Brazil

Country Risk Analysis

November 1, 2009

Executive Summary
This report applies econometric models to determine what the appropriate policy for a
country is and whether or not the government is engaging the appropriate policy. It then
looks to financial and political crises indicators. And finally recommends business
strategy and timing based on the appropriate and current policy.

Brazil is following the appropriate expansionary fiscal policy.

Appropriate Policy Current Policy

Policy Description Expansionary Fiscal Policy Expansionary Fiscal Policy

Exporting to Brazil The appreciating Real will Same.

increase price
competitiveness and
likeliness of payment.

Directly Investing in Brazil:

-- for domestic business Yes. The appreciating Real Same.

will increase purchasing
power. GDP growth will
expand market opportunity.

-- for export out of Brazil No. The appreciating Real Same.

will decrease price
competitiveness of
exports.

Capital investment Cautious. Yes for the Same.

Financial and Energy
sectors. No for export
oriented industries. Hedge
against government
regulations on foreign
investors.

Crises Warnings N/A None

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Basic Information
Population: 198 million
GDP: US$1.5 trillion
Currency: Real

Financial Analysis
Policy and Economic Outlook
The appropriate domestic policy for Brazil is a combination of monetary and fiscal that
have an offsetting effect on domestic interest rates.

Domestic Policy
The appropriate domestic policy for Brazil is expansionary.

The domestic policy analysis examines the relationship between real gross national
product and inflation rates. Using a historical 15 year average, an appropriate target is
set. Based on the countryʼs economic cycle: emerging, transitionary, developed, etc.; a
range is around the target. In this case, Brazil is a large emerging market that requires
approximately 6% inflation to maintain its utilization potential of 6% annual growth. The
target range is set at plus or minus 2% as a developing country. When the real GDP and
inflation rate fall outside of the target zone, a governmental policy shift is indicated to
recover the target. The 6% GDP in this case represents the absolute supply, or capacity,
of the countryʼs economy.
Brazil 10 Target 6, 6 (15Y avg.)
Domestic Performance Range +/- 2%
Brazil has experienced a 8
significant slowdown in GDP in
2009, with growth dropping below 6 08

zero and recovering to about zero. 07

4 09
This significant shift has moved
∆P

annual GDP growth well outside of 2

the target Zone. Since utilization
growth (0%) is much lower than -5 -2 2 4 6 8 10
capacity (6%), the appropriate -2
government policy is an
expansionary policy.
-5

International Policy ∆GDP/Y

The appropriate international policy

for Brazil is to increase its interest rates and appreciate the Real.

The international policy analysis examines the relationship between interest rates and
currency rates, and looks to the countries balance of payments with all other nations to

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 Brazil Target Range +/- 4%
Domestic Performance

determine the appropriate Brazil 7 Target Range +/- 4%

interest and foreign exchange International Performance 5

policy.
07

-5 -4 -3 -2 -1 1 2 3 4 5
Brazilʼs 15 year average
currency volatility establishes -5
a target performance range of

∆Fx
+/-4%. Brazilʼs change in
foreign exchange rates 09 -10

compared to its balance of

payment account as a -15

percentage of GDP shows its 08

currency significantly -20
depreciated in the latter part of
BP %GDP
2008, and has appreciated
during the 2009 recover. In
spite of its recovery, the Real remains depreciated against its target range. In order to
appreciate the currency to the target range, Brazil needs to adopt an economic policy
that increases interest rates and appreciates its currency.

Appropriate Policy
The appropriate policy for Brazil is an expansionary fiscal policy.

Governments have two primary levers to use in order to influence fitness of the
economy: monetary and fiscal policy. Monetary policy deals with the expansion or
contraction of the total money supply. Fiscal policy deals with utilizing government
spending and taxes to stimulate the economy to move in one direction or the other.
Each policy has a differing effect on interest rates. Monetary policy has an inverse effect
on interest rates, while fiscal policy has a direct effect on interest rates.

In order for Brazil to move real GDP towards the 6% growth target, an expansionary
policy is necessary. However, exchange rates are
also outside of their target range of 4% volatility. Expansionary Policy
Therefore expansionary policy must increase " Monetary: M↑ => i↓
interest rates to also appreciate the currency. To " Fiscal: G↑ => (E↑-t↓) => i↑
accomplish this the government should engage in
expansionary fiscal policy that will raise interest Contractionary Policy
rates. This can be accomplished by increasing " Monetary: M↓ => i↑
government expenditures and reducing taxes. ! Fiscal: G↓ => (E↓-t↑) => i↓
E = govʼt expenditures, t = taxes, i = interest
Actual Policy
Brazil has adopted a neutral monitory policy to hold
money supply, and an expansionary fiscal policy to
expand the economy and raise interest rates.

