This content is from: Portfolio
Brazil Is Betting on a New Growth Model: Infrastructure
Stuck in an economic slump, Brazil is hoping investments in its infrastructure will help boost its economy. But will bureaucracy stifle development?
Cuiabá, a dusty, sleepy city of 500,000 that sits deep in the vast grasslands stretching south of the Amazonian rain forest, might not seem like the most obvious place to launch a new growth model for Brazil. It is the capital of the state of Mato Grosso, though theres no real city center to speak of, public amenities are scant, and whatever commerce exists occurs either in small, ramshackle roadside stalls or in large, strangely empty shopping malls. But while the rest of Brazil slumps, Mato Grosso soars: Growth last year reached 8 percent, according to the state economic ministry, and it is expected to continue at the same rate this year, largely on the back of global demand for soybeans, which Mato Grosso produces in greater quantities than any other Brazilian state, and maize.
Cuiabá was chosen as one of 12 host cities for the recent World Cup games, with public money used to build a new stadium (see World Cup Host Brazil Needs Infrastructure Cash). But with World Cup crowds long gone from the 40,000-seat Arena Pantanal, attention has shifted to the BR-163, a two-lane, 2,700-mile road running through the city, linking Atlantic Ocean ports in the north and south of Brazil to the fertile grain pastures of the interior. The stretch of highway that runs through Cuiabá, and for hundreds of miles on either side of the city, is paved. But further along asphalt gives way to dirt and mud a nightmare for heavy trucks that transport produce to the ports, where much of it will be shipped to China.
The stadium is a symbol of the first phase of the plan to grow investment in Brazil, says Mauricio Guimarães, who served as Cuiabás special government secretary for the World Cup. A paved BR-163 represents the next phase. But as Brazils president, Dilma Rousseff, campaigns for reelection and the government deepens the implementation of an ambitious scheme to boost infrastructure, its not clear whether Brazil is ready for a new growth model or whether global investors are interested enough to make it work. Were in a classic middle-income trap, and theres a very clear path to get out of it, says Fernando Martins, a São Paulobased partner specializing in agriculture and transportation at management consulting firm Bain & Co. But following that path will be difficult.
Decrepit infrastructure has long been a barrier to growth in Brazil. The World Bank says total investment accounted for 18 percent of gross domestic product in 2013, placing Brazil well below emerging-markets peers such as Russia (23 percent), India (30 percent) and China (49 percent). Investment has stagnated for much of the past two decades: In 2004 it was 17 percent of GDP; in 1999, 16 percent.
Beginning in 2004, Brazils economy surged on the back of expanding credit and consumption, but in recent years growth has stalled. GDP contracted 0.6 percent in the second quarter, placing Brazil in technical recession for the first time since the financial crisis of 200809. Most forecasters expect the economy to remain sluggish in the second half of the year: The World Bank projects full-year growth at 1.5 percent, compared with a high of 7.5 percent in 2010, and thats at the optimistic end of the range. Government officials recognize we are done with the consumption model, says Fernando Honorato, chief economist at Bradesco Asset Management, a São Paulobased firm overseeing $130 billion in assets. They know we need something else to get the economy going.
The questions of what will drive the next growth wave and where financing will come from are harder to answer. With wages high, productivity low and Brazils demographic bonus evaporating as the population ages, goods and services wont provide much impetus. That leaves commodities. Vale, Brazils leading mining company, has prospered by feeding Chinas appetite for iron ore, and there are great hopes invested in the development of pre-salt oil deposits off the Atlantic coast that state-owned energy company Petróleo Brasileiro estimates could quadruple Brazils oil reserves. But increasingly the low-hanging fruit is in agriculture, says Olivier Colas, a São Paulobased senior vice president at Kepler Weber, Brazils largest silo and grain-storage company. Thats where the most work can be done most quickly and most efficiently to lift productivity.
