Month: March 2023

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries  no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related  economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil  has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle  driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

 

 

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and  capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields,  has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

 

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets  (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance.  Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of  15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

 

 

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in  1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring  multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

The Big Mac, Neo-mercantilists and the Commodity Curse

As the world moves away from the globalization of manufacturing value chains and finance, the protection of domestic markets is back in favor with policy makers. However, the new mercantilists will have to overcome high costs, including overvalued currencies.

The case of TSMC’s investment in a new $40 BB semiconductor  plant is illustrative. The Taiwanese chipmaker gave in to pressure from the Biden Administration  and agreed to build a “fab’ in Arizona, but it does not seem to be happy about it. Recent press reports say the Taiwanese chipmaker’s management is dismayed by “exorbitant costs and unmanageable workers.”

TSMC’s preference for manufacturing at home is not surprising. Taiwan is a model of successful mercantilist policies (repression of wages, directed credit and competitive currency) that create a haven for manufacturing exports. Taiwan, and other Asian “tigers”, have carefully managed their currencies to assure export competitiveness. The U.S., on the other hand, has long favored consumers over manufacturers, and has an overvalued currency, which serves as the safe haven asset for the rest of the world.

We can see the challenges faced by the new mercantilists by looking at relative exchange rates. Below, we shows the Big Mac Index rankings and Real Effective Exchange rates. The Economist’s Big Mac index is a good measure of the overall cost for  businesses to operate in an economy, as the product being compared incorporates farm, manufacturing, and services, including taxes and regulations. Countries with an established vocation for manufacturing exports are labeled in green, while commodity producers that rely more on imports are labeled in bold black. The chart compares three data points — today, 2020 pre-covid and 2010. We can see that across these periods exporters have cheap Big Macs and importers have expensive Big Macs. There are some exceptions for importers, explained by excessive political instability and capital flight (South Africa, Argentina in 2010, Peru and Brazil in 2023).

Brazil and the United States, two countries now enthusiastically pursuing neo-mercantilist agendas, are interesting and similar cases. They both are  countries that have severely deindustrialized, while at the same time expanding energy production aggressively. Both went from large importers of oil to self-sufficient since 2010, which, all else being equal, means  stronger currencies. The implication is that neo-mercantilist policies will be pursued at a high cost, without the luxury of a weak currency.

Real Effective Exchange Rates (REER) tell the same story. The exporters are all close or below long-term averages, with Thailand the possible exception. Vietnam is an interesting case of an aspiring Asian “Tiger” that may be undermined by an appreciating currency, the result of diplomatic pressure from the U.S.

The irony is that commodity prices are likely to remain high in the 2020s because of a more inflationary environment and production bottlenecks. This would mean stronger currencies for commodity producers and even higher costs to implement reindustrialization policies. The “commodity curse” is difficult to shed.