2010 guide to Brazil: Continuity or change?


Laurence Neville
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Brazil is riding high on the economic gains of the past few years, with its membership of the elite of developing nations confirmed. But some have concerns about the direction the country will take under new president Dilma Rousseff.

Brazil emerged from the financial crisis and ensuing global recession a resurgent power, with economic and political credibility that could not have been dreamed of a decade earlier. The country’s international stature soared, buoyed by its resilient economy, forward-thinking politicians and the credibility gained by the elevation of the G20, of which it is a leading member, as the world’s premier economic club. Winning the right to stage the 2014 World Cup and the 2016 Olympics seemed to crown a year of unmitigated success.

A year later and Brazil still has much to be proud of. Both economic growth and financial markets have remained extremely robust while much of the developed world has been stuck in recession or, at best, experiencing sluggish economic growth that is expected to continue in the medium term. Brazil has been confirmed as a crucial part of the elite club of developing nations – along with China and India – widely expected to assume the mantle of the US as the driving force of global political and economic life.

President Luiz Inácio Lula da Silva

President Luiz Inácio Lula da Silva

However, the picture for Brazil is not that simple. To be sure, the country has enjoyed an orderly change of political power – something not to be underestimated given Brazilian and Latin American history – from the political icon that is President Luiz Inácio Lula da Silva (known worldwide as Lula) to Dilma Rousseff, Lula’s former chief of staff, his chosen successor and the first woman president of Brazil. However, the vacuum in the months before she takes office in January 2011 has been filled with uncertainty about Brazil’s future.

The government’s role

Chief among the worries of businessmen, bankers, economists and even ordinary people – although probably a small minority of the latter – is the fear that the state is on the verge of becoming too dominant in the economy. Such observers argue that Lula – despite a similar leftist background to Rousseff – was hemmed in by the experience of decades of economic mismanagement, statist intervention and hyper-inflation and consequently was a fairly conservative politician for much of his two terms of office from 2003.

In contrast, observers say that there is now the temptation to learn the wrong lessons from the financial crisis. It is a point of fact, they say, that government involvement in the economy – and particularly the use of state-owned development bank Banco Nacional de Desenvolvimento Econômico e Social (BNDES) – was instrumental in avoiding a freezing of the financial system, ensuring the continuation of lending to corporates and effectively softening the impact of the financial and economic crisis on the Brazilian economy.

However, those observers now hope that the government of President-elect Rousseff does not accept the arguments of some on the left that the only way to ensure security and stability for Brazil’s economy in the future is to maintain – and even deepen – the scale of government involvement in business life. They point to the message sent by Petrobras’s record-breaking $70 billion equity fundraising in September (see section on Petrobras), in which the government’s ownership of voting shares rose from 57.5% to 64% while the ordinary shares and preferential shares controlled by the government went from 39.8% to 48%.

Moreover, they point to promises made by Rousseff in the week after her election to raise the minimum wage more than the 5.5% proposed in the government’s 2011 budget bill. "What is needed is fiscal, social security and tax reform, not more spending," says Bernardo Parnes, chief country officer of Deutsche Bank in Brazil. Brazil’s welfare system is easily the most generous among leading emerging markets: some estimates put welfare spending at 11% of GDP – similar to countries in Europe with much older populations.

The government already plays a huge role in the economy through BNDES, investment, spending and stakes in major companies such as Petrobras, notes Nick Chamie, head of emerging market research at RBC Capital Markets. "The risk is that politicians always want more power not less. But the idea that the government’s role could expand further is unsettling to many people. Brazil needs to ask itself what the role of the government should be in relation to fostering growth, what is the capacity of the state to do that, and whether such spending represents an effective use of public capital."

The significance of the presidential election

In late November, President-elect Rousseff reappointed Guido Mantega as finance minister and appointed Alexandre Tombini as Banco Central do Brasil president, reassuring observers about the likely character of her regime. Nevertheless, widespread reporting of Rousseff’s Marxist background has tended to obscure her more pragmatic recent career.

Rousseff’s more recent background indicates that she is not the risk that some people perceive

Dilma Rousseff, Lula’s former chief of staff, his chosen successor and the first woman president of Brazil
"Rousseff’s more recent background indicates that she is not the risk that some people perceive," says Roberto Lampl, head of Latin American equities at Baring Asset Management. "She was not only an important part of Lula’s second-term team, as chief of staff, but has served on the board of Petrobras and Vale in the past. However, while she acknowledges that you have to maintain market-friendly programmes she can’t alienate the lower economic segments of the population, which form the base of her political support."

