Recent research has suggested that global investment banks may overestimate the potential and attractiveness of the BRIC countries. A study by a Swiss research institute showed that the EU and the UK remain much more attractive markets for German mid-cap companies than the BRICs. This finding is not at odds with our enthusiasm for the BRIC (and other emerging) markets. It is of course more difficult to operate in these markets and it is a mistake to equate economic size with market potential. It may be too difficult for mid-cap companies to take advantage of these opportunities in a cost-efficient way. But the fact remains that high economic growth and a rapidly expanding middle class will offer considerable opportunities, and large companies with a global reach cannot afford to miss the business opportunities emerging in four of the largest and fastest-growing economies in the world. The increasing economic and financial maturity of the BRIC countries also continues to boost their attractiveness now that the last of the BRICs has received an investment grade rating.
Brazil used to be what sovereign debt analysts call a serial defaulter. Like many other Latin American countries, Brazil frequently defaulted on its external debt obligations during the 19th and 20th century. In 2002 during the run-up to the presidential elections, Brazil again narrowly avoided yet another default. Since then a disciplined, stability-oriented economic policy combined with a bit of good luck (read: rising commodity prices) has transformed the country from a serial defaulter into a net external creditor and, following the S&P and Fitch upgrades, into an investment grade credit.
The improvement of Brazil’s external position has been nothing but impressive. Brazil, like the other BRIC countries, is a net external creditor. Increasing external assets and declining external liabilities turned the public sector and the economy as a whole into net external creditors in 2006 and 2008, respectively. In combination with the retirement of virtually all the government’s domestic foreign-exchange-linked debt, this has reduced the economy’s vulnerability to sudden stops and eliminated the fear of floating. Strong external fundamentals, a floating exchange rate and an inflation-targeting regime have rendered the economy very resilient to even severe future shocks.
Manageable economic and financial weaknesses persist. This year Brazil will be running its first current account deficit since 2002. But even under pessimistic projections, the current account deficits will likely be fully (or largely) financed through net equity inflows in 2008-09. A widening current account deficit should not be of concern. Inflation has been increasing and is set to overshoot the target for 2008, forcing the central bank to hike rates. Importantly, the central bank, the government and society today accept the need to maintain price stability.
The decline in inflation has greatly benefited the poor and has helped President Lula secure a second term in office. It is difficult to see how Brazil’s commitment to low inflation could be seriously undermined. Public sector debt remains high. Net public sector and even more so gross public sector debt remain high. While we project a decline in debt over the next few years, current primary spending dynamics are not compatible with long-term debt sustainability. But for now, sustainability is not a concern. Brazil’s growth potential is relatively limited. One of the main causes has been insufficient investment. Brazilian gross domestic investment amounted to less than half (!) the level of China and India during 2005-07, so it is no surprise that Brazil grew less than half as fast as China and India over the past decade. But although growth is relatively low (it is actually high by the standards of the 1990s), this won’t undermine the outlook for financial stability.
Brazil’s investment grade rating was long overdue. But it will be critical to raise investment levels if the “growth gap” to the other BRIC countries is to be narrowed and remaining economic weaknesses are to be addressed. The remaining economic weaknesses are very manageable. While a raft of potential structural reforms could help overcome these weaknesses, the government could, we believe, “kill four birds with one stone” by limiting the growth in real primary expenditure. Whether this is politically feasible remains to be seen. It remains indisputable that Brazil has taken advantage of the favourable international environment to clean up its balance sheet. It is now in a position to lay the foundation for sustained higher economic growth.