The outlook for fixed asset investment after President Lula leaves office in 2011.
BY CARLOS CAICEDO
Brazil’s economy has been performing well, with growing prosperity accompanying a more interventionist approach in its region (peacekeeping in Haiti, brokering talks between Colombia and Ecuador and mediating in Bolivia). The focus of this article is principally domestic. It concentrates on the economy’s vulnerability to a global slowdown, the scale of infrastructure investment in Brazil, the country’s complex federal system, fundamental changes to the oil industry following vast discoveries, the prospects for a fledgling mortgage market and the political outlook, post-President Lula.
At the time of writing, Brazil’s stock market - a bellwether for Latin America, emerging markets and global growth - has fallen 50 percent in three months. Investors are clearly expecting that Brazil’s dependence on commodities will reduce profits as global growth slows, and that its world-class companies such as Vale, Petrobras, Embraer, Odebrecht and Bradesco Bank will see a sharp contraction in their earnings.
However, Brazil is better positioned to enter a global downturn than it has been previously. GDP growth accelerated [last year]… This reflected consistent macroeconomic policies introduced under the Cardoso administration in the 1990s and duly maintained by President Lula. The commodity boom has been partly responsible for stronger economic growth; but, the expansion of the middle class and its rapid increase in purchasing power has been just as significant. Fiscal discipline has boosted Brazil’s international credibility, and the country’s debt burden has shrunk to about 42 percent of GDP. A hawkish central bank has brought inflation under control during a period of strong foreign exchange reserve accumulation.
Yet, President Lula has made little progress in tackling structural reforms. The private sector continues to operate in an environment of relatively heavy taxation (in part, to fund an unsustainable pension system), outdated labor legislation increases production costs and high real interest rates constrain investment.
Lula’s second mandate ends in 2010. His strong approval rating means he may well ‘anoint’ a successor to ensure policy continuity.
Lula’s approval rating has jumped to 80 percent in his second term, which bolsters his position as the most influential political figure in Brazil. Despite occasional calls from members of his Partido dos Trabalhadores (PT) party to run again, this looks implausible. The Constitution does not allow for three consecutive terms, and Lula knows such a change would polarise Brazil. He is therefore being courted for endorsements by politicians seeking office, both locally and nationally. Lula has often hinted that Dilma Rousseff, the president’s current chief of staff, would make an excellent president, and the media frequently mention her as his heir apparent. However, Rousseff, a former guerrilla fighter and political prisoner, is not very popular within the ruling party, where it is thought that other PT leaders have more merits to lead Brazil.
The leading opposition contenders are Jose Serra, the governor of Sao Paulo state, and Aecio Neves, the charismatic governor of Mina Gerais. Both belong to the Partido da Social Democracia Brasileira (PSDB), Brazil’s main opposition party. The nature of Brazilian politics facilitates the creation of wide coalitions. In fact, Lula has governed throughout his two terms with the support of the Partido do Movimento Democratico Brasileiro (PMDB), a mainstream political party, in Congress. An alternative scenario would therefore be a Lula-endorsed coalition candidate, not necessarily from the PT. This would become more likely if the PT falters in local elections or is once again engulfed in corruption allegations.
None of Lula’s would-be successors appear likely to depart from the macroeconomic policies that Brazil has embraced over the last decade. Jose Serra, however, appears more pro-business, and would be more inclined to tackle structural reforms that have so far eluded the Lula administration.
Heavy infrastructure investment will help offset the effects of the global slowdown.
Investment rates in Brazil look healthy compared to other Latin American countries. Indeed, in the second quarter of 2008, private capital investment expanded at its fastest pace in 14 years. However, investment rates lag well behind India and, especially, China. An inadequate physical infrastructure is constraining Brazil’s productive potential, and Lula has vowed to address this via an ambitious investment plan known as the Growth Acceleration Programme (PAC). The PAC entails more than $500 billion of infrastructure investment in the next five years, constituting between 5 percent and 9 percent of GDP compared with 1 percent currently. The authorities are increasingly engaging local and foreign private investors in the construction of more bridges, roads, railways, hydroelectric dams and ports across Brazil.
