When Brazil’s stock and bond markets lost a third of their value in late October as part of the Asian contagion, the country’s central bank intervened quickly to defend the real against currency speculators, raising interest rates from 21% to 43%.
The market turmoil created losses at financial institutions that had played a leverage game – borrowing dollars to buy Brazilian financial assets. But the question now is whether the government will be forced to continue to keep interest rates high to avoid a devaluation – and how much long-term damage to the banking system it would inflict.
“No country can afford 43% interest rates forever,” says Robert Gay, managing director, Latin American research and chief strategist at Bankers Trust Alex Brown. “If we thought it was going to go on longer than three months, that’s a problem.”
Fearing an extended period of tight money, bank analysts are recalculating their 1998 earnings estimates for the biggest institutions. Brazil’s privately-owned commercial banks are heavily capitalized, with an average 20 to one capital to assets ratio, so serious failures are not expected.
However, earnings hits could be severe should brutal interest rates continue for up to six months. JP Morgan Latin American banking analyst Brian Pearl believes that the three biggest Brazilian commercial banks, Bradesco, Unibanco and Itau “have little margin for error if such a scenario does occur”. If it does, his earnings estimates would be cut by 53% on average.
Although Brazil has been operating with the largest current account deficit in Latin America (3.3% of GDP), analysts say that otherwise the Brazilian markets’ collapse didn’t make much economic sense.
“There is nothing but good news coming out of the economy, and its banking system isn’t in trouble,” insists Gay. But with the Brazilian economy finally turning around this year, its stock market had become a darling of investors worldwide.
That turned out to be its undoing. In the wake of the Asian currency troubles, Korean banks’ margin calls forced them to sell the most liquid assets they owned, including Brazilian shares such as Telebras as well as Brady bonds. This selling started the cascading collapse that leverage creates. Hedge funds were also big sellers.
Adding to the downturn, Brazilian banks were engaged in leverage of their own. With local real interests around 15%, banks had borrowed abroad at 6% interest rates to buy local debt at 22%, as well as local shares and Bradys. “It’s a very good strategy if the currency is stable,” says Gay.
But buying dollars gave the Brazilian banks $34 billion in net foreign liabilities, and such exposure is often a sign of trouble ahead. “Banks are often the Achilles heel of emerging markets if they borrow too much abroad in foreign currency. That exposure can be a problem if confidence is lost in the economy and suddenly those banks want to get out of their dollar liabilities,” explains Gay. But Brazil is not as badly off as many other countries which have suffered banking crises. In Thailand, the banks’ net foreign liabilities were 130% of central bank reserves; in Mexico that number reached 300% in 1994, while in Brazil it is currently only about 70%.
However, when Brazil’s Commodities and Futures Exchange raised margin requirements on currency futures and interest-rate futures contracts, local banks were forced to come up with about $2 billion to meet them. One of the institutions hardest hit at that time was Banco de Investimentos Garantia, an investment bank and market maker for Bradys, which is believed to have lost somewhere between $100 million and $500 million.
Moody’s Investors Service Brazilian analyst Celina Vansetti downgraded the bank’s financial strength rating from D+ to D, with a negative outlook.
Of the bigger commercial banks, Unibanco reported it lost R12 million ($10.9 million) because of an open forex position in dollars. Unibanco is one of the bigger traders, yet so far the problem at Unibanco is still minor, given earnings of R383 million by the end of October.
Bigger woes are likely in the months ahead. “We don’t expect any deterioration of quality until the beginning of next year,” says Vansetti. But by March of 1998 she expects non-performing loans at the biggest commercial banks to double – from between 1.5% and 2% to around 3% or 4%. That’s because she expects that high interest rates won’t be cut sharply, but will come down gradually: “This is a kind of tough scenario for middle-market companies already working on thin margins,” – the type of companies that are the major clients for the local commercial banks. Brazilian banks, like others in Latin America, have lately favoured a strategy of moving into retail and consumer finance, and that may also be stymied by the current developments.
JP Morgan’s Pearl thinks the bank hardest hit by higher rates will be Bradesco, which could suffer a 70% earnings cut should higher interest rates continue for the next six to 12 months. Unibanco could have a 51% drop in earnings, and Itau a 37% decline, he estimates. Lower profits, he suggests, will be driven by a reduction in net interest income because of lower loan volumes, an increase in provisions because of asset quality deterioration and trading losses, and bad interbank lines.
Local bankers are hoping for a quick end to the sky-high interest rates. Some analysts and economists think a devaluation would be better for Brazil than the alternative of a recession its austerity programme could bring. But fears of a return to hyperinflation are keeping the government from such action.
To try to keep local banks from dumping Brazilian assets to pay off dollar liabilities, causing a run on the currency, the government has sold forward more than $20 billion through the local futures and options commission, which has allowed the banks to hedge the dollars they owe.
If the tactic doesn’t work, and Brazil is forced to devalue, it won’t be the banks, but the government, which will have to ante up. Michelle Celarier
