Future-proofing Brazil's boom

STRATFOR

Brazil will hold a presidential runoff on October 31, pitting ruling Workers' Party candidate Dilma Rousseff against former Sao Paulo state Gov. Jose Serra, as neither candidate won more than 50 per cent of vote. Rousseff, who took 46.9 per cent of the vote against Serra's 32.6 per cent, has the advantage of being the preferred successor of outgoing President Luiz Inacio Lula da Silva, who remains quite popular in Brazil (see The cult of Lula, September 28). However, the change in political personalities is not of particular interest to STRATFOR. Brazil faces the same geopolitical opportunities and challenges no matter who holds the presidency.

After decades of wrenching boom-bust cycles, Brazil is now booming. It has the eighth-largest economy in the world in terms of nominal gross domestic product and growth of around 7 per cent, energy self-sufficiency and the potential to become one of the top global oil producers. Brazil's rise did not come easily, nor was it all Brazil's doing. Whether Brazil reaches its regional hegemonic potential will depend on two key factors: its ability to capitalise on Argentina's decline and how it chooses to deal with currency instability that will inevitably increase the real's value on the global market.

Present geopolitical standing

Brazil will take time to determine its strategy as it enters uncharted territory. The path to Brazil's current success was a rocky one, due in no small part to the country's vexing geography. The Brazilian landmass covers more territory than Europe and borders 10 countries. With the exception of the pampas to the south, Brazil's densely forested interior effectively buffers the country from most of its neighbours, permitting it to focus on the challenge of developing the Brazilian interior. In contrast to the US Mississippi River system, Brazil's rivers are not conducive to the kind of cheap, long-distance transport that propels rapid development. Instead, Brazil had to invest an extraordinary amount of resources to build an artificial transportation system comprised of railroads, roads, airports and seaports to link industrial and population centres along the Atlantic coastline with the country's rural interior. Equally problematic, the country's colonial legacy, which entailed the massive importation of slaves from Africa, resulted in tremendous socio-economic distortions that persist to this day.

These constraints meant the Brazilian economy has been slow to develop and has experienced extreme swings between hyperinflation, overheating and recession. It was not until the launch of the Real plan in 1994 that the country developed an economic discipline domestic consumers and foreign investors could rely on to bring in the capital and investment that has propelled Brazil into its current favourable state.

Brazil can only devote attention to its immense internal economic challenges when Argentina, the main Atlantic sea power and Brazil's only real competitor on the continent, is distracted. The fertile lowlands of the Rio de la Plata region to Brazil's south places the country in a natural competition with Argentina. Between these two South American rivals lie the buffer states of Bolivia, Paraguay and Uruguay. Control over this buffer is the first, critical step toward exerting dominance over the Rio de la Plata region of the southern cone. While Brazil has to find the time, money and resources to fight for control of these lands, Argentina is already sitting on one of the most naturally interconnected river transport systems in the world, giving it a source of rapid development, wealth and population growth to keep Brazil in check.



Much of the 19th century was marked by successful Argentine attempts to keep the Rio de la Plata basin out of Brazilian hands through direct military conflict, the creation of Uruguay, and ongoing support of separatist rebels in Brazil's south. For the past several decades, however, Argentina has been consumed with internal issues and a steadily declining economy. The more Argentina is embroiled internally and the less attention it can devote to maintaining authority in the Rio de la Plata region, the better the odds Brazil can project southward in a bid for continental dominance.

The two primary checks on Brazilian power are thus socioeconomic development at home and competition with Argentina abroad. Brazil has made notable progress in the former, and Argentina latter is self-destructing. Brazil thus has an extraordinary geopolitical opportunity. Still, it remains unclear whether the country's leadership has the political coherence and vision to consolidate influence over the South American heartland and more urgently, address an intensifying currency appreciation problem that could undermine the economic success it has achieved to date.

