Odair Abate, the chief economist of Lloyds TSB in São Paulo, explains that Brazil is gripped by a crisis of confidence. The worse it performs, the less faith the population has in it. That, in turn, only serves to exacerbate the situation to the point where Brazil now compares unfavourably with every other Latin American nation, including Argentina. The good news is that for the moment this crisis is confined to the fortunes of the national football team. The bad news is that there’s no reason why it might not spread to the economy.
A quick glance at Brazil’s macroeconomic statistics is enough to show the straits it’s in. Most of the blame can be laid at the feet of the currency, which has depreciated by 25% this year, forcing the central bank to raise interest rates in an attempt to stick to its inflation target of 4%. The central bank gave itself a two percentage point margin on either side, but most analysts now believe inflation is going to overshoot 6% this year, an embarrassing outcome for central bank president Arminio Fraga.
With much of Brazil’s debt dollar-linked, dollar-denominated, or floating-rate, every depreciation and rate hike only serves to increase the country’s debt burden. In the first half of 2001, Brazil had to pay R$59.2 billion ($23 billion) in interest expenses, compared with R$39.9 billion in the same period of 2000 – an increase of more than 48%. Total government debt soared to 51.3% of GDP in June 2001, up from 46.5% in June 2000, and even a R$6.7 billion increase in Brazil’s primary surplus couldn’t stop the government’s total deficit for the first half of the year rising more than 75% year on year to R$28.8 billion from R$16.2 billion.
| Arminio Fraga | ||||||
GDP growth was negative in the second quarter of 2001, for the first time since Brazil’s devaluation at the beginning of 1999. Forecasts for overall growth in 2001 are now generally between 1.5% and 2%, a far cry from the hopes of 4.5% growth at the beginning of the year, and barely more than Brazil’s annual population increase of 1.3%. The depreciation of the currency is likely to mean that Brazil’s nominal GDP in dollars will shrink to $515 billion in 2001 from $592 billion in 2000, according to Francis Freisinger, Merrill Lynch’s Latin America economist.
Meanwhile, Brazil’s current account deficit has been soaring. The Institute of International Finance (IIF) pegs it at $28 billion, or 5.6% of GDP, this year, up from $24.4 billion, or 4.2% of GDP, last year. Worse, foreign direct investment (FDI) has been plunging – for the first time – even as the current account deficit has been growing. Last year, total equity investment in Brazil came to $28 billion, more than enough to cover the current account deficit. This year, the IIF expects that number to drop by more than 40%, to $16 billion, with net external borrowing ballooning to $14 billion to make up the shortfall. Last year, Brazil’s net external borrowing was actually negative: at minus $6.6 billion.
David Mulford, international chairman of Credit Suisse First Boston, sums up the difficulties facing Brazil: “They have had some increase in their inflation levels, they have had some depreciation of their currency, they have had an uncertain political situation as they near the end of the current administration, they’ve had energy problems, and they’ve had a reduction in their growth. The current team in Brazil is certainly capable of addressing these problems, but the current team has a relatively short life now. So the market is probably very uncertain as to what happens next. And you can’t avoid that, it seems to me.”
The bond markets, at least, seem more than just uncertain: Brazil is incapable of issuing plain-vanilla dollar or euro-denominated debt, and the securities it has outstanding are trading at spreads wider than Russia’s.
Leave it to Fraga and Malan
Another view, however, is often expressed by grandees of the international financial community. Bill Rhodes, vice-chairman of Citigroup, for example, says that “the Brazilians are doing a very good job in terms of taking the proper measures”. This view essentially concentrates on the quality of the economic team that president Fernando Cardoso has put in place, led by Fraga and finance minister Pedro Malan.
Ernesto May, director for poverty reduction and economic management at the World Bank, says: “Brazil has had to undertake measures to manage volatility, which they have done very well, by increasing interest rates and increasing the primary surplus target on their fiscal side. That has been put together with a follow-up to the IMF programme. The reforms that they have been taking since the crisis of 1998 have put Brazil in a much better position now to manage the volatility.”
Even Fred Jasperson, head of emerging-market research at the IIF, whose projections for Brazil are so pessimistic, has an upbeat view. “The Brazilian economy is going to be very adversely affected by what is going on in Argentina; it already has been,” he says. “But I think they’re in a very different situation, and I think they’re going to get a lot of support from the official community. And the people in charge in Brazil are just world class: Fraga and Malan and Cardoso. I think they’ll be able to deal successfully with the problem.”
