Outlook for Brazil under Lula

The condition of a country is more important than its leader, so to understand the future of Brazil under its new president, we need to understand its position today.

What can we expect for Brazil under Lula?

The dispute between Bolsonaro and Lula left the country polarized, with both campaigns characterized by an abundance of sensationalist speeches and few concrete proposals. Now that the heat of battle is over, the question becomes: with the election of Lula, what does the future of Brazil look like?

An analogy to corporate finance: when evaluating a company, understanding its business model, market positioning, and earnings history is more critical than evaluating who the CEO is. Similarly, Brazil’s future depends primarily on the country’s position today – the starting point for Lula’s government – ​​and the scenario he will have to face throughout his term. So, let’s talk more about the country that will be governed than about its future leader.

We will comment on how Brazil may be impacted by three major trends that are in evidence on the global macroeconomic scene: i) generalized inflation, a side effect of the policies adopted during the pandemic that was amplified by the rise in commodity prices; ii) the geopolitical crisis caused by Russia’s invasion of Ukraine; and iii) the energy crisis generated by war-related embargoes and by decarbonization policies.

Global inflation

The entire world is suffering from inflation right now because all countries have been hit by the pandemic and most of them adopted very similar courses of action. The main measures are well known: lockdown and emergency aid. Both contributed to creating the inflation that is being fought today.

The contribution of the lockdown came through the disorganization of production chains, which reduced the supply of various products and thus stimulated price hikes. With the reopening and reorganization of markets, which took place some time ago, this factor has been largely overcome and is no longer a central cause of inflation.

The second factor is more difficult to reverse. Pandemic aid programs were mostly financed through the expansion of monetary bases – that is, governments’ printing money – a move that reduces the value of money and therefore causes widespread price increases. This effect is inevitable, as the creation of new money is not accompanied by the creation of real economic value. In a simplified example: if all governments in the world double the amount of money in circulation, everything will cost twice as much, as there will be twice as much money to represent the same existing goods. Obviously, central bank maneuvers do not have the power to make the world richer.

In practice, by printing money and distributing it in the form of emergency aid, governments expropriated capital from all those who invested in assets not adjusted by price indices (fixed-income securities, mainly), and distributed it to the most economically vulnerable populations – quite correctly, in our view, as they were banned from working for their own living during the lockdown. There is a subtlety to this arrangement as the loss of currency value is not immediate. It comes through a wave of inflation that erodes the value of money over time. This is what the world is suffering today.

High interest, the bitter medicine

To combat the problem of inflation, central banks around the world resorted to the classic measure of raising interest rates. The logic is that higher interest rates reduce economic activity, as they reduce the availability of credit for consumption or for new investments. As a result, the general demand for products and services is reduced and prices tend to fall. The problem is that high interest rates are like the fever caused by our immune system to fight a virus. It solves the problem, but only after we’ve been bedridden for a few days. In order to control inflation, it will be necessary to keep interest rates high for several months and, during this period, economic growth is significantly impaired. This is where the risk of global recession that has been talked about comes from.

Inflation and high interest rates are well-known themes in Brazil. Due to the history of our economy, the Central Bank of Brazil has a lot of experience in dealing with inflation problems and knew how to act quickly. It raised interest rates in Brazil about a year before the central banks of developed countries were convinced that this measure was really necessary. It was also more aggressive in action. While the Federal Reserve raised the US interest rate from 0.25% per year in March 2022 to 3.25% currently, Brazil went from a rate of 2.00% in March 2021 to the current 13.75%.

