Brazil: One Step Forward; Three Steps Back?

Conclusion: Rousseff’s lack of actual cuts her latest “austerity” package is supportive of Brazilian inflation on the margin. Like India, this lack of fiscal resolve places more onus on the central bank to curb inflation going forward – a marginal negative for Brazilian equities for the intermediate-term TREND. Furthermore, we detail how current gov’t practices may lead to a long-term structural inflation problem going forward.

 

Position: Short Brazilian Equities via the etf EWZ; Long Petrobras via PBR.

Ahead of today’s central bank meeting, where a +50-75bps Selic rate hike is fully anticipated by economists and traders alike, we thought we’d share with you perhaps more sobering news regarding the outlook for inflation in Brazil over the intermediate-term TREND – sticky, sticky, sticky.

Recent developments have us in the more hawkish camp relative to consensus on Brazilian interest rate policy over the aforementioned duration. This is primarily due to the fact that our analysis of the “prudent’ fiscal policies oft-bandied about by Brazil’s new chief, Dilma Rousseff, leads us to conclude they are much less prudent than is commonly believed by market participants.

Rousseff may have won over a few investors who were concerned about Brazil’s accelerating inflation (including us, on the margin) by standing pat on her bid to limit the increase in the nationwide minimum salary to R$545. More recently, she vowed to cut R$50B from the government budget to help contribute to the stated goal of bringing down inflation toward the government’s target of +4.5% YoY (the latest official CPI reading had inflation at +6% YoY in Jan). Details regarding the cuts were released yesterday.

Regarding said cuts, there is certainly less meat to them than is perceived by consensus. Accounting changes, delays in legal settlements, pure fraud (in the case of the Minha Casa, Minha Vida R$5B “cut”), estimated savings from downward revisions to subsidy payments (which we don’t buy in the face of accelerating inflation), and “cuts” that were never intended to be part of the budget in the first place amount to roughly R$40.6B in “savings”, according to the publication O Estado de Sao Paulo.

That R$40.6B compares with R$13B of “actual” cuts, such as the suspension of procurement programs and public sector hiring freezes (which one can make the case aren’t actually cuts, per se). All told, Rousseff’s grand strategy to dampen Brazilian inflation and interest rate expectations (to limit the real’s gain) is more smoke and mirrors than perhaps perceived by many market pundits (the Bovespa is trading up nearly a full percent on the day).

Perhaps even more sobering from a long-term perspective is Brazil’s return to the public accounting and budget tricks that accompanied Brazil’s struggles with hyperinflation in the past. The Treasury, in the form of direct loans, is making capital contributions to the state-owned bank BNDES – widely known to be responsible for underwriting loans to Brazil’s state-owned and highly-favored private enterprises at rates that are a fraction of Brazil’s benchmark Selic rate.

More simply, the Brazilian gov’t is issuing debt and not recording it on the public coffers, instead opting to record the funds on its books as loans which are to be amortized back to it in the future. The main issue with this is that it allows the gov’t to run a separate budget (via influencing BNDES’ lending activity) that is parallel to the official budget, which Rousseff and Finance Minister Guido Mantega are “working hard” to cut.

BNDES, which used to be self-funding, has loaded up on R$300B in such capital injections since 2008, and the latest projections from BNDES regarding Brazil’s infrastructure investment needs through 2014 are somewhere around R$3.3 TRILLION. While not all of this will be funded through misrepresented gov’t debt, the staggering sum underscores the potential for Rousseff & Co. to be unable to reduce such funding to BNDES should the Brazilian economy’s bout with inflation worsen materially from here.

It’s worth noting that a) Brazil hosts the World Cup in 2014; b) Brazil hosts the Olympics in 2016; and c) Brazil’s largely unpaved, undeveloped roads and woeful energy generating capacity all contribute bottlenecks and rising prices throughout Brazil’s domestic economy and in the global economy via commodity exports. This means the Brazil won’t be able to meaningfully reduce the credit creation associated with the country’s MASSIVE financing needs over the next 3-5 years.

Given this setup, we can foresee a scenario whereby inflation once again becomes the major structural issue in Brazil it once was – particularly if the gov’t continues stoking domestic demand via capital injections to BNDES and if Rousseff, Tombini, and Mantega continue to resist upward pressure on the real. For now, we’re willing to bet they’ll avert such a dire scenario via long-term real appreciation – one of the reasons we remain bullish on Brazil’s currency for the long-term TAIL.

From a more intermediate-term perspective, the high(er) frequency data (particularly much of the manufacturing and consumer data) continues to support our view of the Brazilian economy as being in a state of marginal stagflation as growth slows while inflation accelerates. In this regard, Brazil is not unlike the global economy at large. As the Bovespa rallies today into another lower-high, we continue to caution against buying Brazilian equities here (w/ the exception of PBR); if you’re bullish on Brazil’s long-term growth story, buy it later at a better price.

Brazil: One Step Forward; Three Steps Back? - 1

Moshe Silver

Managing Director

Darius Dale

Analyst