BY WALTER T. MOLANO
Brazil passed an important milestone in 2007, when international reserves surpassed the level of foreign debt. This was an important change from the 1990s, when the economy was suffocating under a mountain of external obligations. International reserves rose to $180.7 billion last year, exceeding the $177 billion in foreign debt. Brasilia was quick to seize on the achievement, heralding its new role as a creditor nation.
Indeed, the nine-fold surge in international reserves, in less than five years, was a major accomplishment. This will be an important argument in its lobbying efforts to secure an investment grade rating.
NOT NECESARILY CREDITOR NATION
However, the fact that Brazil has more reserves than debt does not necessarily mean that it is truly a creditor nation. One needs to look a little closer before drawing such a conclusion.
The commodity boom that started in late 2002 had several effects on the emerging markets. First, it was a positive terms of trade shock, which allowed many developing countries to improve their balance of payments and accumulate reserves. Second, the commodity boom triggered a widespread appreciation of emerging market currencies. It coincided with the debasement of the U.S. dollar, through the simultaneous easing of monetary and fiscal policies. As a result, international investors changed their attitudes on local currency investments. These instruments were once considered to be exotic forays into no-man’s land, but they now became the ticket for easy profits.
Brazil was an interesting case in point. The Banco Central do Brasil (BCB) was trying to overcome the legacies of hyper-inflation, forcing it to employ a tight monetary stance. Therefore, investors earned double digit yields on local currency instruments, while enjoying the appreciation of the Reais—thus producing spectacular returns. Sensing a good opportunity to reduce its dependency on the international capital markets, Brazil used the growing demand for local currency instruments to reprofile its debt—replacing foreign-denominated bonds for more expensive local currency instruments. However, this did not mean that Brazil was reducing its debt or changing its debtor/creditor status. On the contrary, it was only changing the denomination of its obligations—and raising its financing costs in the process.
OBLIGATIONS ARE STILL A DRAIN
Nations classify their debts by the denomination of their obligations, not by the nationality of their creditors. Therefore, local currency obligations owed to foreign investors are considered to be local debt. This was done to reflect the vagaries of the global marketplace. Access to the international capital markets varies, according to domestic or exogenous factors. This makes it difficult for countries to gain constant access to the foreign currency needed to meet their external obligations. However, domestic capital markets are easier to control. The Brazilian government, for example, can print all the Reais needed to meet its local currency obligations. Nevertheless, an obligation is still a drain on the government’s purse—regardless if it is held by domestic or external creditors.
The proof of the pudding lies in a nation’s balance of payments. Brazil had net interest outflows of $7 billion in 2007. That meant that Brazil owed $7 billion more on its external liabilities that it earned on its foreign assets. China, at the same time, received net interest inflows of $43 billion. Malaysia received $220 million in net interest. Even Russia, with its prodigious treasure trove of international reserves, paid $1.9 billion in net interest. The true definition of a creditor nation is one that receives more interest than it pays. Unfortunately, Brazil is suffering a negative carry on its international reserves, earning less than 5% on its assets while paying more than 10% on its liabilities.
The change in debtor/creditor status is a watershed moment. The U.S. became a creditor nation during World War I, when it lent the Entente powers (Britain, France and Russia) $36.2 billion to allow them to import American goods and armament. Like China today, the U.S. was the manufacturing hub of the world. Unfortunately, it slipped into debtor status in 2006, when its net interest payments turned red for the first time in almost a century. The day Brazil registers net interest inflows will be when it can truly brag about becoming a creditor nation. In the meantime, it is just another creditor to the U.S. Treasury—along with almost all of the other countries on the planet.
Walter Molano is head of research at BCP Securities.