Brazil - Investment Case
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EXECUTIVE SUMMARY

No longer the “Country of the Future”… Brazil emerges as the   “Country of the Present”.

For a number of years, Brazil has been considered the “Country of the Future” due to its geographical size, growing population and abundant resources.  Historically Brazil continued to live up to this long standing reputation as the “Country of Future”, as it remained plagued by poor economic conditions, political instability,  poverty as well as immense socioeconomical and bureaucratic challenges.  In 1994, the governmental and business leaders launched a set of measures to stabilize the economy which, have resulted in Brazil securing a position as one of the top 10 largest economies in the world, an investment grade credit rating on its sovereign debt, and has set the stage for sustainable long-term growth for years ahead.  Today, Brazil is now positioned as the “Country of the Future” and is rapidly becoming one of the world’s economic powerhouses.       

Unique Access to Natural Resources

The idea of Brazil as the “country of the future” stems from the large geographical area of the country and the abundance of resources that is possesses. As the fifth largest country in the world, Brazil’s territorial extension is bigger than all of Western Europe and larger than the continental United States.  It shares common boundaries with every South American country except Chile and Ecuador.

Brazil controls a great deal of the world’s most basic resources.  It has the largest farmable area in the world (22% of the territory), 33% of the planet’s forests, and 15% of the world’s potable water. It is the world’s largest producer of coffee, oranges, and sugar-cane; 2nd largest of manioc, beans, soy, beef and chicken; 3rd largest of refined sugar and corn; and ranks in the top ten in the production  of grains,cocoa, eggs, pork,cotton and rice.

In addition, it is one of the few countries in the world that is self-sufficient in oil and is the world’s leader in alternative energy sources.  It is responsible for 33% of the world’s ethanol production., Brazil enjoys an advantageous climate that is primarily free from major natural disasters, and enjoys a temperate climate that extends the growing season beyond that of many other countries. 

In summary, Brazil has more food, forest, water, minerals, and energy than it needs.  These are unique luxuries that many countries do not enjoy, contributing to the rationale that Brazil has historically has been viewed as the “Country of the Future”. Considering the wealth of Brazil’s attributes, what are the factors that have contributed to Brazil not reaching its full economic potential to date?

Young and Strong Democracy

While Brazil is currently the third largest democracy in the world, the democratic form of government in the Country is only 24 years old, which makes it 38 years younger than India’s democratic regime and 200 years younger than that of the United States.  Brazil’s democratic regime began in 1985, after a 21 year military dictatorship.  The military regime that preceded it severely hampered the Country’s development by poor economic policies and rampant corruption, destroyed its credibility by defaulting on its external obligations, and drove the economy into hyperinflation while simultaneously accruing enormous foreign debt.    

In addition to having to deal with carnage left behind due to the dictatorship, the first seven years of the democratic regime also had unique challenges to overcome, creating more hurdles for the fledgling society.    The first President elected, Tranquedo Neves, died from natural causes before even taking office and was replaced by his Vice-President, Jose Sarney, who was not successful or equipped to solve the country’s massive economic problems. The second President, Fernando Collor, took office in 1990 and was impeached, after a crowd of 10,000 peacefully gathered in the nation’s capital to protest against a massive corruption scandal.  When his Vice-President, Itamar Franco, took office in 1992 the Brazilian economy was still unstable and the problems inherited from the dictatorship continued to drag and weigh on the country.

Finally, in 1993, President Franco appointed Fernando Henrique Cardoso (“FHC”) as his Minister of Finance.  One year later, FHC launched the “Real Plan” which introduced the “Real” as the Brazilian national currency and marked the beginning of Brazil’s economic and political stability.  FHC was later elected President in 1994 and served two terms until 2003making him the first elected President since the dictatorship to serve a complete term.

Brazil has made great progress since the dictatorship.  Today, it has an exemplary democratic process supported by one of the most advanced voting systems in the world (expedient and fraud free) and an increasingly transparent regulatory environment. It has introduced several new market-friendly policies favorable both to domestic and foreign investors. Its governmental and financial system levels of accountability have also improved significantly.

All of these factors demonstrate that the Brazilian democracy is maturing and becoming increasingly efficient. The problems that have held Brazil back as just the “country of the future” are now fading behind and the improvements seen over the past several years have set up the basis for an optimistic view of what lies ahead.

Investment Grade Rating Backed by 15 Years of Sound Fiscal Policies

One of Brazil’s major accomplishments over the past 15 years has been the stabilization of its economy.   Since the Real Plan was introduced in 1994, regulators have been focused on controlling inflation, managing the country’s balance of payments, restoring its credibility in the global financial community, and laying down building blocks for a sustainable long-term economic model.

This focus is agreed to by policy makers of all political parties and has been continuous since the plan’s inception.  As a consequence, inflation rates have dropped from an annual rate of nearly 640% in 1994 to an average of 5.4% over the past five years; the country’s net external debt has shrunk from approximately 15% of GDP to negative levels over the same period, and per capita GDP growth (PPP) has soared at an average of 6.2% annually over the past three years.

What makes these achievements even more impressive is that they were sustained and enhanced by the current leftist President, Luis Inacio da Silva (Lula), who followed through with the conservative policies of his predecessor despite their ideological differences.  Therefore, supporting the idea that commitment to sound fiscal policy is a consensus among policymakers from all spectrums of the political environment. 

The maturing political environment and the commitment to sound fiscal policy have rendered Brazil two consecutive investment rating upgrades in 2008.  Today, the country is far different from what it was under the dictatorship regime in the early 80’s when it defaulted on its debt.  The upgrades granted by Fitch and Standard & Poors are a reflection of what is becoming a consensus in the world investment community, that Brazil offers one of the best long-term, risk/reward alternatives in the world. 

Strong Growth, Stability, and Market Friendly Policies Attract FDI

Foreign Direct Investment (FDI) going into Brazil has increased 437% from approximately US$4.4 B in 1995 to an average of around US$23.6 B over the past 5 years. Bradesco, one of Brazil’s major banks, expects FDI to remain above the past 5 year average in 2009, at around US$25 B, despite the global economic crisis.  The surge in FDI is the result of the high risk/return ratio the country offers, driven not only by its stable economy but also by existing market/investor friendly legislation that has recently been enacted. 

