An Economic Analysis of the Role of Foreign Investments in Brazil

Academic Report
This report was prepared by Gustavo de Lima Palhares, Research Associate at the Council on Hemispheric Affairs and Graduate Student at Fundao Getulio Vargas GV Law, along with Guest Contributor Higor Uzzun Sales, a Master in Business Administration by Harvard University.

4/17/2012
1

Index Introduction 1 Investments in Brazil by Non-residents 1.1 Types and Regulation 1.2 Direct Foreign Investments 1.3 Portfolio Investments 1.3.1 Private Equity as an Alternative Investment for Foreign Investors 1.4 Intercompany Loans 2 Recent Government Measures Regarding International Investments 2.1 Taxation and Stock Market Measures 2.2 Fiscal consolidation and growth Conclusion 3 5 5 6 9 12 14 16 16 18 21

Introduction

Since its discovery on the 22nd of April, 1500, Brazil has been a country of evolving, if elusive prosperity and natural wealth. However, only after the passage of many centuries did it take the shape of today: presenting the outlines of a prospective world power with a top-rated world economy.

With a broad spectrum of unique resources, large territory and a behemoth population, it became increasingly clear that after exhibiting a political stability and sound economic fundamentals, it is well within reason that Brazil becomes one of the most serviceable economies in the globe. This scenario started to be revealed as a likely reality after the rapid recovery showed by the country during the 2008 world crisis and the one that decisively fell on Europe in 2011.

The development plan that was being implemented throughout this period allowed the country to become a major destination for foreign investments; but along with its newfound prominence new challenges also have appeared. In other words, with the vast amount of international sourced capital entering the country, other related questions began to be raised: (i) are the existing regulations effective?; (ii) how essential is the current complex of foreign investment for Brazils economic health?; (iii) how dependent is the country on international investments?; (iii) is the present administration driving Brazil in the right direction, considering the aforementioned investments policy?; and (iv) considering the countrys existing modernization policy, will Brazil be able to live up to an array of successful forecasts coming from the most unlikely of corners.
3

Despite the optimism that has been a consistent part of the stories that have circulated in the media over the past seven years, concerning the ongoing investment strategy, only an economic and legal analysis of the countrys recent past and the present can accurately answer these enquiries.

Thus, this report is divided into three main parts. The first section has an informative tilt to it, and is focused on the regulatory and legal implications of the Brazilian legal system, exploring the matter of international investments as its introductory section. Also in this section the text provides a number of legal definitions, pertaining to different types of possible transactions, along with providing a guide to how the investments are actually made. Giving a broad view along with a game plan of the countrys pertinent regulations, this section makes it possible to assess the efficiency of the Brazilian rules regarding the international transactions now being undertaken.

In the second part of this report, an analysis of the measures taken by the government is will be attempted, seeking to verify how effective they are. Also, the importance of the full of spectrum of international investments on Brazils economic success is detailed, based on real-time statistics, making possible to raise issues related to the government policy and suggest different ways out.

The third and last section of this report gives a wide-based conclusion of all the analyses provided, relying on an extensive research project based on many public documents issued by major international institutions, as well as the most current information that has been released by the Brazilian government and the private sector.
4

It can be said in advance, that the government has done a fairly good job in taking the right measures at the right time, but a few concerns still remain. Nevertheless, with the same strategies and philosophy taken by the authorities during the recent world crises, the country can at least identify all the challenges seen ahead.

1. Investments in Brazil by Non-residents

1.1. Types and Regulation

The main ways to mobilize foreign investment in Brazil are through the so called: Foreign Direct Investments (FDI), Portfolio Investments (PI) as well as InterCompany Loans. These investments are aimed at various segments of the domestic market, but it is important to highlight that some sectors can only be financed and developed by national capital, according to the Brazilian Constitution. This includes the: (i) development of activities regarding nuclear energy; (ii) health services; (iii) mailing services; and (iv) aerospace industry. Also, there are a few restrictions regarding the acquisition of rural and border-land financial institutions.

The general rules regarding the entry of foreign capital are regulated by Law # 4.131 dated as of September 3rd,1962 (Law 4.131), but its registration rules are guided by specific rulings issued by the organ in charge of supervising these operations. Authorization by the Brazilian Central Bank (BCB) or by the Brazilian government is not required, according to the article 3rd of the Law 4.131, however, any such foreign capital must be registered (declared). Also, article 5th of the Law 4.313 requires that the
5

aforementioned registration be complete within 30 days from the time that the funds entered the country. This rule is applicable to any foreign capital entering the Brazilian market, and a R$ 100.000,00 fine can be enforced by the BCB in case where the registry process does not respect the deadline, according to article 58 of Law 4.131. Although, the enforcement of this fine is rare, the procedure is essential for the transfer of profits abroad (as a result of oversees profits secured in FDI) and for re-nationalization of capital.

