Brazil technology: Risk overview

Brazil technology: Risk overview
Wednesday, May 04, 2011

FROM RISK BRIEFING

OVERALL ASSESSMENT

Operational risk in Brazil is improving but remains C-rated. Democracy is established but the political system is often ineffective. Party indiscipline obstructs effective policymaking and corruption affects all levels of government. The risk of an armed conflict is low but organised crime impairs the security environment in big cities. Rates of violent crime are high, but foreigners rarely fall victim. The legal system is generally fair but slow. Fiscal and monetary policies are usually cautious. In 2010 the economy rebounded from recession and will grow by 4% in 2011, but a widening current-account deficit reflects low national savings. Taxation is onerous and the system is complex. The formal labour market is relatively restrictive, but industrial unrest poses little threat to business. The financial markets are deepening but lending rates are very high and long-term financing still scarce. Infrastructure provision has failed to keep pace with growth but increased investment is now underway and will help.

Security risk

Personal security is a concern for business because of a high level of violent crime, with a particularly serious problem in Rio de Janeiro, Sao Paulo and other large cities. Inadequacies in the security forces, the easy availability of guns, widespread poverty and drug abuse contribute to the dangers. That said, increased policing in Rio is beginning to cut crime. It is rare for foreigners to fall victim to kidnapping, mugging, hijacking and armed robbery, but occasional clashes between security forces and armed gangs have the potential to disrupt the population. Nevertheless, the risk of armed conflict and insurgency is low, as there are no guerrilla groups. Political protests tend to be peaceful, apart from isolated clashes in rural areas, mainly between the landless workers’ movement (the MST) and local security services loyal to landowners. MST land invasions have tended to increase in frequency in recent years but generally have little overall impact on property rights or business.

Political stability risk

Brazil is a stable democracy. Since two decades of military rule ended in 1985, transitions between elected governments have generally been smooth. The former president, Luiz Inacio Lula da Silva, ruled out changing the constitution to stand for a third term in the October 2010 ballot, bolstering democracy. Influential segments within his leftist Partido dos Trabalhadores (PT) advocate greater state intervention, but cross-party support for orthodox fiscal and monetary policies is firm. Although politicians are discredited, institutions are strong, but reforms are needed to boost effectiveness and transparency. Corruption scandals have periodically put political reform back on the agenda, but momentum is weak and far-reaching changes are not expected. Executive power is checked by a strong legislature. Brazil has a professional diplomatic corps, and enjoys good relations with its neighbours and global trading partners. The incoming Dilma Rousseff government is adopting a more pro-Western foreign policy.

Government effectiveness risk

The Dilma Rousseff government is comprised of a range of generally undisciplined political parties, similar to that under Luiz Inacio Lula da Silva, although she does enjoy a larger majority on paper. But this still means that reforms will often need to be diluted or exchanged for concessions elsewhere. The level of competence among senior officials is high, but lower down, the civil service is often inefficient. The government is attempting to upgrade skills in the civil service by hiring better qualified staff, but fiscal constraints will restrain progress. Political appointments by the Partido dos Trabalhadores (PT) have made inefficiencies worse in some areas. Red tape increases the cost of doing business. Clientelism and a lack of accountability foster corruption at all levels, creating inefficiency, lack of trust and an uneven playing field for business. The police lack the resources to tackle crime and human rights abuses still occur. Measures taken so far to tackle these problems have been weak.

Legal & regulatory risk

Legal and regulatory risk arises largely from the slow and complicated judicial process. Although the system is considered to be generally fair, delays reflect the ease with which legal injunctions can be obtained. The risk that a contract will not be enforced is low, but it may be subject to interpretation by state legislatures. The national business lobby has won tax and regulatory concessions to favour their interests over those of foreign companies, but discrimination against foreign companies has been reduced over the past decade. There is little risk of expropriation of assets, and protection of private property is fair. Some improvements introduced in a 2004 judicial reform that included the introduction of a case law system to make Supreme Court decisions binding will speed up final resolution of contested cases. However, the regulatory framework in sectors such as energy, telecommunications and pharmaceuticals is still unclear and there are concerns about political interference in regulatory bodies.

