Brazil Wholesale Inflation May 2008

Brazil's broadest price index rose at the highest monthly rate in five months in May, increasing speculation that the central bank will raise interest rates for a second straight time at its meeting next week. Wholesale, consumer and construction prices, as measured by the IGP-M price index, rose 1.61 percent in May, the Rio de Janeiro-based Getulio Vargas Foundation said today on its Web site.

Consumer price increases, as measured by the government's IPCA, quickened to 5.25 percent in the 12-month period to mid- May, the fastest pace in more than two years, the national statistics agency said yesterday.



Central Bank President Henrique Meirelles, in testimony to the Brazilian Congress yesterday, said wholesale prices were rising faster than overall inflation and that policy makers have acted preemptively to prevent the increases from spreading to other parts of the economy. .

Meirelles' comments were more evidence that policymakers will raise their benchmark interest rate for the second consecutive time, possibly by 50 basis points to 12.25 percent when they meet next week.The central bank raised the benchmark rate to 11.75 percent from 11.25 percent for the first time in three years last month.

Brazil Current Account Deficit April 2008

Brazil posted the widest annual current account deficit in almost six years as faster economic growth spurred imports and the remittance of profits abroad. Brazil's current account deficit, which offers us the broadest measure of trade in goods and services, increased to $14.7 billion in the 12 months through April, up from $9.54 billion in March, accoding to the latest data from the central bank. This if the widest gap since August 2002. The fastest economic growth in more than three years and a cheap dollar boosted demand for imports, which jumped almost 45 percent in the first four months of this year. Companies benefiting from the expansion are also sending more of their profits abroad to meet the financial needs of their head offices amid an international credit crunch.


It is important to realise that Brazil has been running a current account surplus in recent years, although the IMF are currently forecasting a deficit of 0.7% GDP for 2008.



Record inflows of foreign direct investments have covered the gap, easing concern the existence of a current account deficit will create a shortage of dollars, but at the same time raising concerns about the long term dependence on such flows. Brazil received $37.2 billion of foreign direct investment in the 12 months through April, a record annual inflow.

Brazil's Economy - Not Emerging Anymore?

By Claus Vistesen: Copenhagen

Brazil is interesting; not only because of its fabulous nature, its rhythmic and musical heritage, and its (alleged) repository of beautiful women but also because of the position it commands in the global economy, the latter topic being the focus of this note. Consequently, Brazil's economy represents an excellent point of departure for the evaluation of many highly strung discourses in the context of the global economy and her financial markets. These discourses include the debate on de-coupling/re-coupling, global inflation, Bretton Woods II/global imbalances, and global liquidity/SWFs just to name a few. In what follows, I will try to present an argument to explain why it is that I am so very constructive on the upside potential for Brazil's economy, while at the same time trying to untangle (as I have tried so many times before) some of the above mentioned areas of discussion and debate in the context of the global economy and Brazil.

Perhaps the most telling sign of Brazil's increasing status as a global force to be reckoned with was the recent announcement by Brazil's National Petroleum Agency (ANP) of the discovery of a new oil field (Carioca) which potentially holds as much as 33 billion barrels of oil - enough to supply every refinery in the U.S. for six years - making it the third-largest oil field ever discovered (only Saudi Arabia's Ghawar and Kuwait's Burgan fields are bigger - Ghawar reputedly holds as much as 83 billion barrels of crude, while Burgan is claimed to have up to 72 billion). Coupled with the discovery last year of the Tupi field - which has an estimated reservoir of between 5 and 8 billion barrels of oil, and could itself produce output at the not to be sneezed at rate of a million barrels a day - this is very likely to fast forward Brazil rapidly up through the ranks of global oil producing nations. This new found oil prowess even prompted the president Lula da Silva recently to suggest that Brazil enter OPEC.

Such oil discoveries come at a near-perfect time for Brazil who thus seems set not only to enjoy the upward march of commodities such as sugar, rice, beef, soya, oranges, iron ore etc but now also the black gold. Of course, the set up of a proper supply chain in the context of oil production takes time and it will take at least one year before we see the first barrels rolling in from Tupi not to speak of Carioca. However, Petrobras (Petroleo Brasileiro SA) is not sitting idle and the effects of Brazil's oil discoveries are already rippling through the market. Extraordinary evidence of this was delivered in the context of Petrobras' demand for the world's deepest-drilling offshore rigs to put action behind the recent discoveries. Petrobras is rumored to be hawking as much as 80% of global capacity as a function of the company's demand for deep drilling rigs and given the fact that these things don't exactly come off the shelf with the same ease as flat screens it will take some time for supply to respond to the increased demand thus pushing up rent for these vessels.

In many ways, as Edward also hints in a recent article the oil discoveries mentioned above represent a good initial image of Brazil's growing role in the global economy. Petrobras thus projects investments to the tune of 112 billion USD between 2008 and 2012 which, if realized, are sure to calm down even the most careful treasurer in the Brazilian finance ministry.

Thus assured of Brazil's current economic potential we should take a few steps back and have a look at the historical economic performance of Brazil, how it got to where it is today and where it is likely to go in the future? First, why not take a glance at some charts?

It does not take much of a macroeconomist to see how the stories above tell a story of rapid economic development. Obviously, it is difficult to make solid conclusions solely on the basis of growth figures but as can readily be observed Brazil is moving up in the world. Especially, the figures for PPP adjusted GDP are interesting since they show how Brazil is steadily and unrelentlessly creating an ever larger share of global GDP. The inflation figure also shows that almost a decade's worth of rampant inflation has now receded to much more comfortable levels. As for the allure of Brazilian asset markets the last figure just about sums it up. Over the three year period a US investor investing 1 mill USD the 16th of May 2005 would have been able to walk away with just shy of 4.5 mill USD the corresponding date 2008 (note that the exchange rate is with our US friend here too). Of course, such examples are not kosher as we are not looking at risk (e.g. standard deviation or global beta) but the rate of expansion in the main stock index is still quite remarkable, even border lining on a bubble if you look at the growth rate alone. This performance is, of course, to some extent shared by the other usual suspects who make up the notorious BRIC group, as originally coined by Goldman Sachs. I would not want to take anything away from GS here but simply note that the BRIC narrative is not exactly fitting for what is happening in the global economy. It is indeed true that the four economies are amongst the fastest growing economies of the world but they are very difficult in terms of structural setup which tends to blur the analysis. Specifically, I would distinguish between Brazil, India, and China on one side and Russia on the other. Soon in fact China may join Russia's side of the fence if the inflation bonfire currently experienced proves inextinguishable.

