Home Banking Examining the Potential Impact of Brazil’s Woes on Latin America

Examining the Potential Impact of Brazil’s Woes on Latin America

by internationalbanker

By Gerren Bethel – International Banker

Brazil’s demise has been remarkable. Nearly every major macroeconomic indicator is at historically undesirable levels at present, from unemployment to inflation, and from GDP (gross domestic product) growth to public debt. Moreover, the situation has started to have a notable impact on its Latin American neighbours—negative in some instances, and positive in others—while the outlook for the entire region for 2016 and 2017 has, not surprisingly, been downgraded by most analysts in recent months. With the majority of countries in the region being net exporters of commodities—and with commodities accounting for an average of 70 percent of South American exports—the decline in commodity prices, as well as China’s economic slowdown and the beginning of the US Federal Reserve’s cycle of monetary tightening, have all weighed heavily on Latin America.

Brazil’s disastrous economic performance, moreover, is now responsible for a sharp decline in growth expectations for the region as a whole. Along with Venezuela’s dismal showing in 2015, the two countries are expected to drag down the rest of the region, with the World Bank estimating that output in Latin America and the Caribbean will be flat this year, down from a 2.1-percent growth forecast last June, according to its “Global Economic Prospects” report released in early January. South America alone is predicted to contract by 1.1 percent this year.

In 2015, Brazilian imports from South America dropped by 28 percent, according to Brazil’s foreign trade ministry. Brazil has significant trading relationships with many of its neighbours, especially Paraguay and Bolivia, which export approximately 30 percent of their total exports to Brazil, as well as Argentina and Uruguay, which send about one-fifth. The five countries together are known as the “Southern Cone” countries.


Bolivia and Paraguay are particularly exposed because their exports make up a much greater proportion of their overall economy—11.7 percent and 9.7 percent respectively—than Argentina and Uruguay. Bolivia’s main type of export to Brazil is natural gas and oil, with trade contracts currently in place that run for several years. For instance, the two governments are currently in discussion to renegotiate a gas-supply contract that expires in 2019. Bolivia is offering to sell liquefied petroleum gas (LPG) and liquefied natural gas (LNG) to Brazil, as well as offering beleaguered state-owned energy company Petrobras (Petróleo Brasileiro SA—Petrobras) a stake in its planned Tres Lagunas petrochemical plant. After a horrific year, however, Petrobras is now scaling down on its investments and assets in non-core segments, such as selling its 49-percent stake in its gas-distribution subsidiary Gaspetro. It also has plans to sell thermal power plants supplied by Bolivian gas. In terms of trade, therefore, Bolivia could be hit particularly hard by Brazil’s fall in energy consumption and investment.

The principle exports of Paraguay, in contrast, are agricultural commodities that, despite potentially suffering from a global slowdown in demand for commodities, are not tied up in rigid contracts. If Brazil’s demand continues to drop as expected, Paraguay can more easily relocate its agricultural exports from Brazil to other countries than Bolivia can with its oil and gas contracts. As recent Caixabank research attests, “the balance of commercial risks is more worrying in the case of Bolivia (due to its extensive trade and the composition of the goods traded) but somewhat less in Paraguay”.

From an overall economic perspective, however, Paraguay could be more at risk. The 2012 IMF (International Monetary Fund) study “Intra-Regional Spillovers in South America: Is Brazil Systemic after All?” concluded that Brazil-specific output shocks have a significant impact on its Southern Cone neighbours, and this impact is transmitted quickly, normally within the same quarter. The IMF found that Paraguay was particularly responsive to the cumulative impact of Brazil-specific shocks; indeed, a 1-percent percentage-point decrease in Brazil’s growth is thought to reduce Paraguay’s output by 0.9 percent. Direct investment in Paraguay from Brazil has more than quadrupled between 2007 and 2014, hitting nearly $650 million, while during the last decade, total investment between the two countries has grown by a staggering 276 percent. Forty-two Brazilian companies across a wide range of sectors also established a presence in Paraguay in 2014 alone, while another 400 have sent scouting missions since 2014. Paraguay is aiming to diversify its economy to strengthen its credit rating in the wake of Brazil’s troubles, according to Paraguay’s finance minister, Santiago Peña, who has recently moved to reassure investors following the downgrade of Brazil’s sovereign rating by Standard & Poor’s.

