Corruption continues to cast shadow over Brazil

noviembre 2016

A lengthy and far-reaching political crisis brought Brazil’s economy to a shuddering halt. New president Michel Temer faces an uphill task to arrest the slide.

 

The surge in value of Brazilian equities and bonds may seem one of the more perplexing investment stories in a year that saw the impeachment of President Dilma Rousseff at the end of August and an economy in freefall. 

The Brazilian economy contracted 3.8 per cent year-on-year in the second quarter, which followed a 5.4 per cent fall in the previous quarter. Brazil has now experienced nine straight quarters of economic contraction (on a year-on-year basis); a period that began just prior to Rousseff being elected for a second term in office on October 2014.

A corruption scandal brought about Rousseff’s demise, and continues to cast a long shadow over the country; infiltrating the entire political system as well as big business. Illustrating how far the rot has spread, one of the key individuals behind Rousseff’s impeachment, former Congressman and Speaker of the House Eduardo Cunha, was arrested on October 19 on charges that include corruption, fraud and money laundering. 

 

Figure 1: Brazil is experiencing its worst recession since the Great Depression

 

At the Car Wash

Political risk is unlikely to go away in the short term, according to Tim Alt, Fund Manager, Global Rates, Aviva Investors. The massive corruption investigation called Lava Jato, or Operation Car Wash, centres on the state-run oil company Petrobras and has enveloped many of the country’s leading politicians and business figures. In 2015, prosecutors also launched Operation Zealots, targeting firms which are alleged to have bribed tax officials to reduce their assessments.

Furthermore, the industrial conglomerate Odebrecht is close to reaching a plea deal for its role in the Lava Jato scandal, according to Reuters. Given all these factors, more revelations seem certain to follow. The news agency says that “the vast portfolio and deep political connections” of the Odebrecht group have fed speculation that an eventual plea deal “could bring down a huge swathe of Brazil's political elite”. This includes former president Luiz Inácio Lula da Silva, who faces a number of charges. According to Alt, Lula once enjoyed “near god-like status” in Brazil for overseeing an economic boom that pulled millions out of poverty.

The scandals have tarnished Brazil’s entire political establishment, with recent polls showing that less than a third of Brazilians still believe in democracy. In local elections held in early October, the Workers’ Party of former presidents Rousseff and Lula was ejected from office in São Paulo, while the Brazilian Democratic Movement Party (PMDB) of President Michel Temer lost control of Rio de Janeiro. Moreover, Temer has an approval rating of just 14 per cent, according to a local polling firm, in line with Rousseff’s low standing during the height of her unpopularity. Several of Temer’s cabinet officials, including the anti-corruption minister, have already resigned after being implicated in the scandals.

Credibility under threat

There is an additional complication in terms of political risk, argues Will Ballard, Head of Emerging Markets & Asia Pacific Equities, Aviva Investors. On 31 August, the Senate, while agreeing to impeach Rousseff, allowed the former president to maintain her political rights, a break with Brazilian law that specifies a dismissed president should be barred from holding any government job for eight years.

Two senior members of the Supreme Court have reportedly said the move is unconstitutional. ”There is no clarity over why the amendment was made but inevitably it has raised suspicions that it was done to protect other politicians who are facing charges of wrong doing,” says Ballard.

This has created divisions within the coalition of parties supporting Temer, with some arguing against the last-minute political rights amendment. It also raises doubts about Temer’s ability to push through unpopular reforms, given the legitimacy of his presidency could come under question.

Despite this apparently bleak political background, Temer has a small window of opportunity in the coming months to address some of the main issues facing Brazil, according to Ballard. ”The Brazilian Social Democracy Party (PSDB), the PMDB and some of the smaller parties were able to unite to oust Rousseff from power, and this coalition should ensure the government can pass vital reforms,” he says.

Aaron Grehan, Emerging Market Debt Fund Manager, Aviva Investors, agrees. “The government may be able to pass a sufficient level of reforms to maintain positive investor sentiment in the near term. The risks are likely to lie beyond the first quarter of 2017. After that and the closer we get to the presidential election in October 2018, the harder it will become to pass legislation as the parties start to jockey for power,” he says. 

However, while theoretically, Temer has enough parliamentary support to pass reforms – he requires 60 per cent of both houses in the Congress - his support base could crumble rapidly if he is unable to win support for the reforms in the country.

A highly-fragmented political environment adds a further level of complexity, according to Alt. “There are around two dozen individual political parties, so it is virtually impossible for one party to gain power,” he says. “Moreover, politicians frequently move between parties, and this fluidity engenders corruption since it is impossible to govern without making deals to ensure legislation can be passed.”