Brazil's rise not only in terms of GDP at constant prices but also in PPP terms cuts right across the whole debate on de-coupling which at times has developed into a rather badly played football match between the US and Europe. In this way, I never really was a fan of the original idea of de-coupling whereby the Eurozone ascended to take over from the US as the new global economic power train (and reserve currency repository). I simply think that this debate was principally flawed in its foundation. As such, it was never about whether the Dollar should fall or not, but given that it was always going to adjust downwards, against who and against what was it going to adjust? What we are currently observing in the global economy is then a process of recoupling of unprecedented proportions. Basically, the big economies of Latam and Asia not only want to be rich on population but also on economic wealth and what we are observing across the global economic edifice is the unwinding of the post WWII imbalances in which one half of the world got economic growth whereas the other got population growth. Brazil's rise in terms of purchasing power is a clear sign of this and in this light, the rise of big economies such as China, India, Brazil, and Turkey will change the tectonic plates of the global economy. Ultimately this process may be a difficult transition for the global economy and in particular for those countries yielding their ranks but it should not be lamented.

Too Much of a Good Thing?

Alas, this global process of re-coupling is not a linear and steady one, and it is getting clouded by the Bretton Woods II edifice in which Asian economies alongside petro exporters maintain a fixed exchange rate policy to the US accumulating vast reserves in the process. Brazil finds itself right smack in the middle on an unprecedented global hunt for nominal yield as excess liquidity, wide global interest rate differentials, and key fixed exchange rate regimes determine the global flow of funds. Especially, as the US economy falters, the shift of capital flow to snub the return to negative real yields in the US is piling the pressure on asset markets in countries who maintain open capital and financial accounts. This has prompted many analysts to lament the inflation targeting policy of the central bank as it serves to keep nominal interest rates too high thus sucking in too much capital for the economy’s own good.

The recent lingering backdrop of the external balance into deficit (see below) is among other things used as ammunition. Current interest rates are at a hefty 11.75% and it does not take much financial literacy to spot the carry trading (see appendix) plays available. Recently, Antonio Carlos Lemgruber voiced a similar critique in the context of RGE's Latin America monitor. Mr. Lemgruber's main argument is pinned on one of the most illusive of economic concepts in the form of the output gap which measures the divergence between the potential output and actual output. According to him Brazilian monetary authorities are too pessimistic on behalf of the economy's capacity to grow. Currently the interest rate is set on the basis of a potential growth rate of 3-4% while Lemgruber believes it to more like 7%. This would require a lower nominal interest rate to keep the economy growing without stoking 'inflationary pressures.' In terms of the actual numbers for potential output I tend to side with Lemgruber but we need to realize, I feel, that the measure of capacity in an economy such as Brazil's is tremendously difficult. The reason for this is simple and relates to the process known as the demographic dividend.

This note shall not dwell extensively by the pace of the demographic transition in Brazil but simply note that Brazil quite like almost all of the other socalled emerging economies is closing the demographic gap with the rest of the OECD quite rapidly. The figure below shows this process quite neatly even though we should be very careful about extrapolating on general population momentum on the basis of fertility numbers.

As can be observed there is some uncertainty as regards to the pace of fertility decline going into the 21st century. What can see however is that Brazil is steadily nearing the sub-replacement level and based on expectations we should expect her to continue. In fact, according to the US Census Bureau database Brazil's TFR is already below replacement levels at this point (1.86) although a more detailed analysis is needed to tell for sure. This means that the demographic dividend by which falling fertility provides a period in which the non-working age dependency ratio of the economy declines is now occurring in the context of Brazil. However, we also know that there are no free lunches and the favorable environment provided by the DD is also followed by a less favorable environment as the age dependency steadily rises as well as the productive profile of the country shifts as the age structure effects ripple through. In this light, the DD becomes an opportunity to lock-in the highest possible growth path and this is exactly what Brazil now needs.

It is in this specific context that I see the difficulties in estimating capacity in Brazil since no one really knows at this point. We know however, that capacity is growing in Brazil and that at the present time it is probably somewhat larger than the 3-4% currently fielded by the central bank. The debate thus shores up in a somewhat circular reasoning exercise. There is no doubt that the increasing purchasing power of Brazil's currency (more about that below) is warranted (see Macro Man for a semi-empirical account of this). But in a world where yield is the name of the game inflation targeting policies become virtual magnets for funds at the same time as the policy itself brings little relief in terms of inflation which springs from external headline pressures.

Lowering interest rates could help here but it would hardly stem the flow of carry trades and at the moment inflationary tendencies does not seem to warrant such moves. The crucial question is simply whether Brazil's fundamental growth path and inherent ability to create investment opportunities merit a base return of 11.75% (or similar)? In reality of course this is the same discussion as with the output gap as well as it is a discussion of what the base nominal rate actually consists of in terms of a measure of domestic investment capacity (i.e. a demand perspective) and/or foreign investors view on business risk (supply side perspective). We should also remember that the PPP model is an equilibrium model which predicts parity driven by inflation differentials. This is very difficult to discern in the context of Brazil though if we accept the premises that the economy itself is in a transition. More importantly, how well does the PPP fit the actual realities of the global economy? As recent as yesterday Stephen Jen wrote a neat piece in which he argued that currency appreciation might actually be inflationary in the current context of the global yield hunt. Through such a lens PPP hardly seems to be the right measure to gauge the ‘true’ value of the currency. Yet, as we turn to the next subject we shall see that the real issue here is not so much whether to be optimistic or pessimistic on Brazil's future economic prowess but rather whether Brazil should submit itself to rules of the game which would entail a transition towards a growth path by which internal investment exceeds internal savings, on a flow basis, ... in short, how much of a negative external balance can and should Brazil run?

As I will sketch out below I believe that Brazil can now, in broad terms, go two ways and it is in the distinct interest for Brazil herself and the global economy that Brazil is encouraged on to one road rather the other.

Letting the Capital Flow?

Consequently as we home in on the issues of global imbalances, Bretton Woods II, excess liquidity Brazil becomes an important litmus test for the choices many big countries with comparatively young populations face. Let us begin with the visual inspection to get us off the mark.

As can be observed the appreciation of the Real and the subsequent increase in purchasing power has resulted in a deterioration of Brazil's external balance although as I have argued before endogeous life cycle effects which spring from demographics may be equally as important. The trade balance in goods is not yet in the red most likely due to the push from commodities; if Brazil is now set to enjoy an oil windfall the trade balance in goods can perhaps be kept in the plus. The current account however is now firmly in negative on the back of deficit in services trade and the income balance. The latter subcomponent is not without interest here since a negative income balance is exactly what we would expect in the context of a country such as Brazil with a comparatively young population. If we look at the financing of the deficit we can see that the inflow of FDI has been steadily positive for a number of years which provides initial support for a solid base of financing. Portfolio investments have been somewhat more volatile which is quite as expected but the recent years seem to have seen a sustained and increasing inflow. After all, if I can make a graph of Bovespa such as the one above, so can others. The recent retrenchment of inflows seems to have come as a result of the jitter in credit markets. In this light what we have now is an important test case in terms of just how much capital that will leave Brazil in the context of global turmoil in credit markets. Conventional wisdom would hold that Brazil should suffer an exodus of capital but I am not so sure. In fact, given the amount of liquidity bouncing around I don’t see where portfolio managers would put their money even though, of course, the recent surge of commodities can in some ways be seen as a flight from traditional risky assets.

