Considering their country’s success in escaping the fallout from the 2008 global financial crash, to many Brazilians it must sound churlish or foolhardy to suggest that their economic goose is almost cooked.

When in October 2008 the country’s former president, Luiz Inácio Lula da Silva, predicted that the financial tsunami engulfing the economies of Europe and the U.S. would be no more than a "marolinha" — a little wave — should it ever reach Brazil, he was ridiculed by critics domestic and foreign. Those naysayers were soon forced to bow to the economic foresight of da Silva, a former machine tool operator, as the government flooded a purring economy with cheap credit, supercharging growth that topped 7.5% in 2010.

"Brazil takes off" read the front page of The Economist as foreign capital flooded into the country, with businesses and individuals seeking to invest in an economy increasingly driven by the emergence of 30 million new consumers recently lifted from poverty. Today, Brazil enjoys record consumer confidence, backed by near full employment and accelerating real wage gains. Optimism is buoyant, with the largest oil finds in the Americas in three decades coming on stream while cities across the Latin giant undergo new construction as the country prepares to host the World Cup and the 2016 summer Olympic games.

But in recent months, some of the shine is coming off Brazil’s success story. Last year, GDP grew at just 2.5%. Expansion in the first quarter of this year came in at just 0.8%, amid a rash of downgrades to GDP forecasts for this year and next. Exporters have been hammered by an overvalued currency, while high interest rates are inhibiting local companies across the economy.

Haven taken the acclaim for 2010’s stellar performance, the government is now pointing a finger at the deepening crisis in the European Union, Brazil’s biggest trading partner, as a major cause for the slowdown. Others have looked nervously at the growing economic sluggishness in China, the second biggest destination for Brazilian exports, as Brazilian industrial output closely mirrors Chinese exports.

The China link sparked a renewal of the age-old debate about whether Brazil’s economic success is overly dependent on commodities, more specifically the current super-cycle driven by Chinese demand. Yes it is, argued Morgan Stanley’s head of emerging markets in a recent article in Foreign Affairs. But those who think not point to Brazil’s exports-to-GDP ratio, consistently the lowest among all BRIC (Brazil, Russia, India and China) and Organisation of Economic Co-operation and Development (OECD) economies.

"The commodities boom is undoubtedly helping Brazil, but it started after the economy was back on its feet," says Mauro Guillén, a Wharton management professor and director of The Lauder Institute. "The Brazilians had put their house in order before the commodity boom took off. It is not the determining factor here."

The country’s success is the fruit of the valiant efforts made to emerge from the rubble of its own debt and hyperinflation crises in the 1990s. The Plano Real (a series of government measures undertaken to stabilize the currency), inflation targeting and the law of fiscal responsibility have all slowly allowed Brazil achieve a financial equilibrium unknown for decades, observers note. This has given the government money to redistribute to the poor and banks the confidence to begin extending credit to the majority of Brazilians who previously lived in a restrictive cash-only economy, where even mortgages were unheard of for all but the very wealthy.

The impact of these reforms grew over time to produce the euphoria of 2010. But now observers warn this consumer-driven boom has run into bottlenecks caused by decades of underinvestment. Brazil’s roads are clogged with new cars; the country’s too few ports are often besieged by fleets of trucks unable to unload their exports; and employers have to pick through the poorly qualified graduates of a substandard education system to find the few qualified enough to operate in an increasingly sophisticated economy.

All this pushes up the notorious "Custo Brasil" (the Brazil Cost), the premium paid for doing business in the country, which is further exacerbated by such burdens as a byzantine tax code, a dysfunctional judicial system and antiquated labor laws.

Dealing with the ‘Custo Brasil’

"All these problems are not new. It is no surprise that Brazil needed new ports. But it is a long-term project," notes Wharton management professor Felipe Monteiro. "The problem is that Brazil’s positive overall macro-situation somewhat masks the need to undertake reforms. It is very tough to implement any changes when everything is going well. It is comfortable enough that nothing too bad is going to happen, but it is worrisome enough that it is very hard to [stimulate the] growth and development that we really need for the long term."

When campaigning to succeed da Silva, President Dilma Rousseff dismissed the needs for such painful structural reforms in order to maintain growth. Observers say such a belief was most likely grounded in the certainty that attempting such reforms would quickly exhaust the political capital this little-known administrator-turned-politician had borrowed from the hugely popular da Silva.

Despite record popularity levels, after 18 months in power Rousseff is still unwilling to grasp a reform agenda. Instead, her economics team has sought to counter the economic slowdown by replaying the response to the 2008 crisis and releasing more credit to consumers and companies. This has led to warnings that Brazil is incubating its own subprime credit crisis as the new lower middle class takes on too much debt to pay for a first car and household appliances. After a recent spike, overall consumer delinquencies have started to fall back. But auto-loan delinquencies continue to rise, a worry in a country where 20% of industrial output is tied to the auto sector.

