Brazil risks tumbling from boom to bust

Back in February, in an earlier Insight column, we highlighted the major build up of consumer debt at extremely high rates of interest, putting a significant cash flow burden on the repayment capacity of borrowers.

Since then, the situation has deteriorated further. Pressures are building in the Brazilian credit cycle.

The average rate of interest on consumer lending has jumped from 41 per cent in 2010 to 47 per cent most recently in May 2011. This rise from an already elevated level reflects the cumulative effect of tightening by the Brazilian central bank in order to contain inflation.

The consumer debt service burden, which stood at 24 per cent of disposable income in 2010, is now slated to rise to 28 per cent in 2011.

This compares with 16 per cent for an “overburdened” US consumer and a mid-single digit reading for other emerging markets such as China and India.

In short, the cash flow burden is astronomical and rising.

We calculate that the debt service burden for the so-called “middle class” in Brazil has now breached 50 per cent of disposable income, as high income earners have little need to borrow at rates which are punitive and most of the consumer credit is therefore being directed to the “middle class” for consumption.

The strain is already evident among the smaller banks, which are finding it difficult to access funding. The central bank has now rescued or taken over three banks in distress over the past six months.

Meanwhile, delinquencies in Brazil (defaults in excess of 15 days) have begun to move up rapidly, from 7.8 per cent to 9.1 per cent of total loans between December 2010 and May 2011. Delinquencies are now rising at a very hectic rate. They have risen at 23 per cent in the first five months of this year in absolute terms or at an annualised rate of 55 per cent.

This is troubling as credit indicators have deteriorated even as the economy has stayed strong and the unemployment rates are at a record low.

Normally credit indicators cyclically follow (read lag) the economic cycle. When they begin to deteriorate before any economic weakness it usually represents a structural problem relating to underlying cash flow or underwriting weakness in the quality of credit – Brazil has both problems.

Over time as the economy weakens this is only likely to exacerbate weakness in the domestic credit cycle and could potentially create a fully fledged credit crisis.

Ultimately, Brazil needs to restructure the way it dispenses credit to consumers. More of the lending needs to be collateralised (ie housing related).

And the infrastructure to support credit expansion needs to be put in place, via a credit bureau which is able to share “positive” data (before a customer default) across the industry.

More strategically, we believe the country has to build a higher savings rate and reduce cross subsidies to bring down the cost of credit to levels which are less punitive than currently both in nominal and, more importantly, real (adjusted for inflation) terms.

Brazil has a national savings rate which was 17 per cent for 2010 (this includes savings by consumers, corporates and the government). This compares with a developed market average of 19 per cent and is significantly lower than an emerging market average of 32 per cent.

Hence, if Brazil is to grow to its “potential”, it has to build a reasonable stock of savings which allows it to invest as the economy grows without creating bottlenecks and inflationary pressures that exist as a growth constraint today.

These three basic foundations (ie the right level of collateralisation, the right infrastructure to support credit extension and the right level of lending rates) need to be in place to create a self-sustaining positive cycle.

Without these buildings blocks we are afraid that Brazil will be exposed to significant boom-bust cycles. Unfortunately, we are currently at risk of transitioning from a boom to bust.

The markets seem to be taking cognisance of these factors gradually with the Bovespa index now down 10 per cent since the start of 2011 in local currency terms, making it among the worst performing markets globally.

Despite this, most analysts and investors still seem to be sanguine about the prospects for Brazil. The disconnect will be answered one way or the other before the end of this year.

Paul Marshall is chief investment officer at Marshall Wace and co-manager of the Eureka Fund. The piece was co-authored by Amit Rajpal, portfolio manager of MW Global Financials Funds

Japanese retail investors are set to pour $45bn into Brazil over the next twelve months, boosting the Latin American country’s already overvalued currency and putting even more pressure on local exporters, according to investment bank Nomura.

After reaching $30bn over the past year, investment by Japanese households in Brazil is currently running at $4bn a month, about as much as total foreign direct investment into the Latin American country.

Brazil has long attracted Japanese investors thanks to its attractively high yields and the strong immigration links between the two countries, but a recent flood of cash is likely to only add to Brazil’s currency problems.

“Japanese households buy a lot of mutual funds and right now the favoured currency of those products is the Brazilian real,” said Jens Nordvig, head of G10 currency strategy at Nomura. “They really have a love affair with Brazil.”

Japanese retail investments in Brazil now total about $95bn, according to Nomura, the Japanese investment bank with the biggest presence in Latin America.

Brazil’s interest rate, which at 12.25 per cent is one of the highest among large economies, is a key attraction for investors who can borrow at rock-bottom rates at home, such as the Japanese.

The stereotypical “Japanese housewife”, or private investor, is also more familiar with Brazil than other emerging markets as a wave of immigration a century ago means Brazil is home to the largest community of Japanese outside Japan.

However, these yield-chasing investors have pushed the Brazilian real to a three-year high against the dollar, making it even more difficult for the country’s manufacturers to sell their products abroad and compete with cheap imports.

Siemens, the German industrial group that ranks as Brazil’s biggest electronics conglomerate, recently warned of the danger of Brazilian “deindustrialisation” as the surging real made it harder to export out of the country.

Brazil is expected to keep increasing interest rates this year as it battles to control inflation, meaning that Japanese retail investment into the country could continue at the same pace “for the next several quarters, if not several years”, according to Mr Nordvig.

Even the devastating earthquake in March has had little impact on Japanese retail investments, which mainly take the form of currency derivatives or fixed income instruments.

“After the earthquake, people thought investment would drop off, but it seems to be pretty robust,” said Doug Smith, regional head of research for Latin America at Standard Chartered Bank.

While Japanese retail investors repatriated some money in the few days after the earthquake, flows to Brazil soon stabilised and were already higher in May than they had been before the disaster, said Nomura’s Mr Nordvig.