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September 13, 2006 7:56 pm

Brazil lags behind other BRICs

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When is a BRIC not a BRIC? Or rather, when does it cease to be one?

When Goldman Sachs coined the term BRICs for Brazil, Russia, India and China in 2001, it did so to call attention to the four countries’ potential for fast and sustained growth. By 2041, it predicted, their economies would be worth more than those of the US, Japan, Germany, the UK, France and Italy put together.

The BRICs are on target to fulfil that prediction. But they would do so more quickly if their average rate of growth were not being held back by Brazil.

China’s economy grew by 11.3 per cent year on year in the second quarter. Brazil’s grew by 1.2 per cent. It is set to grow by a miserly 3 per cent this year, probably making it the laggard not just among the BRICs but among all the world’s emerging markets.

Until recently, investors have ignored this problem. But now they are taking notice, with far-reaching implications for debt and equity markets alike.

Brazilians themselves seem not to care about growth. President Luiz Inácio Lula da Silva of the left-leaning PT party appears comfortably assured of winning another four years in office at elections next month.

The reasons for the president’s popularity are many but chief among them is global demand for Brazilian exports – led by China, India and other faster-growing markets. Brazil is recording trade surpluses of more than $40bn a year and, consequently, its currency has appreciated by 65 per cent against the US dollar since the end of 2002.

Inflation is at its lowest level in decades. As the spending power of the poor has increased, the prices of many foods have actually fallen.

The rich are doing nicely, too. Brazil’s central bank uses high interest rates to fight inflation and although its benchmark rate has fallen by 5.5 percentage points in the past year, it remains among the world’s highest, at 14.25 per cent a year. This creates a bonanza for anyone with capital to invest.

But unless Brazil grows, the boom times for rich and poor will come to an end. And by unanimous agreement among economists, Brazil will not grow unless the next government enacts politically difficult spending cuts. On present form – and according to Mr Lula da Silva’s programme for government in 2007-2010 – there is little chance of this happening.

Markets are finally taking this on board. “If investors believed reforms were on the way, future interest rates would have to be much lower than they are priced at now,” says Marcelo Salomon, chief economist at Unibanco, a São Paulo-based bank.

Take the Treasury’s NTN domestic-market bonds, priced to yield interest above inflation. The most liquid papers, maturing in 2009 and 2010, are trading at about 9.5 per cent above inflation. Yet today, one-year interest rate swaps at a nominal 13.8 per cent, with inflation over the next year predicted at 4.5 per cent, suggest real interest rates of about 9.3 per cent.

With Brazil’s healthy current account surplus and the fact that the Treasury, having paid down much of its foreign debt, is now a net creditor in dollar terms, the country should be cruising towards investment-grade ratings.

But what should be the corollary effect – cheap credit and a shift into equities as the economy grows – is not expected. “Brazil isn’t a growth story,” says Walter Molano of BCP Securities, a US brokerage. “It’s a credit story. From an investment standpoint, nobody cares [about growth] as long as they pay back their debt.”

Two things are now happening – or rather one thing with two causes. Fearing a US slowdown and its impact on world growth, investors are looking for a safe haven from expected volatility on global financial markets.

Brazil – traditionally one of the world’s most volatile markets – offers such a haven. But not in liquid assets, which will be shaken as much as those in other countries as liquidity retreats. Instead, investors are moving into receivables funds and other structured assets, often put together for a handful of investors who then hold to maturity, avoiding the need to mark to market. The trick is to structure an asset so it matures once the coming volatility is over – whenever that may be.

The dim outlook for domestic growth is driving a similar trend, not only out of plain vanilla credit instruments but also away from equities. “There is an enormous appetite among foreign investors to be associated with growth,” Mr Salomon says. This means investors are going into real estate credits, for example.

But for equities, Mr Salomon warns: “The stock market depends on global growth and it will depend more and more on domestic growth as liquidity retreats.”

This is the eighth article in a series about emerging markets investing. Read the others at www.ft.com/emergingopportunities

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