Stronger Exchange Rate, Lower Inflation and Renewed Growth
If Brazil had an economy open to trade and its firms were indebted in local currency, deprecation of the exchange rate during a recession would stimulate demand and expand GDP. But Brazil’s economy is closed to international trade, and its companies, besides being highly leveraged, have a large portion of their debt tied to the dollar. Due to the small relative size of foreign trade, the expansion of demand produced by a weaker exchange rate has a small effect, while on the other hand the financial costs in proportion to firms’ cash generation (EBITDA) rise, triggering the need for an adjustment that generates a contractionary effect. Depending on the size of foreign trade, firms’ leverage and proportion of debt in dollars, depreciation of the exchange rate can be contractionary.
Based on data from the Center for Capital Market Studies (CEMEC) and the Financial Stability Report of the Central Bank, we show here that, after 2010, the capacity of nonfinancial firms to generate cash flow fell dramatically, with a steep rise in their leverage, measured by the net debt/EBITDA ratio. Since an important part of their debt was in dollars without full exchange rate hedge, the depreciation in 2015 led, for the aggregate of the nonfinancial firms analyzed in the CEMEC sample, to a financial cost above EBITDA. In other words, companies were forced into a situation where they had to take on even more debt to pay the financial costs of their existing debt, with contractionary effects.
Happily, this situation has finally started to invert. However, the continuity of this positive picture will depend on the government’s success in winning approval of the social security reform. If the proposal is enacted in reasonably intact form – which in our interpretation has a high probability – the trends for appreciation of the real and decline of the interest rate will gain force, establishing the conditions for the economy to recover, albeit slowly in any circumstance due to the excessive leverage. We also examine the less likely scenario, of a flawed pension reform. In this case, the demand for future foreign exchange for hedging purposes would tend to weaken the real, with negative effects on companies’ financial expenses. Besides this, the weaker exchange rate would reduce the intensity of the monetary easing cycle, impairing the recovery of economic activity.
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