Earlier this month, Brazilian government economists said they expect the country to return to minimal growth — barely above zero — in this quarter after spending the previous seven quarters in negative territory. These expectations came about due to President Michel Temer’s economic reforms, which are currently working their way through Brazil’s Congress, along with industry performance and the highly anticipated lowering of interest rates on Oct. 20. On the other hand, Standard & Poor’s said that it has no plans to change Brazil’s negative outlook and that it will take years for the country to regain its investment status. The credit rating agency feels the reforms are in nascent stages, smaller complimentary reforms must also be enacted and implementation remains to be seen. The disparity of information surrounding Brazil’s economic performance and potential recovery therefore merit a closer look.
Recovery Is in Sight
We believe that Brazil’s recession has bottomed out and the country is headed for growth based on the mounting evidence that Brazil’s business community is also preparing for an economic recovery. This type of anecdotal evidence is highly valued in our forecasting for two reasons. First, the business community does not decide lightly where to spend millions (if not billions) of Brazilian reais since its aim is to make money, not lose it. Second, anecdotes tell us where the economy is going while statistics tell us where the economy has been. By the time market changes have shifted enough to register in statistical measurements, and those measurements have been calculated and published, the event has already passed.
Investment
There is growing interest in investing, initial public offerings (IPOs), and mergers and acquisitions (M&As) in Brazil. Economists from major financial institutions like Bank of America Merrill Lynch, UBS and Pimco have said they see potential for more investment in Brazil. Foreign companies have also reported increased investments in Brazil. Bemis Manufacturing, a global plastic products maker, plans to nearly double its investment in Brazil next year to update machinery and expand capacity. Additionally, India’s United Phosphorus Limited (UPL) recently revealed its intent to invest 1 billion reais ($316 million) to construct a plant for synthesizing and producing pesticides — an amount significantly larger than the 200 million reais investment UPL contemplated a year ago.
Initial Public Offerings
The private sector is also indicating confidence that the Brazilian economy is on the road to recovery, with numerous companies planning to execute IPOs. When the Brazilian economy began to deteriorate in late 2014 and early 2015, companies suspended or canceled planned IPOs. The country’s most recent IPO was offered by Par Corretora in June 2015. But since July 2016, three additional Brazilian companies — software company Linx, power utility company Energisa and travel operator CVC — have filed for an IPO and seen investor demand outstrip the quantity of shares the companies hope to sell.
Furthermore, heavyweights in the Brazilian market have laid the ground work for and are planning to host IPOs in the first half of next year. This includes France’s Carrefour, Spain’s Brazilian Telefónica subsidiary Telxius Telecom, Brazilian state bank Caixa’s Seguridade unit and Brazil’s Construtora Tenda (a unit of Gafisa). Companies tend to hold off on launching IPOs until they anticipate economic growth is on the horizon to ensure a good price for their shares, which helps increase their company’s value. (Conversely, launching an IPO during poor economic times means that either there will be few buyers or shares will be sold at undesirable prices.) Therefore, we can view the upswing in Brazilian IPOs as an indicator of economic resurgence.
Mergers and Acquisitions
In addition to IPOs, M&As have also returned to Brazil. During the third quarter, a total of $98.9 billion was raised in mergers, acquisitions and investments of venture capital and private equity. This marks a 109 percent increase compared to the same period last year. About $49.2 billion of these third quarter funds came from foreign companies. According to M&A specialists in Brazil, the most notable characteristic of these recent acquisitions is their contribution to the buyers’ larger strategy for consolidating their presence in the Brazilian market while simultaneously creating local platforms. This indicates that companies perceive less risk and insecurity in Brazil, suggesting an impending economic recovery.
Key Reforms to Watch
The economic reforms that Temer promised upon assuming office have started to take shape and are on their way to becoming a reality. Three major government initiatives will play a key role in shaping the recovery of the Brazilian economy: reining in government spending, reforming the oil industry and executing concession projects. However, all three reforms will require time before they begin to have a positive impact on the Brazilian economy, and their effectiveness will be tested by the weakness that prevails in the global economy.
Spending Caps
Placing limits on government spending is arguably the most important initiative being driven by the Brazilian government. For years during the Luiz Inacio Lula da Silva and Dilma Rousseff administrations, the government was loose with public spending, which created an imbalance in public accounts. In order to rein in public debt, help control inflation and establish an underlying layer of stability in government spending, the Temer government is promoting a constitutional amendment (PEC 214) that will cap government spending for 20 years.
The annual increase in the government’s budgetary spending will be determined, in effect, by the previous year’s inflation rate. However, education and health spending will see some leeway during the first few years of the spending cap. This last element was incorporated primarily to appease public demand and enable Congress to pass the measure. There is also a provision in the law that permits the government to alter the method for adjusting spending, but not until 2028.
