quarta-feira, 2 de junho de 2010

Brazil powers up

31 May 2010 | By Will Jackson
The suggestion that Brazil could be the world’s fifth-biggest power by the next decade would have once sounded far-fetched, but the election of Luiz Inácio Lula da Silva heralded a new era. But how well placed is Brazil to cope with the challenges ahead? Will Jackson reports.

Passengers travelling with TAM, a Brazilian airline, were last month posed a provocative question as they settled down and chewed their complimentary toffees. “Brazil will be the world’s fifth-biggest power by the next decade,” read an advert in Portuguese, attached to the headrest in front. “How will your company benefit from this fact?”
The suggestion that Brazil could be on the cusp of becoming a major economic force would have sounded far-fetched a decade ago. But the election of Luiz Inácio Lula da Silva - or “Lula” for short - as the country’s president in October 2002, heralded a new era of economic stability and wealth creation. Brazil’s GDP grew 3%-6% each year between 2004 and 2008, while interest rates fell by over 10 percentage points.
Even the banking crisis which engulfed the developed world in the fourth quarter of 2008 failed to put a significant dent in Brazil’s economic progress, and the country experienced a relatively mild contraction of 0.2% in 2009. Indeed, the International Monetary Fund (IMF) forecasts a rebound to GDP growth of 5.5% this year.

”Instead of becoming a victim of globalisation, Brazil emerged a victor to claim a leading role in world affairs”
This resilient growth, coupled with economic decline in the established world powers, has imbued Brazil with a growing self-confidence, and nowhere is this more apparent than in Lula’s desire for political influence beyond the country’s borders. The president joined forces with Turkey’s prime minister in May, to negotiate a nuclear fuel swap with Iran - despite direct lobbying from America to support sanctions.
Commentators, including Kevin Casas-Zamora, a senior fellow in foreign policy at the Brookings Institution, a public policy organisation based in Washington DC, noted the significance of Lula’s defiance. “A reformed Brazil has shed its subservient past,” he wrote in April. “Instead of becoming a victim of globalisation, like many in the underdeveloped South, Brazil emerged a victor to claim a leading role in world affairs.”
But despite Brazil’s development, risks to future growth remain. A recent uptick in inflation and interest rates has led to fears that the country could overheat, as wages rise and the country’s creaking infrastructure struggles to cope. Concerns also surround the potential impact of speculative inflows from overseas, and the country’s growing dependence on exports to China. So how well placed is Brazil to cope with the challenges ahead? And what has made its economy so apparently sturdy? (article continues below).
It has not always been this way. Episodes of financial instability litter Brazil’s past; from the oil shock of the late 1970s (which doubled the country’s import bill and triggered inflation of 110% in 1980), to the debt default of 1983, to the knock-on effects of the Tequila, Asian and Russian crises in the mid- to late-1990s. Rapidly escalating interest rates were never far away towards the end of the twentieth century, and the country suffered annual inflation of 764% a year between 1990 and 1995.
As recently as 2002, investors were more preoccupied with the idea that Brazil might follow Argentina, Russia, and Ecuador in defaulting on its public debt, rather than its potential growth. During the summer and autumn of that year, spreads on Brazilian government bonds over American Treasuries ballooned out to 2,400 basis points. Brazil’s currency, the real, fell sharply against the dollar, and inflationary pressures prompted the central bank to hike interest rates from 18% to 25%.
Indeed, the situation became so grave that the Brazilian authorities received approval for a $30 billion rescue package from the IMF in August 2002, despite their earlier assurances that assistance would not be needed.
Markets were spooked by concerns over debt sustainability, but also by the prospect of a win for one of the opposition candidates in the impending presidential election. Fernando Henrique Cardoso, Brazil’s president since 1995, had overseen a raft of progressive policies designed to create a stable economic environment. These included abandoning the exchange rate peg, introducing the real (as finance minister in 1994), inflation targeting and the requirement to run a primary surplus - which allowed the government to begin reducing its dollar-denominated foreign debt.
Fears that Lula’s background in the trade unions (he led a metalworkers union and was briefly imprisoned for a strike conducted in 1980) would be incompatible with Cardoso’s business-friendly reforms faded after the October election, however. Statements on the budget and on debt, and the continuation of interest rate hikes, reassured markets that the new administration would continue Cardoso’s conservative approach to the economy. Spreads on Brazil’s external debt soon fell.
“Going back to 2002, which was when Lula took over, I admit I was a little bit concerned with the debt dynamics,” says Claudia Calich, the head of emerging markets for Invesco in New York. “Bond prices collapsed, so the market was pricing in almost a certainty of default. The debt dynamics were much worse than they are now - you had more external debt, the country’s reserves were much lower.
”But what changed the sentiment of the market was that Lula pursued relatively orthodox policies, along the same lines as Fernando Henrique Cardoso”
“Arguably, if that had persisted for a long time and had been combined with bad economic policies, the country could have gone into default at some point. But what changed the sentiment of the market was that Lula pursued relatively orthodox policies, along the same lines as Fernando Henrique Cardoso.” According to the Center for Global Development in Washington DC, Brazil’s external debt-to-GDP ratio had fallen to 18% by 2008, compared with an average of 27% for countries in Latin America.
In addition to improved debt fundamentals, Brazil’s central bank also began to get inflation back under control. Inflation, which was well above target in 2002 and 2003, fell to 7.6% in 2004, and 5.7% in 2005. For the next three years it moved in a range of 3.1%-5.9%, allowing the bank to cut interest rates from over 25% in 2003, to about 13% in 2008 (see graph, below). “[The central bank] are not formally independent, but in practice there is quite a degree of autonomy,” says Calich. “It is a very credible institution and they have good people in their ranks.”

