3 Economic Challenges Brazil Faces in 2016

Brazil's economy is in a perfect storm of trouble, and the weather forecast for 2016 is not favorable. The country depends on its export-driven commodity trade, and China's slowing demand for these products is a lightning strike.

For investors in Brazil stocks, it has been an unfolding disaster for four years. The iShares MSCI Brazil ETF, for example, fell 75% from a high in 2011 to a recent low in mid-December 2015. Many hedge funds and institutional investors have given up and abandoned the old thesis of Brazil as a renaissance country leading Latin America to better days.

Brazil is facing problems on many fronts in 2016, and with the president facing impeachment on corruption charges, it is not getting any easier to escape the storm.

China's once-voracious demand for commodities, ranging from copper and iron ore to fertilizer and crude oil, was an engine of growth in Brazil. Starting in 2009, this demand began to wane and has not recovered. Tax revenues are falling along with sales, Brazil is in recession and the budget deficit is exceeding 9% of gross domestic product (GDP). The economy will contract by over 3% in 2015.

Brazil does not have the equivalent of a central bank with the bazooka monetary power of Janet Yellen or Mario Draghi. Brazil's option is a small-caliber rifle, the International Monetary Fund (IMF), and it is not enough.

In the third quarter of 2015, Brazil's GDP contracted by 4.5% compared to the same period in 2014. Moreover, private consumption and fixed investment both fell at a record rate. The consensus forecast is for Brazil's economy to contract 2.5% in 2016, but much depends on whether China reinvigorates its appetite for Brazil's commodities.

Meanwhile, the cost of servicing Brazil's debt is running about 20% per year. Debt payments consume 8% of total output, and gross debt is about 70% of GDP. Since 1997, Brazil had put money aside to pay back creditors, but that did not happen in 2015.

Brazil's annual inflation is running over 10%, the fastest rate in 12 years. Short-term interest yields are at 14.25%. Economic theory suggests that yields this high should cool inflation, but the risk is that they only deepen and prolong the recession.

Investors may be attracted to the high short-term yields, but many are hedging their exposure to even higher yields. Brazilian authorities fear that both domestic and foreign investors may lose all attraction to these rates and pull their money out of the country en masse.

One fanciful solution to the debt dilemma is the arrival of an inflationary tsunami that dilutes the real value and extent of Brazil's debt. That is clearly only a Pyrrhic victory at best, however, and it does nothing to solve the underlying problems Brazil faces.

Citizens grappling with mortgage rates running 14 to 20% and car loans as much as 16% annually need something better than a theoretical solution.

Brazil received another blow in late December when Fitch Ratings downgraded the country's debt to junk bond status three months after Standard & Poor's did the same. Institutional investors prohibited from owning junk bonds could be forced to liquidate $20 billion in Brazilian sovereign and corporate debt. The country is now the world's largest sovereign borrower with a junk bond rating. Moody's may be next to send it into junk bond purgatory.

The cost of insuring Brazilian debt with credit default swaps is soaring, and potential investors wonder when the upside to owning this debt will materialize. Meanwhile, interest rate spreads on sovereign debt are at levels last seen in Argentina. The Brazilian real is also feeling the effect, falling 60% over the last four years.

Downgrades of Brazil's credit rating also worsen the outlook for large corporate borrowers, such as iron ore company Vale SA, oil producer Petrobras and big banks.

Bond offerings by Brazilian companies have plummeted 82% in 2015 to about $5.7 billion, and it has accounted for only 9% of Latin American debt offerings this year, compared to 32% in 2014.

With China still in the doldrums, Brazil's commodity-driven economy faces a poor prospect of success in 2016. Crude oil and many other commodities are in agonizing bear markets that show little hope for the near future. Add to this the likely impeachment proceedings against the Brazilian president, and it is difficult to be sanguine about Brazil's rebound in 2016.