Today Brazil is, in market jargon, “ahead of the curve”. Because we started fighting inflation earlier and more vigorously, we are already much closer to having inflation under control than the United States and Europe. The market expects the beginning of interest rate reductions and the convergence of inflation to the usual levels (around 5%) as early as 2023. Brazil will still suffer the impact of the global economic slowdown even with inflation under control earlier, but we have two mitigating factors for this negative effect. The first is that Brazil has a less globalized economy than the United States and Europe. Our foreign trade flow represented 39% of 2021 GDP, compared to a global average of 52% of 2020 GDP. This is not exactly good, as Brazil could have grown more in the past if it had opened up its markets more. However, in this moment of global crisis, our economy is less exposed and should suffer less. The second mitigating factor has to do with the geopolitical crisis.

The new cold war

The war between Ukraine and Russia started in February 2022, eight months ago. The military clash was restricted to the territory of Ukraine, but the effects of the war went far beyond its borders. The West adopted the strategy of not interfering militarily with NATO forces – which would bring a considerable risk of a new world war – but it has positioned itself on Ukraine’s side, providing war weapons, financing its costs in the war, and imposing economic sanctions on Russia.

Russia reacted to the sanctions by restricting the supply of commodities, especially oil and natural gas, to countries that support Ukraine. The main impact of this action is the current energy crisis in Europe, which relied on Russian natural gas to maintain its heating and electricity production systems. We’ll come back to this topic shortly, but first let’s explore a broader geopolitical trend that the war intensified.

Until a few years ago, the world followed a trend of economic globalization. More and more integrated supply and production chains were being created, pursuing David Ricardo’s ideal of taking advantage of the costs of each country to achieve the greatest possible economic efficiency. This movement began to reverse itself with the trade frictions between China and the United States, then under the presidency of Donald Trump. Now, the Ukraine war seems to have convinced the rest of the world that globalization has gone too far and it’s time to take a step back.

The war has made the risks of highly integrated economies even more concrete and visible to all. Angela Merkel decided to make Germany’s energy matrix heavily dependent on Russia, which supplied about 55% of natural gas and 35% of oil imported by Germany. The decision was not economically irrational. Russia had good prices and enough capacity to continue supplying for a long time. However, it is now costing dearly to have ignored the political aspect involved: having a relevant part of your country’s energy subject to the whim of  Vladimir Putin. Interestingly, this risk was pointed out by Donald Trump at a NATO conference in 2018. German politicians dismissed it as unwarranted extremism by Trump and  release the matter.

There are other similar risks that have not yet become problems. For example, today Taiwan produces more than 90% of the world’s high-end processors (<10 nanometer)  and between 30 and 50% of processors in other categories. This largely explains the political tension between Taiwan and China, with the United States interfering so that Taiwan remains an independent territory.

Brazil in deglobalization

With the world more attentive to the risks of dependence on other countries for the supply of commodities and critical products, we expect to see, over the next few years, a movement towards decentralization of production chains and reduction of trade relations with politically misaligned countries. This movement isn’t simple and can take decades, but it is a trend that can cause huge economic impacts.

The logic behind decentralizing supply chains is well known in the business world. It is not recommended to have a deep dependence on any one supplier, as this greatly reduces your bargaining power and exposes the business to the risk of sudden price increases or supply disruption.

Companies take care to avoid overdependence on a supplier even though they can establish long-term contracts and resort to courts to enforce them. Countries do not have a global court to turn to enforce agreements, so there should be an additional concern in selecting as partners those countries that are likely to become politically hostile, as Russia has become to the West.

In practical terms, the expectation is that part of the production chains currently dependent on China will be transferred to countries closer and politically more aligned with the United States and Western Europe. This trend has been called friend-shoring, in analogy to the off-shoring policy that made China what it is today.

The current scenario brings a unique opportunity to Brazil, which has the sixth largest population in the world, cheap labor, extensive territory, and abundant natural resources. In addition, it is close to the United States and Western Europe and closely aligned with Western politics. In this way, we are strong candidates to receive part of the demand currently served by China, which can bring a wave of foreign investment and boost our economic development.

