Lessons from Brazil: Why Is It Bouncing Back While Other Markets Stumble?Published: November 11, 2009 in Knowledge@Wharton
"Of historic importance." That is how Dilma Rousseff, Brazil's chief of staff, described the country's victorious bid in early October to stage the 2016 Olympics in Rio de Janeiro. Rousseff -- a likely candidate in next year's presidential elections -- declared that "Brazil was no longer a country of the future," referring to a popular saying Brazilians use to describe their homeland after decades of missed opportunities despite vast economic potential. Rather, she said, Brazil is now a country "of the present" -- a view shared by many as revelers packed Rio's beaches to celebrate the victory.
Brazil's business community is happy, too. Márcio Garcia, an economics professor at the Catholic University of Rio de Janeiro (PUC-Rio), says that not since the hyperinflation of the 1980s was tamed briefly by the 1986 Cruzado plan (which froze wages and prices, among other measures) can he recall such an upbeat mood in Corporate Brazil.
The mood largely reflects a turnaround in global sentiment toward the country, which has been both rapid and welcome. But as the country bounces back from the global economic crisis -- it was the first country in Latin America to stage a recovery, in the second quarter of this year -- what can other markets, still struggling with sagging economies and lingering recession, learn from its remarkable recovery?
Indeed, Brazil has witnessed ups and downs in its global reputation before. During the 2002 presidential campaign, debt spreads skyrocketed and the currency devalued as investors fretted whether Luis Inácio Lula da Silva, one of the frontrunners, would honor the country's debt obligations. There was relief when it became clear after he won that he would consolidate the generally sound policy orientation of the previous administration, sparking a rally that paved the way for a growth spurt not seen since the 1960s.
That growth trajectory, however, was interrupted by the escalation of the global credit crisis a year ago. The shockwaves of the economic downturn triggered sharp falls in Brazil's Bovespa stock market index, from a bubbly 73,000 peak in spring 2008 to below 30,000 by the fall of that year. It also sent the currency tumbling to 2.5 reais to $1 in December, from 1.55 reais to $1 a few months earlier. The global inventory adjustment, credit crunch and slump in consumer confidence joined forces to cause the GDP to drop an annualized 13% (in sequential terms) in the fourth quarter.
Following the response from global policymakers that pulled the world economy back from the brink, Brazil policymakers' fiscal and monetary actions enabled the country to regain its footing in the first half of this year. Leading indicators suggest a speedy return to Brazil's recent growth rates. Affonso Celso Pastore, a consultant and former president of the Central Bank of Brazil, expects the country to grow by between 5% and 5.5% in 2010, echoing the predictions of others.
The real has recovered to levels recorded before the global collapse, and the Bovespa index has now risen to 64,000, perhaps somewhat overvalued as corporate earnings have yet to pick up. Nonetheless, investors are returning, as was clear when Banco Santander of Spain raised $8 billion -- more than three-quarters of which came from international investors -- in early October when its local unit made its stock market debut, the world's largest IPO so far this year.
On the Rise
But how much credit does President Lula and his administration deserve for Brazil's robust economic renaissance? Felipe Monteiro, a professor of management at Wharton, notes that some observers attribute Brazil's performance on Lula's watch to good luck. But he likens the skeptics to soccer fans who insist that star players who score a goal in every match are merely lucky rather than acknowledging that ability and game strategy matter, too. Consider Brazil's exports, he says: They have held up over the past year thanks to demand from China for its soya exports and iron ore, which is in part due to the Brazilian government's concerted drive to improve trade links with Asia and Africa.
It's true, however, that the main tenets of Brazil's economic policy framework were set before Lula, by the government of Fernando Henrique Cardoso in the 1990s. This included inflation targeting, a floating exchange rate and primary fiscal surpluses(that is, the surplus before interest payments are made to service debts).
But observers acknowledge that Lula has consolidated and deepened the model in a range of ways -- giving the Central Bank greater operational autonomy, raising the target for the primary fiscal surplus, "de-dollarizing" public debt and building a large cushion of foreign exchange reserves to reduce external vulnerabilities. Moreover, experts also point out that Brazil's export diversification, spurred by a more active trade policy and increased focus on "south-south" trade under Lula, helped mitigate the decline in demand from OECD (Organisation for Economic Co-operation and Development) countries during the downturn (as well as helping to win votes for Brazil in the recent Olympic bid).
