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Jamestown Latin America | Trends+Views | Brazil: Aiming for a Return to Growth | May 2013


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Economic conditions in Brazil are likely to
improve this year but structural bottlenecks will
take years to resolve themselves, a testament
to the massive necessity to improve logistics,
transportation and education – all necessary to
improve Brazil’s competitiveness

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Jamestown Latin America | Trends+Views | Brazil: Aiming for a Return to Growth | May 2013

  1. 1. EXECUTIVE SUMMARY Economic conditions in Brazil are likely to improve this year but structural bottlenecks will take years to resolve themselves, a testament to the massive necessity to improve logistics, transportation and education – all necessary to improve Brazil’s competitiveness. •  Financial markets are reflecting a shift in sentiment toward Brazil, due to weaker economic momentum, worsening terms of trade and rising inflation •  Structural bottlenecks prevent Brazil from growing at the same pace as many of its Latin American neighbors •  However, purchasing power of the average citizen has increased substantially in recent years, thanks to a strong labor market •  Key to generating stronger growth is fostering a more transparent environment for investment and capital expenditures TOTAL GDP: 2012: $2.4 trillion (global ranking: 7) GDP PER CAPITA: 2012: $11,522 (global ranking: 57) GDP GROWTH RATE: 2012: 0.9% / 2013E: 3.0% UNEMPLOYMENT: 2012: 5.5% / 2013E: 5.4% INFLATION: 2012: 5.8% / 2013E: 5.8% BRL/USD: 2012: 2.05 / 2013E: 2.02 TRADE BALANCE/GDP: 2012: 0.8% / 2013E: 0.4% 2012 GINI COEFFICIENT: 54.7 2012 INFRASTRUCTURE BANKING: 70 (144) 2012 INVESTMENT/GDP RATIO: 18.5% 2012 PUBLIC SECTOR DEBT/GDP: 55.2% 2012 FISCAL DEFICIT/GDP: -2.5% ECONOMIC SNAPSHOT Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS JAMESTOWN LATIN AMERICA Real Estate Private Equity Contact: Bret Rosen – Managing Director, Research +1 212-652-2141 Rio de Janeiro • Bogotá • Atlanta • New York Sources: Bloomberg, IBGE, BCB Focus Survey, IMF, Deutsche Bank, World Bank, JPMorgan, World Competitiveness Report
  2. 2. At the start of the decade, economic momentum in Brazil was robust and investor sentiment buoyant. With preparations beginning for the 2014 World Cup and 2016 OIympics, the BOVESPA stock index hitting an all-time high, and record amounts of foreign direct investment pouring into the country, it appeared that Brazil’s ‘moment’ had arrived. Indeed, Brazil’s capacity to recover from the global financial crisis impressed many observers and investors, as the economy grew 7.5 percent in 2010, after dipping just 0.5 percent in 2009 (as compared to a 6 percent contraction in 2009 in Mexico). Economic growth combined with social programs such as Bolsa Familia to lift millions out of poverty leading to a growth of the middle class that is unprecedented in the country’s history.1 Booming commodities prices also contributed to massive wealth generation as China became Brazil’s largest export destination.2 Lower interest rates made credit available to wide swathes of the population, inspiring a consumer boom; retail sales exploded, especially of items deemed durable goods, often bought in installments. The Brazilian currency experienced a relentless appreciation, as along with foreign direct investment, massive portfolio inflows entered the country’s equity and fixed income markets. However,thecurrentsentimentinBrazilhaschanged.The last 2 ½ years have been characterized by disappointing growth, leading economists to speculate that there are structural issues in the Brazilian economy that prevent it from growing at similar levels to its Latin American counterparts such as Peru, Chile and Colombia over a full economic cycle. Growth in 2010 was fueled by a fiscal expansion in the run-up to the Presidential election of that year, which fueled higher inflation, a tightening of monetary policy and a hangover that resulted in 2.7 percentgrowthin2011.Lastyear’seconomicperformance was also a disappointment, as business confidence was dragged by the unpredictability of economic policy making and the debt crisis in Europe. Growth was a meager one percent last year. 2013 should bring growth closer to three percent, still below the rate registered in most other large emerging markets countries, and slightly below what is considered potential growth in Brazil. While the consumer remains vibrant in Brazil, the middle class is still