Coming of age

UBS News for Banks, Spring 2008

New equity offerings have more than doubled every year since 2003

The statistics alone testify to a revolution in Brazil’s credit and capital markets. Since 2003, new equity offerings have at least doubled in volume every year. Brazil alone has originated three-quarters of all equity issuance in Latin America since the start of 2006. The less celebrated though larger debentures market has also grown by leaps and bounds, raising 3% of GDP in new issuances in 2006, about 4? times more than at the previous peak in 2001.

Meanwhile, Brazil’s total bank lending surged to 33% of GDP in September 2007, up from 22% in January 2003. Directed credit – mainly to agriculture and residential mortgages, and through the National Development Bank (BNDES) – still amounts to about 10% of GDP. But most of the credit growth in recent years has come from non-directed lending, especially to households. In the 2003–2007 period, mortgage loans increased by more than 80% in domestic currency, and by almost 40% in inflation-adjusted terms. As a proportion of GDP, however, the mortgage figure is still exceedingly low by international standards – less than 2% – suggesting that there is scope for the trend to continue.

What factors lay behind these developments? Benign financial weather across the world (until recently) has certainly helped. Global appetite for emerging market assets has given valuable help in jumpstarting capital market activity. Yet favourable external conditions are not the whole story; the outstanding performance of Brazil in its peer group suggests that domestic developments have also played a part. This is true even for the credit markets. Growth in external funding by Brazilian banks has accounted for only a small fraction of bank credit growth. Between January 2003 and August 2007, indeed, the foreign liabilities of banks fell from 29% to 13% of their total claims on the private sector.

Macroeconomic improvements have helped to set expectations for the future. Since the severe bout of instability in 2002, inflation and market interest rates have fallen (the latter both in nominal and in real terms), while household incomes and corporate earnings and GDP growth have increased. No less important, the perception has taken hold that macroeconomic stability will be sustained. Risks to government and external financing have been dramatically reduced, first by improved flows (primary budget and external current account surpluses) and then by the shrinkage of public debt as a percentage of GDP, by larger foreign currency reserves and by the reduced exposure of public debt to the risk of exchange rate depreciation.

(See also previous article on Brazil’s economic outlook.)

These developments help to reduce the likelihood of sharp reversals in the exchange rate, and, consequently, of strong volatility in inflation and interest rates. This has set the scene for risk premia to fall and for interest rates to converge eventually to those seen in comparable emerging markets. Higher real incomes, lower interest rates and longer tenors mean that borrowers can bear a larger volume of loans, and thus borrow more.

Meanwhile, Brazil’s legislators and regulators have made a number of changes to rules and practices in the credit and capital markets, collectively amounting to a solid body of reform. These microeconomic tweaks have helped amplify the effect of the favourable economic conditions.

In the credit markets, for example, Brazil had a long tradition of protecting the borrower against seizure of collateral. Such indulgence backfired by making credit scarce and expensive. But legislators have now responded with a series of measures to improve the effectiveness of collateral. Individuals can now take on loans that are serviced by direct deductions from their paychecks. Mechanisms are now in place that help lenders to realize their collateral over automobiles and other goods purchased on credit. A similar system is applicable to residential property. Real estate development projects, including their cash flow and the actual property, can now be segregated from the developer’s balance sheet in order to be shielded from his liabilities.

Meanwhile, the new bankruptcy law of 2005 has raised the priority of secured credit for recovery purposes above that of tax claims, and second only to a capped amount of labor claims. Other provisions of the new law improve the prospects for credit recovery. The effectiveness of these measures needs to be tested by market practice and, to a certain extent, in the judicial system. But, given time, all will help to instill greater confidence in lenders.

The story is similar with regard to microeconomic improvements in the capital markets, except that in this case, self-regulation initiatives by the private sector played a leading role alongside the efforts of the securities regulator. At the beginning of the decade, the São Paulo Stock Exchange (Bovespa) introduced a range of differentiated corporate governance segments, in which companies would qualify to be listed according to certain standards of transparency and shareholder rights protection. Progress was gradual at first; in December 2003, less than 10% of the companies listed had adhered to any of the higher governance standard segments, and less than 1% belonged to the topmost segment (“Novo Mercado”). But now more than one-third of companies apply the higher governance standards, and 20% are listed on the Novo Mercado.

Salutary effects Higher governance standards whet the appetite of investors for equities, and at the same time the improved prospects for raising funds in the capital markets add to the incentives for adopting the higher standards. The same is true in the credit markets, as better governance enhances access to credit, while the greater availability of credit provides an added incentive for better governance.

These developments also have a salutary effect on aspects of the economy beyond the capital markets. Improved legislation brings businesses out of the informal into the formal sector. Such ventures are more likely to promote productivity gains. This is particularly true for labor productivity, given that there is more incentive to train staff when labour turnover is lower, as it is in properly established ventures. Investment and the productivity gains implied by state-of-the-art equipment are easier to access when the required capital is available. Faster capital accumulation and productivity gains should boost growth rates in the longer run.

The formalization of the economy driven by improvements in the credit and capital markets may also encourage compliance with the tax codes. As the tax base is broadened, reduced tax rates will suffice to generate the same amount of revenue. Formalization should therefore allow legislators to opt for lower tax in the future, mitigating the powerful drag of existing tax distortions on potential growth. Regulators and market participants will find some additional opportunities to refine the regulatory framework. But the key factor for the continued evolution of the financial markets will be Brazil’s ability to preserve stability and steady growth, even in the face of less benign global conditions.

Eduardo Loyo UBS Pactual,
Chief Economist Latin America