STOCK MARKET CONDITIONED BY ECONOMIC IRREGULARITY

Brazilian share prices and traded volume have been strongly influenced by the inconsistency that has characterised the country’s economy in recent years. Local markets, for which the ·são Paulo Exchange (Bovespa) currently accounts for nearly 95% of total trading, have swung between cycles of euphoria and periods of sharp decline, with prices moving strictly along with traded volume. This section will discuss the evolution, most recent developments and trends of the Brazilian stock markct.

Once the traumatic effects of government intervention to control hyperinflation in the 1980s and early 1990s had been overcome, the market began to recover as prices rnoved up and trading expanded. This trajectory, which began in 1992-1993, became increasingly intense, reaching its peak around the June 1994 stabilisation plan, which created the real and set the tone for economic policy throughout President Cardoso’s entire first mandate.

Mexican crisis highlights first signs of post­real external vulnerability

The repercussions of the Mexican crisis sparked a series of severe adjustments, including a hefty increase in interest rates and federal reserve requirements, which slowed the pace of the economy. The austerity of the measures and the consequent shrinkage of econornic activity, only partially anticipated by the market at the time, sent the stock market into free fall.

The package proved successful though and the economy’s return to normality, aided by advances in some of the main points on the planners’ agenda (notably privatisations), provoked a new upturn where the Bovespa climbed to one of its highest ever levels at the end of 1996 and beginning of 1997.

Post·Mexico boom ambushed by Asian and Russian meltdowns 

The euphoria proved short-lived, however, and expectations were once again undermined, this time by the Asian meltdown, whose fallout contaminated Brazil’s economy leading to another market plunge, which was accompanied by dwindling trading. The Russian crisis shortly aftenwards merely consolidated this tendency. At the same time, there was mounting speculation that Brazil with its shaky economic fundamentals – would be next in the emerging market firing line. Despair replaced hope and prices headed downwards once again.

Dire forecasts following the 1999 devaluation prove groundless

Following the big devaluation of the real in January 1999, when the band system was replaced by a floating exchange rate, predictions regarding the stock market, not to mention the economy as a whole were distinctly gloomy. The general consensus was that a deep recession, accompanied

by a harp increase in inflation ·was imminent. Fortunately, these fears proved groundless. Slowly but surely, the economy began to recover. Despite the greater expense of impores or dollar-pegged tradeables, the general price indices remained under control.

Given prevailing uncertainties, the market’s first reaction was one of caution, since it was as difficult to assess overall trends as it was potencial gains and losses at individual corporate levels. As the clouds began to clear away, however, a selective rally began to set in. Exporters with a low import ratio and reduced foreign currency debt were the first to reap benefits. Less lucky were those firms dependent on the domestic market and whose liabilities were hammered by the devaluation. Only later would companies who were primarily geared to the home market, but whose prices were pegged to international ones, begin to pick up steam. These firms, winners whose devaluation-driven benefits were less obvious, were mostly in the petrochemical and steel sectors. ln varying proportion and pace, the transition from devaluation was felt on their domestic prices. This was often accompanied, and reinforced, by price rises abroad (e.g. pulp and paper, petrochemicals, steel, etc.), in turn strengthening the specific fundamentais of the firms involved and, therefore, boosting their share prices.

AND EVERYTHING APPEARED ROSY AGAIN …

The uncertainties began to dissipate and, given the favourable evolution of domestic economic indicators and a relatively settled international scenario, there was a general feeling that, finally, che country was on the way to sustained growtl. Stock markets took off once again and the Bovespa Index threatened to climb back to its pre-Asian­crisis levels.

Now, however, the pace of US growth began to falter. This tendency was confirmed and the growing conviction that the global economy would be pulled down in America’s wake began to produce effects. One of the main consequences was the price reduction of some of the leading internationally traded commodities, hitting the profits of Brazilian exporters of cyclical products. This reduction was accompanied by a decline in sales volume. At the sarne time, prospects of diminishing growth in the developed nations led to an increase in protectionist measures, America’s restrictions on steel imports being just one example (and there has been recent talk of e}..-panding them further).

