The Legacy of the Eighties
There was nothing structurally wrong with the Brazilian economy in 1981. In fact we were smelling like a rose in terms of growth. The big mistake was not understanding the dynamics of Bank Regulations, but nor did the American government. More than thirteen years have passed, and we reach the first good news of the book.
Over these years, without anyone noticing, with no headlines, the foreign debt was slowly being eroded by US inflation. (NB. This was Pedro Malan’s the economist that negotiated Brazilian Debt costly mistake. He bargained for lengthy extensions not realizing the US inflation would erode the debt, and that more important would have been to negotiate better terms, like the TIPS I proposed at the time I worked for the Brazilian Government. Malan was not the type to read Euromoney for example, and support what his government colleagues were achieving at the time).
The same inflation that corroded the banks' net worth ended up eroding Brazilian foreign debt. To a lay person, Brazil owed US $100 billion in 1982. If you look at the numbers now, through the eyes of the Brazilian Central Bank or the IMF, the debt seems to have actually grown over the years despite every effort made by the IMF and of all the adjustments made by the Brazilian economy.
In 1982, a group of German banks got together to discuss a common strategy with regards the Brazilian debt "problem". The outcome was a common strategy to reduce through various ways the overall debt to 60% of its original level, a more manageable and digestible amount, and take it up from there. Once Brazil reduced its debt to 60% of total, new loans could be resumed, probably at a more discreet pace than the 70's, but at least it would be a return to business again.
Basically the 60% level has been reached, and in fact lending again has been resumed, through euronotes and eurobonds to Brazilian companies.
Because the lending limit problem of American banks has yet to be resolved through adoption of limits adjusted to American inflation, bank lending will not be the main source of foreign lending to Brazil and Latin America. Funding will be raised through private placements directly to pension funds, and that's exactly what is happening with the new Brazilian euronotes.
The conventional wisdom, over the past thirteen years, even among influential Brazilians, is that Brazil has not amortized one single cent of its debt over the years. It would seem that, in fact, Brazil made additional debts, specially interest in arrears, compounding the problem.
The conclusion to be drawn from this reasoning is that one of the main causes that brought Brazil to a halt in 1981 no longer exists. The foreign debt problem is no longer a concern. As any banker knows, any company that cuts its debt volume by half solves its problem entirely.
Brazil today has a marketing problem, not a debt problem. Brazil has AA investment standards; it has always paid the real interest and has paid half of its original debt.
That is why the Brazilian Moratorium enacted by Funaro, Sayad, and Francisco Grow was such a mistake. I once called on the person responsible for the publication of the data regarding the Brazilian foreign debt at the Central Bank; I tried to convince him to take into account the effect of U.S. inflation on our debt, which brought the value of our debt down from one year to the next, not up, as the Brazilian Central Bank's surveys made you believe.
The answer was that this was not a good idea for we would be demonstrating to the international financial community Brazil's ability to pay its debt. Following this chain of thought, bankers would probably demand more and more. This incident took place in 1986, during a period when Brazil was accumulating reserves, hence the reason for the concern with larger demands for debt payment.
The very idea that we were negotiating with bankers is wrong. Bankers are simply brokers.
Brazil was in fact negotiating with old ladies in London and John Doe's in New York, and the banks' stockholders, often simple people with no technical knowledge. These people have the financial resources but not a lot of time to think about Brazil; all they want is for the Brazilian debt to decrease. Actually, international bankers and the Brazilian government had a common enemy: the bank stockholder and the small investors.
Being trained in finance, US bankers knew about the debt's erosion, but kept quiet. The reason is that bankers know that the same inflation that erodes debts is already built into US interest rates. LIBOR, and the Prime Rate, always reflects US inflationary expectations plus a real interest rate. When US inflation reaches 14% per year, interest rates went up to 21% per year.
This means that from a semantic point of view the really was not eroded by inflation, but actually being repaid. Or prepaid, which is financially more correct. Over the years, Brazil has in fact secretly repaid a greater part of its original debt. Not only Brazil has paid all the yearly real interest, but has amortized US$ 50 billion of principal, that's indirectly built into interest rates.
The logic of a financial system in which borrowers repay only a small percentage of the loan at maturity, because of the effects of inflation, is beyond the comprehension of most Brazilians.
Most credit rating companies miss out completely. A country that reduces its debt by one half, has a trade surplus that is 3 times the real interest paid, that has always paid the real interest on its debt, is definitely investment grade quality. But that is not the picture one gets from Standard & Poor's, Moody's and the EIU Country Risk Service, that are not well versed on the effects on inflation.
