Recent oil discoveries, the hosting of the 2014 World Cup and the 2016 Olympics, as well as improved sovereign ratings from credit agencies, have firmly placed Brazil as a ‘must-have’ investment in every emerging market focused portfolio.
However, investor interest in the country has actually been growing significantly over the last decade or so when Brazil first featured among the fastest growing emerging economies – the BRIC economies. The decade has been marked by stable macroeconomic policies – particularly the move to a floating exchange rate regime, stemming of inflation and improved credit availability – all leading up to the emergence of a larger middle class with the buying power to drive demand for homes, durables, cars, and beyond.
Brazil, a key agricultural products exporting country, also successfully reduced its debt with rising reserve flows due to the strong commodity cycle. The government played a key role in establishing political and macroeconomic stability as well as creating a conducive investment climate through important regulatory reforms that have led to the deepening of the capital and financial markets. The country’s currency has, hence, gained importance for trading partners, global multinationals expanding their businesses into the growing economy as well as investors
Brazil is going from strength to strength to emerge as one of the top investment destinations. Brazil is the seventh largest economy at $2.1 trillion GDP and third fastest growing economy among the top 10 economies (by GDP) in 2010
Brazil is recipient to the largest FDI flows in South America
- Brazil’s growth story has largely been driven by growing consumption demand from a large population base whose real incomes are improving, on the back of robust growth in agriculture, industry and services
- GDP per capita, at purchasing power parity (PPP), has risen 56% since 2000 and the economy registered a 7.5% y-o-y growth in 2010 led by 10.1% growth in industrial sector
Brazil’s benchmark stock index (IBOVESPA) has moved in line with the MSCI BRIC Index, and significantly outperformed the MSCI G7 Index
- Foreign Direct Investment (FDI) flows have grown from $25.9 billion to $48.4 billion during 2009-10 backed by strong M&A activity and investments in oil, telecom and infrastructure
- Pertinent policy initiatives to cut fiscal budget and curb inflation have enabled investors to tap into the growth of the economy and have strengthened Brazil’s international reserves position
- Brazil’s IBOVESPA ranks as the tenth largest exchange by equity market capitalization (June 2010) and the equity index has gained 68% since the low in November 2008
- On account of the large Foreign Portfolio Investment (FPI) flows that along with FDI drive Brazil’s foreign exchange reserve accumulation, Brazil’s exchange rate has moved much in tandem with the stock markets; the real (BRL) appreciation has shown as high a correlation as 0.71 with the main BOVESPA stock index monthly returns
Brazilian Real’s performance in the recent years
The withdrawal of foreign capital (during June 2008-February 2009) from Brazilian stock and debt markets due to the flight to safe haven investments around June 2008 was one of the main reasons that caused stock indices to crash and the Real to depreciate significantly. Despite the recent weakness in financial markets that has dragged the Real down with it, the currency has witnessed more than a circa 30% appreciation against the USD since January 2009 and ranks amongst the ten best performing currencies for the period July 2010-July 2011 as well as January-December 2010. The persistent appreciation in Brazil’s currency has been driven by the following factors:
- Strong recovery in Brazil following the global crisis, with 2010 witnessing a strong 7.5% real GDP growth as fixed investment, industrial production, capacity utilization all picked up starting in 2Q 2009
- Favorable interest rate differential compared to developed economies since the historical lows reached during June 2009, has been largely responsible for continued flow of foreign debt investments
- Excessive global liquidity due to loose monetary policy implementation in developed economies, post the economic crisis, has been supportive of strong capital flows to emerging market economies such as Brazil
- Brazil’s central bank and the government played key roles in shielding the economy during the global financial crisis – through a significant economic stimulus package (which spurred a return to growth), adoption of liquidity-boosting measures, and by containing inflation, in spite of declining export demand from recession-hit trade partners such as LATAM, the US and Europe.
