More Signs of the End of Easy Money? Brazil Raises Rates amidst Stagflation

Could Brazil’s actions of raising interest rates signify as another precursor (aside from Japan) to the culmination of the era of easy money?  

From the Wall Street Journal Blog:

Brazil’s central bank on Wednesday confronted an increasingly acute policy dilemma with firm hand and clear voice, seeming to throw its customary caution to the wind.

In its fourth monetary policy meeting of 2013, the central bank voted unanimously to raise its Selic base interest rate by a half point to 8%. In a brief statement, the central bank said the change was “continuing with” an adjustment in interest rates that would help put inflation on a downward path.

Most analysts had expected a more modest quarter-point increase in the face of soft economic growth.

“They finally woke up,” said Paulo Faria-Tavares, managing partner of Sao Paulo’s PTX Lending consultants. “But they need to stay awake or it won’t work.”

The central bank’s policy dilemma became unexpectedly acute earlier Wednesday, when the government’s IBGE statistics bureau released first quarter economic growth figures. The data showed disappointing first quarter growth of only 0.6%. Most analysts had predicted 0.9% growth.

But slower growth is coming at the same time as rising inflation. Brazil’s 12-month inflation rate is currently running at 6.46%, up from 5.84% at the end of 2012. The current rate is skating dangerously close to the 6.5% ceiling of Brazil’s inflation targeting range, which is 2.5%-to-6.5%.

Under Brazil’s 1999 inflation-targeting law, the central bank is obliged to take action whenever inflation bursts through the top of the range. That could happen at any time

Mainstream media seems to be confused about the causal relationship between growth, zero bound rates, and price inflation.

Let’s see what has been driving Brazil’s “inflation”

Loans to the private sector has essentially more than tripled since 2004!!!

Seen from a different perspective or as ratio to the GDP, domestic credit has been on a sharp upside trend since 2007.

But such upswing has been less than the sharp growth surges of the late 80s and early 90s which culminated with recessions.

The same holds true for domestic credit provided for the banking sector.

And where has all such immense growth in credit been flowing to?

The lackluster general growth of the Brazilian economy seems hardly a manifestation of an evenly distributed credit boom

Instead, booming credit as consequence from easy money policies have channeled to titles representing capital goods, particularly stock market and the real estate.

Brazil’s stock market as seen from the Bovespa appears to have been an early recipient as shown by the booms of 2002-2007 and 2008-2010, but not today.

The chart above reveals of the broadening mismatch between credit and income growth. Such mismatch represents a symptom of the property bubble in progress.

The rate of Brazil’s sizzling property boom makes it one of hottest in the world.

According to an article from Forbes: 

When it comes to rising housing prices, no country in the world beats Brazil.

According to Knight Frank’s Global Real Estate Index, released this month, Brazil ranks No. 3 in the world and No. 1 in the Americas for rising home prices. Only ridiculously expensive Hong Kong and Dubai, which are not countries, have seen prices rise more. So in fact, no single country has seen its housing prices rise as much as Brazil.

Brazil housing prices rose 13.7% from the fourth quarter of 2011 to Dec. 31, 2012. By comparison, U.S. housing prices rose 7.3% in the same period, putting it at No. 12 in a list of 55 countries ranked by Knight Frank.

The only other country in the hemisphere to make it into the top 20 was Colombia, with real estate prices rising 8.3% in 2012.

Brazil stands out. And one reason is the low cost of financing. Or at least low by Brazilian standards. Mortgage rates are at least 1.3% a month, and loan payments are generally for just 15 years. It used to be that Brazilians bought homes in cash, but not anymore. They are financing purchases with down payments. Since 2009, when Brazilians starting buying homes on debt, mortgage lending has risen five fold, by 550% between then and 2012.

According to Brazil’s Institute for Economic Research, or FIPE, housing prices rolled into the end of 2012 in seven capital cities on a high note. Prices in all seven cities — from São Paulo to Rio de Janeiro — rose well above the inflation rate of 5%. At the start of the fourth quarter last year, at the end of September, Brazilian housing prices had already risen by 15% while inflation was not even half that.

Looking back at September, FIPE said São Paulo real estate rose 1.5%, three times higher than the national inflation average for the month.

So Brazil’s property bubbles may end soon.

But this has not been solely a private sector affair

Even as Brazil’s government have been posting surpluses, government spending has zoomed by almost 5 times in 11 years from 2002.  Part of such spending growth has been financed by the explosion of Brazil’s external debt.

In other words, tight competition for scarce resources from the sector’s underpinning the property bubble which has been compounded by the burgeoning growth of government spending—all of which has been financed by credit expansion—has led to higher price inflation amidst stagnant growth.

In essence, Brazil endures from both stagflation and asset bubbles.

Yet the actions of Brazil’s authorities if sustained will put enormous strains on these wealth consuming activities over the near term. This will come with nasty repercussions

Every boom eventually turns into a bust, as the great Ludwig von Mises warned:

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances

Such applies to Brazil’s boom bust cycle.

Has Brazil Successfully Inflated Their Debt Away?

So claims popular analyst John Mauldin in his latest newsletter.

You don’t even have to go that far back to see hyperinflation and how brilliantly it works at eliminating debt. Let’s look at the example of Brazil, which is one of the world’s most recent examples of hyperinflation. This happened within our lifetimes. In the late 1980s and 1990s, it very successfully got rid of most of its debt.

