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RCS Investments: Brazil Special Report

RCS Investments: Brazil Special Report

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Published by Rodrigo C. Serrano
This is an extensive special economic report on Brazil, which reviews the country's economic history and the main impediments restraining long-term growth.
This is an extensive special economic report on Brazil, which reviews the country's economic history and the main impediments restraining long-term growth.

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Published by: Rodrigo C. Serrano on Oct 25, 2013
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| Rodrigo C. Serrano, CFA| SIPA | Columbia UniversityMaster of InternationalAffairs ’14 Candidate| New York City, NY| 01-305-510-0181| rcs2164@columbia.edu
October 24, 2013
LATAM Report October 2013: Brazil
Brazil’s emergence as a significant economic force over the pastdecade generated noteworthy investor enthusiasm. From 2003 to2008, an amalgamation of principal factors such as: macroeconomicstability stemming from prior reforms in the country, a recoveringU.S. economy from its 2001 recession, historically low global interestrates, appreciating commodity prices, and rising demand from Chinaset the stage for a sustained period of solid economic growth in Brazil. While most of the aforementioned tailwinds provided a soundincubator for solid economic growth across all BRIC nations during the same period; Russia, India, and China averaged 7.1%, 8.0%, and11.3% respectably; it was Brazil that more than doubled its rate of growth from 2.0% during 1997-2002 to 4.2% from 2003-2008according to the World Bank. This improvement was the best among the BRIC nations. As the 2008 financial crisis approached, many prominent investors and academics,fond of the bullish long-term prospects of the BRIC nations, entertained the decoupling thesis. From the Economist: “Yet recent data suggest decoupling is no myth. Indeed, it may yet save the world economy. Decoupling does not mean that an American recession will haveno impact on developing countries… The point is that their GDP-growth rates will slow bymuch less than in previous American downturns” (Economist: The decoupling debate). While the American downturn and subsequent financial crisis did precipitate a global recession largely debunking the idea that BRIC nations could step in and save the world economy,investor interest in Brazil only intensified when the event seemed like it would be little more than a slight bump in the road in terms of economic growth. Brazil’s economy registered ascant contraction of 0.3% in 2009, which was then followed the following year by thestrongest pace of annual growth in 25 years at 7.5%. Furthermore, Brazil’s Bovespa indexrocketed higher from the nadir of its stock market crash in late 2008 by roughly 129% by theend of 2009, the second best performance among BRIC nations over that period after Russia’sMICEX index.Despite these impressive performance statistics, since peaking in 2010, economicgrowth has been widely lackluster, souring investor sentiment and bringing into the spotlight the panoply of structural problems facing Latin America’s largest economy. This extensivereport covers a brief economic history of Brazil, a focus on the country’s current economicimpediments, and steps for positive future development.
Brazil’s economy is well diversified,having gone through profound transformation beginning in the late 1930s with the establishment of the
 Estado Novo
  by Getúlio Dornelles Vargas. During this period important building blocks, such as the formation of Companhia SiderúrgicaNational in 1941 and Companhia Vale doRio Doce in 1942, were established inorder to overhaul Brazil’s largely coffee- based economy, which suffered from a plunge in coffee prices during the GreatDepression, into a more diversified modernindustrial state. Impetus for reformstemmed from Brazil’s high vulnerability to terms of trade deterioration, which would lead to capital flight. Economic growth throughout World War II was relativelymuted and largely consisted of a recoveryin the utilization of excess capacity caused by the Great Depression. This interval was followed by a brief period (1945-1953)of trade liberalization coupled with a fixed-exchange rate. These policies precipitatedanother balance of payments crisis. It wasduring Vargas’s second term (1951-1954) that Import Substitution Industrialization(ISI) was strongly embraced.ISI was an economic policy espoused by the Singer-Prebisch thesis of inherentinequality in the world economic system.The policy stressed domesticmanufacturing of products in order toreplace imports. Various tools wereimplemented to achieve this goal including:high tariffs to increase the costs of imports to the consumer, discouraging demand;government subsidies to increase adomestic company’s competitive advantage versus its foreign competitors; and anovervalued exchange-rate to discourageforeign direct investment, while facilitating purchases of capital goods by domesticcompanies to invest in domestic industry.