Brazilian law gives the same protection and guarantees to foreign capital investments that it gives to investments made by Brazilian nationals.  The Brazilian government is actively encouraging foreign investment to enhance and stimulate economic growth.  Historically, Brazil has been an important destination for prospective investors as the government permits registered capital and earnings to be repatriated on a tax free basis.  The liberal FDI policies have led Brazil to be a preferred destination for global investors.

Currently there are attractive tax incentives for foreign direct investments, including mechanisms that can be utilized to reduce or eliminate taxes for foreign investors, including private equity.  For example, Law 2689 allows for capital gains and financial transaction tax exemptions on stock market investing for foreign investors.  The investment vehicle know as “FIP” (Fundo de Investimento em Participacoes) is similar to a limited partnership in that it allows for investors to make investments in private entities on a capital gains tax-exempt basis.  The federal government has also granted tax benefits to certain free trade zones.  The Manaus Free Trade zone is the most prominent of all such trade centers to have attracted significant foreign investments, including those from noted US companies.  

This combination of favorable policies, economic stability, and credit rating upgrades has increased the country’s access to capital while decreasing such capital cost.  A higher inflow of cheaper capital is crucial for the country’s future, as it gives room for domestic investments that will ensure sustainable long-term growth.

Income Growth in All Economic Classes to Add New Consumers

The prosperous economic cycle taking place in Brazil is also driven by the increased purchasing power of the middle and lower class. Poverty reduction and income distribution indicators have dramatically improved over the past several years. According to the World Bank, the country’s full poverty rate dropped from 41% in the early 1990’s to 25.6% percent in 2006, with an estimated 6 million people moving out of poverty in 2006 alone. Fueling this substantial improvement has been low inflation and economic growth, targeted transfer programs (including “Bolsa Familia,” a conditional cash transfer program to lower income families), improvements in labor productivity due to gains in schooling, and a reduction in the geographic segmentation of labor markets.

The improvement of poverty conditions has added new consumers to the market.  Over the next decade, these new consumers will play a vital role in taking Brazil into the next level of economic prosperity.  GDP per capita is expected to double by 2018.  As massive wealth creation in the lower income class is realized   over the next decade.

The rise in income levels across all economic classes, and the rising demand that it is forecasted to generate, is likely to take Brazil’s growth story outside the main metropolitan areas to smaller towns across the country.  All this activity is expected to create a cycle of growth that starts with higher purchasing power, leading to increased demand that will stimulate infrastructure investment, thus creating additional jobs and again adding to consumer’s income.  Ultimately leading to a sustainable economic growth model equipped for the long term

Economic Crisis May Favor Brazil in the Long-Run

Brazil will undoubtedly be affected by the Global Economic crisis.  Signs of a decelerating economy have already started to surface, as industrial output and retail sales figures have begun to trend downwards.  The ongoing financial crisis will continue to push confidence levels down (both consumer and economic), suggesting that the borrowing appetite in Brazil this year will be kept to a minimum.  Disappearing investor appetite and the lack of global liquidity will have severe implications for fixed investment and capital flows in 2009.  Overall, Brazil has braced itself for one of its biggest economic slowdown since the Russian default and the Asia financial crisis of 1998, when Brazilian GDP growth fell to 0.1%

Although Brazil will have to face difficult challenges in 2009, it is actually better positioned to weather the storm than the majority of nations around the globe.  While a change in GDP growth from 5.7% in 2008 to an estimated 0.8% in 2009 is a significant setback to the economy, it is not as bad as what other countries are experiencing.  In fact, Brazil is expected to rank among the top 5 highest growth economies in the world in 2009, coming in fourth place behind China, India, and Indonesia. 

Brazilian banks are well capitalized and in better shape than their peers around the world.  The Bovespa has continued to outperform the great majority of global equity indexes and has been recovering well from the sharp drop of 2008.  The reduced foreign debt levels have prevented any major adverse impacts derived from the sharp drop of the real.  In fact, opposite to what has happened in prior recessions, the devaluation of the real versus other currencies may actually help spur exports once global demand starts to pick up.  For the first time Brazil is showing signs that it is becoming a more independent economy able to deal with a major global crisis without running a major risk of default.

The conservative fiscal policies followed by the Brazilian Central Bank (BCB) have placed Brazil in an unprecedented position in this global crisis.  In the past, when there was a sharp drop in the Real, the country was forced to tighten its spending in order to prevent a default.  The BCB has also had to maintain high interest rates in order to control inflation. This strategy prevented the government from being able to provide any type of stimulus to spark the economy, thus, exposing the country to the full extent of international economic crisis.  Currently the Brazilian government continues to keep a tight budget in order to ensure its ability to support its debt, however, because the current global economic crisis has nullified prior inflationary forces, the BCB is finally in a position to cut interest rates and use them as a tool to spur economic activity.

As of December 2008, the Brazilian Selic rate (A Brazilian Central Bank's system for performing open market operations in execution of monetary policy) was approximately 13.75%.  Economists predict that the Selic rate will fall close to 400 BP over the course of this year to levels near 9.75%.  Such a large cut in interest rates would reduce the government’s interest rate expense from 5.6% of GDP in 2008 to 4.7% in 2009. Thus, increasing its ability to invest in the economy and thus preparing Brazil for a strong recovery relative to other nations. 

Ultimately, Brazil averted the major issues currently affecting other nations in the current financial climate. Brazilian banks have relatively low leverage and were not exposed to significant levels of sub-prime lending. The BCB has the ability to lower interest rates, which may well put Brazilian rates at a permanently lower level moving forward, thus, freeing up resources for investments and added economic activity.  Most importantly, the Brazilian economy is, for the first time in decades, in a position to make decisions more focused on the country’s internal needs, as opposed to decisions based mainly on debt management.  The global crisis comes with significant risks and setbacks - the way Brazil handles these difficult times may define the trajectory it will follow in the years ahead.  The country is well positioned to manage the challenges that will be presented as the crisis plays out.  All variables indicate that Brazil will come out stronger and will finally settle into a meaningful growth pattern.

