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.
It is very hard to predict how long Brazil can stay in this situation: with the current level of foreign reserves perhaps five or even 10 years. In the long term, though, it cannot be maintained. The availability of foreign funds made it possible for Brazil to increase imports and this in turn forced domestic companies to increase efficiency and ought to be a key factor in controlling inflation. This exchange rate anchor, which at the moment constitutes the key element in keeping the stabilization plan on track, depends on a high growth rate in the export of tradable goods and continuing high liquidity. The current environment of high liquidity cannot last for ever. Hence, the only long-term way to balance the external accounts is to increase exports.
It is hard to do this at current exchange rate levels. According to a study made by Pactual’s Carvalho, the exchange rate is effectively overvalued compared with June 1994 when the stabilization plan was implemented. The extent of overvaluation depends on the inflation index used to deflate the Brazilian currency. Starting from the level of $1 to R1 in June 1994, using the wholesale price index to deflate the real, the current level would be R0.84 to the dollar. Using the the consumer-price index to deflate the real, shows that it is even more overvalued. On that basis the real would currently stand at R0.64 to the dollar. The wholesale index is the most relevant for exports; the consumer-price index is the one that matters for imports.
Brazil trades with a number of countries, so other currencies need to be taken into account. An additional problem is US deflation, says Carvalho at Pactual. In fact the US still has some inflation shown on its consumer price index, but it is due to non-tradable items (such as real estate and services in general).
It is clear that the real must be devalued to boost exports. The government is also trying to develop other export incentives such as ending taxation on exports, providing more credit at international cost levels and even additional arbitrage opportunities as a result of interest rate disparities between Brazil and international markets.
These measures will certainly help exporters, and in some cases the availability of cheaper credit could be vital for Brazilian companies’ competitiveness, but they alone cannot compensate for the negative effects of a strong real. Another issue, however – GDP growth – could play a role in boosting exports and slowing imports. Imports are in general related to the level of domestic consumption. Exports, on the other hand, could be stimulated by a lack of domestic demand, as Brazil has a strong industrial base. Normally companies would rather sell their products in the domestic market, where the margins are higher. But the situation changes when relevant spare capacity exists. In this case, they have a strong stimulus to export. Good examples among others are the steel and the automobile industries, both important in Brazil. Slower domestic growth due to the current restructive measures should boost export-led growth.
The fiscal deficit should be solved in the long term but the foreign exchange anchor needs to be replaced by a monetary anchor. This means that the domestic currency should be stable as a result of its strong fundamentals. Governments in Brazil have in the long term generated deficits and this did not change after the stabilization plan was implemented. The point is that the government has changed the way the deficit is financed.
Before the stabilization plan the deficit was financed mainly by monetary expansion, creating what is called the inflationary tax. Currently, it is financed mostly by growth in public-sector debt. The present public-sector nominal deficit is around 6% of GDP, very close to its historical high. Total public debt is still manageable at the current level of 36% of GDP, but cannot be allowed to grow too much. Since the government finances its debt using short-term bonds it would be difficult to finance a debt higher than 50% of GDP. The government is aware of this problem and is working on public-sector restructuring.
A lot of progress has been made in restructuring. By 2001, most of the state-owned companies will be privatized. This means that the public sector will be smaller and focused on its strategic activities, such as the control and regulation of the private sector and social issues. In this new environment public-sector accounting will also be much more transparent.
How much time the government has to solve the public-sector deficit issue is uncertain. At some point, though, international capital markets will make a clear differentiation between emerging-market countries. On one side there will be those that did their homework and took advantage of high international liquidity to become strong – candidates for the wealthy nations club. On the other, will be those that simply took advantage of the availability of abundant funds in the international markets to spend more. Brazil has a serious government and a competent economic team that is aware of the country’s structural problems, risks and opportunities. But Brazil will only be among the winners when positive figures predominate.
Financing an export boom
The Brazilian government has one core strategy for the next few years: to boost exports in order to correct the balance of payments current-account deficit. Its target is for Brazil to double its exports over five years (between 1997 and 2002) to achieve a level of $100 billion a year in exports. Since the government does not intend to make any major changes to the prevailing exchange rate, one of the few ways it can pursue this strategy is to increase the availability of credit to domestic exporters or to importers of Brazilian goods and services.