Agribusiness already accounts for 23 percent of Brazils GDP, and the Ministry of Agriculture, Livestock and Food Supply expects 2014 to be a record year: A projected harvest of 90 million tons of soybeans, much of it from Mato Grosso, would make Brazil the worlds leading producer and help push the country into the ranks of the worlds top food producers, which include China, the U.S. and India. Over the next ten to 20 years, agriculture is the place to bet if youre betting on Brazil, says Bains Martins.
If the ministrys 2014 projections are met, Brazilian agribusiness will have grown 34 percent in the past ten years. Remarkably, that growth has come despite major logistical impediments: underdeveloped ports, minimal rail links and agricultural producers reliant on trucks that must use often poor, unpaved roads. Brazils infrastructure creates an average annual economic drag of 12 percent of GDP, says the Belo Horizontebased Center for Studies in Infrastructure and Logistics, compared with 8 percent in the U.S. and 6 percent in Europe. The drag is felt most severely in agriculture. In 2005 it cost $77 per ton to transport soybeans from Mato Grosso to Paranaguá, a port on the southern coast, says Kepler Webers Colas. Today it costs $150 per ton. Once overseas shipping is added, total soybean freight-transport costs, from the producer in Mato Grosso to the consumer in China, amount to $190 per ton, according to the states economic ministry. Argentina and the U.S., Brazils main soybean rivals, can do it for $102 and $64, respectively. Transporting soybeans by rail rather than truck would cut costs by a third, says the Ministry of Finance.
Why not more rails? As so often in Brazil, politics intervened. Lobbying from the auto sector means railroads have not progressed for decades, says Lawrence Pih, CEO of Moinho Pacífico Indústria e Comércio, a São Paulo silo operator.
Bottlenecks at ports are exacerbated by the preference of Brazilian farmers for exporting the bulk of their harvests immediately rather than storing them on-site. Theres a chicken-and-egg problem in much of Brazilian agriculture, Colas says. If we had better infrastructure, farmers would pay less on transport and have much more cash to build storage facilities on farms. By fixing one problem, youd fix the other.
Pouring money into infrastructure allows Brazil to achieve two objectives simultaneously: alleviating the countrys chronic underinvestment and freeing up capital for agricultural producers so they can devote more resources to improving yields and productivity. All of this, in the ideal scenario, should boost Brazils international competitiveness and push the country toward a new growth level. At least, thats the theory.
The reality is more difficult. Despite a commitment from Rousseff to boost investment in infrastructure, her first term has been plagued by miscommunication and mismanagement. Initiated in 2007 under Rousseffs predecessor Luiz Inácio Lula da Silva, the so-called Growth Acceleration Program (PAC) was a $225 billion plan to jump-start development across housing, transportation, sanitation and energy. After taking power in 2010, Rousseff extended the program, but many projects, including World Cup facilities, became mired in controversy because of delays and cost overruns. Fiscal pressures compounded the problem. Public debt is still relatively low in Brazil at 35 percent of GDP, but it is growing, and the federal budget remains chronically in deficit. Rousseff has pledged to meet a primary surplus target of 1.9 percent of GDP this year and 2 percent next year if she is reelected.
National savings, meanwhile, are at 13 percent of GDP, compared with 51 percent in China and 30 percent in India and Russia. Money to invest is scarce, exacerbated by weak growth. In mid-2012, with the World Cup approaching and the public sectors limited ability to push infrastructure development evident, Rousseff announced a plan to develop roads, railways, airports and ports. Some $66 billion of public money was earmarked, but the critical difference with previous efforts was making private investors key players in the funding and operating structures. Whereas the PAC had been driven by the federal government, the projects in Rousseffs 2012 investment package, including 4,350 miles of new roads and 6,000 miles of new railways, involved privatization of one form or another.
A lot of that change in course was driven by the fear of not having projects ready on time for the World Cup, says Bradescos Honorato. But, he adds, the tournament, for all its galvanizing effect in forcing the government to concede the importance of the private sector, was a missed opportunity. We were expecting the government to use it as an excuse to invest in infrastructure in a broader sense in roads, rails and airports. But that didnt happen.
