Former Brazilian Central Bank President Pastore Discusses Brazil’s Future Growth at EMTA Annual Meeting
Former Brazilian Central Bank President Affonso Pastore delivered the keynote address at EMTA’s Annual Meeting, held on Thursday, December 2, 2010. Citi hosted the event in downtown Manhattan, with approximately 300 members in attendance.
In his prepared remarks, Pastore discussed potential economic growth in Brazil. In 2010, Brazil grew approximately 7.7% as the country emerged out of a short recession, and, in 2011, Pastore expects the country to grow at 4.3%, below official government forecasts of 5.5% expansion.
Pastore discussed whether the government’s more optimistic target was achievable. Low domestic savings limits the rate of economic growth, he argued, and only with a significant rise in domestic savings would the economy be able to meet the government’s goal figure.
Pastore argued that an overheating Brazilian economy would need to be addressed by a rate-tightening cycle. While the base assumption was that the Central Bank’s autonomy would continue, the risk of political interference remained.
Taking into account productivity and population growth, Pastore calculated that gross fixed capital formation (GFCF) would have to rise to 25% of GDP in order to reach the government’s target growth rate. However, Brazil has not achieved that level of investment in the past 15 years. During the 1970s and 1980s, GCFC was higher, and the rate of domestic savings was also above current levels. However, since 1994’s monetary reform, Brazil has become more dependent on foreign inflows. The decrease in domestic savings was caused by lower government savings and economic policies that have stimulated domestic consumption (and thus leaving less funds available to save).
Assuming GDP growth of 4.3% in 2011, and the continued favorable terms of trade, Brazil’s current account deficit would climb to approximately $75 -80 billion from $50 billion in 2010. As a result, the BRL should appreciate further. Pressure to prevent further appreciation is strengthening, and the government has imposed taxes on some capital inflows in an attempt to counteract the BRL’s strength.
How could Brasilia’s 5% growth targets be reached? The government could cut government expenditures, or adopt policies that favor more FDI and equity investments (ie more BRL-denominated liabilities) or improve the regulatory framework in order to attract more foreign participation in infrastructure projects. Pastore speculated, however, that the incoming administration would not follow such a course.
Pastore stressed that the government’s goal of reducing the net debt to GDP ratio to 30% should only be achieved through larger primary surpluses. The 30% debt/GDP ratio is based not only on a higher-than-likely 5% growth rate but also on an assumption that real interest rates would decline to 3% in the near future, which he suggested was not a “realistic assumption.” He also criticized “creative accounting.”
The challenge for President Roussef is to stop the rising rate of government spending as a percentage of GDP. The signals being sent out regarding increased austerity were welcome, but not as significant as needed to lower the ratio to 30% of GDP.
Turning to a discussion of interest rates, Pastore noted that interest rates have declined in recent years. Aggregate demand has been boosted by both monetary and fiscal stimuli, and unemployment has reached historical lows. Economist consensus on inflation stood at 6% for the coming year, above the 4.5% target.
Pastore estimated that the Central Bank should start hiking rates with a 200 bps increase in the SELIC in early 2011. If so, inflation would still remain above targets in 2011 (at around 5.5%), but would reach 4.5% in 2012.
The Central Bank was in a classic conflict with the Finance Ministry, Pastore explained. The government would be concerned by additional fixed income flows and further appreciation of the BRL that would result from an increase in the SELIC, but was not willing or able to cut spending that would allow for less rate-tightening. Pastore admitted he was not sure “who would blink first.”
Following his formal presentation, Pastore responded to questions on reserve requirements (“not a perfect substitute for a rise in interest rates to achieve target inflation”) and the sophistication of the financial market in finding ways to avoid IOF taxes (“capital controls tend to work for a while, but there are many doctorates on how markets have devised ways to circumvent them”).
