One of the great gainers from falling global interest rates will be emerging market financial assets – though not everywhere. I’ve just visited one emerging market that should outperform this year: Brazil.
Brazil’s artificially constructed capital is Brasilia. In Brasilia, the Congress building is surrounded by concrete wings jutting out into the sky at right angles. They house the government ministries. It is a symmetric idealized vision of the perfect corporate state, built under the old 1980s dictatorship, where everything was planned and nothing flew.
Much of Brazil’s recent better fortune is due to the undoing of that dictatorship. But its legacy still hangs heavy, particularly when it comes to the judiciary and the constitution.
It means reform will always be gradual and politically convoluted. But that may suffice for global investors, at least over the next year.
Brazil’s recent success has been based on four policy pillars: a floating exchange-rate producing a successful, non-inflationary, depreciation of the currency; a strong central bank successfully targeting inflation; a Fiscal Responsibility Act that seems to have moved the whole political spectrum to the right; and privatizations that have made the economy more efficient and brought in enough equity capital to cover the current account deficit. These things will continue over the next year, unless there is a major mishap that interrupts the flow of foreign equity capital.
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The policy pillars have kicked Brazil’s economic growth to above 4% a year without incurring a major external deficit.
Productivity is also rising – the result of the end of hyperinflation and increased foreign direct investment.
And most important of all, in a low-growth world, Brazil’s is inoculated from disaster by domestically-inspired demand. The positive effects of having real money in their pockets after the end of 1990s hyperinflation are still working through Brazilian households and businesses into higher consumer and corporate investment demand.
Also, the central bank under Arminio Fraga is a firm believer in the new economy miracle for sustainable growth. So it will continue to cut interest rates. The combination of cheaper capital and fast-growing profits makes Brazilian equities look attractive among emerging markets.
If this sounds like a blanket approval of Brazil, it is not. In reality, the dream of Brazil becoming a global super-economy will probably never get outside the four tight walls of Brazil’s darker realities. Rotten wealth distribution and poor education could sap support for the reform process at some point in the future, as it has elsewhere in Latin America.
Indeed, the next two years up to the presidential elections will be light on economic and political reform. The most to be expected is making the central bank autonomous. And longer- term, Brazil is vulnerable to a slackening of fiscal discipline. For the next two years, Brazil will not use its current good economic fortunes to sustain a reduction in public debt. And Brazil has far too much public sector debt, which has been rising faster than in the rest of Latin America.
Brazil’s fiscal success depends on sustaining strong real growth and on real interest-rate stability. In 2000, the government achieved its budget targets. This year’s target is for a budget surplus before interest payments of 3.1% of GDP. That would be enough to drive the debt to GDP ratio down slightly in 2001.
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The worry is that any excess of revenues over that target will be spent. Just as in the US, Brazil should use any excess to run down its debt because of the potential for negative surprises. For example, the judiciary and legislature have recently awarded themselves massive pay increases. And a court decision is likely to force the government to dish out up to $20 billion for unpaid pensions.
However, all these overshoots can be managed by Brazil’s adept policy-makers within the scope of the Fiscal Responsibility Act. This law ensures that increases in spending must be matched by increases in taxes or other spending cuts. So fiscal management over the next two years will be okay even if not superlative.
Brazil is unlikely to deliver many positive surprises on the political front either. The leftist opposition Workers Party appears to have been converted to the market economy as a necessary evil. But their plans of getting to a better society through wealth redistribution create some pretty scary political alternative scenarios for capital markets in Brazil. I don’t buy the line that no party or politicians in Brazil preach fiscal or monetary irresponsibility any more – less maybe, but some still do.
But my best guess is that the right, currently without a candidate to succeed President Fernando Henrique Cardoso, will still win the next presidential election in 2002.
Nevertheless, Brazil’s reformist policy makers have to sow with a light touch that often reaps a sub-optimal result. That this isn’t perceived as a threat by markets is often down to the deft touch of a very brilliant set of bureaucrats at the central bank and finance ministry. Spending a few days with these people and comparing them to many of their Asian and eastern European counterparts convinces me that they are worth about ten points on Brazil’s P/E.
But major tax reform – involving the states – and political reform won’t happen before the presidential election. In Brazil, every change in the labyrinthine constitution requires that a bill survives multiple passages through both houses of Congress and two-thirds majority votes in each house each time. That means reform will always be a tortuous process requiring great energy to achieve even marginal improvements.
All in all, the best investment in Brazil right now is to buy the home-grown growth story at a reasonable price. That means equities above all.