Our Outlook for the ‘Real’
Our outlook on the ‘real’ for the next year is “Neutral” at the current level of c. 1.6117BRL per USD, as on August 12, 2011. We expect the ongoing turmoil in global financial markets, led by the uncertain growth outlook for the US and the European sovereign debt crisis, to significantly erode inflow of equity foreign portfolio investments (FPI) into Brazil, as investors divert funds away from the perceived riskiness of emerging markets. Equity FPI flows have already weakened drastically, driven by a lower GDP growth outlook for Brazil – the IMF’s latest real GDP growth forecasts for the country stand at 4.1% for 2011 and 3.6% for 2012, compared with the 7.5% growth registered in 2010. In addition, Brazilian exports’ high exposure to commodities places the already large current account deficit at substantial risk of widening further as any slowdown in global growth will weigh on commodity prices, which are still at or near record highs and have helped a sustained increase in exports value. Further upward moves for the Real are also largely capped by the government’s stance on preventing further appreciation to protect Brazilian exporters. However, we expect the current exchange rate level to be supported mainly by sustained high levels of foreign direct investments (FDI) and FPI inflows into debt securities. Brazil’s long-term economic growth prospects with improving real incomes driving domestic consumption growth, along with the government’s strong financial position and high forex reserves, should continue to attract large FDI inflows, especially into infrastructure and oil sector projects given recent major oil discoveries in the country. Debt FPI inflows should continue, to take advantage the attractive differential between the US and Brazil’s benchmark Selic rate.
Investment Thesis Foreign investors’ lure for Brazil as an investment destination continues, primarily on account of a robust domestic economy along with significant foreign flows coming in for tapping the domestic economy, investing in oil exploration and production, and infrastructural developments for the 2014 FIFA World Cup as well as the 2016 Olympic Games
2010 y-o-y real GDP growth at 7.5%, however, q-o-q growth now shedding the benefits of low base effect
Brazil has grown at 7.5% in 2010 with y-o-y growth for the four quarters pegged at 9.3%, 9.2%, 6.7% and 5.0%. Q-o-q GDP growth continues to be positive since the recovery in 2Q 2009; however, this was slightly muted at 0.4% in 3Q 2010 and 0.8% in 4Q 2010, primarily on account of agriculture posting de-growth in the third and fourth quarters on a q-o-q basis. GDP has witnessed a y-o-y growth of only 4.2% in 1Q 2011 and a 1.3% q-o-q growth as compared with 2.2% in 1Q 2010.
The broad fundamentals of the economy seem robust and indicate growth potential –healthy retail sales growth (6.9% y-o-y growth in June 2011) reflects strength in domestic consumption and is backed by a steady long-term decline in unemployment (6.2% in June 2011 vs. 7% in June 2010 and an average of 9.3% during 2007). There has been a slowdown in industrial production growth (0.9% y-o-y growth in June 2011, 3.8% in capital goods) and manufacturing sector capacity utilization has declined slightly (84% in July 2011 as compared with 85% in July 2010). However, the Brazilian Central bank’s latest survey (12 August, 2011) indicates that industrial production growth is expected to accelerate with average forecasts at 3% for 2011 and 4.3% for 2012.
Government expenditure that grew at 3.3% y-o-y in 2010, saw de-growth (on a q-o-q basis) in the last quarter of 2010, primarily on account of the government’s conscious effort to reduce expenditure in order to tame inflation. In H1 2011, the government’s expenditure increased 13.4% y-o-y but investments remained flat. Private consumption continues to grow, at 7.1% y-o-y in 2010 and 5.9% in 1Q 2011.
Numerous policy rate hikes to curb inflation, which remains a key challenge
The key challenge for the economy is managing the rising inflation, up from 4.31% in December 2009 to 5.91% in December 2010 to 6.87% in July 2011, crossing the Central bank’s target range set at 4.5% +/-2%. Since the 50bps hike in the Central bank’s benchmark lending rate (Selic rate) in July 2010, the Central Bank maintained the rate at 10.75% till the end of 2010 while increasing the reserve requirements to 12% from 8% on cash deposits and to 20% from 15% on time deposits in December 2010, in a bid to restrict liquidity but avoid increasing the Selic rate, which would have provided further incentive to foreign flows.
The relentless rise in inflation, however, has forced the Central Bank to raise rates five times in 2011 to reach 12.5% in July 2011. Though high food prices is a key reason, inflationary pressures in 2011 have been led by services prices (weight of 24.1% in the inflation index) for which inflation has continued to increase from 7.62% (twelve months) in December 2010 to 8.82% (twelve months) in July 2011 while non-regulated goods inflation has come down from 7.09% to 6.80%. The Central Bank yet again raised the benchmark rate to 12.50% in July 2011 as was expected by market analysts. The latest market survey released by Central Bank on 12 August, 2011, indicates expectations of the current level being maintained till end of the year, with inflation estimated at 6.26% for the full year.