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 i
Brazil Fx +
Policy Comparison LM1
IS IS
1 2

i2
i1

- Fx1 Fx2 + 0 Y1 Y2 +

Comparing the appropriate and current policy on the above chart, we see that Brazil is
engaged in the appropriate policy for its current economic condition. Brazil is currently
holding its monetary supply steady at the LM1 curve. And it is engaging in an
expansionary fiscal policy, creating a shift from the IS1 curve to IS2 curve. This shift lifts
interest rates and appreciates the currency relative to global markets. Brazil is engaged
in sector spending to promote growth, causing an increase interest rates and resulting
currency appreciation.

Brazilʼs sector spending will promote investment primarily in the oil and gas industry.
The resulting increase in interest rates will benefit the financial sector.

However, increasing interest rates and resulting appreciation of the Real may cause
political difficultly as a large segment of the Brazilian economy is based on exports. One
might expect that as the real GDP growth rate approaches 3% and exchange rate
volatility falls within 4%, Brazil will engage in a controlled loosening of money supply to
promote growth to 5% and while fixing the interest rate from further appreciation.

Currency Outlook
The short term Dollar to Real currency outlook is consistent with the above analysis.
Using the Fisher Parity Method, comparing the relationship between interest rates,
inflation rates, and foreign exchange rates, the Brazilian Real is expected to continue to
appreciate against the dollar in both the short and long term.

Current US$1.00 = 1.7830 Real

12 Month forecast: 1.7639 Real
24 Month forecast: 1.7298 Real

Where a = country a; b = country b; i = interest rate; ∆P = inflation; S = Fx spot price; F = forecasted Fx.

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Short Term Financial Crises Indicators
Short term financial crises indicators show no immediate warning signs of any financial
crises in Brazil. It was only 10 years ago when the Real suddenly crashed. Since that
time Brazil has shown steady growth and a more mature approach to financial policy.
While the country is quickly becoming a favorite among global investors, it is still
important to monitor the fundamental economic indicators.

Short term financial crises indicators look for a

rapid change and recover pattern in the stock
markets, real estate markets, real interest -20%

rates, and real foreign currency rates. The +50%

pattern is an increase or decrease of 50%

within a year. This is a warning of financial
crises. If there is a 20% or greater correction
within a year, that indicates the start of the
financial crises. -50%
+20%

While Brazil did show considerable stock

market stress during the economic downturn in
2008 4Q and 2009 1Q, it was not sufficient
enough to warrant concern, and since then has recovered over the preceding quarter.

Short Term Indicators 2008 2008 2009 2009

(percentage change over 3Q 4Q 1Q 2Q
previous 12 month period)

Real Foreign Currency -34% 7% 10% 5%

Real Interest Rates -6% 30% -4% -16%

Stock Market -16% -46% -32% -13%

Real Estate Not available Not available Not available Not available

Medium Term Financial Crises Indicators

Medium term financial crises indicators shows no immediate risk of a medium term
crises in Brazil.

Medium term crisis indicators look at two key indicators. If the foreign reserves can not
support three or more months of imports, then there is a potential debt crises looming in
Medium Term Crises Indicators 2007 2008 2009

Reserves / Months of Import [>3] 17.9 13.4 18.5

Net Factor Payments [>50%] 18.23% 20.52% 18.96%

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the next 24 to 36 months. If the countryʼs Net Factor Payments or Income Balance is
greater than 30% of Exports, then there is a warning of a debt crises; at 50% of Exports,
there is a debt crises. After 1999, like many latin american countries, Brazil engaged in
a policy to hold significant foreign reserves.

Other Factors
Taxation of Capital Markets
The government recently imposed a 2% tax on the purchase of stocks and securities by
foreign investors. While most experts think that this measure is will have little impact on
the markets, it shows the governmentʼs willingness to target international investors.

Political Crises Analysis

Change in Government.
Brazil has presidential election scheduled for October 2010. During election years, fiscal
spending tends to increase as incumbents attempt to create temporary prosperity. As
indicated above, increase in fiscal spending are consistent with the appropriate financial
policy and should not adversely effect the economy.

