Brazil's Infrastructure Challenge

If you ask any Brazilian about the major problems facing their country, one of the first responses (after corruption, of course) will certainly be lack of infrastructure. I have mentioned this issue in previous posts, and there is no doubt that infrastructure has become a major topic of discussion in the national media. With the 2014 World Cup and 2016 Olympics looming (not to mention next month’s Rio+20 summit and the 2013 Confederations Cup), the world is watching closely as Brazil seeks to modernize its airports, roads, ports, and urban transportation systems.

Much of the recent criticism, both national and international, has focused on poor execution and slow implementation, as projects across the country are behind schedule and makeshift solutions such as temporary airport terminals are being proposed. Time is certainly of the essence as the date for the events moves closer. But in fact it is quite normal for infrastructure projects to come in over budget and behind schedule.  In my home state of Maryland, the Inter-County Connector, a major new toll road which finally opened in November 2011, was criticized for years due to ballooning costs and a slow construction schedule. South Africa heard many similar critiques regarding its infrastructure projects in the run-up to the 2010 World Cup. While preparations may not be ideal, I am confident that they will be adequate for Brazil to fulfill its responsibilities as host country for all these events in the years ahead. And if insufficient preparations end up causing Brazil significant international embarrassment during the World Cup, that should serve as a powerful incentive to improve execution of infrastructure projects in the future.

Long term, however, Brazil faces real challenges regarding its infrastructure. At its heart, the issue is not execution but rather financing. Simply put, Brazil needs to come up with a lot of money if it is to pay for the massive reforms needed to update the entire country's infrastructure system and put it on a path to achieve higher rates of economic growth. This represents a major challenge for a country that currently invests only 19% of its GDP.

China serves as a useful foil for Brazil in this regard. Having recently reached middle-income status after years of urbanization and large scale, low-wage manufacturing, China is trying not to hit a wall but rather to unlock a new era of growth to transition from middle-income to high-income country over the next several decades, following in the path of its East Asian neighbors Japan, South Korea, and Taiwan. To achieve this end, the country's leaders have invested massively in infrastructure, creating a new high-speed rail system in addition to numerous other projects. As a result, investment reached 48% of GDP last year. While this extraordinarily high rate was temporarily inflated by the government’s $586 billion stimulus plan to counteract the 2008 financial crisis and has led many to cry panic about an investment bubble, it is not far off from the roughly 40% rates of investment of Japan in the 1970s and South Korea in the 1990s, suggesting that China is following a historical development path that will pay dividends in the future.

Unfortunately, Brazil does not have China’s ability to finance large-scale infrastructure improvements. It has a low domestic savings rate, equivalent to 17% of GDP over the last decade compared with 50% in China. It also does not have a large trade surplus. Whereas China ran extremely large current account surpluses averaging nearly 6% of GDP over the last decade, Brazil ran a deficit averaging -.5%. (Source: tradingeconomies.com) In other words, China saved up the money it made from exports during the last ten years of rapid economic expansion, whereas Brazil spent its earnings. Now, China is able to fund huge infrastructure projects all over the country, whereas Brazil is struggling to find the cash it needs.

President Rousseff’s aggressive focus on reducing interest rates may help in this regard, as falling rates are already lowering the government’s borrowing costs, freeing up money for investment that would otherwise be spent on servicing the debt. However, this step alone will not solve the problem. The Brazilian government’s drive to lower interest rates should improve the country`s macroeconomic fundamentals, but expanding the credit supply will do little to improve the savings rate.

A more important step forward in financing infrastructure projects has been the recent wave of privatizations. Recognizing that the government simply did not have the money to finance much-needed airport reforms, Ms. Rousseff turned to the private sector for help. Infraero, the country’s airport authority, began last year by selling the concession to operate the airport in Natal, a small World Cup host city in the Northeast that has been the most behind schedule in preparations. This February, the agency auctioned off concessions to operate public-private partnerships for three major airports in São Paulo and Brasília. Two more auctions are expected to follow for the airports in Belo Horizonte and Rio de Janeiro. If these projects turn out well, privatizations may become an increasingly important tool in updating the country’s infrastructure.

The downside to privatizations is that investors expect to earn a commercial rate of return, and often end up charging a hefty price tag for use of the infrastructure. I was astounded by the tolls on a recent car trip from Belo Horizonte to the coastal city of Cabo Frio. The road was of remarkably better quality than anything else I had seen in Minas Gerais, but we ended up paying 45 reais in tolls over the course of seven hours in the car, and the price tag was significantly higher for trucks and other large vehicles. Similar fears abound regarding the airline privatizations. After the winning bid to operate São Paulo’s main airport came in at five times the government’s asking price, many have started to worry that the high costs of the concessions will be passed on to airlines and consumers. Private money is desperately needed to improve Brazil’s infrastructure, but the government will have to figure out ways to keep fees from spiraling out of control.

It could start by improving its auction processes. Outside of the problem of keeping bids under control to prevent future spikes in fees, the government should adequately vet proposals at an early stage to ensure that the consortia have the necessary expertise to operate efficiently. The government caused a stir several weeks ago when rumors leaked that it was worried about some of the winning operators’ lack of expertise in operating large airports and history of accumulating unpaid debt, although the transfer of the concessions is still proceeding as planned. In addition to the issues regarding the airport auctions, the proposed high-speed rail project linking Rio and São Paulo has been postponed several times, after three auctions in 2010-2011 failed to yield a single proposal from a national construction firm. The government is currently revising the auction rules, but the project, which was originally supposed to be ready for the 2016 Olympics, now looks to be at least ten years away.

Ironically, Brazil’s ability to attract infrastructure financing may depend on its emerging market foil mentioned above: China. As it has done across the developing world, China is investing huge amounts of money in securing access to Brazil’s export market, due primarily to its appetite for steel, oil, and foodstuffs. China’s massive savings are being used to improve Brazil’s electrical grids, rail systems, and ports. The biggest symbol of Chinese investment in Brazil is the Açu Superport, nicknamed “The Highway to China”, a $2.5 billion project set to open this year that will become one of the main conduits for trade between the two countries.

Yet even with lower interest rates, privatizations and foreign direct investment, it is difficult to see how Brazil will reach the investment levels needed to spring the middle-income trap and become a wealthy country without fundamentally learning to save more and consume less. Brazil has become increasingly reliant on consumer spending, not investment, to finance its economic growth. These three graphs illustrate just how poorly Brazil fares against its BRIC peers in this regard, as it invests little, relies more on consumption, and has experienced a drop in its capital stock per person over the last three decades (courtesy of the Angry Bear Blog):

There is hope that the coming oil boom will flood the state’s coffers, creating a large trade surplus that can then be invested not only in a massive infrastructure program, but also in new health, education, and scientific research and development initiatives. Spent wisely, oil money could be the key to Brazil’s long-term economic success. But the chances are equally high that oil could feed Brazil’s vices, encouraging a bloated public sector, commodity dependence, and lavish, inefficient spending sprees without promoting the key investments needed to put the economy on a more dynamic path. If that becomes the case, Brazilians may have to come to accept dirt roads and sky-high tolls for a long, long time.