expanding, and real wage growth is positive, the giddy attitudes of a few years ago have become more guarded. A third straight year of economic underperformance has dampened animal spirits, and subsequently investors and businesses have been more cautious about the near-term economic outlook. In dollar terms, the BOVESPA index is down 21 percent year-to-date, through June 14, even as the SP 500 is up over 14 percent.3 Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS Economic momentum in Brazil has softened, dampening the enthusiasm of a few years ago 1 Bolsa Familia is a social welfare program of the Brazilian government, part of the Fome Zero network of federal assistance programs. Bolsa Família provides financial aid to poor Brazilian families; if they have children, families must ensure that the infants attend school and are vaccinated.The program attempts to both reduce short-term poverty by direct cash transfers and fight long-term poverty by increasing human capital among the poor through conditional cash transfers. 2 3 Bloomberg. 2006 2007 2008 2009 2010 2011 2012 2013E 2014E -1 0 1 2 3 4 5 6 7 8 CHART 1: BRAZIL ANNUAL GDPYEAR-ON-YEAR (%) Source: Bloomberg and Banco Central do Brasil Focus Survey, May 24, 2013 PAGE 2TRENDS + VIEWS MAY 2013
  3. 3. In the discussion that follows, we pose a few key questions about the country’s economic situation, with responses that intend to address these key issues. What are the main reasons for Brazil’s recent relatively disappointing economic performance? First off, the industrial sector, which accounts for approximately 1/4 percent of total GDP, has essentially been in recession for the last several years.4 An important explanation for this performance has been that competitiveness in industry has been harmed by the strength of the Brazilian real (BRL), which has encouraged relatively cheaper imports while also detracting from Brazilian firms’ ability to compete versus their Asian counterparts. Firms that were previously competitive in the middle of the last decade, when the BRL was at a depreciated level, found margins squeezed as the BRL broke the 2:1 level and headed to 1.60. But even as the currency has weakened 25 percent from its stronger levels reached in the first half of 2012, to 2.15:1 currently, manufacturing has struggled. This provides evidence that the currency strength is not the only factor holding back manufacturing, even though the industrial lobby in the country and politicians tend to focus the debate chiefly on the currency. We point to more structural issues as explanations for this ongoing underperformance, related to 1- High cost of labor amidst a tight jobs market; 2- Inflexible labor markets which make hiring and firing prohibitive; 3- Infrastructure bottlenecks, as Brazil’s transportation and logistics links are ranked among the world’s poorest; 4- Taxation issues; 5- Overall high costs of doing business. The labor market remains an ongoing challenge for business, as the unemployment rate has hovered just above 5 percent, a record low, pushing real wages upwards.At one juncture in 2011, real wages were rising at nearly 8 percent on a year-on-year basis, while the minimum wage in 2012 rose by 14 percent in nominal terms. The World Competitiveness Report points out other challenges that harm competitiveness of manufacturing: Brazil’s port infrastructure ranks 135th of 144 countries surveyed, hiring and firing practices were deemed 114th, while the burden of government regulation was dead last, in 144th place.5 Brazil’s tax take as a percentage of GDP, typically around 35-36 percent, is among the highest in emerging markets, and the tax code can be described as byzantine. The aforementioned factors all contribute to the ‘custo Brasil,’ which translates into the ‘Brazil cost,’ and describes the complexity and costs of doing business in the country. Still,Brazilianindustrycansucceedinparticularareasasis the case with Embraer, the globally competitive airplane manufacturer. Embraer is one of the world’s four largest airplane manufacturers, and has successfully identified a niche market – smaller sized jets – and combined it with world class engineering. Brazil’s competitive advantage PAGE 3 Brazil fares poorly in many global indicators of competitiveness CHART 2: BRAZIL INDUSTRIAL PRODUCTION -20 -15 -10 -5 0 5 10 15 20 25 Jan-09 M ay-09 Sep-09 M ay-10 Sep-10 M ay-11 Sep-11 M ay-12 Sep-12 Jan-13 Jan-10 Jan-11 Jan-12 Source: IBGE and Bloomberg Year-on-Year (%) 4 JPMorgan, Brazil 101, 2012 Country Handbook. 5 Global Competitiveness Report, 2012-2013, World Economic Forum. Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS TRENDS + VIEWS MAY 2013