A stronger currency, the real, since 2005, contributed greatly to the importing of capital goods by making investment less costly. However, recent sharp falls in the currency, tighter global credit conditions and weaker external demand will almost certainly mean that many investment decisions for 2009 and 2010 will be delayed or scrapped. To counter this, the government has promised to make available special credit lines for the completion of ongoing infrastructure projects, particularly for hydroelectric dams, ports, roads and oil infrastructure. (…)
In the case of sanitation, increased state guarantees to projects are attracting more private companies, often as private-public partnerships (PPPs). Odebrecht SA, Brazil's largest construction conglomerate, has created an environmental engineering unit to operate exclusively in the sanitation area. BNDES’ loan disbursements are starting to stimulate the municipal- and state-sponsored PPPs for sanitation. Also, the first federal government-sponsored PPP, a plan to boost irrigation in the semi-arid and very poor region of northwest Brazil, may well also be signed in 2009. It will probably contain foreign companies, including Chilean investors and the World Bank's International Finance Corporation.
Banks such as Bradesco and Itau have stepped up mortgage lending aggressively, while Unibanco and Branco do Brasil have opted for a conservative stance. In terms of foreign banks, Santander-ABN has boosted lending, while HSBC has been more reticent. Overall, then, the US sub-prime crisis has had a limited impact on Brazil’s housing sector because the structure and the level of development are completely different. It does, though, serve as a warning, especially with regard to the growth in securitisation of mortgage-related debt.
Brazil’s federal structure gives states significant autonomy on taxation and business regulations.
This state autonomy raises concerns that contracts are likely to be amended subject to the vagaries of regional politics, or that investors will not be able to get their money back. Indeed, in 1998 and 1999, the states of Rio Grande do Sul and Minas Gerais stopped servicing their debts, forcing the federal government to step in, and triggering one of the worst institutional crises in modern Brazil. However, this triggered a constitutional reform that put a lid on the unchallenged power of regional governors. Since 2000, therefore, governors no longer enjoy unlimited power to veto federal government initiatives and overrule federal guidelines on tax. The Fiscal Responsibility Law in 2000 forbids states from borrowing without permission from the National Treasury and the Senate, and imposes strict debt-to-revenue ratios that should be fulfilled every year. States that breach these limits face federal sanctions, including the confiscation of their revenues.
Governors, however, regularly complain that the new tough controls hamper public investment in their regions, putting an additional burden on the federal government to bankroll public works, including health and education. As a result, since 2006, lawmakers, governors and a few top government officials have been urging changes that restore some autonomy to the states - for example, the freedom to offer a tax holiday to attract investors.
There has been significant state autonomy in the area of sales tax. Private investors in Brazil have to contend with an array of regional value-added taxes known as ICMS. State governors use these variations to try to attract new investment to their regions - in the process, benefitting private investors. For instance, the states of Bahia and Rio Grande do Sul competed to lure Ford to their regions to set up a car assembly facility. Ford finally picked Bahia due to the numerous tax breaks that the state offered the company, which were later reaffirmed by the federal government. Lula’s government is promoting a plan to unify taxation, hoping to trim as many as 40 different ICMS rates to five. Approval of this tax reform in its present guise is unlikely, though, as lawmakers tend to vote in line with the stance of governors.
Major offshore oil discoveries in the Santos Basin will prompt Brazil to change oil laws to secure higher state revenue.
Brazil is far from adopting the radical nationalist hydrocarbon policies implemented in Venezuela and Bolivia. But, the 2007 offshore discovery of potentially tens of billions of barrels of oil in the Santos Basin has prompted Lula’s government to consider radical changes for the industry. The 1997 oil laws were implemented when Brazil faced serious external imbalances, was a net oil importer, and was desperate to develop its oil industry. Brazil offered foreign companies ownership of the oil in exchange for paying 10 percent royalties and regional taxes.
Brazil now looks likely to create a new state-run oil company that will not operate as an exploration or production entity, but that will take control of the new offshore fields and the allocation of contracts. Influential government figures feel that Petrobras, which is 60 percent owned by private shareholders, should not be given management responsibility and, therefore, revenue potential of the new discoveries. Petrobras will probably be in a strong position for selection as the leading partner in any joint venture there, though. The extraction of oil from oilfields located more than 7,000 metres below sea level, underneath thick layers of salt, is very expensive and poses major technological challenges. Foreign companies are likely to be offered production sharing agreements in the deepest offshore areas, where state-of-the-art drilling technology will be needed. There is a modest risk, though, that foreign firms could simply be demoted to the status of mere service providers.
Carlos Caicedo is head of Latin America division at Exclusive Analysis, a UK-based global risk consultancy. This column is an excerpt from the company's Foresight 2009 report. Republished with permission.