Brazil Remains a Top Choice for Investors

Aside from the current headwinds afflicting the Brazilian economy, its long term outlook remains bullish.  Brazil’s economic growth will continue to be fueled by the emergence of a rapidly growing middle class in the years ahead.  Despite the lower growth rates estimated for 2009, economists predict that real GDP growth rates will pick up in 2010 and should remain at a rate of 3.4% over the next decade.  Credible monetary and fiscal policies will help to keep long-term investor interest in vital sectors of the economy anchored. 

The Brazilian growth story will be written by the rise of new consumers as income levels increase.  The new middle class will set a foundation for Brazil to remain stable and to guarantee its place as one of the leading global economies.  Massive wealth creation is expected to take place over the next decade and this added demand will lead to growth both within and outside major metropolitan areas.  This shifting socio-economic dynamic is likely to attract FDI, which will unlock capital investments.  This additional inflow of investments combined with government lead initiatives, such as the Growth Acceleration Program 2007-2010 (GAP), will likely pave the way for elaborate upgrades of Brazil’s infrastructure.

The Growth Acceleration Program promotes investment opportunities in infrastructure.  The main areas of focus are the following sectors: Logistics, receiving a total of US$ 56.3B; Power, receiving a total of US$322.9 B; Social and Urban Projects, receiving US$ 109.4B.  Therefore, by the end of 2010 a total of US$ 488.6B will be invested in infrastructure projects throughout the entire country.  In the Logistical arena, investments will be made in roads, railroads, and ports.  Investments in roads will be made in the South-Central region, where most of the industrial and agricultural production is located, representing 54% of the Brazilian GDP.  The railroad concession program will allow companies to participate in bidding processes for the North-South railroad, East-West railroad, and high-speed train.  The Southern section represents 33% of the Brazilian agricultural production, 72% of land available for agriculture, a high concentration of mineral resources, and a distribution of agricultural and industrial  production through 4 ports.  The East-West railroad investment will be US$ 1.9B to maximize the distribution of agricultural and mineral production, and interconnection with waterways.   The high speed train between Rio and Sao Paulo will include an area of 650 km that can reach up to 36 million inhabitants, and represents 45% of the Brazilian GDP.  The high speed train will connect Sao Paulo (the largest business center in Latin America - 70% of the stock market) with Rio de Janeiro (the biggest tourist center in Brazil.) The estimated investment is US$ 11B.  Exports through the sea in 2008 reached a total of US$ 162 B with an annual average growth of exports of 22% of US$ per annum from 2003 to 2008, and 8% in tons per annum at the same time period.  Investment opportunities will also exist in the energy sector, including generation and transmission of electric power, oil and gas, and bids to procure rigs, supply vessels, and tug boats, long-term contracts with service providers.

Although poverty levels have been considerably reduced, Brazil still has high social discrepancies, thus indicating that there is an entire population of consumers that have not been playing a major part in country’s demand.  Economic growth will continue to raise these consumers out of poverty, which in turn, will increase demand, further spur economic growth, promote added capital investments, and cement a sustainable growth model for the country.

GENERAL COUNTRY OVERVIEW

History, Geography, and Population

History

Brazil was discovered in 1500 by the Portuguese explorer Pedro Álvares Cabral and was ruled from Lisbon as a colony until 1808.  Brazil is the only Portuguese speaking Latin American country, and its Luso influence differs from the Hispanic heritage of its neighbors.   Its economy was based on slave labor and the exportation of Brazilian wood from 1500 to 1550.  The wealth of the colony was based on commodities, principally sugar, in the Seventeenth century, gold in the Eighteenth century and coffee in the early Nineteenth century.

The Brazilian population became even more diverse when, during the late Nineteenth and early Twentieth century, millions of Germans, Italians, Japanese, Arabs, and other immigrants entered Brazil and left their mark on the social system while their descendents became Brazilians.

Following three centuries under the rule of Portugal, Brazil became an Independent Nation in 1822 and a Republic in 1889.  Brazil overcame more than half a century of military intervention in the governance of the country when in 1985 the military regime turned over power to civilian rulers.  A constitutional congressional convention drafted and approved a new Federal Constitution in 1988, and in November 1989 the first direct presidential elections of the post-military era were held.

Even though inflation was controlled by the 1990s, more than one out of four Brazilians continued to survive on less than a dollar per day. In 2002, these socio-economic contradictions helped lead the election of Luiz Inacio Lula da Silva, a former lathe operator and union leader. Lula was re-elected President in the general elections of October, 2006.  The current government has been successful in consolidating macroeconomic stability, while stepping up social spending.

Today, Brazil is the largest and most populous country is South America.  The country continues to pursue industrial and agricultural growth and development of its interior. Exploiting vast natural resources and a large labor pool, Brazil's economy outweighs that of all other South American countries with large and well developed agricultural, mining, manufacturing and services sectors.  Highly unequal income distribution and crime remain pressing problems.

Geography

Brazil is the fifth largest country in the world and the largest one in South America with a total area of 8.5 million square kilometers covering approximately two-thirds of the continent’s entire Atlantic coast.  The country is of continental scope with a size of 4,420 km from North to South; 4,328 km from East to West, an Atlantic coastline of 7,367 km and a total border of 23,103 km.  Brazil neighbors every country in South America, except Chile and Ecuador.  More than half of the country is 200 meters or more above sea level but only a small part rises above 1,000 meters, with the highest peaks reaching an altitude of around 3,000 meters.

Brazil has an extensive river system. The Amazon and its tributaries, which are great rivers in themselves, drain over half of Brazil. Other large rivers include the São Francisco in the northeast and the Paraná and the Paraguay River system, which flow south to empty into the Rio de La Plata. The considerable hydroelectric potential of Brazil’s rivers has been increasingly exploited over the last 35 years.

Forests still cover vast expanses and farmland is found mainly in the South, Southeast and Central West with large areas suitable or adaptable for pasture. Brazil has some of the largest iron ore deposits in the world and mines significant quantities of many other metals, minerals and precious stones.

Population

Brazil has a population of more than 196 million people. The majority of Brazil’s population is located near the coast, where there is the highest concentration of metropolitan centers.  Brazil’s annual population growth has decreased continuously since the 1980’s, and this trend is expected to continue going forward, changing from an annual growth rate of 0.98% forecasted for 2009 to 0.30% forecasted for 2030.  The country’s population is expected to grow to 216 million by 2019. 

