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High rates put the spotlight on Brazil By Silvia Pavoni | Published: 29 September, 2010

Brazil's minister of finance, Guido Mantega, at the G-20 summit in June

Fuelled by high interest rates, the strength of the Brazilian currency should be thwarting growth, but Brazil is not your typical emerging economy, reports Silvia Pavoni. Click here to watch Silvia Pavoni, investment editor, and Brian Caplen, editor of The Banker discuss the effects of a strong Brazilian real and high interest rates on the largest Latin American economy. With arguably the highest interest rate in the world at 10.75% and a local currency, the real, that this year reached a peak in the second quarter of 1.9 reals to the US dollar, Brazil is not your typical emerging market. Even if commodity exporters have not suffered from such conditions - thanks to the ever-growing demand from China (which has replaced the US as Brazil's largest trading partner) - manufacturers are concerned about unaffordably high production costs. Coupling the high currency valuation with a 10.75% interest rate means that the cost of borrowing can be as high as 30% or more for corporates. Further, Brazil's high interest rates and lack of a deep local savings pool have naturally proved a magnet for inward investment. At the end of last year, levels were so high that the government introduced a 2% tax on capital inflows. While this measure has now been removed, the government - which has been increasingly vocal about the dangers posed to the economy by hot money and an expensive currency - has made it clear that it can be quickly reintroduced should inflows speed up again. Finance minister Guido Mantega recently told the local 1


press that the government will take steps to prevent any further appreciation of the real: "We will not lose this game," he said, "you can be sure [of that]." The government is fighting a wall of money. Brazil's high rates become all the more attractive when interest rates remain close to zero in most of Europe, Japan and the US. The investment logic becomes even more persuasive given the country's relatively low risk, says Marcelo Kfoury, Brazil's chief economist at Citi. "Here the interest rates are higher but the risk is not as high, so we've seen an increase in the capital flow. Conservative macroeconomic policies have helped to reduce the risk perception. You also have huge [central bank] reserves and external debt is not so big which makes the government's debt [a safe investment.]" According to Mr Mantega - who has voiced his concerns to the G-20 - there are plenty of precedents for any potential Brazilian intervention. He has suggested that the US and Europe have adopted an easy monetary policy so that their currencies depreciate. And against the backdrop of Japan's recent intervention to bring down the value of the yen, Mr Mantega suggests that Asia is particularly willing to intervene in markets. "It is not only Japan; there is an Asian predisposition to keep their currencies devalued," he says.

Overvalued real Conditions have been worrying Brazilian manufacturers for some time. At the end of last year, JosĂŠ Carlos BrigagĂŁo do Couto, president of the country's shoemakers association Sindifranca, said that exporters needed the real to weaken by 27% from its then level in order to maintain volumes. He said export deals were increasingly difficult to close and that companies were exposed to large losses on big orders. He also warned that shoe exports would likely fall by more than 5% in 2010, and by much more if conditions did not improve. Conditions have improved since the beginning of the year, and the real has been declining since the beginning of the third quarter, sitting at less than 1.72 to the US dollar as of September 17, but many remain concerned about the competitiveness of the country. Darwin Dib, an economist at ItaĂş Unibanco, says more rate increases could be on the horizon, against the backdrop of lower gross domestic product (GDP), which most people expect to fall from the estimated 7.34% this year. "We believe that in the near future, Brazil could face higher interest rates due to inflationary pressures," says Mr Dib. "We are expecting a 200 basis points [bps] increase in the Selic rate [Brazil's benchmark overnight lending rate] starting in 2


June 2011; a 50 bps hike at each monetary policy committee meeting. In the long run, we still believe in a declining tendency of the neutral real interest rate in Brazil. To achieve a lower neutral interest rate, Brazil's economy needs higher potential GDP growth. According to our estimates, it is [likely to be more like] 4.5% to 5%." Moreover, earlier this year, the Association of Brazilian Industrial Equipment Manufacturers, Abimaq, reported some worrying statistics about the cost of manufacturing: it claims that it costs 36% more to manufacture a product in Brazil than it does to manufacture the same item in the US or Germany. MĂĄrio Bernardini, economic adviser to the board of Abimaq, believes Brazil runs the risk of transforming its manufacturing sector into an assembling business. He says that in order to keep their businesses alive, local corporates are being forced to replace products that were previously produced locally with cheaper imported products. Only a few years ago, Brazil was the world's fifth largest producer of industrial equipment. Today it ranks 15th. This is not what you would expect from a booming emerging market. While macro-economic policies have meant the end of high inflation, the combination of growing demand for commodities, high commodities prices and a high real have accelerated Brazil's export of raw materials and semi-manufactured goods, and increased its import of finished goods and products with high added value at cheaper prices. "The dilemma at the moment is: should we keep [things as they are] and destroy our manufacturing industry," says Eduardo Saksida, adviser to the board of Salamanca Capital, an investor in the country. "Brazil needs a long-term growth programme: it can either keep an appreciated real and benefit from high commodity revenues, or do what China does - innovate in industry and keep the currency depreciated in relation to the US dollar."