Macroeconomic risk

Improved policies have stabilised macroeconomic variables and reduced vulnerability to external shocks. Adherence to an inflation targeting regime has been instrumental in stabilising prices, but a weak response to a resurgence in inflation this year is eroding confidence. And the policy mix remains skewed with very high interest rates needed to offset fiscal expansion, triggering capital inflows and currency appreciation. Nonetheless, greater stability, favourable demographics and deepening credit markets lay the basis for a broadening of growth, although tightening will ease growth in 2011 to 4% after 2010’s rebound (7.5%). The current-account deficit will widen above 3% of GDP as imports rise, increasing vulnerability to sudden stops in capital flows, but a large reserves cushion would contain currency overshooting. Still-high lending interest rates will continue to constrain investment. Proceeds from huge oil finds pose challenges for budget and macroeconomic management, once they come on stream.

Foreign trade & payments risk

Brazil is still a relatively closed economy for an emerging market, but trade liberalisation and proactive policies during the past decade have stimulated strong growth of merchandise trade, and the World Bank has noted procedural improvements in the past year. There is a liberal attitude to foreign investment, but taxes have been introduced to stem a surge in capital inflows since late 2010. The transformation of Brazil’s external accounts has significantly reduced the economy’s vulnerability to external shocks, minimising the risk of an imposition of controls on capital outflows. Average import tariff levels have fallen (to an average of 12% in according to the Bank), but exceptions to free trade remain within the Mercosul sub-regional trade bloc. Trade diplomacy has adopted a more aggressive stance on the issue of market access, in particular developed country agricultural protectionism. Brazil recently won a case against the US at the World Trade Organisation (WTO) over cotton subsidies.

Financial risk

The availability of investment finance has long been restricted by tight monetary policy and high lending rates. After the global crunch, credit in Brazil eased. Capital market innovation has suffered from weak transparency. Domestic capital markets are gradually deepening and competition between lenders is increasing. Even so, most local-currency loans are expensive and short term–other than the subsidised credit supplied by the state development bank. Subsidiaries of foreign firms often rely on loans from headquarters or their foreign-based agents to support their local operations at lower costs. There are few restrictions on foreign firms gaining access to the Brazilian markets. The large private banks are well managed, capitalised and profitable, but hold a fair amount of government paper. Taxes on capital inflows have raised the cost of other capital for businesses. The equity and corporate bond markets have strengthened and in the long term will offer alternative financing opportunities.

Tax policy risk

Brazil’s tax burden (of around 35% of GDP) is very high by developing country standards, especially given the poor quality of public services and of the physical infrastructure. The effective tax on corporate income, at 37%, is not excessive by international standards. However, taken together with indirect taxes and generous social security contributions, the tax take rises well above 40% of income. Moreover, the tax system is complex and unwieldy and the multiplicity of indirect taxes imposes heavy compliance costs. Given fiscal pressures, reduction in the tax burden on business is unlikely, although concessions are part of industrial policy and were used as part of counter-cyclical measures rolled out by the government in 2009. A tax reform bill tabled in 2008, aiming to simplify the burdensome tax regime and unify state-levied sales taxes, that was shelved with the global crisis and 2010 elections, is expected to be submitted to congress by mid-year by the Dilma Rousseff government with some changes.

Labour market risk

Progress towards making the labour market more flexible and curbing restrictive practices were unlikely under Luiz Inacio Lula da Silva, given his background as a union leader and his party’s links with the union movement. The Economist Intelligence Unit does not envisage much progress under the incoming government either. The labour market has tightened and employers face a rise in pay demands, sometimes backed by industrial action. Any signs of weakness regarding these claims could damage business confidence. Legislation passed in 1998 has made hiring easier, but high severance pay entitlements make redundancies expensive and complicated. Skilled managers are available and there is a pool of specialised technicians, but low, albeit increasing, enrolment rates in secondary and tertiary education have led to skills shortages. Language skills among the workforce are limited. Labour costs are inflated by a wide range of compulsory benefits, which often add 50-80% to base wages of full-time, permanent employees.

Infrastructure risk

The government’s Programa de Aceleracao do Crescimento investment programme will bear some fruit in the medium term. The staging of the 2014 World Cup and 2016 Olympics will spur upgrades. Transport infrastructure suffers from underinvestment, but some improvement has occurred in ports and railways following privatisation in the 1990s. Several long-term concessions were awarded to private investors in the road network, but most roads are in poor condition. The implementation of new public-private partnerships is proving to be slow. Roads between major urban centres are good, although many small roads are unpaved. Air transport underwent a serious crisis in 2006-07, which exposed severe underinvestment in the air traffic control network. Telecommunications provision has improved since privatisation in the late 1990s. Although Brazil’s energy supply is more robust than in the past, delays in the timeline for projects (including hydroelectric plants) to boost capacity would cause shortages in the medium term.

SOURCE: Risk Briefing

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