The government has a powerful tool for just this purpose: the BNDES (Brazilian Development Bank). With total assets of $53 billion, net assets of $9.7 billion and disbursements of $16.5 billion in 1997, it is the country’s main source of long-term finance. The development bank has a special department to handle export credit, BNDES-Exim. This department was created in 1991. Known initially as Finamex, it was set up as part of Finame, the BNDES agency in charge of promoting the expansion and revamping of Brazilian plant facilities by funding the sale of locally made machinery and equipment. The new department’s operations were linked to exports of capital goods. In 1994 it grew as a result of the implementation of the credit reciprocity agreement between countries belonging to Aladi, the Latin American Association for Integration. As a result, disbursements jumped from $60 million in 1993 to $280 million the following year.
But it was from 1996 that BNDES-Exim became the aggressive institution it is today. “We have created new credit lines and improved the existing ones,” says Renato Sucupira, the BNDES director in charge of BNDES-Exim. The department has broadened its potential client base as it has started to play an active role in various different sectors of the Brazilian economy. As a consequence, disbursements have grown substantially and are likely to go on growing quickly.
“We intend to reach a level of disbursements corresponding to at least 5% of total Brazilian exports from 1999,” says Sucupira. Given the agency’s past performance, this may be an achievable target. In 1997 disbursements grew by 205% over the previous year and in 1998 they are expected to increase by 69% to $2.0 billion. In 1996, BNDES-Exim’s credits represented a mere 0.8% of Brazil’s total exports compared with 2.3% in 1997.
In other Latin American countries export agencies finance an even higher proportion of exports. In Mexico Bancomex finances $10 billion a year which corresponds to 10% of Mexican exports. But it is worth mentioning that 85% of Mexico’s exports go to Nafta countries.
Carlos Eduardo Cavalcanti, assistant to the director at BNDES-Exim, points out that Brazil’s exports are spread throughout the world.
But the availability of long-term credit lines, such as those provided by BNDES-exim, are not always important for encouraging foreign trade. For some types of low added value commodities such as sugar, pulp, orange juice, soybeans and iron ore, these facilities are largely irrelevant. As a result these products fall outside the scope of the department’s credit lines.
Nevertheless, Brazil exports a broad range of products, from iron ore to modern jet planes or big engineering projects and equipment. There are many cases in which the availability of long-term credit lines is essential to cement a deal.
Two recent examples illustrate its importance. The first is Embraer, Latin America’s largest aviation manufacturer. The company carries a relatively high level of debt and it is pinning it hopes for a turnaround on its ERJ145 regional jet. The market for such aeroplanes is from the big regional airlines and the contracts, when they come, tend to be huge. Embraer’s main competitor in this sector is Bombardier’s regional jet, Canadair. Last year Embraer and Bombardier were in competition for a $1.1 billion contract for the sale of 67 regional jets to American Eagle.
Embraer won the deal. And the availability of BNDES-exim credit for American Eagle to finance the whole sale was played an important part in clinching the sale. With Bombardier supported by the Canadian export credit bank EDC, Embraer would more than likely have lost the deal without the support of BNDES-exim.
The other example is the construction of the Three Gorges hydroelectric plant in China. In the international bidding competition held by the Chinese government to provide the $1 billion in equipment, three consortia led by Brazilian companies won orders. The victory of those Brazilian companies was largely as a result of BNDES-exim’s long-term credit lines for exports.
In future long-term credit may become, if anything, even more important to Brazilian companies seeking big contracts. BNDES-exim intends not only to increase its size but also to broaden its client base, allowing a number of smaller companies to be present in the international market.
The gains of low inflation
Pedro Malan, Brazil’s finance minister since January 1995 and the leader of the team responsible for the country’s stabilization plan, spoke to Marcelo Starec about achievements so far and the quest for a balanced budget and sustainable growth
What have been the main achievements since the implementation of the stabilization plan?
The most visible achievement is the control of inflation. The annual inflation rate reached 2,700% in 1993 and averaged over 1,000% between 1988 and 1993. This year will be the fifth consecutive year in which inflation has fallen. This year inflation of between 3% and 4% is expected, depending on the index used, a level that has not been seen since the first half of the 1950s. In the light of the failed attempts at stabilization in the 1980s, when none of the plans lasted more than a few months, the Real Plan can be considered an important landmark in our recent shameful story of inflation control. The second issue is GDP growth. This year will be the sixth consecutive year of sustainable per capita GDP growth. This has not happened since the 1970s.