Many investors incurred in the same mistake, suffering horrendous losses. The average discount of Brazilian debt reached 80% of par value, a totally unreasonable discount given the fundamentals just analyzed. Investors where selling at an 80% discount a debt that was being repaid in real terms every year.
Brazil's ability to pay the debt from an economic point of view was never in jeopardy, but due to faulty nominal analysis, no one realized that tacked into interest rates was a hefty principal pre-payment. The Dart family were right in buying up practically 5% of Brazil's debt.
As of 1995, Brazil's average discount should become nil, or even become positive depending the coupon rate versus current interest rates. Another problem out of the way.
International capital markets make enormous swings whenever interest rate varies between countries, just because inflation rates have changed, whilst real interest rates remain practically the same. So much for not living in the real world, and making nominal world mistakes.
In the Congressional hearing on the effects of the Brazilian Moratorium of the US banking system, a New York banker argued that the US banking system would stop receiving principal. A Freudian slip.
The tragedy of the whole debt debacle, is that a company that pays interest promptly, that pays half the amount of its debt over the years, a company that has a low debt to equity ratio, corresponding to 4% of its equity, is more likely to be a AA or a single A company not a BB as many rate Brazil.
This is the great national tragedy of the lost decade. We were not able to show the world that we where honoring our financial debts in real terms. We share this situation with Chile, Argentina, Indonesia, US and other countries that were not skillful enough to show their correct face to the world. US Congress is unable to show American people that public deficit is not as big critics say, simply because they are calculating nominal interest payments not the real interest payment, usually half the amount.
The second big tragedy is that the economists at the IMF went around the world demanding countries adjust their economies, when the problem was that the Controller of the Currency in the US and banking laws needed to adjust to inflation accounting reality. Using historic accounting values to set lending limits in a inflationary environment does not make sense. Up to this day the IMF does not realize the damage it caused to 800 million people.
The third reason that brought Brazil's growth to a halt in 1981 was high LIBOR rates, which then reached 21%. This was actually a fictitious rate, since it represented the result of the high US inflation real that year, plus a 4.5% of real interest. Americans do not use inflation accounting; they add inflation to their interest rates, giving the investor the impression that the yield is actually 21% per year, when it is not. Spend the interest rate year after year, and you will discover that you have been dipping into your capital, and so has Uncle Sam through its tax rate.
Actually, the country was amortizing its foreign debt in advance due to the US inflation; years later these international interests dropped to the 3% level, placing Brazil back in the comfortable situation of the seventies, when international savings were available at interest rates extremely favorable to growth. Nothing fosters growth as low interest rates. Nothing hampers growth as high interest rate.
For many years Brazil courted the IMF needlessly. If someone was to be courted, it should have been the analysts working for Moody's and Standard & Poor's. Starting in the nineties, these companies become essential to countries interested in attracting pension fund investments; it is unlikely that commercial banks will ever operate the way they did in the past. Banks will operate as cosigners and guarantors for the credit operations Brazil negotiates abroad; they will no longer make direct loans.
It is companies like Moody's and Standard & Poor's that will make an advance evaluation of the business, and will then grade the issuer on a scale from D to AAA. Any country or firm that takes its relationship with these two companies lightly is bound to pay a very dear price when it needs foreign financing.
A case could be made that if all the effort that was made to please the IMF had been directed toward establishing relations with these two credit rating companies, Brazil's reputation would have been better served.
(NB. This was another tragedy of the Funaro-Sayad Moratorium, and it was only Lula and Joaquim Levy that resumed conversations again with S&Ps which I had initiated in 1986.)
Every country's government should strive to decrease its perceived risk as much as possible. In fact, countries should strive to sell its bonds at a premium. The dearest dream of the head of the Central Bank's should be to see its bonds being negotiated at a 10% premium: a 100-face-value bond being traded at 110. After the 1990 debacle we have witnessed the steady fall of discount rates on Brazilian bonds and, as a result, the decrease of the risk rating associated to Brazil. That is why we will soon be opening our doors to low interest rates. The sad part is that this discount was applied to Brazil unfairly, since we never ceased to be a good credit risk.
So far we have seen that Brazil was a country with one of the highest growth rates in the sixties and seventies. We have shown that we know how to grow, unlike Eastern Europe, which lacks business management culture and managers, as well as the accounting and administrative systems necessary for growth. Brazil has them all. Managers may be a little rusty, but they know their wares.