What did happen was that three major airports in São Paulo, Rio de Janeiro and Brasília were privatized and six toll roads put out to private tender. Its not great, but at least its a start, says Alberto Zoffmann, São Paulobased global head of project finance at Itaú BBA, the investment banking arm of Itaú Unibanco, Brazils second-largest bank by assets. Leaders in the ruling Workers Party at first resisted opening public works to private participation, says Pablo Fonseca, secretary for economic monitoring at the Ministry of Finance. There were political concerns over doing investment with private participation, but they dissipated over time, he says. The government is able to be extremely pragmatic.
Analysts agree that the airport privatizations were handled relatively efficiently, although concerns persist over regulatory uncertainty an especially acute problem for long-term investments such as roads, railways and airports. Changes to the airport investment and regulatory framework, such as direct authorization for a new airport in São Paulo, obviously create uncertainty, says See Ngee Muoy, a spokesman for Singapore-based Changi Airports International, which with Brazilian construction company Odebrecht Transport bought Rios Galeão Airport for $8.3 billion late last year. Brazil, Muoy adds, still has much to do to create a pro-business environment and cut red tape.
Road privatizations encountered greater difficulties. With the state-run Brazilian Development Bank (BNDES) providing much of the financing at subsidized rates, usually about 3 to 5 percent, the cost of capital to develop infrastructure in Brazil is often well below market rates a much-needed boon in a country where the benchmark interest rate, the Selic, stands at 11 percent. At first, the government attempted to auction road projects at internal rates of return below what the market was expecting. The private sector communicated its displeasure, and eventually the government infrastructure agency, the Empresa de Planejamento e Logística, raised the IRR to 7.2 percent from 5.5 percent. Over time, all the roads were auctioned off, with one exception: the BR-262, a highway that passes through uneven terrain in eastern Brazil.
In all, Brazil auctioned off more than $40 billion of investment commitments in 2013, the most since the first privatization push, led by former president Fernando Henrique Cardoso in the mid-1990s. The government learned from these interactions with the market, says Cleverson Aroeira, head of logistics and transport at BNDES. This will help in the next stage. It takes time to put in place the right structures to make sure this kind of cooperation between private and public sectors can work efficiently.
The next phase will involve privatizing nine more highways and two railways, and auctioning 79 leases and port concessions. After years of underinvestment Brazil finally has a project pipeline and a differentiated funding structure. BNDES disbursed more than $85 billion in loans last year, with one third going to infrastructure. Subsidized finance from the bank will continue to provide the core of many of the projects auctioned off in the next five years, says the Finance Ministrys Fonseca, but we dont see ourselves as the only financer. We want to attract capital markets and other private sources to these projects. For a start, Brazil has provided tax exemptions for local and international private equity funds devoted to infrastructure, although Fonseca concedes that activity has been limited.
Debt has proved to be a more profitable funding channel. In 2010 the government, after consultation with the private sector, created a new class of tax-exempt project bonds to provide additional financing for infrastructure. In the past two years, 20 projects have been launched using project bonds, although the securities only constitute 10 to 20 percent of total funding. Maturities have been long and yields relatively high, making the instruments theoretically attractive to private sector project backers. But issuance has slowed as investors have waited for interest rates to come down. They might be waiting a while. Inflation continues to creep higher, so theres no expectation market rates will come down soon, says Itaús Zoffmann.
High interest rates have also hampered efforts to boost private sector lending to infrastructure. Fonseca concedes it has been hard to get private sector backing for some projects and says investors will only seek out bank lending once rates fall. But, Fonseca says, Our whole idea in the long run is not to have public participation at all in funding infrastructure projects.
Thats wishful thinking, says Moinho Pacíficos Pih, adding that its not just structural inflation and persistently high rates that make privatization such a challenge: Its the very bureaucratization of the process around infrastructure development.