In terms of the amount of carry trade which seems to worry many an observer I have to note upfront that this is really difficult to read out of macroeconomic data. The real juicy data series here would be high frequency FX data on retail and institutional positions in the spot market. Having said that loans have indeed recently been an increasing part of the financing of the Brazilian external deficit which may hint to carry trading positions. If we further consult the subcomponents in the form of short term loans and currency deposits there seems to be an increasing volatility which may hint to a lot of activity on the short end of the maturity curve. This could be akin to carry trading activity. The big spike which shows a large repatriation of funds could be indication of unwinding of short positions in the money market as the realities of the credit turmoil became apparent. The main quibble with this carry trade analysis is that carry trade usually is carried out in the spot market where, in periods of low volatility, highly leveraged positions earn a hefty daily roll (or so I would imagine). In fact, I would imagine that such strategies frequently form a part of many beta (market) portfolios since when volatility is low and it is clear that the uncovered interest rate parity does not hold carry trading profits are too good not to be had. Obviously, since the credit turmoil washed in on the shores of financial markets I imagine that investors and hedge funds are becoming more careful.

If these are the realities of the current external position of Brazil is there something to be worried about? Should we fret a Brazil with an external deficit due to boom/bust effects from volatile capital flows?

A crucial first step to make here is to pin down the position in which Brazil finds itself with respect to the ability to issue debt since it forms an important part of the overall picture in terms of investor confidence. My feeling here is that a lot of the worry on behalf of Brazil is rooted in history and thus a once bitten twice shy mantle. In this way, many emerging economies can be said to suffer from the so-called original sin which alludes to their creditors’ demand that loans be repaid in foreign currency from the point of view of the issuing economy. Of course, this can quickly turn into a self-fulfilling prophecy since with a large stock of loans denominated in foreign currency a rapid deterioration of the fundamentals of the domestic currency may sharply increase the costs of servicing the debt. Nowhere is this more important than in the context of Latin America in general. On the back of the global recession in 1981-1983 and Volcker’s interest rate hikes the debt burden increased sharply for Latin American countries. Coupled with foreign investors’ flight to safety this pushed Latin America into the so-called debt crisis whose aftermath, among other things, included the subordination to IMF’s and the World Bank’s policy decisions (known as the Washington consensus) since these were the institutions coming to the aid of many the Latin American countries.

However, that was back in the 1980s. Today the global capital markets look decisively different. Not only do IMF’s reserves resemble little more than a minor Asian nation’s war chest but Brazil itself has changed strikingly. Recently, we got Brazil’s upgrade to investment grade by Standard and Poor and if you look at the debt to GDP ratio it does not come off as particularly alarming and has even fallen in the recent years. The ever careful analysts over at RGE’s Latin America Monitor do not seem too convinced however. Thomas Trebat consequently questions the soundness of S&P’s decision to grand Brazil the IG batch. Trebat’s principal worry is that the upgrade comes at a time when Brazil has all the cyclical winds blowing her way and consequently voices caution as to what may happen if Brazil suddenly sees less vibrant times. One example here could be a fall in commodity prices which would widen the external position even more as well as it could bring into question foreign capital’s willingness to buy Brazilian debt. Some part of Trebat’s analysis is no doubt perfectly valid and the investment grade feather should not be seen as an excuse to increase public spending without keeping the balance between receipts and expenses in check. Ultimately, it is also a question of what importance we ascribe to this investment grade edifice. Personally, I feel that the whole global sovereign debt structure may soon move into limbo since if you extrapolate the debt position of countries such as Italy, Japan, and Germany you end up in la-la land as it is clear that at some point, due to their rapid demographic decline, they simply won’t be able to pay. In such a perspective I certainly don’t see why Brazil should not, at least, enjoy the same categorical debt rating. Another theme which Trebat latches onto relates to Brazil’s growing foreign reserves which still cannot match the likes of the USD peggers but still amount to a good cushion. Trebat on the other hand sees it differently as he points to the rather technical point that the reserves, in terms of import coverage, represent a low and highly cyclical factor. I can see the mechanics here but I disagree with the point inferred from them. Basically, Brazil’s ability to sustain an external deficit must, at least in part, depend on the economy’s ability to generate positive NPV projects that can attract foreign capital. Also and perhaps equally as important demand in Brazil for imports must be seen in the context of other nations’ propensity to export and not within a rather arbitrary reference frame of the FX reserves’ import coverage.

In many ways, the mentioning of Brazil’s foreign exchange reserves brings us to the pinnacle of this discussion and Brazil’s role in the global economic edifice of macroeconomic imbalances, excess liquidity, and Bretton Woods II. In this way, the description above could seem to vindicate the idea that Brazil is now submitting itself fully to the global flow of funds. This is not quite true however.

As we can see there is a clear structural break in the pace of accumulation and if we home in on 2007 and 2008 in terms of monthly data this becomes clearer. The recent step-up in reserve accumulation clearly has something to do with the Real’s flight upwards against the USD and on several occasions have heard about Brazil’s plight in trying to stem the flow of capital inflows. We know in this context that the Central Bank on occasions have been dipping its toe engaging in countervailing market operations to put a leash on the Real. A year ago Brad Setser put words on Brazil’s possibilities as he asked …

I wonder when Brazil will start to contemplate an investment fund. Brazil's reserves are mostly in depreciating dollars and it too will soon have more than it really needs.

Now, this proposition is in itself very interesting since it latches on to the whole flurry about state backed investment vehicles known as sovereign wealth funds and where those bulging coffins of FX reserves should actually go. In Brazil’s concrete case the potential deployment of the reserves no doubt links in with the charts shown above of the external balance. As such, it does indeed seem tempting to try to reign in that deteriorating income balance through the placement of some 200 billion worth of reserves. Moreover, as Brad Setser points out most of the reserves is in USD which has not exactly been a fun asset to be stocking as of late.

In the grand scheme of things Brazil’s decision on this is intimately tied in with the discourse on global capital flows. At the moment Brazil is then a net importer of capacity through its negative external balance. If commodity prices suddenly take a dip this role is certain to be intensified. Is this necessarily a bad thing or perhaps more timely should we expect it to be otherwise? After all a negative external balance is not only about an endogenous process of over consumption and under saving but also about the country’s consumption profile as per function of its demographic profile which translate into distinct lifecycle dynamics. I, at least, tend to believe this to be the case. Also, if we accept this view we must also recognize that other countries will have a propensity to export as per function of their age structure. As I have argued many times before this perspective on global imbalances and how demographics affect capital flows is important to slot in alongside the more traditional narrative on Bretton Woods II and USD peggers.

