Rising risks and rates

During the boom years following the 1994 introduction of the Real Plan, private sector hard currency debt load rose strongly. Local interest rates were high and the country had a managed exchange rate with a predictable downward path. Borrowing in dollars – Brazilian companies still prefer dollars over euros or yen – was both cheap and easy.

These days, though, the picture is very different. Although hard currency debt is still just about the only source of long-term finance available to Brazilian companies and is likely to continue being so for many years, the risk of carrying this debt has risen dramatically since the 1998-1999 currency crisis.

By late 1998, following Russia’s domestic debt default and as hedge funds massed against the real, most Brazilian borrowers realized the game was up. A bulging current account deficit led to a collapse in international confidence, which led to an outflow of billions dollars. By January 1999, the government had to stop supporting the real, ending a five-year peg to the dollar and allowed the currency to float. Those that had decided to ignore the warning signals or were scared off by the rising cost of hedging, lived to regret their decision when the real crashed by 30% on January 13, 1999.

This year, risk has grown more extreme with the collapse of Argentina, which has impacted Brazil directly and interrupted a steady downward trend in interest rates. The Selic benchmark interest rate is now at 19% a year in nominal terms, though it is lower in inflation-adjusted terms.

Hedging has become a fact of life for every large company or bank. The real lost 20% of its value in the first half of this year, driving up the local currency cost of servicing foreign debt by the same amount.

Few Taking Chances
Nowadays, few are taking any chances, particularly companies in the services sector that have little or no hard currency revenues, but have taken on large dollar-denominated debts. Mauro Molchansky, executive director of Globopar, the financial arm of Brazil’s Globo media empire, says: “We have hedged cashflow for the next 10 months. Hedging is always a matter of concern, particularly with presidential elections next year. We must borrow in dollars because the local market does not offer good opportunities for us all the time.” Molchansky swapped a ¤100 million, three-year issue into reais in May. He says, “Our timing was good because interest and exchange rates were very favorable.”

Light Serviços de Eletricidade, the Rio de Janeiro power utility owned by Eléctricité de France, was hit by the 1999 real crisis when its $875 million debt rose by a third in local currency terms in just a few months. This forced the company to mount an expensive refinancing operation on the local market. Its burden of long-term debt has fallen as it is replaced with more costly short-term local debt. This time around, Lívia de Sá Baião, Light’s treasurer, says, “We have no unhedged outflows in 2001 and so the impact of the crisis on us was purely economic, not financial.” Light swapped a February $190 million-equivalent yen syndicated loan into reis pegged to the local CDI interbank rate on the day loan closed. Light now hedges half its debt in spite of the cost, which varies between 1% and 3% of the dollar amount.

Yet Light’s second quarter losses more than quintupled to R$264.7 million ($106 million), from a year earlier due to the impact of the weaker real which pushed up the local currency cost of servicing its hard currency debts. Michel Gaillard, Light’s president, says the high level of debt meant EDF “Will have to assume the responsibility for making investments” in the company. Light had R$8.38 billion in debt at the end of the March quarter, of which about 60% was denominated in foreign currencies. Light has one of the highest debt loads among large Brazilian companies.

The power industry is one of the most exposed to currency risk. Following its partial privatization (the federal government still controls most generating capacity and some state governments still own distribution networks), new owners took on debt to finance their acquisitions and pay for modernization and expansion programs. However, their revenues are entirely in local currency and subject to only periodic price reviews by government regulators. For instance, second-quarter net income at Cemig, Brazil’s largest integrated power company, crashed by 80% to R$26.6 million ($10.6 million). CESP, Brazil’s third-largest power generator, said its losses jumped 94% in the second quarter.

GloboCabo, the country’s largest cable TV operator, is also exposed to currency mismatch: half its debt is in dollars, as are the costs of its content, while revenues are mainly in reais. Furthermore, it is very sensitive to fluctuations in the economy since Brazilians cancel their cable TV services more readily than in the US when incomes fall.

Appropriately, then, GloboCabo’s second-quarter results were worse than most analysts had expected. Its losses nearly tripled from the same period last year due to the rising cost of servicing its debts. The company posted a $91.2 million loss, up from a loss of $34.9 in the June 2000 quarter. Globo Cabo has become the second-worst performing stock on the São Paulo Stock Exchange’s Ibovespa index, shedding nearly two-thirds of its value in dollar terms. GloboCabo, which has $641.4 million in debt, announced in July it that was slashing jobs and its investment budget.

Refinancing Risk
Analysts at Lehman Brothers warn that the company’s “current debt amortization schedule calls for payments of $103 million for the remainder of this year. With $107 million in cash as of 2001, [GloboCabo] can barely cover debt payments in the event that it doesn’t generate positive levels of operating cashflow going forward.”

However, Moysés Pluciennik, the company’s president, says “Dollar debt was 58% of our total debt in July and all our short-term debt is hedged. Part of the foreign exchange impact is only an accounting effect, because not all the debt is due soon. But the real question should be, ‘Is Brazil feasible in terms of long-term financing?’ The answer is no.” Like most other Latin American countries, Brazil does not have enough long-term savings for long-term growth, he says. “That is why companies borrow in dollars for long-term finance and that is why you have to hedge your business. I am a sailor; when the weather is rough you lower your sails, so that is what we are doing now.”