All of the incoming foreign capital must be registered through the BCBs system called Sisbacen utilizing its IED mode for FDI, PORTIFOLIO mode for Portfolio Investments and ROF mode for Intercompany Loans. After the registration takes place a number connecting the investor and the receptor is issued (RDE IED/PORTFLIO/ROF), which will then remake future registrations, changes and other transactions.

In 2010 the total amount of foreign capital that had been accumulated has come to represent 30,8% of Brazils GDP, a total sum of USD660,5 (BCB 2011 Census), showing the significance of the international investors and the importance of a efficiently regulated market to the countrys economic success. [1]

1.2. Direct Foreign Investments

For procedural regulation purposes, the BCB considers FDI as all corporate capital participation acquired or paid-up by corporate shareholders or individual residents

abroad, except shares acquired in the financial or stock market (vide article 2o of the Ruling # 2997, issued by the BCB).

As mentioned in the previous section, the Brazilian Law requires all foreign capital to be registered, including FDI. The person responsible for this registration is the receptor (company that will receive the investment) and the investor represented by its Brazilian representative1, according to the Ruling # 2997, article 3o, Paragraph 2o.

In order for the transaction to be executed, the international investors are also expected to have a Tax Payer Registry, called CPF (for individuals) and CNPJ (for corporations), as required by the Normative Rulings issued by the Federal Revenue Office # 461/2004 and 748/2007.

Although wider, the definition provided by the BCB differs from the one considered by major international institutions, like the Organization for Economic Co-operation and Development (OCDE) and the World Bank, which defines FDI as the net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. [2]

One of the reasons that can explain the difference of concepts and the creation of a wider definition of FDI is the need to include every international capital flow under the BCB regulation.

Normative Ruling DNRC # 76, issued in 28 th of December, 1998, requires all foreign shareholders to appoint a Brazilian representative to act on his behalf, with powers to resolve any issues and receive service of process in Brazil.

Therefore, despite the dissimilarity at stake, the BCBs definition of FDI must be taken into consideration when it comes to the domestic rules regarding the investment procedures were set up considering the BCB concept. On the other hand, in order to solidly illustrate the Brazilian economic scenario, the statistics presented in this study take the internationalized concept of FDI into account.

According to the World Bank, in 2007 Brazil received an amount of USD34.6 billion of FDI. This number increased approximately 16.7%, reaching USD48.5 in 2010 [3]. Also, recently the BCB stated that in 2011, from January to November, was registered a netinflow of USD60.1 billion of FDI entering the country, representing an increase of 81,6% compared to the same period in 2010 [4]. Authorities claim that a new record will be broken, when they close out the total amount for the entire year of 2011.

Regarding the destination of FDI flow, research shows that in the Brazilian case the amounts have been well distributed in its market (2010 data). The number one destination is the Telecom industry (11,4%), followed by Food Sector in second place (10.7%) and in third, two areas where classified, Other Industries and Metal Works (10.2%). Also, accounting for a prominent position are the Oil and Gas industries (8.8%) and Mining (4.6%).

These numbers have demonstrated a sharp rise in the amount of investments in Brazil, compared to other nations, due to its political stability and enviable economic position. In addition, unlike other Latin American countries that receive appreciable FDI to be invested in one specific commodity, the destination of FDI in Brazil is fairly uniformly
8

distributed. This indicates greater stability and entails a lower risk of suffering from any market meltdown.

If from one perspective the FDI is an important source of capital and economic development, it also indicates a large reliance on foreign capital and may cause concerns about the eventual impact on the countrys currency. Another concern is the term of the investments, which make a large difference for Brazils long term plan for development (the most valuable foreign direct investment is the long term one). These issues are shared by Brazilian authorities and justify some of the recent measures taken by them, as we shall see in Chapter 2.

Regarding the origin of the FDI, according to the International Monetary Fund (IMF), most of the inflows come from Europe. Therefore, even though FDI amount has a tendency to increase, an aggravation of the European crisis, which could result in a reduction of investments in Brazil.