This new-found stability bolstered Brazil’s resilience to external shocks in the run-up to the financial crisis. Robert Wood, a senior analyst and deputy director of country risk for Latin America at the Economist Intelligence Unit (EIU) in New York, says Cardoso’s introduction of the “three pillars” - stronger public finances, inflation-targeting and a flexible exchange rate - was crucial. “This is the policy mix that countries like Brazil, Colombia, Peru, Chile and Mexico adopted after the crises in the 1990s, and which stood them in good stead going into Lehmans,” he says.
Growth, meanwhile, was boosted by falling unemployment and buoyant global economic conditions. The commodities boom benefited Brazil in particular, as appetite for the country’s natural resources rose sharply - notably Chinese demand for iron ore (one of Brazil’s biggest exports, alongside soybeans and coffee, according to the World Bank). In 2006, the country’s GDP outpaced inflation for the first time in over 50 years, and by the time Lehmans collapsed in September, 2008, the economy was growing at about 7%.
As the crisis took a grip on markets, other factors strengthened Brazil’s economic position. Its banks had little direct exposure to the “toxic” assets that plagued the developed world’s financial system, and the Brazilian government was in a position to deploy several
countercyclical measures. These included tax breaks for struggling sectors such as household appliance manufacturers and the automobile industry, support for indebted companies, and raising the minimum wage.
The central bank also slashed interest rates from 13.75% to 8.75% in early 2009 and - following an annualised contraction of about 13% in the final quarter of 2008 - a V-shaped recovery began to take hold. **
Brazil’s growth, and its resilience, has attracted interest from foreign investors and fund managers (see box, below). What excites them, however, is the prospect of a consumer-led boom as the country’s population becomes wealthier. Calich says economic stability is allowing Brazil to issue fixed-rate and longer-dated debt (the longest-dated government bonds in the market mature in 2041), creating conditions for longer-term lending to consumers.
The number of Brazil-specific funds available to British investors is set to grow this year, with the launch of the first actively-managed onshore Brazil Oeic. Allianz Global Investors expects to unveil the portfolio in October for Michael Konstantinov, who runs the group’s £850m RCM Bric Stars fund. The Brazil Oeic will invest predominantly in Brazilian companies but will be able to allocate up to 30% in other Latin American equity markets.
The Allianz fund follows hard on the heels of the first Brazil-focused investment trust, from JP Morgan Asset Management (JPMAM). The trust, announced in March and launched in April, raised £46.7m during its initial public offering. The trust uses a bottom-up strategy and is managed by Sebastian Luparia and Luis Carrillo. Luparia is based in Buenos Aires, while Carrillo works in New York. They aim to identify opportunities with a two- to three-year horizon.
The biggest player in the actively-managed equity sector is HSBC, with its £1.3 billion Luxembourg-domiciled GIF Brazil Equity portfolio (see table, below). The fund, which is run by José Cuervo, held 30% of its assets in financials at the end of April, followed by 20% in basic materials and 11% in oil and gas stocks. The portfolio invests directly in Brazil, but also in companies which conduct most of their business in the country.
For investors seeking passive exposure to the Brazil story, there are tracker funds run by KBC Asset Management and iShares. The Irish-domiciled iShares MSCI Brazil exchange traded fund has a total expense ratio of 0.74%. It tracks the performance of the MSCI Brazil index and its biggest sector allocations on May 4 were materials (28%), financials (23%) and energy (23%). Both products lagged the active equity funds over the past 12 months, but outperformed on a three-year basis.
“The impact is that it creates a price for Brazilian risk, so that has allowed credit creation to take off,” Calich explains. “Ten or 20 years ago with hyper-inflation it was hard to get credit, because hyper-inflation was the rule and the currency was either collapsing or being changed. This increase in the extension of government debt - and more importantly the fall in government yields in Brazilian real terms - has allowed credit to increase and mortgages have taken off.
“This also then allows the middle class of Brazilians to finally emerge. Purchasing power has improved. In the past, either you had a small minority of wealthier individuals who would buy things in cash and everybody else struggled to make regular purchases. You’re also getting a consumer credit culture, so you’re suddenly getting this large part of the population that at one point was unable, but now they’re becoming middle class and they’re buying things on credit.”
A study by the Getulio Vargas Foundation estimates that 10m Brazilians joined the middle class between 2004 and 2008, and Wood says credit rose from about 25% to 45% of GDP over the same period. While mortgage spending remains low (about 1% of GDP), some commentators forecast a rise to 10% of GDP over the next five years.

