Brazil looks "hot"!

Brazil's economy, Latin America's largest, has been performing well with some strong economic indications and is proving to be an attractive market for investors. But the problem is it looks too attractive. Brazil, one of the strongest emerging markets, has enjoyed some economic successes in recent years. It had a GDP growth of around 5.1% in 2008 and has a strong export sector. When the global financial crisis struck last year, many were wondering what would happen to the emerging markets but most of the emerging markets, particularly China, India and Brazil have emerged strongly from the global recession. Thanks to China, which through its enormous stimulus measures and through its strong trade links with many developing countries, deserves partial credit in helping these developing countries to come out of the economic slump. Brazil's largest trading partner is China. According to my analysis, this strong trade flow between China and Brazil has helped Brazil's export sector. Brazil's GDP (measured at constant prices) grew at 1.91% in the latest reporting quarter of 2009. In this, the household expenditure increased by 2.09%, government expenditure decreased by 0.06%, gross fixed capital formation increased by 0.03%, exports increased by 14.3% and imports increased by 1.54%. Also, unemployment has decreased from 7.7% to 7.5% while the inflation, measured by consumer price index, has increased only by a moderate 0.28%. (Note: All this economic data was collected from IMF's special data dissemination standard to which Brazil is a member). With the economy showing so strong indicators of a robust growth driven not only by exports but also by consumer spending has made many in the world to think Brazil as an attractive investment destination. But this has led to so much speculation and is causing the Brazilian 'Real' to increase in value in the currency markets. So far this year, Brazilian real has gained about 36% relative to the US dollar. With the economic numbers remaining so strong, Brazil had attracted $1.45 billion FDI in Oct 09 (a jump from $945 million reported in the previous month). Even though this would have resulted in an increase in the real's value, its still a good news for Brazil which can use this direct investment to fuel its growth to a more stronger sustainable level. But the thing that worries me is the increase in the value of the total portfolio investments - it has increased from $6.55 billion to $17.6 billion (with the value of foreign investments in Brazilian stocks and bonds increasing from $6.8 billion to $17.1 billion) as of the latest reporting month (Oct 09). When about half of this foreign investment might be real money, i suspect the other half to be speculative money. Brazil has been aware of too much foreign money flowing into it and has taken some measures. It imposed a 2% tax on all capital inflows. But this did not stop the capital inflow. The investors found a loophole and were converting the American Depository Receipts (ADR) into domestic shares and this way it was tax free. The reason why they were doing this - they expect Brazilian real to gain in value and wanted to hold the shares in Brazilian currency rather than in a foreign currency. There's already been so much speculation and appreciation of the real and this is starting to hurt Brazilian exports. In order to curb the currency appreciation, the 2% capital inflow tax was worked out but as I said the investors were using the loophole. So now, Brazil has imposed a 1.5% tax when foreign investors convert ADRs into receipts which can be used to buy domestic shares in Brazil.
But looking at the numbers reported in the last fiscal month (Oct 09) and considering the fact that the interest rates in US and Euro zone are going to remain low for considerable amount of time, I feel that this 1.5% tax will not curb excessive capital inflows into the country on a longer term. This may have a very short term effect but I think hot money will keep coming in for a considerable amount of time. We have to keep looking especially at the portfolio investments that's coming in. If the stock markets rise above normal levels then we have the problem of asset bubbles forming in Brazil. And when US economy stabilizes further in the future, any hike in the interest rates in the US, will cause capital flight from Brazil. This will be very damaging to Brazil since there might be wide swings on the currency at that time. A stock market crash can happen during such moments but we don't want that to happen and this is a little exaggerated situation. So, Brazil should increase portfolio investment tax, if too much hot money keeps coming in and make sure that speculative money is kept out of Brazil. Since very few countries are attracting speculative money, there is generally a large amount of speculative money flowing into any country that's speculated to show strong economic signs. So far, the numbers and indicators are fine but we just have to be very watchful. I hope Brazil's authorities are.