Brazil’s Troubles Mean Further Pressure on the Real

The Brazilian real had an awful year in 2015, plunging 33 percent against the dollar, and analysts don’t expect a much better performance this year. Weak commodity prices have helped push the economy into a deep recession, inflation and interest rates have climbed into double digits, the government is struggling to contain a yawning budget deficit, and a worsening corruption scandal has paralyzed the administration of President Dilma Rousseff.

“The fundamentals are terrible, to put it mildly,” says Win Thin, global head of emerging-markets strategy for Brown Brothers Harriman & Co. in New York. The real fell as low as 4.15 to the dollar in January before recovering to 3.9636 on February 1, little changed since the start of the year, but Thin thinks it will drop to 4.55 by year-end.

Analysts estimate that the Brazilian economy shrank by 3.5 percent last year and will contract another 2.5 percent this year. “It’s hard to have strong negative growth for two years in a row, given population growth and technological advances, but it looks like Brazil is going to do it,” Thin says.

The plunge in commodity prices and weak demand from China are hurting Brazil. Commodities, including iron ore, soybeans, beef and oil, account for about 50 percent of the country’s exports. The Bloomberg Commodity index has plummeted to a 25-year low.

Banco Central do Brasil has been hiking interest rates sharply in a bid to get inflation under control, putting further downward pressure on the economy. The central bank raised its benchmark Selic rate by 250 basis points last year, to 14.25 percent, but with inflation jumping to 10.7 percent last year from 6.4 percent in 2014, analysts see little relief on the rates front. “The central bank is saying that rates are high enough to curb inflation, but clearly they aren’t,” Thin says. “They have to hike rates. Come on, their credibility is going out the window.”

Brazil’s budget deficit ran at a rate of 9.3 percent of gross domestic product in November, and Fitch Ratings cut its sovereign debt rating to BB– in December, joining Standard & Poor’s in giving the country a junk rating. The loss of an investment-grade rating will hit Brazilian companies, which have about $250 billion of outstanding foreign currency debt. “The biggest question for Brazil in the next six months is refinancing that debt,” says Gary Kleiman, senior partner and co-founder at Kleiman International, an emerging-markets research firm in Washington. “The best case is that the problem is limited to a few companies, but it could be an across-the-board crisis.”

These problems would be difficult enough for a well-functioning government to tackle. Unfortunately, the two-year-old investigation into allegations of widespread kickbacks from state-owned Petróleo Brasileiro, which Rousseff chaired for years before becoming president, to leading politicians has crippled the government and brought calls for Rousseff’s impeachment. The scandal deepened in November with the arrests of Delcídio do Amaral, the Workers’ Party leader in the Senate, and André Esteves, the founder of investment bank BTG Pactual. The Brazilian Congress is seeking to launch impeachment proceedings against the president on charges that her government used accounting tricks to hide the true size of the budget deficit.

Confidence in the government’s economic policy took a fresh blow in December when Joaquim Levy, whom Rousseff had appointed as Finance minister a year earlier to tackle the deficit, resigned because of opposition to his austerity measures from within Rousseff’s ruling Workers’ Party. His replacement, Nelson Barbosa, is a close Rousseff aide who is regarded as more fiscally liberal.

What Brazil needs is a new growth model, says David Beker, chief Brazil economist and fixed-income strategist for Bank of America Merrill Lynch in São Paulo. “The consumption sector is exhausted,” he says. “Consumers are leveraged, banks aren’t lending, and unemployment is rising.” Unemployment totaled 9 percent in the period from August to October. A falling currency can help by boosting exports and making foreign investment less expensive, Beker says. So there’s a need for the real to remain weak.

Brown Brothers’ Thin believes Rousseff is unlikely to resign or be impeached. “The opposition doesn’t want power because things are still getting worse,” he says. “Their attitude is, Let Dilma twist in the wind for the next couple years, and then get her party out of power for generations.” Still, the political morass will put further downward pressure on the currency, he and others say.

Kleiman says Brazil’s problems run deep. The 1988 constitution guaranteed fractious politics by creating a multiparty system, and it mandates a large proportion of public spending, making it difficult to bring the deficit under control. “It needs a reform of its entire political and economic framework,” he says. “When you have embedded costs and taxes, there’s not much you can do about it, except at the margins.”

Kleiman thinks the picture is ugly enough to push the real down another 20 percent against the dollar this year, to 5.15 reais to the greenback.

Get more on foreign exchange.