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 a graduate student at Fundao Getulio Vargas GV Law, along with Guest Contributor Higor Uzzun Sales, a Master in Business Administration from Harvard University.

4/18/2012
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 passing of many centuries has it taken the shape of today: a prospective world power with a top-rated world economy.

With a broad spectrum of unique resources, vast amounts of territory, and a behemoth population, it is becoming increasingly clear that after becoming politically stable and establishing sound economic fundamentals, it is well within the realm of possibility that Brazil will become one of the most serviceable economies in the world. This scenario began to reveal itself as a likely reality after the rapid recovery showed by the country during the 2008 world crisis and the one that fell so decisively on Europe in 2011.

The development plan that was being implemented throughout this period allowed the country to become a major destination for foreign investment; but along with its newfound prominence, new challenges also have appeared. With all this new internationally sourced capital entering the country, certain questions arise: (i) are 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 investment policy?; and (iv) in light of 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.

Despite the optimism that has been a consistent part of the stories that have been circulating 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 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 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.

The second part of this report will attempt to analyze the measures taken by the government so as to determine how effective they actually are. Also, the importance of the full spectrum of international investments on Brazils economic success is detailed, based on real-time statistics, making it possible to raise issues related to government policy and suggest possible alternatives.

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.

It can be said in advance that the government has done a fairly good job in taking the right measures at the right time, though a few concerns do still remain. Nevertheless, with the same strategies and philosophy taken by the authorities during the recent world crises, Brazil 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 foreign direct investments (FDI), portfolio investments (PI), and inter-company loans. These investments are aimed at various segments of the domestic market, but it is important to note that according to the Brazilian Constitution, some sectors can only be financed and developed by national capital. This includes the: (i) development of nuclear energy activities; (ii) health services; (iii) mailing services; and (iv) the aerospace industry. There are also a few restrictions on the acquisition of rural and borderland 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 regulatory body in charge of supervising these operations. Authorization by the Brazilian Central Bank (BCB) or the Brazilian government is not required, according to the Article 3 of the law, however, any such foreign capital must be registered. Also, Article 5 of Law 4.313 requires that the aforementioned registration be complete within 30 days from the time the funds enter the country. This
5

rule is applicable to any foreign capital entering the Brazilian market, and Article 58 of the law stipulates a R$ 100,000 fine can be levied by the BCB in cases where the registry process does not respect the deadline. Enforcement of this fine is rare, but the procedure is essential for the transfer of profits abroad (as a result of overseas profits secured in FDI) and for re-nationalization of capital.

All 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 came to represent 30.8 percent of Brazils GDP, a total sum of $660.5USD (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, Brazilian law requires all foreign capital to be registered, including FDI. The person responsible for this registration is the receptor (the 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, 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 applied by major international institutions, like the Organization for Economic Co-operation and Development (OCDE) and the World Bank, which define 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 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 which were set up in consideration of the BCB concept. On the other hand, in order to adequately 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 US$ 34.6 billion of FDI. This number has increased approximately 16.7%, reaching US$ 48.5 in 2010 [3]. Also, recently the BCB stated that in 2011, from January to November, a net inflow of US$ 60.1 billion was registered 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 FDI has been well distributed in the Brazilian market (2010 data). The number one destination is the Telecom industry (11,4%), followed by the food sector in second place (10.7%) and in third, two areas, 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 investment in Brazil, compared to other nations, due to its political stability and enviable economic position. In addition, unlike other Latin American countries which receive appreciable FDI to be invested in one specific commodity, FDI in Brazil is fairly uniformly distributed. This indicates greater stability and entails a lower risk of suffering from any market meltdown.
8

If from one perspective 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 a 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 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 could result in a reduction of investments in Brazil.

1.3. Portfolio Investments

The BCB and the Brazilian Securities Commission (CVM) consider PI to be 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 and 2687, issued by the National Monetary Council (Conselho Monetario Nacional) on January 26th, 2000.

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

The aforementioned regulation dictates that in order for the investments to be executed, three main prerequisites must be made of: a) there must be a representative in Brazil, b) the operation and the investor must register with the Brazilian Securities Commission, and c) register the operation before the Brazilian Central Bank, through the Sisbacen system, using the RDE-PORTIFOLIO mode. The investor must also contract a receiver financial institution (i.e. bank) 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 the same person responsible for all tax matters.

