Problems with Brazil’s Financial System

Observations of Risk:

While systemic risk has been in a decline since the peak of the 2008 Financial Crisis, like all financial systems, the Brazilian Financial System is at risk from both internal and external factors. These factors coupled with developmental issues have created a higher risk environment for Brazil’s financial system in the most recent years. Standard & Poor’s recently awarded Brazil a credit risk of four, on their one to ten scale. A Standard & Poor’s Banking Industry Country Risk Assessment (BICRA) of four is comparative to countries such as Mexico, Italy, Taiwan, Peru, and South Africa.

The four is an average between the awarded economic risk of five and industry risk of three. Standard & Poor indicated that their belief is that Brazil is ‘high risk’ in economic resilience, ‘low risk’ when it come to economic imbalances, and ‘high risk’ in regards to credit risk in the economy. According to a recently published Wall Street Journal article, Standard & Poor’s is in consensus with the International Monetary Fund in believing that enduring external shocks will challenge fiscal performance.

While it is a positive sign that professional opinion indicates that Brazil is a low risk in regards to economic imbalances, it is of great concern that Brazil is high risk in terms of their economic reliance and in regards to their credit risk within the economy. While Brazil is an emerging market with a diversified and intricate economic structure and high domestic demand that is attracting global investors and satisfying many capitalistic ventures domestically, Brazil is still a “low-income” nation.

They have political and monetary leaders in place that have been determined to further the growth of this emerging market for nearly twenty years, by lowering inflation, improving foreign investment, and maintaining growth; yet, they consistently underperform the gross domestic products (GDPs) of other similar emerging markets. This is in part because of a reluctance to invest domestically. This sentiment of a “need to invest” causes an inherent spending risk of its own, as this pressured spending may challenge fiscal performance. What has kept them safe from external events during their expansionary phase has been their balance as a net creditor externally and direct foreign investment. Credit risk within the economy is a major risk in Brazil.

While private sector leverage has doubled over the last ten years, it is still too low at only about forty-seven percent (47%) of the nation’s GDP. New legal framework has made loans more readily available for the average household and has brought balance to the sheets in the private sector; however, the short maturities have created a burden on the average household. The average Brazilian family debt has reached a high forty-two point seven percent (42.7%) of disposable income.

While banks portfolios maintain a healthy balance of corporate and retail loans, the short terms are a persistent problem. Lending and underwriting standards are observed to be quite conservative in Brazil. Unlike the market standards that caused the housing bubble of 2008 in the United States and the ensuing financial crises, all mortgage lending is prime in Brazil with lender and obligor assets backing the loan. With that said, due to cultural differences, mortgages account for only thirteen percent (13%) of all loans in Brazil. Mortgage availability and property investment has been restricted due to the government elimination of a minimum return on savings deposits of six percent (6%).

This allowed the banks to move away from interest rate linked mortgage rates and mortgage rates therefore fell. If regular investment utilizing mortgages is to return, there must be a change in the long-term funding. The maximum loan-to-value percentage is seventy percent (70%) and the average loan does not exceed sixty percent (60%). Where Brazil does lack in credit standards is in regards to their payment culture and the widespread disregard for law. Brazil lacks a positive credit bureau and banks must independently record the behavior of their own clients. While Brazil is further developing their bankruptcy and repossession laws, the collection process has become a costly hassle in too many cases and the recovery value of many overdue assets is inevitably diminished.

Incredibly, the world’s seventh wealthiest nation achieved an average indicator of a measly negative zero point thirteen (-0.13) in regards to rule of law and control of corruption. Brazil’s credit loss rating reached a peak in 2009 with three point nine percent (3.9%) of all loans becoming a complete loss and is expected to remain between three and four percent (3-4%) through 2013 barring a dramatic event. This prediction is based on the high unemployment monthly interest rates at almost one percent (1%) combating the steady GDP growth of one and a half to two percent (1.5-2.0%) throughout the year. Institutionally Brazil is sound but transparency causes fear for the commoner.