The impeachment process highlights the scale of the challenge facing Temer as he seeks to implement unpopular reforms to nurse Brazil back to economic health. “A large proportion of the population and the political elite supported Rousseff’s impeachment,” adds Alt “Yet Temer still had to provide significant financial relief to state governments and to increase the pay of civil servants by an average of 12.5 per cent to ensure he gained sufficient congressional support to pass the impeachment law.”

A fresh start?

Given the need for fiscal consolidation and the likely weakness of private consumption, increased exports and investment hold the key to Brazil’s prospects. That is why structural reforms, such as a simplification of the tax system and the trade regime, and a continuing crackdown on corruption, are vital to encourage foreign direct investment.

Steering Brazil onto a fiscally-sustainable path is the most pressing priority. The budget deficit, at more than 10 per cent of GDP, is the second largest in the G20 and the overall public-sector debt burden is rising fast, climbing by nine percentage points in 2015 alone to 67 per cent of GDP. “We estimate it could approach 90 per cent of GDP in the next four or five years, even assuming that the government implements some structural reforms”, says Alt.

“While such a debt-to-GDP ratio would appear low relative to the developed economies, debt servicing costs are much larger, reflecting higher local interest rates,” adds Ballard.

However, the sharp fall in the currency - the real has moved from 1.53 to the dollar at the beginning of July 2011 to 3.26 to the US dollar at the beginning of October 2016 - is less of a problem than in previous crises. Brazil missed foreign debt payments in the 1980s and required an IMF bailout in 2002, but has much larger international reserves today. Additionally unlike previous crises much of the public debt is owed to local investors. In a May 2015 report, the International Monetary Fund estimated that foreign-currency linked debt accounted for just 3.9 percentage points of Brazil’s gross government debt (which it put at 64.2 per cent of GDP in 2014.)

The government has already proposed freezing budget spending in real terms for 20 years. However, Alt believes reforming the social security system “will prove a key test of the administration’s ability to steer the country’s finances onto a stable path”. Alt points out that “in 2017 social security spending will represent almost half of total government expenditures and will increase towards 80 percent of total spending within a decade if left unchecked leaving very little room for spending on other areas”.

Tackling the social security budget will prove extremely difficult, given it will include highly unpopular measures such as cutting back on pensions and other benefits, delinking inflation from wages and reforming the minimum wage. Brazil is one of the few countries in the world without a minimum retirement age, with workers on average retiring at 54. The government is considering setting a minimum retirement age of 65 for men and 60 for women. Trade unions have already threatened street demonstrations and strikes to protest the reform.

Exports to the rescue?

Ballard says the tax system is amongst the most complicated in the world but believes reform is unlikely to happen. He argues for an overhaul of labour laws and the political system. Alt adds that the trade system should also be tackled “given that export-led growth appears the only viable means by which Brazil can escape its current economic malaise”. Rousseff introduced many protectionist policies and tariffs to shield certain industries.

There can be little doubt that Brazil needs massive structural change and a new economic model to reduce its dependency on commodities. With commodities likely to trade in a ‘lower for longer’ range, Brazil simply cannot expect external factors to come to the rescue.

Domestic consumption is also unlikely to drive economic growth for the foreseeable future, given that household debt has been rising for nearly 15 years. ”Given the experience of household deleveraging in other countries, it is unlikely that credit growth will pick up strongly even if interest rates do start to fall,” says Alt. “Moreover, borrowing costs would remain at relatively high levels even if we saw a significant fall in interest rates. They are certainly unlikely to fall into single figures even on the most optimistic of outlooks.”

In addition, the population is ageing, which will weigh on consumption. The share of Brazil’s population aged 60 years or over is projected to increase from 12 per cent in 2015 to 29 per cent in 2050, according to the UN.  Factors such as social security reform are also likely to prove headwinds to any pick up in consumer spending.

Meanwhile, Ballard adds that a shift in the government’s use of state-owned banks to boost credit growth will weigh on another potential engine of growth. During the Rousseff era, institutions such as Caixa Economica Federal, Banco do Brasil, and the Brazilian Development Bank (BNDES), extended credit effectively at market or below market rates. Temer’s administration has reined in this practice and the availability of cheap credit at below normal market rates has been severely compromised.

That marks a significant difference in the way credit is extended to the broader economy and raises the question of how the government will finance infrastructure projects in the future, and facilitate private sector involvement. Significant reforms will have to be put in place before major infrastructure projects can be launched, Ballard concludes.

Reality or fantasy?

