Brazil has experienced one of the most tense electoral periods in its history, punctuated by episodes of violence and market volatility against a background of polarisation in public discourse.
As The Banker went to press, controversial far-right candidate Jair Bolsonaro had won the first round of the presidential election vote, facing leftist Fernando Haddad in the final vote on October 28.
Yields on Brazil’s 10-year bonds had been rollercoasting in the months to election day, reaching a peak of more than 12.5% in September. The main stock market index, Bovespa, has had a similar uneven performance. Both indicators improved on the first day of trading after the initial vote.
Wider concerns
Despite this volatility, some observers have remained optimistic. “Whoever is going to be in power will do what they have to do – [but] they will not do any crazy stuff,” says Ricardo Gelbaum, institutional relations director of Daycoval, a medium-sized bank based in São Paulo.
Aside from domestic politics there are still, locally and internationally, some important concerns at the top of bankers’ minds. The external environment, for example, is not as supportive as it used to be due to the normalisation of US monetary policy and higher US economic growth. This has negative consequences for a country such as Brazil, which has been attracting international investors looking for higher yields.
More widely, the current US administration’s stance on international multilateralism in trade and politics could play against the Latin American country as well as others. “The global macro scenario will be much less friendly than it has been during the past 10 years; globalisation will pause for [the next] 10 years,” says Roberto Sallouti, CEO of BTG Pactual. “My view is that [the global scenario] will not be as benign as it used to be for emerging markets.” This naturally has consequences for banks’ business and their appeal as equity investments, says Mr Sallouti, who adds: “If you have less globalisation, multiples [might] not be the same.”
The head of investment banking for Brazil at Bank of America Merrill Lynch in São Paulo, Hans Lin, says: “We need a reduction of the global volatility, less noise about trade wars. We need to have some time for the dust to settle on this volatility in order to have a more constructive market for investors, so we can have [higher volumes of] capital market transactions again.”
But the more immediate concern remains Brazil’s own economic environment. After two years of a crippling recession, gross domestic product (GDP) growth was about 1% in 2017 and forecasts for 2018 stand at a disappointing 1.4%, according to Brazil’s central bank. It is not only foreign investors that are voicing concerns about the country’s future; confidence has been muted among local businesses too. What is needed is a real “shot of confidence”, says Mr Sallouti.
Tempered optimism
In its Article IV consultation report in May, the International Monetary Fund (IMF) commented on the large gap between Brazil’s potential and actual GDP. “Investment is currently low due to a lack of confidence. The output gap is so big – you need to restore confidence,” says Mr Sallouti.
Daycoval’s Mr Gelbaum adds: “We have enjoyed good results [in the second quarter of 2018], and the bank is well capitalised, but we are worried because it is still difficult for us to have a long-term perspective.”
Others offer a tentatively more optimistic view. Sandrine Ferdane, CEO of the Brazilian subsidiary of BNP Paribas in São Paulo, says: “The rebound [in economic activity] has been softer than expected, but there are reasons to believe the country is going forward.” Meanwhile, Bradesco’s CEO Octavio de Lazari Junior argues that although the recovery may have been slower than expected, “it is on course and it is more widespread than it was last year”. But he acknowledges of the enormity of the challenges ahead.
“The banking industry challenges are closely related to the challenges of the Brazilian economy. The absence of a structural reform agenda in the country would keep consumer and corporate confidence low, with some impact on credit activity,” says Mr Lazari. “There may be a chance to reach [3% GDP growth] in 2019, but that would depend on swift progress on the reforms front, especially those that improve the business environment. We need to lay the groundwork to grow by more than 3%, especially in order to strengthen investment.”
Dealing with the deficit
The fiscal situation remains Brazil’s main weakness. The deficit, which amounted to 7.8% of GDP in 2017, is something that politicians have been looking to address sooner rather than later to avoid a change in investor sentiment because of its negative impact on rising public sector debt levels in relation to GDP. According to Bradesco, the public sector debt-to-GDP ratio went from 50% in 2014 to the current 77%. The IMF, which uses a different methodology, puts the ratio at 84% in 2017. The outgoing administration has attempted to rein in public spending by introducing limits, a move welcomed by international markets.
A key component of the broader reform package proposed by the government is still missing, however – that of pension reform, which is the country's most politically challenging change, as it could end what international observers believe are currently generous pension conditions. “The adoption of a public spending cap [by the outgoing administration] was an important step forward, but it needs to be complemented by a pension reform in order to be viable in the medium term,” says Mr Lazari. “The country would then experience growth again and this would boost fiscal revenues.”
