Response to a Stratfor Global Intelligence Article on Brazil

A friend recently wrote me about this report on Brazil by one of the leading economic intelligence publishers, Strafor. The article is worth a read, and it’s a freebe. This is part of my response:

“This article is quite a sweeping take on the country, with an interesting geo-economic vision: Brazil is a logistical nightmare, with no natural transport routes, and little coastal space for contiguous development… The observations about infrastructure and the oligarchic system are correct for the most part. I talk about the problem of a protected market quite often in my blog: http://observingbrazil.com/?p=461

I don’t know if the authors have everything correct, however. There was little discussion about Foreign Direct Investment (FDI), which could ultimately be Brazil’s great escape from its present conundrum. A high Real, a huge internal market, and relatively stable vitals means that Brazil is increasingly becoming a place to invest.

Brazil’s manufacturing export industry may whither under a strong Real, but its strong internal market coupled with a strong Real is already attracting manufacturing multinationals, such as Foxconn (the maker of Apple’s Ipad), which will promote a sort of foreign industrialization of Brazil. These foreign investments are already offsetting–in the short term– the negative current account deficit that Brazil would have suffered because of lost export markets (due to the high Real).

This multinational industrialization, may contribute little to Brazilian home-spun industry, however, and it will reinforce the closed-market, high tariff walls that Brazil currently embraces. FDI is interested in Brazil because it is a closed market where firms can gain distorted market advantages over imports, but this advantage is contingent on stable policy. If changes are suddenly put in place to subsidize other domestic competitors, the multinational may lose its advantage.

 The author also omits one of the primary incentives for high tariff walls, a factor that makes them very difficult to remove: tariffs are, in effect, taxes, and these provide government with huge revenues. Although high tariffs mean that Brazilian firms have the advantage over imports in Brazil, these tariffs are so high that they still allow Brazilian firms to be heavily taxed. Many of Brazil’s taxes are indirect, such as labor requirements. By law, employers must pay their formal-sector workers a thirteenth month’s salary, a paid lunch, transport, a basket of basic goods each month, a heavy social security pay-in, and equally heavy compensation pay for dismissal. Direct and indirect taxes on Brazilian industry make it less competitive internationally.

 As I write about here: http://observingbrazil.com/?p=496  almost all value-added taxes are untransparent in Brazil, and unless people start to be realize just how much they’re paying– about 36% of GDP in taxes (more than Canada)–there will be no tax revolt.

All of this goes to say that Brazilian politicians have perverse incentives to keep Brazil uncompetitive, an over-taxed, protected market. And because it is protected from the world market, all areas of society suffer: education, infrastructure, entrepreneurship…etc because there is no need to pull everything up by the bootstraps to really compete on a level playing field with other parts of the world…as it stands Brazil is not a good bet in the long term– the multinationals investing directly in operations in Brazil are the best bets, especially the ones in under-capitalized markets, such as heavy construction machinery (Caterpillar is now investing here). The levels of growth we’re now seeing also occurred in the 1960s and 1970s, but they’re ultimately commodity-based and may not help build-up the industrial base of the country– the large government and heavy tax burden tend to cannibalize gains from growth…

The one positive point about Brazil’s protected market is that it has so far served to protect the country from most of the more gutting effects of recession and volatility occurring abroad. A stronger Real and more FDI have been the most immediate results of this upheaval.

The trick now is to deal with inflation–Brazil’s historical grim reaper–without raising interest rates again. Higher interest rates (they’re already near the highest in the world) make consumer debts more difficult to pay, and increase the cost of capital for domestic industry, once again putting the squeeze on uncompetive industry. They also increase inequality, as those with money in the bank profit generously, and those with debts, grow poorer.” Crime tends to be one of the most obvious results.

I would welcome responses and retorts to this post, because more serious, accessible analysis of Brazil’s long-term economic prospects is sorely lacking.