Brazil Morphs from "Dutch Disease" to Japanification"

A defining characteristic of emerging markets is the high economic dependence that many countries have on commodity exports. Unfortunately, this dependence is a weakness and a major reason for poor economic performance. Financial windfalls and wealth effects triggered by sudden changes in commodity prices or resource discoveries usually lead to boom and bust cycles which bring about negative effects on long-term growth. This has played out repeatedly in emerging markets, most recently with the 2002-2011 commodity “supercycle” and its aftermath.

Venezuela and Nigeria are the most extreme cases of mismanagement of natural resource windfalls, both having squandered their oil wealth and left behind only misery. However, almost all developing countries mismanaged the abundant windfalls experienced during the 2002-2011 commodity “supercycle,” leaving their economies in worse shape than before. This recurring phenomenon of mismanagement of commodity windfalls which undermine long term growth prospects is known in economics as the “natural resource curse.”

The “natural resource curse” is also known as “Dutch Disease” because the Netherlands suffered a severe drop in competitiveness after discovering vast natural gas reserves in the North Sea. The causes of the "curse" have been extensively covered in the economics literature in recent years.

Frederick van der Ploeg in his 2011 paper “Natural Resources: Curse or Blessing?” (Link) discusses the literature and provides a framework of analysis which we summarize below. Following this, we look at the specific case of the 2002-2011 commodity boom on Brazil’s development prospects.

The historical evidence points to “Dutch Disease” being a phenomenon of the post-World War II period. Looking further back to the first century of the Industrial Revolution, resource wealth appears to be a main contributor to economic growth and development. Abundant, cheap and easily accessible coal and iron ore deposits were a key factor for Great Britain’s early industrial takeoff, as they were for Belgium’s (1830s) and Germany’s (1850s). The United States’s industrial takeoff after the Civil War also was supported by ample resources of coal and iron ore and later petroleum. Van der Ploeg attributes these early successes of the industrial revolution to a combination of propitious conditions for private initiative and supportive public policy:

1. Privately-owned mineral rights and attractive conditions for capital.
2. Strong commitments to education and research and development of leadership in mining and agricultural engineering
3. Rapid process of linkages with the manufacturing sector.
4. Particularly in the case of the U.S., persistently high levels of tariff protection.
5. Highly diversified economies which could absorb shocks to one sector.

In the post-W.W. II period successful development is no longer correlated to resource wealth. The economic miracles of this period occur mostly in resource poor countries, like Japan, Taiwan, Korea, Singapore and, most recently, China. Though “Dutch Disease” marks the economic development of most commodity producers., there are significant exceptions. Norway, Australia, UAE, Botswana, Malaysia and Thailand are examples of commodity-rich countries that found a way to avoid the pitfalls caused by price volatility and boom-to-bust cycles. Van der Ploeg attributes the success of these countries to two primary factors: ( 1) strong institutions; and (2) savings mechanisms to smooth out the financial effects of commodity price changes, such as sovereign funds.

Unfortunately, in emerging markets the successful cases are few. None of the conditions listed above which existed in Europe and the United States in the past are today present in most developing countries. The opposite is true. Most commodity sectors in developing countries are dominated by the state, linkages with manufacturing are difficult to achieve and economies tend to be poorly diversified and rely heavily on a few commodity exports for their foreign exchange inflows. Moreover, countries have less flexibility to impose high tariff protection as the U.S. did in the past, which inhibits the creation of linkages with mufacturing. Furthermore, the past four decades of hyper-financialization of markets and open global capital flows have greatly increased the challenges for policy makers. Finally, Van der Ploeg suggests that fledgling democracies, like those of Latin America, are particularly vulnerable to “Dutch Disease” because institutional development has not kept up with political liberties.

The Causes of “Dutch Disease”

The simple explanation for “Dutch Disease” is that financial windfalls from commodity booms promote rent-seeking behavior which concentrates wealth and political power and buttresses the forces opposed to modernization. According to van der Ploeg, commodity windfalls have the following effects:

1. They raise the value for politicians to remain in power and increase their resources to “buy off” constituencies. Patronage is increased at the expense of productive activities.
2. They undermine institutions (justice, press freedom) that oppose corruption and rent-seeking behavior.
3. They undermine entrepreneurship and productive behavior, as the attractiveness of rent-seeking behavior relative to profit-seeking entrepreneurial activity is increased. Businesses find it more profitable to lobby politicians for protection and exclusive licenses than to invest in productivity.

These consequences of commodity windfalls appear to be more pervasive for “point-source” resources with concentrated production, such as oil and mining (and much less so for highly diluted activities like farming). Oil and mining in emerging markets tend to be either controlled by the public sector or subjected to heavy licensing and regulatory requirements that increase the influence of politicians.

The Symptoms of “Dutch Disease”

In addition to promoting corruption and rent-seeking behavior, poorly managed commodity windfalls beget economic instability. A surge in commodity prices for a country with a high dependence on commodity exports results in a liquidity shock and a sudden improvement in solvency. Currency appreciation accompanied by booms in credit and asset prices follow quickly. The typical economic symptoms of a commodity boom are the following.

1. Currency appreciation
2. Deindustrialization; contraction of the traded sector (increased manufacturing trade deficits)
3. Expansion of non-traded sectors
4. Increased monetary liquidity and credit expansion
5. Negative savings
6. Increased vulnerability to economic instability (debt levels, current account deficits)

Typically, when the commodity boom turns to bust, the country finds itself in a very vulnerable situation. A period of austerity follows, currencies depreciate, credit contracts, and asset prices collapse.

