The Brazilian government and the Banco Central do Brasil (BCB) have presented a comprehensive list of measures to tackle the effects of the credit crunch and clogged up money markets. The extent and size of these measures suggest that policymakers in Brazil have recognised the severity of the crisis and are determined to address these challenges head on. While the country is potentially facing the biggest financial challenges since the troubling days of the 1980s and 1990s, the nature of the problem is largely exogenous this time around. Prudent economic and monetary policies have been a key anchor for foreign direct investment into Brazil in recent years and, in my view, preserving such credibility will be vital for the long-term stability of the economy. As such, Risk Watchdog will assess the likely effectiveness of recent key measures to avert a systemic crisis in Brazil.

Every Little Helps
In mid-October, the Brazilian government announced plans to extend loans to companies suffering from heavy foreign exchange and derivative losses, which have seen several firms freeze investment projects. For example, Brazilian pulp maker Aracruz Celulose is suspending an expansion project for one of its plants to preserve liquidity. The company lost some BRL2.1bn as the real continued to fall against the US dollar in October. Similarly, poultry firm Sadia has put on hold plans to build a plant in the UAE and in the southern Brazilian state of Santa Catarina. The government now estimates that more Brazilian companies may be in trouble, which could see fixed investments come to a standstill. Nevertheless, Brazil’s government will seek to avoid making a loss on the loans, and as such will only select companies with solid balance sheets. This should definitely help to keep ‘toxic assets’ off the government books for the time being.

President Luiz Inácio Lula da Silva signed a decree on October 22 enabling state-controlled Banco do Brasil and Caixa Economica Federal to recapitalise financial institutions in Brazil in return for equity. Caixa Economica will also set up a new unit, Caixa – Banco de Investimentos, which will buy stakes in homebuilders in an effort to maintain steady growth in the construction and homebuilding sector. The new unit will initially spend BRL2.5bn on acquiring homebuilders. The measures will seek to boost liquidity for small and medium-sized lenders, and help homebuilders overcome higher borrowing costs. Finance Minister Guido Mantega has highlighted that the federal government expects Banco do Brasil to help increase bank lending at lower interest rates. Moreover, Banco do Brasil is now also teaming up with Brazilian car manufacturers and will make use of newly acquired lending institutions to boost car loans to consumers. The bank is seeking the expertise of the car industry to increase its auto loan portfolio and help to keep Brazil’s car industry afloat – a bulwark of the economy in recent years.

Retail Sales Breakdown and Real Credit Growth, % chg y-o-y

I think that moves to boost consumer and mortgage lending, while potentially supportive of economic growth over the coming year or two, could exacerbate Brazil’s problems over the longer term. Although exposure to US subprime mortgages is very low in Brazil, I’d caution that Brazil has accumulated its fair share of risky loans. Soaring growth figures in credit card and personal loans over the past two years may lead to a hard lending crunch in Brazil’s private consumption sector. A recent spike in the spread of average consumer lending rates over the benchmark Selic target rate suggests that lenders’ asset quality (on consumer loans) is fast deteriorating. The risks, therefore, are that measures to stimulate consumer lending could add significant downside risks to economic growth, rather than alleviate them.

These developments follow an earlier decision by the BCB in October to ease minimum reserve requirements on banks, with the central bank estimating that the move will free up as much as BRL160bn of additional liquidity in the system. Nevertheless, high levels of risk aversion and deleveraging by foreign investors have seen Brazilian assets sell-off sharply as foreign capital flows out of the country. In an effort to reverse or put a stop to this, the finance ministry has now scrapped the IOF tax, introduced at the start of the year. The tax, which replaced the lucrative CPMF tax, levied a 1.5% tax on foreign capital transactions, and 0.38% on foreign currency loans. I think it’s questionable, though, to what extent, at a time of high global financial market volatility and risk aversion, these moves will help to resume short-term capital flows into Brazil. What is more, government efforts to free up liquidity, together with the slashing of the IOF tax will greatly increase fiscal uncertainty in the medium term. I believe that this could add significant downside risks to Brazil primary fiscal surplus.

Spread of Average Lending Rates over Selic Rate

Taking Off The Load
In an additional effort to keep lending in Brazil’s financial system going, the country’s deposit insurance fund Fundo Garantidor de Credito announced on October 27 that it is stepping up purchases of loans from small and medium-sized lenders. With an initial BRL8.5bn at its disposal, the fund will begin buying up loans to help unlock liquidity for smaller lenders, who have been hard-hit by the credit crunch. To be sure, the BCB has been encouraging Brazil’s biggest lenders to buy loans off smaller banks to ease drier liquidity conditions. The central bank has also gone as far as allowing banks to tap funds deposited with the BCB under its reserve requirements to pay off outstanding debt. Finally, the BCB has put as many as 30,000 currency swap contracts up for auction on October 27, allowing Brazilian companies to gain access to US dollars more easily. The move should also be supportive of the real in the short term.

This Must Be What It Sounds Like When Doves Cry?
Although I admittedly have some reservations regarding the latest joint efforts by the BCB and the finance ministry to ease liquidity conditions and help Brazil’s financial system avoid systemic collapse, the authorities are certainly moving in the right direction! However, more will need to be done, if you ask me, to avoid a financial crisis. For one, I am certain that monetary tightening is now officially over – never mind the ‘neutral’ tone by the BCB after keeping rates on hold at 13.75% on October 29 (Risk Watchdog doesn’t like to brag, but this was very much in line with his view!!!). While the bank will likely maintain a ‘wait-and-see’ approach for the remainder of the year, I think the dovish sentiment will eventually prevail by the early stages of 2009, so stay tuned for possible rate cuts.

International Reserves, US$bn

In short, any talk of ‘inflation targeting’ at this point would be completely ridiculous! Inflation concerns will need to take a backseat, if monetary policymakers if they want to contain the impact of tighter credit markets on the economy. The potentially disastrous fallout from a possible default in a neighbouring Latin American economy – a prospect Risk Watchdog does not rule out – should further provide impetus for growth-oriented policies. Therefore, I believe that interest rates may need to be slashed sooner rather than later. Although the central bank has up until now only reluctantly tapped its US$206bn in foreign reserves to prop up the real, I think that the bank’s vast arsenal of reserves should be sufficient to offset the side-effects of lower interest rates, and further unwinding of ‘carry trade’ positions as interest rate differentials with the US Federal Reserve funds rate will narrow (even as the Fed keeps cutting rates). However, with capital and financial inflows slowing and exports falling, reserves will unlikely grow at similar rates as seen in recent years going forward.