Argentina in decline and Brazil's opportunity

Argentina at the turn of the 20th century had the potential to dominate the southern cone and become a global economic power. Argentina's economic blessings created a dangerous sense of complacency in the country, with the country's leadership losing the drive toward industrialisation and instead spending itself into debt on social programs to maintain popularity. Argentina's persistent debt issues, political fragility and declining economy have the country caught in a populist-driven policy net that leaves little room for the politically costly austerity measures necessary to restore its economic health. This gave Brazil a valuable opportunity to develop its interior. From the Brazilian point of view, the threat of Argentine aggression is shrinking dramatically. And with that diminishing threat comes opportunity across the southern Brazilian border.

If Brazil has any hope of breaking beyond its natural fortress to dominate the continent, its ability to consolidate influence in the buffer states will be critical. The task at hand for Brazil is to use Argentina's preoccupation to subtly entrench itself in the buffer states of Bolivia, Paraguay and Uruguay before expanding its influence into the core of the Rio de la Plata basin in Argentina. Brazil has thus far relied on soft power, mainly energy and population integration, toward this end.

For example, Brazil is now Bolivia's main export market for natural gas following the construction of the 3,150 kilometre (1,960 mile) pipeline that began in 1997 and connects Santa Cruz de la Sierra in Bolivia with Canoas in southern Brazil. At the same time, the Brazilian government has used economic incentives to encourage Brazilians to populate its border regions with Bolivia. Some 30,000 Brazilians have become part of Bolivia's population of 9.6 million. Many of these Brazilians in Bolivia are farmers, who together control some 40 per cent of Bolivia's soybean production.

Brazil and Paraguay became tightly linked in 1984 with the inauguration of the Itaipu Dam, the largest hydroelectric plant in the world in terms of electrical generation. Itaipu provides Paraguay with 90 per cent of its electricity and roughly 19 per cent of Brazilian power, giving Brazil enormous leverage over its neighbour. The construction of Itaipu displaced many Brazilians along the border, but those Brazilians then bought cheaper land on the Paraguayan side. Known as Brasiguaios, these Brazilians living in Paraguay now comprise some 8 per cent of the Paraguayan population and dominate Paraguay's soybean and corn production. Brazil also carries substantial influence among the Paraguayan political elite.

Uruguay, which used to be part of the Brazilian empire until it was carved off in 1828 as a result of war between Argentina and Brazil, shares close historical, commercial and cultural ties with Brazil. In 2004, Brazil and Uruguay signed an agreement that allows anyone born on the border between Brazil and Uruguay to have permanent residency in both countries. Some 30,000 Brazilians live in Uruguay and control roughly one-third of Uruguay's substantial meatpacking industry.

Brazil thus has gradually developed the economic, population and political linkages with these states to establish a stronger foothold in the region. Still, it will likely take much more energy and commitment to carve out a Brazilian sphere of influence in the southern cone strong enough for its neighbours to recognise the country's so-called continental destiny. Whether Brazil is able to devote enough attention to this goal in the near term will largely depend on its ability to manage a currency crisis at home.

Real Problems with the Real

Energy firm Petrobras, mining giant Vale and aircraft manufacturer Embraer are just a few of Brazil's corporate success stories that have piqued investor interest over the past several years. For an emerging country, Brazil boasts a relatively diversified economy dominated by the services sector, followed by manufacturing, processed food, agriculture and natural resources. But Brazil will struggle to move away from its commodity-export-driven economic model. After two generations of industrialising, commodity-related products still comprise two-thirds of Brazil's exports. Further complicating Brazil's diversification efforts, the country's brightest economic potential now lies in its ambitious plans to develop the country's massive reserves of deep-sea pre-salt oil deposits.

And with this economic potential comes substantial economic tension. Countries abundant in natural resources that export mostly commodity-related products naturally will devote a substantial amount of labor and capital to those commodity-related sectors. The continual influx of hard currency (most commodity export sales are dollar-denominated) tends to strengthen the country's national currency. Hobbled by a strong currency, non-commodity related manufacturers become less competitive in domestic and international markets, and then often look to the government for support, resulting in what is often termed the "deindustrialisation” effect. At the same time, a country with robust commodities like Brazil will attract large amounts of foreign investment. (To develop the pre-salt fields alone, Brazil is working to attract a minimum of $US220 billion.) More foreign capital in a country also means more capital inflows, e.g., more dollars, causing the local currency to appreciate even further.



