The Brazil Conundrum

The last decade has been exceptionally good for emerging markets. Never before have so many countries grown so rapidly, and at the same time. The average growth rate from 2003 to 2012 was 13.1% for emerging markets, while the long-term average stands at 5.0%. This growth rate was partly due to mean reversion after sluggish growth periods in the 80s and 90s, when the average growth rate for the group stood at 3.5%.

The internal rate of growth was aided by massive international capital flows into emerging countries. Adding to growth was the ensuing credit expansion, increasing consumption. As capital flows have been decreasing, it is important to analyze each country not only to understand the uniqueness of each, but also to convey which countries would likely do better under these new circumstances. This week, we will investigate Brazil.

Brazil’s population of 199 million makes it the fifth largest country in the world in terms of population. Population growth has been rapid, as the absolute number has doubled over the past 30 years. Brazil is also the fifth largest country in terms of total economic size. What we need to remember about Brazil is that it is still very new to the international markets as well as democracy. The constitution was ratified in 1988 and its new currency was introduced in 1994.

We will start by briefly describing Brazil’s history, and then explore how Brazil compares to other emerging markets. We will conclude with market ramifications.

Brief History

Brazil was first discovered in 1500 AD by the Portuguese, who settled in the region in search of natural resources, especially timber. In 1808, the arrival of the Portuguese royal family, who were chased out of Portugal by Napoleon’s armies, initiated a new era of nation building. Pedro I, the young prince, was left in charge of the Brazil colony when the royal family returned to Portugal in 1821. Pedro had plans of his own for the region and, following more than three centuries under Portuguese rule, Prince Pedro established the independent Empire of Brazil in 1822. The country maintained a monarchial system of government until the abolition of slavery in 1888, when the military ousted the Portuguese leaders.


Given the importance of commodity export, coffee and rubber exporters ruled the country by influencing a succession of presidents. In 1930, the populist leader Getulio Vargas seized power through a military coup. A line of easily forgettable presidents followed Vargas, and the country was plagued by rampant inflation. The military took power in 1964 and seriously repressed civil rights while trying to implement economic reform. The military peacefully ceded power to civilian rulers in 1985, and the country held its first democratic election in 1989 with great enthusiasm. The new government was able to get inflation under control through onerous reforms.

Over the past decade, Brazil has benefited greatly from the surge in commodity prices. The wealth effect was multiplied by capital inflows and a credit expansion. Loans to individuals have increased substantially, standing at 12% of GDP, although still a relatively low number in international comparison. The country is now showing some signs of overheating; unemployment has increased, and inflation, although currently manageable, stands at over 6.0%. The government’s response has been to marginally increase infrastructure investment and improve some aspects of the business environment. At the same time, manufacturing has struggled, with many end-markets suffering from the 2008 financial crisis. Additionally, the country’s strong currency and structural inefficiencies have made Brazilian companies uncompetitive in the export markets.

Recent protests have revealed a serious discontent with the current government within parts of the population. It is true that the government has failed to serve some parts of the population by failing to deliver basic needs such as health care and education. However, Brazil has made great progress in the past 10-15 years. The recent unrest likely reflects enhanced expectations.

Location, Location, Location

Brazil has generally lacked threats from outside powers as natural barriers shield it, and historically the country has been inward-looking. Brazil’s land mass is larger than the contiguous U.S. and it borders all countries in South America except Ecuador and Chile. Four features define the country’s geography. The first is the Amazon Basin in the north, which is too wet to be hospitable for agricultural production or large human populations. Second, the tropical savannah in the middle of the country is arable, but due to its remoteness faces infrastructure challenges making it hard to bring agricultural products to international markets. Third, the Brazilian highlands are on the eastern coast, which are home to the majority of the population. Lastly, Brazil is somewhat protected by the Andean mountain range which run along the western coast of South America.

Brazil’s major cities are on the Atlantic and are set up as a series of coastal enclaves separated from each other by natural barriers. It is hard to achieve economies of scale in most regions of the country due to geographic limitations. Historically, the need for large capital outlays to start a new venture have prevented individuals or small companies from starting businesses. As a result, large corporations or rich families have been the initiators of enterprises in new regions. The geographic difficulties also mean that the cost of getting Brazilian goods to world markets is much higher than in other countries, colloquially known as the “Brazil cost.” Due to the lack of small land and property owners, implementing property rights has been difficult. These large investors, that have spent capital to develop a region or funded a project, view themselves, rather than the state, as the prime owners of the land and therefore also feel entitled to create their own rules and rights. The great distances involved make unified peripheral control even harder. Additionally, the lack of government infrastructure means that private owners have to set up their own infrastructure, giving them even greater control over their domain. These entities have not had any interest in creating a more equal society, allowing social mobility or providing education since this could only mean loss of the high degree of control the status quo offers. Oftentimes, after the large sunk costs, these different entities do not cooperate with other regional powers, resulting in isolated areas of development.