Brazil’s recent growth has been quite good compared with the world average but will it be possible to grow at higher rates?
The average annual growth rate in the past five years (1993-97) was slightly below 4%. It is legitimate to desire growth rates superior to that and we are creating appropriate conditions. I would worry about growth rates if we were producing them with the same technology and using the same locations as in the past. I think this is not the case. We are now producing a broader range of goods and services, with a higher technological content and productivity (taking account of all the production factors – not just labour) that has grown at 5.5% to 7.5% per annum in the past four or five years. Such a productivity increase is the base for GDP growth.
Another process, which I think is irreversible, is under way: the decentralization of economic activity. With the productivity increase and structural changes, together with the investments we are making in our people, such as education, I think this could lead us to be confident of growing at sustainable rates. I am not talking about growth bubbles that cannot be sustained. In 1998 a lower growth rate is expected – we are working tentatively with a projection of 2%, although it could be slightly better since a current recovery should be sustained during the second half of the year. This is an adaptation since we needed to respond to last October’s Asian crisis. Growth rates, if not brilliant, are surely not disappointing.
An improvement in living conditions for most Brazilians is occurring, with millions of people entering the consumer market and having access to goods that were once inaccessible because of the inflationary tax and the total lack of credit mechanisms. Our democratic institutions are also consolidating and there is substantial investment in education, which provides the highest social rates of return over the long term. The important thing is to know if we are moving in the right direction, and I think we are. Basically, that is my evaluation for the four-year period since the implementation of the Real Plan and I expect this process will continue, whoever is in charge of public sector management in Brazil in the future. Brazilian society will regain a consensus now that the currency is stable and reorganization of the state is under way. This will lead to a more efficient state, particularly regarding social issues. Brazil changed, is changing and will go on changing in the future and I expect these changes will not be restricted to finance and economics. This reorganization should alter the structure of the production base and also the inflation culture, which we got used to for decades and should definitely discard.
Going back to Brazil’s short-term problems, there is a deficit on the balance of payments current account of approximately 4% of GDP. What will be Brazil’s way of dealing with this?
You are right. The deficit peaked at 4.3% of GDP in the 12 months ended November 1997 and is currently at 4% and on a falling trend. Analysts’ average expectations are of a figure ranging from 3.5% to 3.8% for the current year. That’s a fall compared with last November’s peak. I think this is a result of a balance-of-trade deficit that will be much lower in 1998 than it was last year. Last February, for the first time, the export growth rate was higher than that of imports. There are two basic things to take into consideration in solving the external accounts problem.
First there is the policy that was adopted last year to promote exports. This included the elimination of ICMS [Brazil’s value-added tax] on non-industrial goods that are exported and the creation of an export credit guarantee agency [a joint venture of Banco do Brasil and French export credit guarantee agency Coface]. Other developments include the establishment of Proex to grant export credit lines, managed by Banco do Brasil.
The second and perhaps more important force behind solving the external accounts imbalance is structural change. Ports have been privatized and other transport infrastructure has been improved. There have also been technological advances in production. Currently, between 70% and 72% of our imports are of capital goods and intermediate materials. This indicates an improvement in technological efficiency and an increase in industry’s capacity not only to export but also to compete with imports.
I think Mercosul [a free trade area formed by Argentina, Brazil, Paraguay and Uruguay] is important in this sense since there are no barriers to commercial transactions in the bloc and we are talking of a $1.3 trillion market [the GDP of the bloc as a whole]. A market of this size permits economic production by multinational companies.
We are therefore betting on the continuity of this process of structural change that has been occurring for some years in order to solve balance of payments problems. An important indication of this is the volume of foreign direct investment (FDI) in Brazil. It reached $17 billion last year. This means that over 50% of our current accounts deficit in 1997 was financed by FDI.
Will FDI remain at the same level in the foreseeable future?
We expect so since more privatization is imminent, including the telecommunications and electricity sectors, part of which will be acquired with foreign resources. But it’s worth noting that in 1997 less than a third of FDI was associated with privatization. The rest is investments made by foreign companies betting on the future of Brazil or the region.