Wharton management professor Mauro Guillén notes that Brazil has "put its house in order" -- by consolidating public finances and taming inflation -- and has achieved a "happy medium" between the roles of the public and private sectors. Unlike many countries in the region, there is broad consensus between the political class and business sector over the macroeconomic policy orientation, despite disagreements about taxation and disappointment with the slow pace of structural reforms. "Brazil is on the rise," he says.
According to Guillén, the turning point in the country's path to international emergence came in 2003. That was when Goldman Sachs first referred to the BRIC countries, the grouping that combines Brazil with Russia, India and China as the world's fast-growing developing economies. Another milestone was crossed last year when S&P and Fitch upgraded their ratings for the country in April and May, followed by Moody's this September. Comparisons with other countries in the region -- such as Argentina with its disastrous 2001-02 debt default and persistent faltering credibility, and Mexico, whose weak reforms program has hampered GDP growth -- seem inevitable.
Better Off Than Others
Why has Brazil been more resilient than other markets? Finance minister Guido Mantega has pointed out that, at only around 1.5% of GDP, the fiscal stimulus needed in Brazil to help keep the economy afloat has been much milder than in other large economies, particularly compared with OECD members, which will reduce the hit to public solvency in the long term.
A lot of Brazil's resiliency, however, has to do with the structure of the economy, experts note. The country has a large and growing domestic market, and its exports account for less than 15% of GDP. That's lower than most other emerging markets, and local demand has been sustained through targeted tax breaks and a cycle of monetary easing. Also, backed by a large cushion of reserves amassed in recent years, the Central Bank was able to offer dollar liquidity at the height of the global financial crisis to companies needing to refinance. What's more, liquidity was injected by easing reserve requirements, mitigating the credit squeeze.
Banco do Brasil and Caixa Econômica Federal -- two publicly owned commercial banks which were perhaps regarded during the heady days of global financial innovation as being too conservative -- along with BNDES, the well-capitalized state development bank, stepped in to provide credit, cajoled by the government to do so as private banks, such as Itaú and Bradesco, grew cautious and tightened credit lines. Now, private banks are scrambling to extend credit again and to hang on to market share. Itaú, for example, plans to open as many as 150 branches next year, CEO Roberto Setubal announced in late September.
But all of Brazil's banks can be thankful that, to a large extent, they haven't had to deal with the toxic assets that crippled banks in developed countries. Unlike their counterparts elsewhere, Brazilian banks were not as exposed to the property sector and credit derivatives, and financial soundness indicators were robust coming into the crisis, according to Fabio Barbosa, head of Banco Santander Brasil and the Brazilian Federation of Banking Associations (Febraban). He cites the high capitalization requirement as a key reason for the sector's resilience -- the minimum capital adequacy requirement in Brazil is 11%, compared with 8% under the Basel regulations that other banks around the world follow. In December 2008, the average ratio for the sector in Brazil was 20%, and for the country's five largest banks (accounting for 67% of total assets) the ratio was 18.5%. He adds that Brazil also didn't have a shadow financial system, like in the U.S., thanks to tight regulatory and supervisory oversight. All financial institutions (including investment banks) are under the watch of the Central Bank.
Small and medium-sized banks relying on the wholesale money markets for growth suffered the most, but policymakers eased regulations relatively quickly in 2008, provisionally allowing the Central Bank and commercial state banks to acquire the portfolios of banks in difficulty to help strengthen the system. This enabled, for example, Banco do Brasil, the largest commercial state bank, to acquire the small, weaker banks Banco do Piauí and Nossa Caixa.
Other underlying forces in the country's economy have also been at work. Macroeconomic stabilization has facilitated capital market deepening, and credit to the private sector has grown from 22% of GDP in 2002 to 45% currently and is set to continue rising. Meanwhile, Brazil's labor force has been growing and is among the main factors that will drive domestic consumption over the medium term, observers predict.
Realizing Brazil's Potential
None of this has been lost on foreign investors, notes Monteiro. Indeed, FDI in 2008 reached a record $45 billion, the second largest amount among emerging markets after China. This year, FDI inflows will still be at enviable levels but nonetheless are expected to drop to around $25 billion, rising above $30 billion in 2010.