Although the average age of its population increased significantly over the past 30 years, Brazil is still a young country with an average age of approximately 28 years.  This young profile is expected to change moving forward, as Brazilians increase their life expectancy and families become smaller in size.  The country average age is forecasted to change at a compounded annual growth of 3% per year up to nearly 38 year of age by 2030, in other words, the Brazilian population will become 10 years older on average in the next 30 years.

Macro-Economic Overview

Brazil is one of the top countries in the world in natural resources, providing the country with a comparative advantage in terms of natural products, agriculture, wood, livestock, and minerals. With a population of over 196 million people and a per capita income of around US$ 7.6 thousand per year, Brazil has the largest domestic market in Latin America. 

Brazil is the largest economy in Latin America.  With a nominal GDP currently around US$ 1.3 trillion it represents 36% of the region’s GDP.  Irrespective of the tools employed in measuring the size of national economies, Brazil's is always ranked among the ten largest economics in the world.

Services comprise 64 % of the GDP, followed by industry and agriculture with 31 % and 5%, respectively. Tourism, IT, and banking are the chief sub-sectors of services.  The industry sector, the second most important sector to GDP, includes such subsets as motor vehicles, industrial equipment, chemicals, and aircraft.  The south-eastern region of the country contains the majority of these industries and is responsible for the largest workforce in the region. Appendix III provides further detail on Brazil’s supply and demand components of GDP.

During 2006 and 2007, Brazil’s GDP grew at rates of 3.8% and 5.2%, respectively. According to the International Monetary Fund's World Economic Outlook, Brazil’s GDP growth in 2008 was 5.1%, and predicts a decline by only 1.3% this year compared to an expected decline of 3.3% in the IMF’s January report, with inflation at 4.8% this year compared to the 5.7% realized in 2008. Brazil's growing urban centers account for 75 percent of the GDP. These growth rates are expected to slow significantly over the next two years, with estimates of 1.3% and 3.5% in 2009 and 2010 respectively. 

As we can see in Appendix V, the slower growth rates are expected to be driven mainly by a drop in internal demand growth, expected to fall from 8% to 1% from 2008 and 2009, driven mainly by lower household consumption rates. Reduced household consumption is expected as a consequence of diminished accessibility to capital, lower salary growth, and uncertainty affecting consumer confidence. 

Total Brazilian international reserves (US$196bn) now exceed the total foreign debt (US$163bn) by more than US$30bn, a fact that has allowed Brazil to achieve a risk classification of “investment grade”.

In 2008, Brazil received a total of approximately $US40B of Foreign Direct Investments, 67% in the form of equity capital and 13% in intercompany loans.  This number is expected to decrease significantly over the next two years due to the global economic crisis.  Credit Suisse forecasts a total of $US20B and $US25Bof Foreign Direct Investments for 2009 and 2010.

Brazil’s disciplined fiscal policies have allowed it to considerably reduce its external debt, which has decreased from 26.5% of GDP in 1998 to an estimated 13.5% in 2008.  Although debt levels are expected to increase slightly over the next two years it is expected to remain close to current levels.

General Public Markets Information

Size & Scope

The Brazilian Central Bank measures the countries Financial Investments as the total balance of five key investment vehicles: Funds, Stock Funds, Savings Deposits, Time Deposits, and Investment Funds. As of February 20th, 2009 the combined balance of these vehicles add up to R$1,936 B, the equivalent to US$826B.  Although this number provides a good indicator of Brazil’s public markets, it does not include the country’s Derivatives market value, which historically has accounted to approximately 32% of the Brazilian Financial Markets.

As of March 09 2009, Brazil’s equity market size totals approximately R$1,351B or nearly US$577B. This value represents the market cap of the 393 companies traded in the country’s most important stock exchange, the Bovespa.

Number of Offerings

In 2008 there were a total of 4 Initial Public Offerings (IPO) on the Bovespa, which together raised a total of $US300 MM.  A significant drop when compared to the $US5 B generated from the 25 IPO’s that took place in 2007.  Secondary and mixed offerings dropped to zero in 2008, while in 2007 these totaled $7.2 B from 39 offerings.

Over the past 4 years, the Bovespa has averaged US$16.5 B of IPO’s , with an average of US$400 MM raised per firm.  Secondary and mixed offerings have raised an average of US$5.3 B per year at a ratio of US$200 MM raised per firm.

Top Growth Sectors

Agriculture

Driven by increases in both productivity and in cultivated areas for two decades, the agricultural sector has kept Brazil amongst the most highly productive countries in areas related to the rural sector.  The total agricultural productivity is subject to variations in rainfall. The majority of the population residing in the north-eastern part of the country is dependent on this sector. The growth in the  agriculture  sector  is  variable  because  it  is  dependent  upon  the  weather.  Moreover, a lack of automation in farming is equally responsible for low productivity.

Currently the country has 152 million acres being cultivated, but the government claims that this can easily be more than doubled.  According to the US Department of Agriculture, the country has 668 million acres of available agricultural land.  Brazil produces 40 % of the sugar traded on world markets and output is increasing by nearly 20 % per year. 

Investors also plan to spend more than US$12 B over the next five years to create new and expand existing ethanol plants.  The government believes it can increase ethanol production from the annual level of about 18 billion liters today to close to 200 billion liters by 2025. Producers have invested substantially in expanding ethanol capacity. 

Brazil is also the world's top producer of orange juice and coffee and ranks second in world production of soy beans and meat (beef and poultry) and third for fruits and corn.  The agricultural sector and the mining sector also support trade surpluses which allowed for impressive currency gains (rebound) and reduction of external debt. 

Industry

Brazil has the second most advanced industrial sector in the Americas. Most of the heavy industries are located in the South and South-Eastern parts of the country. The rapid growth in the industrial sector, particularly after 2002, stands testimony to the success of privatization.  The Plano Real provided an increase in economic stability that contributed to the overall industrial growth through the transfer of managerial and technical expertise in heavy industries like aircraft, steel, petrochemicals, computers, automobiles, and consumer durables.  There were also heavy investment in new equipment and technology, a large proportion of which has been purchased from U.S. firms. (Foreign  participation through  the  transfer  of  technical  and  managerial  expertise  in  heavy industries like aircraft, automobiles, chemicals and heavy industrial equipment—contributed to the overall industrial growth.) 

