Brazil's Growth Prospects and Barriers II

As promised, below are some highlights and caveats to the MGI report on Brazil's growth prospects and potential that I did not specifically address in my previous post.

First, a few highlights in the report before the caveats.
- The report is actually a follow up on a 2006 MGI paper. Unfortunately, not much has changed. If the paper seems a little recycled/updated it's because most of the underlying improvements necessary for stronger growth still need to happen.
- The Executive Summary is quite long, but it contains all of the essential elements. It seems that the Executive Summary was created by taking the report and cutting out non-essential phrases, data, and the weaker examples. There is not much additional value from reading the report in its entirety unless you are analyzing the supporting data.
- Few of those studying Brazil point out or benchmark the tax revenue compared to other developing countries. Brazil is at the top of the list, showing that there isn't much more room to grow from the government's end to resolve these problems. Furthermore, this tax level should be kept in mind with the fact that deadweight social losses are exponential. For example, an increase in a tax from $1 to $2 on a certain good does more than twice the damage to the economy than the initial $1 tax.
- Brazil's demographics is another point that few tie to economic performance. However, as I've stated in a previous post, even fewer notice how quickly and drastic the Brazilian birth rate fell and the potential for a demographic "hard landing."
- Tax revenue from the commodity boom was essentially all spent on income redistribution instead of investment, which could have further increased productivity. This is a delicate point to bring up, and the authors do so superbly in a fashion that is both accurate and diplomatic. One potential comparison on this subject would be to Venezuela and oil rig maintenance. Venezuela expanded social benefits instead of keeping its oil rigs well maintained and in order. Because of this policy, oil output unnecessarily fell, which hurt productivity and social benefits in the future. While Brazil's case is far more complex than this, the same lesson could potentially be applied.
- Brazil has many significant and counterproductive protectionist policies. Reducing protectionist policies anywhere is extremely difficult. There is a painful transition period, a lot of money is at stake, and those with money at stake are few and have eloquent lobbyists. The report does not touch on this area, which is understandable considering the size of the issue and the report's focus on high-level items.
- Due to demographics and "generosity," Brazil's pension system is going to spiral out of control far worse than many developed nations if reforms are not made. This is not a near-term critical issue, but MGI does a favor by pointing it out at this juncture and highlighting the impact.
- This anecdote from the introduction is one of the most concise and illuminating points of data to address Brazil's underlying productivity and potential GDP growth in the report. "Mexican auto plants churn out twice as many vehicles per worker as  Brazilian plants, even though a much higher share of their output consists of mid-size and large vehicles, while Brazil's plants typically produce 85 percent of small cars."
- Other illustrative anecdotes were used very effectively, such as the length of rail laid in Brazil amounts to about 10% of that in the United States, even though the two countries are similarly sized.
- There are fewer economic policies as painfully obviously bad as preventing (tariffs+quotas) the importation of food and then creating a commission to limit the planting and harvest of said food. It's a policy that definitely is not unique to Brazil, but the scale was quite large. The report brings up briefly, but in an appropriate fashion, the economic advancements that have arisen from removing some of the worst policies that caused "own goals" on the economy.

