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A Real Conundrum

 April 27, 2012 06:37 PM


(By Fisher Investments) Throughout Brazil's ongoing economic emergence over the past couple of decades, its manufacturing sector has been a source of strength. Since UN records begin in 1970, Brazil's real manufacturing output has nearly quadrupled, and the nation's among the world's top 10 industrial producers.[i] In recent months, however, manufacturing has contracted a bit, and some policymakers are starting to fear the sector will lose global market share if current trends continue—prompting some rather iffy intervention.

One big target is Brazil's currency, the real (BRL). With some of the highest yields in the world, Brazil can be attractive to carry-traders. A brief review: A carry trade is when investors borrow in a lower-yielding environment to buy assets in a higher-yielding one. If done right and the exchange rate doesn't suddenly reverse, the difference in yield is profit. This appears to have been going on in Brazil, which has provided a source of demand for Brazilian assets, but has helped drive the real skyward, making Brazilian exports more expensive in weaker-currency nations—potentially a headwind for an export-driven nation.

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The government has tried to suppress the currency's rise with higher taxes on foreign investment. This didn't necessarily address the underlying causes of currency appreciation, but it did help push the exchange rate down in late 2011. But foreign investment—an important capital source for Brazil—also fell, prompting officials to ease capital controls at year end.

That left policymakers an apparent conundrum: How to help manufacturers compete without introducing broader economic headwinds?

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In early April, President Dilma Rousseff's administration announced its purported solution: a BRL 65 billion ($35 billion) manufacturing "stimulus package." This will eliminate manufacturers' 20% payroll tax through 2013, boost the state-owned Brazilian Development Bank's subsidized lending by BRL 45 billion and increase local-content requirements for public infrastructure projects (Buy Brazilian!). Funding will come from a 1%-2.5% tax on gross non-export corporate revenue and new import tariffs.

On balance, the package seems to be protectionism dressed as stimulus. Finance Minister Guido Mantega largely confirmed as much, saying the measures seek to protect Brazilian industry from nations who've gained a competitive edge through "protectionism in disguise," like currency pegs (China) and loose monetary policy. A fair point, perhaps—cheaper exports have been a tailwind for some nations, and China's efforts to keep unit labor costs artificially low are well-documented. However, history shows a protectionist response may not help Brazil—tariffs and subsidies often bring price dislocations that hurt, not help, domestic producers, which could ultimately bring the very manufacturing flight policymakers aim to prevent.

Yet, one aspect of the package could genuinely help Brazilian manufacturers. Reducing manufacturers' tax burden likely does foster competitiveness and growth over time—extending this past 2013 and enacting similar measures for all Brazilian firms would likely be a net positive (we generally question the efficacy of governments' picking winners and losers among economic sectors). According to the World Bank, Brazilian corporations currently pay among the highest effective tax rates in the world. If history is a guide, a reduction would allow firms to deploy capital more productively, investing in new equipment, software, facilities, labor and the like—all of which tends to boost output (and, by extension, tax revenues!) over time. Lowering existing trade barriers would be an additional positive.

Now, none of this is to say Brazilian stocks perform badly from here or that the country's fundamentally weak. Like all nations, Brazil has its challenges, but plenty of positives exist. Falling inflation has given the central bank room to ease rates, foreign investment is up year-to-date, loan growth is expected to continue and the resource-rich nation should benefit from firm commodity prices. There are simply additional sensible steps policymakers could take to remove some ongoing uncertainties.


[i] Source: United Nations Statistics Division.

source: Market Minder
Disclaimer: This article reflects personal viewpoints of the author and is not a description of advisory services by Fisher Investments or performance of its clients. Such viewpoints may change at any time without notice. Nothin herein constitutes investment advice or a recommendation to buy or sell any security ot that any security, portfolio, transaction or strategy is suitable for any specific person. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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