Mario Fleck, the president of Rio Bravo Investments in São Paulo, says the mortgage and credit markets will develop further, albeit slowly. “In the old days of high interest rates and high inflation, people would not buy houses with terms beyond 2-3 years and most people would buy their cars almost for cash,” says Fleck. “The mentality in Brazilian culture is that it doesn’t matter how much you pay as long as your income is enough to pay the monthly instalments, and that’s true for buying a fridge, a car or a house. But the trend is still very positive for the internal market here.”
Poverty remains a significant problem in Brazil - the World Bank estimates that 9% of Brazil’s 200m population was living on the equivalent of less than $2 a day in 2008, down from 22% in 2003. But the impact of rising wealth and credit creation among the middle classes can already be seen on the streets of Natal, the state capital of Rio Grande do Norte in north-east Brazil - one of the poorest areas of the country. Housing developments are springing up across the city, as middle class buyers move into apartment blocks for security and parking.
”With this capitalisation of the economy and more reasonable inflation and interest rates, we have big opportunities”
The region is attracting foreign money, and organisers estimate that this year’s Nordeste Invest conference - designed to boost real estate and tourism in north-east Brazil - generated about R1.8 billion (£660m) of new business. British companies already operating in the area include Charlemagne Capital and Salamanca Capital, which owns 50% of Ecocil, a local developer. Rupert Hayward, a director at Salamanca, says the north-east is attractive because of a lack of competition from the bigger listed construction firms, and lower land costs.
Outside of real estate, Fleck says wider credit availability offers “a huge opportunity” for other sectors. “With this capitalisation of the economy and more reasonable inflation and interest rates, we have big opportunities for retailers, for consumption, for electronics, and everything that comes with an emergent middle class,” Fleck adds. “That could mean insurance and tourism - things on which people are not used to having the money available to spend.”
In addition to credit expansion, higher wages in the public sector are also enabling consumers to spend more. Between 2003 and 2009, the number of civil servants increased by about 10%, but the total federal wage bill more than doubled in nominal terms. Wood says the government increased the minimum wage by 12% in 2009 - an increase of 7% in real terms, which will feed through to about 40% of workers.
But while higher wages and greater access to credit is bringing better housing and living conditions, fears about inflation are once again coming to the fore. The country’s economy grew by about 2.5% in the first quarter of 2010, an annualised rate of 10%. The EIU forecasts growth of 6.3% this year - well above the IMF’s estimate and too fast to be sustainable, according to Wood.