As a result of the need to maintain political support – and because of Rousseff’s own political predilections – it can be assumed that "some social policies not in keeping with a tight rein consistent with fiscal discipline" could be expected from the new government, according to Chamie at RBC Capital Markets. "Moreover, Rousseff’s reputation as a micro-manager could have implications for central bank policy."

In a note published in November by Standard & Poor’s, credit analyst Sebastian Briozzo says that a continuation of Lula’s policies can be expected in a broad sense. However, Briozzo argues that the differences in personalities and backgrounds of Lula and Rousseff could have implications in how they implement their agendas. "Unlike Lula, Rousseff’s background is more as an executive than a political negotiator or consensus builder," he says.

Briozzo believes this could constitute a significant strength and be particularly important if Rousseff chooses to focus on microeconomic reforms. "Those reforms will require a very active agenda executed in an efficient manner," he says. "However, it remains an open question what political skills Rousseff will bring to deal with the heterogeneous coalition that is the political base of her administration. Because of the size and diversity of Brazil, maintaining the support from the coalition that allows the implementation and execution of the government’s agenda requires a significant level of effort and skills."

Lowering public debt

Brazil’s fiscal position remains the country’s main weakness in comparison with its leading emerging market peers such as China. On the campaign trail, Rousseff promised to cut net public debt to about 30% of GDP by 2014 from 41% now by running a primary surplus (government debt minus interest payments) of 3.3% of GDP until the target is reached. "The point is, however, that no one believes the net debt figure," says Chamie at RBC Capital Markets. "There is trickery involved in achieving the figure. The more appropriate figure to consider is gross debt to GDP, which currently runs at 60-65% of GDP."

Ilan Goldfajn, chief economist at Itaú Unibanco, agrees that net debt figures have been manipulated in recent times through the inclusion of non-recurrent revenues and therefore are to be treated with caution. "The problem is that net debt includes assets, which includes loans to BNDES," he explains. "The general belief is that these loans are of less value than currently assigned to them because they are less liquid, longer-dated and reflect subsidies unlike the Treasuries BNDES is given in return." BNDES has been recapitalized by about R180 billion ($104 billion) over the past 18 months, potentially having a significant impact on net debt.

Nevertheless, Goldfajn believes Rousseff’s pledge to lower net public debt to 30% of GDP by 2014 is of value. "Although there are problems with the net debt figure, the point about reducing debt on that scale is that the primary surplus, which is currently running at 1.5%, needs to be much higher at around 3.5%," he says. "Likewise, should the target be changed to a nominal figure in real the important thing is that it is sufficiently high."

Investment: a brake on growth

According to Bradesco, the Brazilian economy shrank by just 0.2% in 2009 – compared to 4.1% for the eurozone and 2.6% for the US – and is on course to grow 7.6% this year. Over the past 20 years, Brazil’s GDP growth has averaged 2.7%, with huge booms and busts, while growth over the past eight years has averaged 4.5%, with a much more stable profile. Bradesco expects growth to return to this latter average in 2011, following above-trend growth after the economy recovered from the shock of contracting 3.4% in the fourth quarter of 2008.

What is crucial to future growth in the implementation of reforms. Bradesco estimates that average growth of 4.76% is possible from 2011-20 but that this could increase to 6% a year if reforms are implemented. "The main problem in relation to potential growth is one of investment," explains Goldfajn at Itaú Unibanco. "Brazil currently invests 18% of GDP – a low level compared to most Asian economies, which invest around 30%, or China, which typically invests 40% and invested 50% during the crisis."

"The lack of investment is a legacy of the 1980s and 1990s when macro-economic instability made it pointless to invest. Now there is a willingness to invest but the government is expanding spending too fast and consumption is rising too fast, so investment is being crowded out"

Ilan Goldfajn, chief economist at Itaú Unibanco

Although Brazilian investment is gradually increasing and is expected to reach 20-22% in the coming years, according to Goldfajn, that would still enable GDP growth of just 5%. "The lack of investment is a legacy of the 1980s and 1990s when macro-economic instability made it pointless to invest," he says. "Now there is a willingness to invest but the government is expanding spending too fast and consumption is rising too fast, so investment is being crowded out."