On Oct. 10, the Lower House approved the initial text of PEC 214 by a 366-111 vote; it was approved with a vote well above the two-thirds majority (308 votes in the Lower House) needed for a constitutional amendment. The obligatory second Lower House vote on the measure is tentatively scheduled for Oct. 24. After this approval, the proposal will be sent to the Senate for consideration. Again, a two-thirds vote is needed in two separate voting sessions for the amendment to become law.
These changes in Brazilian government spending come at a time of subpar global economic growth and stagnation in many developed economies. The World Trade Organization (WTO) slashed its trade growth forecasts for 2016 and 2017; the latest forecast is now a 1.7 percent increase in global trade this year, down from the initial 2.8 percent projected growth. Next year’s forecast has been reduced from 3.6 percent to 1.8-3.1 percent. The IMF projects that next year’s global growth will barely edge out this year’s growth, at 3.4 percent in 2017 compared to 3.1 percent in 2016.
Such a scenario creates obstacles for the Brazilian government’s plans to stimulate growth. This means, as noted by Carlos Hamilton, Brazil’s secretary of economic policy in the Ministry of Finance, the momentum of the upcoming economic recovery will be slower than in the past. Since the 1980s, the average growth rate during a recovery period has been more than 1 percent per quarter. This increased to 1.5 percent per quarter for the recovery from the 2003 slowdown, and further increased to 2 percent per quarter during the recovery from the 2008 global crisis. However, such dynamic recovery is neither possible nor expected given the global economy’s current state; a more-than-acceptable recovery pace would be 0.5 percent. As a result, this particular recovery in Brazil will seem slower than previous rebounds, at least initially.
Oil
The second most notable government reform is the adoption of more market-friendly regulations in the oil industry. Planned changes include allowing more foreign participation in oil exploration and operation, loosening of local content laws and harmonizing domestic fuel prices with international market values. The ultimate purpose behind these reforms is to attract more foreign investment.
On Oct. 5, Brazil’s Lower House approved the base text for a proposed law that would no longer require Petrobras, a Brazilian multinational petroleum corporation, to operate and hold at least a 30 percent stake in every pre-salt oil block in Brazil. But Petrobras would still be given first preference on all projects and have 30 days to decide whether to participate. In the event that Petrobras wants to operate a block, it must have a minimum participation of 30 percent in the consortium, with the remaining ownership belonging to foreign oil companies. The Lower House is discussing potential amendments to the bill, and one of particular interest is a requirement that strategic blocks still remain under the control of Petrobras and not be operated by foreign firms. However, this opening in oil block operations is expected to give foreign companies more control over select operations, therefore making Brazil more attractive for investment.
Also in the works is the loosening of local content rules in Brazil’s oil industry. These rules specify that materials such as machinery and tools used in the oil industry must contain a certain amount of domestically produced content. Local content laws for oil-related industry can reach as high as 55 percent to 65 percent in Brazil, and the amount of local content that companies pledge is heavily weighted in the current process for auctioning off oil blocks. Decreasing the required amount of local content is under discussion. In addition, there is conversation about decreasing or eliminating the value placed on local content in the auction process and instead giving weight to innovation and/or job creation.
The new local content rules are expected to be phased in throughout 2017. Before this process begins, however, Brazil’s National Council of Energy Policy has to approve an “improvement” of current rules. The council will meet on Dec. 8, and the idea is to have these new rules in place for the 14th round of concessions offering pre-salt blocks in the second half of 2017. The second stage will involve a series of studies and debates to determine a wider policy revision. In the past, Brazil’s local content laws have led to supply chain issues and higher costs for companies that must either pay for more expensive domestically produced goods or pay a fine for failing to meet local content rules. These changes to the local content rules would allow companies more freedom in sourcing materials and facilitate the selection of suppliers that allow them to be more competitive.
Lastly, Petrobras’ leadership has committed to adjusting gasoline and diesel fuel prices more frequently to more accurately reflect international prices, the exchange rate and market share. The company is still recovering from major losses that accumulated in 2011-2014 when Petrobras imported refined oil at high international prices and sold fuel on the domestic market at a loss. Throughout 2016, the company has made progress on capital recovery and reduction of losses. Petrobras CEO Pedro Parente has pledged that the company will exercise autonomy over setting fuel prices and not let Petrobras become a tool for the government’s attempt at controlling inflation. Such a move will allow Petrobras to sell fuel on the domestic market at price or with a small profit margin rather than operating at a loss as it did during 2011-2014.
