Falling Behind
April 2007

Brazil is the only sub-investment grade BRIC country. It risks falling even further behind if the government neglects urgent fiscal reforms required to power economic growth.

Brazil has basked in the glory of its association with Russia, India and China, the fast growing emerging economies that join it in the BRIC bloc. But by many measures it is falling far behind. When Goldman Sachs coined the phrase BRIC in 2003, the idea was that they could outstrip the G6 economies by 2050, both financially and politically. But as other BRICs take off, Brazil is looking increasingly like a low-tech laggard that cannot grow itself out of a debt overhang.

 ”Brazil has been riding the wave of global growth and a great world environment,” says Edgardo Sternberg, emerging markets debt strategist at Loomis Sayles, which manages $88 billion in equity and debt assets worldwide. “Beyond that, little has been done. When that environment disappears, I want to see how well Brazil does.”

The country is coasting on the commodity rally and its private sector is thriving despite one of the most hostile environments in the world. But Brazil risks squandering a unique opportunity to become a world player if the Lula administration fails to match impressive first term fiscal prudence with equally ambitious fiscal reform and investment in infrastructure and education.

“Macroeconomic and financial instability have been reduced in a very significant and structural way, but the conditions for growth to accelerate to a new plateau have not been created,” says Alberto Ramos, senior Latin America economist at Goldman Sachs.

Ramos flags increased public spending through social transfer projects as a drag on Brazil’s projected 3.5% growth for 2007. China, India and Russia should register 9.8%, 8% and 7% economic growth in 2007, according to Goldman. Brazil has averaged just 2.6% growth since 2000, compared to 9.56% for China, 6.65% for India and 6.77% for Russia, Goldman data shows. And even though Brazil has the third largest economy by GDP, it has the second highest ratio of debt to GDP of the BRIC countries, the bulk of which is short-dated, keeping it at the junk rating.

Ramos sees slackening fiscal austerity and an uptick in public spending as cause for concern. “What [Brazil is] doing is reducing the primary surplus, which is quite a dangerous gamble for a country that still has a debt to GDP ratio of 70%. [Brazil] should be more aggressive in reducing the debt load at this stage by saving more of the revenue windfall over the next two to three years,” says Ramos.

By contrast, Mauro Leos, Brazil sovereign analyst at Moody’s says, “China and Russia’s debt ratios have plunged radically.” According to Moody’s, Russia’s debt to GDP fell from a peak of 72.5% of GDP in 2000 to just 10.9% last year. Russia, which defaulted on its domestic debt in 1998, has been using oil exports to retire debt. China’s debt to GDP ratio has declined more modestly to 17.9% from a high of 21.1% in 1998.

“The debt numbers are so powerful [in Russia and China] that we feel even though there are other problems with the credits, such as weak institutions and lack of transparency, those indicators are so strong that the credit risk is similar to an investment grade country,” Leos adds.

Interestingly, India has an even higher debt load than Brazil, at 92.3% of GDP. But Lisa Schineller, Standard & Poor’s Latin America sovereign analyst, says India’s debt profile is stronger than Brazil’s. “India’s fiscal position is not crowding out private investment and growth. Its level of taxation is half that of Brazil and its debt profile is stronger: The average tenor of fixed-rate bonds issued by the government over the last several years is 14 years.” Schineller adds, “Brazil’s history of default and macroeconomic volatility contribute to extremely high real interest rates. This is not the case in India, where local capital markets intermediate domestic savings of some 30% of GDP. The incremental pace of fiscal reform in Brazil has a higher opportunity cost than it does in India.”

Even with the impressive efforts Brazil has made to improve debt dynamics, Leos notes that most of the changes were in external debt, leaving domestic liabilities short dated, floating, and inflation linked. Fitch Ratings notes that roughly a third of Brazil’s domestic debt needs to be rolled each year, and a large share is either floating or inflation indexed. “The risk is Brazil gets stuck where it is,” says Leos.

Outsized Returns

Dedicated emerging market investors are not overly concerned about Brazil’s debt overhang. That is because they are still getting compensated handsomely by the highest interest rates in the world, and liquidity is decent. The Brazil component of the EMBI Global returned 2.2% for the first two months of 2007, compared to 0.66% for Turkey, another Double B rated credit, and 1.49% for Latin America, 1.03% for Emerging Europe. By contrast, Chinese sovereign debt returned 1.87% and Russia yielded the lowest of the BRICs countries, at 1.01%.

