Brazil buys the rumour and sells the fact [hopefully]

Information Transit got the wrong man. I got the *right* man. The wrong one was delivered to me as the right man, I accepted him on good faith as the right man. Was I wrong?
Jack Lint in “Brazil” (1985)

Hopefully, Brazil bought the rumour and will sell the fact — that’s what we’d like to think and this is why. While the media headlines read as follows during the first months of the year: The Slow Implosion of Brazilian Politics in The Atlantic, Political tension inflames Brazil’s market malaise in the Financial Times and Dilma Pickle at the Skimm — the IBOVESPA [IBOV] advanced more than 16% (YTD).

What does the equity markets’ enthusiasm anticipate that contrasts so clearly with the media’s tone regarding Brazil? In any conversation regarding financial markets, it’s impossible to pinpoint a single driver of the market’s momentum, nonetheless the economic context — intrinsically linked to the social context — as well as trends, cycles and structures can provide a better insight of the Mineirazo that has distressed Brazil’s economic history.

OK, back up. When did it start and how bad is it?

Enter the no chill zone. In just five years, Brazil’s GDP went from an annual growth rate of 7.5% in 2010 to a contraction of 3.8% in 2015, the current unemployment level is above 10% — youth unemployment is estimated at 20% — and inflation is higher than 9.1%. By the end of 2015, the economic crisis had set back Brazil’s GDP per capita in USD to 2009’s levels as the effect of an aggressive fiscal expansion and the intense economic deceleration eroded Brazil’s tax revenue; Brazil’s gross public debt has risen to 67% of GDP — just in 2013, it was 52% — and high financing costs constitute more than 8% of GDP, one of the major factors that hold recovery expectations down.

The storm is perfect. The global circumstances are hostile to Brazil’s economy: The expectation of an eventual rate-hike cycle by the Fed can inflict volatility in Emerging Markets, while the economic slowdown in China — its biggest trading partner — and a significant depreciation in commodity prices in the last couple of years — the Bloomberg Commodity Index [BCOM] went from 124.9 [01/03/2014] to 78.5 [12/25/2015] — at a time when commodities was Brazil’s biggest export in 2014 have contributed significantly to the crisis.

Is there something that could’ve diminished the harm caused by the current economic crisis? Abso-fucking-lutely but before imagining the reform initiatives that are expected, it’s worth taking a look some of the economic structures that make up Brazil’s economy.

No one likes a fine scotch [1] diluted in water… except Banco Central do Brasil [BCB]. That’s right, the BCB’s response capacity to the ever-increasing inflation has been diluted by the introduction of an interest rate that competes with the Selic rate [2]: the TJLP [3]. The TJLP rate is determined by the Conselho Monetário Nacional (without going into details, it’s a bureaucratic extension of Brazil’s government) and it’s adopted by the Banco Nacional de Desenvolvimento Econômico e Social [BNDES] and other public institutions, the TJLP’s level is independent of the Selic’s movements and the rate differential represents a government subsidy fuelling a credit expansion mainly through BNDES: for more than 12 years, the TJLP rate has been lower than the Selic rate, at times for more than 10,000 basis points.

Yes, at this point you’re probably thinking: Right… but across the World, different government programs subsidize different ends. True, nevertheless due to the size of Brazil’s banking sector [54.2% of GDP] the constant rate differential between the Selic and the TJLP for more than a decade lead the public banking sector to surpass the private banking sector’s depth — GDP’s 30 vs 24% — consequently, 55% of Brazil’s credit is subsidized, which greatly undermines a central bank’s frequent tool to reduce excessively rising level of prices: an increase in the funding rate’s target.

What looked like a noble public policy determined to widen the credit flow, would significantly impair BCB’s efficiency — a central bank whose autonomy is already compromised: Brazil’s President can name the BCB’s President and directors without the Senate’s approval.

Anything else?

Roussef’s fiscal expansion deepened the crisis by conceding the federal expenses to duplicate in just 4 years [2010 to 2014] and prescind from the reforms that would have preserved Brazil’s fiscal sustainability.