Concentration in telecoms increases risk of contamination by foreign markets

To this deterioration of expectations and the consequent downturn in the Brazilian stock market as of the middle of the firsc half of 2000, the economy was faced with the brutal collapse of technology stocks in ali of the world’s leading markets. This produced a chain reaction, which – together with other specific events, such as the towering prices paid for 3G licences in Europe – called into serious doubt the telcos’ prospects of exponencial profit growth. The face that telecoms (especially certain segments, like long-distance telephony) were no longer as high on the investor preference list as before had important repercussions m Brazil, given that the sector, including internet-access providers and pay-TV firms, accounts for almost half of the Bovespa Index.

Recent developments m the internacional economic scenario also highlighted Brazil’s vulncrability to shrinking flows of international capital. Heavily reliant on external capital to finance its balance of payments, the country will see direct investments crash from US$30bn in 2000 to around US$16bn in 2001.

NO ESCAPING FROM THE EXTERNAL NOOSE …

Brazil’s strong dependence on capital inflow increases the risk of contamination every time a serious crisis erupts in other markets. Like the Mexican, Asian and Russian meltdowns in the past, it is now Argentina’s problems, despite the added shield of the floating exchange rate, that are raising fears and not only affecting the foreign exchange market, but also pushing down share prices and eating into traded volume.

The Central Bank has been pushing up interest rates in order, among other reasons, to prevent any inflationary pressure from the accelerating devaluation, but at the sarne time hitting economic activity hard, a process which has been further aggravated by energy rationing.

Power rationing reduces GDP growth

A disaster waiting to happen, Brazil’s energy crisis is the result of two factors. Firstly, an unprecedented fall in reservoir levels (almost ali the country’s electricity is hydro-generated), due to two successive years of drought in the South-east and North-east; and, secondly, and more importantly, by a chronic lack of sector investments in recent years, either in expansions to plants under construction or in new ones, or even in the development of alternative energy sources. ln the latter case, despite the completion of the Bolivia-Brazil gas pipeline and increased output by Petrobrás, permitting the installation of gas-fired thermal plants, the emergency programme to build these facilities was only underway after the rationing period began.

The measures per se call for a 20% cut m residential electricity consumption and an even heftier 35% reduction by the public sector. Industry and commerce have to save by between 15% and 25% over their average consumption in April, May and June of 2000. ln principle, no new installations will come on stream (due to lack of electricity supply), preventing expansion programmes and investments in new production facilities.

Mass of uncertainties hammers trading

As a result of this conjunction of factors, equities have been on a downturn since the middle of 2000, accompanied by one of the biggest declines in traded volume for years. The Bovespa recently shrank to the dollar leveis prevailing at the beginning of the 1990s, when the economy’s fundamentais were, in general, much worse than they currently are.

Fundamentals improving, despite turmoil The Brazilian economy has been subjected to a series of scructural changes over the last 10 years, and the stock market has also experienced importam modifications. Local firms in various sectors, tested by successive crises, have become stronger. Many sectors, which had been flagging under years of state ownership felt a new surge of vitality following the highly successful privatisation programmes. The Brazilian telecoms industry, for example, is now one of the fastest growing in the world. Buoyed by the euphoria of the first post­real phase (between 1994 and 1996-1997), various expansion plans were initiated in different sectors and many new production facilities were installed, from car makers to manufacturers of leading-edge technological components. This first investment cycle was complemented and consolidated by development programmes unleashed by the massive privatisations of more recent years (particularly telecoms). In addition, the spread of privatisations into other industries has both demanded and encouraged higher investment diversification.

These developments have affected, both directly and indirectly, the country’s listed companies and their share prices. This is why, even during times of accentuated devaluation – whether in 1998, 1999, or ríght now – the lowest points of the Bovespa Index would still have been regarded as peaks in the first half of the last decade.

