Can Brazil Break the Wealth Destruction Cycle in 2013?

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Even with less than 1% growth in 2012, Brazil has had a good decade. Its main exports reached record highs, hyperinflation is history, and macroeconomic strength has given successive administrations the budget leeway to help lift 30 million Brazilians out of poverty. Betting on a robust future, investors have poured money into the country's stock market. If Brazil keeps growing, long- and medium-term investors stand to gain. But the central government’s dramatic but ineffective monetary policy moves suggest that Brazil may still be in a boom-bust business cycle, which has historically been the largest destroyer of wealth – and foreign investment -- in the developing world.

Optimists and Pessimists

Optimistic observers hope that Brazil has broken out of the boom-bust cycle. Brazil has diversified its products and its consumers. The domestic market features a young, increasingly educated, and growing middle class, following declines in both inequality and poverty indicators. Brazil’s exports have improved as well, while natural resource parastatals Vale (NYSE: VALE) and Petrobras (NYSE: PBR) remain the biggest companies, diversified beverage maker Companhia de Bebidas das Americas (NYSE: ABV) recently broke into the top three. On Brazil’s 25 biggest companies list, retailers, grocers, and construction companies have joined the traditional extractive industries and banks. Furthermore, many of these companies have strong businesses in countries other than Brazil.

But after years of good news, 2012 brought a series of bad news for Brazil, culminating in less than 1% GDP growth amid rising inflation and credit default. In response to slowing growth, President Dilma Rousseff cut the benchmark interest rate to 7.25% -- the lowest in Brazil’s history. She also signed legislation granting tax breaks for big nationally-made purchases like cars and began a massive, $500 billion dollar infrastructure improvement plan. The moves pleased economists who long decried Brazil’s astronomical interest rates, tight and expensive credit, and massive infrastructure inefficiencies. Furthermore, the moves are classic monetary policy measures to stimulate the economy and Rousseff deployed them aggressively. While most countries cut interest rates one or two percentage points to stimulate the economy in a recession, Rousseff lowered the benchmark from 12.5% to 7.25% in a year. Massive infrastructure projects are another tactic for employing the unemployed and pumping the economy with money during recessions, but Rousseff launched a huge project while unemployment was at an all-time low and the economy was simply slowing.

So far, Rousseff’s aggressive monetary and fiscal policy tools have not worked. The economy keeps slowing, even after a year of extremely low interest rates. While there may be a delayed effect from both interest rates and infrastructure, low interest rates usually cause a notable effect after a few months. The chart below shows how Brazilian GDP and the iShares MSCI Brasil Index Fund (NYSEMKT: EWZ) share price change relative to the Dow Jones Commodity Index. Even as natural resource companies become a smaller portion of Brazil's economic output and iShares's holdings, price and GDP growth are still highly correlated with commodity prices. 

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Brazil Real GDP Growth data by YCharts 

Boom, Bust, and Loss

Brazil has exported natural resources for nearly 500 years – and Brazilian schools still teach the country’s economic history as a series of boom-bust cycles around different commodities: sugar, gold, diamonds, coffee, and now iron ore and oil. While the boom years bring incredible growth and wealth that builds and populates new metropolises, the busts destroy wealth, particularly investments. Political economist Erik Wibbels's work shows that busts for developing countries, particularly Latin American ones, are twice as deep and twice as long as down business cycles in developed countries. In other words, twice as much wealth is destroyed, on average, when a developing country goes into recession than when a developed country does. Adding to the pain, developing countries’ deeper recessions last twice as long too. Likewise, statistician Morten Jerven’s research reveals that many developing countries regarded as stalled actually have dramatic boom-bust cycles where the busts are so deep that they destroy the growth from the preceding boom. Natural resource exporters like Brazil are particularly vulnerable to more violent boom-bust cycles, and the busts often knock middle income countries like Brazil and Argentina off of their trajectory towards the elusive club of high income countries. 

We should expect Vale's and Petrobras's share prices and forecats to track the outlook of their respective commodities, iron ore and oil. As long as global demand remains depressed, Vale's and most likely Petrobras's share prices will as well. What we should not necessarily expect is Brazil's GDP or stock indexes to so closely track changes in commodity prices, particularly as publicly traded companies diversify away from commodities and towards consumers and industry. For investors long on Brazilian growth, Brazil's ability to use macroeconomic policy to escape or soften boom-bust cycles in natural resources is key.

CallaMarie owns shares of Companhia Vale Ads and Petroleo Brasileiro S.A. (ADR). The Motley Fool recommends Petroleo Brasileiro S.A. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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