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Tax Hurts Brazil’s Credibility

The new Brazil tax on investments hurts its credibility and may make investors re-think the stability and level of risk of the country.


Contrary to official statements and positions in recent months, the last coming from President Lula as late as Friday denying a tax on investment was a possibility and saying that when "false reports [like this one] are published, the entire country loses", [on October 19, 2009] the government imposed a 2 percent tax on fixed income and equity investments effective immediately. It will not affect direct real investment in the productive economy.

This move comes on the back of a massive appreciation of the BRL [Brazilian Real], which year-to-date had gained 37 percent against the dollar, clearly a negative for the non-commodity export sector. The strength of the BRL run had stemmed from not only strong capital inflows and USD [US dollar] weakness, higher commodity prices and the Chinese growth story, but from the strength of the Brazil economic recovery story as well. Brazil has led the region in its recovery post-crisis. The second quarter posted a quarter-over-quarter seasonally adjusted annualized growth rate of 7.80 percent, job creation has offset all the jobs lost in the crisis, and domestic demand is vibrant.


However, this less than market-friendly move, particularly after government statements to the contrary, in our view hurts the credibility of the institutions and may make investors re-think the stability and level of risk of this country, which has been on a trajectory of income convergence and fundamental improvement. This move can be viewed as a political one in some sense to garner points in the run-up to elections in 10/2010. While the market is down across the board, the effects of the measure have been most felt in the equity market -4.0 percent today and the currency +2.84 percent.

Brazil has been the favorite for foreign investment since coming out of its quick recession, as the market correctly viewed Brazil as a key beneficiary of the global recovery. Investors had been betting on Brazil with the expectation that recovering world economy with the United States, Europe, and China importing more commodities would benefit Brazil tremendously. The real appreciation pressures - that of real demand for commodities from these countries, that of massive U.S. depreciation which is an economic inevitability will continue to pressure the BRL despite this anti-investment, net negative move. Clearly such aggressive appreciation hurts the non-commodity export sector, and the government responded with the tax on "speculative" inflows.

Early last year, the government put on a 1.5 percent tax on foreign fixed-income investments to stem appreciation pressures, which it later removed due to the credit crisis. The central bank had been buying USDs in an effort to stem the appreciation since May. It bought $3.5 billion in September, and has bought approximately $14.3 billion year-to-date. This had obviously not been very successful, given the strength of the multiple appreciation pressures. It has led to reserve accumulation - currently at $227 billion.


Bottom-line for the markets: On the back of this decision, we see short-term downside pressure for the Brazilian equity markets and currency. We think however there are opportunities as well as a result as other countries see more upside through year-end.

In our view, Colombia can likely benefit from increased investment flows on the back of Brazil's anti-market decision, if Colombia elects to avoid the imposition of capital controls but rather continues with its market-friendly policy, and as we expect, rather increases its reserves and cuts the benchmark policy rate another 50bps in an effort to stem the pace of appreciation of the COP.

We think Mexico can also benefit from this scenario and indeed, something which has been our call for a couple months, that Mexican Bolsa outperforms other regional markets through year-end. We recommend a long MexBol short IBOV position at these levels. We think there is now short-term downside for the Brazilian Bovespa and likely upside for Mexico on the back of 2009 better-than-market expected economic performance and the positive effects on the Mexican economy of the U.S. economic rebound.

Kathryn G. Rooney is Senior EM Macroeconomic Strategist at Bulltick Capital Markets. This column is based on a commentary she wrote to clients. Republished with permission.


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