The dominant theme in Brazilian financial circles remains the outlook for pension reform. It is a key issue for future fiscal sustainability, but, even if passed, it will have a limited impact on the government’s finances in the coming few years.
What is less discussed and will have a much bigger impact on the financial and economic health of the country in the next five years are changes already made to the country’s state development bank, BNDES.
BNDES is big. According to estimates from analysts at Capital Economics, it is responsible for about 15% of total lending to the private sector and has a balance sheet similar in size to that of the World Bank. So the substantive changes that have been implemented in recent years will have a direct and large impact on the economy.
The changes include those that will encourage small and medium-sized enterprises, innovation and technology; reduce the level of its disbursements into the economy and thereby reduce the ‘crowding-out’ of private finance; improve the functioning of monetary policy and lower the nominal level of the country’s base rate, the Selic; increase the participation of domestic institutional investors in long-term financing through the development of new capital market instruments; and increase both the effectiveness of the deployment of private and public capital.
That rate was set at a big discount to the Selic, averaging 6% since the start of 2013, compared with a yield on five-year local currency bonds of 12%. The difference between the rate at which the government financed itself and market rates represented an effective subsidy to those companies granted TJLP loans.
Capital Economics calculates the impact of the TJLP in the past has been equivalent to about an added 100 basis points on Selic and has aggravated the country’s attempts to lower the country’s high interest rates.
And so over the next five years, the bank will migrate to a new rate called the TLP, equivalent to the five-year NTN-B (inflation-linked) bond yield. That will still be lower than the private sector will charge companies, but the discrepancy will be smaller and – crucially for BNDES director of capital markets, Eliane Lustosa, who is working towards ending the crowding out that the bank has on private sources of finance – it will be more transparent.
“Once the bank has an interest rate that is comparable to the risk-free rate, it will be clear and transparent if there are any subsidies in that rate – with TJLP it is difficult to say,” she tells Euromoney. “We can still provide subsidies, but it is about being transparent about that subsidy.
“We will be able to see the difference in the rate that we are charging the entrepreneur and compare it to the rate they would have in the market. That will make it easier for society to understand the difference.”
Critics of BNDES have long argued that the lion’s share of the bank’s disbursements have been channelled to large Brazilian corporates that could finance themselves through the domestic and international capital markets.
That is now changing and the emphasis will be on creating funds that will finance small and medium-sized companies that can demonstrate “social externalities” across a range of categories, including infrastructure, sustainability, health and education.
There are also more abstract goals that can attract financing, such as innovation and competitiveness – and there is another that has been added for ‘capital markets’.
“There should be some instruments [developed] that help capital markets as an end in itself,” says Lustosa. For example, BNDES has just launched an R$500 million ($160 million) fund to purchase debentures linked to renewable energy companies.
The fund, managed by Vinci Partners, will be a mix of public and private finance.
“We chose Vinci and we have been discussing the idea with pension funds with the idea of having at least AA- ratings,” says Lustosa.
She argues the bank is not necessarily aiming to lower disbursements but rather to make any investments more effective.
She says the recent decline in total investment from the bank has been linked more to economic slowdown and the Lava Jato (car wash) corruption scandal holding back investment throughout the economy.
Another reason she cites for lower levels of investment is behavioural: the widespread corruption investigation has led to a reticence among senior management at the bank to sign-off on new investments.
“We have also adapted our policies in order to be stronger concerning compliance issues, which is very important,” she says. “This is a challenge for BNDES right now because we are trying to be creative at a time when, thanks to the ‘car wash’ investigations, the responsibilities for individuals are high. It’s difficult to find people [to authorize new approaches].
“I keep asking: ‘Let’s come out from under the table.’ It’s easier for a public servant to do nothing because then they are not going to be responsible for anything. It’s always easier to say ‘no’. So now we have an overshooting of that [approach] and people are afraid to take decisions.
“They are afraid – and it’s not just BNDES but also the regulatory agencies. We have to face that: it’s human. After all, the winner of the Nobel prize for economics was a behavioural economist.”
Lustosa, who joined the bank in July 2016, says she is trying to get round this behavioural blockage by creating stronger auditing procedures that will enable people in positions of responsibility to take decisions based on the information at hand – and be confident that even if the decisions turn out to be bad ones, the person responsible has a defensible record.
“I shouldn’t be personally liable for a bad decision if something goes wrong,” she points out. “I just have to decide by doing my fiduciary duty using the information I have now.”
Another big change in approach will be, at least in theory, music to banks’ ears. Lustosa is keen to re-target the bank’s investments to plugging gaps that cannot be financed by the private sector and avoid the crowding out of those investments that can be met with private money.
“We are spending public money – tax-payers’ money – so we have to be transparent and accountable, and the investment should have externalities for society and not just benefits for one shareholder or company,” says Lustosa.
“Having that in consideration, we decided to move from having only disbursements as a goal but [instead] trying to take into consideration other aspects. Because when we only have disbursements in consideration there is another phenomenon at play, which is the crowding out instead of the crowding in [of private finance]. I am in charge of the capital markets area, so we have been trying to move alongside the private sector and our investments should be disruptive and have a multiplier effect while bringing in the private sector. That’s the goal.”
Lustosa repeatedly makes the point that the level of the bank’s disbursements need not fall and that there will always be money for projects that meet these new objectives. But the bank has been asked to repay loans from the ministry of finance to help cover the country’s widening fiscal deficit.
In 2016, the bank repaid R$100 billion to the treasury and in 2018 is expected to pay another R$130 billion. Whatever the bank says publicly, its financing capacity is going to be reduced, and this is where Lustosa’s proposals to work together with the private sector will be crucial if Brazil is to finance its considerable infrastructure needs.