Improving fiscal and overall debt situation; significant measures by the government to cut expansionary fiscal and monetary effects and to address currency’s appreciation
Fiscal position of the country remains robust – at the end of June 2011, external debt was still low at 10.8% of GDP and public sector net debt was at 39.7%, while forex reserves had grown to $351 billion billion as on 12 August, 2011 (growth of 36.4% since end-July 2010 and implied import cover of 18 months).
The new government elected in January 2011 has brought down the government’s expenditure by nearly $30 billion (approx. 1.24% of 2011 estimated GDP) in the announced 2011-12 budget, mainly targeting cuts in administrative and ministry related expenses. These measures to reduce fiscal deficit and government debt level are expected to lower interest rates and tame inflation. These measures have triggered outlook upgrades from ‘stable’ to ‘positive’ by Fitch and S&P and also a credit rating upgrade to BBB from a BBB- issuer rating by Fitch.
The government initiated measures to curb foreign fund inflows in a bid to address the currency’s appreciation that is hurting local exporters. In the second half of 2010, the Central Bank imposed a 60% reserve requirement on banks’ short US dollar positions. In 2011, the Central Bank has intervened in the forex spot market in a big way and also in the futures market with the issue of reverse currency swaps. In March 2011, Brazil increased the tax on international bond sales and loans with an average minimum maturity of up to 360 days from 4% to 6%, and in early August 2011 imposed a transaction tax of 1% on currency derivatives. Such measures indicate the clear stance of the government, though some analysts consider these measures to be ineffective in the long term.
FPI levels have come down during January-June 2011, though significant interest differential over US market continues
The attractive differential in interest rates (increased from 699bps in December 2009 to 930 bps in July 2011) is expected to see foreign flows continuing apace in 2011 as well. Net FPI posted a 46.9% y-o-y growth to reach $67.8 billion in 2010 vs $46.1 billion in 2009. Equity FPI net flows grew 1.7% in the same period, from $37.1billion to $37.7 billion, while Debt FPI net flows surged 231.3%, from $9.1 billion to $30.1 billion.
Discovery of oil in Brazil and infrastructural developments for the 2014 FIFA world cup as well as the 2016 Olympic Games, have led to substantial investments and FDI to Brazil improved to $48.4 billion in 2010 from $25.9 billion in the full year 2009. During January-June 2011, FPI has slipped to $11.6 billion as compared with $23.2 billion in the same period in 2010, led by a 70% y-o-y decline in equity FPI to $2.9 billion in January-June 2011. While equity issuances have been announced by various companies in oil & gas, utilities and consumer markets, there have been postponements, cancellations and weak pricing of issues due to weak market conditions, resulting in primary equity issues remaining flat y-o-y at BRL11.8 billion in January-July 2011. We expect further weakness in equity FPI in light of the recent crash in global equity markets and worries over US economic health and European sovereign debt defaults – deteriorating global investor sentiment typically has a much more pronounced negative effect on equity FPI into emerging markets such as Brazil, as witnessed during the 2008-2009 financial crisis when there were large outflows from Brazil. Debt FPI has also declined by 35% y-o-y to $8.7 billion in January-June 2011 but high real interest rates and a substantial differential over US rates should restrict outflows. FDI, however, continues to grow strongly, at $32.5 billion compared with $12.1 billion in the same period last year.
Little respite seen on the expanding current account deficit
The widening current account deficit is a key concern for the economic impact of the surge in services imports as well as the falling trade balance. The deficit on the current account has grown to 2.3% of GDP in December 2010 from 1.5% in December 2009 and 2.1% in June 2010, primarily due to a 60% rise in net service imports and a 20% fall in net exports.
The trade data for 2010 and 2011 (till July) shows strong recovery in trade with Latin America and growing favorable trade with Middle East and Eastern Europe but the trade with major partners, Western Europe and US, is witnessing increasing imports and no revival in exports.
Brazil’s top 10 commodities related export products (iron ore, soybeans, sugar, coffee, wood pulp, poultry and meat) constituted c.41% of total exports of goods in the 12 months till July 2011. Sustained high commodity prices have helped Brazil’s trade balance increase 64.5% y-o-y to $13 billion during January-June 2011. However, the high commodities related component in total exports exposes the current account to highly volatile commodity prices.
Given this trade scenario and the growing demand for services, particularly transport and leasing services due to the development of oil sector, current account deficit is unlikely to contract in the near future.