Economic conditions in Brazil are likely to improve this year but structural bottlenecks will take years to resolve themselves, a testament to the massive necessity to improve logistics, transportation and education – all necessary to improve Brazil’s competitiveness

1. EXECUTIVE SUMMARY
Economic conditions in Brazil are likely to
improve this year but structural bottlenecks will
take years to resolve themselves, a testament
to the massive necessity to improve logistics,
transportation and education – all necessary to
improve Brazil’s competitiveness.
• Financial markets are reflecting a shift in
sentiment toward Brazil, due to weaker
economic momentum, worsening terms of
trade and rising inflation
• Structural bottlenecks prevent Brazil from
growing at the same pace as many of its Latin
American neighbors
• However, purchasing power of the average
citizen has increased substantially in recent
years, thanks to a strong labor market
• Key to generating stronger growth is
fostering a more transparent environment for
investment and capital expenditures
TOTAL GDP:
2012: $2.4 trillion
(global ranking: 7)
GDP PER CAPITA:
2012: $11,522
(global ranking: 57)
GDP GROWTH RATE:
2012: 0.9% / 2013E: 3.0%
UNEMPLOYMENT: 2012: 5.5% / 2013E: 5.4%
INFLATION: 2012: 5.8% / 2013E: 5.8%
BRL/USD: 2012: 2.05 / 2013E: 2.02
TRADE BALANCE/GDP:
2012: 0.8% / 2013E: 0.4%
2012 GINI COEFFICIENT: 54.7
2012 INFRASTRUCTURE BANKING: 70 (144)
2012 INVESTMENT/GDP RATIO: 18.5%
2012 PUBLIC SECTOR DEBT/GDP: 55.2%
2012 FISCAL DEFICIT/GDP: -2.5%
ECONOMIC
SNAPSHOT
Brazil: Aiming for a Return to Growth – May 2013
TRENDS + VIEWS
JAMESTOWN LATIN AMERICA
Real Estate Private Equity
www.jamestown-latam.com
Contact:
Bret Rosen – Managing Director, Research
+1 212-652-2141
brosen@jamestown-latam.com
Rio de Janeiro • Bogotá • Atlanta • New York
Sources: Bloomberg, IBGE, BCB Focus Survey, IMF, Deutsche Bank, World
Bank, JPMorgan, World Competitiveness Report

2. At the start of the decade, economic momentum in
Brazil was robust and investor sentiment buoyant.
With preparations beginning for the 2014 World Cup
and 2016 OIympics, the BOVESPA stock index hitting
an all-time high, and record amounts of foreign direct
investment pouring into the country, it appeared that
Brazil’s ‘moment’ had arrived. Indeed, Brazil’s capacity
to recover from the global financial crisis impressed
many observers and investors, as the economy grew 7.5
percent in 2010, after dipping just 0.5 percent in 2009 (as
compared to a 6 percent contraction in 2009 in Mexico).
Economic growth combined with social programs such
as Bolsa Familia to lift millions out of poverty leading
to a growth of the middle class that is unprecedented
in the country’s
history.1
Booming
commodities prices
also contributed
to massive wealth
generation as China
became Brazil’s
largest export
destination.2
Lower
interest rates made credit available to wide swathes of
the population, inspiring a consumer boom; retail sales
exploded, especially of items deemed durable goods,
often bought in installments. The Brazilian currency
experienced a relentless appreciation, as along with
foreign direct investment, massive portfolio inflows
entered the country’s equity and fixed income markets.
However,thecurrentsentimentinBrazilhaschanged.The
last 2 ½ years have been characterized by disappointing
growth, leading economists to speculate that there are
structural issues in the Brazilian economy that prevent
it from growing at similar levels to its Latin American
counterparts such as Peru, Chile and Colombia over a
full economic cycle. Growth in 2010 was fueled by a
fiscal expansion in the run-up to the Presidential election
of that year, which fueled higher inflation, a tightening
of monetary policy and a hangover that resulted in 2.7
percentgrowthin2011.Lastyear’seconomicperformance
was also a disappointment, as business confidence was
dragged by the unpredictability of economic policy
making and the debt crisis in Europe. Growth was a
meager one percent last year. 2013 should bring growth
closer to three percent, still below the rate registered
in most other large emerging markets countries, and
slightly below what is considered potential growth in
Brazil. While the consumer remains vibrant in Brazil, the
middle class is still expanding, and real wage growth
is positive, the giddy attitudes of a few years ago have
become more guarded. A third straight year of economic
underperformance has dampened animal spirits, and
subsequently investors and businesses have been
more cautious about the near-term economic outlook.
