The real deal

IFR IMF/World Bank Special Report 2017
10 min read

The business climate in Brazil has improved markedly during the last few months despite all the political turmoil, underlined by a wave of important initial public offerings.

Between 2014 and 2016, only four IPOs took place in Brazil, although the market has taken off this year. According to Thomson Reuters data, Brazil’s equity capital markets deals have more than tripled to 19 from the start of the year to August 23, compared with the same period last year. So far, US$6.7bn has been raised this year.

In July, Carrefour Brazil – Brazil’s biggest supermarket chain and a unit of the French group of the same name – came to market and raised R$5.12bn (US$1.6bn) and, in April, Azul SA, the Brazilian airline, secured R$2bn from its listing.

In February, Movida, the car rental company, undertook an IPO and raised R$645m and Hermes Pardini, the medical services company, R$878m.

BR Distribuidora, Petrobras’s fuel distribution unit, Camil Alimentos, the canned fish producer, and Elektro, the electricity distribution company controlled by Brazilian energy groups Neoenergia and Iberdrola, are also expected to go public later this year.

According to Thomson Reuters, the country’s M&A activity is also up threefold compared with last year, reaching US$41bn in deals, bolstered by the US$21bn sale of Valepar, the holding company with a 53.35% stake in Vale, the Brazilian mining giant.

This activity is taking place in the wake of a severe recession – the economy nosedived by more than 7% between 2015 and 2016 – and against a backdrop of remarkable political uncertainty.

Corruption scandals have claimed the political lives of key political figures, including the ex-president Dilma Rousseff and ex-Speaker of the Chamber of Deputies, Eduardo Cunha.

In July, ex-president Lula da Silva was also found guilty of corruption charges and money laundering stemming from bribes and benefits he received from Petrobras. He was sentenced to nine-and-a-half years in jail but remains free pending his appeal.

At the start of August, Michel Temer, the country’s interim president, survived a vote in Congress on whether he should be tried in the country’s supreme court for corruption. But he is not completely off the hook. The public prosecutor’s office is expected to file two more corruption-related cases against him in relation to JBS, the Brazilian meat processing company, shortly.

“The capital markets have become a lot more open during the past few months,” said Otavio Vieira, a senior partner at Taler, a Sao Paulo-based fund manager. “Merger and acquisitions activity is also picking up strongly. Despite all the political problems, the investment climate is now much better than even one month ago.”

Christopher Gilfond, head of debt and equity capital markets origination for Latin America and the Caribbean at Citigroup, believes the IPO by Energisa, the power distribution company, in July last year – which raised R$1.13bn – was pivotal in terms of opening up the markets.

“This public offering was a watershed event,” he said. “ECM has picked up steadily since then. There was renewed optimism following Temer’s accession to the presidency in August as well. Analysts felt the country’s economic growth could be about to pick up. His government’s vital fiscal reforms are still likely to happen but maybe in a watered-down form.”

Investors seem to have shaken off their concerns about Brazilian IPOs after new issues failed to deliver promised returns over the past decade. Less than one-third of the 115 public offerings that came to market since the start of 2007 yielded returns above Brazil’s interbank lending rate, Thomson Reuters data show.

Problems to overcome

Brazil has two important economic problems that it must solve if the economy is to pick up speed: first, a fiscal deficit of a whopping 8.5% of GDP and, second, sky-high interest charges on credit cards that average 475.8% annually and have left many consumers highly indebted.

One of the main factors behind the ballooning deficit has been the country’s extremely generous social security system. It allows retirement on average at the age of 54 with almost full benefits, compared with 72 in Mexico, for example.

The government is spearheading a constitutional amendment that would set a minimum retirement age for the first time, at 65 for men and 62 for women. Analysts point out that pension expenditures account for almost half of the government’s spending before international debt payments, but the reform is deeply unpopular with Brazilian voters.

The government hopes to get the vital overhaul passed in the Chamber of Deputies in October. But lawmakers say only a stripped-down version is likely to be approved, as they are afraid of upsetting voters ahead of presidential elections in October next year.

The government has also announced a series of micro reforms to try to bring credit card interest down. It wants to centralise credit card receivables onto a single platform and to reduce the settlement period on the cards to only two days from the current 30. At the start of the year, the banking system’s non-performing loan ratio was 3.8%, according to Fitch Ratings.

“Brazil emerged from recession in the first quarter this year,” said Edward Glossop, Latin America economist at Capital Economics, the London-based economics consultancy. “Growth has started to accelerate since then. However, there is a great deal of political polarisation and it is not at all clear that Temer will survive until October next year.”

Capital Economics predicts the economy will expand by 1% this year, 0.5% above the consensus forecast. Interest rates currently stand at 9.25%, though leading analysts expect these could drop to 8% by the year’s end. One of the biggest problems has been the rise in the unemployment rate to 13%.

In July, the Brazilian Senate approved a controversial labour reform bill, the first major overhaul of the system in 70 years. It aims to reduce costs for businesses and allow firms to negotiate contracts freely with employees. Under the changes, union dues – currently mandatory – will become voluntary.

“Brazil’s economic team remains solid and committed to the reform agenda,” said Lisa Schineller, a managing director at Standard & Poor’s, which stripped Brazil of its investment-grade rating in September 2015 (currently, it rates the sovereign BB with a negative outlook).

“We appear to have entered a period of greater political and economic stability. I hope we will not see any backtracking on the momentum for reform. The constitutional amendment on pensions would be an emblematic change; currently, the country has a very rigid spending structure.”

BNDES, the country’s state development bank, is also undergoing a major overhaul that could help kick-start the economy. During the 13-year rule of the Partido dos Trabalhadores (PT), the country’s leftist party, it provided abundant credit at cheap rates to a select group of ‘national champions’ – builders, miners, pulp makers and food processors ­– and became the main source of long-term private sector investment finance. Its portfolio jumped from R$242.5bn in 2007 to R$677.6bn in 2015, helping to swell the country’s national debt.

In future, BNDES will focus new loans on infrastructure and smaller firms while scaling back the use of subsidised interest rates (known as TJLP rates, a below-market rate) for future contracts. The government plans to phase out all subsidies to national champions within five years. Other reforms should open the door to the securitisation of its financing in the future.

One of the key issues in Brazil is the historical structural of the country’s financial sector. According to a recent World Bank study, the Brazilian asset management industry has over 70% of its assets allocated to government bonds, crowding out funding to the private sector. Corporate bonds represent less than 3% of its assets under management, and equities only 8.5%.

This giant imbalance – which has led government bonds to absorb a vast share of domestic savings and financial wealth – has been largely down to the high interest rates on government debt (recently, the short-term real interest rates paid have been hovering around 5% a year).

The government’s huge fiscal deficits have led to the country’s risk premium being higher than other emerging markets, pushing up interest rates on its debt. The government can only break this vicious circle by getting the fiscal deficit under greater control.

However, it is possible that political instability could derail Temer’s reforms. Lula da Silva, now aged 71, was a giant on Brazil’s political scene between 2003 and 2011 and is still popular with a significant segment of the population. He would like to run for the presidency again next year, but if his prison sentence is upheld on appeal, he would be barred from seeking office again for eight years (beginning after any jail time is completed).

“If the economy turns sour again and Lula gains steam politically, it is possible he will avoid a jail term,” said Peter Hakim, president emeritus at the Inter-American Dialogue, a Washington DC-based think tank.

“There is still a market for populist socialism in Brazil. But I believe Temer should be able to make it to the end of his term; he is a very agile politician.”

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The real deal