With these points in mind we could return to my original question of what in fact Brazil should or can do. There are two options. One is to accept the rules of the game and let the capital flow freely in turn making sure to keep the domestic books in order. Another would be to ramp up intervention in the currency markets and to start deploying a state backed investment vehicle to scour the global asset markets for yield. Obviously, this is not entirely a choice to be made at this point but Brazil can still choose to look in either direction I feel. The road taken, be it forced or chosen, will matter a lot however. First of all it will matter for the global economy since the last thing we need at this point is for a country with so favorable growth conditions as Brazil to revert into a growth path driven by excess savings. If Brazil is currently passing through its demographic dividend and even striking oil in the process it also means that the country has a golden opportunity on its hands. One obvious policy proposal I have voiced in the context of other countries is to make sure that fertility does not plunge too far. If the US Census Bureau's estimate is valid and we are already at a TFR at 1.88 it indicates that the process is moving fast indeed. In terms of more plain vanilla economic reforms I would like to reiterate that institutions do in fact matter and now would thus be the time that Brazil enacted those much hailed liberalization reforms and developed efficient markets. In this context the growing size of the public sector as a result of commodity windfall should be watched I feel.

Keep Drilling; when an Ugly Duckling turns into a Swan?

As you can see above I am rather bullish on Brazil from a structural point of view. When I look at Brazil and its underlying economic fundamentals I think that the outlook looks remarkably well. Obviously, there is no automaton here and Brazil may soon enough be struck by a wayward lighting in the context of the global credit turmoil. Yet, current market events are also a test in this case since it will indeed be interesting to see just how much turmoil Brazil will feel if the sh*t does decide to hit the proverbial fan again. How much will the Real really fall and how much of those incoming funds will really leave? Pessimists tend to argue that nothing material has changed in Brazil’s context and that moving into the current patch of slow growth with a widening external deficit presents a large peril. I don’t see it like this at all.

As can be observed however in the references above not everybody agree. One important narrative here is that Brazil has enjoyed a remarkable stint of growth on the back of favorable global conditions which is now set to come to an end. Morgan Stanley’s Marcelo Carvalho recently voiced such an opinion in a slew of notes where he points out that Brazil, although better shielded than before, is far from immune from global financial headwinds. Far be it from me to disagree with a general note of caution. Things may indeed turn for the worse as we progress into the real economic effects of the financial crisis. However, the global economy is now in a position where it needs a Brazil with an external deficit much more than it needs a Brazil with a pegging exchange rate amassing and investing reserves.

I don’t think that Brazil was ever an ugly duckling and while we should not dismiss the voices of caution out there I remain positive on behalf of Brazil. It won’t be easy for Brazil to submit to rules of the global economy where money goes for top line yield. The potential skewness in terms of capital inflows may turn out to be quite large with all the downside risk it brings. However, I don’t quite see how it can be any other way given the economic fundamentals.

Appendix – So what the hell is a carry trade?

Carry trading links in to the principle in the UIP (uncovered interest rate parity) and essentially how this does not hold. The UIP states that the expected change in the spot rate must reflect the interest differential between the two currencies. More specifically the theory predicts that in the context of interest rate differentials the country with the high interest rate will see its currency depreciate (i.e. as it is assumed ex ante that the higher interest rate is a compensation for this depreciation). In formal terms:

If the UIP does not hold we can attempt a carry trade which essentially exploits the interest rate differential between the two countries. Note that in the example below our domestic investor (Ms Watanabe) lose money as the funding currency (the Yen) appreciates.

Assume:

USD/JPY: 120 (indirect quote)

USD/JPY: 115 (indirect quote) - after one month

Monthly USD rate: 0,6%

Monthly JPY rate: 0,012%

We progress in the following steps (amount invested 100 USD)

1. Borrow amount equal to 100 USD (i.e. 12000 yen) in domestic money market and convert spot to invest in the US (i.e. invest 100 USD in US money market)

2. After one month you will have earned 100USD*(1+0,06) which equals 100,6 USD.

3. Convert this amount back to Yen at the prevailing spot rate which in period two is 115. Thus, you convert back to get 100,6*115 which equals 11596 Yen.

4. Use the proceeds for the carry trade to pay back domestic loan. You will have to pay back 12000*(1+0,012) which equals 12014,4 Yen.

In this case we consequently lose as Japanese investors. The percentage lost can be calculated as follows. [(result from carry-payback on domestic loan)/result from carry]*100

i.e. [(11596-12014,4)/11596]*100 = -3,61%.

Note here that the main risk is for an appreciation in the funding currency/low rate currency. In essence there is an almost linear relationship between the % change in the spot rate and the % interest differential spread. I.e. the % deviation from the theoretical prediction of the uncovered interest rate parity. Let us demonstrate.

Over the period in question we observe an appreciation of the Yen to the tune of (115/120)-1 which equals 4,167%. The interest rate differentials earned amounts to 0,588% (0,6-0,012). Now, if we subtract 0,588 from the percentage change in the spot rate we get approximately the loss calculated above (i.e. 3.57%). As such the main risk is (and this is almost always the case) that when volatility is high the spot rate will change much more than can be compensated by the interest rate differential thus resulting in a large potential loss.

Digging deeper into the theory what would be the future spot rate implied by this information given an assumption that the UIP holds? Well, given the fact that the interest rate differential is in favor of the US we should expect the USD to depreciate against the Yen in order to negate the interest spread which could have otherwise been earned. This was what was built into the model but by how much should the USD depreciate as implied by the UIP? As a very rough and ready approximation we can say that the expected change in the exchange rate (E)ΔS is equal to the interest differential; in this case (0.6-0.012) which is equal to 0.588%. A depreciation of the USD of 0,588% would imply a USD/JPY rate of 120*(1-0.00588) which is equal to 119.304.

Brazil's Big PC Tune-in and Turn-on

Brazil ranked as the fifth-largest PC market last year as bank credit offers, installment plans and growing prosperity fueled purchases, especially among low-income consumers. The shift is a boon to Hewlett-Packard and Dell Inc., the world's top PC makers. A tax break for PC makers has allowed them to cut prices and compete with unregulated sellers whose so-called gray- market machines dominated the market.

``You have a consumer market that's exploding as people have more access to credit,'' said Mario Anseloni, managing director of Hewlett-Packard's Brazil division. ``That's transforming the whole economy.''

Total Brazilian PC shipments rose 38 percent to 10.7 million units last year, according to research firm IDC in Framingham, Massachusetts. That marked the first time that shoppers bought more PCs than television sets in the country. Brazil's PC market, which ranked seventh in 2006, is poised to take third place by 2010, behind the U.S. and China. Japan and the U.K. are now third and fourth, IDC said.

Low-income families, eager for Internet access, are buying PCs at a faster pace than any other group, according to the Brazilian Internet Steering Committee. Spending by Brazilian businesses on software, services and computers rose 12 percent to $20.7 billion last year, IDC said. Brazil accounted for almost half of technology purchases in Latin America. Outlays may rise another 12 percent this year to $23.3 billion, IDC said, compared with 4 percent in the U.S.

Brazil, Petrobas, Investment Grade, Soya Exports, Shipbuilding and Consumer Demand - We Have Take-Off!

Petroleo Brasileiro SA, Brazil's state-controlled oil company, continues to drill away and is now about halfway through its offshore Carioca deposit according to Mines and Energy Minister Edison Lobao said. Carioca forms part of Brazil's new pre-salt region, which lies beneath 2,000 meters of water and as much as 4,000 meters of seabed. The pre-salt region is also home to the Tupi field, which holds an estimated 8 billion barrels of oil and is the largest Western Hemisphere oil discovery in three decades. Lobao is also quoted as saying that Betrobras will need more time to determine the size of the Carioca field, so I suppose for the time being it's just a question of "on we go with the drilling".