But Brazil, just as much as any other emerging market, is a confidence game, and these people know well enough what they can and can’t say in on-the-record interviews. It’s also easier to be upbeat about a country when your own exposure to it is relatively small. Off the record, very different views emerge. One veteran emerging-markets player describes Brazil acidly as “the strongest economy in Africa”, and many traders are looking forward to a Brazilian feeding frenzy should Argentina default.
There are also the first niggling doubts about Fraga. Ever since he arrived at the central bank from Soros Fund Management at the beginning of 1999, he set ambitious targets that he invariably exceeded. But there’s a good chance he’s going to miss his inflation target for 2001, and his projections for GDP growth and other macroeconomic variables are far more optimistic than any in the private sector. In interviews, he has a tendency to overstate the upside and avoid the downside, in contrast to the reputation he built up as a straight-shooter: nowadays, there’s a lot more spinning going on.
Jim Wygand, managing director for the southern cone at consultancy Control Risks Group in São Paulo, explains the problems that are facing the central bank. “There’s a vicious circle in this country,” he says. “You run a government deficit, so you’re forced to make your fiscal policy only a restrictive, don’t-spend policy. You then have to react to all shocks to the system with your monetary policy, and the problem with monetary policy is that it’s always pro-cyclical.”
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A pro-cyclical monetary policy was great news in the two years following Brazil’s devaluation at the beginning of 1999: interest rates came down steadily, investment increased enormously, and Brazil moved back onto a growth path. Now the central bank is tightening, and the story is very different. The more the real weakens, the greater the pass-through effect into inflation, which means the higher interest rates have to go, which means slower growth, higher country risk, more hedging, and a weaker currency.
At the central bank, they have an answer to that. Brazil is not Argentina: it has a monetary policy, a floating exchange rate, and positive inflation. All three are capable to some extent of absorbing shocks to the system, whether they be internal, such as the energy crisis, or external, such as the tango effect.
So inflation has gone up a couple of percentage points, real interest rates have done the same, and the currency has weakened to a point where it is undervalued. If you add in fiscal policy – Brazil has been steadily increasing its primary surpluses – Brazil is capable of spreading the pain, as it were, between a number of different policy instruments. Argentina, by contrast, has no monetary policy, a fixed and massively overvalued exchange rate, entrenched negative inflation, and, with the recent zero-deficit plan, no fiscal policy either.
Fraga, for one, sees the floating exchange rate as a wholly positive thing, not as a danger to a system loaded with foreign debt. He calls it “an extra degree of freedom, a new shock absorber,” and says that the recent depreciation in the currency “was a one-shot thing. There was a weakening of the real exchange rate, driven by internal and external factors, which had a one-off impact on our debt.
“With strong banks and a floating exchange rate, debt dynamics will be fine. One should not extrapolate the depreciation which we’ve seen this year into the future. It won’t continue to happen, particularly not in real terms, but we don’t intend to let it happen through inflation, either.”
Fraga might well be right: his deputy governor for economic policy, Ilan Goldfajn, makes a strong academic case that the real is unlikely to depreciate much further than it already has. The key, he explains, is to look at real exchange-rate depreciation rather than nominal depreciation.
A lot of research – much of it carried out by Goldfajn himself, who received his doctorate from MIT, where he studied with Rudiger Dornbusch and Stanley Fischer – has shown that the real exchange rate is very unlikely to fall over the medium term nearly as much as the nominal one has in the short term. “The probability of real exchange rate depreciation is very low,” he says.
It’s the Brazilians who are selling
A more concrete way of looking at it is to try to understand the reasons for the real’s depreciation. Brazilian companies – both domestic- and foreign-owned – are extremely sophisticated, and embarked upon a round of hedging as soon as Argentina started looking fragile.
| Pedro Malan | ||||||
Although no one knows for sure, there’s a good chance that most of those hedges are now securely in place, and that even drastic events in Argentina might not damage the Brazilian currency as much as it has already been hurt. “The Brazilian private sector tends to be pretty pessimistic on Argentina,” notes Citigroup’s Rhodes, and the more pessimistic they’ve been so far, the less hedging they’ll need to do in the future.
The fact is that the course of the real over the next 12 months is extremely uncertain. It’s oversold and could quite easily bounce back, especially if heavy rainfall arrives, alleviating Brazil’s energy crisis.
On the other hand, 2002 is an election year, and even comparatively solid Mexico’s currency plunged alarmingly in the run-up to its elections last year.
But although the rapidly depreciating real is the proximate cause of Brazil’s soaring debt ratios, the underlying problem is much less volatile and much less tractable.
Lisa Schineller, Brazil country analyst at Standard&Poor’s says: “There are fundamental reasons why the real has depreciated. It stems from ongoing perceptions of continued weakness on the current account and trade account.”
Continued weakness on the current account, in fact, is probably the root cause of the vast majority of Brazil’s problems, at least in the medium to long term. The energy crisis will be resolved sooner or later; the 2002 elections will have passed by the end of next year. The tango effect will fade as well, although it could get much worse before it disappears entirely.
But Brazil’s current account deficit looks as though it is here to stay. It might not be above 5% of GDP for ever, but, says Ernesto May at the World Bank, “for the foreseeable future Brazil will be operating with current account positions of the order of 4% of GDP. So they are dependent on their ability to finance those current account positions.”
Brazil’s huge and endemic current account deficits are not based on large trade deficits. Although failure to bring the trade account into surplus was the single largest disappointment of the first two years after the country’s devaluation, Brazil is likely to post trade surpluses soon.
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The problem isn’t even in foreign indebtedness, which accounts, public and private sector together, for about 35% of GDP. That’s a large figure, to be sure, but it’s hardly unmanageable.
The current account deficit is mainly a function of three things: a very low domestic savings rate, a low ratio of exports to GDP, and the after-effects of more than $100 billion in foreign direct investment over the past five years. That money was looking for high rates of return, and indeed some pessimistic estimates put total remittances back to foreign investors at more than total FDI in 2002.
The domestic savings rate is certainly not going to buck up soon: total domestic savings are around 16% of GDP, and growing at a negligible 0.2% of GDP per year.
Nancy Birdsall, senior associate and director at the Carnegie Endowment for International Peace, says: “If you look at the economic evidence, what you see is that in general, savings is an outcome of growth. People save when incomes are going up. It’s a simple, very intuitive thing. When income is going up, your consumption doesn’t go up as fast, and you save. Now the curse of Latin America is that, fundamentally, income per capita has not risen in the last 20 years. When income does go up, a little bit, households use their higher income to catch up to what is their target consumption. So it’s tough, it’s very tough.”
Paulo Leme, Goldman Sachs’ Latin America analyst, sums it up in words that Fraga could never use. (Says Lloyds TSB’s Abate: “Paulo Leme is a close friend of Arminio Fraga. I don’t know if Arminio Fraga is going to tell you everything he’d like to say, but just in case, consider Paulo Leme’s point of view as Arminio Fraga’s point of view.”)
“As much progress as Brazil has done on the fiscal front, with the main headline being a gigantic excess over the IMF targets this year, unless there’s further consolidation of the fiscal situation to increase the domestic savings rates, they will continue to be dependent on external financing,” says Leme.
That is, potentially, the main worry for Brazil. Leme continues:”Unfortunately the low savings rates of the past made them rely on external financing, and today you have a stock of external liabilities which is somewhere on the order of $380 billion to $400 billion. And that in turn generates a structural deficit with the interest and dividend payments, plus the amortization payments. So if the markets are liquid, and risk aversion is low, Brazil works beautifully. But as soon as you shift to high risk aversion and low global liquidity, they become constrained.”
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That, of course, is exactly what has happened, as the US, Europe and Japan enter an unprecedented simultaneous slowdown. The result has been an unexpected rise in the cost of capital in Brazil. “The Brazilian government does not need much more money to manage its external accounts in the next year,” says Lloyds TSB’s Abate. “But the private sector still needs money. It will be more expensive, no doubt about it. That’s why it’s hard to be optimistic about the next year. The world is not growing.”
The enormous size of Brazil’s current account deficit magnifies every hit to the Brazilian system. Mario Gutierrez has looked into the situation in detail, as the main author of the IIF’s August report on Brazil. “The main conclusions are that Brazil’s vulnerabilities to change in external markets continue to be very high because of the large current account deficit and large fiscal deficit,” he says. “This vulnerability to external shocks is going to persist.”
And in one sense – the gross external financing requirement – the current account deficit is literally not the half of it. S&P’s Schineller says: “The current account deficit weighs on Brazil’s credit rating. Brazil has high external liquidity needs. Look at its current account deficit, and its external amortizations, and its external short-term debt. Put the three of those together, and you’re on the order of $90 billion. That’s large. And as a share of international reserves, it’s among the highest of sovereigns rated.”
Is Brazil a single-B credit?
For the moment, the majority of that $90 billion – which corresponds to some 300% of Brazil’s international reserves – is not threatened. A lot of it is trade lines, which have proved to be much less susceptible to global risk aversion than FDI flows: there is very little doubt that they will be rolled over. Nevertheless, that rolling over of trade lines does constitute external financing, and is included in S&P’s calculations of Brazil’s financing needs.
| David Mulford | ||||||
At the beginning of August, S&P revised the outlook on Brazil’s BB- credit rating to negative from stable, only seven months after bumping the country up into the double-B category. Schineller reportedly cited slow global growth and financial volatility in emerging markets as reasons for the move, saying that Brazil could go back to being a single-B credit if the general government deficit remains near its current levels.
And a lot is going to have to go right for Brazil if the general government deficit is to come down. Large cuts on the fiscal side are politically very difficult in the run-up to an election, and no-one wants further tax hikes. Goldman’s Leme paints the positive prospect as one in which Argentina neither defaults nor devalues – and Chac, the Maya god of rain and lightning, smiles on the country.
But it is far from obvious that there’s the political will in the US necessary to keep Argentina from default and devaluation. US Treasury secretary Paul O’Neill in August described Argentina as a country “that continues to consume the money of the plumbers and carpenters in the United States who make $50,000 a year and wonder what in the world we’re doing with their money”.
It’s not the sort of sentiment that financial markets ever heard from Robert Rubin or Lawrence Summers.
Such thinking affects Brazil in two ways. First, it increases Argentine country risk and the severity of the tango effect, the overwhelming brunt of which is borne in Brazil. And on a general policy level, it shows a disinclination on the part of the official sector to construct packages that can prevent or resolve crises, specifically crises in South America. Brazil got more than $40 billion in 1999; the chances of such a deal being put together again have plunged. Few people believe that the $15 billion package Brazil agreed with the IMF this summer would be sufficient to stave off a speculative attack in the event of a catastrophic Argentine default.
A US responsibility no longer?
In fact, international finance seems to be one of the few areas where the George W Bush administration differs markedly from the George H W Bush administration. The Treasury undersecretary for international affairs then was David Mulford, now chairman of Credit Suisse First Boston International.
| Paul Tregidgo | ||||||
“The United States administration has not yet made fully clear where it really stands on these issues,” says Mulford. “It declared some support for Turkey and the Brazil package, but in no case has it offered or agreed to put up bilateral funds. Within the G7 countries the view is that Latin America is first and foremost the responsibility of the US.
“So the US Treasury has caused some uncertainty, first by what appears to be a rather passive role in country crisis situations, and, by criticism voiced both during the campaign and in the new administration of the IMF and World Bank. This has left an impression around the world that they’re not fully supportive of an activist role for these institutions and for the US administration.”
Brazil, by dint of its large current account deficit, is probably more vulnerable than any other large emerging-market country to a fall-off in emergency funds available from the US Treasury and the official sector as a whole. Three years ago, countries could be rescued with the financial equivalent of Colin Powell’s military doctrine of overwhelming force: if untold billions in multilateral and bilateral aid were pledged to a country, confidence would be improved to the point where they would often not need to be disbursed at all.
Those days are over now. “It’s very much different from what it was in the Asian crisis, where every Fund package was accompanied by a bilateral programme. Very little of the bilateral stuff was actually disbursed, but nonetheless that’s a change,” says one senior former World Bank official.
It’s not just Clinton-era liberals who are unenthusiastic about this change. “You can ask yourself whether these smaller-sized packages are perhaps not appropriate,” says one Republican outside the present administration. “They’re not big enough. They have to be big enough to help restore confidence, and they’re really quite small in terms of the risk taken by the official community compared with the flows that are coming in when confidence is restored.”
The rationale behind the new approach was that it would make for fewer crises because there would be less moral hazard in the system. Everybody, especially lenders and bond investors, will be more careful, goes the argument, because if crises do actually occur, private-sector creditors will have to worry about taking a haircut. (This argument generally avoids the fact that most private-sector institutions nowadays mark their positions to market on a daily basis, and suffer their losses when bond prices fall, not when they’re forced into accepting rescheduled terms.)
Proponents of the old way of doing things say that under the present system crises that could be avoided won’t be avoided. Those people cite Korea, which had a large IMF programme, but which had even larger support from the bilateral side, from which nothing was ever disbursed. The availability of a large pool of funds was sufficient to restore confidence, which is normally the critical factor in bail-outs.
The problem for Brazil is that the move to the new policy on aid packages inevitably increases the cost of capital to emerging markets. And Brazil needs more foreign capital on an annual basis than any other emerging-market country.