  4. 4. may have been eroded in some areas, but the country still has world class firms in a number of fields, such as petrochemicals (Petrobras and Braskem), steel (Gerdau, CSN, Usiminas), and autos (mostly foreign companies operating in the market, such as Ford and GM). The industrial base is amongst the most sophisticated in emerging markets, with top management teams, who are experienced navigating challenging markets. Still the overall outlook for industry will revolve around the country’s ability to resolve important bottlenecks, ease regulation and taxation and thrive amidst the backdrop of a currency that still looks fully valued. Are investors correct to be less bullish on the country’s prospects? Indeed, it has become in fashion for Latin American portfolio investors to shift their focus to Mexico and the smaller Andean markets, while Brazil’s growth languishes. While Peru, Chile and Colombia grow four to six percent, and Mexico is enjoying a wave of reform momentum, Brazilian growth has disappointed and there has been no progress on efficiency enhancing reforms. Despite such sentiments, we would argue that many investment considerations and business conditions in Brazil currently are not markedly different from three to four years ago when enthusiasm was everywhere, equities were soaring and credit default swap (CDS) spreads were trading inside of other Latin American peers. Levels of foreign direct investment will still be around $60 billion this year, the domestic market is Latin America’s largest - by far, the growth of the middle class is a trend that we believe is irreversible, and a great number of multinationals are targeting Brazil for the longer-term potential that the country offers. The main shift in sentiment has been due to the increased level of government interference in the economy. Namely, the government has taken on a more statist role especially in its stance vis-à-vis energy (Petrobras, noting local content laws), mining (Vale, where the government helped engineer a management shakeup), banking (pressuring private banks to lower interest margins) and utilities (regarding the tariff regimes).6 Businesses not only complain about the degree of government intervention, but the unpredictability of it. Consequently, the levels of capital formation necessary for the economy to achieve higher rates, has disappointed, and indeed the investment to GDP ratio in Brazil is under 20 percent, whereas Colombia, Peru and Chile display figures in the mid to upper twenties. For Brazil to grow in a sustainable fashion at a rate of five to six percent, a greater level of gross capital formation is required, along with improvements to the various themes described above. What should we expect from 2013? Market economists anticipate growth of three percent in 2013, with improved performance a function of a better global backdrop, a statistical rebound from last year, and the lagged impact of both expansionary fiscal and monetary policy. Typically it takes six to nine months for monetary policy decisions to affect economic outcomes, implying that the economy should benefit from the record low rate on the SELIC (Brazil policy rate) in the months to come. Consumption growth may be 6 Brazil still is benefiting from massive flows of FDI and the impressive growth of the middle class PAGE 4 Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS TRENDS + VIEWS MAY 2013
  5. 5. somewhat weaker than 2012, but will still be the main driver of economic activity. Meanwhile credit growth will remain strong by international levels, likely around 15 percent, but this will be slower than the previous couple years as banks are cautiously optimistic. Manufacturing activity remains unimpressive, although there are some signs of improvement especially in auto production. The unemployment rate should remain in the mid-five percent range, although the pace of job creation is likely to stay low. The major issue, economically speaking, in Brazil at the moment relates to inflation. The most recent inflation projections for April, showed the year-on-year figure at 6.49 percent, just one basis point below the upper end of the central bank’s target band of 2.5-6.5 percent.This high inflation comes amidst a backdrop of weak growth along with a variety of government measures to control price pressures, namely related to food and electricity prices. Services inflation is still elevated, at over