BRAZIL MEMO: COUNTRY RISK

CARLOS GERALDO LANGONI

November 23th, 2020

• The prospect of effective vaccines in the near future has brought down global risk aversion. In the case of Brazil, the exchange rate and future interest rates were positively impacted.

• Brazil’s Central Bank is expected to adjust the base rate, which could reach 6% by 2023.

• Notwithstanding uncertainties, market expectations are moderately optimistic regarding inflation, interest rate and exchange rate. The Central Bank underscores that it is imperative that Brazil corrects the mega deficits in its public accounts.

The vaccine effect brought down global risk aversion, neutralizing the negative impact of the 2nd wave of the pandemic, already sweeping across Europe.

Scenarios:

In the case of Brazil, the decrease in global risk aversion introduced a downward bias in the exchange rate and future interest rates.

In contrast, the decline in business and consumer confidence estimated by the Getulio Vargas Foundation for November - after the recovery that began in May - underscores the weight of domestic factors.

Contrary to rating agencies, markets refer to CDS spreads as a good measure to asses country risk.

It may be worth mentioning the downward bias in the CDS spreads in 2019, particularly after the pension reform. This virtuous trend was interrupted in Q2 2019 due to the Covid-19 shock.

The peak of deterioration occurred in May. Since then, a period of gradual improvement has begun, but still with high volatility.

The Central Bank has accurately signaled the importance of rebuilding a consistent postpandemic fiscal architecture.

This is a critical factor for allowing CDS spreads to orderly return to last year's levels of below 250 basis points.

The inflow of foreign direct investment would return to around US$ 80 billion annually, sufficient to leverage productivity and modernize the infrastructure.

Potential GDP, currently contained at around 2%, would make a quantitative and qualitative leap, inaugurating a new stage of sustainable growth.

Expectations:

The markets are insecure, but a relatively optimistic scenario still prevails. This is especially true of inflation.

The Focus bulletin indicates that the gap between wholesale prices (general price index of 21% in 12 months) and for consumers (consumer price index of 3.25%) tends to narrow drastically next year.

In other words, a specific increase in prices of commodities amplified by the exchange rate is expected but without contaminating inflation projections.

For this reason, the adjustment of the base rate required to meet the official target shouldn’t be traumatic. It’s expected to gradually increase to 6% in 2023.

Foreign exchange overshooting is not expected, but a moderate appreciation bias may occur, leaving the rate below R$ 5 in the coming years.

Activity:

This benign scenario needs to be endorsed by the resumption of the reform agenda, which, albeit partial, will reduce the level of uncertainty.

The private sector will have enough room to lead this new pattern of post-pandemic growth, not least because fiscal policy will have to assume a necessarily restrictive bias.

In short, the imminence of effective vaccines drastically reduces the external component of country risk.

As the Central Bank has been emphasizing there is still plenty to do at the domestic level: such as balancing the mega deficit of public accounts.

The moment is favorable for a take-off: despite uncertainties, market expectations are moderately optimistic regarding inflation, interest and exchange rates.