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Wary Investors Consider High Risk Premium in Brazil

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Despite Brazil’s problems, some experts say its risk premiums are too high.

The former Western powerhouse of the BRICS, Brazil’s economy has stumbled from one of the fastest-growing emerging markets to a place where many investors fear to tread. Beset by rising inflation and unemployment and shrinking manufacturing, consumers have slowed spending, putting the brakes on the economy despite the government’s efforts to help.

One thing that certainly hasn’t helped is the spectacular failure of Eike Batista’s empire and fortune. The man who not so long ago was Brazil’s richest, boasting a $34.5 billion bank balance, is now on the verge of bankruptcy, and has been selling off assets and shedding business units even as his company OGX Petróleo e Gás Participações SA has lost millions for investors BlackRock and PIMCO by failing to produce its wildly optimistic predictions of oil reserves.

While the company said recently that it was reviewing all options to stay in business, hoping that its shareholders and bondholders will cut it some slack as it attempts to refocus, if it fails to survive, it could bring down sister company OSX Brasil SA, the shipbuilding firm that Batista also controls. He’s been dismantling his Grupo EBX conglomerate, but markets may do some of the work for him if he is unsuccessful in buying some extra time for the business to regroup.

That, coupled with a lower outlook on Brazil’s credit rating from Moody’s, has meant that investors have looked elsewhere for opportunity that isn’t so tied to risk, especially since Brazil’s political situation has been experiencing some hiccups as well.

Protests from indigenous peoples arose in June, and again this month, against proposed legal changes to their land rights supported by the farm lobby. Dilma Rousseff, the current president, has seen her popularity suffer as the economy has suffered, and could face a challenge from an unexpected quarter in next year’s election with the alliance of two of the country’s most popular opposition leaders.

Business-friendly Eduardo Campos, the governor of Brazil’s Pernambuco state, joined forces with Marina Silva, a former environment minister who had planned to challenge Rousseff for the presidency. Silva’s weak showing in polls apparently convinced her to ally with Campos, and the combination has been a shock to Brazil’s political establishment, creating a broad reach across the country that could appeal not just to disaffected businessmen but also environmentalists.

However, Rousseff herself seems to have recovered much of her standing since the June demonstrations and is popular with the poor, since her administration has focused on unemployment, still near record lows despite its rise, and the reduction of poverty. The country’s statistics bureau released figures in September indicating that inflation may be slowing at last. And there are some additional signs that change is coming.

According to Markit Economics, the HSBC Brazil Manufacturing PMI Report indicates September growth, the first in two months. Output also rose, for the first time in three months. In addition, job creation was slightly on the rise in the services sector, as private sector output expanded in September for the first time in three months. The financial intermediation and “other services” sectors led the way.

With growth, however small, comes opportunity. Brazil’s risk premiums are high and change is on the way for the country’s high interest rates, according to Ezequiel Aguirre, Latin America fixed income strategy and economics analyst at Bank of America/Merrill Lynch.

 “Our modeling approach results in fair value estimates of local interest rates considerably lower than current market rates, with one-year equilibrium rates estimated at around 80bp below current levels and five-year equilibrium rates estimated at around 120bp below current levels,” he said in a research report. “The model predicts a bull flattening of the yield curve, consistent with our view that interest rates in Brazil are excessively high.”

Policy rate and inflation forecasts drive the view, with an expected 50-basis-point increase in the benchmark Selic rate in October to 9.5% but no further increases after that, and inflation to end the year at a rate of 5.6%. Not all analysts are as optimistic, of course, with those surveyed by Brazil’s central bank predicting interest rates will rise to 9.75%, and some traders believing that they could go as high as 11%.

Other factors implying a decline in interest rates in the short term include a stabilization in Brazil’s currency since the government’s $60 billion intervention program was announced on August 22. Since then, the Brazilian real has gained more than 9%, more than almost any other emerging market currency.

“Factors that have led to higher risk premia in Brazil include: a deterioration of the current account balance, persistently high inflation rates, a decline in the primary fiscal surplus, policy uncertainty, policy heterodoxy, and an overvalued exchange rate. All of these have contributed to the loss of confidence by foreign investors toward Brazil,” Aguirre said. “A shift toward policy orthodoxy to bring down inflation and inflation expectations would go a long way to reduce risk premia, since persistently high inflation contributes to real exchange rate overvaluation and discourages private investment. So would a tighter fiscal policy [i.e., higher fiscal primary surpluses].”

In deciding whether to return to Brazil, said Aguirre, investors “should consider the expected returns offered, the volatility of returns, domestic economic [monetary, fiscal] policies, the liquidity and ease of access to the markets under consideration, the probability of regulatory/tax/control changes.”

Meanwhile, some companies aren’t waiting for change. Brazilian education company GAEC Educação SA announced at the beginning of October that it, together with shareholder and private equity fund BR Educacional Fundo de Investimento em Participações, will hold an IPO so that it can expand in Brazil’s currently hot education sector. The company will provide a primary offering, with the shareholder providing a secondary offering.

It was the second company in the sector to make such an announcement that week; Ser Educacional SA was the first, declaring its intent to raise funds for the first time on Brazil’s stock market. The education industry in Brazil has seen double-digit growth in the past few years, coming in at $11 billion per year, as its tight job market has spurred competition among applicants seeking new and better skills to offer.