Brazil is fortunate in having a large and complex futures market. São Paulo’s Bolsa de Mercadorias e Futuros is one of the world’s largest futures market (see article, page 27). The government – whose dollar-linked bonds are the universal hedging instrument – increased issuance of these securities in 1999 and in 2001 both to finance its deficit and to meet investor demand for dollar hedges from the private sector.

Manufacturing companies with an existing export business or those that have diversified overseas are in an easier situation. Gerdau, the steelmaker, made liability management an integral part of its corporate philosophy years ago when it began investing in steel capacity outside Brazil. It now gets half its revenues from exports or from foreign subsidiaries, mainly from North America. It managed to escape the effects of the collapsing real in the first half of the year on its net debt of R$2.7 billion ($1.08 billion). It said its net debt increased just 0.6% in local currency terms due the devaluation of the real. Gerdau’s gross debts of R$3.4 billion are split evenly between short- and long-term maturities. Roughly two-thirds of its debt is in hard currency, most of which is owed by Gerdau’s foreign subsidiaries. Half of the R$1 billion-equivalent in foreign debt owed by the parent company in Brazil is hedged.

Banks hedge obsessively too, since they get most of their long-term funding from international markets and lend to their local clients in reais. José Guilherme Lembi de Faria, executive director at Banco Bradesco, Brazil’s biggest private-sector bank, says “We want operations to be hedged. We can lend to a company and pass on the currency and interest rate risk to them and charge a spread. “However, this approach merely changes the nature of the risk, shifting it from a currency risk to a commercial risk and leaving the onus for hedging on the final borrower. Lembi de Faria adds that the bank can “Hedge by using dollar-linked government securities. Sometimes we want to issue debt in the international market, but there are not enough hedging instruments available in Brazil.”

With the external markets slammed shut, most companies have little choice other than paying down debt as it matures or refinancing it locally in the hope that the international market will reopen soon. Some large and well-known credits like Petrobras have issued bonds backed with political risk insurance, safeguarding payments in case of default or devaluation while others have set up ingenious international structures to cut their cost of funds.

But most corporates still have to take their chances in the high-cost local markets. At least Brazil is fortunate in having a reasonably deep local debt market, which will always be open for them, even if cost, maturity structure and liquidity leave a lot to be desired. No company can finance an industrial project in the local debt capital markets, which means it must either petition the BNDES national development bank for a loan or look overseas.

This is why 2001 is likely to become a banner year for local financing. In the first seven months of the year, issuance of debentures, the most common private-sector debt instrument, was R$7.24 billion. Issuance for all of last year, when international markets were receptive to Brazilian debt, was R$8.75 billion.

The truth is, though, that the local capital markets are not particularly receptive to corporate issues. Banks will only lend to right borrower and at a steep price. A blue-chip company such as Telemar, the biggest Brazilian-owned telephone company, struggled to place a R$1.3 billion, five-year debenture in July at 70 basis points over the CDI interbank rate. This was slightly less than the return available on government dollar-linked paper. It later raised $1.4 billion in eight-year bonds from a group of banks and equipment suppliers to fund the building of its wireless network. Pension funds, just about the only buyers for corporate paper, prefer longer-dated government paper indexed to the dollar or inflation. Shorter-dated corporate paper is attractive only if it offers a particularly handsome yield.

Looking Locally
Partly because of this, the finance ministry and central bank officials running the national government’s finances are attempting to develop a sophisticated, broad-based debt capital market. Brazil still does not have a well-regulated, liquid and transparent secondary market for government or for corporate debt. Greater liquidity would make it easier to trade debt, improve price discovery, help push out maturities, encourage retail investors to buy debt and entice corporates to issue more on the local market.

BNDES, the national development bank, is doing what it can to improve liquidity and maturities for private-sector issuers. For instance, it has agreed to take a three-year put on corporate debenture issues to improve company liability structures and to encourage private-sector lenders to accept longer maturities. Investors know that if necessary, BNDES will buy the risk after three years and indeed, most do intend to exercise their puts. Eleazar de Carvalho, president of BNDESPar, the bank’s investment arm, says the put, together with contract standardization and Treasury efforts to build a yield curve, should make corporate debt more attractive to pension funds and other institutional investors that need to invest long term.

The bank has also developed more innovative financing structures, such as June’s unsecured five-year $200 million bond offering. The notes are exchangeable into American Depository Shares of Embraer, the regional jet maker and one of Brazil’s biggest exporters, at the note-holder’s option.

Sérgio de Oliveira, head of capital markets at Bradesco, says debt issuance business has dried up recently. “Each Thursday, we hold our capital market committee meetings but here are no deals at the moment. Interest rates are rising and companies are waiting. But this is temporary. Growth will recover. At the moment there is a bubble in fund-raising costs.” Before the central bank drove up its Selic rate, Bradesco and other banks were managing local market issues at prices that were close to or better than those available on the international market.

Oliveira concedes that one of the great shortcomings of the real market is an absence of any secondary trading in corporate debt. However, the government and the investment banking association Anbid are designing standard debt contracts with standard language covering terms, guarantees and pricing. The authorities hope this will encourage the emergence of a secondary market.