Waiting for change

President Lula is under fire as Brazil struggles to capitalize on unprecedented bullish operating conditions. Cracks in the macro story are spreading.

Photographs of the fireball that engulfed TAM flight JJ 3054 and the grim wreckage of the July 17 crash dominated headlines in Brazil for more than a week. The media re-doubled its coruscating attacks on the government of President Lula in its wake, connecting political cronyism and bumbling inefficiency at many of Brazil’ s government agencies with the country’ s decayed infrastructure. That is an image that is likely to stick, even if final blame for the accident is pinned elsewhere.

The contrast between this and the macroeconomic data could hardly be more striking. Brazil is posting record numbers for consumer and business loans, foreign direct investment, capital markets activity and current account balances. Ironically, this accelerating growth is likely to further pressure infrastructure, making coherent, rapid action more urgent.

The first 10 months of Lula’ s second mandate have certainly been hesitating. One of the main headaches for any incoming Brazilian president is getting the roster of appointments right to appease all constituents. Lula must balance the competing interests of the 11 parties of his fragmented coalition to achieve an absolute majority, which in Brazil means 60%, notes David Fleischer, professor of political science at the University of Brasilia. This is a job complicated by the 25,000 appointments that lie within Lula’ s remit, more than 10 times the number in the US, many of which are decided by Congress, he adds.
Lula got off to a slow start by taking three months to put his cabinet together and has proved painfully slow in picking staff for more junior positions. Lula’ s allies are increasingly dissatisfied and some are holding up legislation to make their point. An array of fresh scandals, particularly those surrounding Renan Calheiros, president of the senate, have not helped.

Calheiros is a member of the PMDB, the key party in Lula’ s wide coalition. He is being dragged over the coals primarily for payments made by a lobbyist of a construction company to his mistress and their daughter.

Already, renewal of a law that allows Lula to veto up to some 20% of constitutionally mandated transfers to municipalities and states is bogged down, says Fleischer. Even the renewal of the politicians’ beloved CPMF, a financial transaction tax that generates some 30 billion reais per year – much of it funneled to states – is stalled, Fleischer adds.

There is a significant opportunity cost here, says Christopher Garman, director of the LatAm practice at Eurasia Group. He notes, however, that the print media have long been attacking Lula’ s record, with impact on his popularity. It remains to be seen how the TAM crash will affect him, but Garman predicts the damage will be limited. He reasons that most Brazilians, especially Lula’ s voter base, do not fly.

Useful Legislation
Furthermore, useful legislation will get passed, Garman predicts. New laws are likely to be focused more at the micro level and will generally be welcomed by private investors. Initiatives they need to watch include the gas law, changes to Article 22 of the constitution (currently reserving the right to legislate on areas including water, energy, telecoms and mines to the federal government) and anti-trust legislation, he says. “We’re going to see some progress on getting the private sector what it wants. It just won’ t be as great as they would like,” he believes.

The economic stability that Lula nurtured in the first mandate is paying ever more dividends. “Brazilian companies are starting to command the kind of multiples you would normally see in Europe,” says José Eduardo de Lacerda Soares, partner at São Paulo-based Arsenal Investimentos, a corporate finance and M&A advisory boutique. As rates fall, local debt markets will open up to aid acquisitions.
Mário Mesquita, head of economic policy at the Banco Central do Brasil, says that “improved conditions for corporate funding have definitely contributed to accelerate Brazilian GDP growth since 2006”. Foreign direct investment in June alone topped $10 billion.

Mesquita is forecasting a current account surplus of $10.7 billion for this year, less than the $13.3 billion surplus posted in 2006, but still about 1% of GDP. It will continue to be supported by a strong trade surplus, which he sees coming in at $40.0 billion in 2007, down from $46.1 billion last year. “Buoyant world demand for Brazilian exports, be it commodities or manufactured goods, continues to underpin the trade surplus, even with imports growing at about 26% per year,” he points out.

“The current account balance will keep improving. Export performance has been strong even with a weaker dollar,” says the BNDES. Since its net foreign asset position has improved markedly in the last few years, Brazil’ s traditional deficit in the income account is shrinking, as interest revenues grow, contributing to sustainability of the current account surplus. Market analysts surveyed by the central bank forecast a somewhat larger current account surplus for 2007 – $11.5 billion – and a surplus of $5.3 billion for 2008.

“Public sector borrowing will be zeroed by 2008 or 2009 at the latest,” adds the BNDES. That is based on GDP growth of 4.5%. Wages too are forecast to rise, with nominal average income in the private sector at 5.5% this year, accelerating to 6% next.