Andre HĂźbner, head of trading for Brazilian global markets business of HSBC

Manufacturing transition 3


While it may come as a surprise to many outside of Brazil that this developing Latin America market is struggling with the impact of cheap goods from Asia on its domestic industries, not everyone is pessimistic about the impact on local manufacturing businesses. Octavio de Barros, chief economist at Bradesco, does not see this as the beginning of the de-industrialisation of the Brazilian economy. "The domestic industry is still vibrant; it is diversified; it is becoming [more] internationalised and can be competitive in various segments, both on the domestic market and internationally," he says. "I don't see the fact that 65% of our exports are commodities or quasi-commodities as bad." And Brazil is in a good position to move up the value chain, he adds. "The export of some commodities needs high sophistication and added value [which are created locally]. I don't see [the current situation] as something problematic." If the local manufacturing sector is angry about the value of the real, at least market participants are protected from aggressive trading by hedge funds and other financial institutions in Brazil's highly regulated spot foreign exchange (FX) market. "Unlike in other countries in the US or Europe where you have massive volumes coming from financial institutions, in Brazil's deliverable market, only institutions doing commercial transactions [buying goods or selling their goods], investors bringing capital into Brazil or Brazilians investing capital abroad can participate in the foreign exchange market," says Andre H端bner, head of trading for Brazilian global markets business of HSBC. "Everybody else needs to resort to derivatives." And exporters have the tools to hedge FX risk, says Mr H端bner, with the potential to benefit from an appreciating real. "Exporters can hedge their sales into forward [rate agreements]. Given the high levels of interest rates in the country, the forward [price] in Brazil is about 10% above the spot [price]."

Marcelo Kfoury, Brazil's chief economist at Citi 4


Hot money In terms of fears about hot money flooding the country, some argue that the level of capital coming into Brazil is neither unusual nor a problem. Bradesco's Mr de Barros says that at this stage of economic development it is natural that "external savings" need to take the place of "domestic savings", an economist's way of saying that foreign investment is needed until there is enough domestic capital to do the job. And it is likely to stay that way in the medium term. Local industry will need more money than is available in Brazil for some years, says Mr de Barros, citing national oil company Petrobras's large capital needs to finance the pre-salt oil explorations, and the funds required for Brazil to finance the World Cup in 2014 and the Olympics in 2016. Mr de Barros forecasts a current account deficit of 4% for 2014 and for some years after. "This is not going to be a concern because it will be financed by foreign direct investments," he says. "I don't exclude the possibility of replicating in Brazil the history of Australia, which lived with external deficits for many years without being questioned severely by the markets. In the long term, domestic savings [domestic capital] will grow, thanks to the improvement in people's quality of life and the growth of government reserves."

Central Bank of Brazil interest rates

Cause for optimism Mr Dib gives Brazilian corporates another reason to be optimistic. He points out the link between the increase of the real effective exchange rate (REER) - which takes into consideration inflation - and manufacturing output. As Brazil has benefited from growing demand for commodities and high commodity prices, the country's REER has also appreciated. Historical data suggests there is a positive correlation between a growing real effective exchange rate and the 5


manufacturing sector's investment rate, which would benefit the growth of the manufacturing sector. "The Brazilian economy is a very important global player in soft commodities and metals. The recent situation of high commodity prices and low prices for manufacturing goods in the international market created a huge increase in Brazilian terms of trade, which is one of the main factors behind the appreciation of the REER," says Mr Dib. "The interesting point is that, historically, the Brazilian manufacturing sector usually increases its investment rate when the REER is appreciating, because of the lower import costs of capital goods. This pattern is happening again and should increase the competitiveness of the manufacturing industry."

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High rates put the spotlight on Brazil