January saw a cut in the Selic basic interest rate from 18 per cent to 17.25 per cent, the fifth cut in as many months. Brazil’s economic fundamentals are as strong as they have ever been. GDP growth is accelerating to 3.5 per cent and inflation will remain under control at 4-5 per cent. Real interest rates are currently over 12 per cent and should end the year in single digits. But, how is Brazil managing to go against the direction of global rates?
A combination of global risk appetite, strong capital inflows, a beneficial commodity cycle, a current account surplus and a healthy fiscal balance provide a solid backdrop to consistent growth, falling inflation, and hence interest rate cuts. The result has been three years of a strengthening currency, but this is both a risk and a trigger for further upside, as the strong real, supported by a positive balance of payments, will keep inflation under control, and further the interest rate cuts in a positive cycle.
Notwithstanding the strong currency and growing reserves, foreign flows continue to increase. Foreign direct investment in full-year 2005 will be close to $15bn, with estimates for 2006 of nearly $16bn. Monetary reserves are at all-time highs, closing 2005 at nearly $54bn. The government paid off the remaining $15.5bn debt due to the International Monetary Fund in December. The market continues to speculate on the possibility of investment grade status in the next two years.
The trade deficit remains the main factor influencing Brazil’s current account balance. The trade balance recorded a surplus of approximately $45bn last year. Export growth in 2006 is likely to slow relative to 2005, but should remain strong by historical terms, up 4 per cent to $120bn.
Longer term the strong real coupled with a downturn in the commodity cycle, could spark weakness in 2007 or 2008. Short-term risks centre on politics with the presidential elections looming. In 2001, the year of the last presidential election, the equity market fell 17 per cent and the currency depreciated 15 per cent against the dollar.
The stronger-for-longer commodity cycle, higher energy prices and growth in household income and lower interest rates all point to a continuation of growth in consumption.
Mike Reynal, portfolio manager and co-head of emerging markets, Principal Global Investors.
