Fresh development

The Lula government wants Brazil's development bank to do more for the poor and still support the country's industrial producers. It will be a tricky balancing act.

By Lucy Conger
March 2003
Institutional Investor Magazine

In the town of Cachoeira, in Brazil's impoverished northeastern state of Bahia, leather-tanning companies provide critical work in a region where jobs are scarce. But until last year the tanners were unable to grow through exports. The chief reason: They couldn't afford state-of-the-art Italian equipment.

Then in February 2002 Brazil's National Bank of Economic and Social Development, or Bndes, extended a $6.6 million loan to a leading Brazilian shoemaker that will enable the Cachoeira tanners to import the machinery. By 2004, the development bank projects, the tanners will be producing 1.4 million finished leather goods a year, a quantum leap from their former production of unfinished leather. With plans to export 80 percent of their new line, the companies expect to create some 700 new jobs.

The loan is a modest one for the bank, but its impact will be deeply felt in Bahia. Indeed, few Brazilian institutions exert as much influence as Bndes, whose $10 billion in disbursements last year were the equivalent of 10 percent of all private sector investment in Brazil. Providing long-term loans to corporate borrowers, the bank acts as a vital force in developing Brazil's infrastructure. Since it was founded 50 years ago, Bndes has nurtured many future market leaders, including pulp and paper manufacturer Aracruz and steel producers Cia. Siderúrgica Nacional and Açominas; has salvaged troubled companies; and, in the past decade, has orchestrated the privatization of state-owned companies, netting the government more than $100 billion. Telecommunications providers, transportation companies, energy producers -- all have been shaped and in many ways transformed by Bndes financing.

"The bank has a central importance because it operates the only financial instrument of industrial policy in Brazil," says Luciano Dias, a senior analyst at political consulting firm Goes e Associados in Brasília.

That instrument is about to be redirected. Under Luiz Inácio Lula da Silva, the first leftist ever elected president of Brazil, the powerful development bank is redefining its purpose in ways that could have a far-reaching impact on the economy. No one anticipates a top-to-bottom overhaul of Bndes's mission. But senior deputies in the Lula administration -- including the bank's recently named president, Carlos Lessa -- have signaled a shift in the $48.6 billion-in-assets institution's focus, toward more projects with a social impact, such as rural electrification and urban sanitation.

During the regime of Lula's predecessor, Fernando Henrique Cardoso, the bank extended loans to multinationals, Brazilian or not, and took on the new role of managing the privatization of state-owned assets. Under Lula the bank will take a more interventionist role in the economy, placing an emphasis on increasing the nation's productive capacity and creating more jobs -- as well as eradicating hunger, Lula's No. 1 priority. Zero Hunger was the rallying cry of his presidential campaign, which ended in triumph last fall when he received 63 percent of the popular vote.

"The mark of the new government is social inclusion," says Lessa in a wide-ranging interview with Institutional Investor. He means that the government's goal is to not only increase employment but also to raise the income of the poor and make health care and education widely available. "We think a solution to the country's problems is to expand productive capacity."

To help increase Brazil's productive capacity, Bndes will likely increase credits to small and medium-size businesses -- the largest overall employers -- and fund agricultural enterprises to produce more food, says Lessa, who was rector of the Universidade Federal do Rio de Janeiro before he was named to head Bndes and served for several years in the 1980s as director of social programs at the bank. That marks a departure from the pre-Lula formula, under which close to 50 percent of Bndes's lending was channeled to industrial enterprises like the Cachoeira tanners, 35 percent to commerce and services, 10 percent or so to farming and about 5 percent to social projects. Lessa will certainly boost the share of capital the bank devotes to such efforts as urban water-treatment plants, rural electrification and production of construction materials for low-income housing.

Lessa also hopes to extend the bank's reach beyond Brazil's borders, in keeping with one of Lula's major policy goals: building strong economic ties across the South American continent. The development bank is already the largest in Latin America, doling out more development funding in Brazil than the World Bank and the Inter-American Development Bank together disburse in all of Latin America. Bndes would in theory support Lula's vision by helping to fund Brazilian private investment in the region and such projects as linking electricity grids and railroad networks. "My dream is to support more integration projects in South America," Lessa says. It's a dream shared by the Inter-American Development Bank: "It's time to put physical infrastructure integration at the top of the development agenda," declares IDB president Enrique Iglesias.

But any changes at Bndes are sure to be tempered by the basic -- and, to some, surprising -- fiscal conservatism exhibited by the Lula government so far. "Lula represents a new breed of Latin American labor leader," asserts Alfredo Thorne, head of Latin American economic and policy research for J.P. Morgan Chase & Co. in Mexico City. Thorne says that Lula and his Partido dos Trabalhadores colleagues "will utilize state resources to confront social problems, but they are also conscious that they must maintain disciplined policies, given their country's indebtedness."

