Economy

Brazil faces new market test

Written by Stephen Poloz

International investors appear to be preparing to test Brazil’s mettle once again. Are we in for a repeat of 2002?

Brazil is a big country with great economic potential. This was true back in 2002, as well. But in the run-up to the presidential elections in October 2002, international investors learned that a former trade union activist might have the support to become president. Investors sold Brazilian bonds and stocks aggressively, driving bond yield spreads against U.S. Treasuries to 23 percentage points and pushing down the value of the real.

Luiz Inacio Lula da Silva proved to be a very market-friendly president, who immediately appointed strong candidates to run the nation’s economy and financial system. Relieved international investors returned to Brazil, interest spreads narrowed by 16 per cent in the space of nine months, and the real appreciated significantly.

Although the episode ended well, the financial volatility meant that Brazil lost a year of economic growth in 2003. The economy recovered nicely in 2004, and the outlook is for growth of close to 3.5 percent for 2005-06.

But a problem is emerging. The President’s political party has stumbled into a corruption scandal that threatens to strip them of their previously unsullied reputation. Marketing companies with government contracts have allegedly been funneling the money back to politicians, who are suspected to have used the funds for various purposes, including bribery.

All this, at a time when economic growth is moderating and we are entering the 12-month pre-election window, suggests that a repeat of 2002 is possible. Legislative gridlock in the Chamber of Deputies means that further progress on structural reform may be impossible before the election. And now there is increased uncertainty about the long-term outlook for reform.

So far, markets are showing resilience, perhaps bolstered by memories of the 2003 return to confidence. Moreover, the government is running a primary (excluding debt-service payments) surplus equal to 5 percent of GDP, a very solid situation. Interest rate spreads, which widened briefly to over 4 per cent in August, have receded again to new lows, and the brief depreciation in the currency has been erased. In addition, the stock market has surged again to a new high following mid-year doldrums. The risk, though, is that slower economic growth and higher credit risks in general in 2006 will side-swipe Brazil at a fragile time.

The bottom line? Brazil’s fundamentals remain solid, and its steadfast performance during the last crisis should have made investors less fickle. Nevertheless, companies should brace themselves for more volatility — and if it comes, treat it as another great buying opportunity.

September 22, 2005

The views expressed here are those of the author, and not necessarily of Export Development Canada.

Originally appeared on PROFITguide.com