Brazilian capital markets are booming. Equity and bond issuance has reached all-time highs. FDI inflows are approaching levels last seen during the privatization-driven FDI boom of the late 1990s and early 2000s. The real has been among the best performing currencies over the past couple of years. Is this yet another episode in the long history of boom-and-bust cycles suffered by Brazil since 1970s? The answer is a decisive “no”. The outlook for Brazilian financial markets is very good.
Macroeconomic stabilization following the 2002 crisis has finally begun to bear fruits. Under the Lula administration, disciplined fiscal and monetary policies have coincided with a booming world economy. In combination with a (post-crisis) undervalued exchange rate, sharply rising commodity prices have allowed the economy to undergo a dramatic external adjustment. Not only has Brazil repaid its IMF and Paris Club debt, it has also managed to increase its FX reserves dramatically. The Treasury continues to buy back external market debt.
Last year the public sector became a net external creditor and under current trends the economy as a whole will follow suit in 2009. Market consensus is looking for economic growth of 4-5% in 2007 and 2008, a rate substantially above the ten-year average of 2.5%. With economic growth picking up and nominal interest rates declining to record lows, the political consensus in favour of “orthodox” macroeconomic policies is strengthening further.
This consensus is unlikely to be questioned anytime soon. The political right converted to the current policies during the 1990s, leaving the left as the only place from where a populist challenge could emerge. But it is the left that has hugely benefited from this very policy. It allowed it to retain the presidency in 2006 and to expand its electoral base to the North- and North-East. Current economic policies are very likely to be maintained beyond 2010.
The prospect of long-term economic stability, higher economic growth and lower interest rates (lower cost of capital) have led to an unprecedented surge in financial market activity. Only the short-lived boom following the 1994 real plan comes close to the current surge in economic and financial activity. But that boom was based on a deteriorating fiscal and external position. This time the boom is taking place against the backdrop of declining public debt and an improving external position. The lower level of country risk has led to a surge in FDI inflows. Lower interest rates have led to a “crowding in” of private investment. Bank lending to the private sector has been increasing.
Domestic private bond issuance has surged. Even the mortgage market is taking off, while second-tier domestic corporates have started tapping international bond and loan markets on the back of much lower Brazil risk. The BOVESPA has reached all-time highs. The growth prospects for financial markets are excellent. Of course there is a cyclical element in the current boom. The world economy has been expanding at the fastest rates in decades, commodity prices are high and ample global liquidity has helped keep down interest rates, fuelling financial market activity and asset price appreciation across most EMs. But there is reason to believe that global factors will fundamentally remain supportive of Brazilian asset valuations over the medium term. The integration of China and India into the world economy will affect Brazil via the financial and trade channel. The high commodity-intensity of Chinese growth will lend support to the Brazilian commodity and agricultural (and related) sectors. Over time, Chinese exports could put pressure on the Brazilian manufacturing sector. But over the next few years, China’s integration into the world economy will undoubtedly benefit Brazil.
Brazil also stands to benefit from increased Chinese investment. Chinese ODI has been quite limited so far. Only a trickle of the USD 100 bn in Chinese ODI supposedly promised by President Hu during his 2004 visit to Latin America has taken place. But over time China will increase ODI in order to satisfy its increasing demand for commodities. Brazil as a resource-rich economy stands to benefit.
Brazil remains a relatively closed economy and as such most of the growth will have to be generated domestically. A favourable external environment helps, but once asset prices have adjusted to the lower level of risk and interest rates, continued above-average asset price appreciation will require economic growth. There remain considerable obstacles to higher medium-term growth ranging from the need to improve infrastructure and regulatory regimes over raising human capital standards to ensuring medium- to long-term public sector solvency. The nature of Brazil’s political system will make rapid progress on the structural reform front unlikely. Still, even if little reform takes place, the medium-term outlook for Brazilian financial markets and asset prices will remain favourable.
Brazil is still far from fulfilling its economic potential and it is not going to overcome the considerable socio-economic challenges it faces overnsight. But the financial market and economic outlook will remain strong thanks to improved economic stability, declining interest rates, a much improved outlook for economic growth and supportive global developments.
Brazil is still far from fulfilling its economic potential and it is not going to overcome the considerable socio-economic challenges it faces overnsight. But the financial market and economic outlook will remain strong thanks to improved economic stability, declining interest rates, a much improved outlook for economic growth and supportive global developments.