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Saturday, August 9, 2008

Brazil Country Outlook August 2008

Claus Vistesen: Copenhagen

Brazil is a resource rich country in transition towards a much more diiversified economy where industry and high value services will begin to play an increasing role. Brazil has ample supplies of energy and agricultural products, and is currently hitting that “sweet spot” where a demographically driven growth dividend becomes available. Thus we can increasingly expect to see above trend “catch up” growth as the Brazillian economy benefits from the new wealth which accrues from the rapid global rise in commodity prices while the strong supply of young labour underpins the labour market and significant productivity improvements become available as the economy generally moves towards ever higher-value-added sectors of activity.

Perhaps the most telling sign of Brazil's rising status as a new global force to be reckoned with was the recent announcement by the National Petroleum Agency (ANP) of the discovery of a new offshore oil field (Carioca) which potentially holds as much as 33 billion barrels of oil - enough to supply every refinery in the U.S. for six years - making it the third-largest oil field ever discovered (only Saudi Arabia's Ghawar and Kuwait's Burgan fields are bigger). This, coupled with the discovery last year of the Tupi field - which has an estimated reservoir of between 5 and 8 billion barrels of oil – is now fast forwarding Brazil rapidly up through the ranks of global oil producing nations. Such new found oil prowess has even prompted president Lula da Silva to suggest that Brazil enter OPEC.

But Brazil is not only rich in energy; agriculture – that new high-value sector – is also an important contributor to Brazil’s rapidly growing GDP. Agricultural income should total 155.27 billion reais (US$ 71.4 billion) in Brazil in 2008, according to the Ministry of Agriculture. The estimate is based on crop surveys by the National Food Supply Company (Conab) and the Brazilian Institute for Geography and Statistics (IBGE).

And with global agricultural prices continually hitting record highs Brazil’s agricultural exports were up 15.22% in June over June 2007, and by 5.6% over May. The government estimate for this year’s total output includes 20 crops, some of them temporary ones such as soybean, maize, rice, wheat, sugarcane, and others permanent like coffee, cocoa, and oranges. Compared with 2007, the figure represents growth of 17.11% after inflation. The largest increases were expected to be in beans (87.78%), coffee (48.69%), wheat (40.79%), soybean (31.83%) and maize (30.65%). Brazil is now even producing grapes, and output is growing rapidly in the northeastern states of Pernambuco and Bahia.

Also Brazil's economy created a record 309,442 government-registered jobs in June as higher domestic demand coupled with revenue flows from rising commodity prices lead companies to add staff and increase output. Of these new jobs Brazil's agricultural sector accounted for the lions share, with 92,580 new jobs being created in June, the highest monthly figure recorded since the start of the current time series in 2003.

Recent Economic Indicators

The Brazilian economy continued to expand strongly in the first quarter of 2008, and turned in a respectable 5.84% increase in GDP when compared with the same period a year earlier. Looking at quarter on quarter growth on a seasonally adjusted basis (quarterly growth gives a much clearer “as things are now” snapshot of the current state of an economy at any point in time), the 0.71% reading reflected a moderate slowdown in the economy over the previous quarter. Consumption and investment both contributed to the quarterly growth rate, but it was government consumption which did the heavy lifting in Q1. The negative trade balance also acted as a drag on growth as exports declined while imports rose. Since Brazil is strong on commodity exports, and commodity prices have been very high in recent months, the underlying momentum is positive, although were inflation not to be kept in check some variant of the “dutch disease” could undoubtedly become a problem. At the present time however this danger should not be exaggerated, since underlying investment in capital goods is reasonably healthy, rising at rate of about 19% (12 month average) as compared to a rise of around 6.5% for industrial output generally.
The main driver of economic activity continues to be domestic demand. Private consumption rose in Q1 by 6.% (y-o-y) while investment held up well - rising by 15.2%. Nevertheless, the externally oriented sector has continued to weaken, largely because of the pressure on exports caused by the high Real, and exports were down 2.1% year-on-year. Imports, however, rose steeply - by 18.9%. The other aspect of growth was public consumption, which was up by 5.8%, which was the fastest rate since the middle of 2002.

One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.

On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.

Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

  • Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.

  • The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.

  • GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%

Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1

2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)

Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%