Case in point: On February 7, in a move that cheered foreign investors and outraged the more radical members of Lula's party, Finance Minister Antônio Palocci announced a program of economic austerity. The administration increased the target for this year's primary budget surplus (the government surplus before interest payments) to 4.25 percent of GDP, up significantly from the 3.75 percent figure that Brazil and the International Monetary Fund had agreed to last year. To meet the higher goal and also cover payments on Brazil's $244 billion in public debt will require Congress to impose $2 billion in spending cuts, tax hikes or some combination of the two. The surplus decision, coupled with the central bank's inflation-fighting hikes in the benchmark Selic interest rate, which rose from 22 to 26.5 percent during the past two months, suggests that Lula will insist on fundamental fiscal discipline even as he pursues his ambitious social agenda. Late last month Lula also took a first step toward reforming the tax and pension systems, announcing that the governors of all 27 Brazilian states had joined him in signing a letter of intent to send reform proposals to Congress by the end of June.

For the moment, at least, investor confidence in Lula's fiscal sobriety is giving the new president room to maneuver. Since January 2 the real, Brazil's currency, has fluctuated near a level of 3.5 to the dollar, though it fell slightly in late February amid Iraq war jitters. The price of benchmark government C-bonds rose from 67.11 cents at the start of the year to 70.06 cents in late February. Of course, a war in Iraq, or any other external shock, could roil bond and currency markets worldwide, and that would pose special problems for Brazil, because 30 percent of its domestic debt is linked to the dollar, and a further 50 percent is tied to short-term interest rates.

No matter what the economic environment, revamping policy at Bndes is bound to be a delicate and politically sensitive business. Lessa found this out after just two weeks on the job. On January 31 U.S. energy giant AES Corp., which owns Brazil's largest electricity distributor, the formerly state-owned Eletropaulo, told the bank that it couldn't make an $85 million loan payment. Four weeks later AES announced that it would not make the $336 million payment due on February 28.

Bndes had lent $1.13 billion to AES in 1998 to buy Eletropaulo shares when the utility was being privatized. The company then suffered severe losses when a major drought forced the government to impose energy rationing in June 2001, which resulted in a 20 percent cut in energy consumption overnight. The depreciation of the real in 2002 dealt another blow to the utility.

Unwilling to invest more in Brazil, and determined to hold on to Eletropaulo, AES has offered to hand over two assets to the bank: a generating plant and a power distributor, both located in the state of Rio Grande do Sul in the extreme south of Brazil. As of late February AES was seeking to extend the payment schedule on its entire debt to Bndes. The bank is expected to take a tough stance. Foreign investors are closely following the progress of the talks between the bank and AES, an early test of Lula's ability to negotiate and resolve disputes with multinationals.

Lessa's baptism by fire is an apt introduction to what promises to be a hot seat at Bndes. For a start, he will have to find a modus vivendi with Luiz Fernando Furlan, the minister of Development, Industry and Foreign Trade, who has a strong say in Bndes's affairs as president of its board. A prominent businessman -- his family owns a controlling interest in Sadia, Brazil's leading food processor -- Furlan surprised many by endorsing Lula during last year's campaign. "Lula represents a rare opportunity for change without rupture," Furlan told II.

The minister's perspective is that of an entrepreneur whose company pulls in 42 percent of its revenues from foreign sales in 56 countries. He will make a concerted effort to encourage Bndes to increase Brazilian exports. Lessa, on the other hand, is a leftist economist and longtime devotee of Celso Furtado, a decidedly leftist development economist and former minister of Planning. Observers expect some friction between Lessa and Furlan but nothing too disruptive. "I am entirely sensitive to the minister's concern for expanding exports, and I am ready to cooperate in every way possible," Lessa says.

"The two men are going to move toward a common development model," suggests Goes e Associados' Dias. "Without Bndes, the ministry is just a building in Brasília, and without the ministry Bndes has no power."

The development bank in fact enjoys a certain amount of independence from Brasília because it doesn't depend on government handouts. About 60 percent of Bndes's annual funding -- $6 billion or so, at the current record spending levels -- comes from two public worker insurance funds, with the remainder from other funds administered by Bndes and reflows, or repayments on loans. "The bank broadens the government's capability of acting outside of the [federal] budget," notes Mario Mesquita, chief Brazil economist for ABN Amro in São Paulo.

In Bndes Lessa and Furlan control a powerful tool for shaping the economy. It's a formidable entity. Some 93 percent of its loans are rated between double-A and B, according to the central bank's classification system, ensuring that Bndes's portfolio is in better shape than those of most Brazilian banks. Active in local capital markets, the development bank holds about $5.3 billion in Brazilian equities, roughly 4.5 percent of the total market cap. This year Bndes should raise 8 billion reais, or about $2.3 billion, on local and international markets, with an additional $1 billion coming from international organizations, says Furlan.