The main challenge that Lustosa is setting the bank is to innovate and sponsor capital market financing of long-term infrastructure projects. She accepts that pension funds and other investors are reluctant to accept construction risk, but she thinks BNDES can fund that and then work with the private sector to securitize the less risky operational phase.
Lustosa is even examining the opportunity to create ‘instant’ market liquidity by securitizing the vast array of projects that are now in their operational phase, although the underlying financing of TJLP creates obstacles for spinning them into market-friendly propositions.
Lustosa says it is too early in the bank’s exploratory stage to discuss a securitization strategy in detail but does suggest that, theoretically, she supports such a move, and talks about the sanitation industry as an example.
“There is a chicken-and-egg problem,” she says. “But there are infrequent new issues and buyers tend to hold on to them. BNDES has lots in our portfolio and there could be a virtuous circle from bringing these projects to market, getting the market to finance them, which would create more liquidity and lead to more projects coming to the market and, ultimately, BNDES could finance more projects.”
Pension funds tell us it is very difficult to understand the pre-completion risk. And that’s what we do. That’s our DNA, so we could help a lot by providing a BNDES stamp of approval- Eliane Lustosa, BNDES
Lustosa sees a role for BNDES to help the development of secondary trading of these securities.
“The idea isn’t aimed at just being a market maker,” she says, “but the idea is to be aggressive, because now IT improvements through B3 [the country’s stock exchange company] make trading much more transparent, which is very important for us. We can’t be seen to be choosing counterparties, but exchange-driven trading will enable us to participate. The difference between the bid and ask will not only improve BNDES’ cash flow but will give liquidity to the market.”
Lustosa points out that BNDES is now a registered securities dealer with the central bank and therefore such trading would not be a wholly new operation for the bank.
Lustosa is also working closely with large individual pension funds, as well as the pension funds’ regulator Abrap and the banking association, Anbima, to try to develop a debenture structure that will suit all market participants. Lustosa is keen, given her objectives to achieve more with less finance, to commit less capital and instead is exploring the possibility of providing credit enhancements.
“Pension funds tell us it is very difficult to understand the pre-completion risk. And that’s what we do,” she says. “That’s our DNA, so we could help a lot by providing a BNDES stamp of approval.”
One of the issues for pension funds is that infrastructure bonds are exempt from tax for individuals but not for pension funds and other institutional investors. Lustosa says private banking clients are so eager to get these bonds – especially today as the yield on sovereign bonds has been falling – that the price of these bonds is driven in the bidding process to a level at which pension funds cannot compete.
Lustosa is reluctant to be drawn into the policy discussion that is going on in Brazil about the tax-exempt status of private banking staples. However she does say: “The ministry of finance is having that discussion… only the rich are using those structures and that’s not the idea. There is also another question which is: if you have multiple tax-free instruments such as CRIs and LCAs and infrastructure debentures, there is a problem in dividing liquidity and ending up with illiquid investment pools.”
However, Leandro Miranda, head of Bradesco BBI, thinks two tiers of infrastructure bonds will emerge.
“They’ll be two distinct markets,” Miranda says. “If we are dealing with a transaction that is double- or triple-A, and that goes up to seven or even 10 years with amortization and a five-year duration, then of course individuals would be the main target market. No institutional investor would be able to match it. But for a name that individuals don’t know, or for a transaction that is very long – longer than 10 years – or if the debenture is rated AA- or A+, then the individuals wouldn’t be interested and that’s the room for pension funds. Pension funds will have to be more professional – more skilful in assessing these risks – and that would be a logical development.”
“One of the ideas we are discussing to get around the lack of liquidity is for BNDES to incentivize the market in some way. But we should charge for that,” says Lustosa.
One possibility is the creation of special purpose companies, with BNDES responsible for the debt service coverage rating.
“We would analyze how much debt a project can face in the case of a non-recourse loan,” she says.
If the Brazilian market is to develop such project-specific financing, Lustosa thinks that BNDES could have a pivotal role as she argues the bank understands the risk components better than anybody – from licensing and environmental issues to construction.
“[Non-recourse project finance] is a fiction in Brazil now, but hopefully we will be able to move towards specific project structures in the future,” says Lustosa.
One mechanism being considered that could encourage this development is for BNDES to commit to say 70% of the financing of the special purpose company but initially provide only 40% (the exact proportions are still being discussed) and then provide a backstop arrangement for the rest.
Private-sector investors would be incentivized to issue a debenture that would cover the rest of BNDES’ commitment and if, for any reason, the market is not there for a debenture, BNDES would step in. This makes the bank’s role one of encouraging private finance and acting in a truly counter-cyclical role while also fulfilling its objective as a development bank.
As Lustosa says, doing the same or more with less money.
The fall in the country's base BASE rates at the same time as BNDES’s interest rate is converging with the market rate means Lustosa is operating with a helpful financial environment. Pension funds, asset managers and private banking clients will have to begin to take on risk as they move away from sovereign “risk-free” products that delivered returns higher than the actuarial target in recent years.
In Brazil, one never knows how long conditions will remain stable, so does Lustosa feel a sense of responsibility to act while the opportunity exists?
“Yes, the stars are aligned at the moment,” she agrees. “Sometimes, good initiatives fail because they come at the wrong moment, but the government is facing an interesting situation because we have interest rates going down and we have this movement to make BNDES more effective.
“We can spend less but be more effective; we can take on risk and, by understanding the gaps in the market, provide targeted incentives that avoid crowding out. As investors need to be more aggressive they, too, will need to be more creative and face risks. This is interesting. It might be a moment, like one that we had in 2002.
“I hope we don’t lose this moment.”