Whereas the U.S.’s extensive river system and the Great Lakes region have provided a major water-borne transportation network for crops, livestock, metals and minerals, the Brazilian Amazon has actually been a hindrance to growth. The Amazon is not consistently deep enough to provide reliable transportation for commodities. Even more importantly, the region is too humid to allow for crops to mature and the riverbanks are not set strongly enough to allow for building. The tropical savannah, on the other hand, where most of the crops grow, is landlocked and depends on manmade transportation. In the U.S., the river system allows for inexpensive transportation of commodities from most of the country to the coasts. Additionally, Brazil’s geographic structure is such that most urban centers are set on the coast, which does not allow for the development of the interior. The lack of natural transportation of people to the periphery almost guarantees the insignificance of the country’s interior.

Commodity Addiction

Brazil is dependent on commodity demand, exporting metals, minerals, timber and agricultural products. There have been some studies that indicate that the advances in Brazil have been completely driven by commodity price increases as quantities exported have remained unchanged; however, we doubt this is entirely the case. Brazil has made advances in both agricultural production breadth and expertise. The country is the second largest exporter of iron ore and the largest exporter of soybeans after two years of drought in the U.S. As mentioned above, the Brazil cost is largely due to the great distances involved, the poor road conditions and lack of other infrastructure. This is especially relevant since the country produces many low value-to-weight commodities. Even including the additional costs, the country has been able to increase its export market share.

Dependence on a narrow economic sector creates a deep reliance on the country’s trading partners. Many of Brazil’s end markets suffered economic deterioration during the recession, especially the U.S., China and Argentina, an effect which was exaggerated in Brazil.

Given the importance of commodity exports to the country, the political process is also shaped by the needs of commodity producers. The crops that do particularly well in the country are coffee and sugar, neither one of which is easily mechanized. Therefore, both industries need large pools of low-skilled labor. Due to this need there is a great disincentive to advance educational opportunities, resulting in a small pool of skilled workers and a large number of unskilled workers, in turn creating labor and infrastructure bottlenecks. During periods of strong growth, the lack of skilled labor tends to cause capacity constraints, and it is difficult to boost productivity. Thus Brazil faces persistent inflation pressures.

Historically, Brazil has been one of the highest inflation and lowest growth countries among emerging economies. For example, inflation reached 2,000% per year in the 1980s. The solution to this high inflation was arduous, with capital controls, heavy bank regulation and deep cuts to the government’s budget. In the early 2000s, investors dove into emerging markets; this, coupled with Brazil’s falling inflation as a result of deep-seated reforms, resulted in large inflows of capital into the Brazilian markets. As a result, the Brazilian currency, the real, has appreciated and in turn made Brazilian manufacturing uncompetitive. It is important to remember that the Brazilian economy is mostly commodity related and low skilled, so exports need to compete on pricing rather than the value-added sphere.


Brazil has successfully lifted about a quarter of its population into the middle class category in 10 years. This is no small feat. By comparison, China moved the same proportion of people out of poverty over the course of 30 years. Brazil has been successful in alleviating poverty for the elderly as a result of comprehensive pension reform. However, this has left little money for education reform and commodity dependence has created a need for a large, low-skilled labor pool. However, to sustain the pace of improvements in living standards and support social mobility and equality, education availability and quality is crucial.

Additionally, the slowing population growth rate that Brazil has been undergoing since the 1960s will soon lead to a significant demographic transition. The aging population, in addition to the current low investment levels into human capital, could hinder growth possibilities.

That being said, the country’s large middle class supports the growing domestic market demand and makes the economy more robust. This is not the case for many emerging markets. A study by the Brookings Institute indicates that about half of Brazil’s population is now considered middle class, compared to 10% in China.


Brazil’s government spending is large, approximately 40% of GDP. Government spending in comparable countries stands at about 25%. At these levels, public funds crowd out private investments. Since government investment is centrally controlled, it is generally less market efficient than its private counterpart. Although the country needs huge infrastructure improvements, the government is spending only about 2% of its funds on infrastructure. As a comparison, emerging markets in general are spending about 5%, with China being an outlier at 10%. Additionally, the country spends 5% of GDP on pensions for civil servants, more than twice as much as on infrastructure spending. We do note that the government has made some advances in applying for additional spending on infrastructure.

The issues cited above are unlikely to improve quickly. Reforms are implemented slowly in Brazil and oftentimes favoritism and vested interests keep the country from implementing the changes needed.

Infrastructure spending is technically difficult due to geography, and requires large amounts of investment and high levels of expertise. However, linking the interior and the various coastal cities would sustain growth and encourage further foreign direct investments. Many regulatory hindrances remain in place; as the World Bank reports, it takes an average of 119 days to set up a business in Brazil, the fifth longest period in the world.


Brazil is often referred to as the “end of the whip,” meaning a small jerk of the wand can cause a much larger effect at the end of the whip. Brazil is affected by global growth, especially growth in manufacturing heavy countries, such as China. The acceleration in growth in China, for example, would have a multiplier effect on the Brazilian economy. By the same token, Brazil’s economy will be especially vulnerable in the late global economic cycle or global economic downturn. Brazil should be seen as an early cycle venue for equities. Given the country’s geographic and labor limitations, the country faces capacity constraints at low-growth rates, thus hiking inflation.

If the Brazilian central bank reacts appropriately to these inflation concerns, Brazil could likely be a good place to put short-term funds.

Kaisa Stucke and Bill O’Grady

September 23, 2013

This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

© Confluence Investment Management

© Confluence Investment Management

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