Today, Brazil has very little debt, as it has all been inflated away. Its economy is booming, people trust the central bank, and the country is a success story. Much like the United States had high inflation in the 1970s and then got a diligent central banker like Paul Volcker, in Brazil a new government came in, beat inflation, produced strong real GDP growth, and set the stage for one of the greatest economic success stories of the past two decades. Indeed, the same could be said of other countries like Turkey that had hyperinflation, devaluation, and then found monetary and fiscal rectitude.

In 1993, Brazilian inflation was roughly 2,000 percent. Only four years later, in 1997 it was 7 percent. Almost as if by magic, the debt disappeared. Imagine if the United States increased its money supply, which is currently $900 billion, by a factor of 10,000 times, as Brazil did between 1991 and 1996. We would have 9 quadrillion U.S. dollars on the Fed’s balance sheet. That is a lot of zeros. It would also mean that our current debt of 13 trillion would be chump change. A critic of this strategy for getting rid of our debt could point out that no one would lend to us again if we did that. Hardly. Investors, sadly, have very short memories. Markets always forgive default and inflation. Just look at Brazil, Bolivia, and Russia today. Foreigners are delighted to invest in these countries.

Sometimes I feel like dispensing the role of snopes.com a popular website which serves as “the definitive Internet reference source for urban legends, folklore, myths, rumors, and misinformation.”

Well, here is the account of Brazil’s inflation-debt dynamics according to the Wikipedia.org, (bold highlights mine)

The stabilization program, called Plano Real had three stages: the introduction of an equilibrium budget mandated by the National Congress a process of general indexation (prices, wages, taxes, contracts, and financial assets); and the introduction of a new currency, the Brazilian real, pegged to the dollar. The legally enforced balanced budget would remove expectations regarding inflationary behavior by the public sector. By allowing a realignment of relative prices, general indexation would pave the way for monetary reform. Once this realignment was achieved, the new currency would be introduced, accompanied by appropriate policies (especially the control of expenditures through high interest rates and the liberalization of trade to increase competition and thus prevent speculative behavior).

By the end of the first quarter of 1994, the second stage of the stabilization plan was being implemented. Economists of different schools of thought considered the plan sound and technically consistent.

1994-present (Post "Real Plan" economy)

The Plano Real ("Real Plan"), instituted in the spring 1994, sought to break inflationary expectations by pegging the real to the U.S. dollar. Inflation was brought down to single digit annual figures, but not fast enough to avoid substantial real exchange rate appreciation during the transition phase of the Plano Real. This appreciation meant that Brazilian goods were now more expensive relative to goods from other countries, which contributed to large current account deficits. However, no shortage of foreign currency ensued because of the financial community's renewed interest in Brazilian markets as inflation rates stabilized and memories of the debt crisis of the 1980s faded.

The Real Plan successfully eliminated inflation, after many failed attempts to control it. Almost 25 million people turned into consumers.

The maintenance of large current account deficits via capital account surpluses became problematic as investors became more risk averse to emerging market exposure as a consequence of the Asian financial crisis in 1997 and the Russian bond default in August 1998. After crafting a fiscal adjustment program and pledging progress on structural reform, Brazil received a $41.5 billion IMF-led international support program in November 1998. In January 1999, the Brazilian Central Bank announced that the real would no longer be pegged to the U.S. dollar. This devaluation helped moderate the downturn in economic growth in 1999 that investors had expressed concerns about over the summer of 1998. Brazil's debt to GDP ratio of 48% for 1999 beat the IMF target and helped reassure investors that Brazil will maintain tight fiscal and monetary policy even with a floating currency.

In short, monetary reform via the dollar peg (first), fiscal austerity and the move towards greater economic freedom resulted to the reduction of Brazil’s debt.

Here is the account of the World Bank... (bold emphasis mine)

Brazil’s debt decomposition indicates that primary fiscal balances and real GDP growth have been the most significant debt-reducing factors between 1993 and 2003. Brazil’s primary fiscal balance, which has improved significantly in the recent past, has provided the largest debt-reducing contribution, in particular since 1999. Real GDP growth was responsible for a debt decline of 9.0 percent of GDP over the decade.

Apparently the World Bank says the same-fiscal side reforms functioned as the critical factor in Brazil’s debt reduction.

And here is a paper from the Inter-American Development Bank entitled The Structure of Public Sector Debt in Brazil

Afonso Sant’anna Bevilaqua, Dionísio Dias Carneiro, Márcio Gomes Pinto Garcia, Rogério Furquim Ladeira Werneck, Fernando Blanco, Patricia Pierotti, Marcelo Rezende, Tatiana Didier writes, (bold highlights mine, italics theirs)

Given Brazilian inflationary history, the domestic bonded debt market was recreated in the mid-1960s with the introduction of indexed bonds (ORTNs), which were then conceived as an antiinflationary tool. The idea was that only the money financing of the fiscal deficits was inflationary. In the period of more than thirty years since its creation, the Brazilian open market has evolved into a very sophisticated one. The gross bond debt held by the private sector is currently around one fourth of a trillion US dollars; the megainflation of the 1980s and early 1990s did not inflate away the Brazilian debt.

During the megainflation, most of the debt was placed with banks (and later, with mutual funds managed by the banks) which used the bonds as the asset counterpart of inflation protected deposits (the indexed money, or domestic currency substitute). With the Real Plan this situation is gradually changing. The debt maturity has been lengthened (with a few setbacks, as the recent Asian and Russian crises), and more agents interested in becoming final holders of long debt—as insurance companies and pension funds—are becoming more important in the financial arena.

A radical change in Brazil debt maturity profile and similarly a change in the classification of debt holders had also been a part of Brazil’s debt reduction dynamics. This paper even highlights: “the megainflation…did not inflate away the Brazilian debt”.

Bottom line: Beware of oversimplified misleading analysis.