In dollar terms, the BOVESPA index is down 21 percent
year-to-date, through June 14, even as the SP 500 is up
over 14 percent.3
Brazil: Aiming for a Return to Growth – May 2013
TRENDS + VIEWS
Economic
momentum in
Brazil has softened,
dampening the
enthusiasm of a few
years ago
1 Bolsa Familia is a social welfare program of the Brazilian government, part of the Fome Zero network of federal assistance programs. Bolsa Família provides financial aid to poor Brazilian families; if they have
children, families must ensure that the infants attend school and are vaccinated.The program attempts to both reduce short-term poverty by direct cash transfers and fight long-term poverty by increasing
human capital among the poor through conditional cash transfers.
2 http://www.tradingeconomics.com/brazil/balance-of-trade
3 Bloomberg.
2006 2007 2008 2009 2010 2011 2012 2013E 2014E
-1
0
1
2
3
4
5
6
7
8
CHART 1: BRAZIL ANNUAL GDPYEAR-ON-YEAR (%)
Source: Bloomberg and Banco Central do Brasil Focus Survey, May 24, 2013
PAGE 2TRENDS + VIEWS MAY 2013

3. In the discussion that follows, we pose a few key
questions about the country’s economic situation, with
responses that intend to address these key issues.
What are the main reasons for Brazil’s recent relatively
disappointing economic performance?
First off, the industrial sector, which accounts for
approximately 1/4 percent of total GDP, has essentially
been in recession for the last several years.4
An
important explanation for this performance has been
that competitiveness in industry has been harmed
by the strength of the Brazilian real (BRL), which has
encouraged relatively cheaper imports while also
detracting from Brazilian firms’ ability to compete versus
their Asian counterparts. Firms that were previously
competitive in the middle of the last decade, when the
BRL was at a depreciated level, found margins squeezed
as the BRL broke the 2:1 level and headed to 1.60. But
even as the currency has weakened 25 percent from its
stronger levels reached in the first half of 2012, to 2.15:1
currently, manufacturing has struggled. This provides
evidence that the currency strength is not the only factor
holding back manufacturing, even though the industrial
lobby in the country and politicians tend to focus the
debate chiefly on the currency.
We point to more structural issues as explanations for
this ongoing underperformance, related to 1- High cost
of labor amidst a tight jobs market; 2- Inflexible labor
markets which make hiring and firing prohibitive; 3-
Infrastructure bottlenecks, as Brazil’s transportation and
logistics links are ranked among the world’s poorest;
4- Taxation issues; 5-
Overall high costs of
doing business.
The labor market
remains an ongoing
challenge for
business, as the
unemployment rate has hovered just above 5 percent, a
record low, pushing real wages upwards.At one juncture
in 2011, real wages were rising at nearly 8 percent on
a year-on-year basis, while the minimum wage in 2012
rose by 14 percent in nominal terms.
The World Competitiveness Report points out other
challenges that harm competitiveness of manufacturing:
Brazil’s port infrastructure ranks 135th of 144 countries
surveyed, hiring and firing practices were deemed 114th,
while the burden of government regulation was dead
last, in 144th place.5
Brazil’s tax take as a percentage
of GDP, typically around 35-36 percent, is among the
highest in emerging markets, and the tax code can be
described as byzantine. The aforementioned factors all
contribute to the ‘custo Brasil,’ which translates into the
‘Brazil cost,’ and describes the complexity and costs of
doing business in the country.