The two term president, Luiz Inácio of the leftest Partido do Trablhadores (PT) party has
adopted a conservative economic policy that has allowed Brazil to continue its growth
run for his two terms. While the global economic downturn hit Brazil at the turn of the
year, the economy has shown clear signs of recovery over 2009, bolstering the
incumbent. The leading centrist opposition party Partio da Social Democracia Brasiliera
(PSDB) will run a close challenge that some experts predict will result in a runoff
election. The PSDB also supports a conservative economic policy. The elections should
not pose a significant shift in government economic policy.

Recommendations
Economic Policy
As demonstrated above, the Brazilian government is engaged in the appropriate
economic policy for its current position. Brazil is engaged in an economic policy of fiscal
expansion and currency appreciation.

Exporting to Brazil
Exporting to Brazil is recommended. There is every indication that the current economic
policies will promote a short to medium term rise in interest rates resulting in an
appreciation of the Real against global and US currencies. As the Real appreciates, the
prices of imports into Brazil will decline relative to the prices of domestic goods.
Opportunities to export goods to Brazil will be strongest in markets where imports have
struggled because they were too expensive or have been in markets with price
competitive domestic goods.

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Direct foreign Investment into Brazil for domestic markets
Direct foreign investment into Brazil for the purposes of supplying domestic markets is
recommended for markets that do not compete against imported goods. There is every
indication that the current economic policy will promote strong GDP growth and
appreciate the Real, increasing domestic demand.

Direct foreign investment into Brazil for export markets

Direct foreign investment into Brazil for export markets is not indicated. As the
governmentʼs policy will increase interest rates and appreciate the Real, the cost of
goods manufactured in Brazil for export will increase in price relative to foreign
currencies, making them less competitive.

Capital investment into Brazil

Capital investment into Brazil is cautiously recommended. Brazilʼs fiscal policy will
promote the energy and financial industries, as well as bolster the economy as a whole.
Industries that focus on exporting goods from Brazil should be avoided as they will feel
increasing international price pressure from the appreciating Real. The governmentʼs
recent tax on foreign investors suggest that foreign investors should be cautious of
sudden regulatory shifts focused on them. Strategies for investment should consider
arrangements with local partners such as credit default swaps, domestic holding
companies, etc.

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BRAZIL Annual Report 2005 2006 2007 2008 2009
GDP
Nominal GDP (US$ bn) 881.8 1,089.0 1,333.6 1,575.2 1,473.1
Nominal GDP (R bn) 2,147 2,370 2,598 2,890 2,994
Real GDP growth (%) 3.1 3.9 5.6 5.1 0.0
Expenditure on GDP (% real change)
Private consumption 4.5 5.2 6.3 5.4 2.5
Government consumption 2.3 2.6 4.7 5.6 2.7
Gross fixed investment 3.6 9.8 13.4 13.7 -10.0
Exports of goods & services 9.4 5.0 6.8 -0.7 -9.9
Imports of goods & services 10.4 18.1 19.6 17.8 -9.8
Origin of GDP (% real change)
Agriculture 0.3 4.5 5.9 5.8 -2.5
Industry 2.1 2.3 4.7 4.3 -7.0
Services 3.7 4.2 5.4 4.8 2.8
Population and income
Population (m) 184.2 186.8 189.3 191.9 194.4
GDP per head (US$ at PPP) 8,606 9,108 9,764 10,340 10,330
Recorded unemployment (av; %) 9.8 10.0 9.3 7.9 8.4
Fiscal indicators (% of GDP)
Public-sector balance -3.0 -2.9 -2.2 -1.5 -3.0
Public-sector debt interest payments 7.3 6.8 6.1 5.5 4.4
Public-sector primary balance 4.4 3.8 3.9 4.0 1.5
Net public debt 46.7 45.0 45.1 36.8 42.2
Prices and financial indicators
Exchange rate R:US$ (end-period) 2.34 2.14 1.77 2.34 1.99
Consumer prices (end-period; %) 5.7 3.1 4.5 5.9 4.1
Producer prices (av; %) 5.6 0.8 5.6 13.7 -2.0
Stock of money M1 (% change) 13.1 20.4 33.6 -4.1 7.2
Stock of money M2 (% change) 19.5 18.9 18.6 17.3 12.5
Lending interest rate (av; %) 55.4 50.8 43.7 47.3 45.0
Current account (US$ m)
Trade balance 44,703 46,457 40,032 24,836 22,823
Goods: exports fob 118,309 137,808 160,649 197,943 158,851
Goods: imports fob -73,606 -91,351 -120,618 -173,107 -136,028
Services balance -8,309 -9,641 -13,219 -16,690 -12,715
Income balance -25,968 -27,480 -29,291 -40,610 -30,116
Current transfers balance 3,558 4,306 4,029 4,224 4,051
Current-account balance 13,985 13,643 1,551 -28,192 -15,957
External debt (US$ m)
Debt stock 187,431 193,516 237,472 242,137 232,182
Debt service paid 78,218 62,145 55,319 52,199 43,938
Interest 13,271 14,783 14,978 12,927 9,638
Debt service due 62,618 53,747 55,323 52,199 43,938
International reserves (US$ m)
Total international reserves 53,799 85,839 180,334 193,784 210,123
Source: IMF, International FinancialStatistics.

