Brazil Crisis Grows

Brazil is beset by economic and political woes, which might just make it the perfect time to invest in the country. LatAm INVESTOR investigates...

Had a tough weekend? Spare a thought for Brazil’s president Dilma Rousseff. On Sunday half a million Brazilians took to the streets demanding that she step down.

The protestors are angry at a massive corruption scandal that involved much of the country’s business and political elite – and perhaps even Rousseff herself.

The markets are protesting too. Brazil’s real has slumped to 12-year lows against the dollar, ratings agencies are threatening to downgrade Brazil’s debt to junk bond status while the main Bovespa share index is heading towards lows not seen since the Financial Crisis.

If anything the markets have even more reason to be angry than Sunday’s marchers. Brazil’s economy is heading into its most severe recession for 25 years, external conditions for the main exports are terrible and the country is no closer to solving its long-term chronic structural problems.

In short Brazil’s economy is a mess and it’s only going to get worse.

Funny money

The scale of Brazil’s corruption scandal, known in the media as the carwash because of a petrol station used to launder some dodgy money, is scary. Executives at state oil producer Petrobras overpaid providers for a series of huge contracts in return for bribes. Some of the proceeds of the bribes were then passed onto prominent politicians. The unveiling of this complicated saga is ongoing but so far Petrobras has written off $17billion for corruption related costs and inflated contracts.

"Companies implicated in the investigation have halted projects and Corporate Brazil more generally has been paralysed…"

But it’s not just the size of the scheme that is scary. It’s also the fact that it goes right to the top. The CEO’s of Brazil’s two biggest construction firms, Odebrecht and Andrade Gutierrez, are currently in jail facing charges. These guys manage billion-dollar companies and are highly respected business figures. Rousseff denies responsibility, but as the then Energy Minister, she was chairwoman of Petrobras during the time when Carwash was at its peak. Moreover her party is accused of receiving $200million of funny money from the scheme.

The massive operation to weed out criminal elements in the country’s political and economic elites is also starting to impact the general economy. As Neil Shearing from Capital Economics points out in a recent note: “The crisis has contributed directly to a collapse in construction and fixed investment, as companies implicated in the investigation have halted projects and Corporate Brazil more generally has been paralysed.”

It’s also weakening the government. Even if she avoids being impeached, Rousseff is increasingly looking like a lame duck – despite the fact that she’s at the start of her second term. She has an approval rating of just 8% - a record low for a Brazilian president – and is losing allies in Congress. That matters because it makes her less able to solve the horrendous economic problems.

Economic nightmare

Of course not all of this is Rousseff’s fault. Economies are cyclical and it’s her bad luck that certain cycles are working against her now. The Brazilian consumer is maxed out, household debt levels are at record highs and credit can no longer sustain the country’s shopping boom. The commodity cycle is also going the wrong way, with prices of iron ore, Brazil’s biggest export, at five-year lows and falling.

But many analysts also blame the government’s economic policy. Interference, lavish subsidies and protectionism have all created huge distortions in the economy and hindered Brazil’s ability to react to events.

Brazilians have had enough.

What’s more Brazil isn’t coming into this downturn in healthy position. The government’s budget deficit is running at 8% of GDP, while gross government debt stands around 70% of GDP.

To her credit Rousseff made some big changes at the start of her second term. New finance minister Joaquim Levy was poached from an investment bank and his hawkish determination to cut spending in a previous government earned him the nickname ‘Sissorhands’. But even Levy seems to be struggling to deal with this crisis, recently admitting that he won’t be able to produce the primary budget surpluses that he had promised for this year and the next.

And that’s what’s got the ratings agencies circling. S&P have put Brazilian government paper on a negative outlook. If the debt continues to grow – the most negative scenarios have it hitting 80% in the next few years – then Brazilian bonds will be downgraded to ‘junk bond’ status.

And as if all of that wasn’t bad enough Brazil still looks no closer to solving its long-term structural problems. A creaking, chaotic infrastructure system and poor state education provision both hamper productivity. Meanwhile a strong streak of protectionism is eating away at the international competitiveness of Brazilian companies.

Why on earth?

Given the economic nightmare described above you may be wondering why on earth you would want to invest in the place. The main reason is that Brazil is cheap. Its ongoing problems have brought the equity market to lows not seen since the Financial Crisis, presenting an interesting buying opportunity. The situation in Brazil is likely to get worse before it gets better, but things should start to pick up in 2016 or 2017.