Services

The services sector comprises the majority portion of the GDP, but needs considerable support from the government.  Since 1994, the banking and finance sub-sector has achieved laudable success due to the large scale participation of foreign banking and non-banking  financial  institutions accounting for as much as 16%  of the GDP.   The information and communication technology (ICT) sector had also experienced a similar trend but has further room for growth. The ICT sector faces a shortage of highly-skilled workers as the country’s educational set up has failed to provide this kind of trained manpower. On the other hand, the tourism industry has surged significantly in recent years, giving a boost to the overall service-sector performance. The services sector has come to play an increasingly dominant role in the economy accounting for 68 % of the overall average growth in GDP in the last five years between 2002 and 2007. It increased 4.7 % in 2007, achieving a positive performance of all subsectors, especially in the financial sector with a 13 % increase.  Commerce registered a 7.6 % increase, transportation, mail, and warehouses a 4.8 %, information technology an 8%; real estate services 3.5 %, and other services 2.3 %.

Total Foreign Direct Investment and Major Sectors Receiving Funds

One of the basic characteristics of the Brazilian economy is a high level of internationalization, with foreign corporations playing a leading role in many sectors.  This is not a new phenomenon since historically Brazil has been an important destination for prospective investors as the government permits registered capital and earnings to be repatriated on a tax free basis.

In the 1980’s, however, the external debt crisis ended the Brazilian economy’s long growth cycle.  Brazil started to experience highly volatile GDP growth rates, as well as chronic inflation which stagnated FDI inflows stagnated at low levels.

During the 1990’s, motivated by changes in the economic policy and conditions, with liberalization, privatization, and macroeconomic stability, followed by an increase in demand for consumer durables, international investors began to expand their presence in the Brazilian economy again.

As a result of more favorable economic environment, FDI inflow increased to an average level of US$24B billion annually between 1995 and 2000.  Despite the Asian crisis of 1997, the Russian crisis of 1998, and even the Brazilian crisis of 1999, it is interesting to notice that inflows continued to grow through the year 2000.  After being at low levels for a few years due to a world economic slowdown, the FDI inflow into Brazil declined reaching a nadir of US$ 10 MM in 2003.  In 2004, FDI rose again to US$18.3 B.  Since then the FDI inflows into Brazil have continued to increase and an acme of US$ 45.1 B in 2008.   

Being a major destination for foreign direct investment, in this decade, the country attracted US$ 218.1 Bof FDI Inflows.

Main Sectors

Until 1995, the manufacturing sector accounted for more than 67% of all foreign direct investment in Brazil.  Foreign direct investment in the service sector had a notable resurgence in the second half of the decade because of the privatization of electricity, gas, water, postal services, telecommunications, wholesale, and financial services.  By the year 2000, the manufacturing sector only accounted for approximately 34% of FDI and the service sector was responsible for 64% of FDI.  On the other hand, many manufacturing industries such as food and beverages, automotive, chemicals, and metallurgy continued to attract significant amounts of foreign investment.  The retail and consumer goods sector, more specifically the food and beverages segment, was the most attractive sector and has accounted for more than US$ 5 B in investments since 2000.

Since last decade, the service sector has been the largest recipient of FDI inflows, accounting for more than half of total inflows although it has dropped compared to previous years.  In particular the ICT sector has received the principal share of total FDI inflows.  Other areas that have attracted considerable foreign investments are financial, insurance and business services sector as well as the manufacturing sector that accounted for 38.5% of the total inflows during the same period.  Agriculture and mining also grew accounting for 7.1% of total FDI.

The high FDI inflows have meant an increase in the foreign share in the Brazilian economy.  According to the census of foreign capital made by the Brazilian Central Bank in 1995 and 2000, total sales of foreign majority-owned companies reached 14.4% of Brazil’s total output in 1995.  In 2000, this ratio increased to 19.7%.  Foreign corporations also increased their share of the country’s foreign trade, reaching 41.3% of exports and 49.3% of imports.

Large companies are responsible for a strong role in the foreign capital.  Among the largest 500 private Brazilian companies, those under foreign control accounted for 41.2% of sales in 1989, 49% in 1997, and by 2003, reached 51.7%.  These data show the progress of internationalization of the Brazilian economy.  Financial investors have also increased their investment in the Brazilian market, particularly through Initial Public Offering (IPO). 

PRIVATE EQUITY INVESTMENT OVERVIEW

Fund Raising

According to a new study from “Fundacao Getulio Vargas” (FGV), The Brazilian Industry of Private Equity and Venture Capital has evolved significantly in the last few years, propelled by the world environment of financial liquidity and by the strong expansion of the national economic indicators. The total committed capital grew at an impressive average annual rate of 53.4%, since 2004, reaching US$26.65 B in June of 2008.  In the last 12 months (June 2007 to June 2008), the industry committed capital increased from US$15.91 B to US$2,65 B (+68%). In June 2008, the committed capital of the Brazilian Industry of Private Equity and Venture Capital represented 1.7% of the GDP (Gross Domestic Product), against 0,6% in 2004. Nonetheless, this number is still less than half of the world average range of 3.7 %. In the United States and England, two countries with decades of tradition in Private Equity and Venture Capital, the proportion of this industry in relation to the GDP is equivalent to 3.7 % and 4.7 %, respectively.

The Internationalization of the Brazilian Private Equity and Venture Capital Industry

The maturiation and consolidation of the Brazilian Industry of Private Equity and Venture Capital are evidenced by the fact that 21 managing organizations have at least 10 years of activity. They are responsible for the administration of around 30 % of the whole committed capital of the industry. 

As per FGV study, out of the 67 managing organizations that began their activities between the beginning of 2005 and June of 2008, 46 are from Brazil.  In June of 2008, out of 127 managing organizations operating in Brazil, 107 (79 %) were independent – 7 of which became listed, 15 (12 %) affiliated with financial institutions, 3 (2 %) were from the public sector (2 %) and two (2 %) were from industrial groups or corporate ventures (2 %). While there was a reduction in the quantity of managing organizations affiliated with financial institutions from 20 to 15, the number of independent managing organizations presented a significant growth, from 50 in 2004 to 107 organizations.

