Brazil´s finance minister, Guido Mantega, is keen on setting up a sovereign wealth fund (SWF) to invest some of the large amounts of foreign currency the country is holding. However, the Central Bank, which has amassed about US$160 billion, is not so keen since it feels these dollars should be kept as an insurance against a rainy day. So far the Central Bank has won a victory of sorts and these particular reserves will not be used but Mantega is still determined to go ahead and the Central Bank is likely to become involved whether it likes it or not, as will the National Treasury and the national development bank, the BNDES. The idea was first raised in October but it has gained force a few weeks after it was announced that vast new oil deposits had been discovered off the Brazilian coast. News reports spoke of Brazil becoming one of the world´s largest producers and even a member of OPEC. This may be coincidence but, perhaps, the prospect of all this oil wealth has gone to the head of Mantega and his boss, President Luiz Inacio Lula da Silva. Brazil Political and Business Comment asked a number of eminent Brazilian economists for their views on this issue. Here are the opinions of Luis Carlos Mendonça de Barros, former communications minister and former chairman of the  BNDES, Alexandre Schwartsman, former director of the Central Bank and chief economist for Latin America of ABN AMRO, and Nathan Blanche, a partner at Tendencias consultancy.

According to the International Monetary Fund, over half of the total assets in SWFs are in the hands of countries that export significant amounts of oil and gas. The IMF describes SWFs as “major state-owned players of the 21st century” and says their total size worldwide has increased dramatically from around US$500 billion in 1990 to the current estimate of US$ 2–3 trillion and could rise to $10 trillion by 2012.

So far the IMF has made no comment on the Brazilian plan but Mantega´s idea has received a cool reception from many economists at home who fear it will end up raising the public debt. Should this happen then some observers believe Brazil´s ability to obtain investment grade from the rating agencies – seen almost as certainty – may even be endangered. Other observers think it is a way of intervening on the currency market to keep the Real from appreciating. Mantega was quoted by the Financial Times as saying that the fund´s function would be to reduce the supply of dollars on the market and hold back the rise of the Real. 

Since no definite plan has been drawn up, the result has been confusion and uncertainty and the widespread belief that the Central Bank chairman, Henrique Meirelles, and Mantega do not see agree on the issue. One critic, former finance minister, Mailson da Nobrega, writing in the Estado de S. Paulo newspaper, described it as “an idea which could be yet another which the minister (Mantega) launches without looking into its viability and then later forgets about. That´s the best thing that could happen to it.”

Brazil Political and Business Comment asked a number of eminent Brazilian economists for their views on this issue and will present them in the coming weeks. To start, here are the opinions of Luis Carlos Mendonça de Barros, former communications minister and former chairman of the  BNDES, Alexandre Schwartsman, former director of the Central Bank and chief economist for Latin America of ABN AMRO, and Nathan Blanche, a partner at Tendencias consultancy.

In principle, a sovereign wealth fund is a good idea. However, it should be funded from savings and not from debt. A country like Singapore may have US$ 10 billion to invest but that´s not the case with Brazil which will have to issue debt to pay for the dollars it buys. The net debt/GDP ratio is around 43.7% and the last thing we need at the moment is more public debt.

Perhaps it would be better to adopt measures which would allow the free flow of resources from Brazil abroad and vice-versa which would counter the exaggerated appreciation of the Real.  The government should end the need for companies which obtain resources abroad to bring them to Brazil since this means they do not have the freedom to use these resources as they want, such as to pay foreign suppliers. There are situations in which an exporter has to bring the dollars to Brazil and then has to send them out again to pay for equipment made in other countries, for example. This increases the company´s financial costs. Imagine how much extra a company like Embraer which imports a lot of components from abroad has to pay in its financial costs.

A sovereign wealth fund is also not a good idea for funding the BNDES. The BNDES can fund itself by raising resources directly on the foreign markets as it does today. It would also cause fiscal problems since the BNDES makes loans at rates which are well below the market rates. Having said that, I don´t think that the discussions over a sovereign wealth fund will hold Brazil back from obtaining investment grade.  

According to the proposal, the National Treasury would purchase hard currency in the local market and use these resources to create a SWF, which would, in turn, invest in offshore assets issued by Brazilian companies. These assets could include securities issued by the BNDES funding its local financing activities.