Next, my caveats in recommending the report:
- Even though it's been just over a year, the points related to "strong currency" are out of date. The Brazilian real has depreciated 30-40% over this time period.
- The authors use the fact that Brazil has the seventh largest FDI in the world as an indicator of openness in the financial sector. Brazil has the fifth largest population in the world, an extraordinarily low savings rate, high real interest rates, and a history of underinvestment. FDI, in theory, should be much higher. In a world of negative real interest rates, Brazil is offering 8% real returns. Why aren't foreign investors piling in? The answer is that the barriers for foreigners to invest are significant, especially for certain industries and financial structures. Financial openness to enable the limited purchase of some publicly traded shares and bonds is not the same as opening the economy to the capital infusions that innovate and improve the underpinnings of economic performance.
- There are a lot of suggestions, but there is very little sense of priority and impact. As I pointed out in the previous post, the problems are interrelated. However, many of the recommendation are either too vague or they would do little to resolve the big ticket items that need to happen to achieve 4% GDP real growth. For example, improving public sector efficiency could help, but many countries have succeeded well despite public sector inefficiency. Also, in a country where the government controls so much, exactly what falls under the umbrella of public sector efficiency? The report isn't clear. Public sector efficiency could refer to schools, medicine, zoning, permits, customs, police, safety, unions, etc.
- Improving tourism could help a little, but the highest impact / lowest hanging fruit wasn't mentioned in the report. Half of the world's high-spending international tourists are essentially blocked out of the market for a visa. Compare the maps showing the countries that need tourist visas to visit Peru and Brazil. Travelers from Japan, the USA, Australia, and Canada have to go through the bureaucratic visa process to visit Brazil, but not Peru, Argentina, Chile, or a host of other countries in the region. This obstacle alone is usually sufficient to exclude Brazil as a potential tourist destination. If Brazil wants to maintain a sense of reciprocity for moral reasons or leverage, the Brazilian government can emulate the Argentinian reciprocity fee by charging a fee to those from the United States and other countries.
- Embraer is not a great case study. Embraer was a success, but the Brazilian aerospace firm was a result of many contributing factors, favorable timing, and a bit of luck. While lessons such as "remove tariffs so the industry can become an integral part of a supply chain" are more universally applicable, many aspects of the case study seem to encourage industrial policy that picks winners and losers and sound like more of the same government micromanaging that has yielded few benefits. In some parts of the report this seems to be encouraged, while in others this seems to be discouraged, such as the example of the negative impacts of the BNDES development bank. The problem is not a lack of trying to create another Embraer. The problem is that these attempts are performed with favoritism instead of reform and liberalism.
- There are other cases where a large number of words are used to recommend micromanaging marginally effective incentive programs. Brazil is far enough back on the curve that political capital should be focused on the steps that are politically feasible and can move the needle.
- The report's commentary on getting stricter on regulatory compliance to reduce the informal sector is misplaced. Complexity already  makes regulatory compliance nearly impossible, putting businesses—especially small and medium sized enterprises—at the mercy and fairness of the regulator. The marginal cost of adding a regulator in the current environment is likely negative. The improvements first must come in regulatory structure and reform. Once that is in effect, the budget and activities of regulators could be tweaked.

Overall, the report is a great snapshot and it is my go-to resource when those in my network reach out to better understand Brazil's medium-term prospects.

Brazil's Growth Prospects and Barriers I

A friend of mine reached out to me regarding Brazil's prospects and potential growth going forward. Instead of the usual, "I just want a few interesting and relevant pieces of information," he was actually looking for a deeper dive on structural problems and opportunities. My eventual suggestion to him was to refer to the MGI's "Brazil's Path to Inclusive Growth" report, albeit with caveats.

In this post I will restructure the key points in a framework that I believe is more straightforward. In the follow-up post I'll list out more explicitly the caveats to my "very highly recommended" for my friend.

Brazil needs a dramatic increase productivity in order to increase the growth rate. The report classifies the three principal problem areas to improve productivity in order to achieve consistent 4% GDP growth as "Inadequate infrastructure, a heavy tax and regulatory burden, and a shortage of workforce skills." I have altered it slightly to trade barriers, human capital, and access to capital. While I believe the tax and regulatory burden are a significant drag, eliminating just the trade barrier portion would be sufficient to allow the economy to jump forward, despite the taxes and regulatory burden in other areas. Also, access to capital is addressed in the report, but I believe the overall impact to productivity should be emphasized further.

Three principal areas to change for productivity improvements necessary to drive economic growth:

- Trade barriers: The MGI nails this point. Every year Brazil's economic isolation hampers growth. The sooner interconnectivity increases, the sooner the productivity will increase and 4% real GDP growth target can be consistently achieved. An appropriate understanding of the full level of trade barriers should be approached from a process perspective. The proper question is "What is the full throughput, time, and cost to push goods through the road, rail, and port system?" (I've touched on Brazil's infrastructure, especially maximum throughput, previously in this post with some English source data points.)
The speed, maximum throughput, and cost of Brazilian port and rail have remained far behind in the world of high-speed just-in-time global standards. Take the example of a firm that receives resources from another country, improves them, then sends the more advanced or finished product to a different country. First, the boat must arrive at port. Depending on the volume and the day, the queue into port could take a week. Second, the boat docks and the goods are unloaded. Because customs and inspection do not work 24 hours a day, this can take another week. Third, the import duties must be paid. Because these taxes are not always transparent and the process is complicated, a third party might be necessary to sort out the paperwork. Fourth, the limited dock space slows this process somewhat compared to best-in-class ports in other countries. Fifth, the rail cars travel slowly, spending an extra day before reaching the stop nearest to the factory. Sixth, because the rail network is limited the nearest rail point is over 200 km away from your ideal point of operations. Seventh, poor road conditions delay and add costs to the transportation. After improving the product at your factory, inverse the order of steps above. For these reasons, it is extremely rare for an intermediate production goods to be made in Brazil. Other significant advantages would need to exist in order to make up for these weaknesses. However, we will see below that these advantages have not yet materialized.

