for China to lead the global growth recovery that is forecast by many economists by the end of this year.

Although China has certainly much more weight in the global economy now than it used to have in the past, it would be rather naive to think that the Chinese growth can really lift, per se, the global economy. The reason for that is simple. In nominal GDP terms, the developed economies still account for nearly three quarters of the global economy.

At the present time, China is more dependent on the rest of the world than the world is dependent on China, although commodity exporting countries are directly or indirectly exposed to Chinese growth through its effects on commodity prices. Indeed, the price of oil for example is heavily dependent on marginal changes of demand coming from China, but for this relationship to hold strongly it is also important that oil demand recovers in the major developed economies. This is exactly the kind of circular causality effects that make it difficult to forecast any impact of Chinese growth on world growth.

What China can do, and effectively does, is to weather down the impact of the global recession on its economy by actively mobilizing its huge fiscal and monetary reserves. The cheer size of the stimulus package that the government has enacted is a much needed substitute for growth at times when the exports engine is havoc. China is like a plane that now runs on one reactor, putting much effort on investment in infrastructure and domestic demand. It is better than having no reactor at all, but this public-funded engine cannot support the economy for ever. Exports are still much needed for China, although in the long run the transition to a consumption-led, knowledge-based service economy is the real challenge.

I leave you with some chinese economists' views on China from this interesting panel brought together by McKinsey Quarterly.

Is the BRIC concept still relevant ?

Here is an interesting view on the concept of BRIC (Brazil, Russia, India, China) by Milton Ezrati, senior economist at Lord Abett.

The whole concept behind the BRIC, that these four countries were leaders, is no longer the case today," said Ezrati, who published a report this week titled, "Broken BRIC."

You can watch Ezrati's interview with MarketWatch.com.



It is true that the BRIC concept is as much a marketing invention, coined by Goldman Sachs economists for promoting emerging markets, , as it is a research concept.

However, contrary to Ezrati's view, and although BRICs may be suffering from the financial crisis at various levels of intensity, I still believe the BRIC concept holds much of its explanatory power as an easy way to describe the long term rise of these four large regional emerging powers. No other emerging country can challenge these 4 countries leadership in the "emerging markets universe".

Ezrati is right when he points out at the existence of other emerging countries that should not be excluded from an emerging markets investment strategy.

Chinalco's investment in Rio : the great leap forward ?

Chinalco Operations Map. Source : Chinalco

Chinalco, the Chinese state-owned metals and mining conglomerate, has made a decisive leap forward today by agreeing to invest $ 19.5 bn in troubled mining giant Rio Tinto. This move comes one year after Chinalco successfully acquired - jointly with the Alcoa group - a 12% stake in the UK listed arm of the Rio Tinto group, equivalent to a 9% stake in the group itself.

According to the Financial Times, "the deal, which will involve the sale of minority stakes in some of Rio’s best mining assets and the issue of convertible bonds, marks the biggest ever investment by China in a foreign company. Chinalco will buy $7.2bn in convertible bonds which will convert into Rio shares at a later date. That would increase its stake in Rio from 9 per cent to 18 per cent. The rest of the capital injection comes from the sale of the minority stakes."

As a matter of fact, Chinalco is pursuing an agressive growth strategy abroad, by taking advantage of the current slump in commodities prices, to buy strategic assets at a distressed price. This is consistent with a rising trend among state-backed Chinese companies, not only in the resource sector but in other sectors as well, to consolidate their dominant position at home and to expand abroad, as I wrote in a previous post three months ago.

Indeed, as Yan Janging, from Caijing Magazine reported, according to some experts the current uncertain environment could be a good opportunity for Chinese companies to continue their expansion overseas. He quotes Ian Sperling-Tyler, oil & gas director in Deloitte saying that China's state-owned oil companies may have an especially good chance to buy close to 19 independent oil firms, the market values of which are all lower than their net assets.

Although, the Chinalco Rio deal can still be hindered by regulatory authorities in Chile and Australia, or by angry shareholders in the UK, it is an important symbol of the structural shift in global capitalism. A shift that signals distinct features from the pre-crisis world.

All in all, if there is one more thing this deal tells us, it is that China's thirst for all kinds of commodities remains unquenchable, and that this thirst will be sustained through 2009-2010 by the huge amount of stimulus money flowing into the infrastructure and construction sector. Given the ongoing "supply destruction" and the CAPEX freeze at the global level that we are witnessing now, this will sooner or later push the price of commodities up and reignite the same kind of commodity-driven inflationnary cycle that the world has known over the 2003-2007 period.