Brazil, the Troubled Emerging Market

Soccer, Bosa Nova, partying and food. These are the things that come to mind when you picture Brazil.

But despite all the positives of Brazil, the country has been locked in a difficult battle to produce sustainable growth and prosperity.

The current World Cup isn’t much help for this famed emerging market, as the international sporting event contributes surprisingly little investment to the Brazilian economy.

The troubled star

The ‘BRICs’ is a term coined a number of years back by Jim O’Neil of Goldman Sachs to describe the most promising emerging markets. The first letter of the acronym stands for Brazil.

As much as I’d like to give you some good news about this emerging market, I can only give you bad news about the state of the Brazilian economy.

Inflation continues to be a problem, the economy is producing an expanding current account deficit, business confidence has gone as low as it was during the worst of the global financial crisis, manufacturing is in contraction, the service sector is barely expanding, industrial production is in contraction, capacity utilisation is at only 80%, and consumer confidence has been deteriorating for more than three years.

I told you. There’s not much to get excited about.

What’s making the already difficult business environment in Brazil more difficult is the cost of capital. The central bank interest rate is above 10%. Even worse, the banking lending rate is just below 50%.

This means return on debt capital has to be more than 50% just to break even. This puts more pressure on firms with leverage. Consumer credit card interest rates average 145%. This is hardly encouraging for boosting the economy.

So what happened to the once promising star that was Brazil?

Some of the key problems include a lack of infrastructure investment, protectionism and high taxes.

Despite having the 10th largest railway network in the world in 2011, and having had the fourth largest road network in 2004, infrastructure investment has been poor over the last decade. Infrastructure spending averaged 2.2% of GDP between 2000 and 2011. That was below global average. Only 14% of the roads are paved.

Internet penetration is 50% in Brazil. Although this is not an embarrassingly low number for an emerging economy, Brazil can certainly benefit from higher internet penetration, especially considering that its urbanisation rate is already 86%.

As for the impact that has had on Brazilian stocks, the Sao Paolo stock index has turned out a 249% return over 13 years. That has tracked commodity pricing.

However, the appreciation on the Real was 100%. This would have wiped out a large portion of your Brazilian equity investment return. In addition, the appreciation and inflation resulted in higher labour costs (2011 labour costs were three times higher than 2003 levels) and reduced export competitiveness.

The mechanics

It’s hard to classify Brazil as an emerging market in some respects; while in other ways, Brazil operates similar to other emerging markets.

Brazil has a large services sector. Its agriculture sector is 15.7% of the economy; however, this is larger than its entire manufacturing sector at 13.3% of GDP. This means most of the population lives in urban areas employed in low productivity service industries. There is no doubt that having a more competitive manufacturing sector would lift the country’s productivity.

In most other areas, Brazil is a typical emerging economy. The country has a GDP and a GDP per capita that are driven by urbanisation. Investment and lower unemployment helped to drive up GDP in the last decade. However, it’s hard for Brazil to boost its economy with such a small manufacturing sector, which inevitably leads to low levels of fixed investments.

So, thank god for US$11.5 billion spent on new stadiums for the World Cup. However, is that money well spent? How much use will Brazilians get from this infrastructure once the tournament is over?

Read the rest of this article at Money Morning