Isn’t the exchange rate also an important issue in the trade balance?
We don’t intend to alter our exchange rate policy. We believe it is sufficiently flexible to permit us to adapt to constantly changing international and domestic situations. Today we have a wide exchange-rate band of R1.12 to R1.22 to the dollar. It has been R1.05 to R1.14, R0.97 to R1.06, R0.91 to R0.99 and even R0.88 to R0.93. We also have a mini-band [an area of the large band adopted for short-term moves] of R1.1465 to R1.1525 that we have also moved [within its space] several times during the month. We have made a small amplification of the [mini] bands’ intervals. The interval, which used to be R0.005, is now R0.006. Although very small, this means that we can adapt the policy to prevailing circumstances without altering its design. But I can assure you that we will not make any maxi or midi devaluation or any abrupt change in the management of our exchange rate policy. President Fernando Henrique Cardoso has already stated that if he is re-elected the exchange rate policy will be maintained.
What current-account deficit figure do you consider safe for Brazil?
I think this is always a function of the external financing capacity a country has and of the international environment. The Mexican crisis materialized in 1994 when the current account deficit was close to 8% of GDP. It had grown from 3% to 4%, 5.5%, 6.5%, 7% and finally 8%. In Thailand, for two years the deficit was over 8% of GDP and in the three years before that between 5% and 6%. Obviously, these are now unimaginable sizes of deficit. There is no willingness – partly because of these countries’ experience – in the rest of the world to finance deficits of this magnitude. I think there is not a magic number for a reasonable deficit. But in the light of the circumstances we decided we should have a deficit lower than the one we had, and we are moving in this direction.
What do you expect to be the short and long-term effects of privatization?
Starting with the long term and with the constitutional reforms made during the first half of 1995 and continued later through changes in the law and the creation of the regulatory agencies. The argument then used to defend the withdrawal from the constitution of the obstacles to the private sector participating in telecommunications, electricity, oil, mining, transportation and gas distribution was not purely ideological, as some critics unfairly suggest. Taking a look at the infrastructure, we came to the conclusion that Brazil needed to expand in all these areas. And the public sector alone would not be able to finance it. So it was a responsible and pragmatic attitude to permit medium-term and long-term infrastructure expansion projects to be made by the private sector. Public sector involvement alone would have brought back inflationary tax charges to society as a whole, especially the poorest, to finance it.
There is another aspect to this. In our consolidated fiscal deficit one important component is the demands of public companies on the three levels of government [federal, states and municipalities]. We had many public companies that were making big losses. We therefore had to provide resources from society, as the government does not generate resources, to cover the losses of many companies such as Rede Ferroviaria Federal and Cosipa. Some other companies were breaking even or making profits, but required government resources from time to time for investments to maintain their competitive position. There are therefore good fiscal reasons for privatization: to reduce the pressure on scarce public resources.
There is also the efficiency question. This is not a criticism of the efficiency of a number of competent company managers. However a private company, ceteris paribus, is not subject to the same restrictions that consumer legislation places on public companies or the political interference in choosing managers. So there are some kinds of activities where the private sector is a better manager of scarce resources than public companies. There is also a social imperative. As the public sector divests activities such as steel manufacturing or electricity distribution, scarce resources can be reallocated to essential social services.
Privatization yielded $50 billion from 1991 to 1997 and will provide a further $50 billion in the next three years with the privatization of telecommunications and electricity generation and distribution.
It is clear that structural reforms in the public sector could solve the fiscal deficit. What will be the effect of the social security, public administration and tax reforms on the deficit?
I see all these reforms contributing to state reorganization and operational improvements beyond the reduction of the consolidated fiscal deficit. You mentioned the public administration reform. In fact it does not have immediate effects. However, it will be an enormous stimulus for more efficiency in the public sector. When the security, formerly assured to anyone who got a public job and kept it for two years, is eliminated employees’ motivation to perform well will be stimulated. So I think that in the next years the public sector will show increased efficiency.
There is a huge and growing structural financial imbalance in the social security system that we are trying to solve. Again, immediate results are not to be expected. But to be moving in the right direction is more important than showing good short-term numbers. These could be achieved by some ad-hoc short term government actions but will not solve the problems in the longer term.