Hostile scenario and liquidity shift reduce traded volume

The same cannot be said for volume, which, particularly in the closing months of 2000, fell back (in dollars) to the levels prevailing at the beginning of the 1990s. Many factors were responsible, some of which are connected with the country’s economic crisis. Others, however, are structural in nature and have had a systematic influence, which various measures, in the legislative sphere and from other sources (such as the creation of the New Market) are attempting to correct.

Due to new conditions prevailing on the internacional market and the hefty slowdown of Brazil’s economy, investors in general – and foreign ones in particular – have been pulling out of Brazilian equities.

Conversely, trading of Brazilian shares abroad (in the form of ADRs and other vehicles) has triggered a systematic shift in Iiquidity from the local to the foreign markets. Among other factors, tracling costs are lower there, not being subject to CPMF (financial transaction tax). There are also other advantages for foreign investors – for example, by acquiring ADRs they do not have to transfer money directly to Brazil. Currently, ADR traded volume in New York averages US$69.4bn per year, versus US$85.6 in São Paulo.

Trading also hit by delistings

Liquidity has been further reduced by the simple remova! of certain firms from the market. Following certain privatisations – with the intention, among others, of diluting the auction premium – some of the new owners made buy­back offers to minority shareholders for the purpose of subsequent delisting. There were several such examples in the electricity and financial sectors. ln other cases, the buy-back was accomplished via a swap operation in which shares in the local company were exchanged for securities representing shares in the overseas parent company – with a consequent shift in trading to foreign markets. So far, this procedure has been limited to the telecom sector and some such operations are still under way.

Other delistings have occurred with national or foreign-owned firms whose shares have been rarely traded and/ or whose market capitalisation did not accurately reflect their true economic value, giving the owners an opportunity of reacquiring minority interests. However, the CVM (Brazilian SEC) has recently made certain changes in regulations governing such buy­backs, making them more difficult and potentially more expensive. Further restrictions on such practices are contained in the new corporate law, recently approved by the Lower House and currently being debated in the Senate.

On the other hand, the almost constant frustration over Brazil’s sustained economic growth, with successive crises being intercut with periods of sky-high interest, has not exactly encouraged local investors to move, in any substantial manner, from fixed income into equities. In fact, fixed income funds (with their low credit risk given that they are predominantly composed of government securities) account for 79 .1 % of the mutual-fund industry, while share funds make up a paltry 7.6%.

THE NEW MARKET

There is a growing tendency, particularly in the most developed nations, for the capital markets to replace the banking sy_stem as a source of long­term corporate resources. This has been accompanied by calls for better corporate­governance practices; improved disclosure (both in quantitative and qualitative terms); greater consideration for minority interests on the part of the controlling shareholders; more concern for the environment; and a greater awareness of social responsibilities.

ln order to make investors feel more secure and therefore, create the necessary conditions for strengthening the market on the one hand, and niaking compames more competitive and efficient on the other, both the government and the private sector have been seeking means of improving the ways in which corporate decisions and relations with minority shareholders are governed.

Changes in legislation a step forward, albeit a timid one

The main government initiative regarding legislation was the overhaul of corporate law. The last such modification m 1997, aimed at facilitating the upcoming privatisations, eliminated certain minority interest rights, including that of common shareholders to receive the sarne pnce paid to the controlling shareholders in the case of a change of ownership (tag-along).

The executive sent its reforro proposals to the Lower House, which eventually approved them, albeit in a watered-down version. Nevertheless, they still represented an important step forward in relation to the prevailing legislation. For example, minority common shareholders regained their tag-along rights (although at a ratio of 80% only) if control of the company· should change hands. Stricter rules were inrroduced governmg shareholder remuneration, either via dividends or interest on capital and minority interests would have more say in corporate decisions and more representation on the board of directors and statutory audit committee. Minority shareholders would be compensated by the shares’ fair value in the case of a delisting offer (fair value to be calculated according to the company’s economic value, book value, market value or comparative market multiples). Finally, the maximum ratio of nonvoting shares (PN) would be reduced from 67% to 50% of the total. The bili is currently being debated in the Senate and, if approved, will only have to be sanctioned by the president before becoming law.