eight percent, and has been in the high single digits for quite some time - a function of the tight labor market, which has kept real wages elevated. It is expected that inflation may once again surpass the 6.5 percent limit in the months ahead, but should recede in the second half of 2013 due to relief on the food prices front. The lagged impact of the weaker BRL should also dissipate which statistically will help bring IPCA below 6 percent.7 Still, inflation represents a major political challenge for the Rousseff government, as given the country’s history, there is limited tolerance amongst the populace for persistent spikes in prices. Indeed local media is putting greater focus on price moves across the board. Due to the inflation pressures, the Central Bank (BCB) has engaged in a process of monetary tightening, most recently lifting the SELIC rate by 25 basis points (from a record low 7.25 percent) to 7.5 percent at its April meeting, followed by another 50 basis points hike in May. This came on the heels of 525 basis points of monetary easing, which commenced in August 2011. The Central Bank’s policy stance has been particularly controversial. The COPOM (monetary policy board of the Central Bank) began its easing campaign with IPCA inflation, the main price index, above seven percent, as the COPOM expressed concern about the potential effects of the global financial crisis on Brazilian growth. While GDP did indeed falter, inflation never receded to the 4.5 percent target. Meanwhile the COPOM continued to ease, reducing SELIC to a record low and bringing the real rate to just one percent. Some observers believe that the BCB – although not technically an independent central bank – has been susceptible to political pressure from the government, which clearly prefers a lower interest rate environment. But as IPCA inflation once again surged above the 6.5 percent limit in March, the BCB was left with no choice but to lift SELIC at its April meeting. Markets look for another 100 basis points of tightening in this cycle as the BCB looks to dampen inflation expectations which remain elevated and hopefully bring IPCA back toward around 5.5 percent by year end. Regardless, markets question the effectiveness of the official 4.5 percent 7 IPCA is the most frequently cited inflation index by the central bank, and generally corresponds to the CPI in the United States. CHART 3: BRAZIL INFLATIONYEAR-ON-YEAR (%) 0 2 4 6 8 10 12 14 16 Jan-12 Feb-12 M ar-12 A pr-12 M ay-12 Jun-12 Jul-12 A ug-12 Sep-12 O ct-12 N ov-12 D ec-12 Jan-13 Feb-13 M ar-13 A pr-13 Source: Banco Central do Brasil CPI CPI Net of Food PAGE 5 Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS TRENDS + VIEWS MAY 2013
  6. 6. 8 Based on Deutsche Bank estimates in “Special Report, Brazil Economic Update,” May 9, 2013. 9 10 inflation target as the BCB continued to ease with IPCA well above 4.5 percent, and has only engaged in a relatively timid tightening with IPCA above the tolerance range. The effectiveness of monetary policy in Brazil remains distorted due to the large role of the BNDES (the national development bank) and public banks, all of which are mandated by the government to expand their loan portfolios, typically at highly subsidized rates. On the fiscal side, the Rousseff government has engaged in a variety of measures to try to stimulate activity. Recent fiscal figures have disappointed with the government well off of its 3.1 percent to GDP primary surplus target. Meanwhile, export performance has weakened; during the last decade the trade sector was a major motor for economic growth but weaker terms of trade and competitiveness issues are weighing. The twelve month trade balance is projected at under USD 10 billion for 2013, which compares with 40 billion plus in 2007.8 Even as recently as 2011 the trade surplus was 30 billion. Clearly the economic difficulties faced by Brazil’s neighbor, Argentina, and Europe are weighing, although we note that the Brazilian economy is less dependent on trade than its Andean neighbors. Regarding the currency, the BRL had been generally range bound in recent months, moving not too far or below the 2:1 level versus the USD, although it has experienced some more substantial weakening of late due to volatility in global fixed income markets. The government has succeeded for the most part in engineering a weaker level for the BRL, primarily by discouraging the entry of portfolio capital into the local fixed income market, via the imposition of a rather draconian entry tax regime (the so-called IOF