For the first time in almost two years Brazil´s Central Bank did not cut interest rates when its monetary policy committee, the Copom, met in October. Most observers were fairly relaxed about the decision as the Copom described the move as a “pause” in its accompanying statement. Mauro Rached Rached who is head of the Advisory Desk Brazil for the French bank PNB Paribas in São Paulo correctly forecast the Copom´s decision. In this interview he explains why he believes the “pause” could last until March next year. He also discusses why Brazil has not been as affected by the subprime crisis in the US as it was in previous crises and warns of a possible fall of 2,000 to 3,000 points in the Brazilian stock market, the Bovespa, in the coming months as investors reassess their positions.  

Mauro Rached Rached: The market was divided between those who thought the Copom would cut the Selic rate by 0.25%, as it had in September, and those who thought it would make no change. Initially, I had thought the Copom would leave the rate untouched. The IPCA inflation index in September had been lower than expected and pointed to another cut but I was not convinced that was enough. Economic activity was obviously heated and this became more apparent when the figures for the use of installed capacity were released. The external current account surplus keeps drying up which indicates that the exchange rate is not far from its neutral point. This meant that the Central Bank could no longer rely on its great ally - the appreciated currency - to relieve companies´ attempts to recompose their margins through imports. At the same time the costs of labor are rising faster than inflation as companies do not want to reduce their operations or lose highly trained personnel. Despite the strong growth in rates of corporate investments, there was a good chance that they would not mature in time to avoid any threat to the 2008 target if the Central Bank were to maintain its policy of easing interest rates as it had been doing for almost two years. I thought it was time for the Copom to hold off and let the previous cuts take effect and that´s what it did.

Rached: I think it´s premature to talk of any cut in interest rates this year. The Central Bank should adopt a cautious approach, taking into account the investment rate in the coming quarters, the GDP growth rate etc and start cutting the rate next year. I don’t see the Copom resuming interest rates cuts before its second meeting of 2008 in March.

Rached: We are forecasting the Selic to be near the 10% level at the end of 2008 so I believe real interest rates will keep falling but there is not enough room for them to fall to levels of, say, 4% in three years for example. The government would have to make lots of changes to achieve much lower interest rates than it is prepared to.

Rached: There are two main challenges to be overcome. First of all, reduce the size of the public debt - around US$ 600 billion - and its in ratio to GDP. The net debt/GDP ratio is currently about 44% which is lower than in the recent years but is still high. Secondly, but no less important, there is a heavy tax burden which makes it difficult for companies to make investments and raise the share of investment as part of GDP.
 
The Brazilian economy seems to have avoided any fallout from the crisis arising from the subprime mortgages in the US. Does this mean the Brazil can stand on its own or is it still dependent on the world economy?

Rached: There have been many big changes since the previous crises of 1997-2001 involving Asia, Russia, Brazil and Argentina. Brazil is in a much healthier situation nowadays. During the previous occasions the current account was negative, foreign debt was high and foreign reserves were low. This led to a devaluation of the currency, higher inflation and Brazil had to go to the International Monetary Fund for help. Now Brazil, and most of the other emerging economies, has high currency reserves, positive current accounts and lower foreign debt. Another factor is that the dollar has fallen in value. However, although Brazil and the other emerging countries have not experienced problems in terms of their currencies there has been a shock in relation to the stock market due to globalization. Share prices have been hit but currencies were less affected.

Rached: After a sudden fall it´s normal to see prices rise again. Share prices have recovered somewhat but this has been for technical reasons and is not based on the fundamentals. I don´t agree with the view that simply cutting US interest rates is the cure for all ills. The Fed says it will keep cutting rates to avoid a recession in the economy. This is right but it will be difficult to avoid a recession if the subprime crisis gets worse and starts affecting the behavior of American consumers. Companies are likely to post worse earnings in the third quarter than they did in the second. They will not be bad enough to point to a recession but if they are worse than expected then we could see a correction and share prices would fall.

Rached: I think prices are exaggerated and it would not be a surprise if the Ibovespa lost 2,000 to 3,000 points in the coming months as investors reassess their positions. This would not necessarily be a temporary correction but a consolidation.

Rached: Those which will benefit most from growth in consumption caused by the higher credit availability and real income – retail, banks, construction and input. These are obvious choices but there are also interesting possibilities in electrical energy, airlines and tourism. Highway concessions are a good option but the more regulated sectors are less attractive. Commodities are still performing well and the outlook is good, boosted by China.

Rached: I´m quite optimistic in the medium to long term. For example, I don´t think the US is heading for a recession. The subprime crisis still has to be resolved, of course, but if it does not spill over to the real economy then we can expect the US economy to grow moderately. The figures for industrial production, retail sales, job creation are not as bad as had been imagined e.g. the registered loss of 4,000 jobs in August was revised upwards to the creation of 89,000 new jobs. The European economy is also doing reasonably well, despite the rise of the Euro, and is certainly not heading for recession. Japan is also growing albeit moderately and, of course, China is powering ahead. This is good for the Brazilian economy and I think we can expect growth of around 4% in the medium term.   

Rached: There is little concern. They see the strength of Brazil´s institutions which are democratic and functioning fairly well. The differences between the parties are now more administrative than ideological and the political factor has lost its importance in relation to investment decisions. This has been a great advance. 

(c) John Fitzpatrick 2007