So how can investment be increased? "The government needs to maintain or increase investment in infrastructure, which there is certainly a willingness to do" says Goldfajn. "However, there also needs to be a willingness on the part of government to reduce current spending so that room can be created for the private sector to invest."

Politically it will be difficult to restrict increases in the minimum wage, restrain public sector pay and lower the tax burden, which at 36% of GDP is high for an emerging market, according to Goldfajn. More generally, measures need to be introduced to enable the long-term financing of investment without the involvement of BNDES (see separate article on banking).

Lampl at Baring Asset Management says that there has been some progress on greater involvement of the private sector in infrastructure investment, with successful auctions of road concessions and a proactive approach from Companhia de Concessões Rodoviárias. "However, in many instances private sector investment remains impossible for a variety of reasons, [such as] the role of BNDES, government bureaucracy and tough environmental considerations that slow projects," he adds.

Indeed, David Beker, head of Latin America economics and fixed income strategy at Bank of America Merrill Lynch, says that while there is widespread recognition of Rousseff’s commitment to infrastructure development, "there is a perception among investors of a potential deterioration of the regulatory framework, which could discourage sorely needed investors". Some observers cite changes in Petrobras’s distribution of revenues, in favour of the government, as an example where investors feel short-changed.

Ultimately, the infrastructure sector needs to be liberalized for Brazil to get the scale of investment it needs, according to Lampl. "We need to see more auctions for concessions across the country and across all sectors: for example, airports in Brazil are all currently state-owned and require significant investment," he says. "Union strength in the sector and legal problems make any opening up of airports unlikely. Similarly, huge investment is needed in railroads – this is happening, but too slowly."

Inflation and interest rates

Inflation is a spectre that continues to haunt Brazil despite it being benign by historical standards in recent years. Since coming down from 12.53% in 2002 (according to figures from the Instituto Brasileiro de Geografia e Estatística) to 3.14% in 2006, it has remained within the fairly tight range proscribed by the central bank of 4% plus or minus two percentage points. In 2010, Bradesco expects inflation for the year of 5.3%. What happens next is in some dispute – and of critical importance given Rousseff’s pledge to reduce interest rates.

"When people ask if the world economy can slow Brazil, I reply I hope so. The current benign stagnation in the global economy slows and mitigates inflationary pressures in the Brazilian economy. A rapid recovery of the global economy could cause Brazil to overheat"

Octavio de Barros, chief economist at Bradesco

Bradesco contends that inflation will converge with the target and average around 4.8% in 2011 and 4.5% in 2012. "The major risk is that of a rapid global recovery," says Octavio de Barros, chief economist at Bradesco. "When people ask if the world economy can slow Brazil, I reply I hope so. The current benign stagnation in the global economy slows and mitigates inflationary pressures in the Brazilian economy. A rapid recovery of the global economy could cause Brazil to overheat."

According to de Barros, companies’ perception of industrial competition is helping to constrain inflationary pressure. "A Bradesco survey indicates that 25% of respondents report growing competition in their market – both from new internal competitors and from imports – and that competitive pressure is holding inflation down," he says. "We believe it will allow the Selic rate [Banco Central do Brasil’s overnight lending rate] to be maintained at the current level of 10.75%."

Markets, however, take a less optimistic view of inflation. "Our forecast and the market’s, expressed through interest rate futures, is of inflation of 5.5% this year and next year," says Itaú Unibanco’s Goldfajn. "It is correct that increases in commodity and food prices were being cancelled out by the appreciation of the real, given Brazil’s position as a commodity exporter, but not anymore. The risk is that higher inflation expectations domestically become embedded. Moreover, there is the simple fact that domestic demand is growing at 7-8% while supply is growing only 4-5% – the gap is being filled by an increasing current account deficit, which is also inflationary."

In addition, inflationary pressure is also coming from the rapid growth of industrial production, which rose by 10.62% in 2010, according to Bradesco. "Elsewhere, the service sector is especially at risk, with real incomes growing rapidly, potentially leading to inflation," says de Barros. "That could increase pressure on interest rates, which could make the exchange rate situation more serious that is currently the case."

