Brazil's Slippery Slope

Several months ago I wrote about Brazil's need for a Real Plan for Interest Rates. Since then, things have worsened. When that article was written Brazil's SELIC (the equivalent of the U.S. Fed Funds Rate) was 13.25%. Today, it sits at 14.25%

To put this in perspective, a R$1000 advance on a credit card in a hypothetical January, would require a payback the following December of R$5,152.69. According to Brazil's Central Bank the average credit card APR is 415.3%. Needless to say, the only idea that makes practical sense is to pay off your credit card at the end of each month. Lamentably, 57 million Brazilians are having difficulty doing this. That is over one quarter of Brazil's population. When you remove children and the elderly from the calculus there is reason for concern.

Couple this low to no growth macroeconomic scenario with a debilitating corruption scandal at the highest levels of Brazil's federal government (President Dilma Rousseff is in the middle of an impeachment process), and it is easy to conclude that this is the worst storm Brazil has weathered in the last 30 years.

The consensus is that Brazil needs reforms. From taxes and labor laws to education, from social security to the importation of technology, from healthcare and housing to infrastructure. The list goes on and on.

There was a time when it appeared that Brazil might find a golden mean - a new pathway between classic market-driven neo-liberal economic policy and a more populist-driven socialist ideological framework. Ideology cannot be divorced from either of these approaches, and no doubt the task of carving out a new third-way and thereby a new macro-economic road is not easy.

The problem is that Brazil is dabbling in both of the old economic policy roads and doing it poorly. And a third-way is not on the horizon.

Brazil's Real Novela

Brazil has had high interest rates for over twenty years, since the advent of the Real Plan in 1994. So high in fact, that it has literally impacted perception - of both policy makers and the average worker. Brazilians as a whole are locked-in to short-term thinking. This in turn negatively impacts any notion of long-term planning, which has become an oxymoron. This is true at the national level in terms of infrastructure (or the other needs mentioned above), at the state and municipal level in terms services, and at the level of households.

At the top of the socio-economic pyramid, short-term returns, daily, monthly, quarterly or semi-annually, from fixed income instruments, rival and often exceed the returns of the most ambitious and successful private equity funds.

If that is the case, so the argument goes, why even both investing long-term? Why face that kind of illiquid risk? Especially, when buying government debt (considering compounding daily), let's anyone sit back a cut coupons. Of course, only the top 1% (and more likely even a smaller percentage of that) are positioned to reap those kinds of returns.

For the past 15 years at the bottom of the pyramid (95% of Brazil's population makes less than USD 50,000 year), the consumption of white goods, the purchase of an automobile, even domestic travel became feasible, as millions were elevated from the bottom of the socio-economic hierarchy via credit and an expanding economy based largely on raw material exports. Brazil experienced a consumer renaissance. In 1997, there were fewer than three million mobile phones in Brazil. Today, there are more mobile phones than the population of 204 million. But the chickens are coming home to roost. And again, it will be the poor who suffer the most. Without economic growth, there is no way to keep up with credit obligations (importantly, there was no way to do it with growth, but consumerism is in part based on mass delusion and the ability to roll-over debt).

To compound an already difficult and entrenched institutional setting and bureaucracy, the Worker's Party (the Partido dos Trabalhadores or PT), which came into power with President Luis Ignacio "Lula" da Silva, in January 2003, has spent the past 12 years, institutionalizing and centralizing corruption itself.

All countries are corrupt. But Brazil's mix of labor patronage, an agenda to maintain the Presidency for 20 years (the fulcrum of control of the means of production), which included vote buying in Congress, a bloating by the tens of thousands of the federal bureaucracy with Worker's Party members and supporters, and the global slowdown in commodity exports has presented a fatal cocktail.

The Vultures Are Coming

From an investor's perspective, Brazil is galloping toward massive loss in value across many if not all industry verticals. It will soon be a buyers market (if it isn't already). Uncertainty in Brasília has taken the Brazilian Real to a 4:1 exchange basis with respect to the USD.

The truth is that the core solution for Brazil, the panacea as it were, is massive infrastructure development. Estimates recently released indicate that Brazil will need USD 1.2 trillion over the next ten years for infrastructure. USD 100MM+ a year is a low-ball estimate.

If the idea is to establish and maintain world-class infrastructure along the lines of Western Europe (notice I am excluding the USA), the one fact that has to be faced is that nationwide infrastructure projects can only be financed with long-term debt.

This matching of the infrastructure asset class with the maturity of long-term debt instruments is crucial -- but it is also and currently, out of Brazil's reach. It goes without saying that equity is not a solution for massive infrastructure development with high interest rates, albeit it could be and should be a value-added component of the capital stack in a low interest rate, low inflation rate environment.

With the SELIC at 14.25%, a realistic nationwide infrastructure plan for Brazil is decades away. Long-term debt on the massive scale that Brazil needs cannot be contemplated with the basic bank lending rate at 14.25%. The best the country can hope for are one-off infrastructure solutions (below market rate financing by Brazil's development bank, the BNDES, comes to mind, which is simply more of the status quo).

This is where the Brazilian infrastructure bottleneck begins to show itself. For years, the country has bumped up against a growth ceiling because of the lack of infrastructure. Now with the country in recession and with inflation rising, the misguided use of interest rate increases (in theory to keep inflation in check) is simply making a bad situation worse.

The real choice of Brazil's future and its direction from an infrastructure perspective, is in the hands of the very few - those few who are making (and have made for two decades or longer) absolutely phenomenal returns from fixed income - mostly based on Brazilian government debt. Until these investors (which includes Brazil's leading banks) agree to prioritize Brazil's future ahead of their own ROIs (which can only be done by consensus), Brazil will not be able to turn itself around.

Cleaning up a corrupt political system is commendable, and Brazil appears to be on the road to do that. But it won't be enough.

Put another way, the Brazilian private sector needs to assert itself, which paradoxically means that they have to be willing to sacrifice returns for the good of the country. Returns on investment need to be linked to ROI's internationally (possibly according to industry verticals). Part of the problem in Brazil, is that the wealthy have been spoiled, not only with the ease of making money, but with the ease with which they can generate exhorbitant ROIs. No one is arguing for zero ROIs, just a rationalization of a process that is right now out of control.

The real pressure to keep interest rates high does not come from the government.

Ironically, in the midst of the worst political and economic crisis in recent memory, a dual low interest rate, low inflation rate macro-economic regime, is the only goal worthy of attention by Brazilian policy maker's.

For sage investors, if this policy stance is ever publicly announced, it means that at least the intention is there to make substantive change. Anything less is a clarion call for more of the status quo.