However, from the distribution of the committed capital, it is possible to observe a bigger participation of the independent organizations (both private and public listed) followed by the ones affiliated with financial institutions. The public sector is not much expressive as managing organization and therefore, as committed capital, though it has an important participation as investor in investment vehicles managed by private managing organizations (see item 3.7. for further information).

The 91 managing organizations from Brazil were the majority in the industry in 2008 and corresponded to 72% of the total against 53 in 2004 (75 % of the total). The managing organizations from the US are the second biggest contingent (17) followed by the Europeans (9) and the ones with head offices in Bermuda (3).

It is important to notice the substantial increase in the operations of the international managing organizations in Brazil through their Global and Regional investment vehicles. Furthermore, the participation of the Brazilian managing organizations in the total committed capital of the industry corresponds to 50 %. There was an expressive increase in the relative participation of the European organizations and of structures with head offices offshore, from 1.6 % and 3.4% in 2004, respectively, to 13 % and 16 % in 2008.

The Private Equity and Venture Capital Impact in the Capital Market

The IPO’s (Initial Public Offerings) constitutes one of the natural outlets for investments in PE/VC in the whole world and for many years was not a viable alternative in Brazil due to the volatile macroeconomic environment and high interest rates in the country during the decades of 1980 and 1990. Thus, few companies choose the stock market as a long term investment option in Brazil and, consequently, the IPOs market went through a period of very low activity.

With the improvement of the macroeconomic scenario, increased in global liquidity and reduction of interest rates, the stock market has gained prominence as a long term investment alternative.  In fact, from the year 2004, the Brazilian capital market was taken on a new momentum with a wave of IPOs triggered by the divestments of companies from the portfolios of some PE/VC managing organizations.  Between 2004 and June 2008 there were 110 IPOs which raised US$ 88.5 billion, of which 39 companies had received PE / VC investments before the public offering according to the Center of Studies in Private Equity and Venture Capital of Sao Paulo School of Business.

The Computer Science and Electronics sector remains the largest portion of companies in the portfolio of the managing organizations (22% of the total), although in the past four years there was a reduction in its relative participation (it was 33% in 2004) and the considerable number of divestments that occurred in this sector between 2005 and 06/30/2008.

One of the sectors that stood out the most in recent years was the Civil Construction / Real Estate sector: it increased its relative participation in the total portfolio of the industry (from 3 % to 12 %) stimulated by the reduction of the interest rate, facilitation of government credit to the sector and heating up of the economy. Today this sector has the 3rd largest relative participation in the total portfolio of the industry.

Although still representing a small portion of the total portfolio, the investments in companies shares in the education sector were also among the fastest growing between 2004  and 2008 (+200%), together with the Energy and Agricultural Business sectors (+314% and +133 %, respectively) and Communication / Media (+357%).

In the last four years, the number of companies of the industry portfolio based in the Southeast increased significantly from 66% in 2004 to 80% in 2008. Companies form the South region reduced their relative participation from 26% to 12% and other regions, all together, maintained their relative participation of 8% of the total number of companies in the portfolio.

The total volume of funds raised by companies that received PE / VC investments reached R $ 27.2 B, being equivalent to 31% of the total volume of IPOs issued in the period, between primary and secondary offerings. Between May 2004 and May 2008,  investments in shares of companies disinvested by PE / VC had an average annual return of 17.3% against 1.5% of companies that have did not received PE / VC investments. On 67% of the observations, the returns of the companies invested through PE / VC were positive against 40% of the ones not invested through PE/VC.

HOW FOREIGNERS CAN INVEST IN BRAZIL

The current financial crisis has made many investors take a look around the globe in order to diversify their investments.  Many of the emerging markets have been turning in impressive returns in the recent months.  Brazil is one such location that has been somewhat insulated from the global economic woes.  Brazil’s economy continues to boom and Brazilians are still consuming goods.  Banks are sound and profitable, leverage is low, and fiscal policies are conservative. Brazil is also a large producer of iron ore, steel, paper, oil, ethanol and food, providing the resources that the world will always need.  If you are not a Brazilian, but are interested in investing in Brazil, there are several options.   Since foreigners are not allowed to open a bank account in Brazil, you won’t be able to open a brokerage account at a Brazilian bank, however, several options do exist that will allow you to use accounts in the United States to facilitate Brazilian investing.  

Option 1 – Investing in Individual Companies: Depository Receipts

Currently, there are 35 share certificates of Brazilian companies listed and traded on the New York Stock Exchange (and 1 on NASDAQ).  Brazilian certificates are known as “Depository Receipts” (DRs) and can be bought like any other share listed on the NYSE by using your existing brokerage account in the US.  Depository Receipts are quoted in U.S. dollars.  Other companies that operate in Brazil but that usually have headquarters outside of Brazil have shares listed directly in the US (not as DRs, but as shares) which can be bought like any other share.  These companies often have operating companies in Brazil but holding companies outside of the country.   Here are some examples:  Vale (RIO & RIO-P, top 3 mining company in the world), Petrobras (PBR & PBR/A, top 10 oil company in the world), Embraer (ERJ, top 4 aircraft manufacturer in the world) and many other companies involved in natural resources (VCP, ARA), steel (SID, GGB), food (PDA, SDA), financial services (BBD, ITU, UBB), utilities (ELP, CIG, CPL, SBS), telecom (BRP, TSP, TSU, TNE), airlines (GOL, TAM), real estate (GFA), consumer and retail (ABV, CBD), etc.  

Option 2 – Investing in Mutual Funds

If you would rather invest if a group of companies, there are two easy options for an investor to take. The first option is to look for a mutual fund that invests in Brazil.  Many of the largest banks and asset management companies offer Brazil-specific funds in the U.S. and Europe, like ABNAmro, HSBC and others.  However, many institutions will only offer Latin American funds because they offer more “diversification.”   It should be known that a Latin American fund will usually have a significant percentage of investments in Mexico, which is an economy much more dependent on the United States.  It depends on what your objective are, but if you already have a large portion of your assets in the U.S. or other industrial countries and are seeking global diversification, you may want to target more country-specific funds that target Brazil directly.

