Article on Brazil's "return to prosperity" from Barrons.
April 8th, 2002
The Real Thing
A floating currency and fiscal reforms have stabilized Brazil, paving the way for investors
By Christopher Whalen
In October, 180 million Brazilians will choose a new government for the first time
since 1994. Whether they give the nod to Jose Serra, of the ruling Brazil Social
Democrats, or leftist Luiz Inacio Lula da Silva, or a candidate somewhere between
these political poles, the populace will be affirming the success of the fiscal
reforms implemented eight years ago by current president Fernando Henrique
Cardoso, who is precluded by law from running for a third term. Under Cardoso's
Real Plan, named for the country's currency, the nation's political parties agreed to
pursue fiscal restraint, a dramatic reversal from decades of political
mismanagement and hyperinflation. As a result, gross domestic product is up;
inflation, once an unthinkable 1,000%, has been cut to less than 6%, and Brazil
has become the neighbor its neighbors envy.
Central to the Real Plan was an ill-fated currency peg that fixed the real to the
dollar, following the example of Argentina. In 1999, however, the Cardoso
government was forced to devalue the currency after a spike in the trade deficit,
increases in unemployment and capital flight. The real today is worth 43 cents,
compared with $1.17 at the start of '99 -- a 63% loss in value.
Yet, Cardoso's decision to float the real three years
before Argentina broke its own link to the dollar in
December seems brilliant in hindsight. Unlike
Argentina, which has fallen into financial chaos and
attendant social crisis, Brazil began 2002 with a solvent
banking system and strong capital inflows, and the
recovery now is in full swing. Despite recession in
much of the region, growth in GDP reached 1.5% last
year, and is expected to double in 2002, according to
John Welch at Barclays Capital. The weaker real
boosted Brazilian commerce, thereby transforming the
nation's trade deficit into a $2.6 billion surplus, also
likely to double, and then some, this year.
"Unlike Argentina, Brazil traditionally has been an
exporter of manufactured goods, and has always
attracted foreign investment," says William Gruben,
vice president for research at the Dallas Federal
Reserve Bank. Gruben notes Brazil received $23 billion
in direct investment during 2001, compared with
Mexico's $13 billion (not including Citigroup's $12.5
billion purchase of Banamex).
Since Brazil accounts for one-quarter of Latin America's total equity-market value
of $1.6 trillion, news of fiscal reform and responsible behavior from the main
political parties spells big potential for investors. Last year the country's Bovespa
stock index fell 25% in dollar terms, compared with Mexico's 18% gain and a loss
of 29% in Argentina.
In this year's first quarter, the best for Latin American debt and equity since 1995,
Mexico rallied another 17% and Argentina's Merval fell almost 50%. The Bovespa
declined 3%, a loss that since has been cut to 1%.
Nothwithstanding some recent weakness, Argentina's continuing woes,
Venezuela's currency devaluation and rising oil prices -- Brazil is a net importer --
a growing number of foreign investors are raising their holdings of Brazilian
stocks and bonds. Some see an opportunity to play Brazil's election politics, but
others plan to stick around to reap the benefits of improved fundamentals.
Moody's, which rates Brazil's foreign debt B1, just upgraded its rating outlook to
"positive" from "stable." Standard & Poor's rates Brazil debt B.
Credit for Brazil's return to prosperity rests as much with central bank chief
Arminio Fraga Neto as it does with Cardoso. In March 1999, just after the real's
devaluation, Fraga left his job as a fund manager in New York to become
Governor of Banco Central do Brazil, or BCB. The Rio de Janiero native didn't
know how long the job would last: The currency was under siege, the economy
was weak and turnover among BCB governors was brisk.
But Fraga, 44, is now in his third year on the job, thanks in part to having
followed the examples set by Federal Reserve Chairman Paul Volcker in the early
1980s, and Mexico after 1994. Brazil's central bank used high interest rates to
break the psychology of inflation and stabilize a floating currency. Then, in last
year's fourth quarter, with the real bouncing off its low of 2.8 to the dollar, Fraga
started easing. The BCB cut short-term interest rates in late February to "only"
18%, and with inflation low, some observers expect another rate-cut before the
elections.
"We believe Brazilian debt offers good value," says Julian Eisner, head of
quantitative strategy at Banco Santander in New York. Although yields fell more
than one percentage point in the first-quarter, and price gains might be constrained
in the near term, Eisner thinks Brazilian bonds, still yielding more than seven points
over U.S. Treasuries, offer investors better risk-adjusted returns than Mexican
paper, at two points over Treasuries, or Russian debt, at 3.75 points over
Treasuries. Last month Brazil raised $1.25 billion via a six-year bond issue led by
Goldman Sachs & Merrill Lynch, that priced at 7.30 percentage points over the
Treasury yield curve.