Unfortunately, the boom-to-bust cycle has important negative consequences that may persist for extended periods. The aftermath of the cycle entails:

1. Weaker long-term growth prospects
2. Trade sector and its positive externalities (human capital spilllover effects) do not recover fully when the bonanza is over.
3. Weakened institutions

The Case of Brazil

In 2002 a huge surge in Chinese orders for Brazil’s iron ore giant Vale signaled the beginning of a commodity super-cycle. High prices for iron ore and Brazil’s other commodity exports – coffee, soybeans, sugar, and cocoa – persisted until 2011, with a brief interlude during the great financial crisis. Coincidentally, in 2006 Brazil’s national oil company Petrobras announced the discovery of enormous oil reserves in pre-salt deep-water oil fields. This led Petrobras to announce plans to spend $400 billion to raise production from 1.8 million b/d in 2008 to 5.1 million b/d by 2020. Additional plans by Petrobras’s pre-salt partners and independent producers promised to raise output by another 2 million b/d by 2020, so that by that year Brazil, with a production of 7.1 million b/d, would become the fifth largest producer and exporter in the world. (Oil and gas output for 2020 is now expected to be 3 million b/d)

The combination of a dramatic improvement in Brazil’s terms of trade and the anticipation of a more than tripling of oil output led to a sudden and massive solvency-wealth effect and a financial boom. Unfortunately, the boom did not last, the bust has been dreadful and the long term consequences for growth appear to have been very negative. Is Brazil suffering a bad case of “Dutch Disease”? To answer this question, we can study how its experience fits into van de Ploeg’s framework.

Increased Patronage, Corruption and Rent-seeking

The commodity boom unleashed in Brazil a binge of patronage aimed at securing political power. The ruling Workers Party (PT) government beefed up the privileges of the state bureaucracy and introduced myriad welfare programs to cement important electoral constituencies. At the same time, schemes were organized to syphon off funds from state companies and public auctions. Petrobras, the national oil company, became the epicenter of a frenzy of kickbacks on licenses, procurement contracts and international transactions involving hundreds of politicians and businessmen. Brazil’s largest private contractor, Odebrecht, led a ravenous and pervasive scheme to rig public auctions. Transparency International’s “Corruption Perceptions Index” (chart 1) captures well the dramatic expansion in corruption engendered by the commodity boom. The World Bank’s Worldwide Governance Indicators for Brazil, a good measure of the strength of institutions, show significant declines for all categories. (chart 2)

Chart 1

Chart2 

Currency appreciation and deindustrialization.

The Brazilian real (BRL) appreciated sharply over the 2002-2011 period (Chart 3). The BRL bottomed in July 2002 and peaked in September 2011, moving two standard deviations, from very undervalued to very overvalued. This degree of currency volatility would make it difficult for any manufacturer of traded goods to remain competitive and committed to export markets. Consequently, it is not surprising that Brazil has undergone a severe process of premature deindustrialization (chart 4). This process had started during a previous period of currency overvaluation in 1994-1999 and has intensified since 2004 until now. This extreme level of currency volatility is primary evidence of the mismanagement of natural resource windfalls, and it is in stark contrast to the healthy economies of Asia that are committed to maintaining stable and competitive currencies.

Chart 3

Chart 4

Credit Expansion and Asset Appreciation

The commodity boom brought with it a surge of domestic liquidity. Bank lending to households rose from 7.3% of GDP in 2003 to 18.6% of GDP in 2010 (chart 5). Since the end of the commodity boom in 2011, Brazil’s total debt to GDP has ballooned from 120% GDP to 160% of GDP (chart 6). Public debt to GDP will handily surpass 100% of GDP this year.

Chart 5

Chart 6

The surge in domestic liquidity during the boom years created a huge asset bubble, driving financial assets and real estate prices to record levels. Brazil’s Bovespa stock market index level rose by more than 20 times in U.S dollar terms between September 2002 and August 2008. (Chart 7). The cyclically adjusted price earnings ratio (CAPE) valuation of the stock market reached 34 times, more than triple its historical average. The stock market today is worth less a third third of its value in August 2008 and valuation multiples have returned to historical norms.

Chart 7

From Dutch Disease to Japanification

The evidence shows that Brazil clearly has had a bad case of “Dutch Disease.” Sadly, one could argue that the country would be much better off today if the giant pre-salt oil discoveries had never been made. The corruption scandals of the boom led to the fall of a president and the rise of populism, and the weakening of core institutions. A trend of premature deindustrialization has been accelerated, and the economy is mired in low productivity and low growth. Fixed capital formation is weak and debts have risen to a dangerous level .

Brazil has entered into a process of Japanification where high debt levels and anaemic growth dynamics make monetary policy ineffective. Brazil is the first major emerging market to join the camp of countries with negative real interest rates, which will have unpredictable consequences.

Even with a much weakened currency, the manufacturing sector is not competitive and continues to decline. Ironically, with low growth and low demand for imports, the Brazilian real is very likely to appreciate in the future. This is because the increase in oil production has dramatically improved Brazil’s structural current account, while the agro-export complex and iron ore exports are more competitive than ever. If the current surge in commodity prices, triggered by Chinese stimulus, persists and a new positive commodity cycle gets underway, the BRL will appreciate and new wave of liquidity will drive the financial economy. This could result in a spurt of artificial growth and asset appreciation and a new dose of Dutch Disease.