1.3. Portfolio Investments

The BCB and the Brazilian Securities Commission (CVM) consider PI as all investment executed by non-residents on the Brazilian stock or financial market (i.e. stock exchange, future market, private equity funds etc2), which is regulated by the Resolutions # 2689 e 2687, issued by the National Monetary Council (Conselho Monetario Nacional) on January 26th, 2000.
2

The Brazilian Law assures that all foreign investors have access to the same products available to Residents.

The aforementioned regulation establishes that in order for the investments to be executed, three main pre-requisites must be made of: a) appoint a representative in Brazil, b) register the operation and the investor before the Brazilian Securities Commission, and c) register the operation before the Brazilian Central Bank, through the Sisbacen system, using the aforementioned RDE-PORTIFOLIO mode. Also, the investor must contract a receiver financial institution (i.e. bank), which is seeking to wire the capital. The currency will be closed in the moment of the transaction, when the financial institution and the stock exchange will be in contact in order to execute the transaction.

Regarding the representative mentioned under letter a) above, he or she is the investors contact for all Brazilian Central Bank and Brazilian Securities Commission issues related to the operations. Although not required, the representative is usually is the same person responsible for all tax matters.

According to the Normative Ruling # 419, issued by the Brazilian Securities Commission in 2005, the foreign investor can benefit from a simpler registry process, which consists on transferring the registration procedures to a Brazilian broker. However, a few pre-requisites must be met, such as: a) being engaged with a foreign intermediate institution, and being already registered under its home country laws and regulations, b) the intermediate institution must undertake the responsibility to present any information regarding the investor, whenever solicited by the Brazilian Securities Commission or any by any governmental agency, and c) an agreement must have been

10

signed between the Brazilian Government and the securities commission of the country where the investor resides.

Nevertheless, it is important to note that the intermediate institution chosen by the investor cannot be contracted if it is considered to be from a country which is rated as a high risk country in terms of money laundering and terrorism financing, and must not be cavalierly assessed as a non-cooperative country by some international organizations, as regards to such putative illegal acts.

The 2008 subprime crises, followed by the Lehman Brothers collapse, led every major stock exchange on a downhill course. Consequently the Brazilian Stock Market registered one of its worse indices. However, after a short period, Brazil surprisingly showed a never yet seen economic recovery and sturdy financial system, bringing back investors to its market, as demonstrated by the equity and debt securities table below.
Origin and Amount (millions of USD) of Portfolio Investments in Brazil (equity and debt securities) 2007 All Countries Korea Bermuda Austria Spain U.S.A. 18,366 4,026 3,177 2,819 2,158 2,024 100% 22% 17% 15% 12% 11% All Countries U.S.A. Austria Korea Spain Bahamas 2008 13,872 2,585 2,118 1,558 1,473 1,172 100% 19% 15% 11% 11% 8% All Countries U.S.A. Bermuda Cayman Denmark Spain 2009 17,395 4,218 2,813 1,810 1,759 1,205 100% 24% 16% 10% 10% 7% All Countries U.S.A. Spain Bermuda Denmark Cayman 2010 37,630 18,552 3,715 3,112 2,544 2,098 100% 49% 10% 8% 7% 6%

*Source: IMF

Even though the amount of Portfolio Investments has been increasing between 2008 and 2010, following the same tendency to be seen with the FDI, recent data indicates that PI flows have decreased approximately 12% in 2011.

11

Many reasons may account for this decrease, but the main reason was the expected low performance presented by the Brazilian stock market in 2011, due to Europes finance crisis, which also affected all major stock markets around the world. In addition, a few tax measures taken by the government in 2010, which will be detailed further on Chapter 2.1, which kept some portfolio investors away from the Brazilian market in 2011.

Nevertheless, after the European situation was stabilized and the Brazilian government removed the 2% Tax on Financial Transactions (IOF) on PI in December, 2011, PI in the first months of 2012 have shown a recovery and should keep increasing in 2012.

1.3.1. Private Equity as an Alternative Investment for Foreign Investors

One particular class of PI that has shown strong growth in the last years is the private equity industry. The private equity investments are long term investments, executed by funds, usually with five to ten years horizon, that for the most part focuses in acquiring participation in companies with growth potential or efficiency opportunities with the objective of exiting them once these objectives are achieved, with a return hopefully superior than the average.

The private equity industry is of extreme importance once it has a direct relation with the causes of increase, not only of PI, but also of the other main types described above: FDI and Intercompany Loan. This kind of investment generates market growth injecting

12

capital into projects and business, thus, creating new companies that will also attract foreign capital, through FDI or Inter Company Loans.

