Brazil: Getting the fundamentals right

Brazil has undergone a huge change since the start of its stabilization plan (Plano Real) in June 1994. Before this was implemented, inflation was the great concern for all Brazilians. With an average annual level of over 1,000% between 1988 and 1993, it was the main determinant of a commercial transaction's profitability. There were enormous opportunities for speculation. Goods purchased just before a 50% price increase could generate a huge gain. A sale under the same conditions could mean a big loss.

With annual indices currently at around 5%, Brazilians experience almost the same inflation regime as Americans, British or Germans. Up to now this has probably been the government's main achievement and is a central plank in president Fernando Henrique Cardoso's campaign for re-election next October. Cardoso is the strong favourite to win.

But Brazil still has important economic challenges to face up to, and the failure to tackle them has made it vulnerable to acute crisis in the world financial markets. Up to now, however, the economic team has shown great skill in overcoming obstacles. At the end of 1994, for example, the Mexican crisis put Brazil's stabilization plan at peril for the first time. The economic team, thanks to fast and energetic attitudes, succeeded in keeping the situation under control. The main instruments used were a huge interest rate increase and a reduction in the central bank's foreign exchange reserves to maintain the value of the Brazilian real.

Things were then relatively calm until the end of 1997 when the Asian crisis hit the world economy. Brazil's economic strategy has again shown good results. Andre Loes, chief economist of the investment bank Bozano Simonsen, says that Brazil's central bank has a head start over those in other emerging economies, such as Argentina or Korea, in controlling the outflow of capital. This is because it is relatively more difficult for Brazilians to take their money out of the country.

Brazil faced up to the Asian crisis with $60 billion in foreign reserves. The central bank acted promptly. It sold dollars to maintain the exchange rate and doubled the annual interest rate from 21% up to 43%. After a $10 billion reduction in the foreign reserves in a week last October, the reserves were rapidly rebuilt and are now at around $75 billion. The interest rate has also been gradually reduced and at 25% is close to the pre-Asian crisis level.

Brazil's ability to deal effectively with the crisis has been aided by broad market conditions. There is currently a good level of liquidity worldwide, says Jose Carlos Carvalho, chief economist at Pactual investment bank. Excluding some short periods when the market has been nervous, such as the end of 1994 and October 1997, there are abundant resources available. As a consequence, the yields of public-sector bonds issued by emerging countries have rapidly returned to reasonable levels. After reaching an average 1,000 basis points over US treasuries at the end of 1997, they now stand at an average of 500bp over treasuries. Carvalho points out that such countries as Spain, Italy, Denmark and the UK are cutting interest rates and the current yield for Japanese government bonds is only 1.5% per annum. Under these circumstances, investors will seek out better returns by investing in higher-risk markets. Among these is Brazil, which needs to borrow in foreign markets to implement structural adjustments.

But given high liquidity internationally, do interest rates in Brazil need to be so high? They are currently around 25% a year compared with no more than 7% in developed countries. With annual inflation of 5% this amounts to real interest rates of 20%. Superficially there's plenty of room for a reduction. But interest rates are in fact much lower than they appear at first glance.

The exchange rate is a key issue. Brazil's current account is in deficit year after year. This generates pressure for a devaluation of the domestic currency. For the investor, the relevant measure is the effective gain in US dollars. As the government is signalling a currency devaluation of 8% a year - slightly above domestic inflation, the space for an interest rate reduction diminishes. To this must be added the exchange rate risk, which should also be added to the domestic interest rate. In addition the government imposes on investors a 20% tax on their nominal gains and there is also the CPMF. The CPMF (Contribuicao Provisoria sobre Movimentacao Financeira) is a 0.2% tax on the capital stock, every time the funds pass through a bank account. The relevant gain for the investor is of course the net after all these charges.

So what level of dollar interest rate should be used as a benchmark? Pactual's Carvalho suggest the IDU, a Brazilian treasury bond with a relatively short term (duration of 1.5 years). Hence, the IDU's yield to maturity (currently around 8.8% a year) should be considered as the minimum level for the domestic interest rate, in net terms, says Carvalho. As the net domestic interest rate is currently around 12% (in dollar terms), there is still room for further small reductions. A more substantial reduction would deter fixed-income investors, prompting an exodus of funds and a reduction in foreign exchange reserves.

Current foreign exchange reserves of $75 billion give the central bank a substantial buffer against speculative attacks. It is also something of a guarantee to foreign fixed-income investors that the exchange rate will not change abruptly. It is likely that Brazil will accumulate even more foreign reserves, not least because of the privatization of the electricity and telecommunication sectors, expected to be concluded by the end of 1999. With this privatization there will be direct investments of around $17 billion in 1998 and $10 billion in 1999, says Loes at Bozano Simonsen.

Brazil's foreign exchange reserves mean that its short-term situation is comfortable, but in the long term it needs to implement a restructuring of its goods and services transactions with the rest of the world. Brazil, like most emerging-market countries, has a historical deficit on its balance of services, as it is a net borrower of foreign funds. The balance of trade must be positive if the country is not to become dependent on the flow of new foreign funds, through loans or direct investments, to achieve an equilibrium on its external accounts. The highly positive results obtained during the 1980s changed quickly after the Real Plan. In the past few years Brazil has begun accumulating balance of trade deficits.