jamestown latin america | trends+views | brazil: aiming for a return to growth | may 2013

EXECUTIVE SUMMARY

Economic conditions in Brazil are likely to

improve this year but structural bottlenecks will

take years to resolve themselves, a testament

to the massive necessity to improve logistics,

transportation and education – all necessary to

improve Brazil’s competitiveness.

• Financial markets are reflecting a shift in

sentiment toward Brazil, due to weaker

economic momentum, worsening terms of

trade and rising inflation

• Structural bottlenecks prevent Brazil from

growing at the same pace as many of its Latin

American neighbors

• However, purchasing power of the average

citizen has increased substantially in recent

years, thanks to a strong labor market

• Key to generating stronger growth is

fostering a more transparent environment for

investment and capital expenditures

TOTAL GDP:

2012: $2.4 trillion

(global ranking: 7)

GDP PER CAPITA:

2012: $11,522

(global ranking: 57)

GDP GROWTH RATE:

2012: 0.9% / 2013E: 3.0%

UNEMPLOYMENT: 2012: 5.5% / 2013E: 5.4%

INFLATION: 2012: 5.8% / 2013E: 5.8%

BRL/USD: 2012: 2.05 / 2013E: 2.02

TRADE BALANCE/GDP:

2012: 0.8% / 2013E: 0.4%

2012 GINI COEFFICIENT: 54.7

2012 INFRASTRUCTURE BANKING: 70 (144)

2012 INVESTMENT/GDP RATIO: 18.5%

2012 PUBLIC SECTOR DEBT/GDP: 55.2%

2012 FISCAL DEFICIT/GDP: -2.5%

ECONOMIC SNAPSHOT

Brazil: Aiming for a Return to Growth – May 2013TRENDS + VIEWS

JAMESTOWN LATIN AMERICA

Real Estate Private Equitywww.jamestown-latam.com

Contact:

Bret Rosen – Managing Director, Research+1 [email protected]

Rio de Janeiro • Bogotá • Atlanta • New York

Sources: Bloomberg, IBGE, BCB Focus Survey, IMF, Deutsche Bank, World Bank, JPMorgan, World Competitiveness Report

At the start of the decade, economic momentum in

Brazil was robust and investor sentiment buoyant.

With preparations beginning for the 2014 World Cup

and 2016 OIympics, the BOVESPA stock index hitting

an all-time high, and record amounts of foreign direct

investment pouring into the country, it appeared that

Brazil’s ‘moment’ had arrived. Indeed, Brazil’s capacity

to recover from the global financial crisis impressed

many observers and investors, as the economy grew 7.5

percent in 2010, after dipping just 0.5 percent in 2009 (as

compared to a 6 percent contraction in 2009 in Mexico).

Economic growth combined with social programs such

as Bolsa Familia to lift millions out of poverty leading

to a growth of the middle class that is unprecedented

in the country’s

history.1 Booming

commodities prices

also contributed

to massive wealth

generation as China

became Brazil’s

largest export

destination.2 Lower

interest rates made credit available to wide swathes of

the population, inspiring a consumer boom; retail sales

exploded, especially of items deemed durable goods,

often bought in installments. The Brazilian currency

experienced a relentless appreciation, as along with

foreign direct investment, massive portfolio inflows

entered the country’s equity and fixed income markets.

However, the current sentiment in Brazil has changed. The

last 2 ½ years have been characterized by disappointing

growth, leading economists to speculate that there are

structural issues in the Brazilian economy that prevent

it from growing at similar levels to its Latin American

counterparts such as Peru, Chile and Colombia over a

full economic cycle. Growth in 2010 was fueled by a

fiscal expansion in the run-up to the Presidential election

of that year, which fueled higher inflation, a tightening

of monetary policy and a hangover that resulted in 2.7

percent growth in 2011. Last year’s economic performance

was also a disappointment, as business confidence was

dragged by the unpredictability of economic policy

making and the debt crisis in Europe. Growth was a

meager one percent last year. 2013 should bring growth

closer to three percent, still below the rate registered

in most other large emerging markets countries, and

slightly below what is considered potential growth in

Brazil. While the consumer remains vibrant in Brazil, the

middle class is still expanding, and real wage growth

is positive, the giddy attitudes of a few years ago have

become more guarded. A third straight year of economic

underperformance has dampened animal spirits, and

subsequently investors and businesses have been

more cautious about the near-term economic outlook.