Following up on my post about oil rigs earlier in the week, Petrobras have also announced plans to lease 146 Brazilian-built ships over 6 years to support offshore oil exploration and production. The purchases will be paid for in part with some of the $50 billion Petrobras has earmarked for investment on Brazilian oil equipment over the next four years. It is Petrobras' intention to offer long-term leases to companies that agree to build the ships in Brazil with 70 percent to 80 percent local material.

Petrobras expects to spend $112 billion on expansion in the 2008-2012 period, helping support efforts by the government, its controlling shareholder, to maintain GDP growth rates of 5 percent or more a year. The ship-building plan is part of an industrial policy program which was announced by Brazilian President Luiz Inacio Lula da Silva earlier last week.

To boost shipbuilding in Brazil, Petrobras is helping finance the construction of new shipyards and the renovation of old facilities, including yards in Rio Grande in Brazil's south and in Suape, near the northeastern port city of Recife.

In the 1970s, Brazil was the world's second-largest shipbuilder. Its industry was almost wiped out by the oil shocks of the 1980s, debt defaults and inflation. A key plank in Lula's first-term victory in 2002 was revitalization of the shipbuilding industry. A $3 billion plan for tankers is already under way.

Clearly this rapid expansion is being financed by the ongoing commodities boom, and sustainability will depend with some high degree of sensitivity on the evolution of that boom. Brazilian exports have tripled since President Luiz Inacio Lula da Silva took office in January 2003 on rising world demand for soybeans, iron-ore, beef and cars. The economy expanded 5.4 percent in 2007, the fastest rate in three years, buoyed by rising exports and falling interest rates.

Obviously were there to be a negative commodities shock caused by a rapid slowdown in global growth and large scale capacity overhangs then all of this could go the same way as the 1908s boom, but there are reasons for thinking that this time round - and despite a possible short term slowdown in global growth in 2009 and a temporary downward adjustment in commodity prices - that the mid- to longer-term outlook (5 to 10 year horizon) is pretty bullish. I have elaborated on some of the relevant points in this article/post.

Also Bloomberg today have a very interesting interview with Roberto Egydio Setubal, head of Brazil's second-biggest non-government bank (Banco Itau Holding Financeira). Setubal said his nation is in a "transformation" that's creating the best conditions for business he's ever seen.

Brazil, Latin America's largest economy, has broken a cycle of boom and bust because of rising commodity exports and will enjoy sustainable annual growth of 4 percent to 5 percent, Setubal said in an interview this week in Sao Paulo. An investment-grade rating granted by Standard & Poor's last month will make Brazil a magnet for foreign investors.

Setubal is expanding abroad and at home, capitalizing on the 31 percent rise in Brazil's real against the dollar since May 2006, the collapse of inflation from almost 5,000 percent in 1994 to 5 percent now, and losses at global competitors. He's opening offices in the Middle East and Asia, hiring bankers from Deutsche Bank AG and Merrill Lynch & Co. and looking to buy Brazilian assets that may get dumped by foreign firms at discount prices.

``I don't see Brazil going back,'' the 53-year-old chief executive officer said at his office in Sao Paulo. ``The strong currency and investment grade are here to stay.''

Brazil's $1.07 trillion economy grew 5.4 percent in 2007, the fastest in three years. Controlled inflation led the central bank to cut the benchmark interest rate to as low as 11.25 percent in September, encouraging people and companies to borrow record amounts and boosting profit at Brazilian banks. Lending has increased every month since February 2004 to 992.7 billion reais ($600.8 billion) in March.



Brazil, the biggest debtor among emerging markets for decades, became a net foreign creditor in January after international reserves surged to a record $195.8 billion.

Brazil was the third-biggest market for initial public offerings globally in 2007, according to Bloomberg data. This year, only three companies went public, reflecting the reduced appetite for risk by international investors. Foreign investors bought 75 percent of the shares sold in public offerings in Brazil last year and 49 percent of the ones sold this year, according to the local stock exchange, Bovespa.

``This is a big change in Brazil,''Setubal said. ``Politicians used to believe spending was very popular and nowadays they learned that stable prices is much more popular.''

Update Tuesday 20 May 2008

I another "sign of the times" piece of news Petroleo have today passed both Microsoft and Industrial & Commercial Bank of China to become the world's sixth-largest company by market value.

Petrobras, as Brazil's state-controlled oil producer is known, climbed 3.8 percent to 50 reais, pushing its capitalization to 487.9 billion reais ($295.6 billion), according to data compiled by Bloomberg. Microsoft, which yesterday revived the possibility of purchasing Yahoo! Inc., fell 1.8 percent to $29.46, lowering its overall value to $274 billion. ICBC's A shares listed in Shanghai rose 0.2 percent to 6.22 yuan. The market value of the world's largest bank is 2.02 trillion yuan ($289.3 billion).

Six of the top 10 companies by market value are energy or mining companies, while three are from China.

Petrobras, which has seen its market value quadruple since 2004, is worth 41 percent less than Exxon Mobil, the world's largest company at $498.6 billion. By overtaking Microsoft, Petrobras also becomes the third-largest company in the hemisphere after Exxon and General Electric.

Brazil Retail Sales March 2008

Brazil's retail sales rose 11.4 percent in March, capping the strongest quarter on record, as a credit and investment boom fuels what is Latin America's largest economy. The March gain was led by computer and office equipment sales, the national statistics agency said today in Rio de Janeiro. That put the quarterly expansion at 12 percent, the most since the agency began records in 2000.



Policy makers last month raised the overnight rate a half- point to 11.75 to rein in inflation. Economists are predicting the central bank will increase lending rates further to 13.25 by year end, according to the median forecast in a central bank survey of 100 financial institutions published this week.

Brazilian consumer prices rose 0.55 percent in April, the most in 2008 to date. The annual rate of inflation was 5.04 percent last month, above the mid-point of the central bank's target of 4.5 percent target plus or minus 2 percentage points.

Petrobas Deep Sea Drilling Capacity

Petroleo Brasileiro SA, Brazil's state-controlled oil company, has reportedly leased about 80 percent of the world's deepest-drilling offshore rigs to explore prospects including the Western Hemisphere's biggest discovery in decades. Petrobras is hiring rigs that can drill in at least 3,000 meters (9,800 feet) of water according to Chief Executive Officer Jose Sergio Gabrielli. The world has 21 such vessels, according to Rigzone.com, which tracks the offshore drilling industry.


Petrobras is reportedly negotiating for as many as 17 more vessels to probe the Tupi discovery and neighboring fields. The company already controls almost seven times as much capacity as the next biggest user of rigs that can drill in 7,500 feet of water. U.S. and European oil companies are likely to have to pay $50,000 more per day to lease deepwater rigs during the next three years because Petrobras has already contracted for so much of the worldwide fleet. Such units are designed to cope with high seas and hold equipment needed to bore beneath the seafloor and identify oil and gas deposits as much as 6 miles below the ocean surface.

