Is Brazil “Deindustrializing”?

Several times before on this blog, I have written about the inherent weaknesses in Brazil’s manufacturing base, an important engine for any country’s economic development. Over the last decade, high commodity prices significantly boosted Brazil’s terms of trade, leading to a period of strong growth that led many to claim that Brazil was one of the world’s emerging great powers. Despite its uncompetitive industries, rapid expansion of services, domestic consumption, and pro-poor social spending along with falling inequality gave rise to what local political leaders and international observers dubbed “The Brazil Model”. While I greatly admire the progress Brazil has made over the last decade, I questioned whether this economic success would be sustainable without a comprehensive effort to improve the manufacturing sector. Recently, the failures of the Brazilian Model have become all too apparent, as Brazil’s booming economy has slowed to a crawl.

Economic growth has slowed across the world over the last year, as Europe flirts with recession and China continues to restructure its economy for a “soft landing”. Both developed and developing countries registered weaker-than-expected GDP growth for 2011, but in few places was the shift as dramatic and unexpected as in Brazil. After expanding at a brisk 7.5% rate in 2010, the country slowed dramatically to 2.7% in 2011, barely avoiding recession in the second half of the year. Estimates for 2012 GDP continue to be revised downward, and instead of becoming the region’s shining star, Brazil now lags behind all major Latin American economies in its growth projections.

The culprit of this sudden shift? Weak performance from the industrial sector. After registering robust growth in 2010, Brazilian manufacturing collapsed in the second half of 2011, averaging a monthly -1% contraction, annually adjusted. The situation continues to worsen in 2012 as January and February recorded contractions of -3.4% and -3.9%, respectively. Suddenly, national and foreign observers are worrying about Brazil’s “deindustrialization”. Reviving the manufacturing sector has now become the top priority of the nation’s policymakers.

The biggest reason behind the sudden shift in Brazil’s fortunes has been the rapid appreciation of the real, the local currency. After trading at roughly 2 reais to the dollar for the last several years, the real strengthened to an average of 1.6 reais to the dollar during 2011. This was caused principally by speculative “hot money” fleeing low interest rates in the developed world and attracted to Brazil`s sky-high interest rates, a legacy from past battles against hyperinflation. As the value of the real strengthened, Brazil’s industry found itself struggling to compete domestically against suddenly-cheaper imports, and unable to sell internationally as its products became overpriced. President Dilma Rousseff railed against the effects of this “monetary tsunami” which stimulated growth in rich countries at the expense of emerging economies. To combat the effects of a strong real, the Brazilian government has imposed stricter capital controls and intervened in the currency market, purchasing dollars in large quantities to ease the real back to a rate of roughly 1.87 reais to the dollar.

(An interesting side effect of the strong real: Brazilian tourists flocked to the U.S. in record numbers this holiday season, going on shopping sprees that provided such a boost to the U.S. economy that President Obama has promised to relax visa requirements for the future. And one unfortunate Fulbright scholar had his cost of living shoot up dramatically…)

Exchange rates are incredibly important, and I do not want to suggest that appreciation of the real has not been the main reason behind Brazil’s 2011 woes. A quick look at Germany and China shows just how important a weak currency can be to boosting a country’s manufacturing potential. But the issues behind Brazil’s industrialization go much deeper. The country suffers from an underlying competitiveness problem.

In my previous column on Brazil, I mentioned some of the areas that need drastic improvement in order for Brazil to have more sustainable economic success. These include taxes, interest rates, infrastructure and education.

Lowering taxes should certainly be a priority of the government. While a recent package of temporary, targeted tax cuts to industry is a promising sign, a more long-term, broad-based comprehensive reform will be needed to reduce the negative impact of Brazil’s stifling tax regime.

Incredibly high interest rates, long a scourge on the Brazilian economy, choke the supply of credit for both consumers and producers. The Central Bank has been aggressive in pushing these rates down, and Dilma has made it clear that lowering interest rates is a key part of her government’s economic revival strategy. While taking advantage of a slow international economy to finally push down interest rates to more manageable levels is certainly a good idea, persistently high inflation in the country may limit the government’s room to maneuver in this area.

Infrastructure remains a key concern, but I will write more on this topic in a separate column.

Investment in science and technology has been one interesting initiative of the government. Dilma’s new “Science Without Borders” plan aims to send up to 100,000 Brazilian students to study in top universities across the developed world, principally in the United States. This program represents Brazil’s largest investment in improving its knowledge in high-tech science and engineering in order to build competitive industries in some of the world’s most cutting-edge fields. While the benefits may not become clear for some time, this program could have huge long-term effects on Brazilian businesses’ international competitiveness.

Overall though, the biggest impediment to Brazil’s industrial growth may be the country’s worrying trend of protectionism. With high tariffs and import quotas, Brazil has long been reluctant to force its businesses to compete internationally by promoting more free trade. Fearing that doing otherwise would promote even greater deindustrialization, the government has often been eager to coddle its many inefficient manufacturers. This has resulted in extremely high costs for Brazilian consumers, and an inability to compete even with peers in Latin America.

Brazil’s foil in this regard is the region’s other giant: Mexico. During the 1990s, Mexico opened up its economy to become part of NAFTA. While this did cause a difficult transition process as old, inefficient businesses bowed to competitive pressures and closed, it eventually led to a new generation of efficient manufacturers with a hard-earned competitive advantage. This restructuring eventually turned Mexico into Latin America’s strongest industrial power. The country’s strength lies primarily in assembly, putting together parts manufactured in Asia and exporting the final product across the Americas.

The growing success of Mexico’s car manufacturing industry is a strong example of the country’s strength. While Brazil is most often hailed as Latin America’s most important country, Mexico now enjoys a higher GDP per capita, faster growth rates, lower unemployment, more rapid industrial expansion, and less inflationary pressures than its South American counterpart. (All of this despite a wave of drug-related violence.) It is not alone in this regard. The Pacific nations of South America (Chile, Peru and Colombia), have all embraced free trade in recent years, signing bilateral trade agreements with the U.S. and other nations and lowering taxes and tariffs. All of these countries are now growing faster than Brazil and have experienced industrial expansion, not contraction, over the last year.

If Brazil wants to arrest the tide of deindustrialization, it must force its manufacturers to compete. It should follow the lead of Mexico and Chile and open its borders to more trade, possibly looking to sign a regional free trade agreement. (Mercosur, Brazil’s current free trade bloc along with Argentina, Uruguay and Paraguay, has long failed to promote its goals due to its members’ refusal to lower tariffs.) While this may cause some temporary adjustment difficulties, the industries that emerge will put Brazil on much surer long term footing to maintain and grow its manufacturing base.

The initial signs are worrying. The Brazilian government recently slapped a quota on car imports from Mexico as local manufacturers complained they were unable to compete against their regional counterparts. The immediate worry is that Brazil will cope with recent bad economic news by becoming more, not less protectionist. This is bad news for Brazilian consumers frustrated with absurdly high prices for manufactured goods. It is even worse news for those of us who are excitedly hoping for Brazil to emerge as a global economic power.