(Part Five)

Contemporary challenges: escaping the trap

Contemporary Brazil faces three interlocking problems that pose severe structural challenges to all of the economic stability it improbably has attained: an overvalued currency, Mercosur and China.

As to currency, investor enthusiasm for Brazil's recent stability and theoretical growth prospects has flooded the country with external funding. In addition to complicating always-critical inflation concerns, all that capital is having a demonstrable impact on the Brazilian currency, pushing the real up by more than 50 percent in just the past two years, and doubling it since 2003.

For Brazil's commodity exports – all of which are dollar-denominated – this has no demonstrable impact, but for the country's industrial exports this currency appreciation is disastrous. Because Brazil's infrastructure is inadequate and the country is capital poor, Brazil produces very little that is high value-added; Such industries are the providence of capital-rich, low-transport-cost economies such as Germany and Japan. Instead, Brazil's predominantly low- and medium-value-added industries compete heavily on price. A 50 percent increase in the currency largely guts any price competitiveness enjoyed by Brazil's sheltered industries. The only Brazilian firms benefiting from the mix of impacts are those few high-skill firms that happen to price their products in U.S. dollars, most notably oil firm Petrobras and aerospace firm Embraer – which, while world class by any definition, are not representative of the broader Brazilian economic structure. Second, Brazil has limited itself with the highly distorting and damaging trade network known as Mercosur. Recall that an oligarchy has long dominated the Brazilian economy, controlling most of the country's scarce capital and enjoying a privileged economic and political position. Unlike most trade agreements – which are negotiated by governments on behalf of the corporate world – Brazil's oligarchic background meant these oligarchs negotiated Mercosur on behalf of the Brazilian government.

This abnormal process radically changed the end result. A normal trade deal removes barriers to trade and exposes companies in all the affected countries to competition from each other. In Mercosur's case, the various Brazilian industrialists were able to block off entire swaths of the economy for themselves, largely eliminating foreign competition. As such, Brazil's industrial sector is shielded from competition with outside forces – and even from most other forces within Mercosur. Add in a 50 percent currency appreciation and Brazil's industrial base is now one of the world's least competitive.

Third, Brazil has allowed competition from the one power most capable of destroying that sheltered industrial base: China. Throughout the past decade, Brazilian governments have sought Chinese investment largely to help alleviate some of the country's transport bottlenecks. The Chinese, hungry for Brazilian resources, have happily complied. But that infrastructure development has come at the cost of granting Chinese firms Brazilian market access, and that access – and even the investment – is damaging the Brazilian system.

At its core it is a difference in development models. The Chinese system is based on ultraloose capital access aimed at maximizing employment and throughput, regardless of the impact on profitability and inflation – about as far as possible from the real plan. This has had a number of negative side effects on the Chinese system, but as regards Brazil, it has resulted in a flood of subsidized Chinese imports.

The China trap is catching Brazil in three ways. The first is direct competition for market share in Brazil. The Chinese yuan is de facto pegged to the dollar, so Brazilian goods are now even less competitive versus Chinese goods on the domestic market (even before one takes into account that Chinese goods are for all intents and purposes subsidized). Second, China is engaging in indirect competition for market share by shipping goods into Brazil via other Mercosur member states – a fact that has prompted Brazil to raise non-tariff barriers that penalize Mercosur partners in an effort to stem Chinese competition. Third, the Chinese are among those international investors whose cash is pushing the value of the real ever upward. With every dollar the Chinese invest into Brazilian commodity production, the real goes just a bit higher and Chinese goods edge out their Brazilian counterparts just a bit more.

Resisting these trends will require some clever and quick policymaking along with a remarkable amount of political bravery. For example, scrapping Mercosur and adopting free market policies would throw the Brazilian market open to global competition. That would decimate Brazil's inefficient industrial base in the short run with the expected knock-on impact on employment, making it a policy the oligarchic and powerful labor unions alike would oppose. But it is difficult to imagine Brazilian industry progressing past its current stunted level if it is not forced to play on a larger field, and weakening the hold of the oligarchs is now at least a century overdue. Two more years of a rising currency and an enervating Chinese relationship will surely destroy much of the progress the Brazilians have painstakingly made in recent decades.

The current president, Dilma Rousseff, is a non-charismatic, no-nonsense technocrat well known for demanding respect and results, a good person to have in office given the nature of Brazil's contemporary challenges. Success in any free market-oriented reforms would require brutal and rapid changes in Brazil's standard operating procedures – changes that would undoubtedly come with serious political risks. The alternative is to continue to pursue protectionist, defensive policies while allowing international forces to shape Brazil rather than Brazil developing the means to shape international forces. This could well be the path Brazil follows. After all, the damage being inflicted by Mercosur and the China relationship are direct outcomes of policies Brazil chose to follow, rather than anything produced by Brazil's geography.

We do not mean to belittle Brazilians' achievements to date. Taming their lands, taming inflation and crafting a series of economic sectors fully deserving of international acclaim are no small feats. But insufficient infrastructure, an ossified oligarchy, a shallow skilled labor pool and the looming question of Argentina continue to define the Brazilian position. The maintenance of that position remains largely beyond the control of the Brazilian government. The economy remains hooked on commodities whose prices are set far beyond the continent. Their ability to supply those commodities is largely dependent upon infrastructure in turn dependent upon foreign financing. Even Brazilian dominance of their southern tier is as much a result of what Argentina has done wrong as opposed to what Brazil has done right.

For Brazil to emerge as a significant extraregional power, Brazilians must first address a lengthy list of internal and regional issues. These include – but are hardly limited to – moving beyond their oligarchic economic system, ensuring that Argentina will never again threaten it and formalizing their dominant position in the border states of Bolivia, Paraguay, and Uruguay. These cannot be accomplished easily, but doing so is the price Brazilians must pay if they are to be the masters of their own destiny rather than simply accepting an environment crafted by others.

Recommended reading: Brazil: towards the new Defence White Paper