Capital Blight

The tremendous scarcity of capital and the limitations of the local equity markets in Brazil have prevented the country from successfully growing its corporate sector.

Brazil has depended on imported capital since its independence in 1822, when the new state took out a £2 million loan in London to reimburse departing Portuguese for property losses in the former colony. Scarcity of capital and recurrent debt crises have remained a critical problem ever since. Mauro Molchansky, executive director of Globopar, the financial arm of Brazil’s Globo media empire says, “The greatest problem in Brazil is to generate funding for growth. We have many ideas for future growth and we need to access the market. The challenge is to do this with an adequate cost of capital.”

Globo and other service sector companies that generate local currency revenues but raise debt mainly in hard currencies are particularly vulnerable to the dearth of local financing. Every time the real weakens, it adds to these companies’ debt service charges.

Yet Brazil’s capital markets, its financial system and public finances are evolving. Investors, issuers and intermediaries have grown in sophistication since President Fernando Henrique Cardoso stamped out hyperinflation in 1994 and opened the economy to world trade and capital flows. However, the local markets are still hindered by inadequate regulation, high interest rates – caused by high levels of government budget deficits and mounting debts – and poor liquidity. The result of this is short maturities, high borrowing costs (Brazilian companies issue little equity) and extreme selectivity by lenders.

The tremendous scarcity of capital and the limitations of the local equity markets have prevented Brazil from creating many new companies. Successful start-ups are rare. Small and medium-sized enterprises, usually the fastest-growing companies that create the most jobs, just cannot raise finance on reasonable terms. Bank loans for second-tier credits start at 40% a year, a rate that no legitimate enterprise can sustain for long.

The local markets are a second-best option for the largest and safest names, which can raise money overseas. Companies needing large amounts of long-term financing generally have to go to New York or London, just as their forebears did in the 19th and 20th centuries. Ronnie Moreira, finance director of Brazil’s biggest company, Petrobras, says, “We want easy access to all markets. The local market is important because when there is a crisis we know we can get funding. It may not be at a cost or maturity that we want but it is there when we need it.” Borrowing locally does at least have the advantage of eliminating exchange risk, a question of great concern this year, as the real has lost about one-quarter of its value.

For the first time in recent history, the government has allowed market forces to determine the exchange rate, intervening only rarely to iron out short-run market volatility. The central bank now sets short-term interest rates to meet its inflation-targeting policies, a more transparent and rules-based policy than acting to support the currency as in the past. The result is a substantial change in business culture and attitudes to risk. For decades, companies could borrow in dollars knowing that the local currency would depreciate at a manageable rate. If a major corporation drifted into trouble, its owners could count on a sympathetic hearing in Brasília, the federal capital.

Unprecedented Tranparency

This is no longer the case. Markets operate in unprecedented transparency. The government is subject to oversight from a combative Congress and aggressive news media, making sweetheart deals harder to carry out than before. With Brazil increasingly integrated into the world economic system, it is more vulnerable to outside financial market shocks – especially as its own public finances and external accounts are so fragile – risk on a regional and global level is a serious business challenge. Accounts of Argentina’s breakdown dominate the front pages of the Brazilian business press.

Daniel Dantas, a partner in the Rio de Janeiro investment firm Opportunity and one of Brazil’s most controversial entrepreneurs, comments that “There is a long-term growth trend in Brazil. This is a country that grows, that is dynamic. But we are more subject to crises than other, more disciplined countries. Every five years there is a moderate crisis and a major one every 20 years.” Less than a year ago, pundits forecast a year of high growth and low inflation but the outcome is just the reverse. Uncertainty on this scale means that businesses must continue to operate, as they have for generations, with lower levels of leverage than in more stable countries.

Companies that are less leveraged must either invest less and grow more slowly, or they must operate in sectors offering substantial margins. For most of the past 50 years, when Brazil was sealed off from the rest of the world as successive governments pursued import substitution policies, companies were able to earn handsome returns. As a rule, owners of these companies plowed most of these profits back into their businesses or expanded into new areas. Government loans on generous terms and the fabulous returns on financial markets during the years of heavy inflation in the late 1980s and early 1990s meant companies could live without the markets.

Growing international competition, the decline in government support and the loss of easy financial market profits have forced companies to be far more careful in the way they deploy their capital and raise financing.

It helps that the government says it has understood the importance of developing a local capital market. The finance ministry, central bank, the BNDES national development bank and the CVM securities commission are mostly run by people with extensive experience in the markets, united in nurturing a broad, sophisticated capital market. But Cardoso’s lame-duck government, bogged down by immediate political troubles and a worrying economic outlook, has done little to reform the markets or restructure the social security system.

A Witches Brew

The energy crisis, caused by low rainfalls and inept planning in Brasília, has begun to heighten political tensions sooner than most political analysts had expected. Presidential elections are due in October 2002. The decline in Cardoso’s popularity has raised concerns that a leftist or populist – indeed a combination of the two – could win the polls. The four leading presidential candidates are all from opposition parties. José Serra, the health minister and the government’s favored candidate, ranks fifth with 6% support. Political uncertainty is adding to the witches’ brew of fallout from Argentina and the worsening economic outlook in Brazil.

The good news is that Brazil’s political system, its courts and civil service, and banking system are reasonably solid and should be able to withstand political and economic stresses – even the election of a leftist candidate, perhaps even Luis Ignácio Lula da Silva, leader of the Workers Party (PT) and four-time presidential candidate.

The government, which earlier had hinted that it would not renew its International Monetary Fund program when it ends in November, in August borrowed $15 billion from the Fund to help insulate it from the effects of the crisis in Argentina. Without this addition to its financial armor, the government would struggle to contain speculation as markets become more uncertain and less liquid moving into 2002.