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AmericasJuly 3 2017

How will Brazil emerge from its political drama?

From infrastructure to green energy, Brazil offers myriad investment opportunities. However, such opportunities are contingent on the government not crumbling under corruption investigations, it managing to pass unpopular reforms, and it keeping its word on concession rules, writes Silvia Pavoni.
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Brazil demos

With a three-word tweet, the social media account of House of Cards, the Netflix US political drama, provided on-point commentary on Brazil’s real-life political drama. “Tá difícil competir,” (it’s hard to compete) read the message in Portuguese on May 17. It was the day news broke that Brazil’s president, Michel Temer, had been caught on tape allegedly condoning bribes, in the latest twist in the corruption scandal that has engulfed the country for the past three years. Charges were subsequently filed to the supreme court, but it was left to Congress to decide whether to go ahead with a trial. Mr Temer denies any wrongdoing.

The network of kickbacks and machinations linking Brazil’s political and business elites is the stuff of fiction. The scandal has not only delivered a lethal blow to an economy already badly hurt by the commodities cycle bust, but also cooled the interest of local and international investors. Yet the government is intent on pressing ahead with reforms that it hopes will restore confidence. So are Brazil’s fortunes about to turn?

Economically, the country is improving. It is shaking off its worst recession in decades; inflation has dropped and is expected to remain at 4.1% to the end of 2017; and the benchmark interest rate is forecast to shrink to a single digit by December. The ambitious reforms of labour, pension and tax rules could reinvigorate the economy further, while also making Brazil a more palatable destination for foreign capital.

Reform hopes

Experts point out that Mr Temer’s administration has already achieved something that would have been unthinkable only a short time ago: a constitutional change in order to cap public spending. New rules will restrict annual growth to the rate of inflation for the next two decades.

The government’s efforts to rationalise its public-private partnership programme could also go a long way to attracting international bidders and yield-seeking funds to the 85bn reais ($25bn)-worth of planned infrastructure projects in sectors that include airports, highways, hydroelectric power and oil and gas.

On the other hand, while it is hoped the corruption investigation, dubbed Operacao Lava Jato (Operation Car Wash), will eventually eradicate malpractice, its widening remit has the potential to weaken the government’s efforts in the short term. In April, the operation was extended to scores of politicians, including lawmakers and eight cabinet members, with independent macroeconomic research company Capital Economics saying at the time: “The big risks remain political.”

Luis Alberto Moreno, president of the Inter-American Development Bank, says: “Brazil is not a country for beginners. These are not easy reforms; in any country in the world, within a democratic context, these are all tough things to move ahead.”

Too little, too late?

Indeed, it was widely anticipated the new labour law would be approved in its current form, but the Senate rejected it in June. Passing changes to the pension system will be much harder as, among other measures, they include raising the country’s retirement age to 65 (it is currently around the mid-50s for many public sector jobs). Dirk Willer, Citi’s head of emerging markets research, believes that by the time the reforms get approved, they will be so watered down that they will not make much difference. Others, however, are more optimistic.

Most observers agree that Brazil’s change of tune marks a turning point. This is felt at federal and individual state level, where administrations are seeking to contain public spending and partner with the private sector. For example, soon after taking office at the beginning of 2017, the mayor of São Paulo, João Doria, launched a 7bn reais privatisation programme that will sell and auction dozens of public assets, saying: “The Interlagos race track, or the Pacaembu soccer stadium – these are not activities for the government. These are activities for the private sector and we will put them in private hands.”

Proceeds will be directed to education and health, says Mr Doria, a potential presidential candidate in 2018’s elections. (In keeping with Brazil’s political twists and turns, former president Luiz Inácio Lula da Silva has declared his intention to run, despite being in the sights of Operation Car Wash as part of investigations into state-run oil giant Petrobras. The former president denies any wrongdoing.)

Moreover, new guidelines on concessions have opened the door to international bidders. Operation Car Wash has made this an even more pressing necessity. Along with Petrobras, several international industrial conglomerates have been caught in the scandal, including Odebrecht.

Once Latin America’s most successful construction company, Odebrecht set up a ‘division of structured operations’ dedicated to the payment of bribes to officials to win contracts. At about $800m across a dozen countries in 15 years, it is the largest bribery machine in corporate history. “In the past, Odebrecht, [along with engineering companies] Andrade Gutierrez and Camargo Correa used to take part in the [bidding] consortium as shareholders. Now they’re out of the market for a while,” says Marcelo Allain, secretary of investments and partnerships at the government’s Investment Partnership Programme (PPI), a department that was set up last May.

A brighter environment

Until recently, operating in Brazil’s public service concessions was considered a domestic game. Although nominally open to foreign bidders, tender documents were available only in Portuguese and applicants had to submit proposals within 30 to 45 days, which any non-Brazilian company would have struggled to achieve because of the time needed to clear internal approvals and recruit local advisers.

Internal rate of returns were an underwhelming 8% to 9% while projects were made possible thanks to heavily subsidised funds from development bank BNDES. Now tenders are also available in English, bidders have a minimum of 100 days to apply, and structures have been revised to provide internal rates of return of up to 13%.