The strong performance of Brazil’s financial markets this year is almost wholly explained by investor perceptions that the new government will be far more market-friendly than the Rousseff regime. The economic background certainly remains grim. Brazil is experiencing the longest recession since the 1930s, with Latin America's largest economy shrinking by 3.8 per cent last year and the IMF forecasting another fall of 3.3 per cent this year.

Recent economic data continues to paint a bleak picture. Retail sales fell at an annual pace of 5.3 per cent in July, the worst July since the series began in 2001. Wages declined by three per cent in August,  while unemployment rose to 11.8 per cent in the same month, up from 8.7 per cent a year earlier, according to the Brazilian Institute of Geography and Statistics (IBGE)and from a record low of record low of 4.3 per cent in January 2014. “The continuing upward trend does little to encourage consumer confidence”, says Ballard.

Yet equities are pricing in an economic recovery. “The main index on the Bovespa is trading on around 160 times the trailing 12-month earnings, which reflects the impact of the recession on earnings. A significant recovery in earnings is required to justify that figure yet the recent data certainly does not point to a recovery,” says Ballard.

Grehan says it’s a similar story in the debt market, which has more than priced in any potential improvement in the economic and political environment. “The question now is whether the improvement is sustainable, whether investors are being compensated for the risks and whether expectations match the reality, which is doubtful,” he says.

Despite the difficult backdrop, both Ballard and Grehan see selective opportunities for investors in Brazil although both agree that “the easy gains have already been made”. Ballard points to the re-rating of the Brazilian banks that has taken place this year. At the beginning of this year, state-owned Banco do Brasil was trading on about 0.4 times price to book. It has now recovered to 0.8 times price to book. Meanwhile, privately-owned Itau Unibanco, has risen from a low of 1.2 times price to book to 1.9 times.

Of these names, Ballard says Itau Unibanco is managing its loan book very well. “It is seeking to move away from riskier lending and increase its exposure to mortgages and payroll lending.” Moreover, if interest rates fall and credit growth returns, banks such as Itau “could start to deliver earnings, which make their current share price appear attractive,” adds Ballard

Meanwhile, the local bond market has been a beneficiary of global investors’ search for yield.  “We hold a relatively cautious view given the gains that have already occurred,” says Grehan. “However, there are a large number of corporate issuers and it is still possible to find opportunities.”

Fiscal consolidation

Due to rapid price increases in recent years, the central bank maintained the benchmark Selic interest rate at a 10-year high of 14.25 per cent from July 2015 until October of this year, when it cut rates by 25 basis points, the first time borrowing costs have fallen in four years. Inflation will continue to be a key driver of central bank policy and the local bond markets. 

Consumer price inflation increased last year to the highest rate in 13 years, standing at an average 10.67 per cent, according to the IBGE, and up from 6.41 per cent in 2014. Inflation is now moving in the right direction, declining to 8.48 per cent year on year in September 2016, from 8.97 percent in the previous month. The president of the central bank, Ilan Goldfajn, said in September that the inflation rate will converge toward the official target of 4.5 per cent next year. However, the timing of key rate cuts is likely to rest on the government’s success in passing fiscal austerity measures.

 

Figure 2: The central bank expects inflation to fall towards the official target of 4.5% in 2017

 

According to Alt, most analysts believe the neutral real interest rate for Brazil is around five per cent, which is relatively high. Given that the central bank is targeting inflation of 4.5 per cent, the nominal neutral rate of interest should be 9.5 per cent, says Alt. “Clearly with the Selic standing at 14.0 per cent, there is plenty of scope for the central bank to cut interest rates if inflation moves towards the bank’s target,” he says. “Arguably, interest rates should even be able to fall below the neutral level because of the extreme weakness of the economy.”

The central bank has explicitly acknowledged that given the continuing positive fiscal stimulus, cutting interest rates sharply could have dangerous consequences for inflation. In addition, cutting borrowing costs prematurely could cancel out the benefits of maintaining a high level of interest rates over the past year or so.

”Progress in tackling the public finances will be very gradual,” says Alt. “The market is currently pricing in a much steeper and faster fall in interest rates than is likely to happen.”

Turning to the currency, the real appears overvalued as any visit to the country reveals. However, a currency’s value is determined by external as well as domestic factors. “The Fed’s stance on interest rates can be just as influential a factor as domestic developments. Given the real neutral interest rate in Brazil is around five per cent, and is currently estimated to be around zero in the US, there is a clear real interest rate advantage to investing in Brazil and that partially justifies what some may regard as an overvalued currency.”

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 31 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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