The most importam initiative m the private sphere was the Bovespa’s creation of the so-called New Market, a separate market-within-a-market for shares of companies who voluntarily undertook to adopt corporate-governance and disclosure procedures over and above those demanded by law.

New Market underpinned by respect for good corporate governance

Firms wishing to join the New Market will have to obey a set of new rules, which increase shareholders’ rights and enhance corporate disclosure. An arbitration committee wil] iron out disagreements, so investors can be assured that such questions will be resolved quickly and by specialists.

ln order to allow interested companies time to adapt, the Bovespa created two grades of corporate governance – levels 1 and 2. Level 1 firms must maintain at least 25% of their shares in circulatíon and improve their disclosure, as well as ensuring that new offerings are issued in such a way as to favor capital dispersal. ln addition to obeying these rules, level 2 companies will have to implement American or international accountíng standards (US GAAP or IAS GAAP); effect a buy-back operation involving al] outstanding capital at the firm’s economic value in the case of delisting or a change of ownership; and increase the rights of preferred shareholders. Companies wishing to join the New Market must meet all the level 1 and 2 requirements, as well as ensuring that their entire capital is composed of ordinary shares with voting rights.

Fifteen companies already registered as level 1

On June 26, 2000, the Bovespa announced the first 15 firms to receive levei 1 status. Although adherence to the new standards is voluntary, it is expected to become the norm over time under pressure from the market itself. ln addition, it is to be hoped that the New Market companies will find it easier to raise money, therefore resorting to the rnarket more frequently, and in tum strengthening Brazil’s capital markets. The first 15 companies that received level 1 status are: Bradesco, Bradepar, Gerdau, Globo Cabo, Itaú, Itaúsa, Perdigão, Randon, Sadia, Unibanco, Unibanco Holdings, Varig Brasil, Varig Participações e Serviços Complementares, Varig Participações e Transportes Aéreos and Weg.

MARKET OUTLOOK

The external risks: reduction in the pace of global growth; the Argentine crisis; domestic crises; whether economic – from the interest hikes; the devaluation and the power rationing; or political – the 2002 presidential, state-governor and congressional elections – are still exerting a malign influence on the Brazilian stock market.

While the global slowdown continues to hamper export growth and staunch capital inflow to the developing nations in general (financing and, above ali, direct investements}, Brazil has to face the additional problem of developments m neighbouring Argentina. There are serious doubts as to whether the recent measures taken by the Argentine government, aimed at achieving a zero fiscal deficit in the second half of 2001, will be sufficient to reverse expectations and lead to a return of investrnents (including foreign ones) and an econornic recovery. If this reversal does not occur, the fiscal squeeze may only lead to continued stagnation and even more widespread uncertainty.

But it is not only the externa! threat that is marring prospects for growth and, therefore, those of the stock market. The domestic scenario, partly due to the prior repercussions of the unfriendly climate abroad, is also giving grounds for concern. Economic activity has slowed drarnaticaliy in the wake of higher interest rates, the power rationing and the volatility sparked by pressure on the foreign exchange market, to mention just some of the events that have frustrated initial expectations of 2001 GDP growth of around 4.5%. Now, the market consensus is hovering between 1.8% and 2.4%.

The new agreement with the IMF, announced in early August 2001 by the government, is intended to put the country on the right track for 2002 by preventing any worsening of the current situation. It represents, therefore, a definite step forward, aliaying fears over the financing of next year’s current account deficit and acting as a clear signal that the government will be just as committed as ever to meeting the fiscal targets (although it may be given less leeway).

The reduction in equity prices since the middle of 2000 means that most of the adverse future possibilities have already been incorporated. Brazilian firms in ali sectors are being traded at a substancial discount, ranging approximately from 25% to 40%, over their international peers and, more pertinently, over their counterparts in markets similar to ours.

These discounts also include the effect of the significant increase in Brazil’s sovereign risk on company valuations and, in a more general sense, the uncertainties regarding their earning power should the current economic scenario continue, or even deteriorate. Political factors may also have been taken into consideration, given that the 2002 campaigns may proceed in an atrnosphere still permeated by these doubts. However, some of the prevailing difficulties may be overcome shortly -there is, for example, a reasonable chance that the energy rationing will be suspended throughout the first quarter of next year.