According to Normative Ruling #419, issued by the Brazilian Securities Commission in 2005, the foreign investor can benefit from a simpler registry process, which consists of transferring the registration procedures to a Brazilian broker. However, a few prerequisites must be met: a) engagement 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 signed between the Brazilian Government and the securities commission of the country where the investor resides.

10

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 nation 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 crisis, followed by the Lehman Brothers collapse, set 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 increased between 2008 and 2010, following the same tendency seen with the FDI, recent data indicates that PI flows have decreased approximately 12 percent in 2011.

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 affected all major stock markets around the world. In addition, a few tax
11

measures taken by the government in 2010, which will be detailed further on Chapter 2.1, kept some portfolio investors away from the Brazilian market in 2011.

Still, after the European situation was stabilized and the Brazilian government removed the 2 percent Tax on Financial Transactions (IOF) on PI in December, 2011 PI in the first months of 2012 has 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. Private equity investments are long term investments, executed by funds, usually with five to ten years horizon, that for the most part focuses on 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 better than the average.

The private equity industry is of extreme importance as it has a direct relation with the causes of increase, of PI, FDI and intercompany loans. This kind of investment generates market growth, injecting capital into projects and business, thus, creating new companies that will also attract foreign capital, through FDI or intercompany loans.

The attractiveness of Brazil to private equity investments results from the strong fundamentals in the economy and long-term growth perspective that boosts the investments in FDI and, to a lesser extent the investments in intercompany loans. At the
12

same time, most of the returns expected by private equity firms will result from a strong merger and acquisition (M&A) environment and a 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 US$10.3 billion, and Brazil represented US$8.1 billion of this value, according to Private Equity International magazine. [5]

It should be highlighted that these statistics represent a significant amount compared with other countries in the region. However, Brazil is still at significantly lower levels when 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 as 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 FDI, intercompany loans became a common transaction as due to current legislation it is more difficult for a foreign company to establish an outside branch in Brazil.

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

14

According to a recent Inflation Report issued by the BCB, US$ 12 billion in intercompany loans were registered in 2011, showing an increase of US$3.7 billion compared to the year 2010.

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

Nevertheless, considering the power and value 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 gaining access to a low cost product when shipped abroad.

2. Recent Government Measures Regarding International Investments

As a country rich in natural resources, attractive demographics and a large and growing consumer market, added to its solid strength when it comes to financial, monetary and fiscal tools, Brazils economic success should not come as 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 regarding its taxation.

15

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

2.1. Taxation and Stock Market Measures

One of the most useful tools of government interference 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.

Over 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 below:

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 flow of intercompany loans, pressuring the companies to execute longterm investments in the country. This strategy is a smart move, as it creates incentives

16

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, the government extended the IOF to loans shorter than 3 years in March, 2012.

The removal of the 2% IOF on PI (equities), should increase the PI inflows. Consequently, the companies negotiated with stocks and bonds will benefit as 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. 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

17

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:

*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

18

pricing with other countries. Note that it had a positive evolution from 2008, before the crisis, to 2011, thus decreasing its activity by approximately half.

*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

19

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 US$67 billion of debt in 1987, as well as did its largest neighbors Mexico in 1982 and Argentina in 2001 - and 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 impacted the human emotion that drives investors, and consequently, the market, increasing investor confidence. 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. Registration provides government control and also increases tax revenue. Furthermore, we suggest a consolidation of all regulation issued by the BCB, CMN and CVM. This would provide investors with easier access to the rules regarding their investments, thus showing more transparency and speeding up the procedures.

20

Overall, the recent, all the economic and fiscal measures taken by the government have been fairly effective. Besides a possible dependence on foreign investors, particularly those originating in Europe, authorities have established mechanisms seeking to increase long-term capital, as these types of investments contribute to the governments plan of growth and stability, while generating new long-lasting enterprises and jobs.

Still, despite this positive outlook, there are three main concerns that should be taken into consideration by the authorities, as 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 countrys balance of payments 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. Yet, with its historical flexibility and various economic tools in hand, all of the aforementioned adversities can be overcome. If the will and mentality that has been used for the past years is preserved, maintaining rates and fiscal measures, it is likely that the countrys development will exceed expectations in the years to come.

21

Works Cited: [1] http://www.bcb.gov.br/Rex/Censo2010/port/Resultados_preliminares_Censo_2011.pdf [2] http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD [3] http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD [4] http://www.bcb.gov.br/htms/relinf/port/2011/12/ri201112c5p.pdf [5] Private Equity International Magazine, March 2012

22