Petrobras has signed leases this year for six deepwater rigs, more than twice as many as any other producer, according to Dahlman Rose. The contracts have an average duration of five years and four months at rates of $410,000 to $580,000 a day.

Petrobras plans to start pumping oil in the first quarter of 2009 from Tupi, the biggest find in the Americas since Mexico's 1976 discovery of the Cantarell field in the Gulf of Mexico. Petrobras also is evaluating as many as seven nearby fields, including the Carioca prospect, according to Gabrielli who said Petrobras began signing multiyear drilling leases as far back as 2004 because it foresaw a shortage of deepwater vessels.

Well done Petrobras.

Brazil Inflation April 2008

Brazilian consumer prices had their biggest increase in four months in April because of higher food costs. Consumer prices, as measured by the government's benchmark IPCA index, climbed 0.55 percent last month from 0.48 percent in March, the government's statistics agency said in a report distributed today in Rio de Janeiro. Brazil's inflation rate in the 12 months through April was 5.04 percent.






Brazil's central bank policy makers increased the benchmark interest rate for the first time in three years last month in an attempt to contain inflation. Inflation is emerging as a threat to economic stability after years of ``quiescence,'' and officials must be wary of policies that stoke consumer prices, the International Monetary Fund's deputy chiefJohn Lipsky said yesterday.

``This inflation speed-up must be taken seriously as it creates potentially significant challenges to economic stability,'' John Lipsky, the IMF's first deputy managing director, said in a speech in New York today. A return to 1970s-style high inflation and rising price expectations ``cannot be discarded out of hand,'' he said.

While the surge in energy and other commodity prices is the main cause of the danger, low central bank interest rates and a falling dollar are also contributing, Lipsky said.

Brazil's food prices climbed 1.29 percent in April from the previous month, up from the 0.89 percent increase in March. The central bank targets inflation of 4.5 percent plus or minus 2 percentage points.

Brazil Government To Auction Rice in An Attempt To Stabilise The Price

Brazil's state-owned National Supplies Co. will auction 55,000 metric tons of rice today, the country's ministry of agriculture said yesterday. The government currently has a stock of 1.4 million tons of rice, equivalent to 10 percent of Brazil's annual consumption. The stocks to be auctioned are held in Rio Grande do Sul and Santa Catarina states.

The measure is an attempt to keep prices down and establish a reference price for rice, the statement said, citing Paulo Morceli, basic foods manager of Conab, as the supplies company is known. According to information on the Conab Web site, the rice will be auctioned at 28 reais ($16.98) for a 50-kilogram bag.

The most recent decision of the Brzilian government is just one more example of the way national governments are coming under pressure to offer a response to what is now a global problem: the rising demand for energy and agricultural products. One of the obvious reasons for the sharp rise in demand for agricultural products is the rise in living standards of much of the planet's population when coupled with the fact that food consumption forms a much greater part of the extra income earned in a poor country than it does in a rich one. As a rough and ready rule, the poorer the country the greater the share of every extra dollar earned which will be spent on food.

The poorest of the world’s poor are the 1.1 billion people with income of less than a dollar a day. Around 700 million—almost two-thirds—of these people live in rice-growing countries of Asia. Rice, the dominant staple in Asia, accounts for more than 40% of the calorie consumption of most Asians. Poor people spend as much as 30–40% of their income on rice alone. Ensuring sufficient supplies of rice that is affordable for the poor is thus crucial to poverty reduction. Given this, the current sharp increase in rice price is a major cause for concern.
International Rice Reasearch Institute

Rice As An Example of What is a Global Problem

Thailand's benchmark 100 percent B grade white rice was quoted at a record high of more than $1,000 per tonne recently as a result of constrained supply and rising demand as governments in one rice producing country after another consider taking steps to restrain exports. The price was up from around $950 per tonne a week earlier and $383 per tonne in January. Thailand is the world's number one rice exporter and exports almost twice as much rice as India, its nearest rival.

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In fact Thailand produces about 22 million tons of milled rice annually and exports about 10 million tons. The sharp spike in prices was produced by a report from a World Bank official earlier in the week, and prices did subsequently fall back again after Finance Minister Surapong Suebwonglee siad reassuring words to the effect that Thailand has no plans to limit rice exports.

``If a key exporter like this limits foreign sales, it would be very much like Saudi Arabia reducing oil exports,'' said James Adams, vice president of the bank's East Asia and Pacific department.

Several of the world's food producers - including Egypt, Vietnam, China and India - have recently placed restrictions and limits on food exports in an attempt to contain domestic prices and to reduce protests from urban consumers. Brazil - which this year should harvest an 11.9 million ton rice crop, up from 11.3 million last season - was busy backtracking at the end of last week on an earlier decision to restrict exports. Brazil's Agriculture Minister Reinhold Stephanes followed the example of his Thai counterpart and stated that Brazil would not, in the end, curb exports. Pakistan is also stepping up to the plate in what has virtually become a global emergency and has stressed it has plans to export 2.5 million metric tons this year, according to farm minister Chaudhry Nisar Ali last week.


Vietnam, however, which is the world's third-biggest rice exporter (after Thailand and India), is going to go ahead and reduce rice shipments by 11 percent this year to 4 million tons to ensure supplies and attempt to curb inflation that is its highest in more than a decade (see more on Vietnam in this post). In doing this Vietnam is following in the footsteps of the world's number two rice exporter - India - whol last month put significant restrictions on the export of rice.

Indonesia, which is the world's third-largest rice producer (as opposed to exporter), also intends to hold back surplus rice from export this year in order to bolster domestic stockpiles, according to President Susilo Bambang Yudhoyono speaking on April 18. Export restrictions are particularly threatening to the large rice importers whose populations ofetn depend of the staple for their basic food supply. The Philippines was the world's largest largest importer last year, followed by Nigeria. The Philippines received offers for only two-thirds of the grain it sought to buy on April 17.

Rice is in fact - after wheat - the world's second cereal product. At the beginning of the 1990s, annual production was around 350 million tons and by the end of the century it had reached 410 million tons. World production totaled 395 million tons of milled rice in 2003, compared with 387 million tons in 2002. This reduction in total output which occured around the turn of the century is largely explained by the strong pressure which have been placed on land and water resources, which led to a decrease of seeded areas in some Western and Eastern Asian countries.

Production is geographically concentrated in Western and Eastern Asia, and these retgions now account for more than 90 percent of world output. China and India, between them host over a third of the global population and supply over half of the world's rice. Brazil is the most important non-Asian producer, followed by the United States. Italy ranks first in Europe.


Growth in rice production has, however, been far from linear. Historically, production in ex-Japan Asia has increased steadily but at the end of the 1990s Asian output started to stagnate and in particular in China where rice areas have declined as a consequence of water scarcity and competition from more profitable (oleaginous) crops.