Therefore, although we cannot ignore the uncertainties and risks associated with the presente situation, we also cannot ignore its inherent possibilities. lt would be wise, therefore, to keep a particularly dose eye on Brazil’s stock market: the storm – which has been raging for some time and may continue to do so for sometime – will not go on for ever.

THE BRAZILIAN ECONOMY: A TECHNICAL VIEW

ln this section, we first intend to show that the period 1995-1998 and 1999-2001 differ in terms of the strategy to finance the Brazilian current account deficit and economic growth. The two different strategies adopted to finance the Brazilian current account deficit and the external gap in these two periods implicitly defined the development of domestic capital markets. During 1995-1998, the domestic market of debentures was marked by a lacklustre development. The use of foreign savings in the form of short-term capital reduced the appetite for debentures (denominated in reais) in the domestic market, both in the supply and in the dernand side.

On the other hand, the period 1999-2000 clearly sets the basis for the development of domestic capital markets under the strategies of floating exchange rate system, increased inflows of foreign direct investments (necessary to finance the · current account deficit) and lower domestic interest rates. However, the fragile externai scenario currently jeopardises the basis set for sustainable growth because the Brazilian economy is still constrained by the foreign exchange gap.

The clear cut between those two periods in terrns of the development of domestic capital markets is our second objective in this article. In order to distinguish the periods 1995-1998 and 1999-2001 in terrns of economic fundarnentals and the development of domestic capital markets, we will use a more technical framework presented in the next section. Nevertheless, readers relatively averse to technical details may skip the next section without compromising the full understanding of the two other following sections.

SOME BRIEF DEFINITIONS

It is possible to track the history of the Brazilian capital markets, particularly the primary, with the use of a very simple and well-known macroeconomic equation:

S* = M’ -X’ =(I-Sf}-[Td(G+R)J (1), where:

S* represents external savings. This is mainly comprised of the inflow of US dollars via Eurobonds, Brady bonds, (US dollar­denominated) commercial papers, and (US dollar-denominated) certificates of deposits. It also includes annex IV and VI, foreign direct investment – FDI (including privatised state owned · companies) – and short-tenn loans (constituted mainly by credit lines for trade finance) and long-term loans (conceded by private internacional banks).

􀀒       M – X is the current account deficit, with X’ and M representing exports and irnports of goods and services, respectively.

􀀕       I – Sf is the savings gap, with I representing the domestic level of investment in additional production capacity. Sf accounts for the level of internal financial savings invested in the domestic capital market. The latter mainly includes the primary and secondary debenture markets, IPOs and commercial papers, denorninated in domestic currency. It is irnportant to distinguish Sf from the standard savings terms (S), given in every textbook on macroeconomics. Sr is the flow that comes from the stock of liquidity, which is usually allocated in government securities, debentures, commercial papers, IPOs, shares, etc. On the other hand, S represents the flow of domestic savings, largely dependent on the macroeconomic level of disposable incame and – in general – relatively low in magnitude in terms of finaincing. Therefore, S1 is the sole domestic source of funds for private dornestic investment in additional production capacity (/). Moreover, particularly in the case of ernerging markets, unequal incame distribution means S is relatively low, making S1 the only potential source of funds available to reduce the domestic saving’s gap.

Td – ( G + R) is the government’s primary surplus (or governrnent savings), with Td as tax revenues from domestic income, G the level of the governrnent’s current expenditure and R the transfers (such as social security benefits) from the governrnent to the private sector.

Using equation (1), our intention is to briefly describe what happened both to the Brazilian economy and to the domestic capital market (mainly the prirnary) in two very distinct periods: 1995-1998 and 1999-2001.