- Human capital - Human capital optimizes the use of physical capital and labor. To understand Brazil's limitation of human capital, it is important to focus on three key areas--education, foreign language skills, and presence of foreign workers.
First, on education and skills, I have written a post previously based on an OECD report of Brazil's educational achievements. In summary, top-notch education within Brazil is both expensive and scarce. Quantity and quality of graduates is below that of developing market peers. One interesting piece to note on in education is IT skill development. Due to trade barriers and tariffs, electronics have been very expensive and outside the reach of the vast majority of the population until just recently. Because of this, one notices the lack of intuitive IT skills from Brazilian employees. Brazilians did not grow up exploring and fiddling with these devices, and it shows everywhere from typing skills to understanding system capabilities and limitations. 
Second, few people outside of Brazil speak Portuguese. Language is extremely important in determining trade partners.* English is the standard for international commerce. However, as noted in the MGI report and elsewhere, Brazil lags in language proficiency, especially English. Although English is technically a part of the public school curriculum, the rigor of the public school courses must increase in order for students to at least reach a basic level of reading and writing. 
Third, foreign-born individuals make up less than 1% of the workforce. Immigration from a variety of countries can improve economic performance and diversity. However, Brazil's level of immigration is both very low and skews toward countries with lower socioeconomic conditions than Brazil, such as Bolivia and Haiti. Many of the skills lacking in Brazil's workforce could be developed through cross training by greatly simplifying, streamlining, and liberating immigration when there is an employer sponsor. Currently, if a company would like to improve the quality of the workforce by bringing in a specialist from another country for more than three months, the company must justify that a Brazilian with equivalent skills could not be found, all of the bureaucratic process of employee rights and work papers must be developed, and the employee cannot be paid more than a Brazilian counterpart in a similar position. Furthermore, this process is not merely a formality, and requests are rejected for reasons such as, "not enough relevant experience," as if the company does not know what they are doing when it plans to spend large sums of money in order for this cross-training to occur.
 

- Access to capital - Brazil lacks access to the full benefits of the modern financial sector. Savings rates are low, and government policies further discourage saving. Real interest rates are high and burdensome, especially for capital intensive and small businesses. Many small- and medium-sized enterprises are denied capital altogether, as the limited capital available is sucked up by larger, more established firms. Foreign direct investment (FDI) is regulated and limited, especially in the areas where it is most needed. Simply put, until either regulations and costs on FDI are loosened or savings rates rise, capital available for investment will be limited, and a portion of the increasing compounding economic growth will be left on the table.

As the fifth most populous country in the world and the fifth largest country in the world, Brazil has a great deal of potential. However, productivity determines economic growth, and Brazil has some deep issues regarding productivity growth. Fortunately, other countries in similar situations have overcome similar challenges, and the level of optimism in and about Brazil will change as these structural improvements occur.

* See Language Barrier Index and similar subjects on macroeconomic trade. I am now on the more limited side of the economic journal paywall, but this is a fairly well established subject.

Patience in Affliction

There are certain weaknesses in which I have difficultly showing patience. One of these is when people show a very low pain or physical distraction threshold. I had a colleague once walk in from outside to an important working session. He had been rained on. By his attitude you would think that either he was allergic to water (he was not) or it was raining acid (it was not). He excused himself for over 30 minutes because he had been rained on.

At another point, a very important deal preparation session with a large team as well as an external legal team. A mandated fire drill then occurred in the building. The law firm politely had their office excused because of the "essential nature of their business." (I do not buy that either, but we were the beneficiaries.) However, during this fire drill the building's air conditioning had been turned off. The temperature rose to just over 80 F (28 C). It's a slightly uncomfortable temperature, but one of my colleagues who was heading the deal brought up the temperature of the room about every 30 seconds for the next 20 minutes. Nearly nothing moved forward.

When I see this, I question the passion and interest of those who exhibit this behavior. When the situation is important and time is of the essence, I am not that concerned that your sweat glands turned on.