Brazil has a third problem: China. Brazil's agricultural and mining export boom in large part is a product of China's insatiable demand for commodities. The export of minerals and soybeans, for example, represents 62 per cent of the total export trade from Brazil to China. While Brazil was happy to have a large market for its commodities, Chinese exports of manufactured goods to Brazil (pegged to the US dollar) rose an average of more than 50 per cent annually between 2004 and 2008. Chinese imports now comprise 12.5 per cent of Brazil's total imports, but this figure is also likely a low estimate since China used a number of third party countries like Malaysia and Taiwan exempt from high tariffs. Hardest hit from this trade relationship are, again, Brazilian industrialists, who are unable to compete with cheap Chinese goods flooding the market in the face of an appreciating real. The real has gained 35 per cent against the dollar — and therefore essentially against the Chinese yuan — since the beginning of 2009.

There is no easy solution to Brazil's currency appreciation problem. As long as commodities dominate Brazil's exports and the country remains a magnet for resource-targeted foreign investment, dollars will continue flowing, further boosting the real's value. It is little wonder, then, that Brazilian anxiety over this issue is becoming more prominent. For example, Brazilian Foreign Minister Guido Mantega recently said Brazil is one of many players in a global currency war. The problem for Brasilia is that the Brazilian arsenal is not well-equipped for such a currency war. The country's industry simply isn't geared for international competition and is running out of time to catch up. State plans to devote a substantial amount of pre-salt revenues toward science and technology education are designed to develop Brazil's non-commodity sectors and thus help maintain Brazil's industrial competitiveness. Such long-term plans do little in the near-term to address this issue, however.

For now, Brazil will attempt to cope with the issue by maintaining its floating exchange rate and intervening when necessary to try and tame the real's appreciation. The biggest problem with such interventions is that they risk driving up inflation, an enormously touchy subject for Brazilian policymakers on both the left and right who have rigorously kept the inflation level low (currently at 5 per cent) to avoid a reprise of Brazil's chronic inflation issues. Brazil can also be expected to work around World Trade Organisation rules to impose anti-dumping measures against Chinese goods using China's shipment of exports through third countries as its legal foundation. Still, such moves are putting off more critical decisions that Brazil may eventually have to face.

Alternatively, the country could accept the facts and allow China to crowd out its uncompetitive industries and face the political and social consequences of high unemployment. (Brazil's unemployment rate in September stood at 6.7 per cent.) A country as massive in population and as socioeconomically distorted as Brazil would have a difficult time exercising that option, but it does at least have a high rate of private domestic consumption (around 62 per cent of gross domestic product) to absorb Brazilian goods and cushion the country against price volatility in the global markets. Brazil is more likely to attempt to use its expected oil windfall revenue to subsidise industry at home, though it will be unable to work around the fact these industries cannot be competitive as long as China remains a powerful manufacturing force.

Brazil could also make the politically distasteful decision to pre-empt its currency pitfalls and dollarise the economy to deter the ill effects of devaluation and inflation at the high price of conceding the country's monetary authority to the United States. This would theoretically resolve the currency appreciation issue, facilitate investment into the oil and mineral sectors without inviting inflationary pressure, mitigate the effects of China dumping goods on the Brazilian market, and provide Brazilian industrialists with greater access to a large, stable consumer market in the United States. This option remains extremely unlikely for now, however. Brazil will continue with half-measures in the near term to try and manage this currency crisis and while investors continue to hold confidence in the real and in Brazil's economic management. Anchoring the real to the dollar would also be anathema to Brazil's current attempts to replace US influence on the continent.

The political debate over the future of the Brazilian economy will thus bounce between risking political instability in allowing certain industries to fail, unwillingly encouraging economic stagnation by subsidising those failing industries and coping with hubris in measuring the costs and merits of a more dollarised economy. The path Brazil takes in trying to resolve this currency crisis will determine whether Brazil will be able to sustain its economic rise and whether stability at home can be channelled toward realising Brazil's geopolitical opportunity to dominate the southern cone.

Reprinted with permission of STRATFOR.