Brazil's Shifting Fortunes: This BRIC Economy is Ready to Fall Out of Fashion

Batten down the hatches. Brazil, the media-darling of the world financial press and the poster child for emerging-markets investing, is heading directly into the eye of the storm.

Until now, Brazil has provided investors with a thoroughly rewarding run. Investors who followed Money Morning's October 2008 call to buy the iShares MSCI Brazil Index (NYSE: EWZ) have notched a 160% return.

But with this BRIC country now clearly running into trouble, it's time to trim any holdings you may have.

Here's why…

When Good Governments Go Bad

Since the 2009 run-up, it has become clear that the Brazilian government under Luis Iñacio (Lula) da Silva has not really changed its anti-business approach. Yet next month's combined presidential and parliamentary election (Oct. 3 with a possible runoff election on Oct. 31) looks like it will reward this "bad behavior" with a victory for Lula's handpicked successor, Dilma Roussef, and their leftist coalition.

To understand what we mean, let's start with a look at public spending. Official government spending was budgeted in December to increase by a moderate 10.7% in 2010, and has been subject to modest further trimming since the spending plan was unveiled.

However, spending in Brazil's 119 state-owned companies – which has been accelerating in recent years – is currently expected to increase by 32% this year. Moreover, lending by the Brazilian Development Bank (BNDES) is expected to double from where it was in 2008 to reach 150 billion reals ($87 billion) this year, while housing lending for the first half of the year was up 51% from the same period in 2009.

In addition, the government recently announced an $886 billion infrastructure investment plan for the next seven years, the Program to Accelerate Growth. Brazilian state banking lending has increased in the last few years from 1% of gross domestic product (GDP) to more than 7%, and that figure should realistically be added to the official budget deficit.

Hidden Deficit

A second area of Brazilian backsliding is in the oil sector. The oil law passed last year gives the state full control over oil resources, and it has used that control to charge the partly state-owned Petroleo Brasileiro SA (NYSE ADR: PBR) $8.51 per barrel for rights to 5 billion barrels of oil the company itself discovered (plus all the various other extortions already in place).

As a result, in a market that can best be described as difficult, Petrobras is being forced to raise $65 billion in equity to pay the government and to finance the capital investment needed to exploit its sub-salt Tupi oil resources. Meanwhile, the $42.5 billion to be received by the government is, of course, accounted for as revenue, so the stated deficit should be increased by this amount – another 2.8% of GDP

Combine these two effects, of state bank lending and Petrobras' cash subsidy, and you can see that the forecast of a deficit equal to 2.1% of GDP that was put forth by the Economist panel of experts is actually more like a deficit of 10-12% of GDP. Yet, unlike the U.S. and British economies that have suffered under deficits of this magnitude, the Brazilian economy is in the middle of a roaring boom, with projected GDP growth of 7.8% for this year, according to The Economist.

It's not as if Brazil was under-indebted, either; the excessive public debt nearly sent the country into bankruptcy in 2002, and the leeway before debt repeats the process is less than Brazilian commentators seem to think.

Political Risk

Until a few months ago, it was commonly believed that Lula would be succeeded by Jaime Serra. Granted, Serra is a pretty uninspiring old hack; but he's a centrist who could at least be relied upon to be reasonably favorable to the private sector – and to be not too profligate with public spending.

In recent polls, however, it's Roussef – Lula's preferred successor and former development minister – who is leading handily. Economically unsophisticated voters seem to be giving the government credit for a boom that has in reality been produced by high commodity prices and excessive state spending.

Roussef is a true believer in creating growth through government spending and income redistribution. So if she wins, bet that current policies will be intensified.

Indeed, the road map for their intensification has already been set out.

However, with a true public-sector deficit of 10% of GDP and public spending that's already the highest in Latin America, there isn't much room to expand the state sector before the country runs into big trouble. While commodity prices keep rising, the commodity-dependent Brazil will at least be able to borrow the money it needs.

But if commodity prices falter, a crisis of confidence would be more or less inevitable.

There are positives. Brazil's central bank (the Banco Central do Brasil) continues to maintain an admirably sound interest-rate policy, which has kept the Selic short-term rate – currently 10.75% – far above the current inflation level of roughly 5%. That has prevented the inflationary spiral that would otherwise be well underway.

However, central bank governor Henrique Meirelles declined the opportunity of running as Roussef's vice president, and is likely to retire if she wins. Needless to say, monetary policy would quickly change if an inflationist were appointed as his successor.

Brazil has had these bursts of growth before, and they have always been ended by a debt crisis followed by a period of forced austerity that has wiped out the previous boom's income gains and worsened the country's huge inequality. If Roussef wins, as seems likely, this pattern is likely to repeat within at most two years.

For Brazilian investors and citizens alike, that will certainly be a pity after such a strong run.

[Editor's Note: Why is it that Money Morning's Martin Hutchinson has been right on the money with every one of his political predictions for each of the last three years?

The answer is quite simple. The same skills that made him a successful global merchant banker – where he was easily able to identify winning trends for his clients – also make him one of the very best political prognosticators.

Just look at some of his most recent global predictions. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns – and one is up nearly 25%. He again recommended Korea – which analysts were downgrading – only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.

A longtime international merchant banker, Hutchinson has a nose for profits instincts – as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon – while also warning us about the potentially ruinous pitfalls hidden just around the corner.

With his "Alpha Bulldog" investing strategy – the crux of his Permanent Wealth Investor advisory service – Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll find the time well spent.]

News and Related Story Links:

• Money Morning Buy, Sell or Hold:
  Buy, Sell or Hold: iShares MSCI Brazil Index
• Wikipedia:
  Luis Iñacio (Lula) da Silva
• Brazilian Development Bank:
  Official Website
• Wikipedia:
  Dilma Roussef
• People's Daily:
  Brazil to launch Program to Accelerate Growth
• Bloomberg News:
  Petrobras' Tupi Oil Field May Hold 8 Billion Barrels
• Wikipedia:
  Henrique Meirelles
• Banco Central do Brasil:
  
  Official Website