Is there the possibility of Brazil implementing all its reforms and still being faced with a fiscal deficit?
The fiscal deficit in Brazil has four components. The first of these is the public companies. As privatization progresses, the contribution of these companies to the deficit will tend to decline. The second is the social security system, whose contribution to the deficit should be overcome in the long term. The third is our 27 states (including the capital Brasilia as a state) and 5,507 municipalities. We are a federal republic so part of the problem is in the various entities of the federation. We have currently signed contracts with 23 of those states to make fiscal adjustments over the next few years. The last is the national treasury, which already has a surplus. The problem is not at the federal government level but in the three other components and can be solved over time.
How do you square the aim of reducing the fiscal deficit and simultaneously filling the increased demand from society for more education and health services?
You are right that ex-ante the total demand for spending exceeds the total available funds. But the revenues will all come from society as taxes or debt increase. The major problem is to perceive what changed when we moved from our shameful level of inflation to a civilized one.
During the shameful inflation times, such problems were solved by strategies that increased inflation. Demands were made in nominal terms, so if the government delayed transfers for two months, for example, the expense could be reduced by 40%. Inflation was therefore the mechanism to solve this inequality.
When inflation does not exist, the question that you raised becomes highly appropriate. In this case, society will have to make choices. If you want to expand spending in area X, maybe the solution will be some sort of decrease in other areas. Society will have to define priorities, which are political choices.
Is there any emerging country that you consider a model for Brazil?
We do not have any model or any country we think is very similar to Brazil. We will therefore find our own way, and we are doing so. Of course, it is always important to understand what is going on worldwide and in this case we have a particular interest in our neighbours because of the important integration effort we are involved in. Here relations with Argentina are particularly important.
In your opinion, what measures should be used for evaluating emerging countries?
First the obvious, which is the resources – physical and human. The other is the degree of consolidation of political institutions, which leads to political stability. The third, and most important is an evaluation of the society’s ability to find a way to solve its problems.
If everything goes according to your expectations, when do you think we could again have a sustainable 7% rate of gdp growth?
There is not any rule that the country should grow at 7% per annum.
Maybe this figure is not a completely accurate one, but it is the figure in the minds of most Brazilian economists. What is your opinion of this?
This is because 7% was the average growth rate between 1950 and 1980 and so seems to have been established as a benchmark for the growth rate that should be achieved. However, when we were growing at this rate annual population growth was 3%. This rate was then translated to a per-capita growth rate slightly below 4%.
Today, the population growth rate is only 1.3%. To reach the same per-capita growth rate now, which is the relevant comparison, we should grow at roughly 5.3% pa. And the base [current GDP size] is much bigger than it was then. So I don’t think we should have as a target 7% GDP growth. Our aim is to have a growth rate that can be sustained.
Future of Brazil’s largest bank
Paulo Cesar Ximenes, president of state-owned Banco do Brasil since 1995, talks about the bank’s huge restructuring, and what can be expected for the bank in future.
What is Banco do Brasil’s position in the Brazilian banking sector?
Banco do Brasil is the largest Brazilian bank, with 4,500 branches. At the beginning of 1995 it started a thoroughgoing restructuring. In 1995 and 1996 we had to assume huge losses as a result of bad loans made in the past. Next we increased capitalization and began an investment programme focused on introducing new technology. A colossal clean-up has therefore been made since 1995. Employees have been reduced from 146,000 in 1995 to 85,000. The private banks had been restructured a long time ago, but not the public ones. So with the fall in the inflation rate, Banco do Brasil had to adjust quickly. There was an administrative restructuring. We have created strategic areas to deal with specific kinds of business and clients. We have grown a lot in the insurance business. In 1995, the bank was Brazil’s 53rd biggest insurance group but at the end of 1998 we will be the sixth biggest, with $1 billion in revenues. In this area there is a partnership with private companies (Sul America and Alianca da Bahia) in which have a controlling stake. Since the second half of 1996 positive results have shown up and improvements are continuing to come through.
What are the main areas in which Banco do Brasil is currently a big player and in which the private banks are not interested?
