Three Fronts of Brazil's Perfect Storm

SMITH BRAIN TRUST — Headlines have been gloomy for Brazil in recent weeks. “Worst Recession Since 1901.” “Rio Olympics Face Deep Cuts.” “Pain to Deepen in 2016.” Even the samba has turned sober for the Carnival that will start on Feb. 5. Paulo Prochno, a strategy professor at the University of Maryland's Robert H. Smith School of Business, sees three fronts converging into a perfect storm. “It’s a nightmare of three different things going wrong at the same time,” he says.

1. External Prices

During the boom years from about 2005 to 2012, China and other customers lined up for Brazilian exports. Ships loaded with iron ore, crude oil and agricultural products such as soybeans and sugar raced to meet demand — helping to drive economic opportunities at home. “People were getting jobs, buying things, and companies were making more investments,” says Prochno, a Brazilian who spent his winter break near Rio de Janeiro. He says Brazil failed to anticipate what would happen next. China stumbled, external prices fell, and Brazil found itself heavily leveraged at home. 

2. Internal Corruption

Cronyism is not new in Brazil. Business and government leaders have exchanged favors for decades, creating a complex ecosystem of relationships that benefit the elite at the expense of the masses. “This was the rule of the game,” Prochno says. “If you wanted to do a project or something, you had to pay somebody — whoever was in power.”

What has changed in Brazil is the prosecution of business leaders and high-ranking government officials — starting with a single arrest on March 20, 2014. “For the first time, the investigations were taken seriously in Brazil,” Prochno says. “People started going to jail.”

Prochno cites the scandal as evidence of a maturing judicial system in the young democracy. “I see that as a very positive story for the long run,” he says. “But of course, it also has implications in the short run.”

The prosecutions have created uncertainty while investors adjust to the new climate. “Economic activity has stopped because most of the major companies are implicated,” Prochno says. “No one is making investments, so no jobs are being created.”

3. Bad Economic Policy

The third factor has been the fallout of unsustainable economic policies. Prochno says that during President Dilma Rousseff’s first term, she scaled up a program that gives cheap money to favored firms. “They had this mentality that we need to sponsor national champions,” Prochno says.

Instead, the chosen winners lost their incentives to innovate and compete. When other things started going wrong, Brazil found itself struggling to meet its obligations. Rousseff has changed course during her second term, but the country is still locked in on several long-term deals. 

“It may be a little too late, but now she realized that the economic choices were not that great,” Prochno says. “Now they are paying the price.”

Despite the setbacks, Prochno sees reasons for hope. Criminals have gone to jail. Bloated companies have cut fat. And bubbles have burst, inviting bargain hunters to spend again. He discusses Brazil’s path forward in the following podcast (3:57)…