Brazil Facing a Credit Bubble?

How do you know when a particular market is experiencing a credit bubble? One way is to look at two very different aspects of society, the top and the bottom. Certainly the indications in Brazil are beginning to signal a situation where credit is out of control.

One sure indication is when investment banks, hedge funds, private equity firms enter a market in epidemic proportions. Local hedge funds in Brazil have increased their assets under management by 23 per cent since 2009. Two large US investment firms, Blackstone and JPMorgan Chase, have taken large stakes in local Brazilian firms. The competition is becoming intense and a Brazilian private equity firm complains about the "armies" of global investment firms flooding into the country. This wall of new investment money is pushing up demand and valuations for many local firms. The lure of a country that is the largest exporter of commodities like sugar, coffee and meat seems irresistible when those commodities are reaching record highs.

The other indication has to do with those on the bottom rung of the social hierarchy. The Financial Times reported on one. This particular individual worked as a maid. Although she lived in one of São Paulo’s most dangerous favelas or slums, she was able to afford liposuction. The procedure was only possible, because the surgeon gave her credit. But it does not end there. The poor maid was able to finance not just elective surgery, but everything else including cloths sandals and school supplies for her daughter.

Certainly Brazil seems to be the right place to invest money. While most developed countries were subjected to a decline of 2.7 per cent of their GDP as result of the crash, Brazil in fact grew almost 5 per cent in 2008 – 2009 and 7.5 per cent in 2010. Financial analysts resorting to historical average, point out that Brazilian shares trade at only two times their book value far below the five times book that the Japanese achieved before their market plummeted in 1989 or the seven times book value that dotcom shares reached in 2000.

But this analysis doesn't exactly explain why the Brazilian market, the BOVESPA, has not really increased over the past year and has declined 6 per cent in the past month. In contrast the US market has increased 17 per cent. They are committing the usual sin of assuming that financial yardsticks developed for mature markets can be exported to emerging markets.

Private equity firms, investment bankers and hedge funds only see the illusion of size and liquidity. The Brazil the exchange is now the fourth largest in the world by market value. It offers a playground for complicated for financial strategies and an easy IPO exit for private equity.

But the Brazilian market, like other emerging markets, is quite different. While developed markets offer thousands of companies and diversification, Brazil’s market is limited. Only eight companies account for more than 50 per cent of Brazil's market's capitalisation. Also other mechanisms are not in place. Shorting stock is difficult and expensive. Accurate, timely and complete information may not be available from family or government owned firms like the oil giant Petrobras. Watchdogs may be ineffective in a country that ranks 69th out of 178 countries in Transparency International’s annual ranking of perceived corruption.

But it is not just the equity market. Brazil's new middle class has been on a five-year credit binge that has exceeded even the expansion in other emerging markets. Brazil's credit has expanded 2.4 times GDP compared with 2, 1.6 and 1.2 times for Russia, India and China respectively.

The growth of credit in Brazil is all the more surprising because the interest rates are so high. The average rate for commercial loan is 29 per cent. Consumer rates can be much higher often in excess of 30 per cent. Yet despite interest that is punitively expensive if not usurious, the lending goes on. According to bank Itaú-Unibanco, Brazil’s largest private sector bank, lending could surge as much as 20 per cent this year. Like China, much of this lending is from the state bank BNDES.

Like in the US, the debt service burden for consumers has risen to unsustainable levels. It is now 24 per cent of disposable income. The US consumer debt pyramid collapsed after it reached only 14 per cent of disposable income. Can you say “subprime”?

While the warning signs are there, they are being studiously ignored. Bank Itaú dismissed the idea of a problem. A former central banker, Arminio Fraga, agrees that there might be some issues, but felt that it was not enough to evoke concern. “We may have traces of subprime in the system…I don’t think it has gone that far.” It reminds one of US Federal Reserve Chairman, Ben Bernanke, who in 2007 said “that the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” Not thinking about it does not make it go away.

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