Don't blink: The best is yet to come

Latin American markets breathed a sigh of relief in August when the IMF agreed to lend $15 billion to Brazil. But the country is

Cracks have begun to show in Brazil's economy. As if energy rationing and the eventual lame-duck status of President Fernando Henrique Cardoso were not enough to fret about, Brazil is also suffering the effects of malaise in the global economy and acute pain radiated from Argentina.

According to a recent report by Citibank, Brazil needs about $57 billion in financing this year, including $18 billion for the private sector, and there are deep concerns about market closure. While a large amount of emerging market capital will become available in the second half because of maturing debt, Brazil will need to work hard to attract investors with creative solutions to bank and bond financing, analysts say.

Citing fiscal pressures and slow global growth into 2002, Standard & Poor's in August changed its outlook on Brazil's foreign and domestic currency ratings from stable to negative. The agency noted that Brazil has maintained prudent policies, such as its fiscal primary surplus target and the recently enhanced IMF program, but it cautioned that the structure and level of the country's public debt, budget deficits, and energy shortages remain significant vulnerabilities.

Bear Sterns's chief international economist, David Malpass in New York, has also voiced criticism, advising "we are skeptical that the IMF can commit enough resources to protect Brazil in the event that Argentina devalues or forces a restructuring of its Brady or Eurobond programs."

Malpass suggests that the economic programs are not growth-oriented enough to work, "especially given the ever-strengthening dollar and the harsh external growth environment."

Director Jose Pio Borges of Banco Liberal (now owned by Bank of America), a former president of the Brazilian Development Bank, lauds the government's work in maintaining stability but warns that regulatory hiccups and Brazil's abrupt devaluation have slowed the progress of reform.The former privatization czar expresses his "disappointment" at the rate of regulatory reform, especially within electricity and basic sanitation.

"For some time people have been saying the fundamentals are good, but there has been a deterioration. Keeping inflation under control was a great victory, but the foreign trade surplus estimates have fallen, and there has been a critical decline in foreign direct investment," Borges says.

Government Maintains Composure

Political risk is also a concern, according to Lauro Viera Faria, an economist with Brazil's Getulio Vargas Foundation. He warns that an opposition dark horse could well steal the 2002 elections because of discontent over electricity rationing.

"An opposition candidate could use the energy crisis with much greater success than devaluation, higher interest rates, or the stock market because it affects everybody on a constant basis,"Faria comments.

He says that a shift toward the opposition in 2002 would not necessarily imply disastrous changes in fiscal policy, rifts with the international finance community, or other specters of political rhetoric. However, analysts are alert to the possibility that an opposition government might make heavier investments in health, education, and other social projects that could aggravate the country's fiscal stability. And confronted with a dwindling trade surplus, there is the real possibility that Brazil would be forced to retreat into protectionism, regardless of which camp wins the elections.

Through it all Brazil's financial team has maintained remarkable composure. At a recent luncheon, central bank chairman Arminio Fraga voiced the opinion that the ef fects of Argentina's crisis on Brazil would subside in the next few months. Finance minister Pedro Malan has kept a firm hand on the fiscal reins, calling for nonpartisan responsibility. Other government doyens, meanwhile, have tried to show there is hope for the electricity shortage, and have tried to calm popular discontent with the weaker currency.

According to Klaus Heritt, director of strategic debt for Latin America at Dresdner Kleinwort Wasserstein, the second half of 2001 shows good potential for fund-raising in Brazil despite the widespread criticism of the government.

In the primary Latin American markets, the first half of the year saw substantial activity, with issuance well above redemptions, especially in the first quarter, says Heritt. In the second half, he says, redemptions should be brisk, paving the road for investors seeking high returns with the strong credit names in Latin America, especially Brazil.

Heritt says an overview of the market shows that Latin American redemptions of close to $10 billion and Euro1 .3 billion are expected in the second half, representing the lion's share of total emerging markets redemptions of some $12 billion and Euro1.4 billion.

A Messing in Disguise

"There is a wealth of bonds maturing, and the scenario is appropriate for LatinAmerican issuance, because there is little that investors can do to maximize return in their home markets right now," says Heritt.

While the economy is under strain at the moment, Brazil is still the logical choice for high-yield investment in Latin America, he says. He adds that the impact of the energy crisis thus far has been less than expected, while the IMF agreement announced in August granted the markets some breathing room through disassociation with Argentina's turmoil.

"If Brazil does its work to convince investors that its story is different from that of its neighbors, then it will benefit from a slightly larger share of the reinvestment of the funds being released by those maturing issues," Heritt says.

He believes the bank market will continue to be opened through structured deals, and the bond market should further improve in the second half, even if it has to resort to structured bond issues.

"If the investors can continue to make a decent return, the bank market will still be there, and the bond market will give us additional financing, which may eventually replace a little bit of the foreign direct investment that may not come in this year. In a nutshell, the market is improving," Heritt says.

While the volatility of Brazil's floating currency is worrisome to corporate investors, Heritt points out that the market has trended toward reducing financing costs through enhanced bond structures based on the traditional models used for bank financing.

"Brazil has produced some very creative enhancements, which are starting a new trend toward bond issuance this year," he says, calculating that structured bond issuance amounts to 16% of new issuance in Brazil this year, compared with just 3% last year.

The enhancements include guarantees based on future export revenues and other traditional elements of bank financing that have not been commonly employed in structuring bonds.

Such recent deals include financing for Petroleo Brasileiro (Petrobras), which relied on an insurance guarantee on final interest payments, and Itau bank's subdebt with insurance guarantee on three semiannual coupon payments on a rolling basis. There was also Banco do Brasil's securitization of funds remitted by Brazilian-- Japanese descendants working in Japan, and the GeracaoTiete AES affiliate utility's 15-year bonds with OPIC political risk insurance and currency devaluation guarantee.

"In the case of Petrobras, because of the strategic importance of oil to the country, the deal was priced well below the Republic of Brazil, which is usually impossible to achieve,"he says.

Adapting to the Changes

The challenge, says Heritt, has been to sell the enhancements to bond investors who in general lack the thorough understanding of such nuances."Bond investors have sometimes shied away from such deals because of a lack of familiarity with them," he says.

Bank financing has changed its shape but not disappeared from Brazil, Herin says. Because of changes in the economy since Brazil devalued in 1999, new bank finance deals have adapted to take advantage of trade financing preferred status and political risk mitigation structures.

While so-called clean financing has disappeared for the moment in Brazil following the Eletropaulo and BNDES operations of late 2000, there has been a series of interesting developments related to structured bank deals.

"Trade finance, such as using export performance of crushed soybeans as a guarantee, helps companies overcome the limitations on clean bank financing that arise out of concerns the central bank might impose currency restrictions, which would most likely not affect performance of an export-driven financing," Heritt says.

Since Brazil is one of the world's largest soy exporters, local telecoms and even utilities have been able to count on soy export performance contacts to raise fairly large, longterm, trade-related financing at competitive rates.

"Another option is the use of political risk insurance, either through the parent company or through private issuers or multilateral agencies," says Heritt. On project financing, European banks in particular are firm supporters of the implicit guarantee embedded in the so-called B-loan structure applied together with multilateral agencies' funds, or A-loans, which in some cases reach out to 15 years.

"We wish we could go back to February, when there was so much optimism. But come to think of it, we have gone from an overly optimistic market view to a highly pessimistic one with the crises in energy,Argentina, and so on, and now we're getting back to a more educated assessment of the situation," Heritt says.