Andean Community countries, on the other hand, such as Ecuador, Colombia and Peru, have significantly lower trading dependencies on Brazil. Therefore, from a trade perspective, the spillover impact from Brazil for these countries should be negligible. Venezuela’s own economic demise last year, meanwhile, suggests it will remain vulnerable to Brazil’s decline. In 2015, the Chamber of Commerce reported that Venezuela owed $5 billion to Brazilian firms.

From a financial perspective, some neighbouring countries may have a modest cause to be concerned over the investments they hold in Brazil. The stock of foreign direct investment (FDI) in Brazil from Uruguay, for example, is approximately 7.9 percent of the country’s GDP, while the equivalent of 3.5 percent of Chile’s GDP and 1.1 percent of Mexico’s GDP have also been accumulated as FDI in Brazil, as of November 2015. As far as Brazilian investment in other Latin American countries is concerned, 5.2 percent of GDP is invested in Uruguay, 2.2 percent in Paraguay and 1.6 percent in Peru, with other countries in the region possessing considerably less. According to Caixabank research, this represents a low level of integration in the region, meaning that the impact of Brazil’s recession on Latin America is considered as “small to medium”.

However, some of Brazil’s investment ventures in Latin America have made headlines for the wrong reasons, and will therefore have a considerable impact on the region’s investment climate for some time. Indeed, the “Operação Lava Jato” (Operation Carwash) corruption scandal, which began in March 2014 with revelations of an unprecedented amount of bribery, bid-rigging and kickbacks at state-run oil giant Petrobras, has now led to an investigation of contracts for business in the wider region. Much of the investigation has centred on uncovering why the Brazilian government provided subsidised loans through the Brazilian Development Bank (BNDES) to construction companies in order to finance roads, hydroelectric dams and subway lines in neighbouring countries such as Argentina, Venezuela and Chile, as well as the Amazon, when many of these investments have long been considered economically unviable. It is now apparent that the construction companies were bribing politicians in order to secure such contracts.

In June 2015, BNDES was pressured into releasing data on foreign lending for the first time, which revealed the bank’s “alleged irregularities” in overseas business, as well as loans to businesses involved in the Petrobras scandal. Among the companies under investigation is Brazilian construction giant Odebrecht, which, using billions of dollars of support from BNDES, obtained contracts to build subway systems in Caracas, Quito and Panama City, as well as hydropower dams and other multimillion-dollar infrastructure projects throughout Latin America and Africa. Odebrecht was also instrumental in the development of Cuba’s Mariel economic zone. The BNDES data release revealed that the bank invested $682 million in loans into the project at interest rates far below the market rate, while Cuba promised in return to spend $800 million on Brazilian imports, as well as looking to Brazil for economic and political support in the wake of Venezuela’s demise. Given the expected US hegemonic influence on Cuba as it makes its economic transition in the coming years, Brazil is going to be hard pressed to exert much of a presence in the country. More importantly, however, should harsh punishments be given to the parties involved in the corruption scandal, it will prove to be increasingly difficult for Brazil to secure investment contracts in neighbouring countries, as well as globally, from a reputational perspective. It is likely that countries in the region will start to look elsewhere for investment partnerships, rather than be associated with corruption-ridden Brazil. President Dilma Rousseff is trying to limit the damage on BNDES by vetoing proposed laws that would provide transparency to the bank’s foreign-lending operations. Given the scope of Lava Jato, however, it is inevitable that further irregularities will be revealed.

Given the intense scrutiny on Petrobras and BNDES, one could assume that these institutions will play a more diminished role in foreign diplomacy going forward, while Brazil’s foreign affairs ministry (known as Itamaraty) will once again take the leadership mantle. The result of this, according to Ricardo Mendes, managing partner at Brazil-based business consultancy Prospectiva, will be that both Brazil and Argentina will likely become more cooperative within the Mercosur bloc (the sub-region of Argentina, Brazil, Paraguay, Uruguay and Venezuela). The two largest South American economies have indicated that they are ready to work together to secure a free trade deal with the EU (European Union), and will also attempt to gain enhanced Mercosur access to Asian markets through Colombia, Chile and Peru. Whether this partnership materialises, or indeed whether they achieve their desired results, remains to be seen.

