FORTUNE -- The massive protests in Brazil may have subsided, but the unrest
is far from over, as evidenced by the tear gas earlier this week outside the
Brazil-Spain soccer game in Rio. The turmoil threatens to exacerbate an already
tense situation for the nation's shaky financial markets. The protests, which
erupted last month in response to a hike in bus fares, is undermining the
Brazilian government's attempt to alleviate a potentially disastrous flight
of foreign capital as investors cycle out of emerging markets.
If the government doesn't move to address the grievances of its restless and
frustrated population quickly and prove to the investment community that it is
still committed to responsible government spending, then the country could be
setting itself up for a severe economic downturn.
Brazilians rarely like to rock the boat. They have lived through
dictatorships, corrupt governments and wild economic swings without much popular
dissent. Indeed, this was, after all, the last western nation to ban slavery --
and it didn't come about because of a mass popular uprising, it just happened
because it was time.
But Brazil has changed dramatically in the last few years. Brazilians, now
numbering nearly 200 million, are richer and more educated than at any time in
the nation's short history. An amazing 20% of the population, around 40 million
people, have been lifted out of poverty in the past decade. At the same time,
enrollment in higher education has doubled and the nation's literacy rates among
youths now tops 97%.
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These are all good things for investors to hear. A richer and more educated
population usually leads to a healthy uptick in spending within the country on a
variety of services and assets. This creates an upward spiral in economic growth
where investors are able to reap healthy returns across a variety
of markets.
As such, with an abundance of exploitable natural resources and a growing
service sector, Brazil was the favorite emerging market for many investors,
especially those concentrated in fixed income. Investors were able to park their
cash with ease and reap returns that well exceeded whatever they could get back
in Europe or even in the United States.
Furthermore, as a legitimate democracy with a somewhat competent legal
system, Brazil also offered investors security from political risk, a rarity
among emerging market economies. Brazil was so popular that foreign direct
investment had held steady at around $65 billion from 2011 to 2012 even though
economic growth in the country had stalled. The hope was that Brazil would
bounce back.
But instead of things picking up, Brazil's economy just seems to be getting
worse. Credit rating agencies Moody's and S&P both downgraded Brazilian debt
last month after the government said it was expecting a further slowdown in
economic growth. Traders in Brazilian government debt tell Fortune that
this is causing a major outflow of capital from Brazil's fixed income markets.
As such, dollar-denominated Brazilian bonds are down nearly 8% in the second
quarter of this year, the largest such decrease for a single quarter since 2002,
according to an analysis by Bloomberg.
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There are a few things going on here. First, there has been a mass sell-off
in emerging market debt by investors from Wall Street to London in the last two
months. What started out as a trickle of selling has since turned into a
stampede for the exits -- with debt markets across the emerging market
space taking a pounding, especially Brazil. Secondly, the rout was exacerbated
by the US Federal Reserve, which signaled last month that it may be willing to
raise interest rates in the not-so-distant future. The promise of higher rates,
and, thus, potentially higher returns on U.S. investments, managed to lure
investors away from the emerging markets and back to the U.S.
Brazil's finance ministry has quickly sprung into action to prevent the
hemorrhaging of foreign capital from the nation's debt and equity markets. It
first eliminated a 6% tax foreigners had to pay to invest in Brazilian local
bonds. The tax, put in place by the government in 2010 to supposedly prevent
wild swings in the Brazilian currency, now levels the playing field and should
draw in new investors. In addition, the government recently cut a 1% tax on
currency derivatives in an attempt to boost the value of the Brazilian Real.
Normally, such actions would have been enough to at least stabilize the
sell-off. Investors who had hesitated to enter the Brazilian markets due to the
"foreigners tax" would have jumped in the second they heard the news that the
tax was history. But the tax changes haven't been enough this time around
to lure back investors. That's because of what's going on in the streets of
Brazil's largest cities -- protests and riots.
Fund managers who had stuck by Brazil during the recent market rout will now
find it even harder to do so with millions of Brazilians on the street, shutting
down ports, creating traffic jams, and scaring the government. What turned out
to be outrage at the government for raising transit fares (which had since been
reversed) has now become a protest for everything by everyone with no clear
leader or agenda. Among the dozens of causes that people are protesting include:
transportation costs; Native Indian rights; government spending on the 2014
World Cup and the 2016 Summer Olympics; corruption in state and local
governments; and a bill in the Brazilian congress that would authorize
psychologists to try and "cure" homosexuals.
So far the government, led by President Dilma Rousseff, has failed miserably
to contain the protests, many of which have become violent and chaotic. For
example, over the weekend, hooded protesters armed with screwdrivers and
slingshots set fires and attacked police outside the Confederations Cup soccer
game in Rio de Janeiro. It was a terrible embarrassment for the government.
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So what is the government to do here? With so many different causes and no
real leadership, it seems impossible to get control of the situation. But while
there are many different causes, they all share a common root -- corruption and
mismanagement in Brasilia. Brazil's new middle class is simply fed up
with Brazil's shoddy infrastructure, terrible medical system, super high taxes
and shoddy education. The government purse continues to expand thanks to the
economic boom, but it has failed to reinvest that money in a productive way.
Indeed, the 40 million people who pulled themselves out of poverty did so
because of a surge in commodity prices that helped fuel a boom in the service
sector. The government did little, if anything, to encourage the development of
the boom and kept income taxes at around 40%, by far the highest such tax rate
for an emerging market economy.
It is clear that the Brazilian government needs major reform. For starters,
the President could send a gesture of goodwill to the protestors by reshuffling
her cabinet and firing ministers who have failed to perform. She can also create
an action plan that addresses all the causes and sets forth ideas on how to
address the problems. She should also explain to the Brazilian people that the
protests, while understandably valid to some degree, could be setting the
country up to take a big economic hit. Bond traders from Lisbon to Sao Paulo
tell Fortune that they are afraid of jumping back into the Brazilian debt
markets because of the uncertainty surrounding the protests. Foreign direct
investment last year in Brazil was around $65 billion, but is set to take a big
dive in the weeks to come.
The protests in Brazil aren't going away without some proactive steps taken
by the government to show that it "gets it." So far, the Brazilian government's
usual plan of action, to do nothing and wait things out, isn't working. The
government needs to see the protests as part of a larger social revolution and
should get to the roots of the problem. Investors will be waiting on the
sidelines until they see that Brasilia is making a true and concerted effort to
stamp out corruption and govern in a way fitting for the world's seventh-largest
economy.
Wagner & Garg
The Homebrew crew