What that means is that borrowers, as well as lenders, are going to have to be more cautious from now on. “If Brazil has to pay 12% for capital, it has to be very careful how much it borrows,” says one senior bulge-bracket banker.
In the space of the past year, there seems to have been a very profound shift in the financial community. It used to be thought that international capital flows were a good thing: they would provide the stimulus needed for emerging-market countries to reach their high potential growth rates.
Now the interest, dividend and amortization payments on those capital flows are coming due, and the new gospel is prudence on the balance of payments.
When Brazil and Argentina were issuing hundreds of billions of dollars’ worth of bonds over the 1990s, the talk was of investment in growth and of liquid asset classes. Investment banks would congratulate themselves and the countries on record levels of bond issuance; any drop-off in times of crisis was cause for concern. And most of the interest and issuance was in the big three countries of Latin America: Brazil, Argentina and Mexico.
The upshot is that Brazil and Argentina account for over 40% of all sovereign emerging-market bonds. “The people that have to borrow the most, the people that are most indebted, are potentially the most likely to default,” says the head of emerging markets at one of Argentina’s primary dealers – something that is obvious now in Argentina’s case, but which is only slowly being realized in the case of Brazil.
The pro-cyclical nature of emerging-markets finance means that it is now, when the world is becoming increasingly risk-averse, that Brazil has to borrow the most. “What we have seen is a deterioration in the composition of current account funding, away from FDI, and towards debt accumulation,” says S&P’s Schineller.
That is precisely the course that neither borrowers nor investors want to take at the moment. “The situation we are in is typical of any credit rationing,” says Goldman’s Leme.
“Those that can borrow are not willing to borrow, and those that need to borrow are off the market. Today, the debt market is not closed. But stronger credits like Mexico opt to stay on the sidelines, either because they perceive the spreads do not correspond to the fundamentals, or because they are worried that any transaction that is not perceived as successful may taint the credit.”
And without the prospect of multilateral aid packages large enough to rekindle confidence in the region, private investors are warier than ever of increasing their exposure.
There is no doubt, then, that the region is going through a bad patch right now. Growth rates are falling, both domestically and internationally, which destroys confidence in the region. Funding is hard to obtain at all, and very expensive when it can be found; FDI, too, which was thought of as far less volatile, is plunging as well. And the only topic on investors’ lips is Argentina, and what might happen if – increasingly, the question heard is when – it defaults.
Has the worst already happened?
Some observers look at the severity of the tango effect thus far and conclude that contagion from Argentina has already happened. So long as Argentina continues to suffer from its present difficulties, the argument goes, Brazil will be under pressure. If Argentina were to devalue, however, there would be a one-off shock to Brazil’s finances, after which it would be back on its own. “Investors have been saying that they will be back in Brazil when there is some resolution in Argentina,” says Paul Tregidgo, head of emerging debt capital markets at CSFB.
| Jim Wygand | ||||||
The analogy often drawn is that of Brazil itself, at the end of 1998 and the beginning of 1999. Spreads were sky-high, confidence was plunging, capital was fleeing the country at a rate of billions of dollars a week. But when the big event risk happened – a full-scale devaluation – everything turned around overnight. The stock market soared, bond markets rapidly reopened, and FDI started hitting record highs.
But Argentina can’t devalue without defaulting, and a default is a far, far messier thing than a devaluation. It takes many months at the very least for the initial
work-out, and the consequences in terms of international litigation and lack of access to markets are certain to drag on for many years.
Goldman Sachs’s Leme is more sanguine about what will happen to Brazil in the event that Argentina defaults. “Everybody thinks that we might as well get a resolution for better or for worse in Argentina,” he says. “But I think that the default scenario is by far the most disruptive. If eventually they are forced into the worst-case scenario in Argentina, it will probably be for political reasons and problems of governance, in which case the debt resolution and workout will be a very murky one. And if that were the case, the effect on Brazil would probably be the strongest. You would affect forms of financing like bank financing lines and trade or interbank lines, reducing them; temporarily close bond markets for issuance; and even more important it is quite likely that you would further reduce direct foreign investment. This is because the investor in Brazil is basically the same as the one investing in Argentina. So you could have the three sources of financing, FDI, bonds and bank debt, declining further. And then the perverse effect on Brazil is that it forces a weaker exchange rate and higher interest rates, worsening the debt dynamics and producing higher inflation as well.”
That’s the bad news. The good news is that while high spreads travel quite easily from one country to another, defaults don’t as they once did. Back in 1986, Alan Garcia’s decision to cap payments on Peru’s debts rapidly set off a domino effect: before long, leaders in Venezuela, Brazil and Argentina said they would follow suit, less as an economic measure than as a political one.
