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President Fernando Henrique Cardoso |
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There are a lot of Brazils. As far as the Euromarkets are concerned, Brazil is the largest and most important economy in Latin America, a liquid proxy for the emerging-market asset class as a whole. The CEO of a Spanish multinational will have a somewhat different view. He will see Brazil as an enormous untapped market, a country so potentially rewarding that no international company can afford not to be there. A tourist will be very happy sipping caipirinhas on the beach at Copacabana. The historian sitting next to him will see a country in an uncharacteristic period of relative economic and political stability. He will probably chuckle over his cocktail at the hubris of those who have pronounced an end to the country’s turmoils.
The boys playing football on the beach know that their country has one of the most unequal distributions of wealth in the world. The middle-class worker stuck in a traffic jam and watching them out of the window of his new Ford Ka worries about whether he can afford to use his credit card, which is racking up interest at 10% a month.
The owner of the factory that produced parts for the car is packing a weekend bag in his beachfront apartment, watching the whole scene from his 28th-floor balcony. He’s comparing the view with the one he’s going to have in 12 hours’ time from his other balcony on Central Park South, next door to those rich teenagers whose Brazilian music videos are interrupted by Nike advertisements featuring Brazilian football players.
And all the while, in São Paulo, bankers are working long into the night trying to prepare for a brave new world of lending money to Brazilian companies. In turn, they hope, those companies will start disclosing information about themselves as a result of the need to access capital markets.
The only thing that all of these people have in common is their love for Brazil. It’s a love that is nearly always tempered by exasperation at the country’s inability to really make it. The good news is that the prospects for Brazil have never been brighter. The bad news is that history teaches that such times are precisely when things have started to go wrong.
The Brazilian economy is not the problem. Growth is solid, at over 4% a year; inflation is low, on target, and falling; employment is rising steadily; exports are soaring, and the trade deficit should soon, belatedly, be wiped out. The team of finance minister Pedro Malan and central bank president Arminio Fraga has barely put a foot wrong since Brazil devalued its currency at the beginning of 1999. The only real macroeconomic worry is the current account deficit, which is over 4% of GDP, but that has been more than accounted for in recent years by massive net foreign direct investment.
The domestic capital markets, however, are looking less sunny. Brazil is sorely underleveraged, one of the reasons that the 1999 devaluation was not sufficient to bring the country’s trade account into the black. The other reason is that Brazil taxes its exports, a situation unlikely to be remedied before 2003 at the earliest.
Corporate issuance in the domestic debt markets is rising, but from an incredibly low base. Equity offerings remain almost unheard-of. In fact, it’s more common to find companies buying back whatever small amount of stock they do have listed than it is to see any IPOs. Volumes on the Brazilian stock exchange, Bovespa, are falling, and it’s not clear that a rise in the amount of money that domestic pension funds have under management will make up for the more general exodus from local shares to American depositary receipts listed in New York.
Part of the problem is that Brazilian banks and pension funds have historically done very well for themselves with very little effort simply by lending to the government. With interest rates and government borrowing coming down, they are going to have to start lending more to the private sector. That’s not a change that happens easily overnight: credit analysis of both companies and consumers is something new in Brazil. But at least the banking system is strong. A large part of it is foreign-owned, and it has easily enough reserves to be able to afford to make a mistake or two along the way.
Consumer credit, on the other hand, is still a far from efficient market. Not only do credit card interest rates stand at 10% a month when treasury rates are only 1% a month, but it’s almost impossible to get a mortgage. “Our biggest pent-up demand in Brazil is for housing,” says Roberto Rocha, equities director at Deutsche Bank in São Paulo. But laws that once made repossession almost impossible, preventing lending, are now being replaced with laws that keep property in the hands of the bank until the last payment has been made, preventing borrowing.
Nearly every analyst in Brazil has a shopping list of laws that need to be passed and reforms that need to be made – to everything from the tax and social security systems to the independence of the central bank. Most of São Paulo, it seems, doubts that anything will be done before the elections at the end of 2002. The mood in Rio de Janeiro is more upbeat, however, with hopes high that as employment and consumer confidence rise, president Fernando Henrique Cardoso will be able to build consensus in Congress to pass much-needed legislation.
