Some thoughts on the Brazilian economy, its credit bubble and monetary policy

This article was posted by the very generous Editors from BrazilianBubble.com,  a wonderful blog on Brazil and Emerging markets, on July 31st.  I am very thankful for the generous opportunity they gave me and I hope to be able to provide some interesting content in the near future.

That inspired me to start this blog and hopefully share with as many people as possible some views on economy and investments.

By Carlos Azevedo Junior (guest).

As an active reader and follower of this site, I noticed that within the site’s community there are bright individuals with an acute sense of how the true mechanics of economic development and growth really works. I don’t profess to be an expert. Far from that: I actually believe that I am just one more John Doe among others. The only thing I have is a great sense of curiosity, which often leads me to do some research and look for critical data that exposes the cracks between information the media feeds us daily and the reality behind the scenes. Hence, I would like to share some analysis with you which will shed some light into an interesting topic: How people in key positions within public and private organizations turn a blind eye to reality.

Question: How healthy is the Brazilian economy?

According to the government agencies and many specialists, we are simply facing a correction.

Some thoughts: we are supposed to be an exporting nation – a country rich in natural resources – and recently we have become net importers of good and services. The trade balance from the week ended on June 25th revealed an outright trade deficit of $119 million. Quite concerning. Last week alone, exports dropped 19.7%. And by looking more closely at the data, you’ll note that it has been dropping dramatically since July 2011, a deteriorating scenario with far broader consequences than simply export figures, as it can impact corporate revenues and lead to inevitable cuts in labor and employment.

The consumer sector is also following the downtrend. June’s consumer confidence data produced an ‘across-the-board’ decline. Of particular interest is the fact that June’s decline was led by the Current Situation Index, which fell 3.7% for the month, marking a second consecutive monthly decline.

While the Expectations Index fell less than the Current Situation Index, it still posted a June decline of 1.9% after falling by 3.0% in the last two months. Subsequently, the headline Consumer Confidence Index fell by 2.8% for the month, marking back-to-back monthly declines of 4.0%. When measured in ‘index points’, the two-month decline of 5.2 points (from 128.7 in April to 123.5 in June) represents one of the largest back-to-back monthly declines in the last ten years. History may not repeat itself, but by being a commodity driven nation (and expecting major declines in commodity prices), we might experience scenarios similar to those associated with the worst of the 2007-09 crisis.

I can’t really forecast the future, but I see some troubling patterns on the horizon. The sharp decline in consumer confidence came as surprise particularly given the fact that employment remains strong across the board.

According to the recent Annual Report from the Bank of International Settlements, the situation is as follows:

“Credit expansion in Brazil and other emerging markets far outpaced economic growth in recent years, and high debt levels could be a problem, raising questions about the sustainability of bank performance.”

More troubling and quite concerning was the data on Bank Loans and Consumer Credit for the month of May with Total Bank Loans Outstanding soaring to yet another new all-time high of BRL 2.137 trillion. How and when it is going to reverse?

It amazes me that there are hundreds of articles in the international midia regarding concerns with outstanding loans in China, while, in Brazil, the situation is as bad. Three months ago the figure was “only” BRL 2.070 trillion. In the last 12 months, our outstanding loans went from BRL 1.806 trillion in May 2011 to BRL 2.137 trillion in May 2012. An increase of BRL 331 billion in 12 months is quite remarkable if one considers the current deterioration in economic fundamentals everywhere across the globe.

Is China really the problem?

Things get even more interesting when we realize that total Consumer Credit Outstanding did surge to a new all-time high record of BRL 661.2 billion during May. Some analysis may hint that Brazil is getting into a situation in which people are borrowing in order to try to cover existing debts. The over-indebted Brazilian consumer issue is serious and being ignored.

Things get more complex when we face the reality of the data released by the banks. The default rate on personal/consumer loans is surging rapidly. The default rate rose to 8.0% in May, the highest since 2009, up from 7.8% in April, up significantly from March’s rate of 7.4%. The figure is far higher than May 2011′s rate of 6.4%.

The chart below illustrates my point: the default rate (on personal loans) reached the ‘danger zone’ of past levels associated with economic recessions and macro turbulence.

According to our Central Bankers, the solution for these problems is to expand credit lines.

Now isn’t that amazing? The world has been facing some terrible economic strains due to very loose credit policy and here we are doing exactly the same thing. If these kinds of policies didn’t work in other parts of the globe, why would it magically work in Brazil?

The consumer sector is in trouble, and the clear sign is the continued lengthening in the Average Terms of “Personal” Loans, which reached its own new all-time high of 607 days, up from 571 days in May of 2011. While the longer-term ‘pace’ of consumer credit growth slows, bank lending to the Brazilian government is soaring.

Government ‘credit’ expanded by a huge +4.1% during the month of May, a new all-time high in total credit of BRL 89.8 billion. A year-over-year increase of +31.5%. Interest rates are dropping and will drop further, but it’s absolutely necessary to stop. They must stop, but they won’t. It is not in the agenda. As harmful as this may be, the government will convince the public otherwise.

Everything hints to further easing by the Central Bank – at least another 100 basis points in the second half of 2012. And if there are further global economic problems, it could reach a 150 basis points. Now, that will inflict some sincere pain into our economy. The idea is to depreciate the real. Has Japan improved anything ever since it implemented the policy of low interest rate and depreciation of their currency to try to maintain a competitive advantage on exports?

If rating agencies cannot see what is happening and the differentials in long and short term interest rates – the huge spreads – I hope investors will.

The Brazilian stock market is and will underperform the US markets. Fact of the matter is in essence quite simple: Brazilian companies rely on China (45%) and Europe (35%) for exports. Unless something phenomenal happens, our national market cannot absorb that volume of goods and services. Historically, the Brazilian stock market underperformed the US markets in most of the strong cycles. It is a fact, not speculation. It also managed to do the same in weak cycles. It will not be any different this time. The pattern follows in terms of currency.

As the stock market drops, so does the currency. Now, presently, with so many imported goods being voraciously absorbed by our nation, it will only lead to more inflation. It doesn’t take a genius to figure that out. Weaker currency against imported goods leads to higher prices. And that relationship is terrible for commodities. Hence, being a commodity exporting nation, inflows of capital should diminish.

Many will argue that I am being too negative, but that’s how I’m interpreting the data.

I would be very glad to hear your comments.