How to build Brazil

The Brazilian economy has seen better days.

As H1 2015 came to a close, federal bonds were teetering on the edge of junk status. The country’s runaway debt-to-GDP ratio was close to 60 percent and growing, spurred by the sky-high benchmark Selic interest rate.

The rate had been set to over 14 percent to rein in inflation of close to 9 percent on the real, which was hovering at around 3.4 to 1 against the US dollar. After showing solid growth from 2004 to 2010, Brazil’s GDP wasted no time heading steadily southwards for the next five years, and it is expected that its economy will again contract by nearly 2 percent in the coming year.

LAVA JATO

Partly to blame is a bribery scheme of Olympic proportions involving state-run oil and gas giant Petrobras and some of Brazil’s largest constructors. Exposed in March 2014 by federal investigators via operation Lava Jato, the scandal arose when a cartel of the country’s largest construction companies allegedly used bribes and kickbacks in exchange for control of the procurement process, an arrangement that led to massive project cost overruns.

In the months that followed, hundreds of Petrobras employees and government officials were investigated. Dozens of Workers Party representatives and construction company executives were arrested for alleged participation in the scheme, including Marcelo Odebrecht, familial head of Brazil’s largest construction contractor, who in early August remained in custody. Former president of Grupo OAS Jose Aldemario Pinheiro Filho and five others were convicted for their participation in the scheme in July.

Former Petrobras head and current President Dilma Rousseff, however, has not been implicated for any wrongdoing.

COUNTING THE COST

The Rio Times reported via consultancy firm GO Associates on August 11 that the economic impact of the graft could reach BRL$142.6 billion in 2015. Petrobras alone suffered a $17.1 billion value write-down following the appointment of a new board of directors earlier in the year and second-quarter profits were reported at $531 million as compared with $4.96 billion reported in the same period last year.

In order to stem the flow, many Petrobras projects are being delayed.

“Several notable projects that have been delayed due to the alleged inflation of their contracts include the Comperj Refinery (which ballooned from a $6.1 billion project in 2008 to a reported $21.6 billion in 2014) and the Abreu e Lima Refinery (having increased from an estimated $2.3 billion to $18.5 billion),” Jesse Wheeler, an analyst at research firm BMI, says. “Also, both the São Paulo Ring Road and Uruguay’s $1.2 billion GNL de Plata LNG import facility – which was originally sub-contracted to OAS – have experienced delays.”

As a result, construction companies, most of which are poorly equipped from an equity standpoint, are falling quickly.

“Companies such as Grupo OAS, Galvao Engenharia, and Alumni Engenharia have filed for bankruptcy. OAS was the largest to declare bankruptcy and is the third-largest construction company in Brazil. The filing will see the restructuring of $2.2 billion in debt,” says Wheeler. He notes the Banco Central do Brasil estimate in December that contractors implicated in the Petrobras scandal had a total of $40 billion in outstanding debt.

HARD PIL TO SWALLOW

In an attempt to spur recovery, Brazil’s finance ministry earlier this year launched a BRL$198.4 billion transportation infrastructure package dubbed the Logistics Investment Programme (PIL), but like other attempts to jump-start growth by the Brazilian government, the initiative is receiving lacklustre response from the private sector due to a complex – and therefore costly – regulatory environment that intentionally favours locals.

BMI’s view is that the programme will not be enough to reverse the current construction industry recession, and according to an August 2015 report published by Franklin Serrano and Ricardo Summa of the Center for Economic and Policy Research (CEPR): “The government’s efforts to encourage the private sector to lead economic growth, through contractionary economic policies, tax cuts, and public-private partnerships, had the opposite result.”

Complicating matters further, a recent survey conducted by the Institute for Applied Economics Research (IPEA Institute) shows that only 65 percent of projects with federal budget allocations between 2003 and 2014 were completed.

“What the figures show is that the low investment in infrastructure has not occurred for lack of money. What happened was an inefficiency in the management of public resources,” notes IPEA infrastructure specialist Carlos Campos Neto.

Out of a total BRL$206.7 billion budget for federally-supported infrastructure projects, only $135 billion in work was completed.

NEEDLEWORK

Even with its haystack of challenges, there are needles of opportunity to be found in Brazil, according to a few savvy investors we spoke with recently.

Brookfield Asset Management, for example, is an investment firm that has been active in Brazil since 1899 and currently maintains $18 billion in assets under management in South America with the majority of those assets located in Brazil. Seeing opportunity in the high-inflation environment, Brookfield is reportedly buying up distressed assets across the country with a mind to selling stakes once the real regains buying power.

According to an April 27 report by Bloomberg, the firm plans to dedicate $1.1 billion to the endeavour, though a representative would not comment as to the accuracy of that amount.

Energy development continues to progress across Brazil as well, with the federal government announcing a plan last month to contract two to three gigawatts of solar projects through auctions between 2015 and 2018.

The state of Bahia, for one, recently announced hopes to attract private partners to aid in the development of wind energy assets to support irrigated agriculture and rural schools. The state has solar energy ambitions as well.

A matchmaker of funds and assets with clients active in the market indicated that those in his fold are maintaining a patient eye on Brazil from a distance for the moment. Still, the agricultural infrastructure sector, which includes components such as port terminal silos and other agricultural transportation and storage assets, appears to offer opportunity.

State- and local-level public-private partnerships (PPPs; P3s) are also worth consideration, according to Moody’s latest market analysis. While federal-level P3s can be prohibitively complex and costly for internationals, Moody’s notes that state and local level P3s still hold some promise.

PEDALING ONWARD

As of publication time, Rousseff’s administration is under investigation for possible “backpedaling”, or delaying loan payment disbursal in order to give the appearance of successful budget slimming, a technique Brazilian politicians commonly use that is nonetheless illegal and an impeachable offense.

Impeachment may yet be avoidable, however, as a government official close to the situation reported that Senator Renan Calheiros and Brazilian Finance Minister Joaquim Levy were involved in talks to hash out market-friendly proposals and politically feasible austerity measures.

This lines up with BMI’s view that an opening of the market could stem from Brazil’s scandal woes.

“We believe the scandal will likely open up Brazil’s construction industry to greater participation from foreign firms over the long term.” But the problem, Wheeler notes, is that the local construction companies are strapped for cash, and international construction firms don’t see the benefits in bidding.

“At this time, we believe international construction firms will be wary of entering the Brazilian market in light of the uncertainty caused by ongoing investigations related to Petrobras,” he concludes.