Edwin Gutierrez, emerging markets fixed income portfolio manager at Aberdeen Asset Management, with $3 billion in assets, has roughly 22% of his portfolio in BRICs. Brazil gets the highest allocation, at around 14.5%, mainly in external sovereign debt. “We don’t have to move down the curve in Brazil because we are being paid 12% in government debt, whereas in Russia we have to be in corporates because sovereign yields are so low,” says the investor.

Gutierrez expects to stay invested in Brazil for the foreseeable future because he doubts it will reach investment grade in 2007. If Brazil makes high grade, it can access a much larger and deeper pool of investors who cannot buy junk. Gutierrez sees Brazil’s debt stock as still too short in duration and too heavily reliant on floating rate and inflation-linked instruments. “It is a vulnerability. For Brazil to have a meaningful swing, that composition has to change. It has to improve and it will take time.”

Philip Suttle, global head of emerging markets research at Barclays Capital, describes Brazil’s efforts to reduce its external debt burden as “very impressive”. But he says Brazil is right to transition to growth gradually while sustaining a balance in the rest of the economy.

George Estes, portfolio manager at GMO with $5 billion invested in emerging market debt, is less patient. He has $1.6 billion in the BRICs, with $1 billion of it in Brazil. Estes, who describes his fund as actively managed, is focused on the long end of Brazil’s external curve for the higher yield. Yet he is skeptical that Brazil will reach investment grade in 2007. “Brazil has grown much more slowly than the other countries and I don’t see that changing until they lower their tax burden from 38% of GDP. It is going to be a weight on growth that will prevent them from growing out from under their debt.”

Loomis Sayles’ Sternberg doubts that the second Lula administration has the political capital or will to embrace fiscal reforms. “It seems this administration is struggling with internal politics, juggling the needs of the country and the limitations of what the different party constituents will allow. That is not a good environment for doing any of the reforms required.”

Sternberg adds that sound macroeconomic policy, which has tamed inflation and brought down interest rates, has done little to unleash economic growth. “We have seen rates come down from 19.75% to 12.75%, which is substantial and should have helped and didn’t do anything for growth. The trouble is the country taxes far too much.”

Productivity Crisis

Companies like mining giant CVRD have invested billion in infrastructure to get their goods to market. But the bulk of the private sector must struggle with an ageing system that suffers from chronic underinvestment. The World Bank estimates that Brazil must invest a minimum of 3.2% of GDP per year up to 2010 to revitalize its infrastructure. It would need to spend up to 9% of GDP to bring it in line with current coverage in Korea. “While ambitious, this effort, which would add more than four percentage points to the Brazil’s GDP growth, is not unrealistic. Similar increases were achieved by Indonesia, Korea, and Malaysia from the late 1970s to the late 1990s,” notes Paulo Correa, author of a recent World Bank report on Brazilian infrastructure.

Lula’s second administration put forward the so-called PAC initiative to stimulate growth through infrastructure spending. Brazil spent an average of 21% of GDP between 1995 and 2005 compared to 36% in China and 26% in India. Christian Stracke, head of emerging markets strategy at CreditSights, says almost all economic growth in Brazil since the early 1980s can be attributed to increases in the economically active population, not to investment in the stock of physical or human capital.

The public sector relies too much on a distorting tax system with a series of cascading taxes such as a financial transaction tax, a social security levy on companies that charges firms at every step of production, says Goldman’s Ramos. Some corporate taxes, for example, tax revenues rather than profits, making it very difficult for new companies to grow.

Although India, China and India share large informal sectors, they have much less burdensome public sectors and their biggest advantage is the openness of their economies. “Brazil has misgivings about opening decisively to trade, it is still a closed economy. By comparison, China and India endorse more of a free trade platform with the rest of the world,” claims Ramos.

Underinvestment in education is also holding the country back. “Unusually low spending on education should be far more of a concern for investors and policy makers than it is, as Brazil ranks extremely low amount its Latin American peers, not to mention its peers in Eastern Europe and East Asia,” says Stracke. Admittedly, the previous administration of Henrique Cardoso invested heavily in education, reducing Brazil’s illiteracy rate and raising enrolment in schools, but the effects of that will take a generation to be felt, says Goldman’s Ramos.

