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realclearworld

Brazil tries to borrow its way into prosperity

Mary Anastasia O'Grady in the Wall Street Journal:

Brazil Tries to Borrow Its Way to Prosperity

A five-year credit spree by state banks threatens the country's competitiveness.

Brazilian President Dilma Rousseff traveled to Davos, Switzerland, last month with a message for international investors: Brazil is about to become more competitive. "I want to emphasize that we will not be weak on inflation," Mrs. Rousseff said. "Fiscal responsibility is a basic principle of our vision for economic and social development."

On the way home, Mrs. Rousseff stopped in Cuba, where she inadvertently signaled the opposite. The Brazilian government's development bank—known by its Portuguese initials BNDES—has dumped almost $700 million in subsidized credit into Cuba to finance the renovation of the Port of Mariel. On Jan. 27, Mrs. Rousseff cut a ribbon at the project and promised another $200 million in BNDES credits for a second phase of construction. On the same day the Brazilian newspaper Valor Economico reported that Cuba is now the third top destination for BNDES loans.

http://si.wsj.net/public/resources/images/BN-BL038_amcol0_D_20140209111029.jpg

Cuban President Raul Castro (R) and Brazilian President Dilma Rousseff, chat during the inauguration of the Mariel "megaport" in Artemisa Province, Cuba, on January 27, 2014. Agence France-Presse/Getty Images

What a destination. Since 1959, Castro Inc. has racked up unpaid foreign debt and other claims totaling nearly $75 billion—including $35 billion owed to the Paris Club. Cuba is one of the world's most notorious deadbeats, and the Cuban economy is moribund. So it would seem a high-risk venture to pour credit into the Castro boys' pockets.

But the BNDES handouts are not only about Cuba. They're about the government's longtime aspiration to become a global industrial giant by directing credit. Odebrecht, the large Brazilian construction company that has a contract to modernize the Port of Mariel, is the big beneficiary of BNDES's subsidized loan. As Valor Economico noted, Odebrecht "is feasting in Cuba," where it also has been contracted to overhaul Havana airports with subsidized loans from BNDES.

Subsidizing Brazilian industries is what BNDES exists to do. But the development bank's aggressive lending is at odds with Mrs. Rousseff's claim that Brazil is about to become a serious country.

Thanks to the U.S. Federal Reserve's near-zero interest rates in the wake of the financial crisis, American investors flooded Brazil with dollars in search of higher yields. Brazil complained bitterly about Fed policy—even coining the term "currency wars"—as purchases of the real drove up its exchange value, making it more difficult to sell Brazilian goods, at home and abroad.

On the other hand, state banks partied hard while dollars were sloshing around. Now, as the Fed begins to "taper," the tide of cheap money is receding and the Brazilian beach is littered with dubious state-bank credits.

Brazil does not face an imminent crisis. The central bank says it has some $360 billion in international reserves. Yet with a fiscal deficit of 3.3% of gross domestic product and gross debt of 60% of GDP, Brazil's investment profile is deteriorating.

Lending by BNDES and other state banks like Caixa Econômica Federal and Banco do Brasil is not directly included in gross debt. But since these banks depend on transfers from the treasury and the treasury has to borrow in the market to raise that money, the banks' subsidized lending impacts overall debt.

Since 2008, state bankers have gone crazy pushing money out the door. Goldman Sachs' chief economist for Latin America, Alberto Ramos, told me in an email that Caixa's loan book "grew an average of 45% per year in the four year period 2009-2012." BNDES lending grew 52% in 2009, 9% in 2010, 15% in 2011 and 18% in 2012. Credit expanded 24% per year from 2009-12 at Banco do Brasil. Mr. Ramos wrote that "in all the loan book of all public banks tripled since the end of 2008 and grew by more than fivefold for Caixa."

As interest rates rise, the higher cost of servicing government debt will cause the fiscal deficit to widen further. Burdensome tax and regulatory policies already are a drag on business, and annual inflation is now running at 5.6%. To fight the rise in the price level, the central bank has boosted its overnight lending rate to 10.5%.

There is also the question of quality in what is a highly politicized loan portfolio. In October the Economist magazine reported "leaked documents show that Caixa's analysts think default rates will be 30-50%." BNDES seems to have plenty of dogs too. It reportedly lent the companies led by smooth-talking Eike Batista some $4.7 billion. His empire collapsed last year after his oil company OGX filed for bankruptcy.

The misallocation of credit when the state picks "champions" is pernicious. CIBC World Markets analyst John Welch told me in an email that his own research shows that over 10 years "increases in the percentage of subsidized credit relative to overall credit have led to a decline in growth." There is also the Brazilian tendency in recent years to increase protectionism to keep alive uncompetitive manufacturing companies that have BNDES loans.

High taxes, more protectionism, the misallocation of capital, higher interest rates (for those who are not chosen national champions) and persistent inflation are not the stuff of a competitive economy, notwithstanding Mrs. Rousseff's promises in Davos.

Write to O'Grady@wsj.com

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