David Lubin (Citi) moderated the event’s investor panel. Lubin initiated the session by polling speakers on whether the Eurozone or a Chinese slowdown was the greater concern for 2011. Eric Fine (Van Eck G-175) was most troubled regarding Eurozone issues. Bladex Asset Management’s Tulio Vera specified that, in terms of asset pricing, Europe would be more problematic (“if Spain cracked, it would be...a Lehman II scenario”); however, on a global economic scale, China was potentially the greater threat (with a hard landing in China being transmitted to Latin America via commodity pricing).
Hari Hariharan (NWI) was puzzled by the unexpected rise of UST rates following the announcement of a second round of US quantitative easing (QE2). “Who is correct? Are nominal interest rates suggesting that policy is way behind, or are rates too bullish about growth which might not come to pass?” Both concerns over the Eurozone issues and a Chinese slowdown are integral to this question, he argued.
Is there a risk that Beijing would over-tighten? Dave Rolley (Loomis Sayles) agreed that Chinese authorities, being supersensitive to inflation, would ratchet up rates in the coming year. However, he concluded, the risk that this would destroy growth was minor.
Lubin also asked panelists about global “currency wars” and if speakers believed that China would continue to resist yuan appreciation, thus pressuring other countries to intervene in the FX market, impose capital controls and delay rate hikes. “Yes,” was the simple response from Rolley. Hariharan agreed this would continue to be an “enduring problem, and I foresee no flexibility on the part of the Chinese.”
What assets should investors own in 2011? Rolley expected most growth in 2011 to come from Asia, and was especially bullish on Asian corporates. He added, “you also have to think about Argentina…but have they ever paid anyone par?!”
Vera thought equities had the most upside potential of all asset classes, and Asian currencies were potentially a source of good returns in 2011 as well. Fine liked receiving rates from Mexico and Brazil, as well as Ukraine and Kazakh hard-currency debt.
Lubin concluded by asking what was the optimal level of foreign ownership. “You know it when you see it,” stated Fine, who argued that it could be too high in Indonesia while high levels in Poland and South Africa were probably acceptable. Hariharan admitted he was impressed by many EM officials’ knowledge of exactly how much foreign ownership there was of local debt issues. Rolley acknowledged that there were many “crowded trades” in local debt markets, while reasoning drolly “the alternative of holding cash is not good for long-term employment prospects.”
Joyce Chang (JPMorgan) moderated the event’s sell side panel. Chang reviewed 2010, with the strong performance in both EM equity and debt. Looking forward to 2011, Chang asked speakers for their thoughts on the likely success of the US FOMC’s quantitative easing (QE2) program.
“There seems to be consensus that the economic impact of QE2 is likely to be limited,” opined Barclays Capital’s Piero Ghezzi. More than anything else, it should reduce the tail risk of deflation, which was an important factor, but the cash injection would probably not have more than a minimal effect on growth. Ghezzi thought a third round was likely.
Danny Tenengauzer (Bank of America Merrill Lynch) agreed that a QE3 was likely, possibly of $400 billion. EM growth should drop about 100 basis points overall, to 6.4% from 7.4%, while US growth in 2011 would be 2.3% vs. 2.8% in 2010. Current account deficits would open in many EM countries, and increased FX volatility was also likely.
As for prospects for global growth, Kasper Bartholdy of Credit Suisse noted that growth in many EMs, especially non-China Asia, had been subdued in the recent months. However, signs of stronger growth in the US and China were welcome news. “QE is the lesser of two evils, it is worse if they don’t do it, and it will avert some tail risk,” argued Drausio Giacomelli (Deutsche Bank). The biggest risk to be wary of would be US deflation, he stated. He forecast 2.5% US growth, while acknowledging it could be seen as an aggressive forecast.
Goldman’s Paulo Leme suggested that there would be more surprises on the upside to US growth in 2011, announcing an even more bullish house view of 2.7% US growth. “Things are likely to work out in Europe, but there is going to be a lot of excitement” along the way, he added. Chang revealed her own perspectives, with 5.9% EM growth, and 1.6% developed market (DM) growth; “a widening differential,” she noted.