Could the same thing happen today? “I would come down and say that most policymakers don’t view default as a first option,” says S&P’s Schineller. “But if you look at history, you see a whole series of sovereign defaults. It’s not like it hasn’t happened before, and it’s not like it won’t happen again. Will there be a new attitude towards policy? Will this mean a ripple effect? An Argentine default would have strong reverberations. It’s a different category than Ecuador, Pakistan or Indonesia. It’s an unresolved question.”
The Carnegie Endowment’s Birdsall says: “In middle-income countries like Turkey and Brazil (and now Argentina), there’s a new recognition that these countries can default. Or rather, a renewed recognition: it was forgotten in the halcyon days of the early 1990s.”
| Bill Rhodes | ||||||
Over the past decade, however, pretty much every finance ministry and central bank in Latin America has been taken over by professionals steeped in Chicago School orthodoxy, and the example of Argentina shows that countries will go through astonishing amounts of pain before they consider a default. And while Latin America is full of populist or leftist politicians who say very market-unfriendly things during their campaigns, they generally turn surprisingly conservative once they achieve power. Brazil’s own Fernando Cardoso is a good example; so are Alejandro Toledo in Peru, Ricardo Lagos in Chile, and Carlos Menem in Argentina. Within Brazil, the states and municipalities run by the main leftist opposition party, the PT (including the city of São Paulo), have generally seen their finances improve, not deteriorate.
“This trend to more responsible economic management has gradually penetrated policymaking in every major Latin American country except Venezuela,” says the high-ranking former World Bank official. “The Mexicans had a sexenio change [the six-yearly presidential election] and for the first time in living memory you didn’t have a crisis to go along with it. I do think it’s a sea change.”
Citigroup’s Rhodes says: “No matter who wins the elections in Brazil, they are not going to turn back the clock. I don’t think you’re going to have any major change to the current policies.”
Lloyds TSB’s Abate is almost surprised at the reticence of the PT to advocate heterodox economic policies. “Brazil has followed the path of default more than once,” he notes. “Here, we are afraid of it. Even the most leftist party here in Brazil does not defend it. I don’t know what happened, who convinced everybody.”
Far from defaulting, in fact, most Brazil analysts are expecting an almost seamless continuation of the present government’s economic policies, no matter who wins the October 2002 election. In fact, says S&P’s Schineller, “Given the conservative bent of the electorate, they’re voting for policy continuity. The outcome I expect is policy continuity, and that’s incorporated in the rating.”
A key element in ensuring that continuity is the fiscal responsibility law passed by the Cardoso administration. Such legislation takes a very long time to get through the fractious Brazilian legislative system, but now that it has been passed, it has become almost reflexively engrained into the system, and it’s unthinkable that it could be reversed.
Says Control Risks Group’s Wygand: “I think the policy continuity will come from the fact that a lot of the things in the 1980s and the 1970s that were matters of discretionary policy have now become institutionalized. The private sector is not going to back up to what it was in 1975. It doesn’t matter if the PT gets into office, if the PFL gets into office, if the Liberal Party gets into office, or if Ivan the Terrible takes over. None of that will make a big difference in terms of fundamental, institutional changes that have occurred in the private sector. Brazil is more professional. You can’t put the toothpaste back in the tube.”
Another element is Brazil’s growing middle class. Says former finance minister Marcilio Marques Moreira, who now works for Merrill Lynch and the local chamber of commerce in Rio de Janeiro: “Thirty years ago we didn’t have a middle class. Today we have a middle class with a car, it has a video, and so on. All my servants have cars. They don’t want to erase the gains. They want to compete.”
Nevertheless, markets invariably become nervous during Latin presidential election campaigns. The Brazilian electorate is pretty conservative, but that doesn’t mean that worsening economic performance won’t increase the opposition share of the vote. Brazil’s central bank knows this, and deliberately minimized amortizations in 2002 for that reason.
One fear that has abated slightly is the worry that the energy crisis would give a lot of easy political points to opposition candidates. Different people have different reasons for why the government is responsible for the crisis: too many IMF-mandated spending cuts causing public sector underinvestment; an opaque and ill-managed privatization programme; bureaucrats at the energy ministry deliberately sticking their heads in the sand and refusing to admit that an energy crisis was looming until it was far too late to do anything about it.