We stopped growing in 1981, let me stress it once more, not because our economy was a shambles or because of overwhelming structural problems; we stopped due to a minor error in the US banking system, which does not make adjustments in bank loans to account for US inflation. This error caused an international credit flow of about US$ 15 billion per year to be halted during the seventies.
In practical terms, Brazilian companies are the least indebted in the world.
Because of the high interest rates practiced during the 80's, Brazilian companies used all of the cash flow generated by their operations to liquidate their debts. They never lost their investment capabilities, they only used them to retire debt, instead of buying new equipment.
This process came to an end in 1991 and 1992 because Brazilian companies, irony of ironies, had no more debts to repay.
During the lost decade, Brazilian executives avoided debts like the plague. The end result is that we now have companies with a strong and solid capital base, ready to support a new and accelerated surge in growth and indebtedness. In spite of heavy losses and recession, Brazilian companies enjoy the financial health to lead the country on a new path of accelerated growth. This cannot be clearly perceived in Argentina or in Mexico. In fact, few Brazilian companies went bankrupt in 1990, 1991 and 1992, the worst recession in Brazilian history precisely because they had a strong capital base.
This is a very important factor from the viewpoint of economic growth and leads us to conclude that Brazilian companies will embark on a new cycle of indebtedness, very similar to that of the seventies.
This new debt cycle, stimulated by a 3%-interest-per-year credit availability in the international market will spur Brazil toward new investments and production. By the year 2000 the debt to equity ratio of Brazilian companies should increase to 2,5, that is, 2.5 reais of debt for every 1 real of equity, the same ratio of US companies. This means that Brazilian companies have the financial structure to accumulate -- at compatible interest rates -- four to five times their current debt level. This reflects a huge growth potential. The resumption of foreign loan operations, with the inflow of cheap money, should bring about a drop in the average interest rates in Brazil.
The 50 major banks worldwide lend only 0.6% of their portfolios to Brazil, a figure totally disproportionate to the country's importance in the international economic scenario. Brazilian GNP accounts for 2.8% of the world's GNP. This would be a fair ratio in the destination of resources to Brazil. We should be receiving 2.8% of foreign capital and savings from abroad, just as we should be receiving 2.8% of loans granted by international banks.
That's another 5 fold increase, which should occur as soon as signs that Brazil's inflation problems are over.
The risk is politicians and economists regarding this new surge in debt with the same prejudices of the past. Brazilian public opinion is biased against foreign debt for mistakenly considering it as the main obstacle to economic growth. It fails to take into account the fact that foreign capital interest rates are much lower than rates of the domestic money market.
For years, debt was seen as the main reason for our stagnation. Several political campaigns were based on promises by politicians to renegotiate or even suspend payment of the foreign debt. It will not be easy to convince a whole generation that the reason for our economic stagnation was precisely the opposite — a lack of financing or the lack of cheap loans. The risk of misinformation remains, insofar as some Brazilian economists are already worrying about the increase in the Brazilian debt level — as if this were a negative event.
International bankers, as we have seen, were not exactly blameless in the foreign debt crisis episode. They never explained to the Brazilian public opinion that the real interest rate of their loans were much cheaper than local money.
In effect, for Brazilian banks the debt crisis eliminated from the market exactly those foreign competitors that made loans at much lower interest rates. Brazilian bankers actually were happy to see the debt crisis eliminate foreign competition.
International bankers are more competitive because capital is cheaper and more plentiful in developed countries than in emerging economies.
Foreign capital will also show a renewed interest in Brazil, as long as returns are compatible with the international market.
This is why foreign loans are much more useful than foreign capital.
When inflation comes to an end, which it already has, the world will see Brazil under a different prism.
The Real plan is not an economic plan, as most of the predecessors were. It was an accounting plan. What we did basically was a dollar-translation of our economy, the same way American subsidiaries do with their books in Brazil every year. The Cavallo plan in Argentina did the contrary. They do their purchasing in dollars and their accounting in pesos. The Real plan for a short while only, did its accounting in a constant index URV and its payments in cruzeiros.
Over a two year period inflation had increased from 25% to 45% a month. Those who understand the mechanics of monthly indexation will know what I mean, when I argue that the real inflation rate was actually only 10% a year. Because of labor indexation, any price increase perpetuates itself for ever.
Inflation in Brazil should be understood as being the sum of two parts: indexation plus additional inflation. So what Americans and Europeans call inflation, is actually additional inflation in Brazilian terms. Therefore, inflation has been licked in Brazil as of 1993.