So, tick tock. The current structure of Brazil’s social security programs is not sustainable. Social security benefits have consistently increased, which not only reflects a higher number of beneficiaries but also Brazil’s minimum wage policy: according to Deutsche Bank, roughly 70% of the Instituto Nacional do Seguro Social’s [INSS] benefits are linked to the minimum wage and that’s a big fucking deal because the adjustment of minimum wage is calculated by adding [last year’s inflation, the INPC index + GDP growth of the year prior].

A structural disequilibrium in Brazil’s social security system — whose benefits amount to 7.4% of GDP — can be caused by a generous minimum wage annual adjustment, the absence of a minimum retiring age — Brazil’s average retiring age is 54 — and adverse demographics.

Mo’ money… mo’ problems. Any of Roussef’s successors will have little room for maneuver without a constitutional reform that confers more flexibility to the federal budget: 90% of federal spending is considered mandatory while only 20% of government revenues is not subject to earmarking — to continue this course, under current circumstances, will only intensify the destruction of value: in 2H 2015 and 1H 2016, Brazil’s credit rating was downgraded to junk by the big three and according to Auditoría Cidada, in 2014, 45% of government spending was reserved to servicing debt.

Right, but remind me — What’s been the markets’ reaction to Roussef’s impeachment?

Here is where I intend to be prudent on my analysis: the relationship between public policy and financial markets can be elusive and at times can be relevant in the expectations game.

A count of the news stories that included the words impeachment and car wash [Lava Jato] between 2013 and 2016 when compared to the annual performance of production of capital goods for construction during the same period, presents a clear relationship: the higher the number of stories related to the political crisis, the deeper the depression in the production of equipment for construction.

Soon after the impeachment proceedings started in December, the relationship between a story count that included the words impeachment + Brazil and the stock index IBOV offered a different interpretation: from [01/01/2016] to [04/11/2016] — the day prior to the vote at the Congressional Committee that preceded votes on the floors of the Congress and the Senate — the correlation coefficient of the story count and IBOV was 0.63.

The difference between the nature of both metrics — one looks at the production of capital goods related to construction that took place over the last year and the other is Brazil’s stock index, which basically (and theoretically) reflects the present value of future profits of the index components — and the different moments at which their relationship to news stories related to the political crisis is valued, can entail two appraisals: First, the aversion towards political uncertainty can hinder production of capital goods and second, the economic outlook can improve as a transition in the political leadership that can give way to necessary reforms materializes.

Boring is the new sexy. The accusations against Dilma Roussef aren’t related to the extensive corruption scandal surrounding Petrobras — also known as petrolão — and lack the features that make a scandal sexy: there are no charges of illicit personal enrichment, no mention of secretive bank accounts in Switzerland and there is no tangible evidence — the audio of a tapped phone conversation, for instance — that involves any member of her administration driven by economic or political ambition; in contrast, the accusations against Roussef allude to her administration’s misappropriation of public funds by abusing what is known as pedaladas: the mechanism through which public financial institutions disburse the social and welfare benefits. If there’s a discrepancy between what has been advanced and what is actually requested, then the financial institution covers the difference and informs the Treasury, which must then pay the funds back.

Roussef’s administration abused this mechanism through different financial institutions, yet the most known is Caixa Econômica Federal — one of the main institutions that the Brazilian government would rely on to disburse public salaries, unemployment benefits and Bolsa Familia benefits. Through 2013 and 2014, Caixa fronted expenses 19 times, triggering a negative balance on behalf of the government and while such balance never exceeded 5,600 million Reais, the sum of the transactions totals 33,000 million Reais. Why would it be considered a distortion of pedaladas? Because this practice would help the government to meet its fiscal targets. Luiz Inacio Lula da Silva and Fernando Henrique Cardoso, both incurred 7 times in a negative balance, never exceeding 400 million Reais and the sum of the transactions adds up to 933.2 million Reais — combined— this is 35 times less than Roussef’s operations. In both cases, Caixa was repaid by Brazil’s government in a timely manner, settling the issue without any problems.