Over the last few years, Brazilian banks have also expanded considerably throughout Latin America, with high market shares being achieved in certain countries. In Paraguay, 20 percent of the banking market is represented by Brazilian lenders, while they cover more than 10 percent of Uruguay’s banking sector. In Colombia and Chile, the Brazilian banking presence is around 6 percent, and in Argentina approximately 4 percent. Research from Spanish bank Banco Bilbao Vizcaya Argentaria (BBVA) asserts that the risk of contagion from Brazil to the wider region does exist, but the fact that neighbouring countries mainly contain branch offices, rather than subsidiaries, will be vital in restricting the shock effects.

Nonetheless, a moderate risk remains if conditions in Brazil continue to deteriorate. Latin America’s biggest investment bank BTG Pactual, for example, fired nearly 20 percent of its Brazilian workforce in late January. After former head Andre Esteves was arrested in November over connections to the Petrobras scandal, clients have pulled funds from the bank in droves, which has forced BTG to sell assets and downsize its domestic workforce. It is also currently in talks over whether to sell its Swiss private-banking subsidiary BSI, which has offices in Uruguay. While the rest of Latin America has not been sizeably impacted by BTG’s measures thus far, it is highly likely this will change in the future, especially given the number of countries in Latin America in which BTG has a presence, including Argentina, Chile, Peru and Colombia. Should Esteves be found guilty of significant wrongdoing, a further exodus of investor funds could be reasonably expected, with the resultant liquidity crisis prompting the widespread closure of branches in the Latin American region and beyond.

Some countries, however, could benefit indirectly from Brazil’s woes, with economic power now seen shifting to other major players in the region. As Latin America’s biggest economy declines, two of its Latin American neighbours are stepping up to fill the void—Mexico and, to a lesser extent, Argentina. Although the region’s two main economic powers, Brazil and Mexico, have a low level of financial integration, there is every chance Mexico can close the gap at the top. While Brazil has largely been dependant on China to drive its economic performance, Mexico’s largest trading partner is easily the US, where 80 percent of its exports are bound and where consumer demand is currently healthy. Although Mexico is a major oil exporter, and has thus suffered a significant setback from the oil-price collapse, economic growth was recorded at a solid 2.0 percent in 2015. Furthermore, the outlook for Mexican growth this year is expected to be even more positive, given the country’s solid economic fundamentals—a 2.5-percent inflation rate and unemployment well below 5 percent being among them—as well as a strong showing predicted for the US.

Moreover, investors are also now looking favourably towards Mexico these days, with the country looking set to take the lead from Brazil in terms of capital-market activity. Latin America’s investment banks suffered the worst year since the global financial crisis in 2009, with Brazil being the chief culprit. With its junk-classed sovereign debt staying out of the markets for more than a year, along with Petrobras, which has also remained mute in the wake of its corruption scandal, Brazilian risk premiums have risen dramatically, which has meant that numerous corporates have been unable to access capital markets. Indeed, by the beginning of December 2015, Brazil’s debt capital market (DCM) activity stood at just $70 million year-to-date, starkly lower than the $250 million posted in 2014 for the full year, or the $313 million recorded in 2012, according to figures from Dealogic. Mexico, meanwhile, generated the highest DCM and ECM (equity capital market) fees for investment banks, with 41 and 71 percent shares of total Latin American fees respectively. Last year, Mexican equity fees had topped the $100 million mark, while Brazil’s were less than $20 million—a new post-crisis record low. Investors wanting exposure to Latin America, it seems, are shifting focus away from Brazil and into Mexico.

With much of the responsibility lying at the feet of Rousseff, she is now the least popular president in the country’s history. With the possibility of impeachment proceedings against her being undertaken, opinion polls have her popularity rating at around 10 percent. Irrespective of whether Rousseff actually manages to complete her second term in 2018, it is clear that she has contributed to the shift in political thinking in Latin America. Along with her Argentine and Venezuelan counterparts Cristina Fernández de Kirchner and Nicolás Maduro, both of whom were defeated in recent elections, Rousseff is the latest regional leader of a left-wing, populist nature to display gross levels of economic and financial mismanagement. According to Eduardo Viola, a professor of international relations at the University of Brasília, these elections “mark the decline of the ideological alliance among leftist lines of thought that were hegemonic in the Union of South American Nations in the last decade”. With Mauricio Macri’s appointment, for instance, Argentina is now hoping to return to international capital markets after more than a decade of isolation; should Rousseff also be ousted, it is probable that a more market-minded government will take over. If Brazil moves towards a new economic model like that of much of the rest of Latin America, it is likely that investors will flock to the region once more.

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