These changes are part of a 10-point programme put together by the PPI. Furthermore, new policies at BNDES mean that its subsidised long-term rate, the TJLP, will favour projects that prove they have a social and environmental impact, for which the bank will finance up to 80% of total requirement. A transportation project would receive up to 50%. Crucially, the TJLP, now at 7% (compared with the central bank’s benchmark of 10.25%) will be replaced with a new rate in 2018, which, through to 2023, will gradually be brought in line with the government’s five-year bonds rate.

Political casualty?

Speaking to The Banker in February, the then president of BNDES, Silvia Maria Bastos, stated her intention to turn off the tap on the bank’s over-generous lending practices. Then in dramatic Brazilian style, she resigned three months later – after less than a year in the job – officially citing personal reasons. However, insiders believe she had showed too firm a commitment to BNDES’s new policy, and upset some influential business leaders who have the ear of the government.

“It’s difficult to steer a transatlantic ship,” says Hector Gomez, country manager, Brazil, of the World Bank’s International Finance Corporation (IFC) in São Paulo, referring to BNDES, which he has been advising. Change will be hard because of the volumes and terms of individual loans, as well as the stricter standards required of applicants. The IFC provided assistance with the evaluation of projects’ environmental and social standards. “The only standard they had was to comply with the law; now it’s best practice,” says Mr Gomez.

He adds that so far, for a country the size of Brazil, the pipeline of infrastructure projects has been too small. This had to do with a development model heavily based on consumption rather than investment, which eroded focus and expertise at the government level. “It takes pretty much the same amount of time to develop a project here and in the US: it takes about a decade from when you start thinking about the project to when you put it on the market,” says Mr Gomez. “Not much was happening in Brazil over [the past] 10 years.”

Any cutbacks by BNDES should help make private sector banks more attractive, by filling the gap in lending left by the development bank. Once projects are up and running, investors could be brought in for long-term financing, with international players eventually being called upon once Brazil’s infrastructure finance demands exceed local supply.

So why Brazil?

But there are challenges to overcome. Confidence that concession rules will not be altered throughout the life of the contract is crucial to both bidders and financiers, as is the mitigation of currency risk. Mr Allain says transparency and a solid legal framework are key concerns for the PPI, and that projects will be put on the market only after receiving all the required approvals from interested parties, including environmental licences.

Mr Gomez says there are already some interesting solutions at state level to deal with foreign exchange risk. This was the case when the IFC helped the state of São Paulo put together some auction guidelines, which included a mechanism to protect against severe devaluation. “The state of São Paulo was very accommodating; it did everything it could to address [investors’ concerns], to the point that the documents we have for São Paulo are pretty much aligned with what we have internationally,” says Mr Gomez. “With BNDES in transition, we needed to have something to attract foreign financing.” Such mechanisms are not yet available at federal level.

Despite the progress made, more is needed to attract big international investors that can choose to allocate capital anywhere in the world. They are still largely missing in Brazil, says Renato Ejnisman, head of Bradesco BBI, the investment banking arm of Banco Bradesco. “Typically, the type of investor in Brazil right now is a dedicated investor, a Latam fund or an emerging market fund. But the guys who could invest in the US, Europe and Asia are not really looking at Brazil,” he says.

Mr Ejnisman adds that despite the growth of local funds such as Patria Investments or Brookfields, Brazilian investors seem more wary than international peers about betting on the country in the capital markets. “I think local investors are a little more concerned about the likelihood of reforms being approved and, thinking about the 2018 elections, about who will be the next president,” he adds. Politics continue to obfuscate Brazil’s picture, at least in the short term.

Long-term view

Foreign companies should be looking further into the future, says Li Yinsheng, CEO of China Three Gorges (CTG) Brasil, part of the world’s largest hydroelectric power group and a committed investor in the country. In operation since 2013, CTG Brasil is now the second largest privately owned power generator in Brazil. “[Foreign exchange] is a major risk for foreigners because the currency is not stable. But if you do the maths, if you look at a 10- or 20-year cycle, that will make a much smaller difference,” he says.

China is proving a key long-term partner for Brazil. It has committed $15bn to the Brazil-China Cooperation Fund, three-quarters of the total, which will be invested in infrastructure. It has also provided $37.7bn in capital expenditure between acquisitions and greenfield projects across a variety of sectors since 2007. An additional $30bn has been announced but is yet to materialise.

Few investors can move on the long-term horizon of China or have its financial muscle. If successful, Brazil’s efforts to modernise its economic structure and open up to foreign firms can convince all others who do not, and transcend the country’s current political dramas.

Mr Allain is confident, saying: “PPI was created on May 12, 2016; at that time we had inflation close to 10%, recession and fiscal ‘pedalling’ [a trick used to artificially improve public accounts]. We looked at the horizon and couldn’t see [a way out]. One year later, we can. Of course, there are still some wounds in politics but in terms of the economy we’re back on track. That’s what long-term investors are considering.”

It can only be hoped that long-term investors will take note – enabling Brazil to escape its stranger-than-fiction drama once and for all.

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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