The experience with SWFs shows that, typically, although not always, countries that set these funds up export a single commodity (oil, gas, ore, etc) that feeds the government vaults directly as royalties, dividends, taxes or any other form of revenue, so higher prices translate directly into improved fiscal performance. Since these revenues are cyclical in nature, prudent fiscal management calls for saving them, rather than spending. In other cases, the governments simply run fiscal surpluses independent of commodity performance, but save for the future nonetheless. It turns out that, in the Brazilian case, there is not a single commodity that dominates exports (the 10 most important export products comprise about 30% of external sales), nor are government revenues directly associated to export performance in any meaningful manner. There is, however, an indirect impact of commodity prices, since better terms of trade have allowed domestic demand and domestic output to expand considerably, translating into additional tax collection.

Needless to say, additional collection has been duly converted into extra spending, so that the federal government runs a fiscal deficit (2.6% of GDP), which implies that the only way for the National Treasury to finance acquisition of hard currency for its SWF is to place additional securities locally.

Moreover, if the resources saved in the SWF are to be of use in times of trouble, they should be preferably invested into assets negatively correlated to the performance of the country. Thus, a country that exports, say, oil and gas might find it attractive to invest in companies that would fare well when the prices of these commodities decline (the auto industry?), and very unappealing to have further exposure to oil and gas producers.

The Brazilian SWF, in contrast, would concentrate its assets in Brazilian companies, precisely those highly correlated to the Brazilian performance in general, that is, those who would suffer when Brazil is hit by negative shocks and do well when the country faces positive shocks. This offers no protection at all against bad states of nature, which should be one of the main reasons for any SWF to exist.

I am quite skeptical about the ability of sterilized intervention to affect the path of nominal rates but apparently those who came up with the proposal of the SWF think differently, since one of the main functions of the SWF consists precisely in replicating the Central Bank intervention in the FX market, presumably to depreciate the currency.

That said, reading a recent piece from my friend and competitor Eduardo Loyo I learnt an interesting point. Suppose that, in the absence of the SWF, a Brazilian company would have placed US$ 100 million in securities at a given rate, an amount that would increase to US$ 150 million with the SWF operating at full throttle. These additional US$ 50 million would eventually find their way back to Brazil, where the company operates, undoing the very intervention which would be central in the design of the SWF.

In sum, the SWF proposal suffers from serious flaws: (a) it does not originate from fiscal savings; (b) it does not provide the protection from external shocks that would come from investments negatively correlated to the Brazilian performance; and (c) the very intervention in the FX market that motivates the SWF might be undone to some extent if it encourages local companies to issue securities in excess of those who would be issued in the absence of the SWF. Does not look great, does it?
     

The idea of creating a sovereign wealth fund, as some other emerging countries have, to use some of the current foreign reserves or even increase them by around US$ 10 billion to invest in higher-risk assets has serious problems in Brazil´s case. The first is the cost of accumulating the reserves or buying dollars through the Treasury. Unlike other countries like China, Chile, Singapore and Saudi Arabia, Brazil has to pay an extremely high cost. On one hand when the Central Bank buys dollars, this leads to a torrent of Reais entering the economy which are sterilized by a debt issue which has an average cost of 11.25%. On the other hand, the reserves are invested in American issues which pay the Fed Fund rate of 4.75%. The government´s idea may be to reduce this difference in cost by investing in securities with a higher return than the Fed Funds rate. However, to achieve this, the government will have to invest in variable income which has a much higher risk which means that the costs of accumulation of the reserves, in this case, becomes even higher.

The second point is that the international reserves are an insurance for Brazil against abrupt changes on the international front. This means these assets should be liquid to be used in case they are needed. The idea of investing the reserves in infrastructure projects, for example,  goes against the nature of foreign reserves. Even when the reserves are in variable income, the risk is still very high since the assets are affected by changes in market expectations and can be negatively impacted. In other words, of the US$ 10 billion invested, the government could find it has a lot less than it thinks when it really needs them. This will be reflected in the country risk. It is also worth mentioning that it makes no sense to allocate the reserves to the BNDES since it also raises resources abroad at lower rates.      

The third point is that there is a bureaucratic element involved in relation to how the fund is managed. The finance minister has given no indicator that the funds will be managed by a private institution. In this case, the Treasury could create an asset management company which would require approval from Congress. It would also have to hire specialists and prepare ample material for inspection by the Federal Audit Commission.

Brazil does not need to increase its foreign reserves any further, never mind create a sovereign fund. Instead of increasing the reserves by US$ 10 billion, the government could use this money to double its investment capacity which is currently 0.8% of GDP.

Finally, should this idea come about let us hope that minister Mantega does not want to compete with President Chavez of Venezuela who uses public resources as part of his foreign policy within Latin America.  

© John Fitzpatrick 2007