Latin America (Brazil): That was then, this is now

The bullish case for Brazil goes far deeper than its wealth of natural resources. As the largest Latin American country, Brazil has undergone a fundamental economic transformation over the past two decades, and in recent years has earned new-found credibility fighting the ghost of hyper-inflation.

Changing demographics and hyper-inflation

From the 1980s to the early 1990s, Brazil's economic development was often crippled by hyper-inflation, with growth proceeding in fits and starts. Until recently, each government sworn into office immediately announced revolutionary stabilisation plans, which inevitably resulted in failure. This story began to change in 1994 with the adoption of the Real Plan which led to an appreciation in the currency, breaking the inertia of inflationary expectations. Later, three new macroeconomic fundamentals or 'pillars' were implemented: consolidation of the inflation targeting regime, adoption of a floating exchange rate, and a more serious approach to fiscal policy.

The Real Plan and its related economic model were put into practice by a team of prominent thinkers led by former finance minister Fernando Henrique Cardoso. Unsurprisingly, Cardoso capitalised on the success of inflationary stabilisation by winning two consecutive presidential elections. After this period of comprehensive economic modernisation, the candidacy of Lula da Silva in the 2002 election sparked concerns in the market, due to suspicions of his affiliation with the left-wing Workers Party. Such fears proved unfounded, as the Lula administration maintained Cardoso's economic policy orientation, and to underscore its commitment, the new government increased its target for the primary budget surplus and upheld the Brazilian Central Bank's (BCB) operational autonomy.

The Real Plan's accomplishments

The efforts of the Cardoso and Lula administrations paid off with a turnaround in external accounts, moving the country from a trade deficit of US$6.8 billion in 1997 to a trade surplus today of around US$25 billion. Throughout this period, Brazil diversified its export base, increased its number of trading partners, and managed to attract significant foreign investment. The country's external indebtedness has been reduced to less than 15% of GDP, from around 41% in 1999. International reserves, which climbed from US$40 billion in 2002 to the current US$203 billion, have made the country a net creditor, rounding out the improvement in the balance of payments.

In recent quarters, the trend in the current account balance has reversed from surplus to deficit, but is still modest compared to its peers. Additionally, the BCB has accumulated a substantial cushion of international reserves as a hedge against potential capital flight. We believe that Brazil has successfully changed the perception that it has a fragile economy, with a brittle currency that is prone to violent swings.

Improving fiscal and monetary policies

Another important structural change has been the development of sound fiscal policy, reflected in the fiscal targets that have been achieved every year since 1998. Changes included the approval of the Fiscal Responsibility Bill, which imposed severe penalties on elected officials who exceeded budget constraints. Furthermore, federal debt has been restructured on more favorable terms by eliminating currency-indexed bonds. The credibility achieved by the BCB has been another big factor in the more stable inflation outlook and in recent years, inflation targets have been consistently met. In both 2006 and 2007, inflation was lower than the target's midpoint. The success of the BCB's inflation fight has been praised in the Financial Times and Le Monde.The taming of inflation has created positive ripples throughout the economy, resulting in reduced real interest rates and an expansion in credit. Corporations and investors are making long-term decisions with greater comfort, with a foundation in place for gains in real income and productivity. Capital markets have become more sophisticated, with improved corporate governance and increased opportunities for investments and business expansion. At the same time, labour regulation adds predictability to the wage picture. Corporate growth is likely be driven by the country's burgeoning middle class and the continuing entry of millions into the consumer goods markets. This establishes a solid base for expansion, driven by domestic factors such as consumption and investment, as opposed to the reliance on trade-driven growth and the capital flight of bygone days. All in all, the past couple of decades in Brazil comprise a remarkable evolution. It has progressed from a rustic company model, in which state banks picked the winners and were the sole available sources of funding, to a management optimisation model, whose ultimate goal is to increase shareholder value.

Conclusion

The case for investing in Brazil is a strong one. The world's hunger for commodities, despite the current cyclical slowdown, is likely to increase in coming years, driven by infrastructure investment in the developing world, global population growth and increasing income per capita in emerging countries. Brazil has proven itself capable of fundamental economic transformation and worthy of optimism towards its ability to make further reforms. The growing maturity of its capital markets has been driven by sustained macroeconomic stability, declining real interest rates, better corporate governance and management practices, and the steady growth of its middle class consumer sector. Such accomplishments highlight the attraction of Brazil to global investors as a society committed to free markets, growth, and as an arena of expanding investment opportunities.