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AmericasMarch 18 2011

Does Brazil have a credit bubble?

Fears expressed recently that a credit bubble is emerging in Brazil have been dismissed by bankers in the country. However, there are other risks to the country's economy that do concern them. 
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Does Brazil have a credit bubble?Storms brewing in Sao Paulo, Brazil as credit markets expand too quickly

Brazilian banks are ebullient. In one of the most profitable financial sectors in the world, the big institutions – Itaú Unibanco, Banco Bradesco and Banco do Brasil – continue to post record numbers, boosted by high real interest rates and the rapid expansion of credit to middle-class consumers. In the past eight years, the amount of credit in the economy has more than doubled.

So soon after the credit crisis in the US, some observers have asked whether this may be contributing to a bubble, one early sign of which might be Banco PanAmericano’s distressed sell-off after it emerged that the bank was fudging credit losses in lending. One of the most provocative statements of this fear came from an article written by Paul Marshall, chief investment officer at hedge fund Marshall Wace, and Amit Rajpal, portfolio manager of MW Global Financials Funds.

The article was published in the Financial Times in February, and while it recognised that the total ratio of credit to gross domestic product (GDP) in Brazil is relatively low – 46% compared to 165% in the US – the authors argued that the cost of paying this down for Brazilians is ominous. They stated: “For consumers specifically, the ramifications are serious as the debt service burden has risen to 24% of disposable income and is set to rise further... the US consumer ‘blew up’ when the debt service burden hit 14%.”

Overblown concerns?

However, bankers and economists within and outside Brazil have come forward to argue that, despite some concerns, the Brazilian situation is quite different. They say the debt service burden has been stable and perhaps overstated, and that credit growth can continue without posing any real systemic risk to the national economy.

“You can never say that there is no risk of a credit bubble,” says Ilan Goldfajn, chief economist at Itaú Unibanco, Brazil’s largest private sector bank. “But I don’t think the risks are overwhelming or that the risks are higher than in other places outside of Brazil.”

There are some obvious differences between the situation in Brazil and that of the US in 2008. Mortgage lending makes up less than 5% of GDP and securitisation plays no role. Barclays Capital also responded directly to Mr Marshall and Mr Rajpal's article, challenging the notion that debt servicing costs are too high or have even been growing.

BarCap's analysts “looked into official (and hard) data to prove the opposite” of the conclusion reached by the article. “Extended loan terms and lower interest rates, both a result of increased penetration of secured types of consumer loans (auto and payroll loans explain roughly 70% of the growth in consumer credit), led households to manage to keep total debt service fairly stable throughout [the past four years] at 20% to 25% of total income.”

Silvia Valadares, head of economic analysis at Itaú Unibanco, says relevant calculations for the consumer debt service burden (consumer debt servicing as a percentage of GDP) come up with widely varying outcomes – and that Brazil’s is still likely to be lower than that of the US. “When we calculate it as a ratio of GDP we find that it was 10.5% in the US in 2007, and for Brazil now it’s 9.7%,” she says. “Next year we don’t expect it to go much over 10.2%. Since we have started from a much higher rate of delinquency than the US, much of that has long ago been priced in.”

Generating growth

Brazil’s current economic rate of growth – 7.6% last year and projected at 4.5% this year – is partly the result of the fact that the stability that allows for credit growth is present for the first time in a generation. Before the introduction of the real and very high interest rates in the 1990s, the hyperinflation they were meant to tame meant credit was unavailable to large portions of the population. The secular trend of interest rates to fall – and this very low starting point – leads many to believe such growth is sustainable. Walter Malieni, director of credit at Banco do Brasil, points out that the credit to GDP ratio in stable Chile is almost double that of Brazil.

Others offer views on why the situation should not be blown out of proportion. “I don’t think there is a systemic risk,” says Tony Volpon, head of emerging market research for the Americas at Nomura Securities in New York. “Credit growth is concentrated in the new middle class, a large part of the population, but they started with almost no credit at all. They have seen very big increases in wages and income over this time period so there has been some fundamental backing to this [credit growth]. And the large banks which are systemically important are pretty well capitalised, much more than when the US had credit problems.”

Brazil’s own history of financial crises means it has a very conservative set of regulations, which requires banks to demonstrate a high degree of transparency and large capital reserves. Many of the large banks hold more capital than is required by law.

As for the cost of servicing debt in Brazil, Mr Volpon says: “We looked at the data in the Financial Times article and we came up with numbers which were nowhere near what they got.”

Mr Goldfajn explains that it might be counter-intuitive that credit as a ratio of GDP would rise so fast without a corresponding rise in the cost of servicing that debt, but the rapid maturation of Brazil’s credit markets have made that possible. The increased levels of debt are spread across longer terms and with lower rates.

“There are three important things: the amount of leverage, the interest on that leverage, and the maturity of the leverage. If at some point we start to see debt going up without the other two changing, then we should be worried. But we aren’t seeing that at the moment,” says Mr Goldfajn.

A note of caution

Of course, the widespread view that the fears of Mr Marshall and Mr Rajpal were overstated does not mean there are no grounds for caution. After the crisis, the Brazilian government instituted a largely effective set of counter-cyclical policies and is only now applying the brakes. The government expanded spending but also credit into the economy, led by state-run Banco do Brasil, and may not have stopped quickly enough. And there is the issue of high levels of capital inflows to the country and the risks they pose for moderating credit growth.

In a speech delivered in February, Luiz Awazu Pereira da Silva, deputy governor at the Central Bank of Brazil, said that although the bank redirects these inflows into reserves, “there is always a part that stays in the market. And that part has been getting bigger in the past few months, adding to a less than healthy expansion in [consumer] credit.” But at the same time, he does not judge this as a big risk to the economy and cites the government’s “macro-prudential measures”, largely increasing banks’ reserve requirements, as adequate to the task of handling it. “It is important to emphasise that, with regards to credit, we only saw it necessary to mitigate risk in certain types of consumer credit,” he says.

The expansion in consumer credit to the new middle classes occurred largely in payroll loans, so-called ‘consignado’, and auto loans – as a post-crisis measure the latter also had the advantage of boosting Brazil’s auto construction industry. Mr Volpon says that, as with some of the fiscal heating that happened at the end of the presidency of Luiz Inácio Lula da Silva, this credit expansion might have overstepped recently. “There has been some exaggeration in certain segments of the market – in the auto sector, car loans, basically – and the central bank itself has realised that things have got out of control,” he says, adding that he central bank is trying to address this.

Ms Valadares says that even with the state-led push to expand credit, there has actually been a deceleration in recent years. “During the crisis, in 2008, we were increasing loans in real terms by 20.8%, then in 2009 by 15% and in 2010 by 12%.”

“Fiscal policy was too expansionary [after the crisis was resolved],” says Mr Goldfajn. “Government credit expansion also needs to understand that it should not be expansionary after the fact. But there are other risks I am more concerned about than the possibility of a bubble,” he says. “There is the fiscal expansion, the capacity of financing long-term investment, among others. These are important issues that concern me a lot more than whether there is a bubble in credit.”

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