The attractiveness of Brazil to private equity investments results from the send fundamentals in the economy and long-term growth perspective that boosts the investments in FDI and, to a lesser extent the investments in Intercompany Loan. At the same time, most of the returns expected by private equity firms will result from a strong merger and acquisition (M&A) environment and solid financial and stock market, which are exactly the main factors that boosted PI in the country recently.

To put the various components into perspective the interest of foreign capital in this investment class, here we should note that the total of capital invested in private equity in Latin America during the year of 2011 was USD$10.3 billion, and Brazil represented USD$8.1 billion of this value, according to the Private Equity International magazine. [5]

It should be highlighted that the aforementioned statistics represent a significant amount compared with other countries in the region. However, it is still at significantly lower levels compared to China and India. Below are two charts with the evolution of committed capital in the private equity industry in Brazil, as well the penetration of this industry in Brazil compared to other countries.

13

*Souce: FGV Cepe

*Souce: Empea IMF

1.4. Intercompany Loans

The Intercompany Loan is a form of foreign investment that is executed by transferring money from a foreign company to its Brazilian subsidiary, by way of a loan. Much like

14

the FDI, the Intercompany Loans became a common transaction once it is more difficult for a foreign company to establish an outside branch in Brazil, due to the current legislation.

Once the transaction is made from a foreign company to a Brazilian subsidiary, the Intercompany Loans take place after a previous FDI has successfully been made. Thus, a representative will already be appointed when the loan happens and will also be the representative of this matter.

According to recent Inflation Report issued by the BCB, it was registered at an amount of some USD12 billion of Intercompany Loans in 2011, showing an increase of USD3.7 billion compared to the year 2010.

Despite the aforementioned increase, this scenario could change in 2012, once the amount of short-term Inter Company Loans is expected to decrease due to the 6% tax imposed by the government for loans shorter than 3 years.

Nevertheless, considering the power and value that the Real has accumulated in recent years, a decrease of short-term foreign capital in the country should benefit the economy, reducing the value of the countrys currency. Additionally, long-term investments would be attracted, generating more jobs and prosperity in the long run, and exporters would have the added advantage of having access to a low cost product when shipped abroad.

15

2. Recent Government Measures Regarding International Investments

As a country rich in natural resources, attractive demographics and a large and significantly growing consumer market, added to its solid strength when it comes to financial, monetary and fiscal tools, Brazils economic success shouldnt be a surprise. However, in order for progress to come faster and confirm the countrys status as a world power, a few measures should be taken, especially concerning its taxation.

Recently the government has taken actions seeking to strengthen its market on a medium to long-term plan, taking into account currency issues and the mentioned taxation problems.

2.1. Taxation and Stock Market Measures

One of the most relevant tools utilized by the government to efficiently interfere in the currency exchange rate and control the amount of foreign investments in the country is the aforementioned IOF, which applies to exchange and PI operations.

Throughout the past years the IOF percentage has faced many changes implemented regarding the countrys situation at the time, which reflected on the currency rate and amount of PI entering Brazil, as illustrated in the timeline bellow:

16

History of Capital Controls in Brazil Mar-08 IOF of 1.5% introduced on foreign portfolio. Oct-08 Following Lehmans bankruptcy and resulting BRL depreciation, the government suspended the 1.5% IOF tax on foreign fixed-income investments. Oct-09 As the BRL appreciated again, the government re-introduced the IOF on foreign portfolio investments, at a higher rate of 2%. Oct-10 The government raised the IOF on foreign fixed-income investments to 4% and then to 6% two weeks later (the tax on equity investments remained 2%). Jan-11 The BCB introduced a new reserve requirement of 60% of banks short USD position in the spot market above USD3bn (lowered to USD1bn as of July 2011. Mar-11 The government imposed a 6% IOF on external bonds and loans shorter than 360 days. Apr-11 The 6% IOF on external bonds and loans was extended to maturities shorter than 720 days. Dec-11 The government removed the 2% IOF on foreign portfolio investments in equities. Mar-12 The 6% IOF on external bonds and loans was extended to maturities shorter than 3 years.

It is important to highlight that the measures taken in March and April 2011 had a larger impact on the flows of Intercompany loans, pressuring the companies to execute longterm investments in the country. This strategy is a smart move, once it creates incentives for investors to actually contribute to a countrys economy and social condition, generating long lasting jobs and projects, since the investor will be charged a 6% IOF if the loan lasts less than the period stated. With that in mind, government extended the IOF to loans shorter than 3 years on March, 2012.