Important caveat: Now, because I did not have much of a choice, I've to put up with the elements, rain, snow, sun, heat, and cold, for many years of my life. Accordingly, I am probably not the most fair judge of this behavior. Glass houses and such.

Currency Swings in Brazil

In a recent conversation with a non-Brazilian colleague concerning strategy in Brazil she said, "Yeah, the Brazilian Real has weakened a lot, but that's just temporary. Exports will increase and it will stabilize." Because we had to move on to another topic, I did not have the opportunity to explain why I think that viewpoint is incorrect, especially for Brazil.

Take the macro equation: Trade Deficit = Capital Inflow. To balance out that equation, the exchange rate must adjust. For example, too much capital outflow coupled with a trade deficit or weak surplus causes a currency to weaken.

However, there is a big lesson to note in these situations: "Cash runs faster than boats." When people decide to pull their capital out of a country, it's a pretty quick process. The best example of this was Thailand and the 1997 financial crisis. Cash flees, but the advantage in exports takes months if not years to shake out. Also, the initial negative abrupt adjustments can delay the advantages in exports. With this backdrop, let's look at Brazil. Since the facts below are non-controversial, I'll be linking minimally.

First, the economy is doing poorly. Real GDP is about zero.
Second, 6-8% inflation has a direct weakening effect on the currency.
Third, Brazil is/was relatively expensive. Even basic commodities were comparable in cost to some of the most expensive cities / countries in the world.
Fourth, Brazil has pretty stringent capital controls for both inflow and outflow. If money decides to leave, it probably won't be coming back soon, as those involved probably had to bite a big bullet to get it out of the country.
Fifth, and this is the primary point of the rest of this post, even though cash is faster than boats, in Brazil cash is far far faster than boats.

I once had an extended and very interesting conversation with a banker who works in Brazil's import/export area. He explained that the ports were essentially all "effectively" operating at 100% capacity, and the amount of excessive demand would determine the number of day wait and/or peak pricing. For example, during the soy spike (and various other commidity spikes) in 2012, agriculture was trying to export everything possible. However, the net effect was a drastic increase in rail freight costs, shipping costs, and trucking costs. Essentially, little made it through, and what did make it through had it's economic rent extracted primarily by the distributors. Afterward, to avoid a "someone once told me," I poked around a bit more on Brazil's ports. The best article I could find in English also hit on the same points as the banker.

- Bureaucracy: "Every ship that arrives in the country waits at least 5.5 days to have the goods delivered by agencies such as IRS, the National Sanitary Surveillance Agency, the Ministry of Agriculture and the Docks. The world average is three days."
- Logistics: The physical ports in and of themselves are okay. However, the rail system is abysmal and access by road is limited. "The logistical problems of access are evident, the bottleneck of access from the cargo container terminals generate unproductive periods, which are highly detrimental to the foreign trade and financial activity of Brazil. It is a fact that the rail network and roads in the vicinity of the ports are insufficient."
- Union issues: not only are there occasional strikes, but many workers are only present during business hours on non-holidays. "In Brazil, the organs responsible for clearance of goods run only during business hours. It is the only country among the world's major economies which does not have these services available 24 hours."

Perhaps the Brazilian Real will rebound significantly, but it's difficult to foresee that happening over the medium-term.

Gates Foundation - Initiatives for the Future

A few last comments (for now) on the future.

The Gates Foundation annual letter is out and focuses on four developments that they both foresee and are pushing in the developing world.
1) Infant Mortality - Five simple steps to drastically improve infant mortality.
2) Africa Agricultural Productivity - Agricultural productivity by region of the world over the last 100 years is fascinating. Africa has lagged far far behind in these agricultural developments. This problem is more complex than infant mortality because best practices change according to both climate and infrastructure.
3) Mobile Banking - Discussed here previously.
4) Electronic Learning - Discussed here previously. The potential impact combined with mobile developments is interesting to note.

Antibiotics and Desalinization

In a previous series I pointed out two potential critical turning points in our potential future. The first was antibiotics (downside risk), and the second was low-cost desalinization (upside potential). In the past few months there have been breakthroughs in each of these areas. Although the breakthroughs could be considered "small," these smaller breakthroughs are necessary steps to reach the eureka breakthrough moment.

Antibiotic breakthrough: Multiple target binding bacteria as well as a novel method to efficiently test many many more antibiotics. My long run bet on humanity just might be shorter than I anticipated.

