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Bankruptcy Looms For This BRIC Nation -- Here's What To Avoid

Wednesday, November 20, 2013 - 8:30am

In early 1997, the world was in awe of the record growth of Southeast Asia's "tiger economies" as markets opened and foreign investors rushed to fund new ventures.

However, by January 1998, stock markets across the region had lost as much as 70% of their value, and the crisis had spread to the rest of the emerging world. Even behemoth Russia wasn't immune, defaulting on its debt that same year.

Such massive and rapid growth relied on a constant influx of dollars to fund deficits and pay higher amounts of foreign debt. At the first sign of economic cracks, foreign investors withdrew their accounts, leading to a plunge in currencies and leaving the region's governments unable to pay debt denominated in now more expensive dollars.

Now it seems another emerging market has not learned much from that episode -- and may be doomed to repeat it soon.

A Financial Crisis With A Latin Flair
Latin America escaped the most recent crisis in 2008, with the region managing 4.5% growth in 2010. The iShares Latin America 40 (NYSE: ILF) jumped 120% in the two years after the March 2009 lows, outperforming the S&P 500 Index by 40%. Housing prices have increased dramatically for more than a decade, and credit for homeownership flows like water.

From my vantage point in Colombia, I talk to investors regularly -- and few want to acknowledge that trouble could be on the horizon. The Colombian national soccer team made the World Cup selection for the first time in six years, regional economies are strong, and Brazil is hosting two major events in the next three years.

And that brings us to the tipping point.

Athens Calling
In 2004, the world marveled as the Olympics returned to its Greek homeland in Athens. Greece spent $16 billion on those Summer Games, 10 times the original budget, in hopes that tourist dollars would pay the bills when they came due. Four years later, Greece was bankrupt; nearly a decade later, the country has just entered its sixth straight year of recession with a 28% unemployment rate.

Now Brazil has won the right to host the 2014 World Cup and the 2016 Summer Olympics. The country is spending more than $14 billion on World Cup projects, $3.3 billion of which will be spent on stadiums that are unlikely to have much real economic use after the games. The largest stadium being built, the Estadio Nacional, will hold 70,000 spectators. In comparison, the entire 57 games of the recent regional championship brought in only 50,000 people.

Brazil bid a $14.4 billion budget for the 2016 Olympics, equal to about 4% of the country's total tax revenue of $338 billion. If the 2007 Pan American Games, held in Rio de Janeiro, are any indication, the budget for the World Cup and the Olympics could be dwarfed by cost overruns. The Pan Am games were originally budgeted to cost $177 million with final estimates topping $1 billion for the event, over budget by sixfold.

Even if the cost overrun for the 2016 Games is not as bad as the Pan Am games, it will almost definitely run over budget. Every Olympiad since 1960 has gone over budget, by an average of 179% in real terms. That overrun would put the Brazil Olympics at $25.8 billion. Add this to World Cup spending of at least $20 billion, and Brazil's fiscal position looks precarious at best over the next few years.

Brazil desperately needs infrastructure spending, and some of the event budgets will be put to good economic use. The problem is that the lasting benefit accounts for only a small portion of the total spending.

An Unsustainable Path
Inflation in Brazil has begun to take hold, with consumer prices jumping 5.8% last month from a year ago. This is well above the central bank's 4.5% target and likely means that the 9.5% benchmark interest rate will continue upward. With the surge in public spending on the Cup and the Games, inflation is unlikely to moderate, but higher rates could choke off other business spending. Lower economic growth will hit tax revenues and the public burden could become unsustainable.

Brazil 2014 Budget
Ministry of Planning and Budget

Brazil spends 43% of its annual budget on debt and interest payments. Take out upward of $45 billion (13% of the budget) for the World Cup and Summer Olympics -- and it's apparent huge cuts will need to be made.

The value of the local currency, the real, has already fallen more than 12% this year, and higher inflation plus weak economic growth could cause it to fall further. This could lead to problems paying the country's dollar-denominated debt -- much like what happened during the Asian crisis of 1997. The country has been able to raise funds fairly easily, with a recent $7 billion 2025 offering -- but will it be able to pay the money back?

In recent research by Wells Fargo Securities, Brazil ranked fifth of 28 countries deemed most vulnerable to a crisis. The research focused on credit growth, ability to meet dollar demands on foreign debt and the exchange rate. Brazil ranked second on the list for highest increase in private sector debt to GDP since 2009, signaling that recent growth in loans may be too rapid.

More ominously, protests against corruption and the high price of the World Cup erupted in Brazil this year. Ultimately, I think the burden from the games will result in a change in the government and a default on debt. State-controlled Petrobras (NYSE: PBR) could be hardest hit as the government wipes out shareholders to prop up the debt situation. Shares are already down 70% from the 2009 high but could fall much further.

With presidential elections looming next year, Brazilian politicians will probably follow the typical playbook of boosting social spending to win re-election and worrying about the bills later. This may temporarily stave off a collapse, but the situation becomes more dire and inescapable as we look to 2015 and beyond.

Metals miner Vale (NYSE: VALE) has rebounded from its low this year but could also fall victim to the government's need for funds. The shares may be supported over the next year on infrastructure spending, but the long-term outlook is negative.

Beyond individual Brazilian companies, a bankrupt Brazil would almost certainly throw the rest of Latin America into a regional recession. The country accounts for more than 40% of the regional economy and imports more than $26 billion in goods and services from Latin American countries. In the same Wells Fargo study, six of the top 10 countries most vulnerable to crisis are in Latin America, with Colombia, Argentina, Peru, Chile and Mexico also seen as at risk.

Risks to Consider: Shares of the largest Brazilian companies are not expensive at 14 times trailing earnings and could get a boost from infrastructure spending in the short term. Investors may miss out on some rebound pricing but would do well to avoid a possible major crash in the long term.

Action to Take --> Spending ahead of the presidential election in 2014 may drive the economy for another year, but I would avoid Brazilian companies as long-term investments. Keep an eye on spending for the Cup and the Games to signal when you may want to take profits on other stocks from the region. A collapse of the government might not cause world markets to buckle, but it would definitely affect regional names and probably emerging markets across the globe.

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Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.