Zaks Investment Advisory Service

Brazil – part II

Last time, we spoke about Brazil. I described how over the past five years, the Brazilian stock market index shot up almost tenfold in US dollar terms, more than similar stock indexes in other major developing countries. How to account for such rapid growth? One explanation fits not just Brazil but all the other developing nations, as well: each one starts out at a very low level. Large relative growth is in effect a relatively small one in absolute terms. Nevertheless, not all poor nations grow. The economy of the very same Brazil was developing slowly for many years. So what changed?

Brazil’s economy became a market one just recently. For many years, the country was ruled by military juntas of various stripes that managed the economy – or rather, distorted it – by subsidizing some industries and levying heavy taxes on others. One of the driving forces behind all these regimes was the principle of economic self-sufficiency: making Brazil independent from foreign imports. To a certain extent this recalls the ideas of the Romanian dictator Nicolae Ceausescu, but thankfully with less catastrophic consequences for the nation. Democracy returned to Brazil only about 20 years ago. The new government managed to lower the inflation, which it inherited from the previous regimes; privatized many enterprises; stabilized the country’s currency; pared down its internal debt; and gave private companies freedom to grow. It is worth noting that the economic stabilization plan, which in Brazil was called the Plano Real, coincided in almost all its details with the so-called Washington Consensus: a set of 10 specific economic recommendations backed by the World Bank and the International Bank for Reconstruction and Developed. In the case of Brazil, they worked very well. Of course, economic development is never a smooth process. For example, Brazil was affected by financial crises that swept through Southeast Asia and Russia in 1998, as well as by the Argentine crisis. Nevertheless, the country’s economy is moving in the right direction.

For a relatively poor nation (in terms of per capita purchasing power, Brazil is 1.5 times poorer than Russia), it has a pretty balanced economy. We discussed how Russia’s economy is for the large part built around natural resource exports. China exports goods that are mostly consumed in the West: for now, China’s domestic market is incapable of supporting economic growth on its own. Brazil exports a great deal, too, but the share of exports in the economy is not that big. The economy is largely tailored for domestic consumers. For this reason, the Brazil central bank may afford its currency, the real, to fluctuate freely depending on supply and demand. As we know, demand for the real has been growing in recent years, resulting in its appreciation.

Brazil’s economy is unusual in one respect: it is almost the only country on earth not to be producing biofuel (ethanol) at a loss. Biofuel production is now all the rage, even while being inefficient. As you know, our ethanol industry, which for the most part uses the process of refining corn into ethyl alcohol, only exists thanks to government subsidies. According to some calculation, these subsidies account for $1.90 of every gallon of biofuel. But Brazil gets its ethanol from sugar cane. The cane grows in tropical regions and its natural photosynthesis process is far more efficient than corn’s. As a result, the energy yield of refined cane is high enough to be economically profitable. In our country, cars cannot run on ethanol alone: the most we can do without substantial engine work is adding 10-percent ethanol to regular gasoline. But because ethanol in Brazil is cheap, many of their cars are designed to run on pure ethanol.

Still, you will not get far on ethanol alone and Brazil needs oil. Brazil does not have sufficient oil supplies and has to rely on imports. But recently, the Brazilian oil company Petrobras announced the discovery of a new Atlantic Ocean deposit. The field is called Tupi and, according to preliminary estimates, contains eight billion barrels of oil. This is the largest deposit discovery since Kazakhstan’s Kashagan field in 2000. It is possible that in a few years, Brazil will turn from importing oil to exporting it.

As I have said, the Brazil stock market has been soaring over the past five years. But we must remember that Brazil had suffered through several financial crises before then, ones which resulted in significant price drops on the stock exchanges. For example, the market lost 45 percent in 2002 (although it did gain 140 percent in 2003). Knowing how fast Brazilian stocks have been rising, one could presume that investment firms would organize funds specializing in Brazil. But this is not the case. There are almost no mutual or closed-end funds for Brazil. There is, however, an exchange-traded fund that is called the Brazil Index Fund. Its value has multiplied tenfold in the past five years. In addition, several major Brazilian companies have issued so-called ADRs. These include the above-mentioned Petrobras, the gigantic mining company Vale do Rio (RIO), and the quite successful midrange airplane producer Embraer (ERJ).

Of course, Brazil’s future is hard to predict. It faces many obstacles along the way, such as enormous tax rates and a gaping income disparity: the inequality between Brazil’s rich and poor is one of the largest in the world. But its diversification and dynamism suggest that Brazil’s economy will continue to grow for many years to come.

And with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.