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Brazil Back in the Clutches of Capital
Flight
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Drafted By: Jephraim P. Gundzik http://www.pinr.com In 2005, many analysts and investors became overly complacent about investment risk in emerging markets. Some even confidently asserted that dramatic improvements in underlying fundamentals sharply reduced long-term investment risk in many countries. Nowhere has this complacency and overconfidence been more apparent than in Brazil, which thanks to excessive global liquidity enjoyed a flood of foreign portfolio investment in 2005 and the initial months of 2006 despite increasing political and social instability and slowing economic growth. Tightening global liquidity has already burst Brazil's stock market bubble. As Brazil's political, social and economic fundamentals continue to deteriorate in the months ahead, foreign capital flight could accelerate, prompting significant currency depreciation or devaluation. Foreign Portfolio Investment Floods Into Brazil Historically, devaluations and defaults in emerging markets have been sown from the seeds of complacency and overconfidence. During 1998, foreign investors poured money into Russia's domestic fixed income market even though political, social and economic fundamentals were all deteriorating rapidly. These investors believed Russia was "too big to fail," meaning that they expected the International Monetary Fund (I.M.F.) and Washington to forever provide Moscow with sufficient liquidity to prevent a ruble devaluation or debt default. Complacency toward increasing investment risk and overconfidence in the I.M.F. and Washington led investors down the primrose path, at the end of which were not riches but collapsing asset values, ruble devaluation and painful debt and restructuring. Complacency and overconfidence among foreign investors also led directly to Argentina's default and devaluation in 2001. The I.M.F. and Washington were largely to blame for building complacency and overconfidence in the case of both Russia and Argentina. While Argentina's monumental default has thankfully muted the I.M.F.'s and Washington's influence over emerging market investors, banks and brokers have stepped up their spin, downplaying investment risk across emerging markets. This has encouraged enormous inflows of foreign portfolio investment into many countries since the beginning of 2005, especially Brazil, India and Turkey, all of which have suffered dramatic stock market and exchange rate reversals in the past few weeks. Of these countries, Brazil has seen the largest inflow of foreign portfolio investment. According to official balance of payments statistics produced by Banco do Brasil, Brazil's central bank, net portfolio investment inflows into Brazil were not unusually heavy in 2005. However, Brazil's official balance of payments statistics are not capturing the enormous amounts of foreign portfolio inflows that are essentially being conducted "off balance sheet." This is clearly seen in a different statistical series produced by Brazil's securities exchange commission, Comissao de Valores Mobiliarios (C.V.M.). The C.V.M. data depicts the stock of foreign portfolio investment in Brazil rather than the flow of foreign portfolio investment, which is used in the central bank's balance of payments statistics. According to C.V.M. data, the stock of foreign portfolio investment in Brazil increased by over US$23 billion in 2005 to $53 billion. In the first four months of 2006, the stock of foreign portfolio investment in Brazil rose another $30 billion to $83 billion Of the $83 billion stock of foreign portfolio investment perched in Brazil at the end of April 2006, 80 percent was dedicated to Brazilian equities, according to the C.V.M. The existence of huge off-balance sheet inflows of foreign portfolio investment into Brazil during 2005 are further corroborated by central bank disclosure of the scale of foreign exchange market intervention conducted in 2005. According to Banco do Brasil data released in mid-January 2006, the central bank purchased $21.5 billion in the foreign exchange market in 2005. The Brazilian Treasury purchased a further $9.3 billion through brokerages, bringing total government intervention to $32 billion. About 25 percent of the increase in the stock of foreign portfolio investment during 2005 and the first four months of 2006 can be attributed to rising equity values. The remaining $40 billion of inflows represent new foreign portfolio investment into Brazil's equity market. In addition to equities, foreign investors have also dumped money into dollar/real currency swaps sold by the central bank. These swaps give foreign investors exposure to Brazil's very high short-term interest rates. Including these currency swaps, the total stock of foreign portfolio investment in Brazil at the end of April 2006 was probably near $100 billion or about 12 percent of G.D.P. The enormous inflow of foreign portfolio investment over the past 16 months, which is short-term by nature, has been instrumental to President Luiz Inacio Lula da Silva's government's drive to reduce its external and dollar denominated domestic debt. It has allowed Brazil to repay all of its outstanding obligations to the I.M.F., amounting to about $15 billion. It has also offset about $6 billion of federal government short-term domestic debt linked to the exchange rate of the real against the dollar. Many analysts and investors have concluded that this reduction of dollar denominated debt is extremely positive. However, Brazil's government has merely