In dollar terms, the BOVESPA index is down 21 percent

year-to-date, through June 14, even as the S&P 500 is up

over 14 percent.3


Economic momentum in Brazil has softened, dampening the enthusiasm of a few years ago

1 Bolsa Familia is a social welfare program of the Brazilian government, part of the Fome Zero network of federal assistance programs. Bolsa Família provides financial aid to poor Brazilian families; if they have children, families must ensure that the infants attend school and are vaccinated. The program attempts to both reduce short-term poverty by direct cash transfers and fight long-term poverty by increasing human capital among the poor through conditional cash transfers.

2 http://www.tradingeconomics.com/brazil/balance-of-trade3 Bloomberg.

2006 2007 2008 2009 2010 2011 2012 2013E 2014E-1

0

1

2

3

4

5

6

7

8

CHART 1: BRAZIL ANNUAL GDP YEAR-ON-YEAR (%)

Source: Bloomberg and Banco Central do Brasil Focus Survey, May 24, 2013

PAGE 2TRENDS + VIEWS MAY 2013

In the discussion that follows, we pose a few key

questions about the country’s economic situation, with

responses that intend to address these key issues.

What are the main reasons for Brazil’s recent relatively disappointing economic performance?

First off, the industrial sector, which accounts for

approximately 1/4 percent of total GDP, has essentially

been in recession for the last several years.4 An

important explanation for this performance has been

that competitiveness in industry has been harmed

by the strength of the Brazilian real (BRL), which has

encouraged relatively cheaper imports while also

detracting from Brazilian firms’ ability to compete versus

their Asian counterparts. Firms that were previously

competitive in the middle of the last decade, when the

BRL was at a depreciated level, found margins squeezed

as the BRL broke the 2:1 level and headed to 1.60. But

even as the currency has weakened 25 percent from its

stronger levels reached in the first half of 2012, to 2.15:1

currently, manufacturing has struggled. This provides

evidence that the currency strength is not the only factor

holding back manufacturing, even though the industrial

lobby in the country and politicians tend to focus the

debate chiefly on the currency.

We point to more structural issues as explanations for

this ongoing underperformance, related to 1- High cost

of labor amidst a tight jobs market; 2- Inflexible labor

markets which make hiring and firing prohibitive; 3-

Infrastructure bottlenecks, as Brazil’s transportation and

logistics links are ranked among the world’s poorest;

4- Taxation issues; 5-

Overall high costs of

doing business.

The labor market

remains an ongoing

challenge for

business, as the

unemployment rate has hovered just above 5 percent, a

record low, pushing real wages upwards. At one juncture

in 2011, real wages were rising at nearly 8 percent on

a year-on-year basis, while the minimum wage in 2012

rose by 14 percent in nominal terms.

The World Competitiveness Report points out other

challenges that harm competitiveness of manufacturing:

Brazil’s port infrastructure ranks 135th of 144 countries

surveyed, hiring and firing practices were deemed 114th,

while the burden of government regulation was dead

last, in 144th place.5 Brazil’s tax take as a percentage

of GDP, typically around 35-36 percent, is among the

highest in emerging markets, and the tax code can be

described as byzantine. The aforementioned factors all

contribute to the ‘custo Brasil,’ which translates into the

‘Brazil cost,’ and describes the complexity and costs of

doing business in the country.

Still, Brazilian industry can succeed in particular areas as is

the case with Embraer, the globally competitive airplane

manufacturer. Embraer is one of the world’s four largest

airplane manufacturers, and has successfully identified

a niche market – smaller sized jets – and combined it with

world class engineering. Brazil’s competitive advantage

PAGE 3

Brazil fares poorly in many global indicators of competitiveness

CHART 2: BRAZIL INDUSTRIAL PRODUCTION

-20

-15

-10

-5

0

5

10

15

20

25

Jan-0

9

May

-09

Sep-0

9

May

-10

Sep-10

May

-11

Sep-11

May

-12

Sep-1

2

Jan-1

3

Jan-10

Jan-11

Jan-1

2

Source: IBGE and Bloomberg

Year-on-Year (%)