Last but not least, nominal interest rates have fallen, with the short rate down to 11.5% in July, meaning Brazil no longer has the highest real rate in the world (Turkey has that honor); and although inflation is trending up (3.96% in the 12-months to June) it is offset by the appreciation of the real, which diminishes import costs.

Credit Still Booming
Higher wages and the strong currency help feed growing demand in the consumer sector that banks are eager to meet. The credit boom that started three years ago shows little sign of slowing. The last year and a half have seen new areas such as auto loans take off, with banks including Banco Itaú and ABN AMRO posting growth of some 30% annually there. Payroll deducted loans continue to grow, while unsecured loans are also on the rise, although banks are keeping a careful eye on portfolios.

The next story in the credit area should be a leap in competition. That is likely to come from two sources, the weighing in of state-owned banks and a wave of IPOs that is helping to recapitalize small and medium-sized banks.

Banco do Brasil claims a 17% market share in payroll loans and that portfolio has been growing close to 100% year on year, says Celina Vansetti-Hutchins, senior analyst at Moody’ s. “Banco do Brasil has a captive audience. If they can leverage these clients, the market is theirs to be exploited,” she says.

Lumbering state-owned Caixa Econômica Federal also looks keen to grow its consumer lending portfolio. Caixa has been responding to its loss of market share in lending with a broad advertising campaign. If it does decide to come into the market aggressively, it may not have profit maximization at the top of its priorities, further squeezing bank spreads, reasons Vansetti-Hutchins.

The latest wave of bank IPOs and acquisitions in the credit sector is also being closely watched to see what impact competition might have on spreads. Banks including Sofisa, Banco Pine, Daycoval, and state-owned Banrisul have all reinforced capital and are likely to spend at least some of the proceeds on building portfolios of consumer credit.

Day of Reckoning
Ironically, all this growth is likely to bring the day of reckoning on Brazil’ s lousy infrastructure closer. The BNDES says progress with building out infrastructure is being made. According to June data from BNDES, approvals for infrastructure projects grew 88% in the prior 12 months, year-over-year, with the bank’ s disbursements hitting 19 billion reais, or a 10% increase.
Every sector is facing strain. For example, chaos in the air is mirroring and to some extent exacerbating ever-worse traffic conditions on the ground. The city of São Paulo alone has seen a 26% increase in the number of cars registered in the last two years, fuelled by consumer demand and banks’ voracious appetite for secured lending. There has been almost no progress in enhancing transport infrastructure.

And Brazil may soon have to confront another energy crisis. Since the black-outs of 1999 and rationing of electricity, Brazil has enjoyed surpluses, in great part thanks to abundant rains in a system dominated by hydroelectricity. It is now supplying energy to Argentina, which foisted an energy crisis on itself by state intervention to keep pricing artificially low amid a rapid economic pick-up. Brazil’ s schadenfreude could be short lived.

If economic growth continues to pick up, energy shortages could come as early as next year and intensify in 2009-2010, says Fleischer. Even at a slower pace of growth, energy is likely to pose a problem in two or three years while the next major generating capacity additions are not likely until 2012-2013, he believes. It remains to be seen whether the proliferation of small energy generators will stave off the crisis.

Potential investors are paying close attention to the proposed gas law. Current legislation, dating from 1997, leaves questions over access to pipelines owned by Petrobras unclear, says Garman. The new law will seek to clarify that through a regulatory framework and fees. The law seeks to induce private sector participation in the area and define their position with respect to Petrobras. “It marks a significant step forward,” he says.

The Lula government is also working to clarify the role and oversight of regulatory agencies. The pendulum is swinging in favor of provisions to guarantee continuity of funding for them, with a proper budget replacing the idea of administration contracts with goals and penalties, an idea derided by most. Even so, the executive is likely to feed the agencies issues to consider and keep close tabs on them.

Leadership Required
When Lula was jeered in July at the Maracanã stadium at the opening of the 15th PAN-American games, his supporters shrugged it off as orchestrated by his opponents. The fall-out from the TAM crash is not so easy to defuse.
The appointment of Nelson Jobim – who successfully handled the fiendish job of running the Supreme court – as minister of defense shows that Lula can make change. Sadly, it has taken a crisis to make that happen. It is hoped that this Teflon president, who seems increasingly concerned by his legacy, will start to use his enormous popularity to effect change without waiting for the next disaster. The fact is that most analysts see that as unlikely.

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