The bank has a dual role. At the same time as having to be competitive and attend to our clients’ needs, the bank has to cope with some public policy objectives. It is very important in rural areas, in particular catering to the needs of small-size agricultural producers. Banco do Brasil is also important in foreign exchange and export promotion. The bank manages Proex, which is the main fund for exports promotion. As virtually all the companies that export or could potentially trade internationally are clients, we are in a good position to do all of this.
Banco do Brasil’s balance sheet indicates a $2.4 billion loss in net financial income in 1996. However, in the 1997 figures a $2 billion profit was recorded. Did the loss come about as a result of the extensive restructuring programme?
Yes, of course. But note that our results for 1995 and the first half of 1996 were adversely affected by the growth of bad loans. That resulted in net financial income being hugely negative in 1996. In 1995 we started a wide-ranging auditing process which brought to light many problems. We then had to make many provisions for credits that had previously been considered sound.
Do you consider that currently the bank’s credits as a whole are safe?
There is no doubt that we are building a very healthy portfolio. The bank’s recognition that it was carrying a large number of bad loans was a huge turning point, leading to a cultural change
Is the sale of your asset management business an attempt to become more focused?
This is one of the objectives, but not the main one. Big international asset managers are coming to Brazil and are seeking distribution networks, as can be seen in agreements recently made between them and retail banks. Banco do Brasil could have done the same thing, but we concluded that it was possible to go one step further.
We could offer a controlling stake to such a player. In Brazil fund portfolios are mostly invested in fixed income. In our case, we manage $25 billion from third parties and only about $1 billion is not in fixed-income investments. As Brazil changes, this proportion will alter and we will then need a partner with equity expertise.
In the next few years, do you expect Banco do Brasil to retain its dual character as a private and a public bank?
In a competitive environment it becomes difficult to maintain that duality. Since the treasury will not continue giving money to the bank, its survival will depend on its market performance. The tendency in Brazil seems to be to entrust the management of entrepreneurial activities to the private sector and this is likely to be true of Banco do Brasil.
Rebuilding the private sector
For decades Brazil thought it had found the perfect model to achieve rapid development. The state controlled large chunks of industry and channelled investment into the infrastructure projects the country needed. But since the stagnation of the 1980s, Brazilians have been aware of the need for a new economic model. Only now, with the wholesale privatization of the electricity and telecommunications industries, is the new order taking shape
This is a historic moment for Brazil. The country is currently revising one of the most sacred fundamentals of the development model it has pursued for decades. The basic assumption of this model was the direct involvement of the state, through the state-owned (or controlled) companies, in all areas of infrastructure to make it possible for private domestic and foreign companies to invest and grow.
The state created and nurtured large state-owned (or controlled) companies to carry out this involvement. And for a while the policy achieved tremendous results. Between 1950 and 1980 the economy grew by an average of 7% a year. Brazil was transformed from a country where the most important economic activity was coffee plantations to one with a strong and diversified industrial base.
But poor performance during the 1980s undermined confidence in the system. It has since become clear that Brazil was not facing a short-term crisis during that decade, but a turning point in its development. On one side, the government did not have resources to make the investment necessary for the continued growth and improvement of the country’s infrastructure. On the other, because of their inefficiency, low profitability or both, the government was obliged to provide constant subsidies to these companies. It became ever more clear that the country would need to embrace an alternative model: those companies would have to be privatized and the size of the public sector reduced.
This big change to Brazil’s development model is now taking place, made possible by the availability of a huge amount of private funds for investment in these long-term projects. With the support of the majority of the voters, Brazil’s privatization programme is gradually moving forward.
The government began by carrying out the least controversial privatizations. It sold companies which the state had taken over as a result of bankruptcy. At the same time it privatized companies in sectors where its presence could not be justified, such as the steel industry. The process gathered pace and is now reaching its climax with the sell-off of the electricity and telecommunications industries, key sectors of the Brazilian economy. By the end of next year, these industries should be totally privatized. The sale of controlling stakes in these two sectors should generate $50 billion in revenues for the government and is the major event forecast for the Brazilian privatization programme in the foreseeable future.
In the electricity sector some distributors have already been successfully privatized. Federal government investments in this area have been held through Eletrobras, the state holding company for the sector. Eletrobras has three key areas of activity: it is accountable for electricity generation, transmission and also for the sector’s banking activities. Meanwhile, distribution is controlled mostly by Brazil’s 26 states. Up to now, only some of the local distribution companies have been privatized. The sell-off of the distribution sector, currently in progress, is progressing without significant difficulties.