The international trade in rice is estimated between 25 and 27 million tons per year, which is only a very small part (5-6 percent) of total world production., and this makes the international rice market one of the smallest in the world when compared with other grain markets such as wheat (113 million tons) and corn (80 million tons). It also means that the price level is very sensitive to comparatively small changes in the level of exports coming from some key exporters. As can be seen from the chart below, global stocks of rice have declined substantially since the turn of the century. While in part this can be explained by product market efficiencies and the sustainability of lower inventories, it does mean that the sensitivity of the traded rice price to any supply side products has risen considerably of late. Also of note is the way in which stocks of rice have fallen inside China, reflecting the problems the country is having in finding the food to meet the needs produced by the rising living standards of its population (with pressure to transfer land from rice production to other crops or to commercial uses).

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Besides the traditional main exporters (Thailand, Vietnam, India and Pakistan), a relatively important but still limited part of the rice which is traded worldwide now comes from developed countries in Mediterranean Europe and the United States. There are two major forces behind this: new food habits in developed countries and new market niches in developing countries.


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As we have seen, rapid eceonomic growth across Asia is now putting enormous pressure on food prices. Consumer prices in China, the world's fastest-growing major economy, soared 8.7 percent in February, the fastest pace in 11 years. In Thailand, inflation is running at 5.3% (March) but this is still enough to worry the government, while in Vietnam, inflation jumped to 19.4 percent this month, the fastest pace since July 1995. Vietnamese food prices jumped 30.6 percent from a year ago, with the component including rice leaping 30.1 percent from March 2007 and 10.5 percent from February 2008.


The Food and Agriculture Organization said in February that 36 nations including China face food emergencies this year. World rice stockpiles may total 72.1 million metric tons by end of July, the lowest since 1984, the U.S. Department of Agriculture said.

Prices of agricultural commodities are also being driven by investors looking for alternatives as the dollar and stocks drop. Global investments in commodities rose almost 33 percent to $175 billion last year, according to Barclays Capital. The UBS Bloomberg Constant Maturity Commodity Index of 26 raw materials climbed to a record on Feb. 29 and is up 16 percent so far this year.

But not everyone wants to restrain exports. Rubens Silveira commercial director of Rio Grande do Sul state's Rice Institute said the state - Brazil's No.1 rice grower - should export about 10 percent of this years crop at current prices, and argued that these exports will both help support domestic prices and provide incentives to producers to invest in improving output. Mainstream economists tend to agree with him:

``Limiting exports is pure politics and bad economics since export controls destroy the incentive of farmers to plant more rice,'' Nobel laureate Gary Becker, an economist at the University of Chicago, said in an interview. ``But governments tend to favor the urban workers over the farmers, since urban groups are more politically active.''

And it isn't only rice that is under pressure. Wheat prices are also rising fast. Wheat for July delivery was trading at around $8.1750 a bushel on the Chicago Board of Trade last week, down from the February peak, but still up 62 percent in the past year. Global wheat production is expected to rise 6.8 percent in the 2008-09 season as record prices spur farmers to sow more, the International Grains Council said last week. Wheat output is expected to climb to 645 million tons from 604 million tons this season, according to the London-based council. Inventories are forecast to gain 12 percent to 128 million tons, led by an increase in the U.S.

Global wheat production will advance approximately 6 percent in 2008 over 2007 - to an all-time high of 640 million metric tons - as record prices spur farmers to grow more according to Rabobank estimates. That is 37 million metric tons up on output in 2007 . Plantings will also gain 5 percent and global stockpiles will rise 9 percent they suggest. But then we might like to note that even with a 6% growth rate in output (which is no mean rate of increase) prices have still risen by 62 percent. This gives us some measure of the scale of the problem.


The prices of wheat, corn, rice and soybeans have all risen to record levels this year on shrinking global stockpiles and rising demand from the food, feed and biofuel industries. The rally has meant higher costs for everything from Italian pasta to Japanese noodles, and spurred street protests from Haiti to Ivory Coast.

``We have been neglecting our basic rice production infrastructure and research and development for 15 years,'' said Robert Zeigler, director-general of the International Rice Research Institute in the Philippines. ``

India's output is increasing rapidly, but so is demand there, as high rates of economic growth boost incomes. Indian wheat output may climb to 76.8 million tons this year, according to India's agriculture secretary PK Mishra. That's up on the 74.8 million tons estimated in February and up from 75.8 million tons last year. Indian rice output is also expected to rise to a record 95.7 million tons, from the 94.1 million tons estimated on Feb. 7. That's 2.5 percent more than the 93.6 million tons produced a year earlier, but still far from enough to stabilise Indian wholesale prices which are now running at the fastest pace in nearly three years.



I have a much fuller study of the whole issue of global living standards, population growth and agricultural output in my "Food Prices, Farmland, Global Rebalancing and Rural Labour Shortages" post on the Demography Matters blog.

Petrobas Stock on the Way Up

The biggest oil discovery in the Western hemisphere in three decades and speculation about the existence of an even larger deposit has turned Petroleo Brasileiro SA into the world's most expensive energy producer, at least in terms of its share price to profits ratio. Petrobras shares currently trade at 17.2 times profits after rallying 87 percent over the last year. (By way of comparison Petrobras's price-earnings ratio was 8.77 a year ago and under 5 back in June 2004).This makes Petrobas shares effectively twice as expensive as Russia's Lukoil and or the netherland's Royal Dutch Shell, and 50 percent more expensive than Exxon Mobil - which only this week announced that total output was down 10% in the first three months of 2008 when compared with a year earlier - as investors focus on the Rio de Janeiro-based company's oil finds rather than its falling profits. Lukoil trades at 7.77 while Royal Dutch Shell is at 7.6 times earnings. Irvine, Exxon's PE ratio is 11.60. The remainder of the world's 10 largest oil producers are also cheaper than Petrobras at this point.

Exxon’s overall oil and gas production fell 5.6 per cent from the year-earlier quarter. Production in Africa, a key new area of investment, fell 20 per cent as high oil prices and contract stipulations forced it to hand over more of its production to host country governments. Venezuela’s nationalisation of its oil fields also hurt the group’s volumes, as did declines at Canadian gas fields. Unlike Royal Dutch Shell, which is stressing its research in second generation biofuels, and is a leader in making natural gas into transport fuels, Exxon has long argued that traditional alternatives, such as wind power, have proved uneconomic. But it says it is researching future fuels that it is less ready to talk about publicly. The figures are likely to increase pressure from investors for Exxon to raise dividends. It devoted $8bn to buying back its own shares and $1.9bn to dividends while adding another $6.9bn to its now $40.9bn cash pile.

The Brazilian government's controlling stake in Petrobras may add to the stock's attraction on speculation the company will get favorable treatment in exploiting oil. President Luiz Inacio Lula da Silva's administration pulled 41 exploration licenses from an auction after Petrobras found the Tupi oil field Nov. 8, a discovery that caused the stock to jump 14 percent, the biggest rise in nine years. Tupi, 155 miles (250 kilometers) off Brazil's coast, may have 8 billion barrels of recoverable oil.