The abuse of this practice would allow Roussef to artificially boost public spending and make holes in the budget disappear, triggering a primary public deficit during an election year. The comparison between the dimension of the pedaladas, which sum up to 40,000 million Reais, with the estimated losses originated by petrolão: 29,000 million Reais is not an assertive one. As petrolão’s losses are directly linked to illegal, personal embezzlement driven by corruption and political ambitions, the extent of the pedaladas constitute a series of illicit funding between government institutions with fiscal consequences. The economic harm induced by Roussef’s administration compromised the government’s credibility, boosted Brazil’s federal indebtedness and stimulated the perception of uncertainty in financial markets — all of this, in the middle of a perfect storm.

Joga bonito, no mas. Despite the fact that Temer’s advancement to the Presidency follows the letter of the law, Temer is an interim president whose political capital is inferior to that of an elected president: In April, 58% of Brazilians backed Temer’s impeachment as Vicepresident (61% approved Roussef’s) and Temer is not alone: 77% of Brazilians also expect Eduardo Cunha’s impeachment, who serves as President of the lower house of Congress, the Câmara dos Deputados, and along with Renan Calheiros, the President of the Senate, has been implicated in the Lava Jato probe over claims of money laundering and tax evasion, respectively. Bit by bit, Brazil is turning into no country for old men.

Brazil’s chronic dysfunctional politics — which reflect record low approval ratings — is a risk that can thrive amid the country’s economic turmoil. The political coordination that is crucial to restore order and stage a comeback will be subject to the Lava Jato probe that may involve members of the new administration. The municipal elections that are due in October will limit any alliance Temer’s government may build with the opposition in Congress — which in turn will shorten the window of opportunity to bring about the reforms needed to stabilize rising price levels and recover (any?) economic growth.

Now, the popularity of Dilma Roussef’s impeachment doesn’t necessarily translate into Brazil’s majority consent of fiscal austerity and as the Lava Jato probe carries on, political survival at all costs will be incompatible with austerity measures through the deepest recession the country has ever seen.

IBOV’s YTD return in May reached the target level most analysts had expected to reach by year’s end: the equity markets anticipated the transition at the federal level of government, topping the return in sovereign debt. Flows to Brazil ETFs also support this trend: they are up 13% this year [14/05/16]. When comparing Brazil’s break-even rate to countries with similar credit ratings, the differential could be interpreted as a bit of excess of pessimism in Brazil’s government debt.

5 year CDS—the most common indicator to measure a country’s risk—has greatly diminished in 2016: more than 150 basis points at 329 on [14/05/16], a level that contrasts with other Latin American countries’ significantly lower CDS’ levels, like Colombia (227) and Mexico (167).

The decline in Brazil’s risk perception in 2016 was also reflected in its yield curve: 3 & 4 year maturity bonds registered the biggest contraction, by more than 400 basis points.

Is it time to get my feet wet in Brazil?

It’ll depend on your patience and risk tolerance — I know you’ve heard this countless times but it really is true, specially in Emerging Markets [EM] — there’s no question the conjuncture presents opportunities and such opportunities conceive risks that are inherent to EM in crisis, the foremost being dysfunctional politics. The play that quantitatively makes sense — when considering the country’s risk premium — is fixed income.

The first moths of the year, investors bought the rumour that a transition at Brazil’s federal government could potentially lead to recovering economic growth and turn around what until now has been a Mineirazo into an Instanbul’s micracle… turning the rumour into a fact that Brazil might be able to sell to the World — proudly.


You can read the Spanish (and slightly edited) version at Distintas Latitudes. Pásele, con confianza.

[1] Product Placement. Please click here. OK, it’s a joke but Talisker is goddamn good and that is a fact.

[2] Sistema Especial de Liquidação e de Custódia. Interest rate target of Banco Central do Brasil. [14.5%] retrieved from: http://www.bcb.gov.br/?INTEREST

[3] Taxa de Juros de Longo Prazo. Long term interest rate of Brazil, its level is determined by the Conselho Monetário Nacional (CMN). [7.50%] retrieved from: http://www.bndes.gov.br/SiteBNDES/bndes/bndes_pt/Ferramentas_e_Normas/Custos_Financeiros/Taxa_de_Juros_de_Longo_Prazo_TJLP/