Next year, the Brazilian government wants to hold two bidding rounds for the oil industry. One round will be held in June for marginal oil and gas fields, and the 14th bidding round of exploratory oil blocks is set for the second half of 2017. The regulatory changes aim to attract foreign investors to participate in these bidding rounds and inject new life into Brazil’s oil industry. The lack of recovery in oil prices and no guarantee of a price increase may pose a challenge. Low prices deter investors by making it difficult for them to see high returns on their investments, meaning more favorable domestic conditions are essential to potential bidding success.
Concessions
Although it has gained less media recognition, the Brazilian government’s support of and drive to restructure infrastructure concessions are just as important for Brazil’s economic recovery as spending caps and changes to the oil industry.
The government is preparing measures to address failing concessions contracts while also streamlining future concessions by reducing red tape, decreasing government interference and ensuring legal security. The Rousseff administration had aimed to execute extensive infrastructure concessions contracts and projects but the attempt was not a resounding success. Several concessions holders, particularly for highway and airport contracts signed in 2013 and 2014, have failed to meet contractual commitments for investment and financing. The government is looking to create a route that will allow concessionaires to quickly escape their projects; the government also wants to provide a fast turnaround and once again offer the projects to the private sector. The goal is to avoid a dramatic forfeiture processes. Such a move will help eliminate delays on much-needed work to improve infrastructure in the country, which will help create jobs and ultimately increase competitiveness.
Another forthcoming change is the removal of regulatory bodies from selecting concession models and formulating bidding documents. Rather, there will be a push for regulatory agencies to concentrate on supervising the contracts. The period between releasing bidding rules and holding the auction will be expanded to100 days. Also, calls for tenders would only be announced after preliminary environmental licensing.
To facilitate these initiatives, the Brazilian legislature approved in September the creation of the Investment Partnerships Program. The program aims to expedite the concession of major infrastructure projects (projects that are both underway and planned) to the private sector and facilitate other privatization measures. The government program will offer $30 billion in long-term loans with funds being drawn from the Brazilian Development Bank and the investment arm of the Workers’ Severance Fund. Over time, the government plans to reduce the use of public funds for financing infrastructure concession projects. Currently, such funds can finance up to 80 percent of the investment in these projects; however, this percentage will be reduced as time passes.
So far private-sector banks have committed to offering warranties for the loans. The government hopes these warranties will replace the bridge loans that private-sector banks were granting as a way to jumpstart projects won in auctions. Historically, securing financing for such projects has been a long and arduous process. The success of these new infrastructure concessions largely will depend on how fast the government can work internally and with private banks to approve financing.
Successful concessions bids and execution of investment are necessary to improve Brazil’s infrastructure network. “Brazilian Cost” – the increased operational costs inherent to doing business in Brazil – is a major underlying issue that causes the country’s economy to lag in competitiveness. A wide variety of components contributes to this cost, including but not limited to heavy tax burdens, excessive bureaucracy, a comparatively expensive labor pool, trade barriers and infrastructure deficits. The Brazilian Cost problem is multifaceted, with no single solution. However, revamping the concessions framework with the goal of improving infrastructure can go a long way toward cost reduction, which will not only improve profit margins and reduce existing companies’ costs, but also attract new companies and investors to Brazil, further stimulating the economy.
At present, the government has announced 34 projects that are to be handed over to the private sector with auctions slated for next year. Many of the concessions auctions planned for 2017 deal with transit routes used to transport bulk natural resources like iron ore and grains. Once again, the regulatory changes aim to make participation in the concession projects more attractive. It is important to keep in mind, however, that infrastructure projects move slowly. Even in the event of successful auctions, there will be an expected lapse between assuming the concession, executing the project and seeing the economic benefits brought about by more efficient infrastructure networks. That said, such projects are necessary for ensuring stronger fundamental underpinnings of transportation costs and efficiency in the economy for years to come.
Conclusion
From an economic perspective, the worst is now behind Brazil, and the country will soon be firmly in its recovery phase. The growing interest in investment, IPOs and M&As in the country indicates that the business community plans to see a stronger, growing economy next year. While such an assertion does not align with all the economic indicators released in the media, we take the same outlook as the business community, which, as a whole, looks forward and thrives by accurately predicting growth.
Additionally, three government reforms – spending caps, oil industry regulations and infrastructure concession – will play key roles in the country’s economic recovery. None of these reforms will have an immediate impact on the economy, but their benefits will grow stronger over time. The reforms will happen amidst unfavorable global economic conditions such as slow growth, lagging trade and low oil prices. As a result of local conditions and the expected lag time for reform, Brazil’s recovery will not seem as dramatic or dynamic as past recoveries. However, the reforms will lay the groundwork for a stronger economic base that should help Brazil handle and more effectively mitigate future economic downturns. |
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