4 JPMorgan, Brazil 101, 2012 Country Handbook.5 Global Competitiveness Report, 2012-2013, World Economic Forum. http://reports.weforum.org/global-competitiveness-report-2012-2013/#=


TRENDS + VIEWS MAY 2013

may have been eroded in some areas, but the country

still has world class firms in a number of fields, such as

petrochemicals (Petrobras and Braskem), steel (Gerdau,

CSN, Usiminas), and autos (mostly foreign companies

operating in the market, such as Ford and GM). The

industrial base is amongst the most sophisticated in

emerging markets, with top management teams, who

are experienced navigating challenging markets. Still

the overall outlook for industry will revolve around the

country’s ability to resolve important bottlenecks, ease

regulation and taxation and thrive amidst the backdrop

of a currency that still looks fully valued.

Are investors correct to be less bullish on the country’s prospects?

Indeed, it has become in fashion for Latin American

portfolio investors to shift their focus to Mexico and

the smaller Andean markets, while Brazil’s growth

languishes. While Peru, Chile and Colombia grow

four to six percent, and Mexico is enjoying a wave of

reform momentum, Brazilian growth has disappointed

and there has been

no progress on

efficiency enhancing

reforms. Despite

such sentiments, we

would argue that

many investment

considerations and

business conditions

in Brazil currently are not markedly different from three

to four years ago when enthusiasm was everywhere,

equities were soaring and credit default swap (CDS)

spreads were trading inside of other Latin American

peers. Levels of foreign direct investment will still be

around $60 billion this year, the domestic market is Latin

America’s largest - by far, the growth of the middle class

is a trend that we believe is irreversible, and a great

number of multinationals are targeting Brazil for the

longer-term potential that the country offers.

The main shift in sentiment has been due to the increased

level of government interference in the economy.

Namely, the government has taken on a more statist

role especially in its stance vis-à-vis energy (Petrobras,

noting local content laws), mining (Vale, where the

government helped engineer a management shakeup),

banking (pressuring private banks to lower interest

margins) and utilities (regarding the tariff regimes).6

Businesses not only complain about the degree of

government intervention, but the unpredictability

of it. Consequently, the levels of capital formation

necessary for the economy to achieve higher rates, has

disappointed, and indeed the investment to GDP ratio in

Brazil is under 20 percent, whereas Colombia, Peru and

Chile display figures in the mid to upper twenties. For

Brazil to grow in a sustainable fashion at a rate of five

to six percent, a greater level of gross capital formation

is required, along with improvements to the various

themes described above.

What should we expect from 2013?

Market economists anticipate growth of three percent in

2013, with improved performance a function of a better

global backdrop, a statistical rebound from last year,

and the lagged impact of both expansionary fiscal and

monetary policy. Typically it takes six to nine months

for monetary policy decisions to affect economic

outcomes, implying that the economy should benefit

from the record low rate on the SELIC (Brazil policy rate)

in the months to come. Consumption growth may be

6 http://www.ft.com/intl/cms/s/0/bfa4af22-b0d5-11e2-9f24-00144feabdc0.html#axzz2Tpob5KQ7 http://www.ft.com/intl/cms/s/0/2bf35426-5593-11e0-a00c-00144feab49a.html http://www.economist.com/news/finance-and-economics/21564884-interest-rates-fall-spreads-and-profits-are-coming-under-pressure http://www.bloomberg.com/news/2012-09-11/brazil-cuts-energy-costs-to-boost-growth-through-competitiveness.html

Brazil still is benefiting from massive flows of FDI and the impressive growth of the middle class

PAGE 4



somewhat weaker than 2012, but will still be the main

driver of economic activity. Meanwhile credit growth will

remain strong by international levels, likely around 15

percent, but this will be slower than the previous couple

years as banks are cautiously optimistic. Manufacturing

activity remains unimpressive, although there are some

signs of improvement especially in auto production.

The unemployment rate should remain in the mid-five

percent range, although the pace of job creation is likely

to stay low.

