Trade and Investment

Why Brazil should open up to the world

Jaana Remes
Partner, McKinsey Global Institute
Patricia Ellen da Silva
Partner; Head, Brazil Office, SYSTEMIQ
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Despite a decade of rapid growth and falling poverty rates, Brazil has failed to match the global average for income growth – let alone to achieve the kind of impressive gains posted by other rapidly transforming emerging economies. As of 2012, Brazil had become the world’s seventh-largest economy, but it ranked only 95th in the world for gross national income per capita (IHS Economics and Country Risk data). To raise household living standards, Brazil needs to find a new formula for accelerating productivity growth.

Building deeper connections with the rest of the global economy could provide the opening to do just that. The global economy is increasingly characterized by an intricate web of connections that go far beyond the trade of goods. Flows of finance and services such as IT and business-process outsourcing are expanding. Increasing numbers of tourists, students and workers are crossing borders and exchanging ideas. In the realm of digital communications, the concept of borders has all but disappeared. Global exposure enables companies to absorb more of the world’s rapidly expanding flows of innovation, technology, research and ideas (Baldwin 1992, Canuto et al. 2013).

Missing out on the benefits of ‘connectedness’

Recent research finds that countries that are centrally connected within the various types of global network can gain up to 40% more GDP growth from them than the least connected countries – but when it comes to connectedness, Brazil ranks only 43rd in the world, below other major emerging economies such as India, China, Russia and Mexico (McKinsey Global Institute 2014a). Although it ranks relatively high in financial flows (at 18th place), it places 39th for flows of goods, 40th for services and 38th for data and communications. Its worst showing is in people flows – a category in which it ranks 115th.

Pursuing greater openness and engagement in all types of cross-border exchanges could yield opportunities for productivity enhancements and economic growth. In addition to entering new markets, Brazil can benefit from embracing the performance pressures that come with international competition. These effectively challenge local firms to evolve and become more efficient by, for example, implementing lean processes, investing in research and development, or integrating the latest technology. Based on an assessment of how global networks influence economic growth, we estimate that Brazil has an opportunity to add up to 1.25 percentage points to its average annual GDP growth with greater global connections. (McKinsey Global Institute 2014b).

Brazil is firmly established as a major player in the global commodities trade, but the attendant pressures on its currency have led to a growing trade deficit in manufactured goods. If Brazil hopes to diversify its exports, it will be critical to compensate for this cost disadvantage by developing distinctive skills and capabilities – particularly in industries adjacent to commodities. Today its exports are equivalent to 13% of GDP – far below India (24%) or Mexico (33%). The World Bank ranks Brazil only 124th in the world for ease of trading across borders, and it notes that the cost of exporting a container from Brazil is $2,215 – more than double the OECD average (World Bank 2013). Poor road and rail infrastructure, combined with cumbersome procedures and bottlenecks at Brazil’s ports, constrains growth.

In recent years, Brazil has focused on establishing international trade partnerships with other developing economies and strengthening the Mercosur trade bloc. But its emphasis on forging “south-south” agreements is not likely to open up large markets for high-value trade in the near term. Pursuing agreements with larger and more developed markets would allow Brazil to increase trade volumes, integrate more fully into the production networks of multinationals, and increase its access to leading-edge technology and processes.

Openness and productivity

While Brazil has exposed some sectors to global market forces, others remain heavily protected and taxed – and a comparison shows that openness has been more effective in boosting sector productivity. Brazil is the world’s seventh-largest producer of automobiles, for instance, but its heavily protected auto industry ranks 21st in global exports – and a disproportionate share of its output goes to Argentina, its Mercosur trading partner. By contrast, Mexico has become deeply immersed in global value chains. Its auto plants produce 53 cars per worker per year, compared with 27 in Brazil, even though 85% of the cars produced in Brazil are small (54% in Mexico).

This performance stands in sharp contrast to Brazil’s success in cultivating an aerospace industry. Embraer was created in 1969 as a state-owned company, and its early growth was fed by providing production contracts and imposing import tariffs. But Brazil also took concerted steps to develop specialized talent and create research and development infrastructure. In 1994 the company was privatized and opened up to the global economy. Since then, Embraer has gone head-to-head with global competitors for international contracts – and has thrived as a result. Today the company has offices, subsidiaries and joint ventures around the world. Brazil has lifted import tariffs on aircraft components, allowing Embraer to source from global suppliers.

Brazil’s agriculture sector, too, has grown more productive since it was gradually opened. Beginning in the early 1990s, Brazil began eliminating price controls and marketing boards that regulated production of certain crops; it also reduced export tariffs and import restrictions. After an initial wave of disruption, Brazilian farmers and agribusinesses responded by taking steps to boost their efficiency, generating positive spillover effects. Production of tractors and other agricultural equipment, for example, has quadrupled in the past three decades, and exports of these machines have increased 24-fold since 1970. Today the yields for Brazil’s main crops are on a par with those of developed economies, thanks in part to a strong tradition of research in agriculture.

Moving up the global value chain

Brazil is increasingly relying on exports of raw primary goods rather than moving up the value chain with exports of more sophisticated, skill-intensive products. This is cause for concern, since research has shown that producing and exporting more sophisticated goods is correlated with economic growth (Hausman et al. 2007). If most consumers can afford only lower-priced products and services, Brazilian companies are discouraged from producing more sophisticated, high-end products. To create higher-quality jobs and increase productivity over the long term, Brazil needs to promote entrepreneurship and innovation – and global flows of venture capital, skilled migrant workers, and data and communication can facilitate this process. Individuals and small businesses can now participate more easily in a digitally connected global economy; increasing their access to capital and establishing business incubators that can create a more robust start-up culture.

Brazilian policy-makers have traditionally focused on mitigating the risks of openness, but today government and business leaders must also consider how to harness the potential of global flows to increase productivity and push the boundaries of innovation. A more effective approach to industrial policy would focus on developing human capital and building the necessary infrastructure to integrate states into a single domestic market and then connect Brazil to the world. More integration with global markets and value chains could provide competitive pressures that spur Brazilian companies and leaders to improve operations and invest in efficiency – ultimately leading to the kind of broad-based productivity gains that raise incomes and living standards.

Author: Patricia Ellen, Partner, McKinsey & Company and Jaana Remes, Partner, McKinsey Global Institute.

Image: A Brazil fan poses with a flag on top of Corcovado mountain at the base of the Christ the Redeemer statue ahead of the 2014 World Cup, in Rio de Janeiro, June 8, 2014. REUTERS/Paul Hanna

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