Features : Firm Foundations

Sound fundamentals are the key reasons why Brazil, Latin Americas largest economy, and its capital markets have been able to withstand a major corruption scandal.
As the political scandal around President Luiz Incio Lula da Silva reached its peak over the summer, nervous investors began to consider bailing out of Brazil. Surprisingly, though, the countrys markets barely flinched. While Lula has been weakened by the scandal, which started in June and has led to several of his top government and party aides resigning, neither Brazilian stocks nor the countrys macroeconomics have been badly affected.


Helped by rising demand in China, Brazilian steelmaker Acesita has grown revenues this year. After hitting a low in July, its stock has been climbing steadily and was selling for more than $35 in mid-Octobera 15% improvement over a year earlier. So attractive is Acesita that Arcelor, the worlds second-largest steelmaker, made a bid in October to buy the company.

In fact, by mid-October the Bank of New Yorks Brazil ADR Index was up 43.04% year-to-date. Much of that was fueled by a combination of the Brazilian companies actual performancesmostly strong improvements over last yearand confidence in the economic fundamentals of Brazil. The fundamentals are extremely strong, says John Welch, the New York-based chief Latin America economist with Lehman Brothers. The markets got worried in August when finance minister Antonio Palocci was accused of corruption by a former aide, but after those charges receded, the threat to economic policy also receded, Welch says.
More recently, a pro-Lula politician, Aldo Rebelo, was elected president of the Brazilian lower house, Welch points out. The election enables Lula to regain control over the legislative agenda after several months suffering a gradually weakening position.


Banco Bradesco, Brazils top private bank, has seen its ADR jump from $34.82 in July to $50.17 on October 10. That brought its increase year-to-date to an impressive 100%. The results are partly tied to the banks performance so far this year; in the first half it managed to more than double its net income over the same period last year.

Although the investigation into corruption continues, most analysts believe the threat to the market is largely over. The market believes the political crisis does not pose any relevant threat to conducting economic policy, says Jos Carlos de Faria, a So Paulo-based senior economist for Latin America with Deutsche Bank. Long-term finance obligations and foreign direct investment are taking care of Brazils finance needs, adds Victoria Werneck, a So Paulo-based economist with UBS. Foreign direct investment last year reached $18.2 billion, the highest in Latin America and a 79% increase over 2003, according to the United Nations Economic Commission for Latin America and the Caribbean (ECLAC).


CVRDs preferred ADR (Rio-P) rose from $27.85 in July to $36.38 on October 10. That was also a 49% increase year-to-date. CVRD, the worlds largest producer of iron ore, has seen continued strong demand from China. And global iron ore demand is rising faster than CVRD can boost its production.
This year will be the third consecutive year Brazil runs a current account surplus, an achievement that is expected to be repeated next year as well, Werneck notes. The surplus this year will be 1.7% of GDP and next year 0.7%, the IMF forecasts.

Last, but certainly not least, the countrys central bank has been given de facto autonomy and has done its job well. Lula, contrary to what everybody believed, let the central bank act autonomously in order to meet its only goal, to bring inflation down, Werneck says. Confounding expectations, the central bank did its job well. Despite the uncertainty resulting from the corruption scandal, Brazils inflation this year is expected to reach 6.8%, only slightly higher than last years rate of 6.6%, according to the IMF. Next year it should fall to 4.6%, the fund forecasted in its latest world economic outlook, released in September.


The ADR of Gerdau, Latin Americas largest steelmaker, has gone from $10.39 in July to $13.92 on October 10. The latest price is also a 16% improvement year-to-date. The company has been helped both by rising demand in China and more recently from Hurricane Katrina repair efforts on the US Gulf Coast.
The outlook also shows that Brazils economy should expand by 3.3% this year and another 3.5% next year. While the 2005 forecast is lower than last years 4.9% growth, its still higher than the GDP growth rate the fund expects in Mexico this year (3%). More importantly, as far as popular support for Lula goes, real wages have been increasing on a sustained basis given the central banks success in bringing inflation down, Werneck points out.

Finally, Brazils international reserves are now at a whopping $57 billion, a substantial increase from the $27 billion in December 2004, Werneck says. You have all these things a country needssolid fiscal front, low inflation, a growing economyso it can weather a big, big storm, she says. If you look at every single factor, Brazil is doing fantastically better than in 2002, she adds, referring to the year before Lula assumed office.


Startup and low-cost airline Gol has seen a slight increase in its ADR pricefrom $29. 70 in July to $31.45 in Octoberyet it can boast rising revenue and net income as it increasingly takes market share from the established flag carrier, Varig.
Improved corporate governance, according to Welch, certainly has helped Bovespa, the So Paulo stock exchange. While its hard to tell yet what impact the new regulations will havetheyve only been in place some 18 monthsthere has been a lot of movement in terms of shareholder resolution, which was a big problem before, he says.

The main impact will be felt over the medium- to long-term rather than today, says Werneck. I think its very important, indeed, but at the current stage with GDP growth and consolidation of an orthodox and serious fiscal policy, this is not the main trigger [behind market optimism], she says. Another factor behind optimism in the markets is that Brazils high interest rates are expected to drop soon, providing a welcome incentive for business in the country, Welch points out.


Helped by soaring international oil prices, Brazils state oil producer Petrobras can boast an ADR price increase of 58% year-to-date. The October 10 price of $57.21 is also significantly higher than the July closing price of $45.72.
Brazil has also benefited from a strong increase in exports. Last year they totaled $96.5 billion, an increase of 32% from 2003, according to ECLAC. Companies that have done particularly well include iron ore exporter CVRD and steel producer Acesita. Even with a negative impact of a global slowdown, it will take a lot to hurt the balance of payments, de Faria says.

Joachim Bamrud