Published by Minyanville

In a surprise move, Brazil’s Central Bank has pulled the interest rate down to 12%, propping up claims that the economy is finally cooling after unsustainable 7.5% growth in 2010, but also stoking fears that the government has little commitment to curbing inflation which exceeded 7% in August, the first time since 2005.

The move reverses five interest rate hikes this year, which took the Selic rate to 12.5%. In an uncharacteristically long statement, the Central Bank explained their 5-2 decision to lower the rate, which takes into account a “substantial deterioration” in global markets as well as slow domestic growth.

However, there are concerns that the Central Bank has bowed to political pressure from President Dilma Rousseff who practically demanded a rate cut in a radio interview earlier this week. Rousseff is fighting a battle with critics who see her as a “political novice,” unable to control either her own cabinet or an out of control economy.

While the Brazilian Central Bank is not independent in the same way as the US Federal Reserve, it essentially acts independently. However, recent events will stoke claims that Rousseff is too hands on with the country’s big business and economy, following a change of leadership at mining firm Vale (VALE),  which many believe was done to align the company with the interests of the nation.

“I think it's a huge mistake. They gave in to political pressure," Tony Volpon, economist and Latin America strategist at Nomura Securities in New York, told Reuters. “The central bank is making a bet that it is 2008 all over again but Central Banks shouldn’t be in the business of making bets.”

John Welch, a Brazil economist at Macquarie Capital in New York, agreed. Talking to the Wall Street Journal,  Welch said: “This is not going to help the credibility of the Central Bank at all. I think this is a mistake and they will have to go back on it.”

Since the beginning of 2009, the real has appreciated 46% against the US dollar, encouraging cheap imports, notably from China, as well as stifling growth in the manufacturing sector as exports become less and less competitive.

“We see two scenarios going forward,” said Neil Shearing, Senior Emerging Markets Economist at Capital Economics in London, in a note to investors. “In the first, the developed world averts a fresh crisis but growth remains extremely sluggish for the next few years. In this instance, capital should continue to flow to emerging markets with better fundamentals, which should support Brazilian growth in the near-term but at the risk of storing up problems for the future.

“In the second scenario, the developed world tailspins into a ‘double-dip’ recession, and a renewed flight to safety by investors leads to capital outflows from emerging markets. In this scenario, Brazilian growth would slow sharply, with the risk of a renewed recession.”

Shearing expects the interest rate to be down to 11.5% by the end of the year, falling further to 10% by 2013. However, of the 62 economists polled by Bloomberg, including Shearing, not one predicted this week’s rate cut. The same was true of 20 analysts surveyed by Reuters.

HSBC has asked whether the rest of the emerging markets will “go Brazilian,” in a note to clients: “Expect everyone, with only a few select exceptions like India, and perhaps Thailand, to lay off tightening for a while,” it read.

Emerging markets, however, are not being expected to buoy the rest of the world’s economies. A survey of the US companies with the most emerging market revenue showed that the figure had fallen around 15% since April, according to Goldman Sachs. This compares to the US recession of 2008 when Brazil, Russia, India and China, “became the engines of the global economy,” write Michael Patterson and Simon Kennedy of Bloomberg.

Looking Forward
Brazil’s own 2012 budget assumes 5% growth in 2012, higher than economists’ average of 3.9% and optimistic compared to this year’s slowdown. Such an optimistic figure could risk overestimating tax revenue, forcing more budget cuts in the coming years.

However, Brazil’s budget is not as strict as that of many other nations. The government may spend up to the maximum authorized by Congress but there is no obligation to do so. Therefore, budgets are often inflated to insure greater availability of funds.

Rousseff will be keen to steer clear of budget cuts, which will not only upset the country’s growing middle class but her own allies who appear to be dwindling.