Author: Joachim Bamrud
Sound fundamentals are the key reasons why Brazil, Latin America’s largest economy, and its capital markets have been able to withstand a major corruption scandal.

feart01a As the political scandal around President Luiz Inácio Lula da Silva reached its peak over the summer, nervous investors began to consider bailing out of Brazil. Surprisingly, though, the country’s markets barely flinched. While Lula has been weakened by the scandal, which started in June and has led to several of his top government and party aides resigning, neither Brazilian stocks nor the country’s macroeconomics have been badly affected.
logo01 Helped by rising demand in China, Brazilian steelmaker Acesita has grown revenues this year. After hitting a low in July, its stock has been climbing steadily and was selling for more than $35 in mid-October—a 15% improvement over a year earlier. So attractive is Acesita that Arcelor, the world’s second-largest steelmaker, made a bid in October to buy the company.

In fact, by mid-October the Bank of New York’s Brazil ADR Index was up 43.04% year-to-date. Much of that was fueled by a combination of the Brazilian companies’ actual performances—mostly strong improvements over last year—and confidence in the economic fundamentals of Brazil. “The fundamentals are extremely strong,” says John Welch, the New York-based chief Latin America economist with Lehman Brothers. The markets got worried in August when finance minister Antonio Palocci was accused of corruption by a former aide, but after those charges receded, the threat to economic policy also receded, Welch says.

More recently, a pro-Lula politician, Aldo Rebelo, was elected president of the Brazilian lower house, Welch points out. The election enables Lula to regain control over the legislative agenda after several months suffering a gradually weakening position.

logo02 Banco Bradesco, Brazil’s top private bank, has seen its ADR jump from $34.82 in July to $50.17 on October 10. That brought its increase year-to-date to an impressive 100%. The results are partly tied to the bank’s performance so far this year; in the first half it managed to more than double its net income over the same period last year.
Although the investigation into corruption continues, most analysts believe the threat to the market is largely over. “The market believes the political crisis does not pose any relevant threat to conducting economic policy,” says José Carlos de Faria, a São Paulo-based senior economist for Latin America with Deutsche Bank. Long-term finance obligations and foreign direct investment are taking care of Brazil’s finance needs, adds Victoria Werneck, a São Paulo-based economist with UBS. Foreign direct investment last year reached $18.2 billion, the highest in Latin America and a 79% increase over 2003, according to the United Nations Economic Commission for Latin America and the Caribbean (ECLAC).

logo05 CVRD’s preferred ADR (Rio-P) rose from $27.85 in July to $36.38 on October 10. That was also a 49% increase year-to-date. CVRD, the world’s largest producer of iron ore, has seen continued strong demand from China. And global iron ore demand is rising faster than CVRD can boost its production.
This year will be the third consecutive year Brazil runs a current account surplus, an achievement that is expected to be repeated next year as well, Werneck notes. The surplus this year will be 1.7% of GDP and next year 0.7%, the IMF forecasts.

Last, but certainly not least, the country’s central bank has been given de facto autonomy and has done its job well. “Lula, contrary to what everybody believed, let the central bank act autonomously in order to meet its only goal, to bring inflation down,” Werneck says. Confounding expectations, the central bank did its job well. Despite the uncertainty resulting from the corruption scandal, Brazil’s inflation this year is expected to reach 6.8%, only slightly higher than last year’s rate of 6.6%, according to the IMF. Next year it should fall to 4.6%, the fund forecasted in its latest world economic outlook, released in September.

logo04 The ADR of Gerdau, Latin America’s largest steelmaker, has gone from $10.39 in July to $13.92 on October 10. The latest price is also a 16% improvement year-to-date. The company has been helped both by rising demand in China and more recently from Hurricane Katrina repair efforts on the US Gulf Coast.
The outlook also shows that Brazil’s economy should expand by 3.3% this year and another 3.5% next year. While the 2005 forecast is lower than last year’s 4.9% growth, it’s still higher than the GDP growth rate the fund expects in Mexico this year (3%). More importantly, as far as popular support for Lula goes, real wages have been increasing on a sustained basis given the central bank’s success in bringing inflation down, Werneck points out.

Finally, Brazil’s international reserves are now at a whopping $57 billion, a substantial increase from the $27 billion in December 2004, Werneck says. “You have all these things a country needs—solid fiscal front, low inflation, a growing economy—so it can weather a big, big storm,” she says. “If you look at every single factor, Brazil is doing fantastically better than in 2002,” she adds, referring to the year before Lula assumed office.

logo03 Startup and low-cost airline Gol has seen a slight increase in its ADR price—from $29. 70 in July to $31.45 in October—yet it can boast rising revenue and net income as it increasingly takes market share from the established flag carrier, Varig.
Improved corporate governance, according to Welch, “certainly has helped” Bovespa, the São Paulo stock exchange. While it’s hard to tell yet what impact the new regulations will have—they’ve only been in place some 18 months—there has been a lot of movement in terms of shareholder resolution, which was a big problem before, he says.

The main impact will be felt over the medium- to long-term rather than today, says Werneck. “I think it’s very important, indeed, but at the current stage with GDP growth and consolidation of an orthodox and serious fiscal policy, this is not the main trigger [behind market optimism],” she says. Another factor behind optimism in the markets is that Brazil’s high interest rates are expected to drop soon, providing a welcome incentive for business in the country, Welch points out.

logo06 Helped by soaring international oil prices, Brazil’s state oil producer Petrobras can boast an ADR price increase of 58% year-to-date. The October 10 price of $57.21 is also significantly higher than the July closing price of $45.72.
Brazil has also benefited from a strong increase in exports. Last year they totaled $96.5 billion, an increase of 32% from 2003, according to ECLAC. Companies that have done particularly well include iron ore exporter CVRD and steel producer Acesita. “Even with a negative impact of a global slowdown, it will take a lot to hurt the balance of payments,” de Faria says.

Joachim Bamrud