What has surprised everybody, however, is the way in which a kind of blitz mentality has taken hold in Brazil. Everybody has been told to reduce their energy consumption by 20%, but many people have slashed it in half, and entire states have seen consumption drop by over 40%. Air conditioners have gone quiet, and there’s a national fixation on people turning off lights. To be sure, the energy crisis is not good for the government, and if rolling blackouts arrive then tempers might start shortening. But there is also a sense in which the crisis has managed to bring the country together, and the political repercussions have been much smaller than most analysts initially expected.
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Rio de Janeiro: let’s hope the lights don’t go out when the national soccer team is playing |
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But the broader socio-political picture has much more entrenched instabilities, which threaten Brazil’s development far beyond next year’s elections. Brazil’s politics is among the most intense and complicated in the world, but ultimately politicians are reliant on the voters, and those who vote are much better educated than the populace as a whole.
The average Brazilian adult has just five years of schooling, and about 16% of the adult population is illiterate. Nearly all children now get eight years of education (the amount considered to be the minimum needed for it to be cost-effective for a company to attempt to train a worker), but it will take a while for those children to enter the workforce, and when they do the global economy will have advanced further, and global education standards increased.
Wygand says: “Back in the 1960s, you could industrialize, you could get yourself 50 or 60 fig pickers, train them, make them industrial workers, and get some kind of immediate feedback from that and make yourself very competitive. How do you take a kid from the favelas of São Paulo and make him a computer whiz in the same period of time? He has to be literate first. He has to have access to computers. He has to have access to a great deal more infrastructure to make himself competitive than was the case 30 years ago.”
The role of the military
Wygand worries about Brazil’s disenfranchised, especially the MST, the grass-roots landless peasant movement. “If these countries intend to remain democratic, and I have no guarantee that that’s going to be the outcome,” he says, “they’re going to have to dramatically improve their level of statesmanship. Look at the Argentine military right now. They’ve been whacked by 70%, they’ve closed down the academy. They’re not going to be very happy. They’ve got guns. We saw in the papers the other day in Brazil that the army has been going around spying on these ‘destabilizing’ influences. An internal document in the army says that we may have to step over the normal civil liberties boundaries in order to check on some of these institutions. The fact is the MST represents in Brazil a group of people that is relatively large, that has no saleable skills. How do they get the system to respond to them if the skills that they possess are not highly useful in a globalized economy?”
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Years of financial othordoxy have not equipped Brazil’s poor to compete in global economy |
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While Wygand is not saying that there is any immediate risk of a military coup in these countries, he’s also saying that it can’t be ruled out. “You know what scares me?” he asks. “You get a military government come into power, and they say number one, the first thing we need in this place is an industrial policy, we have to protect domestic business. But Argentina is 80% foreign capital. If somebody says to me as a multinational management figure in Argentina, we’re going to give you tariff protection, I’m going to take that because I know I can get a cartelized market arrangement for myself, and legally. The government is saying we’ll protect you. I’d have to be stupid not to accept that. I’m not an Argentine, but I’m running a business in Argentina, suddenly somebody comes up and says you develop behind a tariff wall? I’m gonna take that.”
That said, Brazil’s democracy is very solidly entrenched. The Carnegie Endowment’s Birdsall says: “They’ve really made a permanent switch since the 1980s. There’s no discussion of Brazil going back to a military, authoritarian type of democracy like Venezuela. It just can’t happen politically.”
The fact is that Wygand’s hypothetical military government would have very good reasons for concentrating on domestic industry and exports at all costs, in Brazil even more than in Argentina.
The $100 billion of foreign direct investment that Brazil has attracted over the past five years has professionalized industry, but it has also created a huge current-account deficit that can only be addressed in the long term by a massive rise in exports. What’s more, both the telecommunications and the energy sectors in Brazil are in need of many more billions in foreign investment. If it’s not forthcoming, Brazil won’t be able to compete internationally, but if it does come, then the quantity of annual remittances abroad will only increase.
Trade is the key
The only answer for Brazil over the long term is to increase massively both its imports and its exports: with the latter accounting for just 8% of GDP, the country is still suffering from the legacy of the days of import substitution, when the stated aim of the government was to produce everything domestically.
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Marcilio Marques Moreira |
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Goldman’s Leme says: “What can we learn from the experience of Brazil going forward for Latin America? If Brazil is experiencing problems today, it’s because of the insufficiency of its trade regime to increase exports. And it’s not a matter of the exchange rate. It’s a matter of having no access to bigger markets that are protected. Unless Brazil changes its trade policy to fully integrate, through FTAA or Nafta, with the US; unless it is able to increase two-fold or three-fold its export base, like Mexico did, Brazil will continue to have very strong vulnerability through the balance of payments. The lesson here is that no matter how good policy has been on the fiscal side, unless they open up and integrate with the US and European Union, their balance of payments and growth rates in Brazil are not going to be satisfactory in the next five years.”
