Special Focus: Brazil
“You drown not by falling into a river, but by staying submerged in it.” Paulo Coelho
Last year’s performance of the Brazilian soccer team at the domestically hosted World Cup carries many of the characteristics of this country’s economic performance: great expectations, some glimpses of samba and yet a macroscopic failure near the end.
Brazil’s economy and financial markets were the darlings of investors for the past fifteen years; it was hard to resist a country endowed with so much from sun to land, from natural resources to fun loving people. Many experts were quick in dismissing the mistakes of the past such as the recurrent currency crises or the lack of infrastructures – physical and social – calling this decade the new era.
Unfortunately, somewhere on the road to “El Dorado,” the going got tough. A global commodity slowdown showed an old dependence from the country on the basic materials cycle and the administration of President Roussseff was less than stellar in economic decision making.
Economic projections for 2015 are rather gloomy. Inflation is seen pushing the high level of the official range at 6.99% and GDP growth is now forecast at only 0.13%. These stats spell stagflation, a much feared economic outcome.
One of the issues Brazil is confronting has to deal with its lack of openness. A recent report by Canuto, Fleischhaker and Schellekens of the World Bank highlights just as unusually closed the Brazilian economy is. Exports plus Imports equaled only 27.6% of GDP in 2013. Often the county size is used as an explanation for its relative closeness; however, in the six countries with larger economies than Brazil the average trade-to-GDP ratio is 55%.
The report goes on highlighting a significant lack of trade dynamism at the corporate level. The number of exporting companies in Brazil is just under 20,000, the same as that of Norway, a country of just 5 million people. Out of this 20,000 lot, only a few companies are responsible for the lion’s share of Brazilian exports. Canuto et al. report that the top 1% of exporters generate 59% of total exports. Furthermore, the top 25% of exporters controls 98% of exports revenues. This oligopoly makes sure corporate dynamism is stifled, a fact confirmed by low entry rates; few new companies break into the club and established exporters retain a very high survival rate.
This situation reflects poor integration into transnational value chains. Most Brazilian exports incorporate few components and intermediate goods imported from other countries. Canuto et al. point to different factors to explain this lack of integration in the global value chain: factors such as precarious logistics, high transaction costs related to international trade and last but not least policy decisions to favor local content over international integration.
Solutions to this inefficient value chain need to go beyond currency devaluations, as the problem was usually handled in the past. A reformation of the value chain process is needed; uncompetitive production segments should be restructured and intermediate segments should be opened up to international integration. Brazil must move away from stressing vertical integrated supply chains sheltered by protectionist barriers and embrace global value chains where its comparative advantages can be leveraged (natural resources, specific manufacturing processes and selected services).
This process of openness must start with a rekindle of the spark with international investors. A few positive signs may be arising; a report from Citi shows how flows from the banks clients have turned positive this month after being strongly negative in December. A breakdown of money flows shows real money investors (pension funds and other institutions) with positive flows into Brazil while leveraged investors (hedge funds) are still negative.
The conundrum for investors, international and local, remains the currency. While, as stated earlier, a long term turn-around of the Brazilian economy cannot rely solely on a devaluation of the Real, it is clear that a currency relative re-pricing will continue. Admittedly, the Real’s correction might have been sheltered so far by the carry trade which has probably put a cap on BRL weakness, however, most analysts expect more weakness and we have seen targets at BRL 3/USD.
At the micro level, Brazilian companies seem to be starting to respond to the macro threats. Capex is focused on cost reduction and on improving competitiveness. Additionally, a JP Morgan survey reveals that more local companies are planning to have greater exposure outside of Brazil. In fact, the share of Capex dedicated only to the domestic market is targeted to decrease in 2015 to 38.3% of budget versus 44% last year.
In conclusion, the strategy view on Brazil remains at best neutral. Too much macro uncertainty and political confusion makes an investing bet unbalanced. The FX trend is also a headwind that from an international perspective is hard to offset. Better times will surely come but it is a long way to Tipperary.