Sunday, 19 August 2018

IMF/World Bank 2007: Keeping up the pace

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Brazil has come along way in recent years but there is still so much more to do. The nation is hurtling toward investment grade ratings possibly before the end of 2007. But the government still faces several stumbling blocks, including weak local debt markets, inefficient taxation, poor regulations and vast energy needs. Anthony Dovkants reports.

Back in 2002, before Luiz Inacio Lula da Silva's Workers' Party came to power, the Real slumped to four to the US dollar and external debt weighed heavily on the coffers as interest rates soared above 20%. C bonds had also lost more than half of their value and whispers of default were hitting the market, despite outgoing President Fernando Henrique Cardoso's ability to put together the IMF's largest standby agreement totalling US$42bn.

No one then believed Brazil would become the multilateral's poster child and that by early 2005 it would be able to quit the accord and leave the IMF without its best customer. Since then, Latin America's largest economy has also taken great strides toward putting itself on a path toward investment grade. In fact, the list of achievements is long.

“Brazil has come a long way in tackling its significant external vulnerability which is markedly different today compared with five years ago," said Lisa Schineller, director of sovereign ratings at S&P. "With pragmatic policy implementation it slowly reduced its debt-to-GDP ratio and improved its debt composition. The combination of these factors have made the prospect for growth stronger than it has been in the past.”

Brazil's debt load has increased from US$392bn in 2003 to US$645bn today, but that doesn't account for a strengthening Real against the dollar. Perhaps more important is the fact that the country's debt to GDP has dropped about 1,000bp since 2005 and its debt composition is now longer term and less vulnerable to external shocks.

Between 2005 and 2006, Brazil took out its Brady paper via an impressive US$4bn-plus C bond swap for new 2018s before buying back the remaining US$7bn. The sovereign ended its annual external funding programme of up to US$6bn and told the market it no longer needed to fund itself overseas.

The government also started to reduce its volatile local floating-rate paper and for the first time began to issue fixed-rate paper extending beyond the five-year mark – a move that was helped by the removal of a 15% withholding tax that opened the door to multibillion dollar foreign investor flows.

FRNs today make up 22% of the total debt stock versus more than half in 2002, while fixed-rate paper has come out of nowhere and is at 30%. That was deemed impossible at the start of this decade.

Brazil increased its international reserves to more than US$160bn from sub US$20bn in 2002, and brought the Real down to below R$2.00 to the dollar. It also always beats its own primary budget surplus target of 3.8% by a comfortable margin. In July, the surplus was R$7.9bn, or 4.37% of GDP.

Furthermore, the nation's net debt to GDP ratio, which has for years remained elusively stuck above the 50% mark, has today dropped to 44.4% after Brazil changed its methodology to a fairer system. In other words Brazil's net-debt-to-GDP ratio is already at investment grade levels.

On the equities side, the Bovespa has become one of the fastest-growing equities exchanges in the world. The IPO market took off with small companies finally finding an audience overseas and locally as bankers found new names for the insatiable appetite of equity investors.

Consequently, Brazil trades like an investment-grade credit. In the latest selloff, the sovereign has outperformed its South American peers and it is rated by all three core ratings agencies one notch below investment grade amid expectations that any one of them could raise the nation to Triple B.

But even if Brazil reaches investment grade, Brasilia cannot afford to sit on its laurels and slow the pace of reforms. "Challenges remain for continued improvement on the fiscal side where the size of the debt still crowds out private-sector investment and a lower debt burden would open the door to higher private investment," said Schineller.

Furthermore, “to date Brazil's fiscal adjustment has rested primarily on revenue increases [rather] than expenditure consolidation," she added. "Plus bringing down spending would permit lower taxation, feeding into an even better growth outlook for the medium term.”

Politically, the relatively immature democracy also needs to improve the strength of its institutions. It should, for instance, make the central bank fully autonomous, though in practice it does enjoy much independence.

On the regulatory front, Brazil needs to do more to shore up its regulators in telecoms, aviation, environment and energy by paying better, increasing their powers and improving the regulatory framework.

For example, the nation is potentially heading toward a new energy rationing crisis, which was last seen in 2001–2002 when consumers were punished for using too much power. More investment needs to be made, though a weak regulatory framework on the environmental side has led to acute delays and a slowing in investments.

Brazil also needs to do more to encourage entrepreneurs into the country. In early September, a body representing Chinese companies complained about bureaucracy, heavy taxation, the difficulty of getting visas, ancient labour laws and the complexity of opening a company.

It does not stop there. Despite Brazil claiming there are no capital controls in place anymore, Brazilians cannot send funds to their own accounts abroad as the central bank does not allow it.

On the DCM front, Brazil has been slow to support its corporate debt market. The debenture and ABS markets enjoy next to zero liquidity. The government needs only remove a 15% withholding tax and the local market could become as important as Mexico's. But Brasilia is reluctant, given that a corresponding flood of higher-yielding corporate paper could well detract interest from sovereign issuance.

No one knows what impact such a move would have, but more inflation-linked paper will likely be issued, and more borrowers would likely come to market. Such changes would also lower the cost of borrowing as there are only about 15 investors looking at this market. Today, however, the market is failing to keep up with last year's volumes of US$35bn, only managing US$15bn so far in 2007.

Another problem is the overall taxation system. Levies are at the equivalent rate of plus 35% to GDP, while the government fails to pick up an equivalent of 30% to GDP in taxes a year because of fraud.

On the regulatory front, the CVM and central bank regulations have single-handedly dismantled local ABS and external subordinated and perpetual debt markets respectively. The former should be at least US$10bn in size this year instead of more than US$3bn year-to-date and the latter, which is currently non-existent, should be more than US$2bn in 2007, bankers argue.

Earlier this year, the central bank issued rules prohibiting perpetuals from carrying call options, making them unattractive to investors. Another problem is the way capital is recognised under 10-year non-call five subordinated debt instruments. The central bank decided that since issuers call their paper at year five, such transactions should be recognised as five-year issues and not 10 with a five-year call.

As a result, capital treatment starts to change after the first year as opposed to the fifth previously. Capital recognition is now 100% equity in the first 12 months, before falling to 80% equity and 20% liability by year two, 60% equity in year three, 40% in year four and 20% until year five. Under the old rules, there would be 100% equity treatment until year five.

As for the CVM, the securities regulator decided ABS receivables should be accounted for on the balance sheet as liabilities and not as equity.

An outcry by issuers and top banks has prompted the central bank and the CVM to take another look at their rules and possibly revamp them. Bankers hope both institutions will have reverted back to the old rules by 2008 as such tough regulation puts the central bank and the CVM out of kilter with their peers overseas.

Ultimately, the government has some tough decisions to make if it is to keep the economy growing at a strong and sustainable rate at plus 3.5% annually. Overseas, the hope can only be that the Brazilians make everything less complicated. It is hoped that Congress focuses more on reforming its tax system, its labour laws, and its securities regulations as well as creating a level playing field for corporates in the debt capital markets.

The sovereign should also think hard about creating a new exchange focused exclusively on debt trading, said bankers. This would help boost secondary markets by bringing in retail and institutional investors.

With any luck, the a new debt exchange could replicate the unprecedented success the Bovespa has enjoyed this year after marketing efforts boosted daily trading volumes from less than US$400m a day to over US$2bn. Only then will Brazil have created the necessary foundation to realise its potential on the debt side by providing a cheap, thriving and vibrant backbone to borrowing in Brazil.

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