(c) Economist Intelligence Unit 2009

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BRAZIL Quarterly Report 2008 2009
1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr
Central government finance (Rm)
Revenue 160,847 177,367 185,013 208,586 158,959 n/a
Expenditure 166,444 170,148 168,018 176,937 203,697 n/a
Balance -5,596 7,222 16,995 31,648 -44,739 n/a
Output
Real GDP at 1995 prices (R bn) 255.6 259.4 262.9 254.1 251.6 256.4
Real GDP (% change, year on year) 6.1 6.3 6.7 1.2 -1.6 -1.2
Industrial production index (2002=100) 126.5 127.8 129.8 117.2 109.2 113.3
Industrial production (% change, year on year) 7.0 5.7 5.9 -6.7 -13.6 -11.3
Employment, wages and prices
Unemployment rate (% of the labour force) 8.4 8.1 7.8 7.3 8.6 8.6
Real average earnings (% change, year on year) 2.5 2.8 5.9 4.4 n/a n/a
Consumer prices (1993=100) 2,760 2,810 2,854 2,884 2,919 2,955
Consumer prices (% change, year on year) 4.6 5.6 6.3 6.2 5.8 5.2
General price index (1994=100) 376.0 389.7 400.9 405.3 n/a n/a
General price index (% change, year on year) 8.8 12.1 13.2 10.8 n/a n/a
Financial indicators
Exchange rate R:US$ (av) 1.74 1.66 1.67 2.28 2.31 2.07
Exchange rate R:US$ (end-period) 1.75 1.59 1.91 2.34 2.32 1.95
Deposit rate (av; %) 10.2 11.0 12.6 12.8 11.2 9.3
Money market rate (av; %) 11.2 11.7 12.9 13.7 12.6 10.3
M1 (end-period; R bn) 182.9 184.9 192.9 222.4 191.7 200.0
M1 (% change, year on year) 18.0 13.3 10.6 -4.1 4.8 8.2
M2 (end-period; R bn) 1,672 1,756 1,835 1,918 1,939 2,018
M2 (% change, year on year) 17.8 18.0 18.1 17.3 16.0 14.9
Ibovespa index (end-period; 29/12/83=100) 60,968 65,018 49,541 37,550 40,926 51,465
Ibovespa index (% change, year on year) 33.1 19.5 -18.1 -41.2 -32.9 -20.8
Sectoral trends
Vehicle production (ë000) 792.9 905.8 930.4 591.4 n/a n/a
Manufacturing production index (2002=100) 126.0 126.1 128.5 117.2 n/a n/a
Metals production index (2002=100) 125.9 125.4 124.1 109.3 n/a n/a
Pharmaceuticals production index (2002=100) 113.6 124.4 134.2 133.6 n/a n/a
Pulp, paper & products production index(2002=100) 127.6 130.0 128.5 125.2 n/a n/a
Retail trade index, volume (2003=100) 134.8 140.5 143.8 163.1 139.7 147.7
Foreign trade (US$ m)
Exports fob 38,690 51,954 60,215 47,083 31,177 38,775
Imports fob -35,932 -43,415 -51,826 -41,802 -28,185 -27,800
Trade balance 2,758 8,539 8,389 5,281 2,992 10,975
Foreign payments (US$ m)
Services balance -3,322 -4,821 -4,791 -3,756 -2,856 -5,170
Income balance -10,686 -11,231 -10,562 -8,083 -5,938 -8,682
Net transfer payments 987 899 985 1,353 840 736
Current-account balance -10,260 -6,611 -6,013 -5,308 -4,944 -2,130
Reserves excl gold (end-period) 194,223 199,822 205,539 192,844 189,398 200,458
Sources: Fundacao Getulio Vargas, Conjuntura Economica; IMF, International Financial Statistics;
Banco do Brasil. (c) Economist Intelligence Unit 2009

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