Option 3 – Investing in Exchange Traded Funds

iShares MSCI Brazil Index (EWZ) is an Exchange Traded Fund (ETF) which mirrors the Morgan Stanley Capital International Brazil index.  Currently, if buy a share of EWZ, then you are investing in the equivalent of 24% Petrobras, 21% Vale, 13% Brazilian Banks, 6% steel companies, and 36% in various other companies.  This option may be the easiest for you to invest in Brazil if you already have a brokerage account.  You can find the updated holdings of this fund online.  In order to purchase this ETF, you simply put the symbol “EWZ” in your broker’s online system and purchase it like you would any other stock. 

Option 4 – Foreign investment in Brazilian Financial and Capital Markets

Brazil has actively sought direct foreign investments for many years.  Therefore, Brazil has issued a resolution (CMN Resolution 289/2000) that allows non-resident investors to have the same access to Brazilian financial and capital markets in order to allow non-residents to invest in commodities, futures markets, and investment funds.  Listed below is an excerpt from a website portaldoinvestidor.gov.br that indicates the rules and regulations for international investors to gain access to the financial and capital markets of Brazil.

According to the website portaldoinvestidor.gov.br: “the Securities and Exchange Commission, through its Rule 419/2005, created the simplified registration of the non-resident investor. Generally, based on this Rule, the brokerage firms (and the custodians) may perform the simplified registration of its non-resident clients given that the following prerequisites are complied with:

  • the non-resident investor must be a client of a foreign intermediary institution, before which he is duly registered under the applicable country of origin legislation;
  • the referred intermediary institution would take before the brokerage firm the obligation to present, whenever requested, all the information required by the CVM Rules that deal with investor registration within the ambit of the securities market, duly authorized, as well as other information required by Brazilian public bodies with inspection powers; and
  • the capital market regulating body of the foreign intermediary institution's country of origin would have signed with the CVM a mutual cooperation agreement that would allow the exchange of investors' financial information.

Furthermore, the country in which the foreign intermediary institution is located should not be considered high risk as regards money laundering and terrorism financing, and should not be classified as non-cooperative by international organs, in relation to the fight against illicit actions of that nature.”

CONCLUSION

ENABLING ENVIRONMENT

Since being named in the BRIC group of emerging economies in a 2003 report by Goldman Sachs- along with Russia, India, and China- Brazil has grown at an average rate of 3.8 %, reaching 5.4 % last year.  The country’s GDP per capita has risen 120 %to US $6,951 in 2007, and local consumer demand has continued to expand at an impressive pace.  The recent consecutive upgrades to investment grade in early 2008 have quelled the long-standing worries about government insolvency.  Several vital developments have led to a resurgence of investments and have made Brazil the most lucrative private equity market in the region.  Recent institutional changes have led to a number of improvements in the macroeconomics, institutional and regulatory landscape, capital markets, and corporate governance that have allowed for the sustainability of the private equity and venture capital market in Brazil. In fact, PricewaterhouseCoopers recently declared in its annual report,  “One thing is clear: within the BRICs, Brazil is the cou
ntry that has the most developed capitalist system, in terms of its institutions, its market economy,  the flexibility of its economic policy and democracy.”  Several key developments will play a fundamental role in continuing to drive the economy over the next ten years.  Domestic demand will ultimately remain the key driver of the economy, and rising disposable income levels will attract greater investments into Brazil.  Over the next decade, it is the rise of the Brazilian consumer that will lure foreign direct investors and turn the economy into a regional powerhouse. 

EFFETIVE MACROECONOMICS POLICIES

Since the introduction of the plan “Real Plan” in 1994, Brazil has managed to suppress the inflation that once plagued at rates as high as 2,400 % per year.  The economic stability plan was based on the super-indexation of its economy, a change in its currency, and a rise in interest rates.  The towering interest rates constrained aggregate demand and led to a sharp appreciation of the nominal exchange rate.   This introduced an era where the country was able to start using traditional instruments of economic policy and was able to align relative prices correctly, especially salaries.  Market mechanisms began operating more efficiently and prices were no longer a reflection of an exchange rate correction or inflationary inertia and Brazilian corporations were again able to accurately assess their viability and predict their need for resources.  Controlling inflation however caused an escalation of the public debt and a deficit in the balance of payments which fueled foreign debt and increased external vulnerability.  This culminated in another currency crisis in 1999 and a loss of a substantial amount of foreign reserves.  In 1999, the government introduced an economic policy that combined a floating exchange rate system, inflation targeting, and a primary fiscal adjustment in combination with various tax reforms to address the costs associated with the monetary stability plan of ’94.  This new combination of economic policy based on a tri-pod system allowed Brazil to reduce real interest rates to below ten percentage points, to reduce external vulnerability, and to contain the growth of the public debt.  Brazil’s macro-economic performance from 2004-2008 was the best in the last thirty years largely because it has recorded consecutive current account surpluses for the last five years.  Brazil’s gross national debt has declined dramatically since President Luiz Inacio Lula da Silva (Lula) was elected president in 2002 while Brazilian exports have tripled largely due to rising world demand for soybeans, iron-ore, beef, and cars.  In 2007, Brazil had a trade surplus of $40 B.  Net currency inflows reached a record $87.5 B thanks to rising foreign investment coupled with high domestic interest rates.  In February 2008, Brazil emerged as a net foreign creditor for the first time and was able to pay off its debt to the International Monetary Fund.  Foreign currency assets exceeded liabilities by more than $4 B in contrast to the net debt of $165 billion at the end of 2003, Lula’s first year in office.  The latest figures estimate Brazil’s foreign reserves at $205 B, four times higher than in 2004.  Brazil has also been gaining international market share in its exports, from 0.83 % in 1999 to 1.12 %t in 2007.  Approximately 55% of Brazilian exports are manufactured goods and not raw materials (25%) as many people believe. 