Mexico, after all, has many of the same structural problems that Brazil has: little room for manoeuvre on the fiscal front, an over-reliance on monetary policy, and susceptibility to a slowdown in the US economy. But none of that seems to matter in the eyes of investors.
“Even as South American countries are experiencing a sharp drop in FDI, Mexico is experiencing precisely the opposite,” notes Leme. “This leads us to a longer-term lesson, which is even though Mexico has been hit by very severe cyclical shocks in the US, the structural trend of long-term integration with the US and the European Union far supersedes the size of the other shocks. And you’re beginning to see more interest from the European companies that were focusing on Brazil and Argentina. All of a sudden they’re having second thoughts and thinking again about Mexico. US companies in the electricity sector that were planning to go to South America, now they’re hoping to have a good reform in the electricity sector in Mexico, and go there.”
Mexico not only has the advantage over Brazil of being in Nafta, it also has the huge advantage of having a relatively porous 3,000-mile border with the US. Unemployed Mexicans can often find work in the US, while Brazil has the opposite problem, of economic migrants coming in from such countries as Bolivia, Colombia and even, now, Argentina.
Brazil says that it’s committed to entering into large-scale trade negotiations. But it is also committed to Mercosur, the South American free trade area, which has proved relatively ineffectual. (Chile has pretty much given up on Mercosur, deciding to concentrate instead on North America.) “These countries have to do like Mexico, they have to integrate themselves into bigger trading blocs,” says Leme. “And Mercosur is absolutely insufficient. It helps, but you’re a thousand times lower in the scale than what you need.”
Brazil’s geographical remoteness is definitely a problem here, just as it is in all attempts to boost the country’s tourist industry. And the big fish – Europe and the US – seem in no hurry to dismantle trade barriers on the agricultural side, which is Brazil’s big strength. Merrill’s Moreira says that Brazilian beef exports to Europe, because they’re taxed on a weight basis rather than a value basis, end up being taxed at 370%. “It’s incredible,” he says. “There’s no level playing field.”
Moreira accentuates the positive: prospects of increased trade to China and Japan; a high enough share of the world market in sugar and soy beans that Mercosur can be price makers, not price takers. He also points out that Brazilian companies, following in their Mexican counterparts’ footsteps, have started entering the US market directly. Brazilian juice company Cutrale, for instance, has bought 10,000 acres of land in Florida, which it will turn into citrus groves.
But no-one really believes that Brazil will be able to see its exports explode in the same way that Mexico’s have done. “Like so many other developing countries, they face almost closed markets for the products in which they’re competitive,” says the Carnegie Endowment’s Birdsall, citing both orange juice and steel.
Brazil will push, of course, but it faces formidable barriers. Lloyds TSB’s Abate says: “Why should you invest in Brazil in the long term? That’s a very good question, and the most difficult question. It has to invest more in energy. It has to do tax reform, that’s very important. It has to be able to keep an independent central bank. There are many tasks to be done. It would be an incredible optimist to say that Brazil is ready to grow at 4% in the years following after the election. It’s not the reality. Things work slowly here. We cannot be optimistic in the long term.”
Reasons to be pessimistic
So while many observers still claim to be optimistic on Brazil, there are many reasons for them not to be. Hope for growth in neighbouring Argentina has already evaporated. Meanwhile, Asian countries without large amounts of sovereign debt, such as China, Korea and India, are doing much better than any South American country. And sovereign debt cannot be legislated away.
Ever since the introduction of the Real Plan in 1995, the international financial community has loved Brazil, with its lucrative string of sovereign and commercial bond issues, privatizations, and M&A deals. At one point, there was even hope that there would be an active Brazilian equity market, complete with IPO mandates. Those days are over now, and no-one knows whether or when they will come back, even once the global economy turns around.
Brazil is not facing imminent crisis, and its sheer size and the very lack of international trade means that it will be able to continue as a going concern for many years to come. What’s more, Brazil has proved very resilient in the past. It sailed through the tequila crisis, the Asian crisis, the Russian crisis and even its own crisis, coming out of each one stronger than it went in. On the face of it, there’s no reason to think that the Argentina crisis will be any different. But it’s always the problems that are easiest to solve that get solved first. The difficulties facing Brazil now could constitute its gravest test yet.