The problem therefore was getting the self perpetuating effect of indexation out of the system, especially because it had reached a 40% a month figure. The Real plan did just that. For those that are engineers, the Real plan was a clever way of doing a rotation of the coordinate axis, or the second order of an equation.
Leaving the details aside, there are two points that make the Real different of the many unsuccessful cousins. It was the first plan not to create a repressed or pent up inflation during the intermediate phase, ready to explode when the plan reaches completion.
During the many price-freezing, the repressed inflation would blossom immediately after the completion of the plan, i.e., the un-freezing.
Every plan has a beginning phase, an intermediate and an ending phase. The Real plan actually ended on July the 1st 1994, when the currency was transformed or rotated on its new axis. The point being is that the Real has already successfully reached completion and inflation has not rebounded as in the last two plans. (NB. Alexandre de Castro and Roberto Macedo were still in 1995 claiming that the Real Plan would not work!)
Many a specialists on Brazil expected inflation to explode after the Presidential elections, claiming in fact that the plan was political not really long lasting. (NB. Leftist Journalists in Brazil, refused to mention the success of my book, believing I was canvassing for Fernando Henrique Cardoso. This last sentence proves that I was not betting on any of the two candidates, and predicting that the plan would work whomsoever became president. Jo Soares, years latter, apologized in public for suggesting I was a canvas and not a serious economist predicting the future.)
The Real plan was also the first not to distort the price system in Brazil, contrary to the Cruzado Plan which destroyed it with a price freeze.
Considering that in the seventies there was an inflow of US$ 15 billion annually, it is only reasonable to forecast that, with inflation coming to an end in the nineties, US$ 30 billion will flow in annually, probably much more. This is no exaggerated forecast if we see it in the new context of economic globalization. I estimate that, between 1995 and the year 2005, US$ 36 to 45 billion will come in annually. (NB remember this was written in 1992.)
Neither government technicians nor public opinion are prepared for the high growth scenarios that this book proposes. Plans for such optimistic situations have not been drawn, and this might result in lower growth. As a result, there might be bottlenecks such as a lack of products in certain sectors. The opening of the economy can overcome these temporary scarcities with imports. Some difficulties remain, however; it will be impossible to import electric power, for instance, and there will certainly be supply shortages. Surely, the Brazilian government and companies will have to make every effort towards energy conservation and high investment in this area, which the rest of the world has already made.
Every time you mention electric power shortage, Brazilians usually panic, because they know it takes ten years to build a hydroelectric plant. In fact, this is not the only solution. There are other energy sources such as thermoelectric plants; its basic equipment is a turbine, which can be imported in less than six months and put into operation in 18 month's time. The power shortage scenario should not frighten anyone. This obstacle can be overcome, paying a maybe higher price than if plans had been made ahead of time.
We were not concerned with investment in power generation or in other areas because the prevailing atmosphere was one of disproportionate pessimism. Neither the foreign debt deterioration nor the restart of economic growth were then in sight. The feeling that Brazil is growing again, in a sustainable way, is now accepted by some experts. The growth recorded in 1993 was initially seen as a temporary consumption bubble.
There is so much available capital in the world, let me repeat, that there is a shortage of investment opportunities to use up the whole supply coming from pension funds, insurance companies and intensive savings-generating entities.
Around the year 2000 companies like General Motors will have more retired than working employees. As a result, the inflow of social security contributions of GM employees will be lower than the expenses with the plant's retirees.
There are around eighty thousand pension funds worldwide. The largest US pension fund, the TIAA — Teachers Insurance Annuity Association —which congregates teachers and intellectuals and has a total of 1.6 million participants, holds a US$ 100 billion portfolio.
That is why, in spite of our lack of credibility and of the financial marketing mistakes of the past, we will start receiving foreign money once more. We might even say that these investments are pressing to enter Brazil, since the country has never made use of institutional advertising to show institutional investors where these US$ 150 billion have been invested.
Brazil should have spent about 0.1% of this total in advertising, merely to tranquilize the dozens of investors who believed in our country. This would have reduced risk rates and spread rates considerably. Brazil's largest banks, Bradesco and Nacional, spend proportionately much higher amounts in advertising to attract clients.
Our companies will be very profitable in 1995 and 1996, due to their high gross margins. Since Brazilian companies traditionally re-invest 80% of their profit, when our economy starts growing again this high profitability will be channeled to investments in production and development.
A great number of coincidences show that Brazil, in the early nineties, faces a series of situations similar to the ones that preceded the economic miracle cycle that took place two decades ago. Some aspects and indicators are even better than those at the start of the golden period of our economy, as we will see in the following topics.
Read the following chapters: