Argentina and Brazil Grow Together

Shannon O'Neil, Foreign Affairs, July 13th 2016

This year has been a rough one for South America’s two largest states. Brazil—once lauded as a rising global power—has fallen deeper into recession and political turmoil. And although Argentina is finally attempting to transform itself into a model of sober pro-market governance after years of Peronist populism, it shares with its northern neighbor a grim set of economic and political indicators: stagnating growth, endemic corruption, and a new government beset by high expectations. As a result, Argentine President Mauricio Macri’s initially high approval ratings have declined since he took office in December. In Brazil, meanwhile, interim President Michel Temer comes close in unpopularity to the disgraced Dilma Rousseff.

Despite their undeniable problems, however, there remains in both countries a cause for optimism. Argentina and Brazil are, for now, absorbed in their own domestic dramas, but they have within easy reach the long-term solution to their economic woes: each other.

ARGENTINA’S SLOW REFORM

Over the past 12 years, Argentina has suffered from economic mismanagement under the presidencies of Nestor Kirchner and his widow and successor Cristina. Yet even after years of misrule its path forward is easier than that of Brazil, in part because Macri has used his first six months in office to reverse many of his predecessors’ most damaging policies. His government devalued the currency, cut energy subsidies and public spending, removed taxes and other regulatory burdens on most exports, reformed the country’s discredited statistics agency, and resolved a decade-long battle with the “holdouts,” or those international creditors who refused Argentina’s marked-down payment offers on defaulted sovereign debt. Although some of these changes were made by presidential decree, many—including the repeal of the laws preventing a final resolution of the thorny debt issue—were successfully passed through the opposition-held congress.

Macri’s push for reform is aided by a favorable political landscape. The Peronist opposition, although historically dominant, is today divided among mutually suspicious camps. Its current leaders, such as the failed presidential candidate Daniel Scioli, lack the political skills or charisma to unify the bloc, and Cristina Kirchner’s mounting legal troubles—she allegedly defrauded the treasury of over $5 billion during her last months in office and laundered money through her Santa Cruz-based hotels—limit her potential reach.

Favorable political conditions aside, however, Argentina’s economic outlook is poor. As a result of energy price increases, wage hikes, and currency devaluation, prices rose 6.5 percent in April and four percent in May, bringing the annual rate of inflation to more than 40 percent. Unemployment is edging toward eight percent, and since Macri took office, 1.5 million have joined the ranks of the poor. Macri’s political coalition is loose and fragile, and to keep it together he will need tens of billions of dollars to pay pensioners, bail out insolvent provinces, and create jobs through ambitious infrastructure projects.

Much of this money will have to come from abroad, and to that end Macri and his ministers have been courting international financial markets and foreign corporations. His administration raised a record $16.5 billion from bond markets in April, and his ministers have secured promises of billions more in foreign direct investment from multinational titans such as Coca-Cola, Dow Chemical, Exxon Mobil, and Shell. Most of all, Macri needs to convince skeptical Argentines to invest in their own country. His government is preparing to offer a tax amnesty in order to entice some of the estimated $500 billion in Argentine money held abroad; even if only a fraction of that amount returns home, it could turn the economy around.

To succeed, Macri will need to do three things by the end of the year: move GDP growth from negative to positive; create private sector jobs for tens, if not hundreds of thousands of workers; and control inflation. The stakes are higher than one man’s political career. If Macri is successful, his party could sweep next year’s October midterm elections, solidifying the free market economic model. His failure, on the other hand, would give the Peronists—who are by and large responsible for the country’s current woes—a chance to reunify and take power.

CRISIS IN BRAZIL

If Macri faces a difficult road ahead, Temer has walked into a full-blown disaster. Brazil’s political class has been devastated by the ongoing corruption scandals surrounding the state-owned oil company Petrobras. Temer, the former vice president who took over in May following Rousseff’s suspension, lacks the legitimacy of an electoral mandate, and during his first two weeks in office he lost two ministers—a full ten percent of his cabinet—to corruption charges, with a third resigning a few weeks later. In the midst of this whirlwind, it has been difficult for Temer to govern at all.

The economy, meanwhile, is on the verge of a depression. Nearly 2 million Brazilians lost their jobs last year as GDP shrank and unemployment reached a four-year high. And in the short term, there is little the government can do to help; Brazil’s state-controlled banks are maxed out on consumer lending, interest rates remain high due to stubborn inflation, and both state and federal governments are struggling under growing debt burdens. In the longer term, the economy is weighed down by the infamous “Brazil cost,” a euphemism for the country’s byzantine tax system, rigid labor laws, inefficient regulations, and bottlenecked infrastructure. The World Bank and World Economic Forum both rank Brazil in the bottom half of the globe in ease of doing business.