Still,Brazilianindustrycansucceedinparticularareasasis
the case with Embraer, the globally competitive airplane
manufacturer. Embraer is one of the world’s four largest
airplane manufacturers, and has successfully identified
a niche market – smaller sized jets – and combined it with
world class engineering. Brazil’s competitive advantage
PAGE 3
Brazil fares poorly
in many global
indicators of
competitiveness
CHART 2: BRAZIL INDUSTRIAL PRODUCTION
-20
-15
-10
-5
0
5
10
15
20
25
Jan-09
M
ay-09
Sep-09
M
ay-10
Sep-10
M
ay-11
Sep-11
M
ay-12
Sep-12
Jan-13
Jan-10
Jan-11
Jan-12
Source: IBGE and Bloomberg
Year-on-Year (%)
4 JPMorgan, Brazil 101, 2012 Country Handbook.
5 Global Competitiveness Report, 2012-2013, World Economic Forum. http://reports.weforum.org/global-competitiveness-report-2012-2013/#=
Brazil: Aiming for a Return to Growth – May 2013
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4. may have been eroded in some areas, but the country
still has world class firms in a number of fields, such as
petrochemicals (Petrobras and Braskem), steel (Gerdau,
CSN, Usiminas), and autos (mostly foreign companies
operating in the market, such as Ford and GM). The
industrial base is amongst the most sophisticated in
emerging markets, with top management teams, who
are experienced navigating challenging markets. Still
the overall outlook for industry will revolve around the
country’s ability to resolve important bottlenecks, ease
regulation and taxation and thrive amidst the backdrop
of a currency that still looks fully valued.
Are investors correct to be less bullish on the country’s
prospects?
Indeed, it has become in fashion for Latin American
portfolio investors to shift their focus to Mexico and
the smaller Andean markets, while Brazil’s growth
languishes. While Peru, Chile and Colombia grow
four to six percent, and Mexico is enjoying a wave of
reform momentum, Brazilian growth has disappointed
and there has been
no progress on
efficiency enhancing
reforms. Despite
such sentiments, we
would argue that
many investment
considerations and
business conditions
in Brazil currently are not markedly different from three
to four years ago when enthusiasm was everywhere,
equities were soaring and credit default swap (CDS)
spreads were trading inside of other Latin American
peers. Levels of foreign direct investment will still be
around $60 billion this year, the domestic market is Latin
America’s largest - by far, the growth of the middle class
is a trend that we believe is irreversible, and a great
number of multinationals are targeting Brazil for the
longer-term potential that the country offers.
The main shift in sentiment has been due to the increased
level of government interference in the economy.
Namely, the government has taken on a more statist
role especially in its stance vis-à-vis energy (Petrobras,
noting local content laws), mining (Vale, where the
government helped engineer a management shakeup),
banking (pressuring private banks to lower interest
margins) and utilities (regarding the tariff regimes).6
Businesses not only complain about the degree of
government intervention, but the unpredictability
of it. Consequently, the levels of capital formation
necessary for the economy to achieve higher rates, has
disappointed, and indeed the investment to GDP ratio in
Brazil is under 20 percent, whereas Colombia, Peru and
Chile display figures in the mid to upper twenties. For
Brazil to grow in a sustainable fashion at a rate of five
to six percent, a greater level of gross capital formation
is required, along with improvements to the various
themes described above.
What should we expect from 2013?
Market economists anticipate growth of three percent in
2013, with improved performance a function of a better
global backdrop, a statistical rebound from last year,
and the lagged impact of both expansionary fiscal and
monetary policy. Typically it takes six to nine months
for monetary policy decisions to affect economic
outcomes, implying that the economy should benefit
from the record low rate on the SELIC (Brazil policy rate)
in the months to come. Consumption growth may be
6 http://www.ft.com/intl/cms/s/0/bfa4af22-b0d5-11e2-9f24-00144feabdc0.html#axzz2Tpob5KQ7
http://www.ft.com/intl/cms/s/0/2bf35426-5593-11e0-a00c-00144feab49a.html
http://www.economist.com/news/finance-and-economics/21564884-interest-rates-fall-spreads-and-profits-are-coming-under-pressure
http://www.bloomberg.com/news/2012-09-11/brazil-cuts-energy-costs-to-boost-growth-through-competitiveness.html
Brazil still is
benefiting from
massive flows
of FDI and the
impressive growth
of the middle class
PAGE 4
Brazil: Aiming for a Return to Growth – May 2013
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5. somewhat weaker than 2012, but will still be the main
driver of economic activity. Meanwhile credit growth will
remain strong by international levels, likely around 15
percent, but this will be slower than the previous couple
years as banks are cautiously optimistic. Manufacturing
activity remains unimpressive, although there are some
signs of improvement especially in auto production.
The unemployment rate should remain in the mid-five
percent range, although the pace of job creation is likely
to stay low.