The major issue, economically speaking, in Brazil at the

moment relates to inflation. The most recent inflation

projections for April, showed the year-on-year figure at

6.49 percent, just one basis point below the upper end

of the central bank’s target band of 2.5-6.5 percent. This

high inflation comes amidst a backdrop of weak growth

along with a variety of government measures to control

price pressures, namely related to food and electricity

prices. Services inflation is still elevated, at over eight

percent, and has been in the high single digits for

quite some time - a function of the tight labor market,

which has kept real wages elevated. It is expected that

inflation may once again surpass the 6.5 percent limit

in the months ahead, but should recede in the second

half of 2013 due to relief on the food prices front. The

lagged impact of the weaker BRL should also dissipate

which statistically will help bring IPCA below 6 percent.7

Still, inflation represents a major political challenge

for the Rousseff government, as given the country’s

history, there is limited tolerance amongst the populace

for persistent spikes in prices. Indeed local media is

putting greater focus on price moves across the board.

Due to the inflation pressures, the Central Bank (BCB)

has engaged in a process of monetary tightening,

most recently lifting the SELIC rate by 25 basis points

(from a record low 7.25 percent) to 7.5 percent at its

April meeting, followed by another 50 basis points hike

in May. This came on the heels of 525 basis points of

monetary easing, which commenced in August 2011.

The Central Bank’s policy stance has been particularly

controversial. The COPOM (monetary policy board of

the Central Bank) began its easing campaign with IPCA

inflation, the main price index, above seven percent,

as the COPOM expressed concern about the potential

effects of the global financial crisis on Brazilian growth.

While GDP did indeed falter, inflation never receded to

the 4.5 percent target. Meanwhile the COPOM continued

to ease, reducing SELIC to a record low and bringing the

real rate to just one percent.

Some observers believe that the BCB – although not

technically an independent central bank – has been

susceptible to political pressure from the government,

which clearly prefers a lower interest rate environment.

But as IPCA inflation once again surged above the 6.5

percent limit in March, the BCB was left with no choice

but to lift SELIC at its April meeting. Markets look for

another 100 basis points of tightening in this cycle as

the BCB looks to dampen inflation expectations which

remain elevated and hopefully bring IPCA back toward

around 5.5 percent by year end. Regardless, markets

question the effectiveness of the official 4.5 percent

7 IPCA is the most frequently cited inflation index by the central bank, and generally corresponds to the CPI in the United States.

CHART 3: BRAZIL INFLATION YEAR-ON-YEAR (%)

0

2

4

6

8

10

12

14

16

Jan-1

2

Feb-1

2

Mar

-12

Apr-12

May

-12

Jun-1

2

Jul-1

2

Aug-12

Sep-1

2

Oct-12

Nov-12

Dec-1

2

Jan-1

3

Feb-1

3

Mar

-13

Apr-13

Source: Banco Central do Brasil

CPI

CPI Net of Food

PAGE 5



8 Based on Deutsche Bank estimates in “Special Report, Brazil Economic Update,” May 9, 2013.9 http://www.brasil.gov.br/para/invest/taxes/tax-on-financial-operations-aka-iof/br_model1?set_language=en10 http://www.pac.gov.br/

inflation target as the BCB continued to ease with IPCA

well above 4.5 percent, and has only engaged in a

relatively timid tightening with IPCA above the tolerance

range.

The effectiveness of monetary policy in Brazil remains

distorted due to the large role of the BNDES (the

national development bank) and public banks, all of

which are mandated by the government to expand

their loan portfolios, typically at highly subsidized

rates. On the fiscal side, the Rousseff government has

engaged in a variety of measures to try to stimulate

activity. Recent fiscal figures have disappointed with the

government well off of its 3.1 percent to GDP primary

surplus target. Meanwhile, export performance has

weakened; during the last decade the trade sector was

a major motor for economic growth but weaker terms

of trade and competitiveness issues are weighing. The

twelve month trade balance is projected at under USD

10 billion for 2013, which compares with 40 billion plus

in 2007.8 Even as recently as 2011 the trade surplus was

30 billion. Clearly the economic difficulties faced by

Brazil’s neighbor, Argentina, and Europe are weighing,

although we note that the Brazilian economy is less

dependent on trade than its Andean neighbors.

Regarding the currency, the BRL had been generally

range bound in recent months, moving not too far or

below the 2:1 level versus the USD, although it has

experienced some more substantial weakening of

late due to volatility in global fixed income markets.

