Brazil is hot now what?

For more than 40 years Brazil's economy has been "on the verge" of taking off-but repeatedly has been held back by entrenched inflation, spurts of nationalism, and a weak political system.

Today, though, there is ample evidence that the world's fifth-largest country in population (170 million) and ninthlargest in GDP ($600 billion) has turned the corner once and for all.After five consecutive years of outstanding performance that has brought economic and political stability-plus a literal flood of foreign direct investment-- there's no denying that Brazil is flying high. Foreign investors have more than doubled their stakes in Brazil since 1995, to nearly $100 billion. Thus, more direct investment has entered the country in the past five years than all investments in previous years combined. The macro picture, relative to an increasingly gloomy world outlook, is downright bullish.

"Last year GDP was up 4.5%, and we had anticipated about 4% growth for this year," says Banco do Brasil's chief economist Uilson Melo Araujo in Brasilia,"We're still evaluating what the impact of a domestic energy crisis might be, but it's hard to see GDP going below 3% this year, even with the most pessimistic scenario."

That energy crisis, caused by drought that is crippling the country's mostly hydroelectric-based power systemand a California-style rate-fing issue that has gutted investments in recent years-could be an unwelcome surprise. Already the government is imposing rationing and electricity cuts of up to 20% as of June 1 will take a big bite out of industrial production in coming months.

"Either Saint Peter will have to save us again with a lot of rain to refill our reservoirs," says Fernando Quartim Barbosa Figueiredo, adviser to private Brasilian power company Rede, "or Brazil has to build a lot of new gas-burning thermal power plants soon."

Ironically, perhaps the biggest threats to Brazil's continued short-term growth today are external. Neighboring Argentina, a key trade partner with many ties to the Brazilian economy, continues to wobble along in a debt crisis and prolonged recession that taint the whole region. More important, the abrupt slowdown in the US economy and the looming prospects of a global slump can only bode ill for Brazil and its big export markets.

Yet, in a country whose favorite phrase is deixa comigo (leave it to me), these challenges pale in comparison to the systemic gridlock that has kept Brazil tangled in a spiral of inflation and debt for most of its modem history.

Helping the country break out of that debilitating cycle is the primary accomplishment of President Fernando Henrique Cardoso. He laid the foundations for today's outstanding performance as finance minister in 1994-bringing inflation down from 1,100% in 1994 to 14.8% within a year. He then rode the popularity borne of that success to two consecutive terms as president. Barred by the constitution from seeking reelection again in October next year, Cardoso's imminent departure from Brazil's political stage-and the absence of an obvious successor-introduces another element of doubt about the country's ability to continue its winning ways.

Brazil is hot. But should investors be concerned that another chill is just around the corner?

"We are more optimistic than at any time since the return of democracy in 1985;' says Paulo Ferraz, executive director of Brazil's Bozano Group and chairman of Invest-- shop.com, an online investor portal he founded in 1999.

"The foundation of the reform process here is strong. Unlike other countries-like Chile or Mexico-Brazil pursued a political solution first, and then a solution to its economic problems.We're the first country to do that, and it gives me great faith in our system."

Looking ahead, Ferraz says: "Will there be stress? Sure. But that's how the world works. In the midst of that, Brazil will continue to grow, and inflation will stay under control. Period."

Francisco Gros, a former central bank president and ex-Morgan Stanley Dean Witter executive who now heads the national development bank, Banco Nacional de Desenvolvimento Economico e Social (BLADES), has a similar view."Brazil made absolutely tremendous progress throughout the 1990s, and there have been extraordinary changes in the economy," he says. "We've finally put inflation behind us, from a technical point of view, and people understand this issue is resolved.This is absolutely fundamental. Our Law of Fiscal Responsibility holds the line on public finance.

Today's conservative monetary policy should stand, even with the arrival of a new president next year. "The risk of having a candidate who would change things is low," says Osanan Lima Barros, executive superintendent and head of international operations for Banco do Brasil. "Brazilian society would not accept it. There is no space to trade inflation for growth."

That guards against a return to the old ways of deficit spending that kept former governments-and the Brazilian economy-in a hole for decades. In fact, the government had a $10.5 billion primary budget surplus in 2000. But equally important have been Cardoso's steps to embrace privatization of key industries and to open the economy more broadly to global competition.

"Brazil has enjoyed a period of stability based partly on the privatization of big service companies," says Eduardo B. Gentil, managing director of Goldman Sachs's investment banking division in Sao Paulo. "The pent-up demand for services in these areas-- mainly telecommunications, electricity, and banking-has created a virtuous cycle of investment and growth. The question now is whether the cycle can last and go beyond these sectors. Multinationals have taken big stakes in utilities and banking, but they still haven't expanded much in the area of consumer products, for example."

These once-in-a-lifetime sales of government assets have brought in a host of big foreign players, such as Spain's Telefonica,Telecom Italia, SBC, and Telecom Portugal in the telecom sector;AES, Duke Energy, Electricite de France, El Paso Energy, and Enron in energy; and BBVA, BSCH, ABNAMRO, and HSBC in banking.The resulting flow of FDI in the $20 billion+ per year range (reaching $30.6 billion last year) has offset Brazil's current accounts deficit since 1998 but at a cost of some de-stimulating of domestic capital markets."A lot of big companies have been bought by foreigners who then de-listed them," says Gentil. "That has hurt the stock market and capital markets in general."

