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stratfor.com
With or Without Lula, Reasons for Worry in Brazil
21 June 2002
Summary
International investors are growing significantly more worried about Brazil's financial stability. Fears that the country's next president could be an anti-market socialist are partly to blame for the increasingly negative perceptions. However, regardless of his ideological beliefs, it is very likely that the country's next leader will be forced to default on government debts believed to top $300 billion. If Brazil defaults, the rest of Latin America would feel the spillover consequences.
Analysis
Moody's Investors Service lowered its rating on Brazil's federal government debt from "stable" to "negative" June 20, reflecting growing international concerns about the fragility of Latin America's largest economy. Brazilian government officials complained that nervous investors were overreacting to new polls, which give socialist presidential candidate Luis Inacio "Lula" da Silva almost a 20-point lead over his nearest competitor in October's national elections.
The so-called "Lula factor" -- concerns that a socialist who opposes free market policies could be elected president -- undoubtedly is coloring how Wall Street and other global financial markets perceive Brazil's stability. However, these concerns would be justified even if da Silva were not leading the presidential race. Regardless of his ideological convictions, Brazil's next president likely will have to declare a default on the country's debt payments and force government debt bondholders to accept a cut in the value of their bonds.
If Brazil defaults, spooked international investors likely would scale back the declining flow of capital to Latin American economies even more. In a region long characterized by a weak export base and heavy reliance on foreign capital, a steep and abrupt drop in foreign investment could force Latin America into a deep recession -- accompanied, in many countries, by increased political pressures to restructure or suspend debt payments. Given that most Latin American governments are also heavily indebted to their local banks, any government debt defaults likely would cripple local banks as well, causing more economic damage and fueling political and social turmoil in many countries besides Argentina and Brazil.
Brazil's total government debt totals an estimated $317 billion -- including $217 billion of domestic debt and slightly more than $100 billion in foreign debt, according to ABN Amro analysts. About 28 percent of the total is linked to the exchange rate, 40 percent of the domestic debt is linked to the U.S. dollar, and 51 percent is tied to the overnight interest rate, which leaves debt service costs highly vulnerable to a falling currency and rising interest rates.
However, private Brazilian analysts estimate their country's total debt at $344 billion, or almost 75 percent of GDP. That's up from less than 40 percent of GDP just four years ago, despite receiving about $100 billion since 1995 from the privatization of state-owned companies. By comparison, Argentina's federal government debt was about 50 percent of GDP before Buenos Aires defaulted on $142 billion in December 2001.
Additionally, Brasilia must raise $50 billion before the end of 2002 to cover all of its financial needs -- or more than twice the amount Argentina needed and failed to borrow on international markets before it finally defaulted. The need for Brazil to tap international and domestic credit markets is urgent: The country's combined exports, foreign direct investment (FDI) inflows and projected tax revenues are billions of dollars short of the federal government's total financing needs, according to Brazilian Central Bank sources.
The country's economy grew an anemic 0.6 percent during first quarter 2002, according to private Brazilian economists. As a result, projected full-year growth has been downgraded to just 2 per cent for 2002 from 2.5 percent at the beginning of the year. Even this downward revision assumes the economy would grow at least 3 percent in the third quarter and 4 percent in the fourth quarter -- targets that now appear dubious, given the sharp decline in Brazil's exports and FDI inflows anticipated this year. In fact, FDI inflows during May 2002 were about 60 percent lower than the same month last year, according to Latin American Newsletters Ltd.
Brasilia recently announced plans to tap $10 billion in loans from the International Monetary Fund (IMF) to help plug its growing fiscal hole and defend the currency. The money forms part of a $15.6 billion IMF aid package that was agreed immediately after Argentina defaulted. Brazil now has only $980 million of this aid package still available, and IMF officials in Washington said June 20 that no additional aid is planned at this time.
Brazil's Central Bank also started buying LFT floating-rate treasury bills due in 2004, 2005 and 2006 while offering T-bills maturing in May 2003. This exercise indicates that investors are increasingly reluctant to buy any government debt paper maturing too long after Brazil's next president takes office -- but it also introduces a very significant risk factor if the presidential election results upset financial markets. |