The outgoing government sent a pension reform bill to Congress in 2016, but it was abandoned after a corruption scandal broke that involved outgoing president Michel Temer. After so many delays, there is a strong belief among the financial community that the election winner will have to grasp that nettle again. “Regardless of the election outcome, we are certain that pension reform is going to be one of the first things on the agenda,” says Mr Lazari.
Bank of America Merrill Lynch’s Mr Lin adds: “The biggest hole in our [public spending] account is pensions. If we don’t do that reform, [public spending will just keep] on going up. So there is no point having a spending cap without pension reform. That is why [it] is so important. We need to do it properly so we can have a better outlook for the future.”
A need for speed
The stakes are high – and the outcome will also depend on the depth of the reform. “If the new president does not manage to approve a pension reform quickly – a reform with a minimum of ambition, a good reform – we’ll face some risks in the macroeconomic environment. The risk would be a country with higher inflation and higher interest rates. Such risk is unfortunately very concrete in Brazil,” says Zeina Latif, chief economist at XP Investimentos.
In addition, the new president will need political skills to confront interest groups and to push his agenda through Congress.
There are other, more positively received reforms that have been implemented under the current government. The labour reform helped reduce labour costs and was cheered by businesses. “When my customers tell me about their business in Brazil, they often mention the labour law, which has allowed immediate productivity gains,” says BNP Paribas’ Ms Ferdane. “It is a government that took measures that companies consider relevant because they put the country on a recovery path in terms of productivity.”
Bank of America Merrill Lynch’s Mr Lin adds: “The Temer government did actually achieve a lot in terms of reforms. [And it] put together concessions, such as airports – they were able to bring strong international players. [State electricity giant] Eletrobras was quite successful in selling some [of its] distribution companies as well. That government had really put together the formula to bring investors back on the concessions.”
Cautious on credit
Solving Brazil’s challenges will likely lead to improving a number of suppressed indicators, such as credit ratios. As a consequence of Brazil’s anti-corruption investigation, known as Lava Jato (Car Wash), which began untangling a wide-ranging, high-profile bribery network in 2014, large public banks have cut lending and some large private banks have also postponed credit expansion.
Wider economic problems have further constrained lenders’ credit ability and corporates’ requests for financing. Credit to Brazil's private sector in relation to GDP has declined in recent years and, at 59.7%, the level in 2017 level was below that of 2012, according to the World Bank.
But this has a silver lining, says Daycoval’s Mr Gelbaum, who notes that businesses starved of financing will translate economic growth into higher demand for credit, potentially in a short amount of time. “Banks and companies are underleveraged. This is very positive because if things improve, the recovery will very quick,” he says. Daycoval already registered a 15% annual increase in credit in the first half of 2018, adds Mr Gelbaum. Uncertainty, however, is dampening any further optimism, with Mr Gelbaum saying: “It could be more, but we cannot yet see very clearly what is coming ahead.”
There are other challenges. XP’s Ms Latif states that banks in Brazil still have trouble recovering unpaid loans. “Here they only recover about 10% to 15%; in the US it is 80%. In other countries that are similar to us it is 35% to 50%. Credit recovery is very low, so the cost and risks of credit activity are high,” she says. This is why banks slam on the credit brakes at any sign of crisis because the loss potential is very high, adds Ms Latif.
Winning back foreign players
There are trends, however, that are reshaping banks’ credit activity and that are not a direct result of the economic and political turmoil. The digitalisation of banking products is the most obvious, and may also provide new funding sources to some. “There are a series of phenomena that are taking place in the Brazilian financial industry that may be a threat or an opportunity,” says BTG’s Mr Sallouti. “[New technology and digitalisation] will eventually lead to some democratisation of funding, with specialised banks and fintechs. Our expectation is that in four or five years we will be retail funded, which is a revolution. Instead of being 100% wholesale funded, we will be retail funded. This will allow us to have a greater credit portfolio.”
Bradesco’s Mr Lazari adds: “From the microeconomic point of view, a constant search for operational efficacy in banking will remain the greatest challenge in an environment where there are new players and new technology amid greater competition.”
Fierce competition, as well as economic and political challenges, have at times been strong enough to discourage foreign players from remaining in the country, says Ms Latif, as operational costs and level of risks have been too high to bear. “It is still a challenge to deal with this ‘Brazil cost’,” she says.
Sector-specific factors, such as digitalisation, are reshaping growth opportunities for Brazil’s banks. But these can play only a marginal role if economic and political issues remain unresolved. Brazil’s next president will need to push on with reforms and rebalance the country’s public finances if he is serious about reigniting economic growth.
