stratfor.com
Brazil: Investors may Soon See Argentina-Level Problems
9 May 2002
Summary
Despite international investors' fears over the likelihood of a socialist winning Brazil's next presidential election, the real dangers to the country's economy will come from opposition and intransigence by state governors and Congress toward whomever is leading the country. Within 18 months Brazil could be following Argentina into a lengthy economic recession and crippling financial crisis.
Analysis
International lenders and financial markets have reacted negatively to new polls showing that Brazil's socialist Workers Party presidential candidate Luiz Inacio "Lula" da Silva holds a substantial and growing lead five months prior to the October 6 elections. In the past two weeks, leading Wall Street investment banks such as Morgan Stanley Dean Witter and Merrill Lynch shifted their recommendations for Brazil from "overweight" to "market weight," a signal to investors to stop increasing their exposure in that county.
Brazilian Finance Minister Pedro Malan has said he believes some foreign investment banks are suffering a case of nerves at the sight of a socialist -- who has made strong statements condemning U.S. dominance in the Americas -- leading the country's presidential race. While Brazil is not at imminent risk of a financial crisis, any sign of reduced international confidence will translate immediately into higher interest rates and more pressure on its currency, especially at a time when neighboring Argentina's economic and political crisis is rapidly worsening.
Amid their concerns about da Silva, both Malan and Wall Street are missing the real point about Brazil's next leader. Whoever replaces President Fernando Henrique Cardoso in January 2003 will be significantly weaker than was Cardoso, and likely will have serious difficulties working with a fractious national Congress and powerful state governors. Whether Brazil's next president is da Silva or someone more appealing to international investors, the country's state governors will have a great deal more wiggle room to evade their fiscal bargains with the federal government, while Congress likely will be less willing to support the new president's legislative agenda.
As a result, Brazil's foreign and domestic public-sector debt likely will begin to climb even before the next president takes office in January 2003. The rise in Brazil's debt load during 2003 -- as a percentage of both gross domestic product and exports -- will follow a front-end decline of at least $7 billion in exports during 2002.
This will skew Brazil's debt-to-GDP and debt-to-exports ratios and fuel even higher interest rates. High rates will cut into corporate investments and profits during 2003 and quite likely the following year as well. By the end of 2003, if not sooner, Wall Street analysts likely will be seeing in Brazil many of the same structural problems that predated Argentina's financial meltdown last December.
Brazil's Finance Ministry and Central Bank claim that the country's domestic and external debt levels are rational and manageable. For example, the Central Bank estimates that total public-sector debt at the end of March 2002 was 680.7 billion reals, or 54.5 percent of GDP. The federal government accounted for only 34 percent of the total public-sector debt, with the balance owed by state and municipal governments and state-owned enterprises. Moreover, nearly 80 percent of Brazil's total debt burden is of domestic origin.
Brazil's Finance Ministry also reported that the country's total external debt at the end of January 2002 was $209.5 billion, of which $181.7 billion was medium- to long-term debt and only $27.8 billion was short-term debt. The private sector holds 55.9 percent of this external debt, while the non-financial public sector owes 44.1 percent. However, the government's external-debt figures don't gibe with the World Bank's estimates that Brazil's foreign debt totals $237.9 billion.
In fact, Brazil faces a vicious set of debt dynamics that could only be reversed through an export boom, which is unlikely to happen for two reasons. First, Brazil mainly exports price-sensitive commodities or industrial products in areas where no one wants to liberalize rapidly (agriculture, commercial aircraft, steel, etc.). And second, while Cardoso has presided over the longest period of economic and political stability in Brazil's recent history, the country's economic growth has been consistently sub-par, due to structural fiscal and legal deficiencies that its corporate oligarchs and political establishment are unwilling to reform.
Cardoso insists that Brazil has a healthy economy, but too many caution lights are blinking simultaneously to accept his assurances at face value. For example, economists like Gary Clyde Hufbauer of the Washington, D.C.-based Institute for International Economics (IIE) note that Brazil's current account deficit is about 4.6 percent to 5 percent of GDP, the government's fiscal deficit is nearly 5 percent of GDP and the country's total debt-to-GDP ratio is increasing about 3 percent to 4 percent annually.
In 2001, Brazil finally achieved a $2.6 billion trade account surplus after six years of external deficits and a major currency devaluation in 1999. However, this achievement was offset by a $27 billion deficit in services and external debt payments.
Moreover, with 67 percent of the heavily leveraged, high-margin Brazilian financial system's assets concentrated in just 10 banks, the rapidly growing problem of bad loans at many of the country's 180 banks could easily spin out of control in 2003 if relations deteriorate between Brazil's next president, state governors and national Congress -- as STRATFOR believes is likely.
The financial system's structural strains are already showing. Despite moderately improved official growth forecasts for 2002, Brazil's benchmark interest rate is currently about 18.5 percent, which is much higher than investors would like. Additionally, the Central Bank in April raised its official base inflation target for the second time in two months to between 4.5 percent and 5 percent.
Meanwhile, Brazilian government and corporate borrowers are already facing tighter international credit markets, as heightened political risk perceptions drive interest rates higher, which also places increased pressure on the country's currency. In fact, the credit-risk agency Fitch currently has a BB- rating with a negative outlook on Brazil's long-term foreign currency, and a B+ rating on the country's long-term local currency.
Brazil needs to achieve sustained growth rates similar to those enjoyed by Chile during the late 1980s and throughout most of the 1990s -- at least 6 percent to 7 percent annually -- to avoid falling back into the political instability, hyperinflation and skyrocketing budget deficits that have undermined the country's hopes of becoming a leading economic power for over 50 years.
However, in 2001 the economy only grew 1.6 percent and the Cardoso government expects growth of just 2.5 percent in 2002, rising to 3.5 percent in 2003. At these sub-par growth rates, Brazil's next government may find it impossible to keep the country from following Argentina into a lengthy period of economic recession and crippling financial crisis. |