1995-1998: The use of external savings (S*) and the lacklustre development of domestic (primary) capital markets

lt is fair to say that external savings (S*) from 1994 to 1998 financed not only the external gap (M’ – X’) but also the lion’s share in the expansion of investment in domestic production capacity (J). Relatively high domestic interest rates (measured by the Selic rate1 ) and foreign exchange coupon (FEC)2 were both responsible for a significant inflow of foreign savings through annex VI – mainly via fixed incame funds for foreign investors – and through the issue of US dollar-denominated Eurobonds and commercial papers. Of course the use of the FEC depended heavily not only on the high differential between the Selic rate and the international risk free interest rate, but also on the stability of the spot R$/US$ rate. Exhibit 7 shows the correlation between the FEC and the inflow of foreign currency thorough annex VI and via the issuing of US dollar-denominated fixed income securities.

Most of the inflow of foreign reserves through fixed incame funds (annex VI) was concentrated in domestic government securities denominated in reais and the remainder was largely constituted of CDs issued in reais by large and healthy banks. This means that, within the framework of equation (1), external savings financed the savings gap (I – S1} and, at the same time (e pour cause), the domestic primary debenture market was severely constrained on the supply side. High domestic nominal interest rates and the relative stability of the spot R$/US$ rate – together with the use of instruction 63 by private companies – drove large and medium-size companies and corporations to leverage themselves in the international market instead of the domestic fixed income market. Exhibit 8 shows the evolution of primary issues of debentures in the domestic market as a proportion of the inflow of external savings via annex VI and the issuing of Eurobonds and US dollar-denominated CPs.

The ratio between primary issues in the domestic market and in the internacional market fell significantly between 1995 and 1998, with the exception of 1997. Particularly during 1997, the average ratio rose to 48.4% not because of the increase in financial instruments issued in the domestic market. As a matter of face, it rose sharply because the placement of Eurobonds fell substantially during that year due to the international financial crisis that took place in October 1997.

At the same time, the relatively high Selic rate and the increase in confidence both in Cardoso’s first aclministration and in the stability of the spot R$/US$ rate drove domestic pension funds, asset managers and treasuries to concentrate their investments in government securities denominated in reais. This means that, on the demand side, the issue of debentures by private companies was also relatively constrained between 1995 and 1998. Exhibit 9 shows the demand for government securities vis-à-vis the demand for private securities issued in the domestic market.

Of course, the Mexican crisis, which lasted from the very end of 1994 to 1 Q 1995, the currency crisis in South-east Asia in the middle of 1996, the international financial crisis in October 1997 and the Russian ‘default’ in 2H 1998 forced the Brazilian Central Bank to raise the nominal Selic rate. This, together with the acceleration in the privatisation of state-owned companies in 1997 and 1998 (which corresponded to a large inflow of foreign direct investment – FDI – in both these years), was aimed at maintaining exchange rate stability through the attraction of further foreign savings. Nevertheless, the negative effects of the Russian crisis, the associated contagion effect, the Brazilian government’s primary deficits obtained during 1 Q 1998, and the poor primary surplus generated in 1998 (0.3% of GDP) jeopardised the government’s ability to redeem its debt servicing and principal on domestic public debt. As a result, high (nominal) domestic interest rates not only effectively capped external savings via annex VI but also drove domestic players to go long in (spot, futures and forward) US dollar-denominated assets abroad. At the very end of 1998 and the beginning of January 1999, the outlook for the domestic capital market (both primary and secondary) was bleak and the devaluation of the real appeared to be a tour de force.

1999·2001: The use of external savings (S*) via FDI and the (still) incipient development of domestic capital markets

The abandonment of the currency band regime and the adoption of the floating exchange rate system implied a shift in monetary policy. High nominal interest rates and foreign exchange coupon (FEC) could no longer be the general rule in attracting foreign savings (S*) necessary to finance the current account deficit ( M’ – X’) and  the savings’ gap ( I – S1). Exhibit 10 shows the gradual decline in the Selic rate and the negative FEC in 1999 and 2000, which is explained not only by the marked depreciation of the spot R$/US$ rate in 1999 (of approximately 48%) but also by the gradual fall in the nominal Selic rate.

