COUNTRY REPORT / BRAZIL
As Brazils president Luiz Incio Lula da Silva embarks on his second term, investors are increasingly demanding stronger growth and more reforms.
As much of Brazil was focusing on a heated presidential election in late October, mining giant CVRD was busy acquiring Canadian nickel producer Inco for a whopping $17.6 billionthe biggest ever acquisition by a Latin American company. As well as creating the worlds largest nickel producer, this bold move also exemplifies the trend in recent years by several major Brazilian companies including CVRD, Petrobras and aircraft manufacturer Embraerto gain recognition as world-class firms.
Brazil has a very dynamic private sector, especially in the industrial part, well diversified by product and regionand a world-class set of companies, says John Welch, senior Latin America economist at Lehman Brothers. Partly helped by strong demand for commodities such as iron ore from China, Brazils economy is expected to grow by 3.6% this year and another 4% next year, according to forecasts from the International Monetary Fund. Bear Stearns is less optimistic, expecting a 3.1% expansion this year and 3.7% next year. Both forecasts compare favorably with last years 2.3% growth rate, however.
The outlook is positive in the short term due to a smooth transition process and the continuing favorable tone of external factors [such as a] positive commodities picture and the US growth outlook less threatening than originally foreseen, says Enrique Alvarez, Latin America fixed-income strategist at London-based IDEAGlobal. However, further out, large doubts will subsist on the ability of the president to pass critical reforms.
Despite the increased GDP growth rates, Brazil lags significantly behind the other BRIC countries Russia, India and China, for example. They have typically grown at rates between 6.4% and 10.2% the past few years and are slated for similar growth this year and next, according to the IMF. Anybody who wants to invest in Brazil in the long term will probably face growth constraints, says Pedro Tuesta, a Latin America analyst at London-based market analysis firm 4Cast. In the short term, there will be some consumption growth, driven by Lulas policies, but not enough to boost the current growth rates much, he says.
That means Lula will have to implement a series of reforms aimed at making the economy more competitive. Competitiveness is the key, asserts Riordan Roett, the director of the Latin American studies program at Johns Hopkins University. The other BRICs are increasingly competitive; Brazil is not.
Brazil also lags behind Mexico and several other Latin American countries when it comes to competitiveness. Thanks to a large budget deficit, high levels of government debt and a wide interest rate spread, Brazil ended up in 66th place among 125 nations in the latest global competitiveness index ranking by the Switzerland-based World Economic Forum. That was a decline of nine places from last year.
Investors say necessary reforms include making the social security system more efficient, reducing and simplifying taxes and liberalizing labor regulations. In social security, there is still a lot to do, says Tuesta. That is still a hindrance on the fiscal side. Further simplification of Brazils tax code and the elimination of distortions on interstate commerce would provide a stronger foundation for more dynamic growth, argues Lisa Schineller, a credit analyst at ratings agency Standard & Poors.
Another major drag on growth is the immensity of state expenditure, which leads to a tax burden of nearly 40% of GDP, Welch points out. The size of the state is way too big, he says. They have to shrink it. Reduced government expenditure would allow meaningful tax reductions, Schineller says. However, the likelihood of that happening anytime soon was diminished when Lula during the campaign attacked the privatizations that took place during the government of his predecessor, Fernando Henrique Cardoso. The only nasty and perverse outcome [of the election] was that privatization became a point of attack as opposed to a good policy, Welch says.
The size of the state is not the only factor dampening the countrys growth. High interest rates are a constraint, says Tuesta. Cutting interest rates, which are among the highest in the world, would boost growth, he says. The central bank, led by the widely respected Henrique Meirelles, has cut rates several times but is still under pressure to cut them further. One of the principal arguments for keeping the rate high has been the fight against inflation. This year it is expected to end up at 4.5%, down from last years 6.5%, according to the IMF. In 2007 it is slated to fall further to 4.1%, the fund forecasts.
A New Inflation Paradigm
The main strength [of the Brazilian economy is that] they have conquered the inflation demons, argues Tuesta. The country has come to the realization that you have to reduce inflation to grow. It used to be that there was a tradeoff: You want growth, you have to have inflation. Thats no longer the case.