Experts generally agree on what needs to be done to fix the Brazilian economy: rein in entitlements, de-index wages from inflation, change energy laws, and step up concessions to the private sector. Most of the policies that need to be changed, however, are written into Brazil’s book-length constitution and require a three-fifths congressional majority to alter. As a result, Temer’s efforts to restore confidence in Brazil’s economy have been limited to halting the growth of public spending and enacting symbolic measures such as a reduction in the number of ministries. Real reforms will need to wait for an electoral mandate, likely not until 2018.

Still, Brazil has an economy of $1.5 trillion and over 110 million workers; it can recover. Exports are already rising due to the weakened currency, and foreign investment remains strong, bringing in $75 billion in 2015 and $17 billion in the first quarter of 2016. And although admittedly costly in the short term, the corruption investigations, prosecutions, and convictions are changing the way Brazil works for the better. Over the last two years, over 100 people have gone to jail, including high-ranking political officials and business leaders. Companies are scrambling to create compliance departments and improve corporate ethics. Even skeptical Brazilians doubt that this time “everything will end in pizza”—a common refrain expressing skepticism that things will ever really change. If the investigations continue Brazil will become a better place to live, work, and invest.

BETTER LIVING THROUGH TRADE

Argentina and Brazil both face the long-term challenge of transitioning from economies based on the boom and bust of the commodity cycle to more value-added economies based on manufacturing and services. Balancing the government budget, simplifying the tax code, improving infrastructure, and adopting more market-friendly policies will all be crucial to managing this transition. But perhaps the simplest path forward is through trade.

As two of the most closed economies in the world, Argentina and Brazil both stand to benefit enormously from trade. Both countries’ trade-to-GDP ratios—a common measure of openness—are at the lower end of the global scale, and neither has negotiated free trade agreements with partners beyond its immediate neighbors. A McKinsey study estimates that if Brazil opened its economy up to the world it could boost annual GDP growth by over one percent. Argentina would reap similar rewards from the productivity and competitiveness gains that accompany trade liberalization. The good news is that both are taking steps in the right direction. Argentina recently became an observer to the Pacific Alliance, a Latin American trading bloc, and Brazil is working to ease trade restrictions with the United States. Both nations want to revive stalled trade negotiations with the European Union, and both are talking about joining the Trans-Pacific Partnership (TPP).

Trade integration with the European Union and the United States will be important. But perhaps more important will be further integration within Latin America, so far limited by the lack of any sincere effort to revive Mercosur, the South American trade bloc. The fate of the free trade area reflects a long history in Latin America of rhetorically praising integration while doing little about it in reality. After its initial success—regional commerce quadrupled between 1991 and 1998—Mercosur stumbled when Brazil devalued its currency in 1999. Unlike NAFTA, which survived the 1995 peso crisis to create an integrated production platform, Mercosur never recovered its momentum. As hard times hit, member nations turned away from each other, gutting the agreement by adding hundreds of loopholes and temporary exemptions. Venezuela’s 2012 entrance politicized the body and further weakened its efficacy and credibility.

As a result, despite dozens of initiatives and agreements, Argentina, Brazil, and the other nations of South America remain relatively economically isolated from one other. As the nature of global trade has changed, isolation has becoming increasingly costly. Today two-thirds of international trade involves intermediary goods, or goods used in the production of other goods. This reflects the rise of global supply chains in which final products are the result of production networks that extend across multiple countries. Global Value Chain (GVC) participation indices, which measure how integrated a country is in its trading partners’ supply chains (and vice versa), show Argentina and Brazil lagging well behind their counterparts in Asia, Eastern Europe, and North America.

In recent decades, trade has helped many nations, especially those in Asia, to emerge from poverty. Yet talk of global supply chains simplifies the reality of an economic world dominated by dense regional linkages, with separate Asian, European, and North American trading hubs. To become globally competitive, South America will need to foster similar cross-border production. Argentina and Brazil have an incipient base; they are already among each other’s largest trading partners, and both exchange more with the other in value-added goods—car parts, aircraft components, and petrochemical products—than either sends to China. It is only by pushing this integration further that Argentina, Brazil, and the rest of South America can set themselves on a more promising path to growth.