Obstacles to reform
There are many obstacles. For starters, Cardoso is a lame duck, constitutionally debarred from running for re-election. Congress is fractious at the best of times, and never more so than when there’s a wide-open election in the offing. And historically, the best chance of getting reforms through is when a crisis has concentrated minds: ironically, the very success of the Brazilian economy over the past couple of years has reduced the perceived urgency of reforms.
| Winston Fritsch | ||||||
“There is a paradox that very positive, encouraging numbers may be the cause of the risk,” says former finance minister Marcilio Marques Moreira, now a rainmaker for Merrill Lynch in Rio de Janeiro. “In Latin America, reforms go better in a crisis. If things go reasonably well, there is reform fatigue. That is the main risk, a slowdown of reforms and privatizations.”
Analysts are unanimous that questions about which reforms might be possible have to be seen in the context of what the Cardoso administration has already achieved. Its key achievement was the fiscal responsibility law, watershed legislation passed at the height of the devaluation crisis when Brazil was negotiating a massive bail-out package with the IMF.
“The urgent things have already been done,” says José Carlos de Faria, Deutsche Bank’s economist in São Paulo. “We had the fiscal responsibility law approved. We have time now.”
The fiscal responsibility law is one main reason why foreign direct investment has held up so strongly over the past couple of years and why, for the time being, people aren’t too worried about what might happen in the event the opposition wins the presidency in the 2002 elections. The country has essentially committed itself to keeping its fiscal deficits shrinking, which should single-handedly be sufficient to ensure that interest rates can continue to fall and private-sector investment continue to rise.
“It’s much easier now to imagine that Brazil will have much more reasonable fiscal accounts in the future, even if it is not this coalition which will stay in power after the elections in 2002,” says Andre Loes, chief economist at Santander in São Paulo. “Even if it is the opposition, which traditionally gives less importance to fiscal adjustment, you’ve introduced much automaticity with the fiscal responsibility law, which is very good.”
And Richard Rainer, Merrill Lynch’s managing director for investment banking in São Paulo, points out the silver lining to the black cloud of congressional sclerosis. “It takes a long time to make a decision in this country, to pass laws, to make constitutional amendments,” he says. “But if things are done properly, it’s very difficult to go back, as well. That’s the advantage.”
Winston Fritsch, the chairman of Dresdner Bank Brasil, also likes the legislative ju-jitsu by which congress’s aversion to change can be used to solidify reforms. “Reforms are tricky things,” he says. “When you start doing them, you run against what analysts call the status quo bias. Lots of people fear to lose, even though they don’t have a direct interest. Then you create a new coalition of people who back the new world. We have been implementing reforms for quite a long time, almost 10 years. So there’s already a coalition of employers and employees who would hate to go back to a closed economy, to a state-owned economy. I think that’s irreversible, as is fiscal balance. Some of the opposition may not like it, but they would never say that in public, or run against it. So I think that even if the opposition wins, the fundamentals of this growth and stability background to the Brazilian economy won’t change. I’m quite confident about that, and so are the markets.”
The social security deficit, however, is not covered by the fiscal responsibility law. And while there has been some attempt to rationalize the system for private-sector workers, it remains untouched as far as civil servants are concerned.
“You have a lot of acquired rights in Brazil,” says Loes. “For instance you generate 4% of GDP deficit in the social security account for retired civil servants. fihich is a shame, because you have all the country transferring 4% of the national income to a bunch of retired people.”
A demographic opportunity
Retired civil servants get incredibly sweet deals in Brazil, and receive money that could be put to much better use building up the country’s physical and human infrastructure. And far from getting better, the problem is set to get worse, with the social security deficit as a proportion of GDP rising steadily over the next 20 years even as Brazil’s demographics become increasingly unable to support it.
| Arminio Fraga | ||||||
“There is an incredible demographic opportunity,” says Moreira. “We have a very young country. The bulk of the nation is between 15 and 45 years old, the high point of learning capacity and the high point of productive capacity. That will not be for ever. It is the optimum moment now to have many reforms, to increase our savings rate, to give this push.”