The key to success of the electricity distribution companies has been a policy guaranteeing that for a certain period, cost increases can be passed onto customers. Light, Rio de Janeiro’s electricity company, has obtained this right for no less then eight years. The measure gives investors confidence that the government will not prevent them from compensating for the effects of inflation, a common problem in the past. It also protects investors from another potential source of uncertainty, the fact that the future price of electricity at the generational level has not yet been decided. The measure therefore provides an insurance policy against any future government action to impose price reductions to benefit customers or to increase the cost of electricity purchased from the generators.
But the length of time for which increased costs can be passed on to customers has been progressively reduced. It started at eight years and was only four for the recent privatization of Coelce, a distributor controlled by Ceara state. But this may still give the newly privatized companies long enough to reap some profits. The current electricity selling price for the distributors is highly advantageous for them. According to Servulo Lima, analyst at the investment bank, Bozano Simonsen, their gross profit margin ranges between 50% and 55% on average.
What happens after the measure expires is not yet clear. The general idea is that the government will ensure that the efficiency gains achieved by the privatized companies will be passed on to customers. But it has not yet been decided what sort of parameters will be used to decide the size of price cuts. International comparisons may play a role, a possibility mentioned in the recent concession contracts. Brazil has higher tariff differentials (the average difference between distribution and generation tariff) than its Latin American counterparts. In 2002 and 2003, when most of the concession contracts of privatized companies will be revised by Aneel (the national agency for electric energy), it seems quite probable to expect price cuts for the distributors.
Aneel, created in 1995, is the government’s agency responsible for regulating the sector. The power for decision-making in the electricity industry is gradually being transferred from Eletrobras to this agency. Electricity distribution, however, is just one part of the sector. It is important to look at transmission and generation also to fully understand what is going on in the Brazilian electricity industry.
The future of transmission lines is a key issue in the process of privatization. Eletrobras, through its subsidiaries, owns a transmission grid which consists of 44,600 kilometres of transmission lines. The book value of the grid is approximately $20 billion. As the government intends to create a competitive market for the sector, it will be essential to have very clear and detailed rules about the way energy is transferred from one region to another. The way such a private grid will operate has not been entirely established. In the days when control over electricity was almost entirely in the hands of Eletrobras, planning was relatively simple. But in the new model the integration of the whole system will be a lot more complicated. There will be a number of independent generators, each aiming to achieve their own individual objectives.
There is also the possibility that industrial companies, those in the steel sector for example, could harness energy currently wasted within the manufacturing process and sell it to the grid. Therefore many observers are keen to know whether the grid will have open access, permitting all electricity produced to pass through it. A study by Eletrobras provides a possible answer. It forecasts that electricity consumption in Brazil will grow at a rate of 5.3% a year between 1997 and 2006. In this environment, there is more likely to be a shortage of electricity in Brazil than a surplus.
“All electricity will be welcome,” believes Marcelo Monteiro, analyst at investment bank Pactual. “Of course there will be certain regulations for the grid’s participants. However, the new model’s general rule seems to be clear. The government will structure the system in order to achieve competition, whenever it is viable.” Will the grid also be privatized? “Our opinion is that Eletrobras will keep the grid for three to five years and privatize it afterwards,” says Lima at Bozano Simonsen. Privatized or not, the main issue will be its legal set-up, to be designed by Aneel. The detail of the grid’s regulations will be key to determining the efficiency of the new model.
In the power generation sector the market is anxiously awaiting the formal announcement of the sale of Gerasul, part of the electricity-generation assets owned by Electrobras. The sale was to have been announced in February and is now expected in August. The way this company is sold could be considered a benchmark for the privatization of the rest of the generation industry, as it will be based on the model used for Gerasul’s privatization. The government may offer the generation companies something similar to the pricing guarantees given to the distribution companies. This may consist of guaranteed prices, secured demand or a long-term financing plan for the acquirers. But there will probably be no major surprises in this part of the privatization process, as the current average tariff of $33 a megawatt for the supply (generation and transmission) of energy is generally seen as reasonable. While in the long term, most of the industry expects to use a spot market for energy, based on short-term supply and demand, for the time being – the next five years at least – the government will continue to set electricity prices. When market prices are eventually established, the industry expects prices to fall gradually over time.
