Can Brazil's Capital Markets Deepen? / by Mark Langevin

610px-Brasil_coin_1_real(1).jpg Joonkyu Park’s recently distributed IMF Working Paper (September 2012) provides an excellent overview and description of Brazil’s capital market evolution in recent years. In particular, it suggests that future policy efforts should point toward further diversification of market structure to limit the dependence on short term and indexed investment tools and promote longer-term private sector financial instruments.  According to Park,

“Capital market development in Brazil is a key policy issue going forward to foster savings, investment and absorptive capacity in a context of prospects for sizable capital flows in the medium term…  Brazil’s capital market remains focused on short-term instruments. Most financial contracts among residents are indexed to the overnight interest rate, although there has been a gradual trend towards increasing duration in the recent years. This largely short-term structure reflects long-standing fundamental factors, including a legacy of past high inflation that typically is associated with a more short–term focus for investing. Moreover, the flatness of the yield-curve––a reflection of the high level of short-term interest rates and degree of indexation of debt holders––contribute to a low secondary market turnover ratio, constraining overall market development (see Figure 1).”

Park points to three principle challenges for moving capital markets deeper. First, he points to the comparatively small number of offerings in the private equity market as an obstacle to deepening capital markets, especially given domestic investors’ propensity to buy up short term, indexed instruments.  Park makes his case by detailing the disproportionate role that private foreign investors play in Brazil’s stock market, BOVESPA.  Second, while the public sector has made measurable strides in reducing the relative burden of short-term debt exposure in recent years, government and private bond markets continue to face distinct challenges.  Government fixed rate bonds continue to mature at two years or less and the private bond market, and according to Park,

“The private bond market remains much smaller than that for the government. The outstanding issuance of corporate bonds has risen to almost 10 percent of GDP in 2011, but the market is still very concentrated in short duration rates, with a limited investor base and less diversified issuers. This suggests that the private fixed income market is not a significant long-term financing source for non-financial corporations.”

Lastly, Brazil’s capital market development continues to rely on relatively short term investment tools, with low levels of private sector investment in industry and technology.  In parallel, the Federal Government’s development bank, BNDES, has grown into a gigantic capital market agent.  In the face of underdeveloped and short term capital markets coupled with the worldwide financial crisis, Park points to the “doubling of the size of BNDES’ balance sheet from 71⁄2 percent of GDP in 2007 to over 15 percent of GDP in 2011 (almost 10 percent financial system lending) (see Figure 15).” as both the result of the shallow capital markets in Brazil and possibly an impediment to deepening them in the future.

Park sums up the situation,

“further progress will require continued policy effort to assure macro stability and financial sector reforms to promote the development of longer-term private finance.”

Clearly Brazil has made great progress in creating a stable capital marketplace, and if Brazilians by and large increase their savings and diversify their mutual fund investments toward longer term investment tools that finance industrial and technological activities, then future development and deepening of capital markets are likely to be forthcoming. Yet, this is easier said than done, Brazil must continue to manage fiscal and monetary stability, increase productivity, and save earnings rather than spend it on the consumer economy.  Certainly Brazilian policymakers have demonstrated a keen ability to balance the need to invest with consumer demand in recent years, but the global downturn could further challenge the juggling act for years to come.  In the meantime, Brazilian development will continue to depend on public finance and foreign investors.