"In the last two years, many people did overextend themselves. Many people are indebted. They cannot take on more. Families that entered the consumer market in 2009 cannot take on more. Like a snake, they will take time to digest what they have already consumed," notes Flávio Fligenspan, a professor at the Federal University of Rio Grande do Sul.

"We do not have the same capacity to grow at more than 7% aided by credit as in 2010," Fligenspan notes. "But I would not exaggerate and say that the growth model based on credit has exhausted itself in Brazil. I think it is absurd when there is an enormous need for consumer goods among many Brazilian families and this will depend on credit. Despite growing considerably, credit in Brazil is still small compared to size of the economy. The model has lost force but is not exhausted."

The government’s efforts to release more credit into the domestic market has involved an offensive against the country’s high interest rates, which, though low from an historical perspective, remain considerably higher than any other emerging market with an inflation targeting regime, and stratospheric compared to developed economies. Brazil’s central bank has undertaken an aggressive easing cycle while Rousseff has used the presidential pulpit to browbeat private banks into lowering their "unacceptable" rates on private loans. The government hopes lower rates will mean that more capital will shift into productive investments rather than remain parked in government paper.

The easing of inflation since last year, along with a recent decline in rates, has given the government cause for optimism that the strategy will work. But the headline rate does not reflect the input inflation experienced by companies. With the difference being made up by companies’ margins, observers say this runs the risk of exacerbating a slowdown in investment and a sudden switchback in the inflation rate and, with it, the return of higher rates.

"The government is applying patches to an increasingly exhausted growth model rather than undertaking the structural reforms that would provide more lasting solutions," warns David Fleischer, a professor at the University of Brasilia. Problems such as infrastructure bottlenecks, a poorly educated workforce and the high cost of doing business all require reform of Brazil’s highly inefficient public sector, which Fleischer says over regulates, overtaxes and overspends — and then spends badly, crowding out the private sector. "The problem is that Brazil’s congress has no interest in reform. This will probably require a public mobilization by civil society, and this takes time and effort," he adds.

Curbing Corruption

Reform is also necessary to tackle another ill that afflicts the country’s economy — corruption. Infrastructure bottlenecks are not just caused by the country’s low investment rate — the lowest among the BRIC nations — but by the poor quality of the little it does invest. "In Brazil, we have this philosophy that the Brazilian state is the great investor, but we know it is very inefficient and very slow to make decisions," says Adriano Pires, head of the Brazilian Infrastructure Institute. Pires cites the government Program for Accelerated Growth (PAC after its initials in Portuguese), which was run by President Rousseff when she was da Silva’s chief of staff. "If you look at the PAC, it has not even managed to invest the amount budgeted for it and it has been riddled with scandals."

The drag of corruption on the country’s economic growth and development is not to be underestimated, warns Marcos Fernandes, a professor at the Getúlio Vargas Foundation in São Paulo: "Unfortunately, the cost of corruption is much greater than simply the money stolen."

Fernandes has identified R$40 billion (US$19.5 billion) of public money reported stolen between 2002 and 2008 by state anti-corruption bodies, a number that only represented part of the true total. He calculates that if invested, that Rs$40 billion could have added 1.3% a year to GDP on a timeline of five years or helped reduce from 43% to 22% the number of Brazilians without access to basic sanitation services. "Corruption retards the social and human development of the country and economic growth in which the government gives with one hand while taking away surreptitiously with another," Fernandes notes.

Meanwhile, by once again priming the economy for more consumption, critics contend that the government is delaying taking on another longstanding challenge — the fact that most Brazilians remain chronic spenders averse to saving. "This is not just in Brazil, but throughout Latin America, where it is very difficult to see a virtue in savings because they know from experience that you save for a few years and then something happens in the economy. There is a crisis; there is inflation; there is a problem in the banking system — and suddenly you lose part of your savings or maybe all of them," Wharton’s Guillen notes. "There is a bias against savings."

This low level of savings accentuates the country’s addiction to running current account deficits that must be covered with capital inflows, which historically must be attracted by high interest rates. High rates have helped push up the currency, in turn hurting exporters. The low savings rate also lies behind the lack of money available for investment in infrastructure, which is producing the bottlenecks that in turn push up the "Custo Brasil."

Without tackling these problems, Brazil risks once again becoming a growth laggard, Wharton’s Monteiro says — that is, using its natural advantages to avoid recession, but failing to achieve the growth rates needed to lift incomes closer to developed nations.

"I think there will be 3% [or] 4% growth because of investments in things like the oil reserves, plus the Olympics and the World Cup and the growth from the middle class," he notes. "These alone are enough for Brazil to grow…. I am not concerned that Brazil in the next two to five years will be recessionary, unless something really catastrophic happens in Europe. But I don’t expect that is it going to grow by 7% or 8%. It will not. There is a limit there because all those bottlenecks are going to show up."