There are signs the government is rethinking its privatization model to increase the involvement of local companies in the sectors where important asset sales are still pending-power generation, water treatment, and airports.The imminent privatization of state electricity transmission company Furnas shows that this shift in policy is at work already. Rather than selling the company to a strategic investor (or group, usually dominated by foreigners) as in most previous privatizations, Furnas shares will be sold by auction in the capital market.

Yet, only about 25% of the FDI inflow has been related to privatizations. "Overall sentiment toward Brazil among foreign investors has changed," says David Bunce, head of consulting firm KPMG in Sao Paulo. "Four years ago Brazil wasn't even on the list of A.T. Kearney's survey of foreign investment plans of CEOs of the Global 1,000 companies. Now, Brazil has passed the United Kingdom, and is in third place behind the United States and China. For Brazil, the basics are better than ever."

Under the best scenario, FDI flows will wane a bit this year and next."Direct investment coming into Brazil will decline because of tighter liquidity in the developed economies," says Maria Fernanda Freire de Lima, economist at Sao Paulo-based research group Sociedad Brasileira de Estudos de Empresas Transacionais (SOBEET). "Also, there may be a possible cutback in European investments due to the weakness of the euro. The privatization process is winding down, and eventually there will be a natural decline in investment opportunities in Brazil, but the trend is for FDI to stabilize at levels well above the rates seen in the 1970s and 1980s."

The role of foreign companies in the economy and the

future of Brazilian companies as dominant players in their own country and abroad, is certain to be an issue in next year's "super election" campaign-which will involve the selection of new governors and most members of Congress, as well as a new president.

"This will be the thing that marks 2002," says Roberto Setubal, president of Banco Itau in Sao Paulo, the country's second-largest private bank. "An election like this will throw everything up for debate, including the model for the economy. But Brazil has passed the phase of questioning certain things like the commitment to fiscal balance, so I am optimistic even in such a political year."

This topic gets to the core of what the Brazilian market is all about today, and how it will evolve. "The culture of Brazilian business always was oriented toward the local market, which historically has been closed and protected," says Luiz Fernando Furlan, president of Sadia, a poultry and pork producer that is one of the country's contenders for world-class exporter status, with sales last year of $1.6 billion."We can be very competitive in food exports, and this is an area that will see an increasing presence of Brazilian companies in the 21st century," he says."So far, there are almost no Brazilian `global brands' in any industry, but that has to change."

Even companies with a strong global presence, such as state oil company Petrobras, have trouble building a crossborder image. Petrobras earned $5.1 billion in net income last year, making it the sixth most profitable oil company in the world-after Exxon Mobil, BP, Royal Dutch Shell,TotalFina Elf, and Chevron. With extensive operations around Latin America, Petrobras five months ago aimed to change its name and logo (which resembles the Brazilian flag) to something less offensive to customers in neighboring countries. But when it was announced in Brazil that Petrobras was to become Petrobrax, the uproar at home (especially in Congress) was immediate and vociferous. After seven months of secret preparation, the Petrobrax name was killed in a day.

For his part, Sadia's Furlan has just negotiated a joint international marketing pact with Sadia's smaller domestic rival Perdigao (sales of $1 billion last year), to combine forces for a stronger push into poultry and pork product export markets with a new global brand.Their combined exports last year were almost $700 million. Although Brazil (mainly represented by Sadia and Perdigao) already has an 18% share of global poultry exports-trailing only the United States-there are still formidable obstacles to further growth.

"Our problems are weak infrastructure, high cost of capital and taxes, bureaucracy, and import duties; says Furlan. On top of that, Sadia and Perdigao face a stone wall of nontariff barriers in the biggest market of all, the United States. "They use unreasonable restrictions, sanitary requirements, quotas, and technical regulations to keep us out of the US market,"he says. On the other hand, his US competitors are blocked out of the Brazilian market, too.

These are the kinds of issues-along with long-running disputes over the sale of Brazilian steel products and some manufactured goods in the United States-that ought to foster Brazilian interest in the proposed Free Trade Area of the Americas. (see Mexico story, page 48) But Brazil exports much more to Europe ($17 billion to eight key countries in the region last year) than to the United States ($13.2 billion in 2000). At best, the Brazilians are lukewarm toward a hemispheric free-trade bloc. At worst, they simply don't trust the "protectionist" Americans. Regardless of how the free-trade debate works out, Brazil

is a major trading country-but still has plenty of room to grow relative to competitors such as Mexico, Taiwan, and South Korea.Those countries boosted their exports by an average of 1011% from 1984 to 1999, while Brazil's exports grew less than 4% annually. (See table, page 33)

This reflects another cultural quirk in the Brazilian business mentality. Comfortable with a domestic market that is roughly as big as the rest of Latin America combined, few exporters feel compelled to export for survival.

Yet, the effect of a sharp devaluation of the real a year ago finally is kicking in as an export booster. Brazil's central bank estimates the trade balance for 2001 will show a $1 billion surplus-compared with deficits averaging $4 billion a year since 1995.

Significantly, exports are no longer overly dependent on agricultural commodities such as coffee, soybeans, and orange juice. Brazil's biggest export item in 2000 was aircraft, with Embraer selling $3.1 billion worth of regional jets overseas.The Silo Jose dos Campos-based company has an order backlog of $11 billion.

With so many of the right pieces in place for sustained growth, the game is now Brazil's to lose. "But this is still not a done deal, even though we have the people who know how to do the job," says BNDES president Gros. "The real issue is Brazil's ability to keep pushing through with the changes to make this a more open and competitive economy.The obstacles are not external.We have all we need to determine our future. It's our fault if we don't do it right."