Surviving Against the Odds

A handful of Brazilian companies has shown it can more than thrive in the cut and thrust of the global economy. Siobhan Morden, Latin American local markets strategist at ABN AMRO, says successive 2006 rate cuts have still not taken full effect and should feed into higher economic growth for Brazil as private sector companies tap the local markets for financing.

Matthew Hickman, portfolio manager at Credit Suisse Asset Management, which has $4.9 billion in emerging market equities and $450 million in Latin America, believes Brazil’s macroeconomic stability, “will allow real interest rates to come down, a financial system to mature. Penetration of credit allows companies to plan in the longer term.”

Caio Auriemo, chairman of Brazilian diagnostic imaging firm Diagnósticos da América SA (DASA), which went public in 2004, says macroeconomic stability should not be underestimated. Between 1974 and 1998 he relied on rolling over 30-day high interest loans from local banks to finance growth. In 1998, a private equity firm took a stake in DASA and groomed it to tap financial markets. That pushed the client base to 50,000 clients a week from 1,500.

DASA wants to become the leading provider of diagnostic imaging services in Latin America and like many companies in Brazil, hopes to benefit from domestic consumption. DASA imports diagnostic imaging equipment from Japan and the US. Previous Brazilian administrations have done much to nurture the medical sector and Brazil has become a leader in generic drugs.

“We have very good medical schools in Brazil connected with external universities. The government invested a lot in healthcare and our industry is lucky to have this momentum,” says Auriemo. However, he admits financial support for investment in research and development is lacking. “In Brazil we don’t have enough support for research and development, so we decided to be the suppliers of the doctors. We don’t try to have patents on technology.”

Brazil excels in aerospace and agriculture. Embraer, which was founded in 1969 as a state-owned company and privatized in 1994, is a source of national pride. It has become one of the largest aircraft manufacturers in the world in commercial, defense, and executive aviation, with a market capitalization of around $8.3 billion.

And Brazil is the world’s largest producer of green coffee, orange juice and sugar, with a 2005 market share of 36%, 60% and 20% respectively. It is the world’s second largest producer of ethanol, with a total output of 16 billion liters in 2005. China is the world’s third largest ethanol producer, with 8% market share, followed by India with a nearly 4% stake.

Oil-dependent countries, especially in Asia, have announced official programs to increase the use of biofuels. Brazil recently revived a 1975 National Ethanol Program (“Pro-álcool”), developed as an alternative to oil in the aftermath of the first oil crisis. After a decade of glory, in 1989, the program collapsed because of a severe shortage of ethanol locally. The first hybrid car that could run either by gasoline and/or ethanol was launched in 2003 and, since then, demand has increased significantly. During the first nine months of 2006, flex-fuel cars accounted for 80% of new car sales in Brazil. Investment in the sugar industry is surging as a result.

Relative Maturity

Suttle says Brazil’s financial system and domestic capital markets are more mature and robust than those of Russia, India and China. “Brazil has a very strong banking system and a real equity market with first world practices. China is the wild east. In China, there is a dual system with a new economy that has many first world standards and practices and then there is the state owned system with its legacy problem.” One Brazilian hedge fund manager, who buys Brazilian and Chinese stocks, describes China’s fledgling equity market as “a black box”. By contrast, Brazil has the most progressive corporate governance principles in Latin America, he says.

Hickman says “China may be growing at a great rate but it is a far less well balanced economy with an undeveloped financial system compared to Brazil. That would give me concern over the longer term.” Barclays Suttle commends Brazil for being “much more willing to let markets work” and highlights the free-floating currency. “The government played a role in the whole dollar adjustment story, and that is in a major contrast with the other three countries that are running close to fixed exchange rate policies,” adds Suttle.

What is needed now is more vision on the fiscal reform side, claims Ramos. “The administration has been shy in investing political capital to get these reforms approved. They don’t think they need to approve a social security reform and they have been very timid at pushing for labor reform. That is a problem when you don’t see any advances in the fiscal area.”

It will probably take another crisis in Latin America to shake governments out of their complacency. In the past, Brazilian politicians have only taken action when things have been dramatically bad. It remains to be seen whether the second Lula administration has what it takes to bring Brazil up to speed with other large emerging markets. LF

Latin American Financial Publications Inc.
www.latinfinance.com