The Bottom LIne: The Brazilian bubbleburst

WASHINGTON, July 18 (UPI) -- Last fall, "the bottom line" surveyed Brazil's political economy and found strong reasons to invest in the country's equity and debt markets. The call had both economic and political roots, but at the bottom it reflected the belief that newly-elected President Inacio Lula da Silva was vastly underestimated.

Since that call, reinforced by a followup report in April, the gap between yields on Brazilian dollar debt and U.S. debt has been cut by more than half, while the Bovespa stock index has declined risen more than 80 percent in dollar terms. At the least, those numbers suggest investors review their Brazil exposure. In fact, given recent political and economic events, it may be time for zero long, and selected shorts.

1. PENSION "REFORM"

It's very likely that a pension reform proposal crafted by Jose Pimentel of the Workers' Party will be approved in short order. From what sources tell us about President Lula's review of the document, it will bring bring perhaps $18.5 billion in relief to the system, roughly what Mr. Lula asked for, though it will do less to improve incentives for government pensioners to work and save by leaving intact existing tax disincentives and implicit early retirement provisions.

This pension reform -- "reshuffle" would be more accurate -- has been long expected, and if anything, is coming in a bit late and a bit small. Most important, it does little to improve employment incentives along the lines of the U.S. welfare reform of the mid-1990s. Instead, the proposal fiddles with benefit levels with few changes in conditionality or taxes on wages by retirement age workers. This leaves a vast class of Brazilian ex-bureaucrats in their 40s with little reason to re-enter the work force.

By contrast, one of the little-known secrets of Russia's boom in the last several years was the collapse of the old Soviet pension system in 1998-2000. Trimming $15 or $20 billion of Brazil's obligations is useful for the country's long-term balance sheet, but as it's turned out, will do little to stimulate structural improvement in the labor market. If anything, it may be a time to sell the news.

2. BRAZILIAN DEBT

Pension reform still leaves $300 billion in public-sector debt, counting the states and localities, at a time when Brazil's economy appears to be entering a slow-growth stall at best.

Early this year, Lula held off from even toying with a default, or playing hardball on negotiating a breathing space, for the simple reason that he had no room to maneuver. When everyone fears a default or massive devaluation to begin with, there's little incentive to execute one, and little leverage with which to scare the creditors.

Recent improvement in prices on Brazil's debt and equity prices give Lula some of that leverage. According to a senior advisor to his 2002 campaign, the president plans to use it in the coming weeks. The plea for debt relief, this sources says, may come as part of a broader economic stimulus package, or as an appeal to global or regional trade negotiators. Lula will ask for either some forgiveness of principal, or renegotiated interest rates, or both, under a formula that will apply to other emerging market countries as well.

"Lula feels he has been a good citizen, on the debt, exchange rates, and other issues," says the advisor, noting that, for example, he has substantially muted his opposition to a U.S.-led hemispheric trade agreement to the point where Brazil is now an ally, with a few caveats. "Now he feels Brazil should get some consideration."

That isn't likely to be forthcoming. Any Lula appeal on debt to the high-deficit U.S. -- or even the slow-growth European Union -- is likely to receive muted disinterest at best. It will, however, splash cold water on the markets, especially for debt.

3. MONETARY POLICY

Last year, Brazil executed something many Latin economies seem to covet -- a "real" Brazilian real devaluation in which the currency fades, but domestic wages don't fully catch up. At the same time, a weakening U.S. dollar gave Lula and some other developing-country leaders added help. With the dollar falling against most European and Asian currencies, holding a steady exchange rate against the U.S. was comparably easier. And brought with it a falling real against the Euro, the yen, and the Korean won, to name just a few.

The result was an increase in the country's competitiveness in international markets and a gust of wind in Lula's sails. "If I knew that the Brazilian real were going to be stable from now on," economist John Mueller of LBMC, LLC write last fall, "I'd be willing to predict... the Bovespa is a 'buy' at this level."

But with the gradual return of inflation, and the rise in stock prices, Brazil has already made up most of the ground. In fact, an index of Brazil's price level, at historical lows of 70 relative to the U.S. just nine months ago, has climed back to 110 -- nearly a 60 percent gain. The real has indeed held steady -- but against a falling dollar. Brazilian reserve growth, needed to defend the real against a potential run, peaked at around 2 percent of output -- several months ago. It's been declining sharply since.

Domestically, Brazil is one of the most leveraged countries in the world. Personal credit at banks is at a level approaching Argentine levels, and net debt is high, despite rates on automatic overdrafts, which many consumers use as de facto credit cards, at an astronomical 200 percent plus. By the end of last year, loan delinquency had declined to 14 percent, and appears to have fallen further in the first quarter. In the last two months, however, the delinquency rate rose.

Under current bankruptcy laws, meanwhile, badly run companies can essentially obtain perpetual freedom from debts. Thus, a run on both consumer and corporate credit is possible, one that could produce an immediate reserve crisis given Brazil's tenuous debt and currency position.

President Lula aims to "fix" some of these problems, and his bankruptcy reform might, in fact, make matters better. His proposal to require lower rates on consumer interest, however, would weaken the financial sector just as it's getting on its feet, and facing rising delinquency and default rates. And Lula's efforts to bash Brazil's local telephone company over rates, and regulate other major sectors in the economy, while understandable given their oligopoly power in the market, won't produce the kind of stimulus he's looking for.

BOTTOM LINE

In the coming weeks, Brazil will thus face intense pressures to lower interest rates (to help consumers, some companies, and the exchange rate), and to raise them (benefiting creditors, reducing inflation, stabilizing the real.) There are more votes on the consumer and debtor side -- so bet on a devaluation of the real.

Following the real's slide, there will be a crisis of confidence, similar, perhaps, to that faced by Bill Clinton in the U.S. in 1993-94. In the long run, this could well mean a renewal of Brazilian restructuring, and growth, in 2004 and beyond. Lula already has a "Republican Congress." His Workers' Party has only a small share of Brazil's multi-party congress, mainly controlled by the center-right. This will come, however, after a correction.

There is even a raised possibility of outright default or a mega-devaluation, especially (paradoxically) now that Lula has convinced markets it's not likely. This is not the scenario we expect; rather, a reasonable decline in the real of 20 percent to 25 percent, a better deal on sovereign debt, and some bankruptcies in the banking sector but not on a Mexican scale. Investors, though, should watch overnight rates closely, as in Mexico in 1994. It's worth noting that in Mexico's case too, the currency crisis came not immediately but some months after the establishment of a new government rhetorically committed to a stable peso.

Lula is correct in sensing the danger of recession, but is unlikely to reach for the right tools to deal with it. A 2004-2005 rebound is likely, especially if the country comes through the next few months looking to real incentive-based reform of the state sector, banking and credit laws, and Brazil's still-massive transfer payments system. (One option: True land reform, based on using unused tracts rather than grabbing privately owned real estate, to empower -- and employ -- the nation's vast reservoir of unemployed, and in some cases homeless, human capital pool.)

Still, this revival is likely to follow an adjustment phase. We're out for now.

Long-only investors should certainly trim their Brazilian exposure. At this point, Argentina, Bolivia, and Chile look like better debt and equity plays in Latin America. The aggressive may want to short vulnerable Brazilian firms and sectors, such as Petrobras (PBR), Brazil Telephone (BTC), and the banks. The cautious will at least want to take profits of 50 percent or more after what has been a spectacular run.

(Gregory Fossedal is chief investment officer of the Democratic Century Fund, managed by the Emerging Markets Group. His firm may hold some of the securities mentioned his articles. Individual investors should contact their own professional advisor before making any decisions to buy or sell these or any related securities.)