The government has succeeded for the most part in

engineering a weaker level for the BRL, primarily by

discouraging the entry of portfolio capital into the local

fixed income market, via the imposition of a rather

draconian entry tax regime (the so-called IOF tax on

financial operations, which was reversed this month).9

The BCB has been active at times in the market, especially

when it perceives volatility as too high. It does fear a

BRL much above 2.1 in our view, as this would make its

inflation fight even more challenging. Weighing on the

currency, however, is the aforementioned weaker trade

balance, partnered with a widening current account

deficit. Indeed the flow of foreign exchange has turned

negative in Brazil for the first time in years.

How can Brazil outperform?

While sentiment toward Brazil has shifted somewhat,

we tend to view the pessimism as overdone (and

would argue that the optimism of a couple years was

also overdone). There are plenty of reasons to look at

Brazil in a positive manner. Namely, the government

has set forth plans for very ambitious infrastructure

investments, which will be intended to include private

capital.10 The privatizations of several airports last year

could represent a productive first step in this regard.

Meanwhile a series of PPPs (public-private partnerships)

focused on roads, airports and highways will be

crucial to help absolve portions of the country from

major substantial bottlenecks. The government plans

to increase by 50 percent the kilometers of toll roads

CHART 4: BRAZIL SELIC RATE (%)

6

7

8

9

10

11

12

13

14

Mar

-09

Jul-0

9

Nov-09

Mar

-10

Jul-1

0

Nov-10

Mar

-11

Jul-1

1

Nov-11

Mar

-12

Mar

-13

Jul-1

2

Nov-12

Source: Banco Central do Brasil

Benchmark Interest Rate

PAGE 6



under private concession, by 33 percent the capacity of

privatized railroads, and it will likely privatize two more

airports on top of the three privatized last year.

The pressure on important segments of the private

sector could subside, namely related to banks. Some

within the government are conscious that increasing

heavy-handedness has dampened investors’ appetite

and with presidential elections forthcoming in less

than eighteen months, it is crucial for the Rousseff

government to deliver stronger growth. Certain officials

realize that a less interventionist state can help in this

regard.

Meanwhile, another key facet to observe will be the

battle versus inflation. If the BCB can engineer a gradual

monetary tightening that lowers inflation expectations,

markets will be relieved. With the BOVESPA trading at

a low multiple, some interest has returned to the stock

market and indeed recently several large IPOs occurred,

including the insurance arm of Banco do Brasil in a

several billion dollar

deal.11 Finally, the

policy debate in

Brazil may heat up as

elections approach.

It is entirely possible

that the economic

disappointments of the last several years become a

focus of discussion, with opposition parties perhaps

gaining traction by advocating a friendlier policy mix.

In conclusion, we do believe that economic conditions

in Brazil are likely to improve this year but structural

bottlenecks will take years to resolve themselves, a

testament to the massive necessity to improve logistics,

transportation and education – all necessary to improve

competitiveness. Meanwhile economists such as those

at Morgan Stanley continue to highlight the so-called

‘supply-demand’ mismatch.12 Indeed over the last

three years retail sales rose 24 percent while industrial

production fell 0.6 percent. A substantial portion of

the populace has felt pretty good, with wages up, the

economy enjoying full employment, the middle class

expanding, government subsidies plentiful and credit

generally more available than it was a decade ago.

Hence, and assisted by the BRL, purchasing power and

consumption are strong. But supply is not, due to the

issues we highlighted that have affected investment

expenditures. With the country’s tax structure (tax

burden of 35 percent of GDP is particularly high), and

concerns about the level of skilled workers in the labor

force, this mismatch may takes years to resolve itself,

implying that any periods of strong growth lead to

inflation. Finally for investments to blossom, terms of

trade will need to improve, which may hinge on the

resurgence in global commodities demand, as there

historically has been a strong correlation between

commodities prices and the investment cycle in Brazil.

11 http://www.ft.com/intl/cms/s/0/f1a30ef8-ae8f-11e2-8316-00144feabdc0.html12 Morgan Stanley, Brazil Economics and Strategy: Growth Mismatch Survival, Winners and Losers, April 1, 2013.

Central bank is attempting to tackle the inflation problem

PAGE 7