The new Central Bank team’s strategy was clear: the funding of the current account deficit would be achieved mainly with FDI rather than with the inflow of US dollars associated mainly with annex VI funds. Three conditions had to be fulfilled in order to achieve this:

• interest rates would have to tumble during 1999 and 2000 in arder to boost economic growth;
• the privarisation schedule would have to be rigorously followed; and
• mergers and acquisitions would have to gradually substitute the gradual and finite privatisation of state-owned banks and companies.

Exhibit 11 shows the effect of this strategy: the GDP growth rate started to recover gradually in 1999 and increased significantly in 2000, while the inflow of FDI remained strong, but still concentrated in sectors in which companies were ready privatised.

Within a scenario of falling nominal and real imerest rates, credit expansion and floating (and depreciated) spot F/X rate, Brazilian companies turned to the domestic market to finance their CAPEX. ln the light of equation (1), the savings gap started to be partly funded by the stock of liquidity, which had been repressed mainly in government securities between 1995 and 1998. This means that, on the supply side, the offer of debentures sharply increased relative to the issues placed abroad. The volume placed in the domestic market rose significantly relative to the international market m 1999 and more significantly in 2000 (see Exhibit 8). On the demand side, the appetite for real-denorninated government securities significantly decelerated during 1999-2000 while, at the same time, the demand for debentures issued in the domestic market started to slowly mcrease, having experienced a consecutive three year decline before 1999 (see Exhibit 9).

OUTLOOK 

In the light of equation (1), the basis for the economic recovery was therefore set at the beginning of 2000:

• the current account deficit should be almost entirely financed by the inflow of FDI, which is part of the external savings;
• the funding for private companies’ CAPEX should originate more from the domestic capital markets, particularly debenture issues and IPOs; and
• the government should generate progressively higher primary surpluses (averaging 4.0% of GDP per year) for the next five years and the Central Bank should reduce domestic interest rates in order to boost GDP growth and to reduce the debt servicing cost.

The deterioration in the external scenario (mainly in the US and in Argentina) during 2001 jeopardised the growth of Brazilian exports and the inflow of FD I. The external gap, therefore, continues to haunt the financing of development and growth. As a result, the Brazilian government has had to go back to the IMF for additional funds to be used in 2001 and 2002. This also illustrates why there are some fundamentals in the marked depreciation ( of 26% YTD) of the spot F/X rate in 2001. Finally, it is the reason for the increase in the basic interest rate (the Selic) from 15.25% to 19% p.a. between the beginning of the year and July.

Will these circumstances change significantly in 2H 2001 to make the outlook in 2002 less gloomy? It is possible: the Brazilian capital markets – as shown in this section – have a stronger domestic base and do not heavily depend on volatile external savings to fund sustainable growth. Moreover, it is clear that the government’s intention is to increase its solvency through progressively higher primary surpluses and a significantly lower Selic rate. It is true that it is hard to expect an appreciation – or even a small depreciation – of the spot F/X rate and marked drops in domestic interest rates in 2002 (the external scenario is still very uncertain). However, the floating exchange rate regime and the fact that inflation is still under control make it possible for companies and investors to have longer term perspectives regarding investment decisions. This represents the structural basis required for any recovery in capital markets.

Notes:

1 The Selic rate is the basic interest rate used in overnight operations and interbank loans involving government securities denominated in reais.

The FEC is the difference between the basic domestic interest rate (measured, in this case, by the nominal Selic rate) and the sum of the depreciation of spot RS/USS rate ,its the internacional risk free interest rate.

Which corresponds to in equarion [Td -(G+R)] <O in equation (1).

* Acknowledgements: The authors owe thanks to Ana Higa, Cristina de

Andréa, Rafael Jwci, Ricardo Ventilho Figueiredo and Sílvio Micheloto for all the data, support 2nd comments which they contributed to the article, without implicating them in any errors and omissions contained herein.

Marco Antonio Maciel PhD, Chief Economist and Head of Fixed Income Research, and Reginaldo Alexandre, Head of Equity Research, Itaú Corretora de Valores S.A., São Paulo, Brazil.