The right choice
Scott MacDonald, chief strategist at Aladdin Capital in Stamford, Conn., a $1.6
billion hedge fund, sees more upside in Brazil than in most markets globally,
including those in Asia that already have rallied sharply. "There are not many
choices for investors," says MacDonald, who argues that Mexico now has a de
facto peso-dollar currency peg and is suffering the same deteriorating terms of
trade seen in Brazil prior to 1999.
Like many analysts, he puzzles over
the fact that Mexico's equity and
debt markets continue to benefit
from strong capital inflows, despite the country's deteriorating economic
fundamentals and a currency that is by some counts 30% overvalued. A former
analyst for the U.S. Treasury, MacDonald foresees no credit upgrade for Mexico
in 2002, but expects a rating upgrade for Brazil.
As Brazil attracts new inflows of foreign investment, the shares of oil giant
Petrobras, financial conglomerate Unibanco and Banco Bradesco, the nation's
second-largest retail bank, all are catching an updraft. Renewed
merger-and-acquisition activity in the telecom sector and elsewhere also is
boosting shares. This year, ING Groep acquired 49% of insurer Sul America
Seguros for $400 million, and Molson of Canada announced the $765 million
purchase of Cervejarias Kaiser, Brazil's second-largest brewer. Nestlé soon will
boost its share of the country's chocolate market to more than 50%, with the
announced purchase of local rival Garoto, Brazil's last independent chocolate
brand.
Damian Fraser, chief Latin American strategist for UBS Warburg, considers
Brazil's equity market cheap at seven times 2003 estimated earnings. Mexico, he
notes, is selling for 11 times projected earnings, while the Standard & Poor's 500
fetches 18 times estimates for 2003. Fraser likes Telemar Norte Leste, a local
telecom operated by Tele Norte Leste, which began trading as a separate listing on
the Sao Paulo exchange last September. He's also recommending cyclicals such as
Petrobras and Companhia Vale do Rio Doce, the world's largest iron-ore producer.
After the final sale of government shares on March 21, CVRD's American
depositary receipts began trading on the New York Stock Exchange under the
symbol RIO. The ADRs have rallied 2, to 27.50.
Fraser thinks Brazil's market can defy expectations of a pre-summer retreat, and
rally strongly into the fall election. With inflation around 5%, he also looks for the
BCB to lower rates. That said, most analysts expect Brazil's interest rates to
remain in the mid-teens for the balance of the year.
Investing in Brazilian stocks means owning the floating real, whose gyrations
greatly affect the dollar value of Brazilian assets. If the BCB allows the nation's
money supply to grow too fast, says Barclays' Welch, the markets push the real
lower, forcing the central bank to raise rates. For example, the ratio of M2 to
hard-currency foreign-exchange reserves hit a peak of almost 5-to-1 in the third
quarter of 2000, after which the real weakened and the BCB raised interest rates.
By last year's fourth quarter the money-supply/foreign-exchange-reserve ratio had
retreated to 3-to-1. It's no coincidence that the real then rebounded, says Welch,
who expects the Brazilian currency to finish 2002 above current levels.
The BCB can afford to let the real float freely because Brazilian banks for the most
part have been weaned from currency speculation, and unlike Argentina's banks
hold mostly domestic assets and liabilities. Fraga credits the BCB's tough
regulation of banks, as well as the government's no-nonsense approach to tax
collection, with enabling the Cardoso Administration to improve the Brazil's fiscal
health in the midst of a recession. Disputing advocates of a dollar peg, Fraga says
a "clean" float, free of central-bank intervention, is the best way for Brazil to
maintain price stability and compete globally.
The markets may test the BCB's inflation-fighting resolve as the October elections
approach, though most foreign analysts think the broad commitment to low
inflation and job creation is shared across the political spectrum. Yet, investors
also may wonder why Brazil's interest rates remain so high and its foreign debt so
cheap compared to Mexico.
Says Fraga, "Investors remember the 1980s -- the failed policies and broken
promises. The reforms led by Cardoso and others were the government's first test
to earn credibility from our citizens and global investors. The October elections
and the transition will be the second test for Brazil, to see if the commitment to
reform is permanent and above politics. When we make a successful transition,
the world will see that we are very serious about price stability and fiscal
discipline. The cost of capital will decline internally and abroad, and Brazil will
move to the next level in terms of economic growth."
Among Fraga's supporters is former Federal Reserve Chairman Paul Volcker, who
helped establish Brazil's central bank in 1965 and visits the country frequently.
Volcker continues to worry about the effects of Argentina's default on global
capital flows, but likes Brazil's prospects and says he expects his fellow Princeton
alumnus to have a long tenure as governor of the BCB.
Christopher Whalen is a New York-based writer and investment banker.
Copyright © 2002 Dow Jones & Company, Inc. All Rights Reserved. |