“Latin American economists, in the eraafter World War II, argued thatstructurally the global economy worked infavor of countries in the core of the systemand against countries in the periphery.The periphery supplied raw materials and was dependent on the core for markets,investment, credit, and manufacturedgoods. In general the prices for rawmaterials and agricultural commoditiesremained low and the cost of manufacturedgoods rose. The structural argument wasused to promote import substitutionindustrialization or ISI. Domesticmanufacturing was encouraged to replaceimports” (Blouet p.8). Over the following3 decades until the 1980s, Brazil wouldincorporate varying degrees of ISI tonurture its infant industries and diversifyits economy.The results of ISI throughout Latin America were mixed in general. Returning to Blouet:“Advantages of Import SubstitutionIndustrialization were: 1. Economies become more diversified and lessreliant on commodity exports; 2.Manufacturing adds value in the production process and generatesincome; 3. Industrialization creates jobs and should reduce unemployment; 4. Producing goods at home reducesimports and outflows of currency; 5.Higher protective tariffs on importsgenerates revenue for governments…Disadvantages of Import SubstitutionIndustrialization: 1. Competition fromimported goods is lost; Consumers payhigher prices; 2. The licensing, bygovernment agencies, of favored
manufacturing companies opens the process to political pressure andcorruption; 3. Favored companies canallocate the market between them andnot compete aggressively; 4.Manufacturers, with a comfortablemarket share, might have littleincentive to invest in the latest technology. Efficiency and the qualityof goods lags; 5. ISI usually results inhigh priced goods, few of which arecompetitive in export markets” (Blouet146).Brazil’s industry indeed flourished, transforming from one focused on the production of consumer goods into one with emphasis on the production of heavyindustries and their inputs. Moreover, traditional industries, such as food products, textiles, and clothing werereplaced by more capital-intensive and value-added industries such as transportation equipment, machinery,chemical production, and appliances. Inaddition to Companhia SiderúrgicaNational and Companhia Vale do RioDoce, other prominent companies formedduring ISI include: Petrobras (founded1953) and Embraer (1969). Throughout the late 1960s and early 70s, extraordinaryeconomic growth approaching double digit percentages became dubbed as an“economic miracle.”“The average growth of industrialoutput between 1945 and 1979reached 8.8 per annum. Themagnitude of structural change in the post-war years can be seen, firstly, by the share of the industrial sector in theGross Domestic Product (GDP), which grew from 24.1 percent in 1950 to 40.9 percent in 1980 – whereasagriculture declined from 24.3 percentin 1950 to 10.1 percent in 1980.Secondly, modern industries such asmachinery, electrical materials, transport equipment and chemicals performed particularly well. Theirshare in manufacturing output jumpedfrom 12.6 percent in 1949 to 43.6 percent in 1980. By contrast, traditional manufacturing experienceda sharp relative decline, the mostnoticeable cases being those of thefood and textile industries, which sawa reduction in their share of manufacturing output from 31.9 and18.6 percent in 1949 to 13.9 and 6.4 percent in 1980, respectively”(Colistete p. 6).The global recession of the late 1970sand early 80s signaled the beginning of theend for ISI. While the policy producedmany positives for Brazil’s economy, 2 pronounced negative features precipitatedits demise: chronically high inflation fromhigher costs of domestically made goodsand consistent current account deficits due to an overvalued exchange rate, which were financed with mounting externaldebt. Before the recession, the expectationfrom investors financing this debt was thatISI would result in a solid manufacturing base with substantial upside in the exportmarket. Subsequent current accountsurpluses would then be used to pay back the debt. Unfortunately, Brazil’s terms of  trade deteriorated significantly throughout the 1970s, beginning in 1973. “TheOrganization of Arab Petroleum ExportingCountries (OPEC), which brings together the world's largest producers, cancelsexports of oil to countries that supportedIsrael in the Yom Kippur War againstEgypt to Syria. The product's price rosefour times higher. Brazil is hampered because it was still a major importer: in the1970s, about 80% of the oil consumed in the country was imported. The ‘Brazilianmiracle’ begins to slow down and the

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