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Impact Investing

IPE special report May 2018

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Brazil in classic first phase

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When Brazil sneezes, not only Latin America but the rest of the world runs the risk of catching a cold. A lesson, one assumes duly learnt after last year's bout of 'Asian flu'.
As one of the world's top 10 economies, accounting for 50% of South America's GDP, and with important trade links with the US, Brazil is a bellweather economy. Hence the anxiety at the beginning of the year when Itmar Franco, governor of the country's second most populace state, Minas Gerais, announced a 90-day moratorium on the rural region's $15bn (E17.25) debt to central government. What worried analysts was that this may be endemic of a wider cash flow problem, and not merely a political issue rather than economics" as suggested by Carlos Kawall, chief economist at Citibank. Walter Stoeppelwerth, Latin American analyst at Robert Fleming Securities in London for one, disagrees. "The major concern is can the government stabilise the cash flow problem, especially as central government has an over 50% cash requirement," he says. Until some stability returns to the local currency, Stoeppelwerth believes the government will remain in difficulties.
Jane Heap, Latin American Strategist at Deutsche Bank in New York agrees. "We are looking for the Real to rise and interest rates to go down to relieve the fiscal deficit, which is the big problem.
Until then the markets will remain volatile."
Specifically Heap mentions reforms in financial transaction taxation, and civil service pensions which would help to reduce the government's costs and expenditure. Such reforms were resisted by parliament at the end of last year, when the IMF made the austerity package part of the deal for its short-term loan of $41bn to help defend the real. At the end of January the Central Bank of Brazil drew a line in the sand denoting the value of the Real. At the time Francisco Gross, Latin American chairman of Morgan Stanley Dean Witter said, "No-one takes the line seriously." Sure enough it was duly washed away, together with Gustavo Franco, governor of the Central Bank, by a tidal wave of speculation. Now it is hoped that parliament will actively support the reforms.
But what impact will the package have on the markets if, as seems inevitable if past experience is anything to go by, the loans are used to repay foreign debt? "Our feeling is the major impact on corporations will see them passing out dollar debt to the long term. Some sectors such as electricity have huge debt, but it is mainly long term," says Stoeppelwerth. Heap agrees, pointing out that both electricity and mining sectors have high dollar debt, but also that their main revenues are also in dollars, unlike the sectors which caused problems during the Asian crisis. Stoeppelwerth is also concerned over whether the government of President Fernando Henriqué Cardosa will be able to contain inflationary pressures. Any sustained rise in the Bovespa share index will need sectors other than telecoms, which have fuelled recent rises, to perform well. "The market is stuttering where there is US$ exposure, although there are no signs of any insolvency problems,"says Stoeppelwerth. "The market is taking a superficial view at the moment; where there are dollar problems sell, where not buy. Telecoms have a net positive position, 80-90% of utility debt is long term, and a company such as Petrobras, has just over half its debt in dollars and so is viewed positively."
He believes we are seeing the classic first phase of devaluation, and that there could be some very aggressive trading ahead. Heap agrees that the market will continue to be volatile until interest rates fall. "Earnings potential for corporations will be hit by the recession and higher taxation and costs. All in all it will be a difficult year ahead. " Her advice is to stay liquid and concentrate on companies not so hard hit by the recession. "Luckily there is not a lot of short-term high dollar debt. Previous high inflation limited the amount of lending, and so locally events of the past month or so may not be quite as cataclysmic as suggested," maintains Heap.
She also suggests that fixed interest investment has regained some ground, and will probably follow the fluctuations of the exchange over the next few months.
As for the domino effect, Heap does not expect an Asian-style collapse across the region. "Obviously countries such as Argentina and Mexico will be affected because of trade, but it is hard to imagine a run on their currencies. If there is, it is most likely to be because of other problems causing volatility locally," she says.
Stoeppelwerth points out that measures of foreign investment in Brazil still indicate the world is underweight in the country, and generally the consensus seems to be that this is not a crisis similar to Mexico in 1982. Bundesbank President Hans Tietmeyer has gone on record that the internal position of Brazil is better than at first imagined. A sentiment echoed by the analysts above. The European Central Bank is not so sanguine, but seems to be taking an over pessimistic view. Seventeen years ago exposure to the region was concentrated, but today the spread of risk is much broader. This should mean that although the preventative medicine of the IMF was not wholly successful, hopefully the new prognosis will help to prevent contagion.
Kevin Hall

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