So how does the inflation outlook square with Rousseff’s pledge to reduce interest rates? There is widespread concern about how Rousseff – who was deliberately vague about most of her financial policies during the election – plans to fulfil this goal. "Rousseff wants to lower real interest rates, which are among the highest in the world at a real rate of 6%, to a real rate of 2.5-3%," says Baring Asset Management’s Lampl. "However, to do that without spurring inflation will require fiscal tightening."

Reining in government spending is by far the most effective way to control inflation, according to a survey of investors by the Banco Central do Brasil in November, which indicated a cut in public spending of 1% of GDP over a year could lower the Selic rate by 100 basis points. However, the fear is that the difficulty of reducing spending could prompt Rousseff to consider other methods to lower rates. One possible solution would be to fudge the issue. Rather than seeking to lower real rates, Rousseff could put pressure on the central bank to lower the Selic rate. "This would simply make the yield curve steeper due to fears about inflation," notes Douglas Smith, head of Latin America research at Standard Chartered.

However Rousseff chooses to try to lower rates, her actions will be extremely informative of her general approach to economic policy. "Policy changes designed to engineer the lowering of rates will be central to the evolution of government policy under Rousseff," says Chamie. "They will indicate how serious the government is about addressing some of the underlying problems in Brazil’s economy."

The appreciation of the real

The appreciation of the real – as Brazil’s economy has prospered and global commodity demand risen – has been one of the defining characteristics of the Lula era. The currency has more than doubled in value since Lula took office in January 2003 and has gained more than a third against the dollar since the start of 2009. "To some extent, the appreciation of the real in recent times has been softened by the fact that almost all currencies have appreciated against the dollar," says Chamie at RBC Capital Markets. "Consequently, there have been fewer pressures from bilateral trade than would otherwise be the case."

Nevertheless, in a bid to control the pace of appreciation, in October 2009 the government introduced a 2% Imposto sobre Operações Financeiras (IOF) or tax on portfolio inflows, which targets foreign investment in Brazilian fixed income and equity markets.

Since then, the IOF for fixed income investments has been increased to 4% in October this year and then, in the same month, hiked further to 6% (with the tax remaining at 2% for equities). At the same time, the central bank has continued its frequent dollar auctions – two a day since September – to reduce pressure on the real. In early November, Brazil’s foreign exchanges reserves stood at $285.2 billion compared to $230 billion a year earlier.

Opinion on whether the IOF has served its purpose is sharply divided. "At the margin, the exchange rate has stopped increasing for now," says Goldfajn at Itaú Unibanco. To be sure, by mid-November, the real was 3% lower than a month earlier when the IOF was increased while other currencies continued to appreciate against the dollar. However, de Barros at Bradesco says that "no serious economist believes that the government can change the trend for the exchange rate". He adds: "The government’s objective is only to slow the rate of appreciation and reduce volatility. The Ministry of Finance is fully aware of the anti-inflationary pressure that results from appreciation."

What is not disputed is that the increase in the IOF has some negative consequences for Brazil generally and the government directly. "Brazil’s economy runs structural nominal fiscal deficits, which naturally leads to increasing public debt in nominal terms," explains Diego Donadio, head of foreign exchange and interest rate strategy for Latin America at BNP Paribas Brasil. "To finance such debt the participation of foreigners is important and the IOF increases derailed investors’ confidence in the regulatory framework. Foreign investors hold more than 55% of the outstanding debt of long-dated fixed-rate bonds (a total of R56 billion) and 10% of the total public debt (R150 billion)."

The IOF also runs the risk of reducing the government’s ability to fund the current account deficit, which the government expects to reach $49 billion in 2010 – or around 3% of GDP – and $60 billion in 2011. "Currently Brazil is relying on portfolio inflows rather than foreign direct investment (FDI)," explains Beker at Bank of America Merrill Lynch. Before the crisis, in the first quarter of 2008, FDI was $36.8 billion while portfolio investment was $45.2 billion. By the second quarter of 2009, falling markets had led to a sharp outflow of portfolio funds (a decline of $11.8 billion) while FDI remained steady at $41 billion. The most recent figures for the third quarter of 2010 show FDI of just $30.9 billion compared to portfolio investment of $66.7 billion. "Changes in the IOF run the risk of reducing portfolio inflows at a time when FDI inflows aren’t there to fill the gap," says Beker.

see also:
Brazil: Continuity or change?
Drilling for the future
Banking: Levelling the playing field