Is Brazil heading towards a subprime crisis?

Earlier this week Brazil’s Finance Minister, Guido Matega, beamed with exuberance as he reported that the economy had become the fifth largest in the world, overtaking both the UK and France. Brazil’s output grew by 7.5 per cent in 2010, driven by the growth of exports, foreign investment, consumer demand and government spending – its fastest rate since 1986. In terms of growth, Brazil’s economy is now the third fastest expanding economy in the world. Gross Domestic Product (GDP) had reached $2,215 billion in 2010.

However, there are concerns about whether the strength of Brazil’s economic growth can continue on its current trajectory. The escalating cost of living is a major concern for the central bank. Inflation touched 6.1 per cent in February, much higher than the Bank’s target of 4.5% and nearing its upper limit of 6.5 per cent. Early in the month the central bank tightened monetary policy further by raising interest rates by 50 basis points. This is the second increase this year and rates have now reached 11.75 per cent – the highest inflation adjusted rates of any large economy. But raising interest rates is a double-edged sword. While it is a move that will help to combat inflation, the undesirable consequence could be further pressure on Brazil’s currency, the real, to appreciate against the dollar. High interest rates and robust economic growth has attracted “hot-money” flows from foreign investors. This has driven an appreciation of the real against the dollar of almost 40 per cent in the last two years.

Credit bubbles

The arrival of hot-money has led to rapid credit growth. The amount of credit available to individuals has doubled as a percentage of GDP since 2005, with many households borrowing money at high interest rates to pay for everything from fridge freezers to cosmetic surgery. Although interest rates are some of the highest in the world, consumers are eager to own products that were previously unattainable. Worryingly, one of the fastest growing areas in the credit market is the provision of mortgages.

The debt service burden on consumers is reported to have reached 24 per cent of disposable income, with many analysts predicting the growth of credit to continue at its current pace throughout 2011. Incidentally, the financial crisis started in the US when levels of debt servicing for consumers were just 14 per cent of disposable income. Banks in Brazil charge an average lending rate of around 25 per cent and when it comes to unsecured consumer lending, rates are north of 30 per cent. This is against rates of about 2-5 per cent in other advanced economies. With interest rates expected to rise further this year, some commentators have speculated that the debt burden may reach 30 per cent of disposable income. There has also been some anecdotal evidence to suggest that people are borrowing the deposit for their real estate loans!

It is hard not to draw comparisons with the credit fuelled consumer boom in the West over the last 10 years and the emergence of the subprime crisis. A lot of credit is on offer by banks at high rates to consumers who ultimately run the risk of not being able to service their debt.

However, in many ways the provision of credit in Brazil has the potential to implode with a greater force than what was seen in the US. The credit agencies and risk management infrastructure lacks credibility and is relatively undeveloped. A central credit bureau, which would share information on individuals’ credit history and incidents of default, is still not yet approved due to consumer protection issues. This has enabled consumers to take out multiple lines to credit without the lenders’ knowledge. This has been made even easier as most loans are unsecured and so there is no collateral involved.

From a macro-economic perspective, a low savings ratio and overvalued currency are putting pressure on economic growth and damaging the competitiveness of exports. Economic progress has been built on the strong foundations of Luiz Inácio Lula da Silva and his predecessor, Fernando Henrique Cardoso, managing to forge strong relationships with major global trading partners and building a reputation for macroeconomic stability. As a result, Brazil has been rewarded with investment and a buoyant bond market. However, policy makers have a delicate task of unwinding the current credit bubble without causing a rise in unemployment which in turn could lead to a liquidity spiral in which credit is extracted from the system.

The Future

Brazil has enjoyed a sustained period of economic growth and its population has benefited from a massive increase in standards of living over the last 20 years. It is now the 5th largest economy in the world and it is entering a new era of economic and political change.

The immediate risk facing Brazil is the outlook for its currency and the implications of further quantitative easing in the West and capital inflows into the country. The real has appreciated sharply over the last 12 months and with so much of the economic development driven by foreign investment, which has increased employment levels and in turn, consumer spending – it has to remain competitive on the global stage if it is to avoid a sharp downturn in trade. In addition, banks are awash with cash from foreign investment and so credit availability has risen markedly to individuals, which is supporting consumer spending. The mortgage market is now gathering pace and this should be ringing alarm bells to Brazil’s policy makers.

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