Desalinization continues to push forward. Graphene had already been established in prior studies and experiments, primarily from Lockheed. However, one primary challenge has been to develop a method to efficiently clean the filters. This appears to be a change in concepts for filter cleaning which can be further improved upon.

I want to reiterate the importance of desalinization in a slightly different way. There are a lot of young marginally employed males living in areas facing water scarcity because these regions are arid and have poor water management. As water shortage becomes an ever more serious issue to those living in these areas, these young men could become a local destabilizing force, and consequently become these regions can export this instability throughout the world.

Imagine an environment with a severe water shortage and no job prospects. Your short-sighted government and their cronies wasted it all and, for some reason you don't understand, the government is not able to get more of it. The gut reaction for many (most?) is to throw these pernicious and evil officials out by any means possible, especially once the photos leak of lavish parties and swimming pools behind those 50 foot walls of theirs.

Hubris and Statistics

I recently finished a fascinating Econtalk podcast with Joshua Angrist dealing with different methods in Econometrics and how slowly we have gained knowledge in the field over time. The podcast had me reflecting on four of my statistics-related experiences. All are examples of hubris or folly (primarily mine) in the use of statistics.
Disclaimer: My work is not this disgraceful all the time. I label these "learning experiences" for a reason.

1) Econometrics Competition - This might surprise most of the people who know me, but I once won an econometrics competition. Each candidate needed to submit a model together with the theoretical reasoning to justify along with their data. The product we were dealing with was somewhat of a signalling/luxury good, so my model included an exponential component as well as an attempt at instrumental variables. I somehow won. However, when actually applying the model later in the real world, it was simply mediocre and no better than many of the other submissions. Getting the good job sticker sadly did not enhance my ability to predict the future.

2) Predicting tax revenue - In college I worked on a predictive tax revenue model for a nearby municipality. The municipality needed to decide a budget in August of the preceding year, but it was still unaware of what tax revenue, primarily sales revenue, would be for the next year. My team and I were able to create a very strong predictive model. There was just one problem. Our largest errors from prediction were quarters in the two final years, 2001 and 2002. There was this invention called the internet, and online sales started to heavily impact municipal sales tax revenue. The model still performed decently, but the world is not a statistical distribution with 11 fixed primary variables that were true for the last 15 years and will be true for the next 15 years. The world is a complex place, and what makes it complex is not just the randomness and noise, but also the unprecedented. This same lesson applied to the airball in AAA rated mortgage-backed securities five years later.

3) Inverted demand curves - Another project I once worked on dealt with perishable goods that actively changed prices. I was assigned to come up with a type of elasticity and competitive response framework, but I was only provided the company's pricing data. After about 20 hours of fiddling, I discovered that the demand curve was inverted. The more the price was raised, the more quantity sold increased. I discovered the ever elusive Giffen good! I wasn't quite that naïve, but I didn't take the time to structure my thoughts and the request before diving in. Then the realization came, "Of course. We raise prices in anticipation of higher volume." This isn't randomized data that they created for this test. They just want after-the-fact justifications. Also, without competitive data and other critical pieces of information that drive sales, even a randomized experiment would likely lead to incorrect results, as the pricing effects would likely be overwhelmed by the noise of holidays, competitive price changes, weather, advertising, etc. I wasted time with a comically obvious error because I was "thinking fast" before I was "thinking slow." Just because one's task is thinking doesn't mean one is being thoughtful.

4) Willful Ignorance - I was performing a project for a company that was to be acquired. During this work I discovered that the revenue from the existing customer base was on a downward trajectory and the rate of new customer acquisition was obviously slowing (very negative second derivative) in every existing market in which the company participated. The company was making up for this revenue by incrementally adding a few medium-sized markets periodically to the mix, but with every round these new markets were less and less favorable for the company. I took this analysis with some statistical tools and presented it to some senior management members. I was immediately shut down with explanations like, "well, there's no seasonality control here" and other explanations that did not hold any water whatsoever. Shortly thereafter I was reassigned and then pushed out. It wasn't until after that I had realized the obvious, "They were selling the company, you nincompoop. Of course they don't want to provide ammunition to their buyers."

Statistics is a tool. Outside of a laboratory, and even sometimes within a laboratory, it's a very imperfect tool, and sometimes an irrelevant tool. The future is complex and filled with new challenges and people with their own agendas. If you don't stop and look around once in a while, you could miss it.