Petrobras shares rose another 5.6 percent on April 14 after the head of Brazil's oil agency said the offshore Carioca prospect may hold the equivalent of 33 billion barrels of crude, large enough to be the world's third-biggest field. Chief Executive Officer Jose Sergio Gabrielli said later Petrobras is still exploring to determine Caricoa's size.


The strong performance by Petrobas helped lead Brazil's Bovespa to a 6.3 percent jump on April 30, making it the world's best-performing equity index this year among the 20 biggest markets, after Standard & Poor's assigned the country an investment grade credit rating. Brazilian markets were closed yesterday for a holiday.

Petrobras, now the world's ninth-biggest company, with a market value of $248.3 billion, is still half the size of Exxon, the largest oil producer. However Petrobas's valuation surpassed PetroChina's last November - after shares of the Beijing-based oil company posted their biggest monthly retreat ever.


Fourth-quarter profit at Petrobras declined about 3 percent as costs increased faster than sales. The company produced an average 2.34 million barrels of oil, natural gas and natural-gas liquids a day in March, down from 2.35 million barrels a day the month before.

However Brazil's biggest company by market value looks less expensive when viewed relative to the oil it owns. Petrobras trades for the equivalent of 34.91 reais (or $20.58) per barrel of proven reserves. That's cheaper than Exxon's $22.19 a barrel and Royal Dutch Shell's $23.80 per barrel of oil equivalent in reserve. Under this measure, Petrobras is still more expensive than BP and Lukoil, which fetch $14.75 and $4.71 a barrel.

It should not be forgotten however that pumping oil from the most recent Brazilian discoveries, parts of which are 32,000 feet (9,800 meters) below the ocean's surface, will require boring almost twice as far down as the world's deepest offshore well. So there are tachnological issues to take into account here. But still, once these are resolved (assuming they are) Petrobas seems to have its hands on rather a lot of oil at just the time when global demand seems set to rise and rise.

Brazil Debt Raised To Investment Grade By Standar and Poor's

Brazil yesterday received an investment grade credit rating for the first time from Standard & Poor's, sending the benchmark stock market index to a record and yields on dollar bonds to an all-time low.

Brazil, whose economy grew last year at the fastest pace since 2004, should be able to maintain annual growth of as much as 4.5 percent, S&P said in a statement. The country's long-term foreign currency debt rating was raised to BBB-from BB+. Foreign direct investment, which reached a record of $34.6 billion last year, is likely to cover the country's current account deficit this year, the ratings company said.

Brazilian exports have tripled since President Luiz Inacio Lula da Silva took office in January 2003 on rising world demand for soybeans, iron-ore, beef and cars. Brazil, once the world's largest emerging-market debtor, became a net foreign creditor for the first time in January as international reserves swelled to a record $171.6 billion from $37.6 billion at the start of Lula's first term. Credit-rating increases usually result in lower borrowing costs for nations and companies.

The Bovespa climbed 6.3 percent to 67,868.46 in Sao Paulo trading, making the index this year's best performer among the world's 20 biggest stock markets. The real strengthened 2.6 percent to 1.6623 versus the U.S. dollar, the biggest one-day gain in the currency since Aug. 17, when the Federal Reserve unexpectedly cuts its discount rate.

The yield to the 2015 call date on Brazil's 11 percent bonds due in 2040 fell by 21 basis points to 5 percent in New York, according to JPMorgan Chase & Co. The price rose 1.602 cents on the dollar to 136.301 cents, the highest since the country issued the securities in 2000.

Brazil's federal debt was 1.36 trillion reais ($813.8 billion) in March, the Treasury said April 24. Foreign debt was 106.3 billion reais. Brazil is rated Ba1, or one level below investment grade, by Moody's Investors Service. Fitch Ratings ranks the country at BB+.

Brazil's rating is now in line with those of Colombia and Romania and is four steps higher than its level in July 2002. In Latin America, Mexico and Chile, whose economies are smaller than Brazil's, have a higher rating.

Brazil's economy expanded 5.4 percent in 2007 and is expected to grow 4.6 percent in 2008, according to estimates of about 100 economists in a central bank survey.

The acceleration in growth prompted Brazil's central bank on April 16 to raise its benchmark lending rate for the first time in three years as inflation accelerated above their 4.5 percent target. Rising food costs and consumer demand pushed inflation to a two-year high of 4.73 percent in March from an eight-year low of 3 percent in the prior year's period. Economists now expect policy makers to raise their target rate to 13 percent by year- end, with annual inflation estimated to reach 4.79 percent this year, a central bank survey published April 28 showed.

High government spending and public debt remains Brazil's ``foremost credit weaknesses," S&P said. Net government debt reached 47 percent of the country's gross domestic product in 2007, ``higher than in similarly rated credits and above 20 percent for the BBB median,"

Update

The FT had an interesting article on this topic today. Perhaps the central point was this one:

Brazil is still a long way from the top-notch triple A ratings of the developed economies, such as the US, Britain and Germany, but its rise out of junk or speculative grade is important as it allows some of the biggest pension and insurance funds to invest in the country. Many of these big institutions are not allowed to channel funds into countries rated below investment grade because of the dangers that these economies will default, losing their clients vast sums of money.

Also today Moody's announced their view on investment grade for Brazil. Moody's - which rates Brazil's foreign currency debt Ba1, one rank below investment grade - stated that Brazil must reduce debt and spending while lengthening the maturity of its government securities before it can earn an investment-grade credit rating. Standard & Poor's last week raised Brazil to investment grade, citing pragmatic fiscal policies and stronger economic growth.

``There are two elements that are important when you move a rating -- you need all the support behind the improvement of fundamentals, and those elements are there in Brazil,'' according to Mauro Leos, vice president and senior credit officer at Moody's in New York. ``You also need a serious reduction of liabilities.''

An increase in government spending as a percent of gross domestic product over the last five years, largely because of higher pension payments, is the principal challenge, according to Moody's.

``The upward trend in primary spending, which went from 15 percent of GDP in 2003 to 18 percent in 2007, reflects the evolution of pension payments.... Still, Brazil's debt ratios remain high relative to the Baa investment-grade peer group and, in some cases, when compared with the Ba non-investment-grade peer group......Standing at some 56 percent of GDP, Brazil's government debt ratio compares with a 34 percent debt-to-GDP ratio for the Baa investment-grade peer group.''


Moody's will evaluate improvements in Brazil's fiscal accounts through the third quarter this year and then decide if the country can receive a positive outlook.Should a positive outlook be awarded, Brazil would then be placed under review before it could claim an investment rating.

Pension payments, which account for more than 40 percent of primary government spending, have increased in absolute and relative terms because more than half of benefits paid are indexed to the minimum wage, Moody's said. The minimum pension has experienced over 10 percent real annual growth since 2003 when President Luiz Inacio Lula da Silva took office.

A commitment to primary surplus targets and declining interest rates have been helping contain the debt-load, and the ratio of gross debt to GDP declined to 55.6 percent in 2007 from 58.4 percent in 2003.