Low Country Risk

The post-‘99 external adjustment resulted in the reduction of the country risk and the appreciation of the currency.  Brazil’s long-term foreign currency sovereign debt was upgraded to investment grade by Standard & Poor’s on April 30th 2008 and by Fitch ratings on May 29th 2008.  The promotion to investment grade causes Brazil to be more attractive to international investors especially for funds earmarked for long-term projects.  Brazil’s inflation is the lowest among the BRICs and ended 2006 at 3.14 % the lowest in a decade.  In 2007, because of increasing food prices, inflation rose to 4.46 %.  Accumulated inflation is currently standing at 5.23 % below the government’s target of 6%.  The external adjustment of ’99 is perceived as long lasting given the gain in market share, higher trade balance, diversity of exports and destinations.  As such, Brazilian inflation is expected to be systematically lower and less volatile from now on.  Only thirty percent of bank assets are foreign-owned, compared to over eighty percent in Mexico. To the extent that Brazilian banks also have very low foreign liabilities, the economy is somewhat protected from a major credit contraction in international financial markets.  Brazil is likely to withstand any external liquidity shock given that its non-financial public sector external debt / FX-Reserves ratio fell from 292 % in December 2002 to 32.7 % in September 2008. 

Aggressive Fiscal Policies

Brazil is among the best positioned economies in Latin America to weather the current fiscal financial storm and a rapidly deteriorating global macroeconomic outlook.  Certainly the global outlook continues to deteriorate and the Brazilian economy will be impacted by tighter liquidity conditions and more expensive domestic credit.  In order to mitigate the liquidity constraints policymakers and central bankers are acting to pre-empt a credit crisis by issuing short term loans to the banking system, spending international reserves to offer funding to the export sector, relaxing the reserve requirements for the banking system and delaying the introduction of higher reserve requirements on cash deposits for two months (to 1/16/09), and increasing financial resources of BNDES to be used in exports financing.  In total, these measures are expected to add $7.2 B to Brazil’s financial system and to prevent a sharp decline in the private sector credit growth next year.  The nominal interest rate is expected to remain at 13.75 %, given the growing focus on liquidity

INVESTOR FRIENDLY INSTITUTIONAL & REGULATORY LANDSCAPE

Brazilian economy has significantly benefited from prudent fiscal, social, and monetary policies.  Existing legislation that has recently been enacted is though to be both market and investor friendly.  Brazilian law gives the same protection and guarantees to foreign capital investments that it gives to investments made by Brazilian nationals.  The Brazilian government is actively encouraging foreign investment to enhance and stimulate economic growth.  Historically, Brazil has been an important destination for prospective investors as the government permits registered capital and earnings to be repatriated on a tax free basis.  After being at low levels for a few years, foreign direct investment (FDI) has recorded an upswing.  The liberal FDI policies have led Brazil to be a preferred destination for global investors. The retail and consumer goods sector and more specifically the food and beverages segment was the most attractive sector for FDI in Brazil, and has accounted for more than $5 B worth of investments since 2000.  The Brazilian property market is highly attractive to both domestic and foreign investors.  To step up motivation among investors, the government has created a level-playing field for both local and foreign investors. Very few restrictions are imposed on foreigners to own local property, with the exception of areas that are used for defense and communication. 

Tax Incentives

Currently there are attractive tax incentives for foreign direct investments, including vehicles that can be utilized to reduce or eliminate taxes for foreign investors, including private equity.  For example, Law 2689 allows for capital gains and financial transaction tax exemptions on stock market investing for foreign investors.  The investment vehicle- FIP (Fundo de Investimento em Participacoes) is similar to limited partnership in that it allows for investors to make investments in private entities on a capital gains tax-exempt basis.  The federal government has also granted tax benefits to certain free trade zones.  The Manaus Free Trade zone is the most prominent of all such trade centers to have attracted significant foreign investments, including those from noted US companies. 

Improving Efficiencies

Since 1991, the government has been streamlining its existing policies exhaustively.  The capital flows have become more fluid because the arcane registration processes to get money flows approved have now been streamlined so that it is no different than any other developed country.  The government has now also disregarded old policies which discriminated between foreign and domestic investors. Foreign investors are now permitted to venture into most economic sectors, with the exception of some sectors on the grounds of strategic significance.  Finally, the relatively new bankruptcy law in Brazil has essentially removed the arbitrary judge-ruled bankruptcy/liquidation proceeding and has replaced it with a chance to have a controlled recovery process

WORLD CLASS GOVERNANCE

The main corporate governance agents include the stock exchange, Brazilian Securities and Exchange Commission, and the Brazilian Institute for Corporate Governance. 

In the sphere of corporate governance, Brazil is not just ahead of other Latin American countries but also surpasses other major emerging economies like India, China and Russia.  Moreover, the Brazilian corporate governance practices are far more advanced than that of other developed countries.  In Brazil, corporate governance was promoted in a much more didactic manner than in the US, with the primary focus being on how a company should protect minority shareholders from the controllers.  However, corporate governance in the US was based on corporate scandals.  The Brazilian corporate governance laws aim at formulating strict internal controls.  The law has provisions that control self concession of salaries, bonuses and stock options.  Moreover, they prohibit close relations between company executives and Board of Directors. 

THE TIME IS NOW

For investors looking for dynamic returns from a rapidly growing economy while still being able to invest in companies and management teams culturally similar to the US, Brazil is the place to go. Many believe that over the next several years the real growth will be in the emerging markets, especially the so called “BRIC” countries of Brazil, Russia, India and China. However, across this group there is great disparity in language, business practices, political systems, and cultural norms. As the only Western Hemispheric BRIC, Brazil and Brazilian companies can seem very familiar to US investors. This becomes particularly important when investors seek to learn more about a company and its plans. Whereas visiting and speaking with business owners from some countries can be particularly challenging due to language and cultural issues, working with Brazilian companies provides investors the ability to interact with management teams schooled and familiar with western business practices and, quite often, fluent in
English.

For US investors seeking access to the Brazilian growth machine, there are several options including the ADR’s (America Deposit of Receipt) of Brazilian companies trading in the US, index and Exchange Traded Funds (“ETF’s”) tracking either the BOVESPA or synthetic indexes composed of a basket of stocks of Brazilian companies, or the stocks of Brazilian companies directly listed on a US exchange. This last category, directly listed US stocks, has the potential to offer US based investors the best of all worlds; namely, the ability to participate in the growth of engine of Brazil while being offered the transparency and liquidity of the US capital markets. Although there are currently only a handful of such Brazilian companies listed directly in the United States, more companies are coming to the market as more investors become aware of the potential of the Brazilian boom.

To download a PDF of this report which includes the Appendix, please click this link: Case Study_Brasil FINAL.pdf





Posted 08-07-2009 10:03 AM by InvestorsInsight.com
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