swapped a variety of medium- and short-term dollar liabilities for an equal amount of short-term real-denominated liabilities to foreign investors. Because foreign investors can be expected to demand dollars for their real-denominated investment assets in the event of liquidation, there has been no change in Brazil's effective currency liability position. What has changed dramatically is the ratio of Brazil's foreign exchange reserves to the stock of foreign portfolio investment. In 2004, Brazil's foreign exchange reserves were $52 billion while the stock of foreign portfolio investment in Brazil amounted to $35 billion. At the end of 2005, reserves amounted to $54 billion and the stock of foreign portfolio investment was about $65 billion. As of April 2006, foreign exchange reserves were $57 billion while the stock of foreign portfolio investment surged to an estimated $100 billion. Although Brazil's foreign exchange reserves appear substantial, they are dwarfed by the stock of foreign portfolio investment in the country -- investment that can easily turn into foreign capital flight, reducing foreign exchange reserves to nothing. The unfolding collapse of Brazilian equities signals that the flight of foreign capital from Brazil has begun. Judging from recent exchange and interest rate movements, most of the foreign money exiting the stock market has found a temporary home in Brazil's domestic fixed-income securities. More Bad News To Trigger Further Capital Flight Rapidly tightening global liquidity, spawned by rising interest rates in the United States and Europe and the end of quantitative easing in Japan, has already begun to encourage foreign capital flight from Brazilian equities. In the months ahead, continued deterioration of Brazil's political, social and economic fundamentals will increasingly weigh on the country's overvalued exchange rate. Exchange rate weakness could easily turn into substantial depreciation and even devaluation. Growing political instability in Brazil during 2005 was largely dismissed by foreign investors. Corruption scandals in 2005 eroded governance by weakening President Lula's coalition government. Ongoing investigations, plummeting popular support and continued infighting within the government coalition and Lula's Workers Party (P.T.) itself effectively halted the Lula government's work in 2005. Corruption scandals continued to weigh on the Lula government in the early months of 2006, forcing the resignation of Finance Minister Antonio Palocci. Governance will continue to deteriorate as the October general elections approach and legislative work stops completely. The downward slide in governance has provoked growing social instability, another issue overlooked by foreign investors. In addition to recent gang violence in Sao Paulo, Brazil has also seen an upsurge in labor strikes and protests by farmers and land reform activists in the past two months. Social protests are likely to escalate further as Brazil's myriad social organizations find their political voice during the next several months. Weak governance and increasing social instability have politicized the Lula government's economic policy. The central bank has aggressively reduced interest rates while the government has ramped up spending, including a 17 percent increase in Brazil's minimum wage. The hike in the minimum wage, which also increases pension payments to millions of Brazilians, will widen Brazil's budget deficit in 2006. Another factor that will push the budget deficit higher is dramatically weaker economic growth in the second half of this year. Brazil's slowing economic growth fell to 2.3 percent in 2005 from 4.9 percent in 2004. In 2006, economic growth will probably drop below two percent. Economic weakness in 2005 was broad based. In addition to slowing export and industrial production growth, private consumption growth decelerated and investment growth turned negative -- hardly signs of the emerging economic powerhouse painted in many corners. Although economic growth accelerated in the first quarter of 2006, this acceleration will probably be very short-lived. Slowing economic growth helped push inflation lower in 2005 and the initial months of 2006. Overly loose monetary and fiscal policies, however, combined with exchange rate depreciation, almost guarantee a resurgence of inflation in the second half of 2006. Other factors likely to push inflation higher are rising international crude oil prices, rising domestic ethanol prices and rising natural gas prices as a result of Bolivia's recent energy sector nationalization. Accelerating private consumption growth, fueled by the minimum wage hike, will also push inflation higher. Higher inflation and exchange rate depreciation are likely to force Brazil's central bank to reverse course on interest rates in the not too distant future. Rising interest rates in Brazil will quickly slow economic growth. Economic growth will be further weakened by a sharp deceleration in U.S. economic growth in the second half of 2006. It is unlikely that higher interest rates will stop the depreciation of the Brazilian real. Rising interest rates will push Brazil's stock market lower, speeding foreign capital flight, leading to further exchange rate weakness and possibly exchange rate devaluation. The recent downdraft in Brazil's equity market is neither "volatility" nor a correction. It is a strong indication that foreign capital flight has begun. Report Drafted By: Jephraim P. Gundzik Complete archives at http://www.sitbot.net/ Please let us stay on topic and be civil. OM
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