The major issue, economically speaking, in Brazil at the
moment relates to inflation. The most recent inflation
projections for April, showed the year-on-year figure at
6.49 percent, just one basis point below the upper end
of the central bank’s target band of 2.5-6.5 percent.This
high inflation comes amidst a backdrop of weak growth
along with a variety of government measures to control
price pressures, namely related to food and electricity
prices. Services inflation is still elevated, at over eight
percent, and has been in the high single digits for
quite some time - a function of the tight labor market,
which has kept real wages elevated. It is expected that
inflation may once again surpass the 6.5 percent limit
in the months ahead, but should recede in the second
half of 2013 due to relief on the food prices front. The
lagged impact of the weaker BRL should also dissipate
which statistically will help bring IPCA below 6 percent.7
Still, inflation represents a major political challenge
for the Rousseff government, as given the country’s
history, there is limited tolerance amongst the populace
for persistent spikes in prices. Indeed local media is
putting greater focus on price moves across the board.
Due to the inflation pressures, the Central Bank (BCB)
has engaged in a process of monetary tightening,
most recently lifting the SELIC rate by 25 basis points
(from a record low 7.25 percent) to 7.5 percent at its
April meeting, followed by another 50 basis points hike
in May. This came on the heels of 525 basis points of
monetary easing, which commenced in August 2011.
The Central Bank’s policy stance has been particularly
controversial. The COPOM (monetary policy board of
the Central Bank) began its easing campaign with IPCA
inflation, the main price index, above seven percent,
as the COPOM expressed concern about the potential
effects of the global financial crisis on Brazilian growth.
While GDP did indeed falter, inflation never receded to
the 4.5 percent target. Meanwhile the COPOM continued
to ease, reducing SELIC to a record low and bringing the
real rate to just one percent.
Some observers believe that the BCB – although not
technically an independent central bank – has been
susceptible to political pressure from the government,
which clearly prefers a lower interest rate environment.
But as IPCA inflation once again surged above the 6.5
percent limit in March, the BCB was left with no choice
but to lift SELIC at its April meeting. Markets look for
another 100 basis points of tightening in this cycle as
the BCB looks to dampen inflation expectations which
remain elevated and hopefully bring IPCA back toward
around 5.5 percent by year end. Regardless, markets
question the effectiveness of the official 4.5 percent
7 IPCA is the most frequently cited inflation index by the central bank, and generally corresponds to the CPI in the United States.
CHART 3: BRAZIL INFLATIONYEAR-ON-YEAR (%)
0
2
4
6
8
10
12
14
16
Jan-12
Feb-12
M
ar-12
A
pr-12
M
ay-12
Jun-12
Jul-12
A
ug-12
Sep-12
O
ct-12
N
ov-12
D
ec-12
Jan-13
Feb-13
M
ar-13
A
pr-13
Source: Banco Central do Brasil
CPI
CPI Net of Food
PAGE 5
Brazil: Aiming for a Return to Growth – May 2013
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6. 8 Based on Deutsche Bank estimates in “Special Report, Brazil Economic Update,” May 9, 2013.
9 http://www.brasil.gov.br/para/invest/taxes/tax-on-financial-operations-aka-iof/br_model1?set_language=en
10 http://www.pac.gov.br/
inflation target as the BCB continued to ease with IPCA
well above 4.5 percent, and has only engaged in a
relatively timid tightening with IPCA above the tolerance
range.
The effectiveness of monetary policy in Brazil remains
distorted due to the large role of the BNDES (the
national development bank) and public banks, all of
which are mandated by the government to expand
their loan portfolios, typically at highly subsidized
rates. On the fiscal side, the Rousseff government has
engaged in a variety of measures to try to stimulate
activity. Recent fiscal figures have disappointed with the
government well off of its 3.1 percent to GDP primary
surplus target. Meanwhile, export performance has
weakened; during the last decade the trade sector was
a major motor for economic growth but weaker terms
of trade and competitiveness issues are weighing. The
twelve month trade balance is projected at under USD
10 billion for 2013, which compares with 40 billion plus
in 2007.8
Even as recently as 2011 the trade surplus was
30 billion. Clearly the economic difficulties faced by
Brazil’s neighbor, Argentina, and Europe are weighing,
although we note that the Brazilian economy is less
dependent on trade than its Andean neighbors.
Regarding the currency, the BRL had been generally
range bound in recent months, moving not too far or
below the 2:1 level versus the USD, although it has
experienced some more substantial weakening of
late due to volatility in global fixed income markets.