Bndes played a pivotal role in supporting Brazilian companies -- and Brazil's external accounts -- in the stormy months leading up to the presidential election, when investors anxious about an impending leftist victory drove the real down some 35 percent. As spreads on Brazilian bonds jumped from 700 basis points over U.S. Treasuries in February 2002 to 1,700 basis points as the election approached, and after Argentina defaulted on trade lines, foreign banks cut trade financing to Brazil for the first time in 30 years. Bndes filled the gap by expanding its export lending to 40 percent of its portfolio. Then, as Brazilian companies capitalized on the weak real, exports soared, pushing the trade surplus to a record $13 billion, from $2.6 billion at the start of 2002. Both Lessa and Furlan say Bndes's emphasis on funding exports will continue under Lula, particularly if international trade financing remains scarce.



BNDES WAS FOUNDED IN 1952 BY BRAZIL'S THEN-president, Getúlio Vargas, who sought to reduce the country's dependence on foreign capital. The bank extended long-term, below-market-rate loans to private and public sector companies. At the outset all of Bndes's funding supported public enterprises and projects, but by 1979 fully 83 percent of lending was to the private sector. The point was to encourage companies to make much-needed investments in the country's industrial production and infrastructure.

Launched with $250 million in assets, the bank made just $9.2 million in disbursements in 1953, its first full year of operation. In its early years Bndes backed the construction of railways and power plants and then, from the late 1950s through the mid-1960s, funneled much of its resources into building up the country's steel industry.

As the government promoted domestic producers and sought to minimize imports, Bndes was instrumental in developing a nascent Brazilian capital goods industry. The bank helped create national champions in cement, pulp, mining and chemicals. "The great machos of the private sector benefited substantially in the expansion of their enterprises -- they owe that to Bndes," says Werner Baer, an economics professor at the University of Illinois at Urbana-Champaign and author of the classic study The Brazilian Economy: Growth and Development. Over the years, the bank has also helped troubled companies by buying their shares through its investment subsidiary, BndesPar.

In 1996 the bank began orchestrating Cardoso's privatization program. Between 1996 and 2002 privatizations of steel, petrochemicals, fertilizer, mining and telecommunications companies produced $103 billion in revenues. Bndes officials supervised consultants and produced financial analyses to help the government determine if the prices set at auction were fair. "Bndes was a guardian of the seriousness of the privatization process," says a former employee of the bank.

In coming months the bank will be moving away from its focus on privatization because, as Lessa says, "there is almost nothing left to privatize."

But along with underwriting whole industries and overseeing privatizations, Bndes throughout its history made loans designed principally to benefit the working class and the poor -- for sanitation, health care and public education. In the Lula era the bank will place a higher priority on such social projects and expects to increase spending substantially beyond the recent level of 5 percent of total disbursements.

Bndes's core activities, such as helping troubled industrial enterprises, won't be abandoned. "No country can let its companies go broke," notes Lessa. The bank foresees Brazil's energy sector requiring an additional $7 billion in Bndes financing over the next five years, to recover fully from the June 2001 drought. Bndes was also poised to come to the aid of Brazil's national airline, Varig Brasil, after it missed a January leasing payment and had one of its Boeing 777s impounded. But the carrier merged last month with rival airline TAM, which should reduce its costs. "Brazil cannot do without the aviation sector, for reasons of national integration," Lessa points out.

Bndes's historic role in financing infrastructure projects, downplayed in recent years, will be strengthened. "I very much like to finance railroads," says Lessa, citing one export-boosting project to link soy-producing regions in Brazil's interior to Atlantic ports. Brazil ranks as the world's second largest producer of soybeans.

Export lending will remain a high priority. It represents a fast track to boosting production and employment, says Development Minister Furlan. He estimates that a 10 percent increase in exports this year will result in 400,000 new jobs.

Bndes also sees exports as a way to bolster the small and medium-size businesses that generate a disproportionate number of jobs. One likely scenario: The bank encourages the formation of export-oriented consortia of small producers of shoes, clothing, fruits and flowers, all products that Brazil now sells competitively in the global market.

To support Lula's Zero Hunger campaign, Lessa plans to back investments that increase production of food, especially chicken, fish, beans, eggs and milk. "Protein is the great nutritional deficit," Lessa says. Bndes will also fund systems to deliver food to cities, where 80 percent of Brazilians live.

As Bndes funds more social projects, it will need to keep a careful watch on the risk profile of its loan portfolio. Last summer, as the real weakened and Brazil's sovereign bond spreads widened, Standard & Poor's downgraded the country's credit rating from BB+ to BB. Bndes's rating moves with the sovereign's rating. "There is risk with social projects, but you cannot anticipate it; if the risk worsens, that will be reflected in the rating," points out Daniel Araújo, an S&P analyst in São Paulo.

Still, Bndes is likely to remain a better bet for foreign creditors than most Brazilian banks: The development bank's nonperforming-loan ratio is just 3 percent -- half that of the typical Brazilian commercial bank.

Sustaining that performance record while pursuing the bank's new mission to spark job growth and help eliminate hunger won't be easy. But it's the clear mandate of the first leftist ever elected to lead Brazil.