The central bank, Banco Central do Brasil (BCB), has done anm exceptional job of mitigating financial crises of recent years. Due to a long history of high interest rates, the BCB has put into place highly sophisticated monitoring systems of banks and financial institutions and has taken a high amount of control as the financial regulator. The BCB has proven to be proactive and adaptive during changing times in Brazils markets; however, trust is still lacking. Banking standards are comparative to international standards yet while reporting to the regulatory body is mandatory, transparency is an issue with the public.

While system-wide funding is rising and sources of funding are expanding, government regulation and involvement is minimal. Stricter regulation on market making could improve secondary market liquidity and therefore better opportunity for funding. BNDNEs must move away from direct financing of larger corporations and help develop long-term corporate debt if this market is ever going to achieve better regulation, transparency, and fair price. Major External Risk Factors:

Beyond these basic observations, there are some significant risks that Brazil is highly vulnerable. Given the Brazilian reliance on their status as a major commodity exporter, they are at risk to fluctuations in commodity prices. Fluctuations in oil prices have severely influenced Brazilian commodity prices in recent years. Furthermore, financial instabilities in the major economies importing Brazilian goods have also created negative impacts. Unfavorable developments in China and other economies could also pose a significant risk to the demand for Brazilian exports. Brazil in the most recent years has been a center for foreign investment.

These new investments in Brazil are at risk from capital flow volatility as well as any sudden change in sentiment. A drastic event abroad could damage exchange rates and a drastic event domestically could change foreign investors sentiments. This is not an overwhelming risk as Brazil’s central bank keeps a large stock of international reserves, domestic banks are mostly funded locally, and domestic banks have a low net foreign exchange position. Major Domestic Risk Factors:

Brazil’s credit to GDP ratio has grown exponentially over the last twenty years and has doubled in the last decade. This has proven to be a dramtic experience for multiple major economies and helped lead to the world financial crises of 2008 that began with the housing bubble in the United States. As already discussed earlier, the banks have proven to keep amble capital and are highly regulated and the credit to GDP ratio has remained relatively low while the gap is narrowing and the credit expansion is slowing; therefore, Brazil is not highly concerned with this risk.

The positives that mitigate this risk however have led to vulnerabilities of financial risk in the household and real estate price pressures. While Brazilians take on credit in similar manners to other world economies, their high interest rates and short maturities have led to some distress in recent years. Their debt service to income ratio is very high at twenty three percent (23%) and with expected continuing levels of high unemployment and increase in real income growth, some households will be in great distress.

Credit and delinquency trends are worsening as some households are already feeling the pressures. Drastic appreciation in real estate prices, as high as thirty percent in major population centers such as Rio de Janeiro and Sao Paolo, are expected to level off and bubble in the near future. This will hopefully be alleviated by the low share that mortgages have in the portfolios of the average bank, being only about thirteen percent (13%). Conclusion:

While Brazil is an emerging market, it is still a low-income nation. The markets of Brazil are changing drastically and Brazil has seen an increase in foreign investment. These factors have lead to intensified risks both domestically and externally. Aside from foreign interest, Brazil has placed itself under a magnifying glass and the central bank has proactively created regulatory processes that have mitigated the effects of international crises of recent years and that have thwarted crises domestically.

While the Banco Central do Brasil has proven to be a significant source of power and stability, the government has still yet to fully develop the legal confines and regulations of the financial system. Barring a major fluctuation that would effect Brazil’s export economy, Brazil is still following course to decrease inflation and increase funding but must create more transparency, long term funding assets, and improve credit delinquency processes if they do not want the average household to fall into distress.

“Banking Industry Country Risk Assessment: Brazil.” . Standard & Poor’s, 24 2012. Web. 2 Dec 2012. .

“Brazil: Financial System Stability Assessment.” (2012): n.pag. International Monetary Fund. Web. 2 Dec 2012. < http://www.imf.org/external/pubs/ft/scr/2012/cr12206.pdf>.

Goldfajn, Ilan, Katherine Hennings, and Helio Mori. Brazil. Banco Central do Brasil. Financial System in Brazil: Resilience to Shocks, No Dollarization, but Struggling to Promote Growth. 2003. Web. .

Manuel Pereira Afonso Ribeiro, Fernando. “The Brazilian Financial System: A World in Transition.” (2000): Minerva Program n.pag. George Washington University Library. Web. 2 Dec 2012. .