The Battle for Brazil

May 10, 2016

Brazil is in crisis as the ‘new Latin America’ confronts the old in the region’s largest economy

Strategic importance

“Brazil is the country of the future and always will be” – the old saw about Brazil has been on the go for more than half a century but it never seemed more apt than it does today. A corruption scandal is tearing Brazil’s political and economic elite apart while the country is suffering its biggest recession for a generation.

Brazil matters for emerging market investors. Any general LatAm investment fund available for retail investors will have a big Brazil weighting. Which reflects both the enormous size of the economy – almost 40% of the region’s GDP – and its sophisticated capital markets, which are Latin America’s most developed and thus offer plenty of investment options.

But that’s not the only interest. Brazil offers a fascinating insight into the trends that are shaping Latin America. A simple, crude way to put it is that there is a ‘new Latin America’ which is battling to replace the old. And Brazil is the major theatre of war.

Old school politicians meet newly-independent institutions

Even for Brazil – a country well used to corruption scandals – the current crisis is shocking. Leaders of the country’s largest and most-respected corporations bribed the state oil company to award overpriced contracts. Some of the proceeds were then recycled to top politicians of various parties. The president is facing an impeachment process, while the former-president was suddenly made a minister in a bid to grant him extra protection from prosecution.

Brazil has had plenty of corruption scandals before. What’s different this time is that the institutions, such as the judiciary and the federal police, are managing to hold the politicians and economic elites to account. Politicians can no longer cover up their dirty deals and as a result there are Brazilian billionaires sitting in jail, something that didn’t happen before.

corrupt businesspeople no longer think that the government can protect them

One of the most interesting explanations for this comes from Lucas de Aragao, a director at Arko Advice a Brazil-based political analysis firm. He notes that elite unites within Brazil’s federal police have been given top training and equipment by the US and various European countries. The result is that a cadre of investigators are able to monitor the communications of the most powerful people in the country.

“This has had a profound effect because businesspeople no longer think that the government can protect them. Brazil has always had corruption but before, if you were a businessman corrupting a public official, you could expect some support if you were caught. But when you have a team of independent investigators hunting you down with top technology, it is hard for a government official to squash that. If you look at Mensalão (an earlier vote-buying scandal), there were only two plea bargains because most of those involved thought that they would be protected at some stage. So far with the Lava Jato we’ve had almost 20 plea bargains because those involved realise that they can’t be saved by a corrupt official.”

Lucas’s point was confirmed recently when Marcelo Odebrecht, the jailed head of the eponymous Brazilian construction titan, revealed that he would reveal information on the corruption scandal in a bid to reduce jail time.

It would be naïve to suggest that this scandal will rid Brazil of corruption forever. All countries, including the UK, are tainted by it. However, the egregious, shameless large-scale corruption that blights Brazil – and the rest of Latin America – becomes harder when you have independent institutions that hold politicians to account.

This can be seen in a wave of anti-corruption movements across Latin America. The central theme is that in most Latin American countries, true democracy is only around 30 years old. So you have a new generation, the first to grow up in freedom, which is not afraid to confront elites.

A new type of economic crisis

Economic crisis, like corruption, is also a familiar experience for Brazilians. Like the rest of Latin America it has suffered an extreme cycle of boom and bust. Spurts of growth in the 60s and 80s, were fuelled by foreign debt, which eventually led to a painful default when local currencies collapsed. That then led to long periods of stagnation, which is one of the reasons Latin America fell behind Asia in the development race.

But Brazil hasn’t made that mistake this time. At 70% of GDP Brazil’s public debt is large, but lower than most European economies. Crucially the government avoided the mistake of racking up huge dollar loans, and most is denominated in the Brazilian real and held by local investors. The country also has meaty foreign exchange reserves. Meanwhile inflation of 10% may seem high but is low and very controlled by Brazilian historic standards.

Brazilian policymakers deserve some credit for avoiding the pitfalls of their predecessors. But during the boom years, when commodity prices were soaring and Brazil briefly overtook Britain as the world’s sixth-biggest economy, they fell into a new trap.

As Latin American specialist at Japanese bank Normura, Tony Volpon, told LatAm INVESTOR:

The Brazilian government made huge steps in redistributing wealth and reducing poverty. In a country like Brazil, where there are lots of poor people, that is obviously a very good thing but raising your minimum wage can make your labour force unproductive. You need to have the right combination of capital [ie investment in capital goods and technology] to ensure that a labour force stays productive as the cost of that labour rises. But the Brazilian government was investing just 1% of GDP a year in the infrastructure works needed to boost productivity. The Brazilian private sector invested slightly more, reaching 21% of GDP at one stage, but that was still low compared to other emerging markets such as China.

This is the new economic challenge for Latin America. Apart from a few basket cases, such as Venezuela, most Latin American countries are in a solid macroeconomic position. They are not about to repeat the mistakes of the 20th century. But their next challenge is to improve productivity, which is woefully low across the region. So investors should look for opportunities in education, technology and infrastructure.