WSJ: Dark Side of Brazil's Rise

September 14, 2011

4 minute read

Brazil is probably the most exciting investment prospect in the Western hemisphere over the next decade, but with its rapid growth comes issues, some of which we've outlined in the past.

Much like India and China, they are having trouble dealing with all the easy money being created by Uncle Helicopter Ben (and Japan). There is little need for that money in a limp U.S. economy, with low yields - so outside of times of crisis, that money flows globally creating dramatic impacts on those countries. Brazil is one of the destinations, as the performance of its currency (despite efforts to tax foreign investment) has shown the past few years. The WSJ delves further into the 'dark side' of this country's rise.

Brazil is booming amid a tectonic shift in global investing toward the developing world that has lifted its stock market, strengthened its currency and provided financing for new ports and World Cup soccer stadiums. But while foreign investment is mostly a good thing, there are downsides. The abundance of cash has helped fund riskier bank loans and fueled a potential real-estate bubble. By some measures, the Brazilian real is now the world's most overvalued currency, and many local factories aren't competitive in global markets.
Daily life has become so expensive that movies, taxis and even a can of Coke cost more in São Paulo than in New York. Rio de Janeiro apartment prices have doubled since 2008, and office space in São Paulo is suddenly more expensive than Manhattan.
Concern about the strong real is a key reason why Brazil's central bank late last month cut its benchmark interest rate by half a percentage point to 12%, reversing course after a year of rate hikes. The move risks spurring inflation and spawned a debate in Brazil on whether the central bank had succumbed to political pressure. But Brazilian officials say the country's high rates have lured speculative foreign investments that pump up the real and hurt the economy.
Brazil's real has weakened 6% against the dollar since the central bank cut rates, but even so it is still up some 36% since Jan. 1, 2009.
Some executives in Brazil fret that the cost of doing business has risen so fast that their country may be unable to become the manufacturing power it has aspired to be for generations. Brazilian industrial production actually fell 1.6% in June from May for the first time since the 2008 global financial crisis. Factories are losing their overseas markets and getting beat by cheap imports because Brazilian labor, parts and transport have first-world price tags—even though Brazil still has all its third-world drawbacks, like bad roads, poorly educated workers and high crime rates.
Brazil isn't the only developing country encountering problems of plenty. In China, heightened investment flows have contributed to food inflation in cities that some economists say may provoke social unrest. In Turkey, the government has tried a similar approach to the one just adopted by Brazil's central bank—slashing interest rates to prevent inflows from strengthening the currency too much. But the lower rates have helped spark a big rise in bank credit and fears of a credit bubble.
Money flows easily into Brazil because it has a free-floating currency and sophisticated stock, bond and derivative markets, unlike China. Indeed, many investors seeking exposure to China get it by investing in Brazil instead because it's a major seller of raw materials to the Chinese. Brazil is the world's biggest seller of iron ore, beef, chicken, sugar and coffee. And it just made new oil discoveries off its coast that could make it into a leading global producer of that as well.
Of course, capital that floods into a country can flood out of it. Leaders in emerging economies are concerned that a financial catastrophe in the developed world—such as sovereign defaults in Europe—could cause a sudden reversal of investment flows. That would prompt jarring falls in currency, real estate and other prices that have soared in places like Brazil during the boom.
Brazil President Dilma Rousseff's eight-month-old administration has fought a difficult battle to keep the real from rising. Brazilian officials blame near-zero interest rates in the U.S. and Europe for making it possible for hedge funds to borrow cheaply in the rich world to place bets in Brazil. "We have to defend ourselves from this immense, fantastic, extraordinary sea of liquidity that finds its way to our economies in search of returns that it can't find in its own," Ms. Rousseff told Latin American leaders on July 28 in Lima.
Brazil has been announcing new measures almost monthly to stifle the flow, such as a tax on bond purchases, or to offset its impacts, such as a multibillion dollar package of subsidies for manufacturers hit by the soaring real. Manufacturers say the currency is still too strong and the subsidies aren't enough.
One reason the policies may fail: Even after cutting its interest rates to 12%, Brazil has among the highest real interest rates, or rates in excess of inflation, of any major economy. That makes Brazil a prime target for "carry trade" speculators who borrow money cheaply where interest rates are near zero, deposit it in Brazil and pocket the difference.
It turns out that international capital flows a lot like water. Close one hatch and it pours in another. Brazilian officials suspect that when the country moves to restrict speculative investments, the money is being disguised as direct investments in companies. The evidence is a 260% spike in foreign direct investment to $38.5 billion in the first six months of the year.
Armed with a strong currency and cheap financing, a new class of Brazilian jet setters are getting on planes and shopping like mad in countries where goods are cheaper. Brazilians spent $8.5 billion on overseas shopping sprees this year—60% more than last year. Malls near Miami are hiring Portuguese-speaking salespeople and opening Brazilian restaurants to serve them.
Credit bubbles are another concern. Credit is rising rapidly in the big emerging-market countries—Brazil, Russia, India and China. Lately, loan-default rates have ticked up in Brazil.