As late as 1994, Brazil registered an inflation rate of 2,075%, following years of similar hyperinflation. However, inflation is still a potential problem. Some experts doubt the government will be able to reach its goal of 4.5%. Bear Stearns, for example, forecasts it will hit a rate of 5.7% in 2006 before falling to 3% in 2007.
If Lula does decide to aggressively pursue reforms aimed at making Brazil more competitive, the results wont be immediate, warns Alvarez. Any reforms that are implemented will have a long-term horizon in affecting growth, as modifications to the current regimes in pensions, taxes and labor markets will be phased in and not have an immediate impact on the economy, he says. He predicts that Lula will first aim at getting the political challenges out of the way before starting on the economic ones.
Lula da Silva has initially spoken of a political reform to come as a priority in his second administration, and we deem that this will target the perceived corrupt structure of the current administration, seeking to clear the path of this element before moving forward toward actual economic reforms, Alvarez says. The corruption ballast will need to be removed before any adequate policy initiatives have a chance of passing through congress.
Lula has been plagued by several major corruption scandals since June 2005, which have resulted in the resignations of key members of his government and the governing PT party. He has denied any wrongdoing despite charges of the opposite from his critics. The latest scandal almost certainly cost him an outright victory in the first round of elections on October 1 but was not enough of an issue to deny him the second round on October 29. They had three weeks to prove corruption, and nothing stuck, Welch says about the period between the elections. As a result, he says, it is unlikely that Lula would be impeached.
Although the PT did not secure a majority in congress, Lula will probably forge a working coalition with the largest party, the PMDB, Welch predicts. But several experts doubt there will be much change, at least in the short term. Nothing will change in the next year at least, Tuesta says. What is negative for the long term is that he is not willing to take on necessary reforms on the economic side.
Roett agrees. There has never been great enthusiasm for economic reforms in Brasilia, he says. I expect the pace for reform in the second term will be about as good as the firstmeaning not enough and probably too late.
Investment on the Rise
After a decline last year, foreign direct investment (FDI) is on the rise again. This year it should reach a total of $18 billion, an increase of 19.2% from last year, Bear Stearns forecasts. FDI slumped by 17% in 2005. While it has struggled recently, Brazil does well compared to its BRIC peers in terms of FDI. In 2005 it lagged behind China but was ahead of India and Russia.
But more important, exports are booming and are expected to reach $134 billion this yearan increase of 13% from last year, according to Bear Stearns. CVRD, which accounts for 22.4% of Brazils trade surplus, reported a 46.8% increase in exports during the first half of the year. While China accounts for much of the export growth, Brazil has also seen significant growth in exports to the United States. Combined, the two markets have helped the Port of Santos in Brazil become the largest container port in Latin America.
Brazils large number of exportable value-added products and essential commodities such as iron ore are among the countrys main strengths, argues Alvarez. But some observers warn the commodities boom may be a double-edged sword. Roett points out that there is great demand in the short term, but the country has no control over pricing. Welch disagrees. Brazil is not as vulnerable as people think in commodities because they import a lot as well, he says.
Apart from the growing FDI and exports, Brazil is also seeing another strong year among its leading companies. State oil company Petrobras, the largest company in Brazil, boosted its net income by 58.1% to $3.4 billion in the first half of 2006, while revenues grew by 26.4% to $17.3 billion. Last year, Petrobras was the most profitable company in Latin America despite lagging oil companies Pemex of Mexico and PDVSA of Venezuela in overall revenues.
CVRD, the worlds largest iron ore producer, boosted net earnings by 19.5% to $6.1 billion in the first half, while revenues grew by 7.6% to $18.4 billion. Meanwhile other major companies also reported strong third-quarter results. TAM (Brazils top airline) doubled its third-quarter profit to 25.1 million reals (approximately $11.7 million), while Brasil Telecom, a leading operator, posted a 64 million reals profit compared to a 25.1 million reals loss in the same quarter last year.
Despite the growth challenges, Welch for one is an optimist when it comes to Brazils future. The outlook is very positive, he says.
Joachim Bamrud