Regarding the removal of the 2% IOF on PI (equities), as already mentioned, should increase the PI inflows. Consequently, the companies with stocks and bonds negotiated will be benefited, once PI is an important source of capital to these companies. Another consequence is an indirect boost of the market sector that these businesses run. In addition to the changes at stake, monetary stabilization and the conversion of Brazilian real interest rates to international readings are a strong incentive to various regime stock markets. Investors tend to shift investments in Government Bonds (titles of debt) to long term investment in equity markets, for example.

17

The actions taken by the government lately are in general positive. However, the way the currency has been handled and the uncertainty of how much the authorities will keep devaluing, has to remain a concern. If a pattern is not established foreign investors may hesitate to invest.

2.2. Fiscal consolidation and growth

Despite the two recent world credit crises, one originated in the subprime mortgage industry in the U.S.A. and the other in the sovereign credit default risk pool in Europe, the government was able to achieve its primary surplus during the recent past years, at a time when the sharp manifestation of the financial crisis took place. Though the government was able to adopt several incentives, involving decreased industrial tax rates during the crisis, in order to restore growth, Brazil was able to perform better than other nations. Besides other facts stated above, the timely elimination of these tax incentives (implemented at the time of the crises) can also be explain by the rapid restoration of the country growth, since it helped to maintain the fiscal balance creating a healthy tax position. Below is a chart with the evolution of the primary surplus in the last years:

18

*Source BCB This fiscal consolidation was also perceived by the international market. The market perception of the fiscal position in the country is reflected by its sovereign risk, measured by the cost of Credit Default Swaps (CDS). These instruments are contracts that insure against the default of sovereign debt. Therefore, when the CDS cost is low, it indicates that the country risk is also low. Below is a graphic comparing Brazilian CDS pricing with other countries. Note that it had a positive evolution from 2008, before the crisis, to 2011, thus decreasing its activity approximately by half.

19

*Source Bloomberg

Regarding foreign investments, the maintenance of healthy fiscal accounts generates two main streams of impacts. The first one, which is more direct and easier to measure, is the lowering of capital costs in the country. The second impact results in the improvement of the expectations and confidence of the market when it comes to the Brazilian economy. For a long time the Brazilian economy has struggled, having short cycles of euphoria and crisis, which inhibited long term investment planning. These events generated an environment of prudence and caution as shown by the international market, decreasing the investors expectations and confidence, which was not necessarily beneficial for solid economic development. No one can deny that there were many reasons for that to happen if the countrys recent past is brought up. Brazil experimented with five different currencies in a period of eight years, from 1986 to 1994, declared a moratorium on USD$67 billion of debt in 1987, as well as did its largest neighbors -

20

Mexico in 1982 and Argentina in 2001 - and also faced crises such as the 1997 Asian financial crisis and 1998 Russia devaluation and defaulting on its debt. More recently, the efforts taken by the government seeking economic stability have positively instigated the human emotion that has driven the investors and consequently, the market, making them more confident for investors. This sentiment has been labeled by John Maynard Keynes as the "animal spirits", in his classic The General Theory of Employment, Interest, and Money. . Conclusion

Regarding the current regulation for international investments, Brazil has met the requirement of international parameters encompassing every form of investment requiring registration for all aspects of the economy. Nevertheless, the weak enforcement of a significant fine in case of violation of the demanded registration must be remedied. The registration provides government control and also benefits the revenue in taxes. Furthermore, we suggest a consolidation of all regulation issued by the BCB, CMN and CVM is suggest. This would provide investors with easier access to the rules regarding their investments, thus, showing more transparency and speeding up the procedures.

Recently, all the economic and fiscal measures taken by the government have been fairly effective. Besides a possible dependence on foreign investors, especially the ones originating in Europe, authorities have established mechanisms seeking to increase
21

long-term capital, once these type of investments contribute to the governments plan of growth and stability, while generating new long-lasting enterprises and jobs.

Nevertheless, despite the positive perspective, there are three main concerns that should be taken into consideration by the authorities, since they have the capacity to affect the local economy growth, and the foreign investments associated with them: (i) the uncertainty regarding government measures, considering the countrys volatile currency rate; (ii) the increasing dependence of the economy on China and the relevant imports of raw material; (iii) the growing gap in the balance of payments of the country due to low savings rates (a credit crunch with a large gap, could generate a domino effect on the existing flows of capital).

It is clear that Brazil has yet to face many different challenges. With its historical flexibility and various economic tools in hand, all of the aforementioned adversities are expected to be overcome. If the will and mentality that has been used for the past years is preserved, maintaining rates and fiscal measures, it is most likely that the countrys development will exceed expectations in the years to come.

22