Brazil’s Potential China Crisis

When the People’s Bank of China raised interest rates in July — the third such hike of the year as the central bank struggles to slow that country’s speeding inflation — Brazil’s benchmark Bolsa de Valores, Mercadorias & Futuros de São Paulo, or BM&F Bovespa, index tumbled as investors took profits, fearful that a slowdown in China would lead to an economic reversal in Brazil. “The key concerns related to China are the fear of a hard landing worsening the global growth outlook and causing a dip in commodities prices, and higher domestic inflation and the associated risks of further policy tightening,” explains Pedro Martins Jr., São Paulo–based head of Brazil research for BofA Merrill Lynch Global Research. Commodities-related shares account for nearly half of the MSCI Brazil index, he notes, and a downturn in those prices could expose the country to a significant stock market downturn. The two nations have forged close economic ties in recent years, with China eclipsing the U.S. as Brazil’s largest trading partner since 2009. Last year trade between Brazil and China topped $56 billion — roughly $10 billion more than Brazil’s trade with the U.S., according to Brazil’s Ministry for Development, Industry and Foreign Trade. China is also the largest foreign direct investor in Brazil, with FDI of about $17 billion in 2010, or more than one third of the $48.5 billion that flowed into the country last year — a huge jump from the $300 million that China invested in 2009 — according to Sobeet, an association that examines Brazil’s economic ties to other countries. The growing interdependence between these two economies is yet another factor weighing heavily on the minds of investors already worried about sovereign-debt defaults and double-dip recessions, but they may be overstating the risk. “Brazil’s gross domestic product growth — which is a function of volume not income — is largely driven by domestic demand not commodities exports,” explains Carlos Constantini, head of research at Itaú BBA in São Paulo. “Consumer spending represents a robust 62 percent of GDP, while total exports represent less than 13 percent — of which commodities-related exports represent about two thirds, or less than 9 percent. In other words consumer spending is over six times larger than commodity exports.” More important are the dynamics of income and labor, which directly drive consumer spending — and those dynamics remain solid, with record low unemployment and positive real labor income growth, Constantini adds. Anxious investors can also look to the recent past for reassurance. “The Chinese tightening cycle in 2006–2008 did not prevent Brazilian equities from rallying, as the former took place due to strong economic growth,” Martins says.

Moreover, “we see a very tight iron-ore market that should continue to support prices at a relatively high level for the next quarters,” says Rodrigo Góes, co-head of research at BTG Pactual in São Paulo. His advice to money managers who are still not convinced: “Be more exposed to stocks directly related to Brazil’s domestic economy.”