In particular, there are concerns that the country has spent too much money on higher wages and too little on infrastructure to support greater consumption and trade. Wood says Brazil is “notoriously poor” at infrastructure, in contrast to other emerging nations such as China. “Brazil has spent very little in public investment as a share of GDP - it’s only around 1 or 2%,” he says. “During this boom, you’ve had an increased tax take but unfortunately the quality of spending hasn’t been great. In the crisis, it went into civil servants’ pay packets rather than being used to fund projects to increase productivity.”
According to the World Bank, Brazil could significantly reduce its expenditure on logistics through investment in transport infrastructure - at present, it takes twice as long for Brazil to export than America. The government has ramped up spending by introducing the “PAC” accelerated growth programme, which aims to spend up to R40.5 billion on logistics, including R27.7 billion on almost 5,000 kilometres of roads - although Wood notes that only 50%-60% of PAC money has been spent so far.
”Everything is going very well so far, but down the road Brazil does not have the infrastructure to grow beyond 5%, maybe 6% a year”
Investors sense an opportunity. According to Jonathon Ong, a portfolio manager at Macquarie Funds Group, demand for electricity is growing at 1.2-1.3 times GDP a year, while vehicle traffic is rising at a similar rate. He has been overweight Brazilian infrastructure for several months, including investments in electric utilities, toll-roads, railways and ports. Ong points to government estimates that R90 billion will be spent on Brazilian infrastructure in the next five years - much of it related to the country’s hosting of the World Cup in 2014 and the Olympic Games in 2016.
But some commentators remain sceptical on PAC. Fleck recalls that even before the economy slowed during the banking crisis the country’s ports were struggling to cope with increased shipping. He dismisses the programme as “window dressing” but says that better infrastructure is crucial. “Everything is going very well so far, but down the road Brazil does not have the infrastructure to grow beyond 5%, maybe 6% a year,” he adds. “Doing some work on this infrastructure might change Brazil forever.”
Going hand in hand with the uptick in inflation are fears that Brazil could attract speculative capital inflows from overseas. In its April World Economic Outlook, the IMF noted the strong recovery in Latin America and the Caribbean, but also warned that inflation-targeting countries in the region may be vulnerable to short-term inflows as they seek to prevent overheating. “There is [an] argument for keeping interest rates low for a longer period than justified by domestic cyclical considerations, because higher interest rates may attract speculative capital inflows,” it said.
Brazil took measures to limit speculative foreign inflows in 2009, with the introduction of a 2% tax in October. “The received wisdom is that it doesn’t have much effect, but it coincided with the exuberance towards Brazil in the third quarter,” says Wood. “One could argue that the signal sent by policymakers was that they are ready to do something, to throw some sand in the works. Managing the capital inflows will be a challenge, but they’ve done reasonably well so far.” Wood says he does not expect the tax to increase, unless there is further appreciation in the real.
Despite the risks of inflation and speculative capital inflows, Wood says most of the concerns centre around Brazil’s ability to manage growth - a problem that is “a luxury to have”. However, the full realisation of Brazil’s potential is still some way off. “The next period is about consolidating the stabilisation story,” Wood says. “Brazil is well positioned to grow 4.5 - 5%, but even at those rates you’re not going to see a rapid convergence with income levels in developed markets. So although it’s doing well, and the middle class is doing well, the economy will still be lagging behind the developed markets for a while.”
• Will Jackson was a guest of the Association for Real Estate and Tourism Development (ADIT) at the 2010 Nordeste Invest conference in Natal, Brazil.


**Note: This article was updated on June 1. Robert Wood’s comment that “policymakers threw everything but the kitchen sink at the meltdown” referred to countries in the Organisation for Economic Cooperation and Development (OECD) and China - not Brazil. This quote was removed.

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