Monteiro sees little likelihood of radical policy changes under the new administration taking office in January 2011. (Lula is constitutionally barred from a consecutive, third term.) After all, he says, the country's managed float and exchange rate policies have worked well. But with the real expected to appreciate as Brazil's growth outpaces that of OECD members, there will be pressures from exporters, particularly in manufacturing, to weaken the exchange rate. Indeed, the government introduced a 2% tax on portfolio inflows on October 19 to curb the recent appreciation of the real, a controversial measure raising fears about government intervention. A bigger problem would be a shift to more explicit exchange rate goals. According to PUC-Rio's Garcia, such a policy move would be a major setback and investors will be monitoring the election campaigns closely for any warning signs.
Further concerns, meanwhile, are being raised in other areas. Marcelo de Paiva Abreu, an economics professor at PUC-Rio, cites the "electioneering and populist" side of Lula, which has led to the "explosive rise" in government spending. According to de Paiva Abreu, it represents an "erosion of macroeconomic prudence."
Then there is the growing specter of government meddling in the private sector, which was already evident when it recently began exerting pressure on home-grown multinational Vale to increase local investment rather than focusing, as the mining company has been, on overseas expansion. According to de Paiva Abreu, policy shifts by the Lula administration during the election year could cause Brazil's GDP growth path in 2011 to return to the "voo de galinha" ("chicken hops") between 1980 and 2002.
Also weighing on corporate minds is the "custo Brazil" -- the additional cost of doing business in the country because of poor infrastructure, weak tax and labor reform, and other problems. Reducing that cost burden has been slow and piecemeal under Lula. Yet even if the reform process under the next administration is disappointing, Wharton's Guillén sees fewer risks of Brazil succumbing to, say, Mexico's plight, where a lack of reforms caused GDP to grind to a halt even before the U.S. recession struck. Brazil's economy is "more diversified and the environment for private enterprise and competition is stronger," he says.
Increasingly, the private sector will be looking outside its domestic borders for diversification and growth, too. According to Monteiro, as global M&A deal-making thaws, the internationalization strategies pursued by Brazil's emerging multinational companies -- such as Vale along with oil company Petrobrás, steel maker Gerdau, BRF Brazil Foods, cosmetics company Natura and construction-to-chemicals conglomerate Odebrecht -- will resume, and other companies are likely to join the fray. But that won't mean an end to their challenges. To survive in the global arena, these companies, he notes, will need to learn how to replicate the success of emerging multinational companies, such as Banco Santander and Telefónica in Spain and Samsung, Hyundai and LG in South Korea, which internationalized rapidly over the past 10 to 20 years and are among the top players in their sectors today.
Going global might be tough for many Brazilian companies. According to Aldemir Drummond, academic director of the BRICs program at Fundação Dom Cabral business school in Belo Horizonte, an inward-looking culture still prevails in Brazil, and a challenge will be for the new administration to support the outward operations of home-grown companies, rather than, as in the past, casting them in a negative light for being exporters of capital. Drummond also suggests Brazil's politicians should take lessons from their Chinese counterparts and play a more active role in helping companies expand abroad.
But how can the country maintain the momentum of recent months? Guillén notes that the answer lies in the ability of the country's public and private sectors to tackle its greatest challenge: bridging the gap between Brazil's "separate countries" -- the first world at the core of its big cities with world-leading companies and high purchasing power, and the third world keeping millions living in poverty in smaller cities and the countryside. Despite improvements that began in the 1990s, Brazil still has one of the highest income and wealth inequalities in the world, according to the World Bank. Guillén says that addressing this requires further investment in education and the expansion of national social programs, such as Bolsa Familia, which makes small monthly payments available to 12 million poor households so that they are able to keep their children enrolled in school and provide them with medical care.
Against that backdrop, Monteiro says the sense of urgency created by the staging of the World Cup in 2014 and the Olympics in 2016 can be "very positive" as it spurs the public and private sectors to carry out badly needed infrastructure investments. Transportation in particular -- upgrading airports and building a high-speed train between São Paulo and Rio de Janeiro -- is already high on the list of priorities. According to the president of the Central Bank, Henrique Meirelles, Brazil has a $240 billion fund for national development, which is already being spent in capital programs for Rio 2016.
The World Bank predicts that if Brazil continues on the path it is on now, it will move from being the tenth largest economy in the world today to the fifth largest by 2016. To achieve this, Lula said on his weekly radio show "Breakfast with the President" on October 26, Brazil needs to keep growing. The Brazilian economy, he said, "is like a Ferris wheel, which cannot stop. And what are we doing? We're making it turn."