No Reason to Be Bullish on Brazil

No Reason to Be Bullish on Brazil

Amid talks of tax and pension reform and the measures before Congress

at the moment,
Lula’s government has made no attempt to reduce government
payrolls or make the huge bureaucracy
more efficient to meet the needs of
the population. On the contrary, he has created several new secretariats.


Richard Hayes


Brazil’s second sovereign risk bond issue thus far in 2003, this one for US$ 1.2 billion, was a huge
success. According to the arrangers, Deutsche Bank and Goldman Sachs, demand for the Brazilian debt paper from
investors exceeded US$ 5 billion. This placement plus those of several banks and corporations, in addition to the IMF
standby facility, make it appear that regardless of what happens from here on out, Brazil will avoid a default this year.
2003 borrowing requirements will be easy to attain. It will be a few months at least, until interest in "emerging
markets" and specifically Brazilian debt instruments drop off.

To what can be attributed this change of heart in the last ten months, is a topic for lively discussion. The
Brazil risk as measured by the JP Morgan Chase index has fallen to around 700 base points from over 2000 in the
period before Lula and his economic team began to look like neo liberals. Brazilian C bonds reached their peak last
week of over $0.92 to the dollar. The real has strengthened to its highest level against the US$ since July of 2002
before the fear of the consequences of Lula’s possibly becoming president became obvious. Fitch, one of the three
big agencies that rate bonds, recently upgraded Brazil’s classification.

It could be that the analysts, bankers, fund managers, investors, brokers and investment bankers have
thoroughly examined the political and economic situation in Brazil. They may have determined that the government is
making the necessary adjustments that will lead to sound, lasting economic growth that will enable Brazil to increase
its trade balance and FDI (Foreign Direct Investment), the only real sources of funds to enable the eventual
payment of hard currency obligations, other than new loans.

However, the real reason for this sudden display of confidence in Brazil is yield. With interest rates in the
US their lowest since the Depression of the ’30’s and about to be lowered when the Fed next meets and those in
Europe and Japan still unattractive, it is no wonder that Brazilian paper at around 10 percent has appeal.

The real economy is worsening. Unemployment in the greater São Paulo region is over 20 percent,
according to some reports. The automotive industry is in a major slump that has rippling effects with suppliers of parts,
tires, glass, and steel along with causing problems for dealers. Inventories of new cars are high and layoffs are
common. Retail sales are down as industrial activity contracts. Astronomical interest rates and excessive taxation
means that most Brazilians work to support their government and the banks.

Amid talks of tax and pension reform and the measures before Congress at the moment, Lula’s government
has made no attempt to reduce government payrolls or make the huge bureaucracy more efficient to meet the
needs of the population. On the contrary, he has created several new secretariats. These include Economic and
Social Development, Fishing, Women, Human Rights, Racial Equality, Personal Advisory to the President, Press and
Publicity and Personal Spokesman to the Presidency. Also a couple of new Ministries were inaugurated. These organs
help to provide jobs for politicians of the PT and some of the other parties that compose the fragile ruling alliance
who were defeated in last years elections.

Foreign investment needed for infrastructure is apt to remain reluctant to come in. The experience so far in
electricity generating, transmission, and distribution has not been positive. The regulatory agencies that were established
during former President Fernando Henrique Cardoso’s privatization period are being weakened by the government’s
wishes to control the sector. ANEEL, which regulates the electrical field, was set up to protect the consumer and
assure investors a reasonable return on their investment. The experience of foreigners who ventured into Brazil in the
mid to late nineties is not apt to serve as examples that will encourage others to do so. Consequently power
shortages similar to those which necessitated rationing two years ago are sure to appear when and if the economy picks up.

Changing rules have made it difficult for mobile phone operators. Petrobras is doing little to encourage
further investment from overseas in petroleum exploration, refining and distribution. After several years of rational
professional management, the company, Brazil’s largest, seems to be slipping back into its nationalistic habits of the
past. Brazil Watch, perhaps the most interesting newsletter about this country, had an excellent commentary about
Petrobras in its June 6th edition.

Overseas investors are rarely interested in owning highways or port facilities in unstable countries like
Brazil. Therefore improved infrastructure will have to come from local sources, as has been the case so far in
highway privatizations. The story of the railroads is mixed, but foreign participation in those operating the privatized rail
lines seems to be working out. Replacement and refurbishing of rolling stock move at a snail’s pace, however.

So far the government has not become actively involved, which is a good thing. Efficiency is better although
there is plenty of room for improvement. Ferronorte recently inaugurated a new stretch in the southern part of Mato
Grosso state that will save money for producers of soybeans who can use rail rather than trucks to reach the port of
Santos. The same goes for sugar millers in São Paulo state who are doing their best to take advantage of freight
savings as well.

Exports have kept the economic situation from being worse than it is. The trade surplus, which may reach
US$ 20 billion this year, is in no small part due to exports of agricultural products, pulp and minerals. The
government announced an ambitious agricultural financing program recently that, if actually implemented, should provide
ample funding for planting, harvesting, fertilizers, farm equipment, and the commercialization and storage of ethanol,
corn, rice and other grains. Imports continue weak as a result of the slump. The trade surplus alone is not enough to
balance the current account, which hopefully can be plugged by inflows of dollars even though they may be short term
and speculative in nature. Time will be gained.

The clamor over high interest rates and the government’s economic policies continues. Wednesday
COPOM (Comitê de Política Monetária— Monetary

Policy Committee), the central bank’s committee that determines interest rates, will probably lower the SELIC
or basic rate from its current 26.5 percent level. A slight reduction will by no means kick-start the economy but it
may take some pressure off Lula and his economic team.

There are enough technical justifications, mainly a reduction in the rate of inflation, that COPOM can use to
avoid being accused of capitulating to political pressure. Foreign analysts, who seem to be in no hurry to point out
anything negative about the conduct of Brazil’s economy, will no doubt gloss over this.

As a matter of fact, combating inflation with such high interest rates makes no sense at all since Brazilian
inflation is not demand driven. The true reason behind such high interest rates is that if lowered too much, speculative
capital taking advantage of interest arbitrage opportunities might disappear causing problems in covering the current
account deficit.

EMBRAER’s sale of over 100 new passenger jets to American Jet Blue will bring in over US$ 1 billion in a
couple of years. The head of Jet Blue is from a Mormon missionary family and spent years in Brazil as a youth. This
may have helped tip the balance toward EMBRAER away from Canada’s Bombardier.

Lula and Bush will meet again in Washington on Friday. Lula will be the first head of state that opposed the
Iraqi invasion to be invited for luncheon at the White House. The US is aware of Brazil’s importance in the
hemisphere and seems to be going out of its way to be nice to Lula. They do not want another Fidel Castro or Hugo Chavez
on their hands. With luck the Latin American Free Trade Agreement can be pushed ahead from its standstill.

Finally, Lula had his first real taste of vocal opposition to the proposed Social Security and Pension reforms
as 20,000-30,000 noisy government workers protested in Brasília this past week. It was only five years ago that
Lula led a similar protest against Cardoso’s proposals to do more or less what Lula’s government is trying to
accomplish now. A strike has been threatened for July. In general, the public is not sympathetic to the demands of
government workers to maintain their privileged status. Lula’s personal popularity remains high and will be needed as he
grapples with the many challenges ahead.


São Paulo, 16 June 2003

Richard Edward Hayes first came to Brazil in 1964 as an employee of Chase Manhattan Bank.
Since then, Hayes has worked directly and as an advisor for a number of Brazilian and international banks
and companies. Currently he is a free lance consultant and can be contacted at


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