Energy crisis

Let’s go back to the issue of gas shortages in Europe. The story began with the plan to decarbonize the economy to fight global warming. This topic ended up mixing scientific and political agendas, but, in a very simplified way, the relationship between the concentration of CO2 in the atmosphere and the increase in the average temperature on earth has been known for more than a century. Even so, it has been only in the last few decades that nations took joint action to deal with the problem, whose main mission is to reduce the amount of CO2 emitted by economic activity.

In this context, reducing CO2 emissions in the production of electricity was one of the main measures planned. As a result, Europe deactivated thermoelectric plants that used coal and oil and replacing them with natural gas thermoelectric plants, which emit around 50% less CO2 than coal and 40% less CO2 than oil for the same amount of electricity produced. Germany was one of the countries that was most committed to this movement and is now, therefore, is suffering a lot from the cuts in the supply of Russian natural gas.

Despite the problem with Russia, the main Western economies must continue the movement of decarbonization of the economy, with the goal of achieving neutrality in carbon emissions by 2050. The plan is quite bold and involves greatly reducing the use of fossil fuels. We could debate how likely it is that the objective will be met, but will keep our attention today on why this decarbonization policy favors Brazil.

Brazilian energy

Our country has a very different electricity production matrix compared to the rest of the world. In 2021, 67.4% of the world’s electricity was produced from fossil fuels. China produces a third of global electricity, 65.9% from fossil fuels, and 63.2% from coal. In contrast, only 20.3% of Brazilian electricity comes from fossil fuels, and only 3.7% from coal.

A first advantage of the Brazilian electricity matrix is ​​its lower exposure to the price variation of fossil fuels in the market. With 77.4% of our electricity coming from hydropower and renewable energy, we are more dependent on rainfall and other weather factors.

Another advantage is that our energy is quite clean, especially compared to China. A kWh produced in China emits, on average, 541 grams of CO2 and a kWh produced in Brazil emits 142 grams of CO2, an amount almost 4 times less. This is a differential to attract countries that seek carbon neutrality. By shifting demands for industrial activities with high electricity consumption from China to Brazil, they could reduce 74% of the CO2 emitted by the chain.

This generation’s opportunity

It is not every day that we see Brazil emerging from a macroeconomic crisis before developed countries, in an extremely favorable position to reap the fruits of a trend towards migration of important production chains and with an energy matrix that is now highly valued due to the decarbonization project of the global economy. It is an opportunity that we should not pass up.

It is not necessary for our government to do anything brilliant for the country to benefit. It would be enough to demonstrate to the world that it will be a serious and responsible government, which seeks to facilitate the development of business in the country and is aware that financing populist measures with fiscal irresponsibility is a strategy that takes a toll further on and destroys good economic prospects. In short, a government strategy focused on not making big mistakes, instead of trying to carry out wild projects, would be an excellent start.

The counterweight to this hope is that Brazil has an unfortunate history of squandering good opportunities. Our population still has little political maturity and formal education, which sometimes generates great public discussions around agendas of low practical impact for the country, leaving aside what could really make a difference in our lives. In any case, the risk of wasting a good opportunity is always a better scenario than having no opportunity at all.

What to expect from Lula

Now with the victory guaranteed, we hope that Lula will reveal who will be nominated for Minister of Economy and be more transparent about his government plan. The biggest risk is that Lula will end the spending cap and return to economic intervention policies, as he defended during his campaign, but we believe that the configuration of the new National Congress and the alliances created to win the elections are relevant brakes for policies in this direction. If not completely prevent them, they should at least postpone them and make them milder.

In fact, with the National Congress on the center-right and the president on the left, negotiations tend to be slower and more confrontational, hindering the Executive’s actions in general. Therefore, it is to be expected that Lula will adopt a more center-oriented stance.

On the positive side, Lula has a good international image, especially among European countries. This favors the success of the diplomatic agenda necessary to attract foreign investment and establish new international trade agreements. Lula is especially well positioned to leverage the discourse that Brazil has a clean economy, echoing his campaign slogans.