Brazil through the keyhole

Read our article in the Cayman Financial Review Magazine, eversion 

There is now a general appreciation that Brazil is a global economic powerhouse, variously measured today as the fifth or sixth largest economy in the world, known to be rich in natural resources, having a population of some 190 million people, and benefitting from a range of positive stereotypes in relation to its natural beauty, sporting prowess and musical heritage. 

What are the implications of Brazil’s emergence for the Cayman Islands? This article summarises some of the future challenges and opportunities facing Brazil and the role that a well regulated, professionally serviced, tax neutral jurisdiction such as the Cayman Islands can play in facilitating the exploitation of those opportunities.

Oil

Brazil currently ranks 9th globally amongst oil producing countries and with recent discoveries of enormous offshore “pre-salt” (the term given for certain geological formations deep beneath water, rock and salt) reserves is aiming to ramp up production so as to be the world’s fifth largest producer of oil by 2020.

In the context of political instability and dwindling reserves in the Middle East (a September 2012 report by Citibank forecasts that Saudi Arabia will by 2030 only produce enough oil for domestic consumption) the focus on Brazil as an energy producer can only grow. Brazil is only beginning to expand oil production: pre-salt oil fields currently account for only 2 per cent of the country’s yields, while it is projected that they will account for 40 per cent by the end of the decade. Extracting oil from pre-salt fields presents enormous technical challenges.

However, it also provides the opportunity for Brazil to continue to develop its expertise in deep water extraction, as well as for international suppliers and investors to share in the growth of the Brazilian energy industry. As well as the massive capital investment necessary to enable extraction, Brazil will need to develop a first class oil service industry to support the expansion.

Aside from the technical challenges there are other conundrums to work through. The Brazilian government is imposing increasingly strict local-content requirements on pre-salt production. While it may be entirely right that Brazil should focus on maximising domestic benefit from its growing expertise in ultra-deep drilling, manufacturing capability constraints and relatively uncompetitive support industries, together with a skilled labour shortage, may hamper growth.

Another recognised deficiency is inadequate infrastructure, which is an area the Brazilian government is aiming to tackle.

Infrastructure

Notwithstanding the longer term infrastructure improvements required to support Brazil’s growth, Brazil’s need to improve its infrastructure is put in stark perspective by the approaching 2014 World Cup and 2016 Rio de Janeiro Olympic Games.

Both short and long term infrastructure development will require the participation of the private sector, which will need to be satisfied that the returns on long-term high cost projects are sufficient, particularly given that the political and regulatory position in Brazil for such projects is relatively unstable.

President Dilma Rousseff has recently announced her government’s determination to lower production costs in Brazil, including examining ways to lower power costs and increase the competitiveness of Brazilian manufacturing.

In mid-August the Brazilian government announced that it would award road and railway concessions to private businesses, in a stimulus package expected to amount to 133 billion Reais (R$) (some US$65 billion). R$42 billion is to be directed at improving and expanding nine important routes, and R$91 billion to financing 12 railway projects. The privatisations relate to some 7,500 kilometres of road, compared to the 5,200 kilometres currently the responsibility of private businesses.

Further private sector stimulus packages in respect of sea and airports are expected to be announced in September, after the time of writing.

The awarding of concessions to private enterprise is significant in itself: both President Rousseff and her predecessor belong to the left-leaning workers’ party and have resisted pressure, including widespread public sector strikes, to ramp up state spending and public sector salaries.

Domestic consumer spending

It would be remiss to ignore the fact that there are high levels of inequality in Brazil, and social problems arising therefrom. Nevertheless the middle class in Brazil has variously been described as being between 50 million and 85 million. Whatever “middle class” means in practice, such numbers equate to the entire populations of any of the largest western European economies.

Increasing domestic consumption by a relatively young and increasingly affluent population will be an important driver of the economy. Aside from the willingness for overseas producers to break into or increase Brazilian market share, local enterprises will require financing and expertise to increase their production.

Slow down…

Brazil has not managed to escape the effects of the global economic slowdown: after GDP growth of 7.5 per cent in 2010 and 2.7 per cent in 2011, the growth figure for this year is expected to dip under 2 per cent, largely due to decreased exports.

The response of the Brazilian central bank has included steadily decreasing the benchmark Selic rate. By end-August this was set at 7.5 per cent, still high by current standards internationally, but both the lowest rate since the Real was introduced in 1994, and very low by Brazilian standards, given that hyper inflation in the country is not a long distant memory. Apart from reducing interest rates for stimulus purposes, the Brazilian government is keen to ensure that the Real does not overvalue. Time will tell if the current Selic rate is the low water mark: the monetary policy committee has indicated that it will be resistant to further cuts, as it expects growth to return.

Nevertheless many commentators expect rates to remain relatively low for the medium term at least.

Investment funds

Conversely this slowdown may increase Brazilian domestic appetite for offshore investments. In recent times domestic fixed income accounts have provided Brazilians with relatively secure and high earning savings vehicles, in the additional context of a historical lack of appetite for exposure to alternative investments, and restrictions on overseas placements by Brazilian regulated funds. Although Brazil has a highly regulated and sophisticated domestic funds industry, the range of potential domestic investments is relatively narrow.

However, from 2007 the Brazilian regulator began relaxing restrictions on overseas investments by regulated funds, albeit within defined parameters, which has led to an increase in Cayman subsidiaries of Brazilian funds established for portfolio diversification purposes.

Of course investment funds are established to facilitate inward investment as well: investors worldwide have an appetite for exposure to the growing Brazilian economy generally. Investment vehicles continue to be established for specific sectors including real estate, agri-business and aquaculture amongst others, in addition to the industries discussed above.

The Cayman connection

Although every transaction needs to be structured on its merits, the Cayman Islands has a number of advantages which make it the offshore jurisdiction of choice for capital raising and joint venture vehicles to support Brazil’s infrastructure requirements and service industries, as well as it being the pre-eminent jurisdiction for offshore investment funds globally.

Brazilian banks and financial management subsidiaries of Brazilian conglomerates have long utilised Cayman Islands vehicles and structures to access the international capital markets. Recent examples of the use of the Cayman Islands for debt capital markets transactions include a medium term note issue by the Cayman Islands branch of a Brazilian bank in the total principal amount of R$0.5 billion, and US$, euro and sterling note issues by the Cayman Islands finance subsidiary of a Brazilian energy company totalling some US$9 billion.

In the funds sphere, in addition to the formation of bespoke Brazilian investment fund subsidiaries described above, there is an increasing appetite in the private wealth sphere for use of Cayman Islands companies to serve as regulated or unregulated funds for family investments.

The segregated portfolio company structure is popular amongst Brazilian financial institutions and fund managers as it allows them to operate a single platform while segregating investments by client and/or investment parameters.

Brazil is a waking giant and will play an integral role in the world economy for future generations. The Cayman Islands can provide an important role in accelerating its emergence.
 

 

Brazil