The privatization of Light and Cerj, two local electricity distributors in the state of Rio de Janeiro, show some of the problems the sector faces. Successfully privatized in 1996, both companies have encountered difficulties, especially since December. There have been shortages of electricity lasting more than a day in many neighbourhoods. This has raised concern about the efficiency of these companies and the efficacy of the whole programme. On the one hand, the companies have achieved strong profits. On the other hand the performance of the companies seems to have worsened as far as their customers are concerned.
Aneel has responded firmly, asking the two companies to act quickly to solve their problems. If they do not they risk penalties that could include the loss of their concessions. The threats seem to have hit home, and the companies are currently working hard to remedy the shortages. But what went wrong with these companies? One possible explanation is that what happened was a consequence of the companies’ restructuring, with the work force having been reduced. Many employees who had worked at the companies for a long time and were experienced at dealing on a daily basis with old equipment were fired. In addition, investment has not been made at the speed needed to solve the companies’ structural problems.
This controversy seems to have taught the government a useful lesson. The demands of the concession contracts, which had been rather generic in the case of Light and Cerj, have become more specific for the more recent sale of distributors, according to Monteiro at Pactual. “This is of course a learning process,” he says. “Contracts are getting better all the time.”
The privatization of the Brazilian telecommunications industry is well advanced and is expected to be fully implemented in the third quarter of this year. The government has been carrying out a certain amount of restructuring before the privatization takes place. Previously, the industry consisted of a holding company, Telebras, which controlled Embratel (the long-distance carrier) and 27 other subsidiaries, one for each of Brazil’s states. Last January, there was a spin-off from each of the subsidiaries, with the cellular assets separated from the fixed-line assets. The shareholders of the local subsidiaries received one share in each of the two new companies for every one they held in the old company.
At the same time the government created competition within a new cellular frequency spectrum, known as band B. The government divided band B into 10 concession areas, and invited bids for each one. The result, says Alexandre Gartner, analyst at Bozano Simonsen, was revenues of $8.3 billion. The only concession which has not yet been sold is for the Amazon region, because nobody was interested in bidding for it.
The next step in the process, taken on May 21, was the break-up of Telebras into 12 holding companies: three for fixed-line telecommunications, eight for the cellular business and one for long-distance calls. The shareholders in Telebras will receive one share in each of these new companies for each Telebras share they currently hold. Meanwhile, shareholders in the subsidiaries will continue to hold shares in the same subsidiaries which will, together with others, be controlled by one of the new holdings. Since these companies will probably go private in the future, with just the holding companies remaining publicly traded, there is a risk regarding their valuation. There will be roughly 130 traded telecommunication stocks. Many of them will be relatively illiquid and are likely to be overlooked by analysts.
But in spite of these problems, the design of the new models will permit competition in all parts of the telecommunications market. The controllers of band A cellular companies will face competition from band B companies and vice versa. The fixed-line companies will also face future competition on their concession areas. Moreover, from 2001 the government will begin selling concessions for PCS (personal communications services, a higher frequency spectrum), which will bring more competition to the market. And there is more good news. “Even with the death of Sergio Motta [the communications minister who was closely identified with the privatization programme] the process will continue and we really expect the privatization of the sector to occur in the third quarter of this year,” says Oliver Mizne, analyst at Garantia. In fact, many key details of the programme have been released recently and have met with the market’s expectations.
The way the bidding process has been arranged should also make it possible for this sector to grow rapidly in the coming years. The government could have approached privatization in two basic ways: one would have encouraged growth and the other would have produced a short term reduction in prices. They clearly chose growth. That makes sense in view of the fact that most Brazilians still don’t have a telephone line. A short-term reduction in prices would benefit only the minority which already has full access to a telephone line. But even so, the design of the privatization process should ensure that tariffs fall gradually over time.
The restructuring of Brazil’s electricity and telecommunications industries will lead to a fundamental transformation of the country’s infrastructure, with a positive impact on the economy as a whole. This wave of privatizations will certainly become a cornerstone of Brazil’s new development model in which the relationship between the public sector and the private sector will be quite different to that of the past few decades.
