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The Top BRIC in the Wall Teeters

Over the last decade, Brazil has grown to become the world's sixth largest economy by nominal GDP, a staggering feat fueled by a massive increase in its middle class ranks.

The nation has been rife for investment opportunity based on its fundamentals and strong commodity sectors, and finds itself as the leading BRIC (Brazil, Russia, India, China) emerging market.

But the recent wave of public protests over the last month could be signaling that Brazil has hit a major snag in its quest to displace France in the top five economies, and its opportunities for growth and fortune may be faltering as the nation experiences increased political turbulence.

The wave of protests began a month ago in Sao Paulo after the government increased bus fares by 10% (a rate that subway fares seem to rise in New York every other week). But the increases were quickly revoked in San Paulo and other major cities after the protests became much larger than about mere bus fares.

Residents have been especially frustrated by a lack of transparency across the country, and the government's increased taxation and decreased returns to average Brazilians in the form of basic and essential services.

Brazil has spent approximately $30 billion to showcase itself to tourists during the 2014 World Cup and 2016 Olympics. Meanwhile, the nation's anti-poverty programs have a mere annual of budget $10 billion in a nation of 191 million.

The widespread demonstrations have produced a national movement to demand better education, healthcare, and transportation services. Despite the protests, the country simply can't meet these obligations at this time for one simple reason: government can't keep up with economic expansion.

Brazil provides one important economic lesson that no one talks about when it comes to rising middle classes in emerging nations.

Many governments are not prepared for population shock or the shock of economic growth.

And while this stands to create a wave of new problems for investors looking abroad for investment opportunities in Brazil, it also teaches a valuable lesson and opens new doors to wealth in South America.

The Retched "Incline" of the Middle Class

Ten years ago, Brazil had one of the most unequal economies in the world when it came to income levels between the rich and the poor.

But as the nation has undergone a dramatic economic boom, fueled by the commodity boom of the last decade, a more equitable income distribution has become the norm.

From 1999 to 2009, the Brazilian middle class grew by 31 million people, according to the Council on Foreign Relations. To put that into perspective, that's more than the entire population of Texas and New Mexico combined.

That level of growth is nothing short of staggering. But as every economist knows, for every action, there is a reaction.

The dramatic rise of the middle class in Brazil has now created a massive strain on the government's ability to provide essential services. As spending power has increased, so have the Brazilian population's expectations of how its government should operate and provide for the people. One of the most common excuses, naturally, is a lack of resources in order to meet this level of demand.

But Brazil already has some of the highest tax rates in the industrialized world. According to Filipe Campante, a professor at Harvard University's Kennedy School of Government, at least 36% of the nation's annual GDP translates into taxes.

Brazilians are likely adverse to tax increases on their rising take-home pay, and are increasingly frustrated by a corrupt government that continues to spend money recklessly (which seems like a theme in every nation on the planet.)

And the lack of transparency on how the government is spending money is only furthering public mistrust in Brazilian institutions. $30 billion is a lot of money to spend on sports complexes, and it would be more comforting to the overtaxed if politicians showed them a receipt every now and then.

While the lack of transparency and increased tax levels should be especially troubling for any Brazilian taxpayer, they also concern us as investors as well. Nonetheless, they help provide a better understanding of what tools we need to better gauge which nation provides the most security for our investments.

Economic Freedom and Government Transparency Drastically Reduce Risk

Financial freedom is the true driver of growth and development in a nation. The centralized planning of the World Cup and Olympics isn't going to provide any true long-term stability to the Brazilian markets. Only economic freedom will. And right now, Brazil continues to flounder in that department.

Our Martin Hutchinson uses something called the "Liberty Investment principle" when evaluating which economies he trusts for investments for Money Morning readers.

Martin and I both agree that the Heritage Foundation Index of Economic Freedom is the best way to understand each country's investment opportunity, by allowing us to understand the levels of taxation and government participation in the nation's market. The lower the score for each metric, the better. The index also provides a scaled raw score to rank 185 nations on their economic freedoms, including property rights, investing rights, and access to credit.

Martin also argues that "each country should also have a high level of integrity-meaning they follow the rule of law. A good score on Transparency International's Corruption Perceptions Index is a good measure of this."

In both scenarios, Brazil drastically fails both tests. Brazil ranks 69th in transparency and 99th in economic freedom.

Both of these figures should be extremely troubling to an investor, since it signals that the government isn't allowing its people to address the market shortcomings. The lack of infrastructure and basic services signal that Brazil isn't quite ready for prime time, and that it needs to provide greater opportunities for the people to solve its own problems with market-based solutions.

It also suggests that if you are looking to invest in South America, it would be more beneficial to find opportunities in locations with high scores on both scales, since it signals greater transparency and limits risks of government failure to maintain infrastructure growth to meet its rising middle classes.

Such countries include Chile (currently the 6th freest economy, 20th most transparent), Uruguay (36th freedom, 20th in transparency), and even Colombia (37th freedom, 94th in transparency), the latter having made a significant amount of progress in the last decade. Meanwhile, investors should avoid Argentina (160th economic freedom, 102nd in transparency).

For the record, the United States has fallen dramatically in these rankings as well the last few years,
from 4th in 2009 to 10th today. It now sits behind economic powerhouses like Mauritius and its thriving tourism business, and Denmark.

Looking forward, Brazil has a number of infrastructure problems that are being addressed by massive government spending projects. But the failure to meet essential services is driving a massive outcry from its middle class.

Such failures are hindering robust growth potential for the nation, and until corrections are made, and economic development becomes a national priority, investors must proceed with caution.

See Martin Hutchinson's take on the top counties for investment in South America.

Join the conversation. Click here to jump to comments…

  1. enthusceptic | July 6, 2013

    Arab Spring, Turkey, Brazil, there are many more dominoes… Take a look at Peru too!

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