tax on financial operations, which was reversed this month).9 The BCB has been active at times in the market, especially when it perceives volatility as too high. It does fear a BRL much above 2.1 in our view, as this would make its inflation fight even more challenging. Weighing on the currency, however, is the aforementioned weaker trade balance, partnered with a widening current account deficit. Indeed the flow of foreign exchange has turned negative in Brazil for the first time in years. How can Brazil outperform? While sentiment toward Brazil has shifted somewhat, we tend to view the pessimism as overdone (and would argue that the optimism of a couple years was also overdone). There are plenty of reasons to look at Brazil in a positive manner. Namely, the government has set forth plans for very ambitious infrastructure investments, which will be intended to include private capital.10 The privatizations of several airports last year could represent a productive first step in this regard. Meanwhile a series of PPPs (public-private partnerships) focused on roads, airports and highways will be crucial to help absolve portions of the country from major substantial bottlenecks. The government plans to increase by 50 percent the kilometers of toll roads CHART 4: BRAZIL SELIC RATE (%) 6 7 8 9 10 11 12 13 14 M ar-09 Jul-09 N ov-09 M ar-10 Jul-10 N ov-10 M ar-11 Jul-11 N ov-11 M ar-12 M ar-13 Jul-12 N ov-12 Source: Banco Central do Brasil Benchmark Interest Rate PAGE 6 Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS TRENDS + VIEWS MAY 2013
  7. 7. under private concession, by 33 percent the capacity of privatized railroads, and it will likely privatize two more airports on top of the three privatized last year. The pressure on important segments of the private sector could subside, namely related to banks. Some within the government are conscious that increasing heavy-handedness has dampened investors’ appetite and with presidential elections forthcoming in less than eighteen months, it is crucial for the Rousseff government to deliver stronger growth. Certain officials realize that a less interventionist state can help in this regard. Meanwhile, another key facet to observe will be the battle versus inflation. If the BCB can engineer a gradual monetary tightening that lowers inflation expectations, markets will be relieved. With the BOVESPA trading at a low multiple, some interest has returned to the stock market and indeed recently several large IPOs occurred, including the insurance arm of Banco do Brasil in a several billion dollar deal.11 Finally, the policy debate in Brazil may heat up as elections approach. It is entirely possible that the economic disappointments of the last several years become a focus of discussion, with opposition parties perhaps gaining traction by advocating a friendlier policy mix. In conclusion, we do believe that economic conditions in Brazil are likely to improve this year but structural bottlenecks will take years to resolve themselves, a testament to the massive necessity to improve logistics, transportation and education – all necessary to improve competitiveness. Meanwhile economists such as those at Morgan Stanley continue to highlight the so-called ‘supply-demand’ mismatch.12 Indeed over the last three years retail sales rose 24 percent while industrial production fell 0.6 percent. A substantial portion of the populace has felt pretty good, with wages up, the economy enjoying full employment, the middle class expanding, government subsidies plentiful and credit generally more available than it was a decade ago. Hence, and assisted by the BRL, purchasing power and consumption are strong. But supply is not, due to the issues we highlighted that have affected investment expenditures. With the country’s tax structure (tax burden of 35 percent of GDP is particularly high), and concerns about the level of skilled workers in the labor force, this mismatch may takes years to resolve itself, implying that any periods of strong growth lead to inflation. Finally for investments to blossom, terms of trade will need to improve, which may hinge on the resurgence in global commodities demand, as there historically has been a strong correlation between commodities prices and the investment cycle in Brazil. 11 12 Morgan Stanley, Brazil Economics and Strategy: Growth Mismatch Survival, Winners and Losers, April 1, 2013. Central bank is attempting to tackle the inflation problem PAGE 7 Brazil: Aiming for a Return to Growth – May 2013 TRENDS + VIEWS TRENDS + VIEWS MAY 2013