Many of the rail and road projects pass through the Amazon basin. Development of the Amazon has long been a fetish for domestic and foreign would-be architects of Brazils economic expansion. Theodore Roosevelt noted in Through the Brazilian Wilderness, an account of his 1914 expedition to explore the Amazon, that the rain forests many rapid rivers could provide nearly unlimited force to populous manufacturing communities; he predicted that with communication and transport links established, the Amazon would eventually provide the crucible for a great industrial civilization.
Brazils plans have some of the same grandiosity about them, but its complex environmental licensing scheme, which is at its most stringent in the Amazon, and compromises and trade-offs built into the federal-state power structure make it a time-consuming process to bring projects to the shovel-ready stage. These are the complications of any democracy, notes Bains Martins, but Brazil is probably more bureaucratic than most other democracies.
This custo Brasil does not just make the cost of doing business high, it also inhibits many of the market-based financing mechanisms the government is looking to foster. Beyond unfavorable yields, project backers are reluctant to issue bonds in the early stages of a project because the instrument might mature before environmental licenses have been approved. Says CEO Pih: Risks are at their highest for many infrastructure projects in their early stages. You dont know whether your license is going to get approved; you dont know whether anyone is going to use your railway; theres uncertainty over bond payments. The difficulty of doing business in Brazil adds to this.
Theres evidence BNDES is thinking creatively about these problems. The bank is looking to provide guarantees to projects and their backers. This, logistics chief Roeira says, could see BNDES guaranteeing coupon payments for project bonds or buying 100 percent of the rail capacity, then selling it to a third-party service provider.
Whatever the merits of these innovations, global investors have largely stayed away; the parties bidding on concessions have mostly been local construction and logistics companies. Given that most project revenues are denominated in reais, exchange rate risk has played a part, as have expectations of a hike in U.S. rates. Most observers, however, put the reluctance of foreign capital to commit to infrastructure down to the presidential election, the first round of which takes place on October 5.
The death in an August plane crash of Eduardo Campos, the candidate for the Brazilian Socialist Party, and his replacement by Marina Silva, the Environment minister in Lulas first cabinet, has turned the campaign on its head. Before the crash most observers saw the race as a shoot-out between incumbent Rousseff and center-right candidate Aécio Neves. Now polls give Silva 34 percent of the first round of voting, versus 35 percent for Rousseff, and have her beating the incumbent in the October 26 runoff by a considerable margin. Rousseff and Neves have committed to infrastructure development, but Silvas attitude is harder to discern. Her main economic adviser, Eduardo Giannetti da Fonseca, has said her program will not differ from that put forward by Neves, the market darling. Silva has committed to inflation and fiscal targeting and the free float of the real. But there is concern over how she will reconcile her environmental views with policies to boost agriculture and investment.
Itaús Zoffmann says, Investors are in a wait-and-see mode, anxious about what will happen over the first six months of the new administration and whether the candidates shared commitment to fiscal rectitude will remain intact. On the one hand, easy monetary policies in the developed world mean there is an abundance of global capital to be put into infrastructure; beyond China, which places the state at the center of infrastructure development, Brazil may be the only country pursuing large capital works programs. On the other hand, CEO Pih says, with growth contracting in the second quarter, Brazil is now in a recession, and rates of return for infrastructure remain unattractive. So why would anyone invest here?
Rousseffs first term did make progress. Four years ago we had no pipeline of projects, no instruments to get private capital to finance the projects and no real political will to engage the private sector in investment, Bradescos Honorato says. Now we have all three. In a country of riches whose specialty has been unrealized promise, that counts as progress. The old joke has it that Brazil is the country of the future and always will be. Now consensus has emerged that investment is the future. But financing, building and managing large-scale investments is more arduous than fueling a consumption boom with cheap credit. The investments will happen; its just that they wont be built at China speed or even the speed that Eisenhower built the interstate highway system, says Bains Martins. They will happen, but theyll be slow.
Whether they will come to fruition with participation from global investors, however, remains as clear as the muddy waters of the Amazon. All we need now, Honorato says, is confidence.
Get more on emerging markets.
Follow Aaron Timms on Twitter at @aarontimms.