The big question is whether a new government led by today’s opposition will see the same urgency to strike while the iron is hot. “All the changes we have had in the economy since 1994 are the work of Fernando Henrique Cardoso,” says Roberio Costa, the senior economist at Citibank in São Paulo. “Cardoso was finance minister in 1994, he became the president in 1995, and then he was re-elected in 1998. So this change is really something that worries us. It is a very important turning point, and we can have the continuation of this trend, or its abortion.”
Cardoso’s popularity, while showing a decided improvement from the approval ratings of around 12% seen at the end of 1999, is still very low, with disapproval ratings still much higher than approval ratings. This is bad for two reasons: Cardoso’s unpopularity reflects on his coalition as a whole and could reduce the number of seats they keep in the general election. It also diminishes the control that he has over the coalition, and the chances he will be able to keep it together and nominate a unanimously approved successor candidate.
All the same, there’s a lot of optimism that the coalition will come through in the end, even if the markets are in for a bumpy ride. “There’s going to be more volatility next year as each opinion poll comes out, if it’s some extremist, some guy from the left,” says Merrill’s Rainer. “This is a true democracy here. People change their views. You go from the left leading throughout the elections, and all of a sudden towards the end there’s always a change. The voting generally comes out conservative. But I think there’s going to be much more volatility next year. Much more volatility.”
Dresdner’s Fritsch is counting on economic growth to come to Cardoso’s rescue. “The economy has tremendous inertia, it’s moving up in a very solid cycle, not inflationary, so I think the timing’s perfect,” he says. “The political timing for an election is very, very good.”
Deutsche Bank’s Faria takes the psephological approach. “In Brazil, if you look at the last three elections, the candidate who was leading the polls one year before the election did not get elected. There is a chance that there will be continuity and the coalition will remain in power.”
And Santander’s Loes is even upbeat about the prospects should Cardoso’s man lose. “Sometimes when the opposition comes to power, they are even tougher than the current government,” he says. “Finally they discover that it’s very easy to be like the club of students in the university saying everybody’s a bastard. When you come to power you see how difficult it is. So in some of the municipalities and even some of the states where the opposition is in power, they have been doing a very good job on the fiscal side.”
Of course, the fiscal side has already been taken care of, largely by the passage of
the fiscal responsibility law. The challenge now for the remainder of this government’s term in office and for whoever succeeds Cardoso in office is to implement the rest of the reforms needed to turn Brazil into a world-class economy.
Reform hit lists
At the top of most people’s lists of needed reforms are social security reform, to reduce the huge deficits in the social security system; pension reform, perhaps including partial privatization, to give people some control over their own pensions; corporate law reform, to force companies to recognize minority shareholder rights; tax reform, to make the export sector and financial markets more efficient; and the independence of the central bank.
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Most observers place little hope on any of these things being achieved before the elections. Central bank independence is probably the most likely, if only because it’s generally defined in only the vaguest of terms.
“When you talk about central bank independence, I think this law will be passed before the end of Cardoso’s government. But there’s not unanimity about what central bank independence means,” says Dresdner’s Fritsch. “In practice, I think the central bank is independent and it has a clear mandate to fight inflation. And it’s working. It’s respected. In Brazil, the central bank has a clear mandate, and as far as Brazilians think inflation’s an issue which has to be fought, the central bank has tremendous independence.
Because that’s where the buck stops. It’s not by legislation that you give a central bank independence. The key issue is how the population see inflation fighting as a social objective. That’s what gives independence to the Bundesbank.”
Many would like to see Arminio Fraga stay on at the central bank, if only for a transitional couple of years, in the event of an opposition victory in the presidential election. There seems little chance of that at the moment, but with finance minister Malan certainly leaving office at the same time as Cardoso, some sort of continuity would be very welcome. Brazilian financial markets have never seen their central bank as successful or well-respected as this one is, and there are some fears that the departure of Fraga could mean the end of a golden inflation-targeting era. After all, he has only held his job for two years.