As for how European issues will affect investor impressions of EM risk, Ghezzi revealed that, in a survey of clients, a total of 65% cited concerns that DM fiscal issues would be the major theme of 2011, vs. 20% who cited bubbles and concerns over the results of loose monetary policy. He called on the ECB to take pre-emptive measures, rather than having emergency weekend crisis-solving sessions. He stressed that Spain does not have a solvency problem, rather any issue would be liquidity. Thus, the ECB could assist by providing liquidity and prompting the Spanish bank consolidation process. However, he had little faith that the ECB would actually take a pre-emptive stance.
Bartholdy stressed that those who feared the ECB did not have the resources to back Spain were wrong, while Ghezzi countered that the concerns were not for Spain but for additional EU sovereigns that would potentially follow any Spanish crisis.
Leme praised the pre-emptive stance former Brazilian president Cardoso and former Central Bank president Fraga had taken in 2002/3 in a similar circumstance when a solvent Brazil was threatened by a crisis of confidence. “They announced a commitment to adjust, they got the financing from the IMF and what could have been a big problem was eliminated in a couple of weeks,” he reminded attendees. Leme worried, however, about the painful political backlash that could divert policies.
Panelists discussed the potential for inflation to derail the EM success story. “There is no question that inflation has made a big comeback, it’s a theme for all of us with clients,” stated Bartholdy, expressing concerns over Central Bank dovish postures. At this stage, it is mostly a food price issue, which he attributed to weather phenomenons rather than loose monetary policy. In the future, food prices would stabilize at higher levels, assuming no further dramatic weather disturbances, he stated.
Tenengauzer was relatively dovish in his forecasts for EM Central Bank tightening. Everybody is expecting a return to rate-hiking mode, he observed, with Bank of America Merrill Lynch expecting 150 bps in Brazilian hikes and 75 bps in Chinese hikes over coming months. These were well below what has been priced into the market, he noted, and was based on a forecast that economic data in coming months would dampen pressure for Central Banks to take aggressive measures.
Giacomelli expected 125 bps in Brazilian rate hikes, although he expected the market to price in 250 bps in hikes. “We are not that hawkish, you have to differentiate between headline and core inflation.” Leme expressed a more hawkish forecast of 250 bps in SELIC rate hikes, adding “I see no reason for them to wait.”
“China is clearly not a country that is willing to tolerate a big slowdown in economic activity,” concluded Ghezzi, who derided 25 bp rate hikes and increased reserve requirements as “a joke.”
The outlook for Latin American countries generally looked good next year, benefiting from factors such as commodity pricing, FX realignments, etc., according to speakers. Leme believed commodities could outperform again in 2011, and would support Argentina (soy) and oil-exporting Venezuela and Mexico. Giacomelli expressed some skepticism whether Argentina would continue to be a good buy throughout 2011, although he was still recommending it. Chang noted that the majority of the EMBI’s high-yielders remained Latin American credits (“my view on Venezuela has always been ‘don’t over-analyze it!”).
Turning to China, and a discussion of whether investors had become too sanguine in their views on Chinese growth and potential China-related risks, Tenengauzer noted that his firm actually disagreed with the US Treasury stance that China’s current account surplus is too large, pointing out that the current account surplus as a percentage of GDP is declining rapidly. As a result, fair value for the CNY should be 6.50, which he recognized was out of consensus.
China would continue to be a strong driver of growth, according to Leme, and officials are able to keep it in the neighborhood of 10.5% annual growth. Tenengauzer forecast an 8.5% to 8.7% growth in China, and suggested India might take the lead from China.
“It is always fairly easy to see potential disaster scenarios in China, they just tend to not materialize,” stated Bartholdy. Complacency has occurred because the government has proven itself able to recapitalize banks in times of concern; the other potential issue is wage inflation contributing to higher CPI inflation.
The panel concluded with top trade ideas for 2011. Leme recommended equities and commodities for 2011, with fixed income less compelling next year. Chang agreed that equities would outperform and among her favored trades were currencies such as PHP, CHP, PLZ and MXP. Bartholdy liked high-yielders Argentina and Venezuela (the latter seconded by Tenengauzer), as well as the BRL, ZAR, PLZ and KRW.