The government has succeeded for the most part in
engineering a weaker level for the BRL, primarily by
discouraging the entry of portfolio capital into the local
fixed income market, via the imposition of a rather
draconian entry tax regime (the so-called IOF tax on
financial operations, which was reversed this month).9
The BCB has been active at times in the market, especially
when it perceives volatility as too high. It does fear a
BRL much above 2.1 in our view, as this would make its
inflation fight even more challenging. Weighing on the
currency, however, is the aforementioned weaker trade
balance, partnered with a widening current account
deficit. Indeed the flow of foreign exchange has turned
negative in Brazil for the first time in years.
How can Brazil outperform?
While sentiment toward Brazil has shifted somewhat,
we tend to view the pessimism as overdone (and
would argue that the optimism of a couple years was
also overdone). There are plenty of reasons to look at
Brazil in a positive manner. Namely, the government
has set forth plans for very ambitious infrastructure
investments, which will be intended to include private
capital.10
The privatizations of several airports last year
could represent a productive first step in this regard.
Meanwhile a series of PPPs (public-private partnerships)
focused on roads, airports and highways will be
crucial to help absolve portions of the country from
major substantial bottlenecks. The government plans
to increase by 50 percent the kilometers of toll roads
CHART 4: BRAZIL SELIC RATE (%)
6
7
8
9
10
11
12
13
14
M
ar-09
Jul-09
N
ov-09
M
ar-10
Jul-10
N
ov-10
M
ar-11
Jul-11
N
ov-11
M
ar-12
M
ar-13
Jul-12
N
ov-12
Source: Banco Central do Brasil
Benchmark Interest Rate
PAGE 6
Brazil: Aiming for a Return to Growth – May 2013
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7. under private concession, by 33 percent the capacity of
privatized railroads, and it will likely privatize two more
airports on top of the three privatized last year.
The pressure on important segments of the private
sector could subside, namely related to banks. Some
within the government are conscious that increasing
heavy-handedness has dampened investors’ appetite
and with presidential elections forthcoming in less
than eighteen months, it is crucial for the Rousseff
government to deliver stronger growth. Certain officials
realize that a less interventionist state can help in this
regard.
Meanwhile, another key facet to observe will be the
battle versus inflation. If the BCB can engineer a gradual
monetary tightening that lowers inflation expectations,
markets will be relieved. With the BOVESPA trading at
a low multiple, some interest has returned to the stock
market and indeed recently several large IPOs occurred,
including the insurance arm of Banco do Brasil in a
several billion dollar
deal.11
Finally, the
policy debate in
Brazil may heat up as
elections approach.
It is entirely possible
that the economic
disappointments of the last several years become a
focus of discussion, with opposition parties perhaps
gaining traction by advocating a friendlier policy mix.
In conclusion, we do believe that economic conditions
in Brazil are likely to improve this year but structural
bottlenecks will take years to resolve themselves, a
testament to the massive necessity to improve logistics,
transportation and education – all necessary to improve
competitiveness. Meanwhile economists such as those
at Morgan Stanley continue to highlight the so-called
‘supply-demand’ mismatch.12
Indeed over the last
three years retail sales rose 24 percent while industrial
production fell 0.6 percent. A substantial portion of
the populace has felt pretty good, with wages up, the
economy enjoying full employment, the middle class
expanding, government subsidies plentiful and credit
generally more available than it was a decade ago.
Hence, and assisted by the BRL, purchasing power and
consumption are strong. But supply is not, due to the
issues we highlighted that have affected investment
expenditures. With the country’s tax structure (tax
burden of 35 percent of GDP is particularly high), and
concerns about the level of skilled workers in the labor
force, this mismatch may takes years to resolve itself,
implying that any periods of strong growth lead to
inflation. Finally for investments to blossom, terms of
trade will need to improve, which may hinge on the
resurgence in global commodities demand, as there
historically has been a strong correlation between
commodities prices and the investment cycle in Brazil.
11 http://www.ft.com/intl/cms/s/0/f1a30ef8-ae8f-11e2-8316-00144feabdc0.html
12 Morgan Stanley, Brazil Economics and Strategy: Growth Mismatch Survival, Winners and Losers, April 1, 2013.
Central bank is
attempting to
tackle the inflation
problem
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