“The central bank needs to continue to be managed as it has been for the past two years,” says Tomas Malaga, chief economist at Banco Itaú in São Paulo. “In several ways much of the growth that we are experiencing right now is thanks to the right monetary policies and the right inflation target. So the next government somehow has to inherit this system. That’s going to be tough, because there is too much ignorance about what monetary policy can do and cannot do, what central bank independence means.”
Beyond that, social security reform would be a very good place to start, reckons Santander’s Loes, because it would free up a lot of resources that could then be applied to tax reform. If the social security system weren’t running a 4% of GDP deficit, there would be a lot more scope to cut or abolish the sort of taxes that are choking the system, especially those on exports and financial transactions.
“It was a good decision to do the fiscal adjustment,” says Loes, “even at the price of all those crappy taxes. But the way we did that, you turned the tax structure into something even more regressive. This is something that we have to fix.”
Insufferable imposts
Top of the list of levies that need to go is the CPMF financial transactions tax, a kind of stamp duty that almost seems designed to discourage the development of domestic capital markets in Brazil. It also applies to exports, placing Brazilian companies at a competitive disadvantage, hurting the real and thereby preventing interest rates from coming down faster.
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“You have a problem with the debit tax, the CPMF tax. That’s a constraint,” says Merrill’s Rainer. “It’s recognized that that’s an inefficient tax. It doesn’t disappear this year, it doesn’t disappear until the middle of 2002, maybe it gets renewed again, but at some point it disappears, when there’s some kind of tax overhaul in the country.”
But it’s not clear how much time the government has. “We cannot delay tax reform any longer,” says Itaú’s Malaga. “Because otherwise we will put too much pressure on the floating exchange rate. Our exports are not competitive. I’m sure this year exports are the driving force of the economy, and the exchange rate is at the right level. If we can simplify taxes, probably exports will do even better.”
Malaga is looking for partial tax reform in the near future, the sort of thing that the federal government can do on its own without having to enter into tortuous negotiations with the states.
In Rio, however, Merrill’s Moreira says that the top of the Cardoso government is preoccupied not by tax reform, which is politically dangerous even if the states are excluded, but by corporate governance. “We need capital markets,” he notes. “The government is giving top priority to the corporate laws, which is very important for minority rights and governance. I believe it can be passed before the election. There are some groups against, but if the government shows strength and gives it high priority, then it can. It decreases the need for the new market. But it goes a step beyond this law.”
The development of a more vibrant equity market is a major priority (see box). For the time being, however, the real growth has been in the domestic fixed-income market. Companies are issuing what are by Brazilian standards very long dated bonds – up to three or five years at floating rates. It’s not obvious that investors are really being compensated for the extra risk, however: the spreads between corporate and government debt are very tight.
Issuers have overwhelmingly been strong banks and foreign-owned corporations, and there’s little evidence of the market making clear distinctions between credits.
“We have seen very significant growth in commercial paper, debentures, bonds and notes,” says Itaú’s Malaga. “It’s growing because the fund industry is growing. It’s a good time for companies to issue bonds.”
Between bond issuance and bank lending, there’s no doubt that Brazilian companies are starting to get leveraged. It’s long overdue: Brazil has been one of the most underleveraged economies in the world for years. But the problem is that it’s far from clear that Brazil, with its large current account deficit, is equipped to deal with the boom in growth that could result from increased borrowing and investment.
“Brazil has no problem with financing the current account deficit now,” says Dresdner’s Fritsch. “The problem is if Brazil wants to grow at 6%, then you either grow domestic savings, or you have some problems. I don’t fear the current account deficit at present growth rates. But this is below what the animal spirits of the entrepeneurs are going to deliver. If you go on bringing interest rates down, you have to put on the brakes, because the current account may deteriorate.”
When exports were anathema
In the long term, the domestic savings rate in Brazil might rise, especially in the wake of pension-fund reform. But in the short term, there’s no doubt that the biggest problem is the current account deficit. The Brazilian national development bank, BNDES, is attacking the problem by trying to boost exports by acting as something of a national development bank. Brazil’s exports are very low, because the country is only slowly coming out of the era of import substitution, when exports were anathema and the country was determined to be self-sufficient in everything.
| Andre Loes | ||||||
Merrill’s Moreira gives a brief history lesson. “Our economic history was marked by cycles of exports, beginning with exports of wood, especially Brazil wood, which was a very important red dye in the 16th century,” he says. Brazil went on to export sugar, cattle, gold, during the Industrial Revolution, and then coffee. “It was mainly agrarian exports,” says Moreira. “So when we entered the industrialization process, exports were somewhat demonized. Import substitution was the word. That mentality still persists.”
That explains, says Moreira, why Brazil’s trade balance didn’t shoot into surplus following the devaluation of 1999. “If you don’t have this assumption when you change the exchange rate it’s not immediate,” he says. “Having said that, it’s interesting how new industries and new sectors are leading to exports. Last year we exported $1 billion of mobile telephones. We export a lot of furniture. We export fish, and scallops. These are areas where Brazil has enormous potential.
Fisheries, for example. We have 8,500 kilometres of coastline. Already one third of the exports is based on fish. There’s nobody who can export pulp at Brazilian prices.
Nobody can export chicken. Our chicken costs $1,000 a tonne. In Europe there’s an $800 subsidy, in the US a $600 subsidy per tonne.”
Santander’s Loes looks at that 8,500 kilometre coastline and sees something else. “Brazil has a deficit in the tourism account, which is ridiculous. I don’t think that Brazilians should not go abroad. We should just be much more concerned about tourism than we are. This creates a lot of jobs, much more than industry. This country’s very beautiful, very pleasant, and the people are very nice. And you have sun almost all the year. It’s ridiculous that you don’t have a well-developed tourism business in Brazil. It’s incompetence.”
Between the export sector and the booming infrastructure sector, Brazil is likely to be able to continue to attract a lot of foreign investment. FDI won’t necessarily stay at the level of 5% of GDP it reached in 1999 and 2000, but it should be able to cover most of the current account deficit.
But Brazil’s dependence on foreign inflows does make it much more vulnerable to external shocks than most economies whose exports account for only 8% of GDP. “The big risk from outside Brazil is that Brazil has a 4% of GDP current account deficit,” says Loes. “If it was 2% I would not bother about external shocks.”
Even so, the two biggest exogenous risks on the horizon seem relatively benign for the time being. Argentina, with the support of the IMF, is holding itself together. Even if Argentina did implode, most economists reckon that Brazil would be severely affected for only a few months. After all, Argentina’s economy is very small by Brazilian standards, and trade between the two countries is modest.
Minimal US exposure
And with US Federal Reserve chairman Alan Greenspan aggressively cutting interest rates, the risks of a severe recession in the US also seem to be dissipating. Again, Brazil is much less exposed to the US than, say, Mexico is: The US accounts for little more than 20% of Brazil’s exports.
The biggest risk is probably in the other direction: that negative wealth effects and low growth in the US will spill over into Europe and force companies to think twice before continuing to throw billions of dollars at Latin American expansion plans.
But foreign direct investment increased steadily through the Asian and Russian crises and then Brazil’s devaluation; it’s not likely to plunge just because the US is slowing down. The telecom licences have been bought and paid for, for instance; now the telecom infrastructure needs to be installed.
Of all the different Brazils, the one seen by the Spanish CEO is probably the one that will ensure steady, if not explosive, growth for the foreseeable future. Brazil rose to third place in February’s rankings of the most attractive investment destinations in the world, behind only the US and China, according to AT Kearney’s FDI Confidence Index. It is also the most attractive FDI destination among Spanish companies. No matter what happens either domestically or in the US, that’s unlikely to change.
